Understanding Inflation

Inflation is the gradual increase in the cost of goods and services over a given period of time.

Updated: May 31, 2024

 Understanding Inflation



Inflation:

Inflation is the gradual increase in the cost of goods and services over a given period of time.

Some facts about Inflation:


  • The rate at which prices for goods and services rise is called as Inflation.
  • Typically, Inflation is a broad measure, such as the overall increase in prices or the increase in the cost of living in a country. 
  • But it can also be for certain goods, such as food, or for services
  • How much more expensive the relevant set of goods and/or services has become over a certain period can be represented by Inflation.
  • The rate of dropping purchasing power can be reflected in the average price increase of selected goods and services over some period of time. 
  • Sometimes, inflation is classified into three types including demand-pull inflation, cost-push inflation, and built-in inflation.
  • The Consumer Price Index and the Wholesale Price Index are the most commonly used inflation indexes.
  • Inflation can be viewed positively or negatively depending on the  rate of change and individual viewpoint.
  • Some inflation can be seen in those with tangible assets, like property or stocked commodities as that raises the value of their assets.

Understanding Inflation:


  • The price changes of individual products over time can be easily measured. However, human needs extend beyond just one or two products as they need a huge and diversified set of products as well as a host of services for living a comfortable life. which  commodities like food grains, fuel, metal, utilities like electricity and transportation, and services like health care, entertainment, and labor. 
  • Therefore, the overall impact of price changes for a diversified set of products and services needs to be measured so that the increase in the price level of goods and services in an economy over a period of time can be represented for a single value.
  • The cost of living for the common public gets impacted by the loss of purchasing power when price rises which ultimately leads to a deceleration in economic growth.
  • There will be a sustained inflation when a nation's money supply growth outpaces economic growth.
  • Necessary steps are taken by the monetary authority (like the central bank to manage the money supply and credit to keep inflation within permissible limits and keep the economy running smoothly to combat this 
  • Monetarism is a popular theory in which the relation between inflation and the money supply of an economy can be explained.
  • Inflation is measured in a various ways depending upon the types of goods and services.
  • Deflation is the opposite of inflation, which indicates a general decline in prices when the inflation rate falls below zero percent.
  • Inflation and deflation can be calculated by tracking changes in the cost of goods and services with the help of Price indices.
  • The headline inflation rate, sometimes referred to as overall inflation are calculated by taking in to account the increase in the cost of food, petrol, and other items.
  • High inflation can suffocate the economy by diminishing purchasing power just like too low inflation can hamper the growth by keeping too much money in savings accounts, as people hold off on spending while they wait for the value of their money to increase.
  • The ideal inflation rate can lead to the correct kind of economic growth as it encourages people to spend money now rather than store it for the future.
  • Both the Consumer Price Index (CPI) and the Wholesale Price Index (WPI) are used in India to measure inflation. 

Causes of Inflation:


Although, the root of inflation can play out through different mechanisms in the economy, it is the root cause of an increase in the supply of money.
Money supply of a country can be increased by the monetary authorities either by printing and giving away more money to citizens or legally devaluing or reducing the value of the legal tender currency. 
Money supply of a country can also be increased by the monetary authorities by loaning new money into existence as reserve account credits through the banking system by purchasing government bonds from banks on the secondary market, which is the most common method.
The money ends up losing its purchasing power in all of these cases.
Demand-pull inflation, cost-push inflation, and built-in inflation are the three types of mechanisms used to drive inflation.

Demand-Pull Effect:


Demand-pull inflation occurs when the overall demand for goods and services is stimulated by an increase in the supply of money and credit to increase more rapidly than the economy's production capacity.
This will increase the demand and lead to rise in price.
Positive consumer sentiment is a result of people having more money, which in turn, leads to higher spending, which pulls prices higher.
So, a demand-supply gap will be created with higher demand and less flexible supply, which results in higher prices.

Cost-Push Effect:


The increase in prices working through the production process inputs results in Cost-push inflation.
Costs for all kinds of intermediate goods rise when additions to the supply of money and credit are channeled into a commodity or other asset markets.
This usually happens when there is a negative economic shock to the supply of key commodities.
These developments will result in higher costs for the finished product or service and work their way into rising consumer prices. 
For example, a speculative boom in oil prices will be created when the money supply is expanded which means there is an increase in the cost of energy that contribute to rising consumer prices, and will be reflected in various measures of inflation.

Built-in Inflation:


Built-in inflation can be related to either adaptive expectations or the idea that people expect current inflation rates to continue in the future.
People may expect a continuous rise in the future at a similar rate when the price of goods and services rises.
So, workers may demand more costs or wages to maintain their standard of living and this increased wages result in a higher cost of goods and services.
This wage-price spiral continues as one factor induces the other and vice-versa.

Types of Price Indexes:


Multiple types of baskets of goods are calculated and tracked as price indexes depending upon the selected set of goods and services used.
The Consumer Price Index (CPI) and the Wholesale Price Index (WPI) are the most commonly used price indexes.

Wholesale Price Index (WPI) :


The wholesale pricing index (WPI) is the cost of a typical basket of wholesale goods.
The overall expenditures after taking a basket of 697 items into account is illustrated by it.
WPI was used by the Reserve Bank of India until 2014 to determine monetary policy. 
The WPI is a popular measure of inflation in which the changes in the price of goods are measured and tracked in the stages before the retail level.
WPI items mostly vary from one country to other, but they usually include items at the producer or wholesale level.
The WPI is calculated by the Ministry of Commerce and Industry and the WPI basket consist of Manufactured Goods (65 percent of the total weight), Primary Goods (20.1 percent), and Fuel and Power (5 percent of the total weight).
RBI has now switched to the Consumer Price Index as it overlooks services and bottlenecks between wholesalers and retailers. 

The Consumer Price Index (CPI):


The weighted average of prices of a basket of goods and services which are of primary consumer needs are examined by CPI.
Transportation, food, and medical care are included in CPI.
The CPI is a measure of changes in retail prices based on 260 commodities, including some services.
The pricing for representative goods and services is regularly gathered, usually once per month and a track of any changes are kept by the Ministry of Statistics and Programme Implementation. 
Rate measures will be compared by using a base year which might be regarded as the 'first' year in the specified time frame.
Usually, Prices in the base year are set to be 100 to simplify calculations. 
Price changes for each item in the predetermined basket of goods are taken and average them based on their relative weight in the whole basket to calculate CPI.
The retail prices of each item, as available for purchase by the individual citizens are the prices in consideration.
Price changes associated with the cost of living can be assessed by using changes in the CPI.
It is one of the most frequently used statistics for identifying periods of inflation or deflation
CPI =( Cost of Basket at current prices /Cost of Basket at base prices )x 100 is the formula used to calculate the Consumer Price Index.

The Producer Price Index (PPI):


The Producer Price Index (PPI) is a similar variant as WPI that measures the average change in selling prices received by domestic producers of intermediate goods and services over time.
Price changes from the perspective of the seller and differs from the CPI is measured by PPI which measures price changes from the perspective of the buyer.
It is possible that the rise in the price of one component (say oil) cancels out the price decline in another (say wheat) to a certain extent in all variants.
The average weighted price change for the given constituents is represented by each index which may apply at the overall economy, sector, or commodity level.

The Formula for Measuring Inflation:


The value of inflation between two particular months or years can be calculated by the above-mentioned variants of price indexes.
Although, a lot of ready-made inflation calculators are already available on various financial portals and websites, it is always better for you to be aware of the underlying methodology to ensure accuracy with a clear understanding of the calculations.
Inflation can be measured by using the formula : Percent Inflation Rate = (Final CPI Index Value/Initial CPI Value) x 100

Advantages and Disadvantages of Inflation:


Inflation can be construed as either positively or negatively, depending upon which side one takes, and how rapidly the change occurs.

Advantages of Inflation:


  • Individuals who have tangible assets like property or stocked commodities priced in their home currency may want to see some inflation as that raises the price of their assets, which they can sell at a higher rate.
  • Speculation can be a result of inflation by businesses in risky projects and by individuals who invest in company stocks because they expect better returns than inflation.
  • An optimum level of inflation generally promote to encourage spending to a certain extent instead of saving.
  • There may be a greater incentive to spend now instead of saving and spending later if the purchasing power of money falls over time which may increase spending, and may boost economic activities in a country.
  • The inflation value can be kept in an optimum and desirable range with a balanced approach.

Disadvantages of Inflation:


  • Buyers of assets like property or stocked commodities may not be happy with inflation, as they will be required to shell out more money.
  • People who hold assets valued in their home currency, such as cash or bonds, may not like inflation, as it reduces the real value of their holdings. 
  • Inflation-hedged asset classes, such as gold, commodities, and real estate investment trusts (REITs) should be considered by investors looking to protect their portfolios from inflation.
  • Another popular option for investors to profit from inflation is  Inflation-indexed bonds.
  • Major costs will be imposed on an economy with high and variable rates of inflation.
  • The effects of generally rising prices in their buying, selling, and planning decisions must be taken in to account by businesses, workers, and consumers.
  • An additional source of uncertainty may be introduced into the economy due to this, as they may guess wrong about the rate of future inflation.
  • It is expected to rise to the general level of prices by time and resources expended on researching, estimating, and adjusting economic behavior which is opposed to real economic fundamentals, that inevitably represent a cost to the economy as a whole.
  • There can be a serious problems in the economy because of even a low, stable, and easily predictable rate of inflation, which some consider otherwise optimal.
  • It is always into the hands of specific individuals or business firms whenever new money and credit enters the economy.
  • When the new money is spend by the business firm and circulates from hand to hand and account to account through the economy, the process of price level adjustments to the new money supply proceeds.
  • Cantillon effect is the sequential change in purchasing power and prices.
  • The process of inflation not only increases the general price level over time, but also distorts relative prices, wages, and rates of return along the way as Inflation does drive up some prices first and drives up other prices later.
  • Distortions of relative prices away from the economic equilibrium of a country are not good for the economy.