The concept of inflation is not new. However, most people are either fully ignorant or confused to a significant extent about it. However, each individual must study the concept and understand its impact on one’s personal life and the country’s economy. A basic understanding of what inflation is, how it is caused, and how it can be managed will help the individual protect their assets and be a worthwhile entity in the economic fabric of the country.
What is Inflation?
The term ‘Inflation’ refers to a general decline of the purchasing power of a given currency over a period. It is usually felt by the common people as a rise in the prices of commodities purchased or services availed. If a certain quantity of a specific item costs more this year when compared to the price of the same quantity of the item last year, it is probably due to inflation. It means you can only purchase less of anything with the price that bought more during the previous year. Since inflation reduces the value of money, those who hold more cash will be affected more, while those who have wealth in the form of other assets can benefit, because their prices go up and they can earn more if they sell them. Inflation is generally expressed as a percentage of increase in the prices from one year to the next.
Inflation is usually measured using several indices, the most common ones being the Consumer Price Index (CPI) and Wholesale Price Index (WPI).
- Consumer Price Index
The Consumer Price Index is the average value of the rise in the price of select consumer goods and services most commonly used, such as items related to food, medical care, and transport. A predetermined selection of goods and services at specific quantities is considered for the purpose. The price increase of each item is noted and then the values are averaged to get the CPI. It serves as an indication of the rise in the cost of living in a particular region or country.
- Wholesale Price Index (WPI)
The Wholesale Price Index is a value that helps measure the price increase of goods at the wholesale level. While CPI measures the increase in the price of goods purchased by consumers, WPI is generally calculated on items bought and sold between businesses. There is no consumer involved in these transactions. Instead, it is about the prices of items sold in bulk between traders, producers, and dealers and usually involves bulk sale.
How is Inflation Caused?
An increased amount of currency present in the market is usually considered the primary reason for inflation. That is, if there is more cash in circulation, prices increase. The increased amount of currency in the market could be due to several reasons, such as the government printing more currency and letting it into circulation, statutory devaluation of the currency, or loaning more money by the Central Bank to the financial institutions and banks.
There are various mechanisms through which this increased supply of currency in the market manifests as inflation. They are the Demand-pull Effect, Cost-push Effect, and Built-in Inflation.
- Demand-pull Inflation
More money and credit in circulation means more money than earlier with each individual. It will be translated as an increased purchasing tendency of people. It will create an increase in demand for goods and services that the production capacity of the economy may not be able to satisfy. It is a situation where buyers are more and there is not enough stock to satisfy all. It means the seller will try to transfer the goods to people who are ready to spend more money. This automatically increases the prices of goods. Demand-pull inflation may be caused by various macroeconomic reasons. One is a reduction in taxes by the government that leaves the consumer with more money to purchase goods. Another reason is the increased consumption of products overseas which reduces the availability of goods for domestic customers.
- Cost-push Inflation
Cost-push inflation results from an increased production cost. It can be due to various factors such as an increase in the price of capital or labour, or a scarcity of raw materials due to some natural or other reasons. An increase in the price of raw materials can also cause a similar situation. Also, sometimes, the production companies have to meet the demands of increased tax levels, which can also affect production funds. The result of all such factors is a decreased availability of goods and services, which naturally hikes the prices for the end-customer.
Inflation Rate in India and the USA (2009-2019)
The below statistics depict the inflation rate in India during the last 10 years. There are two sections in the figure. The upper line graph shows the actual inflation level and the lower bar graph shows whether it was a decrease or increase and by what per cent. The inflation rate for 2009 can be seen as around 11% while at the end of the graph, i.e., as of 2019, it is near to 8%. That is a reduction of around 3% during the decade. It is also well below the two peaks that occurred during the decade, namely during 2009-2010 and 2012-2013. A reduction in inflation rate is a good sign. However, there is something negative too if you look closely enough. i.e., currently, the graph is a rising one since 2017. During 2017-2018, there has been a 2.3% increase and again a 2.8% increase during the 2018-2019 period. If the trend continues, it will further increase in the future, which is not good for the economy.
The inflation rate of India (2009-2019)
Image source: Macrotrends.net
Let’s also see the inflation scenario of the USA during the past decade. The below graph shows the USA inflation trends during the 2009-2019 period.
The inflation rate of the USA (2009-2019)
Image source: Macrotrends.net
What started at a very low value, even a sub-zero level, around 2009 is seen at around 1.8% in 2019. In 2015, it had come close to zero again. And during 2018-2019, it is showing a declining trend. It can be seen that the highest fall during the decade has been in 2009, and the highest rise, in 2015. The highest peak of inflation occurred in 2011, which is approximately 3%. It can be seen that during the entire decade, the inflation value has mostly been between 1% and 3%. This is in stark contrast with the graph of India, where a value of less than 4% can be seen only once during the decade. That was in 2017, which is around 2.5%. During most years of the decade, the India graph is seen to fluctuate between 4% and 10%.
Why Inflation is High in India and Less in the USA
As is evident from the above statistics, the inflation scenario in India and that in the USA display contradictory trends. While India’s inflation rate is much higher compared to the preferred value, the value in the USA is far below the ideal. Let’s examine the reasons behind the rising inflation of India and the dipping one in the USA.
- The Indian Inflation Scenario
While India’s inflation rate in October 2020 was 7.61%, the highest since May 2014. The prices of almost all commodities such as fuel, housing, healthcare, and clothing have seen a rise in recent times. But the highest increase has been in the foodstuff area with vegetable, meat and fish prices rising in a manner not usually witnessed. The rise of the prices in foodstuff is the main contributor to the increased inflation rate of India. This kind of hike in price is strange as the demand for commodities has seen a decline with the Covid-19 pandemic.
The preferred inflation value as set by the government of India is 4% with a margin of 2% up or down. That is, the value should stay between 2% and 6% in any case. However, most of the times during the current year, it has been above 7%, which is an unhealthy situation. During the Covid-19 scenario, certain commodities such as gold and fuel have seen a hike in their prices. This has been so because of major supply restrictions and high tax rates. These reasons have affected almost every other commodity in the market. Such reasons have often been the culprits for India’s inflation rise from time to time.
- The US Inflation Scenario
Now, let’s look at the picture of inflation in the USA. Although the Federal Reserve’s ideal value for inflation is 2%, it has been mostly below that level on average. The average inflation rate of the USA over the past decade has been somewhere between 1% and 1.5%, which is lower than the ideal 2% rate. This is in a way the reverse situation when compared to India. While in India inflation rise is the problem, in the USA it has been going far below the preferred value and struggling to hold on to it.
Economists have been studying the US inflation scenario since log back and had found certain correlations between different economic factors. One such discovery has been the ‘Phillips Curve’ that shows the relationship between the unemployment level and inflation rate. According to the theory, it has been observed that the two parameters have an inverse relationship with each other. i.e., low unemployment will push inflation up and high unemployment will pull it down. Since its discovery in the 1950s, the theory had been helpful for experts to study the American economic posture for a long time. The theory is based on the fundamental supply-demand relationship. When the economic activity is healthy and production high, unemployment levels drop. However, due to the increased demand for resources, prices can go high.
However, since the Financial Crisis, such theories are bafflingly disturbed and have become fully unreliable. The unemployment rate in the USA has witnessed historic lows in recent times and still, the inflation rates are fighting to rise to the preferred 2% line. As per Phillip’s Curve, with such low rates of unemployment, the inflation could be expected to be extremely high. However, the opposite is what is being witnessed.
That said, it is not the first time it has happened so. Though Phillip’s Curve worked for the 1960s, it had failed briefly in the 1970s when the oil prices went up. It showed that unemployment alone could not be considered when studying inflation. Other factors, like the increase in energy prices, must be considered. However, the theory was not dumped altogether. To a significant extent, it had been in use for most cases. The latest studies by experts have suggested many reasons that could be affecting the inflation the way witnessed currently and depending less and less on factors like unemployment or energy prices alone. The following are the major assumptions:
- Anchored inflation expectations could be holding inflation tied to a certain level irrespective of fluctuations in factors like unemployment. Since the government openly declared the inflation target as 2%, people could be displaying a tendency to see it stable at that point and all activities could be driving it in the anticipated direction regardless of changes in other economic factors.
- Globalization is another factor that could be affecting inflation. Unlike earlier decades when the economy was mostly dependent on domestic affairs, today it is also dependent on what happens overseas.
- Technology is also a factor that resists price increase. It is because the spread of the Internet and e-commerce has made prices and transactions transparent.
- Labour market changes also affect inflation as global supply chains and various modern-day parameters have reduced the bargaining power of labour in many ways.
- Government Policies and Methods of measuring inflation could also be a reason for unexpected inflation trends.
All of the above factors need not be true. Or they could all have a mixed effect with their partial potentials. However, these are the factors as per experts that could be affecting inflation apart from traditional parameters like unemployment where the trend depended upon a direct relationship between resource utilization and inflation.
The above comparison of inflation fluctuations between India and the USA shows that such economic metrics can be different from country to country. In each country, there could be separate reasons that could explain the inflation behaviour. The same factor can have a different impact on the inflation rates in different countries.
What is Negative Inflation?
Negative Inflation, also called Deflation, is the decline in the prices of goods and service due to various reasons. A general decrease in the prices of many commodities is witnessed when there is deflation. It could be due to a reduced supply of money and credit in the country’s economy or factors such as increased productivity or technological developments.
It results in the rise of the purchasing power of money. Consumers benefit from deflation as they can purchase more goods at the price with which they could only get less quantity of goods pre-deflation. However, it can harm various sectors. Borrowers also could suffer as they will have to pay back money that has more value than that when they borrowed.
What is the Appropriate Rate of Inflation in India as Per RBI?
As mentioned earlier, the Reserve Bank of India has set the value of 4% as the target inflation rate for the country. However, over the past many years, it has not been able to achieve that level. Although there is a 2% up or down margin set, which means that the inflation rate is allowed to fluctuate between 2% and 6%, the actual value has been above 7% for a while. The Covid-19 Pandemic has also caused the value to steadily increase.
How Inflation is Adjusted by RBI
It is the Reserve Bank’s responsibility to ensure the country’s economic health. Thus, the RBI takes various measures to bring down the inflation to the prescribed mark when it wanders above the line. RBI takes various measures for price control of commodities such as regulating the supply of money and credit and increasing the bank rates, repo rates, and cash reserve ratio. Another step to controlling inflation is the buying of dollars. Reducing the money supply by RBI reduces the demand in turn, which brings down the prices. Though these steps concentrate on bringing the demand down, a better method is to improve the supply side, though it is not as easily accomplished.
How Inflation Affects our Investment/Savings
During inflation, the fundamental value of currency declines. It simply means that you will only be able to purchase less quantity of goods with your money while you could buy more of them with the same amount before inflation. Thus, wealth in the form of money will suffer, which means investments and savings will have a negative impact. At the same time, the value of your assets in the form of land, gold, or other goods that can be sold for money stays protected.
Suppose you have savings of Rs. 1000 which will fetch an interest of 5%. It means that after one year your savings will increase to Rs. 1050. At the same time, when you consider the effect of inflation, the value of Rs. 1000 will reduce after a year to a lower value, say Rs. 930. It means that the interest of Rs. 50 fetched by your investment will only have a value of Rs. 46.5. In other words, you have a total of Rs. 1050 at the end of the year but only with a value of Rs. 946.5.
How to Protect Your Investment/Savings from Inflation
Inflation is something that you cannot help. If you are in a vulnerable position, you will have to endure the negative effects of inflation. In other words, if your wealth is of the kind that can be negatively impacted by inflation, you will have to face the consequences. But there are ways in which you can beat inflation. The trick is to convert your assets into something unaffected by inflation. One method is to convert them into assets like real estate, gold and other material as inflation mostly affects assets in the form of money.
However, if you want to keep your wealth in the form of money and still beat inflation, you will have to choose investment methods that are unaffected by inflation. There are several investment solutions such as tax saving investment schemes, stock market, mutual funds, SIP (Systematic Investment Plan), life insurance, and bonds that provide a return much above the magnitude of inflation rates.
Is Inflation Good or Bad?
So far, the discussion has been about the negative impact of inflation. But is inflation all bad? Or is there any benefit from inflation? Yes, inflation is bad when it goes to a high level. But, there are several good points too with inflation that helps the economy and individuals.
Inflation is particularly good to a country when the economy functions below its capacity. It means that resources and labour are not used enough. In this condition, when there is slight inflation and prices start rising a bit, people tend to think that the prices would increase further. Hence, they spend more and buy more so that they don’t have to buy them later at a higher price. It helps in boosting production and put unused labour and resources to the right use. It thus helps the economy to be active and stay healthy.
Formula to Calculate Inflation
The inflation rate calculation is easy. For this, the CPI (Consumer Price Index) is used. When calculating the inflation over a year, the CPI of a commodity from the CPI basket is used. The difference between the CPI value at the beginning and end of the year is taken and divided by the beginning value. Then it is multiplied by 100 to get the percentage value. The inflation rate formula can be written as:
Inflation rate = [ (CPI2 – CPI1) / CPI1 ] x 100
where CPI1 and CPI2 are the CPI values at the beginning and end of the year.
For example, if CPI1 and CPI2 are Rs. 150 and Rs. 160 respectively, then
Inflation rate = [ (160 – 150) / 150 ] x 100 = 6.66%
From the discussion so far, you have understood that the value of money doesn’t remain the same. There is always the effect of inflation on the money you own. After every year, the value of the money decreases. If you have, say Rs. 1 crore today, you can purchase a luxury car worth Rs. 1 crore with it. In other words, the car costs Rs. 1 crore today. However, if you don’t buy the car this year and instead just keep the money with you, its value comes down after a year, and you won’t be able to buy the same car with that money, because it will be costing slightly more because of inflation. i.e., you will have to pay more than Rs. 1 crore if you buy it next year. It can be met if you invest the money for one year so that you accrue interest on it.
Suppose, you don’t purchase it the next year either. Then, the price of the car will go up further and you need still more money for it, which can again be met if it is still in the investment. Suppose you will buy a similar car after 30 years. The car’s price then will be far higher than today. It could only be met if your money is invested for 30 years because at that time Rs. 1 crore will be returned as a much higher amount by adding the interest accrued. The value of an amount at a future date is known as the ‘future value.’ Thus the value of Rs. 1 crore after 30 years will be its future value at that point, and Rs. 1 crore is its ‘present value.’
The future value can be calculated using the future value formula as follows:
Future value = Present value x (1 + Rate of return)^ Number of years
Suppose the rate of return is 7%. Then, using the formula, the value of Rs. 1 crore after 30 years when interest is added to it will be:
Future value = 10,000,000 x (1 + 7/100) ^ 30 = 81,164,974
It means you will need more than Rs. 8 crores to buy the same car after 30 years.
Why People are Ignorant about Inflation
The major reason why people don’t think of or consider inflation much in their day to day life is that they don’t understand the core concepts. A study in the UK showed that 62% of adults do not understand the concept of inflation. Even those who manage to collect information on its basic theoretical definition fails when it comes to understanding it in practice.
Inflation is a pretty abstract term to many. It needs imaginative power to think of future values and fluctuations in a macroeconomic system. Moreover, practically, there is no straightforward calculation or analysis of the concept of inflation. There could be many factors affecting even the calculations and assessments of inflation from time to time. Even experts are divided concerning many points when calculating and analysing inflation. Many economists are not sure whether the figures making the rounds are indeed true. Nor do they have the proper tools for fool-proof verification of such macroeconomic facts.
Difference between Real Return and Nominal Return
The concepts of Real Return and Nominal Return are related to investments. The Nominal Return is the pure return value on investment without consideration of inflation effects or deductions of taxes or any other charges. It is the basic returns generated from an investment. However, it is not the return the investor gets in their hands as there are deductions and adjustments on it.
The returns after the adjustments of inflation and tax is what is available to the investor, and is known as the Real Return. Thus the Real Return is the actual amount of return on which an investor has their rights. While it is the realistic benefits, the Nominal Return also has its advantages.
The difference between the two is that while Real Return is the exact return gained by the investor, Nominal Return, though not available to withdraw, shows the actual value of the investment. It tells you what the investment can yield. Since it is a pure value independent of taxes or inflation, it can help compare the benefits of different investments. It is convenient since taxes may be different for different investments and a comparison between them becomes difficult when the Real Return value is used.
Why FD is not Enough to Beat Inflation and One Should Invest
As is clear from the above discussion, money kept idle or even in a savings bank cannot overcome the effects of inflation as the returns from savings will be lower than the inflation percentage. That’s why people usually consider FD (Fixed Deposits.) In an FD, the interest is supposed to compensate for the decline of money value due to inflation. However, it’s tricky as taxes are again deducted from the interest gained. In other words, the benefits of FD usually mentioned are before the deduction of taxes. Hence, FD is not a viable solution to overcome the effects of inflation.
Moreover, it is the interest gained that compensates the value drop of the principal in the FD. If one withdraws the interest, it’s again an amount without adjustments for inflation.
Thus FD cannot help patch up the loss of value on the principal amount due to inflation. Hence, one has to resort to better options such as mutual funds, stock market investment and SIP.
Inflation increase is a spectre for a country like India. Rising inflation will have far-reaching consequences in a country where there is a sharp divide between the rich and the poor. Hence, inflation is to be regulated at all costs. Adequate awareness of inflation is necessary for the common people and not just experts. It helps the lay people to seek the best investment opportunities that can overcome the negative effects of inflation on their money. Though RBI takes necessary measures to regulate inflation, they don’t always bring about the expected results. It is also the responsibility of every citizen to understand inflation and associated concepts to protect their assets from the declination of value and also contribute positively to the health of the economic system.
Inflation is an economic term that means rising prices of goods and services within a particular economy over a particular time. And generally, with the rising prices of goods and services, the consumers’ purchasing power decreases also affecting certain other financial decisions. It is the rise in the general level of prices, in which a particular unit of currency buys less than it did as compared to the previous periods. This means that an individual would require about 1000 Rs. in 2020 to purchase the same amount of goods and services as 300 Rs. would have purchased in 1990.
Generally expressed in percentage, inflation indicates a decrease within the buying power of a nation’s currency. The measure of inflation over a while is referred to as the rate of inflation or the inflation rate.
General effects of Inflation
Inflation affects consumer disbursement, enterprise investment, employment rates, government’s policies and programs, and interest rates. Once inflation is high, the value of living gets higher. Beyond reasonable level inflation ultimately hurts economic growth. Inflation can reduce the value of investment returns; hence clear understanding of inflation is extremely important.
If there is a lack of understanding of inflation then it can prove injurious to an investor’s investment portfolio. President Ronald Reagan said, “Inflation is as violent as a mugger, as scary as an armed robber, and as lethal as a hitman”. Although it can prove beneficial as when the economy is running below capacity, it means that there is somewhere unused labour or resources, so inflation supposedly helps increase production.
More rupees render to more spending, and hence more aggregated demand. More demand, to be met, triggers more production. So, a certain level of inflation is required in the economy to promote the production of goods and services and to discourage stocking of money in the savings. Till it is balanced and at an optimum level, it is really helpful for the economy. But beyond a certain level, it prevents companies from investing, saving increases, unemployment grows, and overall economic growth is badly affected.
As money generally loses its value over the time it is important to invest the money, hence ensuring the overall economic growth of the country. Individuals additionally invest in stocks as it benefits them.
Inflation, if done the right way, can prove beneficial to the economy. It enables economic growth. It allows adjustment of real wages and prices. It is better than deflation, where the general price levels in the country fall, as deflation can lead to recession.
How inflation is measured in India and US
In India, inflation is measured by the Ministry of Statistics and Programme Implementation, a central government authority, which ensures the smooth running of the overall economy. The Reserve Bank of India uses tools such as the repo rate (Repo rate is the rate at which the central bank of a country, in the event of any shortfall of funds, lends money to commercial banks) to limit the inflation within a band.
The government also influences inflation through its fiscal policy, taxation, etc. In India, two main indices exist to measure inflation, namely, Consumer Price Index (CPI) and Wholesale Price Index (WPI). They measure retail and wholesale price changes respectively. The CPI calculates the variation in the price of commodities and services such as food, education, electronics, clothes, medical care, etc. While on the other hand, WPI captures the goods or services sold to smaller businesses by larger businesses for selling further.
While in the US, the rate of inflation is determined by calculating changes in the average price of a constant bunch of goods and services, often called a market basket. Inflation is usually determined by using a general price index, such as the Consumer Price Index (CPI).
In a price index, the price of a market basket is divided in any given year by the base year’s basket’s price of the same goods and services.
The rate of inflation is then determined by calculating the change in the percentage in the price index, says Consumer Price Index (CPI), across different periods. For example, the CPI was approximately 253 in September 2018, and nearly 256 in September 2019, hence making the rate of inflation about 1.6% over this period of one year.
So basically, the fundamental notion behind determining inflation is that at a particular time, the price of a constant basket of goods and services. But in real life, this is next to impossible for basically two reasons. First, is the qualitative factor, that the quality of nearly all kinds of goods and services changes over time. Due to this reason, the increase in the prices over time is due to the enhancements in quality and not inflation.
For example, a movie ticket may cost more today than it used to be in the 1960s, but a cinema today is also in colour and offers way better resolution and services. So, it would be wrong to say that all of the increase in the price of movie tickets is due to inflation; only the part of the money that cannot be explained by quality improvements would be accredited to inflation. Second, new products are brought into the marketplace over time and are only gradually merged into price indices to make their fixed baskets as they are essentially different from any of the historical goods. Statistical agencies try to regulate data to explain such factors, because, if these problems are not suitably accounted for, the calculated inflation would not be accurate and most likely exaggerated.
Causes of inflation
Inflation is chiefly caused due to demand-pull and cost-push inflation. Demand-pull inflation happens when the demand for goods and services in the economy surpasses its capacity to produce them. As demand tops supply within the economy, there is pressure upon placed on prices of such goods and services resulting in the rising inflation. Cost-push inflation happens when there is an increase in the cost of input goods and services.
The main causes of inflation in India are low supply or production and higher demand of various commodities leading to a demand-supply gap which further leads to a hike in prices, that is, inflation, to facilitate production. Excessive flow of money also leads to a hike in prices as money loses its purchasing power. Some other major structural factors could be:
- Supply bottlenecks leading to a shortage of commodities.
- Middlemen deliberately causing the price increase.
- Cheap loans being availed by the bank
- Printing of more currency by the Central Bank of the nation.
- Economic growth giving more purchasing power in the hands of the people.
- Black marketing, hoarding also push up inflation.
- Increase in wages and salary.
Types of inflation based on the inflation rate
Creeping Inflation, as the name suggests is when the prices gently rise. It is conjointly referred to as Mild Inflation or Low Inflation as it is the lowest or the mildest form of inflation. Prices rising by less than 3% each year is Creeping Inflation. This kind of inflation makes people anticipate that the prices of the goods and services will keep on going higher.
If creeping inflation continues to persist for an extended time then it known as Chronic Inflation, as the rate of inflation continues to increase without any downturn, leading to Hyperinflation. It could be either in Continuation or it could be Intermittent. It occurs generally when there is an increase in production costs.
The inflation rate higher than the Creeping Inflation is Walking Inflation. When prices rise between 3% and 10% each year, then it is known as Walking Inflation. Walking inflation generally signals for the occurrence of running inflation hence it should be considered as a sign of caution, according to some economists. If not checked timely then it may eventually lead to running or Galloping inflation.
Walking inflation and Creeping inflation joined together are called Moderate Inflation. When prices rise below 10% per year, it is known as Moderate Inflation. It is generally more stable inflation.
A very rapid growth in the rate of inflation is known to be as Running Inflation. Prices rising between 10% to 20% per year, it is said to be running inflation.
When prices rise between 20% to 1000% per annum, galloping inflation or jumping inflation is said to have occurred. From the second five-year plan period, India is facing galloping inflation.
Prices at an alarmingly high rate lead to Hyperinflation. The inflation is so rapid that it becomes difficult to even measure its magnitude. However, when the inflation is more than 1000% per year, it is called as Hyperinflation. The worst example of hyperinflation ever recorded is of Zimbabwe from the year 2004 to the years 2009 under Robert Gabriel Mugabe’s rule.
What if the inflation becomes too high?
If inflation becomes too high, then it may lead people to severely restrain their use of the money or the currency, leading to speeding up in the inflation rate. High and quickening inflation completely hinders the normal workings of the economy, harming its ability to supply both goods and services. Hyperinflation can even lead to the complete relinquishment of the use of the country’s currency (for example- North Korea) and thus leading to the implementation of an external currency (in this case, dollars).
Inflation interrupts with the overall pricing mechanisms in the economy, consequentially resulting in businesses and individuals earning lower than the ideal spending, investment, and saving decisions. Moreover, due to inflation, people often engage in activities such as diverting resources, to protect themselves from the negative impact of inflation. But such decisions reduce the overall economic growth and hence resulting in the lowering of the living standards.
Other negative impacts of Inflation
Inflation lowers down the efficacy of money as a medium of exchange. High inflation would mean that it becomes tough to put a certain value on goods and services because the price or the value of money keeps on falling and falling. As discussed, the extreme cases of inflation, that is the hyperinflation prices can rise to an extent that money becomes insignificant and people start relying upon a trading system or a barter economy. For example, Germany 1922, Hungary 1946.
The instability of the inflation rate keeps on increasing with the increasing inflation. This would mean that it will be tougher to place a value on money, and hence it becomes even tougher to determine a store of value. And, with high inflation, there will be increased menu costs. This is the cost of changing price lists to show the changing worth of money.
Moreover, higher inflation is bad for capital investment, which would mean due to inflation there would be a lower accumulation of productive capital and hence leading to slower economic growth for a long time in the future. Businesses are very less interested in setting up the industries and factories using the current currency if the goods made today have to be sold in the future in return for the money that is worthless due to inflation. And also, a lesser or smaller capital stock would mean lesser labour productivity and hence meaning slower wage growth.
Louis R Woodhill has even documented that higher inflation leads to lower levels of investment, higher unemployment, and lower GDP growth.
With high inflation, there is a relocation in the purchasing power from those on fixed nominal incomes. This relocation of the purchasing power of currency will also occur between the international trading partners. Higher inflation (where there are fixed exchange rates) will affect the balance of trade and will be responsible for the exports of the economy to become more expensive. There can also be adverse effects to trade from an extended uncertainty in currency exchange prices resulting from the inflation.
Moreover, Inflation can give rise to enormous protests and revolutions. For example, inflation (food inflation, in particular) is known to be one of the key reasons that gave rise to the 2011 Egyptian revolution and the 2010–11 Tunisian revolution, according to many witnesses also including Robert Bruce Zoellick, the then resident of the World Bank. Egyptian President Hosni Mubarak was exiled only after18 days of demonstrations and the protests and the Tunisian president Zine El Abidine Ben Ali was also exiled, and the demonstrations soon spread into several countries of North Africa and the Middle East.
The allocative efficiency is also affected, as the relative price of goods and services is likely to change when there is a change in their supply, giving out a signal to both the sellers and the buyers to redistribute the resources in reply to the new economic conditions. But when the prices keep on changing due to inflation, the changes caused because of genuine relative price signals, say quality, actually become difficult to differentiate from the change in prices caused because of the inflation, and hence the agents are slow to retort to them, which eventually lead to low resource allocative efficiency.
Also, with high inflation, companies must keep on changing their prices often from the “menus” to keep up with the changes caused due to inflation. But repeatedly changing prices is itself a rather expensive activity whether it is the requirement to print new menus, or it is the extra effort and time to put in to keep on changing the prices.
It can be concluded that inflation is the silent danger that eats away the real worth of your money over time.
Conclusion on the inflation rate
So, it can be deduced that any kind of unpredictable or high rate of inflation is regarded to be as detrimental to the overall economy. They increase inadequacies in the entire market and hence make it tough for individuals or companies to decide on a budget or to plan for the long-term. Inflation can prove to be a strain on the overall productivity as the companies in this situation are forced to move the resources away from the goods and services to concentrate on profit and losses caused due to the inflation. Savings and investment are discouraged due to the ambiguity about the forthcoming purchasing power of money. Inflation can also be the reason to enforce the hidden tax increases.
What does the US do?
Countries such as the US it is usually agreed upon that inflation should be kept as little as possible to curtail these distortions in the economy. Some economists would argue that a zero-inflation rate is ideal; but a zero rate of inflation can make an accidental deflation to occur, which would be even costlier than inflation itself. So, to balance out these two risks, often there is a positive approach, such as to keep inflation low, that is around 2%, to lower the inadequacies within the economy while at the same time shielding against deflation.
How to tackle inflation?
The best way to beat inflation is to start saving investing and saving early in assets whose returns will ultimately beat the rate of inflation. One has to invest in growth assets, for example, real estate and equities. It can produce both income and capital appreciation.
But while choosing as to why buying assets you should always take the inflation rate in the consideration. Otherwise, it might expose you to the risk of gaining negative returns. It would guarantee the return you get is a few percentage points higher than the percentage of the inflation rate.
Role of equities in tackling inflation
Stocks carry the potential with them to give returns higher than the rate of inflation. Moreover, if the investment is held for more than a year, then the returns you get from equities are not even taxed! Those who want to make investments at once can construct their very own portfolio. For the rest, the alternative source for the equity funds could be mutual fund houses!
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