What is inflation?

“Inflation” is perhaps one of the most bandied about words in the financial world. It refers to a phenomenon that has an immense impact on day-to-day lives. And yet so few fully understand it. Not anymore; not with your friend CoinSwitch around.

Here is an example that might help recognize inflation instantly. In 2019, the cost of 1 kg of apple was ₹100. By 2020, the cost had shot up to ​​₹110—a 10% rise in prices. That, right there, is inflation.

What is inflation

Inflation implies a considerable increase in the prices of goods and services over time without a corresponding increase in wages. It causes a decrease in the value of money.

What is Inflation Rate?

When various commodities whose cost increases over time are placed in a group, the percentage of increase can be analyzed by considering one particular year as the base year. The percentage of the increase in costs is called the inflation rate.

Inflation analysis aims to measure the effect of cost variations for an extensive range of goods and services. Since investments are affected by inflation, investors need to understand the many fallouts of inflation. This article will help you do that.

It’s is triggered by multiple factors, such as:

• Government spending: When the government of a country either spends more on the people or taxes a smaller amount, it leaves some excess money in consumers’ pockets. As a result, the demand increases, encouraging inflation.
• Economic growth: When an economy grows, the demand and spending power increase. This, in turn, causes a rise in the cost as a larger group of people can afford a more significant amount of goods and services, resulting in inflation.
• Money supply policies: These are policies that determine the currency flow in a country. When they are designed to make the flow shoot up and the economy’s ability to produce goods and services is not able to keep pace with the resulting rate of supply, the worth of the currency drops. Result: inflation.
• Devaluation: This term refers to a descending adjustment in the exchange rate of a country. It decreases the value of the currency, and the outcome is inflation.
• Anticipation of inflation: Sometimes, large groups or companies presume that inflation is going to occur, so they hike the prices of their products to get ahead. This action, based on the expectation of inflation, in turn, causes inflation.
• Non-economic reasons: Non-economic factors can create inflation in an economy. For instance, a flood can destroy crops, shrinking the supply of farming goods and causing a rise in the costs of commodities. Again, the result is inflation.
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What are the Inflation Types?

Inflation can be classified into different types. The types are related to the causes. Some of these types are listed below.

Demand-pull inflation

This is caused by a quick rise in demand for certain products and services. The rise in prices associated with demand-pull inflation occurs when there is insufficient production of goods and services to keep up with the demand. For example, Apple’s superior marketing policies and products are pushing up the demand for iPhones, which might, in turn, push the costs up exponentially.

Cost-push inflation

A rise in the cost of production cost, raw materials, and labor causes a decline in the total supply of certain products and services. Cost-push inflation occurs when spending on the making of goods increases. An example of cost-push inflation is the rising prices of essential goods. These goods may get more expensive to produce and grow, depending on several factors, including climate change.

Built-in inflation

This kind of inflation is also called a wage-price spiral. When the prices of essential goods and services rise, people sometimes assume that the increase will continue at the same rate for the foreseeable future. This sets off demands for higher wages. The improved incomes, in turn, result in greater costs, thus creating a vicious cycle of sorts. This scenario is thus termed built-in inflation.

How is inflation measured?

First, you need to determine the cost of a particular product over the past year. Then do the same for the current year. Finally, apply the formula below to measure the inflation rate.

Inflation = Price of year 1 – Price of year 2 / Price of year 1 x 100

This formula is to calculate the inflation rate for a single product. It represents the percentage-wise increase or decrease in the cost. It can be used to compare the inflation rate over time.

Types of price indices

The most frequently used price indices are:

1. Consumer Price Index (CPI)

This is the most common measure of inflation. It is used by consumers, businesses, financial markets, and policymakers. It involves calculating the total variation in consumer costs over time, based on an illustrative basket of products and services.

2. Wholesale price index

The wholesale price index, or producer price index, quantifies and tracks variations in the cost of products before they reach consumers. It has to do with products that are traded in huge quantities between businesses or producers. Wholesale price indexes are an indicator of the level of inflation of a country.

Is moderate inflation good?

Moderate inflation is one of the fallouts of a developing economy. As an economy develops, demand will increase. And increased demand will naturally trigger a slight rise in prices as suppliers attempt to produce more. Moderate inflation is thus a sign of a healthy economy. It helps fight the detrimental impact of deflation on the economy.

How does inflation affect you?

Inflation affects everybody, but it impacts each person differently. Inflation lifts costs, thus reducing buying levels. It also drops the value of savings, pensions, and fixed assets.

As inflation rises, wages also are expected to increase. But the rate of increase of both wages and prices is often not the same. If that applies to your case, you may feel the pinch. And if you rely on a static salary—such as pensions—inflation may significantly impact your living standard. Higher inflation affects savers, too, as it erodes the buying power of their savings.

However, it can be advantageous for borrowers. That’s because the inflation-attuned worth of their unpaid debts minimizes over time.

What is Inflationary and Deflationary Gap?

The Deflationary Gap is the degree by which average demand decreases aggregate supply. It is considered deflationary since it causes the price level to decline. The deflationary gap generates deflation and lowers the economy’s wage and price levels. While, inflationary gap is the overflow of consumer spending over the amount required to keep full employment stability. Inflation is caused by an inflationary gap, which raises wages and prices in the economy.

How does inflation affect economies?

Like most things, inflation too comes with its pros and cons. Here is where we take stock.

The positives

The rise in prices that we associate with inflation may sound all negative. This is the other side of the story.

1. Better returns: Usually, inflation boosts the production of essential goods. This means producers get better revenues. Inflation also brings enhanced investment returns. Entrepreneurs and investors get spurs for investing in fruitful activities that offer improved returns on their investments.

2. Employment opportunities and improved income: Better employment opportunities also come with inflation. As production improves, the demand for manpower increases, leading to increased employment chances and better incomes.

3. Advantages for borrowers: If the rate of interest a borrower is paying is less than the rate of inflation, he or she automatically benefits from the process. This happens because the worth of money that the borrower is paying is less than the money he or she borrowed.

The negatives

There are some obvious problems created by inflation. Some of them are listed below.

1. Static income households are disproportionately hit: People reliant on a fixed income, such as pensioners and salaried individuals, will suffer a drop in their real income. Inflation thus reduces their purchasing power.

2. Greater variation in income distribution: When inflation occurs, entrepreneurs and businessmen make better profits, while in real terms, fixed-income groups get less than their actual salaries. Hence, the variation in earning distribution is higher during inflation.

3. Increase in hypothetical investments: As prices rise at a rapid rate, people are not aware of how much the cost of living will increase in the coming months. So people tend to jump into speculative investments.

4. Reduced capital growth: Chronic inflation makes people prefer goods over money since the currency’s value diminishes the fall. It reduces the desire to save, leading to reduced investments. Overall, it negatively impacts capital accumulation because an economy’s capital accumulation depends on the growth of the investment.

5. Export income drop: As the raw material costs and production increase, the charges for export products rise during inflation. In this situation, the demand for these products may fall in foreign markets leading to a fall in the income from exports.

In conclusion, remember, inflation is not something we can choose or reject as individuals. We can only understand it better, factor it in while we plan for our future, and hope that our governments do what they can to keep inflation moderate.

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