Inflation or inflation rate is the decline in the purchasing power of a currency over time. A quantitative estimate of the rate at which purchasing power declines may be reflected in the increase in the average price level of baskets of selected goods and services in an economy over time. An increase in the general level of prices, often expressed as a percentage, means that the unit of currency is effectively buying less in the earlier period. The opposite of inflation is deflation, which occurs when the purchasing power of money increases and the price decreases.

Inflation indicates an overall increase in the general price level of goods and services in a country. When we read that last year inflation was 7%, it doesn’t mean that price of every product like milk, cars, clothes, etc., increased by 7%. It means compared to the previous year on average prices of all goods & services increased by 7%.

Important Points:

– Inflation is the rate at which the value of a currency falls and as a result the level of prices for goods and services rises.

– Inflation is classified into three types: Demand-Pull inflation, Cost-Push inflation and Built-in inflation.

– The most commonly used inflation indexes are the Consumer Price Index (CPI) and the Wholesale Price Index (WPI).

– Inflation can be viewed in a positive or negative way depending on the individual outlook and rate of change.

– Those who have tangible assets such as property or stocked commodities may prefer an increase in inflation which increases the value of their assets.

– People with cash do not like inflation as it reduces the value of their cash holdings.

– Ideally an optimal level of inflation to stimulate spending, rather than savings to an extent, so as to nurture economic growth.

Understanding inflation:

While it is easy to measure changes in the price of individual products over time, human needs to exceed one or two such products. Individuals require a large and diversified array of products and services to lead a comfortable life. In such a situation, inflation can become a problem for them. They can include commodities like food grains, metal, fuel, utilities like electricity and transportation, and services like healthcare, entertainment, and labor.

Inflation aims to measure the overall impact of price changes for a diversified set of products and services, and allows for a single value representation of the increase in the price level of goods and services in an economy over a period of time.

During the last decade average, annual inflation in India was around 8.4%. After tax average annual rate of return on fixed deposits (assuming tax @20%) was around 6.2%. Thus by investing in FDs you were actually reducing the value of your money by approximately 2.2% every year, instead of growing it. The rate of return on savings deposit account is always less than return on fixed deposits (FD) and interest rate on bonds are comparable with returns of fixed deposits. So, people who invested in fixed deposits actually lost money in the real sense. During the same time, stock markets generated an after tax average annual return of 16%.  Certainly, makes sense to start investing in equity and stop losing money by investing in bonds and FDs.

Causes of Inflation:  

Inflation can be caused by multiple factors with demand-pull and cost-push inflation among the most common.

  1. Demand Pull Inflation: Demand-pull inflation happens when the demand for certain goods and services is greater than the economy’s ability to meet those demands. Inflation depends on price, which is determined by demand and supply. So, if people have more money leading to more demand than supply, price increases. This is called demand pull inflation.
  • Cost Push Inflation: Cost-push inflation is the increase of prices when the cost of wages and materials goes up. These costs are often passed down to consumers in the form of higher prices for those goods and services.  
  • Built-in Inflation: Built-in inflation is related to adaptive expectations, the idea that people expect current inflation rates to continue in the future. As the price of goods and services rises, workers and others come to expect that they will continue to rise in the future at a similar rate and demand more costs or wages to maintain their standard of living.

Types of Price Indexes:

  1. Consumer Price Index: A comprehensive measure used for estimation of price changes in a basket of goods and services representative of consumption expenditure in an economy is called consumer price index. Inflation is measured using CPI. The percentage change in this index over a period of time gives the amount of inflation over that specific period, i.e. the increase in prices of a representative basket of goods consumed.
  • Wholesale Price Index: The WPI is another popular measure of inflation, which measures and tracks the changes in the price of goods in the stages before the retail level. While WPI items vary from one country to other, they mostly include items at the producer or wholesale level.
  • The Producer Price Index: The producer price index is a family of indexes that measures the average change in selling prices received by domestic producers of intermediate goods and services over time. The PPI measures price changes from the perspective of the seller and differs from the CPI which measures price changes from the perspective of the buyer.

Favorable points of Inflation:

  1. Higher Profits since producers can sell at higher prices
  2. Better Investment Returns since investors and entrepreneurs receive incentives for investing in productive activities
  3. Increase in Production
  4. More Employment and Better Income
  5. Shareholders can earn a good income since companies book more profits and tend to share it with their shareholders via dividends
  6. Benefits to Borrowers – The real value of the money returned is less than that of the money borrowed.

Impacts of Inflation on Economy:

  1. Fixed-Income Groups experience a fall in income including salaried employees, pensioners, etc.
  2. Inequality in Income Distribution Increases
  3. Upsets the Planning Process
  4. Speculative Investment Increases
  5. Harmful Effects on Capital Accumulation
  6. Lenders face Losses
  7. Negative Impact on Export Income.

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