Inflation is one of the most familiar words in economics. It’s often used to describe the impact of rising oil or food prices on the economy.
For example, if oil prices go up by $25 per barrel, then input cost of business and transportation costs will increase. In response, the cost of many other products and services will rise.
Inflation may plunge countries into a long period of instability.
Prices are like market air supply. It tells businesses or consumers when to produce more or consume less. High inflation is like contamination to this air supply. It creates difficulty among businesses to interpret price signals. Therefore they defer their investment decisions until prices are settled.
Inflation and unemployment rates are considered as two economic indicators that help to determine an average citizen’s financial health.
In this article, you will learn what inflation is and how it is measured.
What is Inflation?
Inflation is an economic term which means it increases your cost of living.
Inflation is the rate of increase in prices over a given period of time. It’s a continuous price rise of almost everything such as food, clothing, housing, recreation, transport, consumer staples, etc, thereby decreasing the purchasing power of your money. it increases the cost of living in a country.
Inflation is expressed as a percentage. It’s a rate at which prices of goods and services rise over a period. This means, a unit of money or currency effectively buys less than what it was capable of buying in prior periods. In other words, one unit of money buys fewer goods and services due to inflation.
For every month, inflation rates are calculated both on a year-on-year basis to know how prices have changed over the past year and on a month-on-month basis to know how prices have changed over the past month.
Don’t think of inflation as a price rise in one or two items or services. It refers to the broad increases in prices of almost everything across the economy.
Due to high inflation many middle and lower class people will watch their income and savings get wiped out.
Hyperinflation is where prices rise by 50% or more per month.
A retired employee who bought fixed deposits @5.3% per year will be worried by seeing inflation jump to 7.1% as his purchasing power gets clobbered.
However a home buyer who bought a house at a low interest before rising in inflation will be happy seeing the price rise in real estate by 50%.
Government tries its best to control inflation by monitoring money supply, prices, and controlling interest rates.
What is the cause of inflation?
Inflation is not automated. It’s created due to certain circumstances. It can be good or bad depending on how the rise in prices impacts your pocket.
For instance, a rise in real estate value can increase the price of property you hold, which can be sold at a higher rate to make more money. However, buyers of the property will not be happy with the rise in price as they have paid more.
There are generally two causes of inflation: Demand pull effect and cost push effect.
Demand pull effect
Printing and giving away more money to citizens, increase in supply of money and credit stimulates the overall demand for goods and services. If it increases more rapidly than the economy’s production capacity, then such increases in demand leads to price rises.
When people get more money, it leads to higher spending. This higher demand for goods and services pulls prices higher. Due to this a demand-supply gap is created, which results in higher prices.
Excess circulation of money leads to inflation as money loses its purchasing power. With people having more money, they also tend to spend more, which causes increased demand.
Cost push effect
When there is a negative sentiment to the supply of key commodities, cost for these commodities increases. These developments lead to higher costs for the finished product or services. For instance, recent increase in oil and energy costs due to global uncertainty contributed to rising consumer prices, which reflects in various measures of inflation.
As the price of goods and services rise, people demand an increase in salary and wages to maintain their standard of living. This increase in wages results in higher cost of goods and services.
High demand and low production or supply of multiple commodities create a demand-supply gap, which leads to a hike in prices.
Type of price indexes to measure inflation
Inflation is measured by the government using two indices.
Most commonly used inflation indexes are the consumer price index and the wholesale price index. Now let us learn what is consumer price index (CPI), what is wholesale price index (WPI),and how these are measured.
Consumer price index – CPI
Cost of living of consumers depends on the prices of many goods and services. In order to measure the cost of living of consumers, the government agencies conduct various surveys to track over time the cost of purchasing those goods and services.
The cost of this basket of goods and services expressed relative to a base year is consumer price index (CPI).
The percentage change in Consumer price index (CPI) over a period of time is consumer price inflation.
For instance if a base year Consumer price index (CPI) is 100 and the current year Consumer price index (CPI) is 115, then consumer price inflation is 15% over the year.
The biggest cost of inflation is erosion of real income due to rising prices which inevitably reduces the purchasing power of certain consumers.
For instance, pensioners may receive a 5% yearly increase in their pension. If inflation is higher than 5%, the purchasing power of these pensioners falls.
Consumer price index (CPI) is a measure that examines the weighted average of prices of a basket of goods and services which are of primary consumer needs.
Change in consumer price index used to assess the rise or fall in price associated with the cost of living. Every country reposted their Consumer price index (CPI) on a monthly basis.
Formula used to measure inflation;
Percentage inflation rate = (Final CPI Index Value / Initial CPI Value) x 100
Wholesale price index (WPI)
In India, inflation is measured by taking the wholesale price index (WPI) and consumer price index (CPI). These two indices measure changes at the retail and wholesale price levels, respectively.
Wholesale price index (WPI) measures changes in the price of goods in the stages before the retail level. This means it measures price change in items at wholesale or producer level.
Formula to calculate inflation;
[(WPI in month of current year-WPI in same month of previous year) / WPI in same month of previous year ] * 100
What is Stagflation, deflation and hyperinflation ?
Stagflation means the inflation is at a high, the country’s economy is not growing and the unemployment is rising.
When price declines throughout the entire economy and purchasing power increases, it’s referred to as deflation. It’s the opposite of inflation.
When prices are falling, most of the consumers delay their purchases expecting prices to fall further. This will lead to less economic activity, lower economic growth and lower income for producers.
Hyperinflation takes place when prices rise by at least 50% each month. It occurs when inflation rises rapidly and the value of currency of the country tumbles rapidly.
A moderate rate of inflation of 2% or 3% is considered as beneficial for an economy. Due to this reason government agencies and RBI will always strive to achieve a limited level of inflation.
The most powerful way to protect yourself from inflation is to increase your earning ability and income.
For better return on your investments you can go for stocks or any other investment which will give you a year-on-year increased rate of return to beat inflation. You need to consult your financial advisor before taking any decisions that can impact your financial goals.
