What is Inflation?
Inflation can be defined as decline in the purchasing power gradually. The diminishing rate of the purchasing power can be reflected in the economy, by the increase in price of goods and services.
Eventually, an increase in overall prices, as a percentage, indicates that unit of money purchase of goods and services are fewer than before. Inflation is in contrary from deflation, which occurs when there are prices decline and the purchasing power increases which leads to flow of liquidity in economy as well.
Causes of Inflation
An increase in the supply of money cause Inflation, which can occur through different reasons in the economy. The Monetary authorities increases the supply of money in different mechanism:
- Printing and distributing more money in the economy.
- Decreasing the value of legal tender currency.
- Commonly, lending new money into existence as reserve account credits through the banking system by purchasing government bonds from banks on the secondary market.
When there is an increase supply of money and credit in the economy, which induces the overall demand for goods and services to increase faster than the economy’s production capability is called Demand-Pull Effect.
With more money to dispose, leads to increase in purchasing power, which increases demand and Prices for goods and services. It causes Demand-supply gap. The higher the demand, lower the supply gets. Hence, with higher prices inflation increases.
Cost-push Inflation occurs, when there is an increase in the prices of manufacturing process inputs. Resulting, the supply of goods or services to decrease and demand to remain the same, which push up the prices.
For example, Cost-push inflation might happen, if the wheat supply decreases it will hike the prices of flour. Eventually, the average cost for producing the bread increases.
Built-in inflation is linked to the consumer believing that present inflation rates to continue in future. The working class will perceive that the cost of living and goods and services will increase. Eventually, they will expect or demand higher salaries to maintain their level of living.
The greater earnings will lead them to spend more. In this way, expectation of high inflation can lead to inflation.
Effects of Inflation
- Economic Growth
- Higher wages
- Increase in Consumption
- Low savings
- Cheaper Debt
How to measure Inflation?
The inflation rate is measured by Consumer price index (CPI), Producer price index (PPI), etc. Every index captures different aspect of price changes in the Indian economy. To get the comprehensive picture of the rate of inflation, multiple indexes are considered to ensure accuracy.
The Consumer Price Index (CPI)
The CPI measures the average changes in prices of goods and services which consumers pay for. The eight major categories people spend money on: Medical care, food and beverages, housing, transportation, education and communication, recreation, and other goods and services.
CPI uses “Basket of goods” technique to calculate the price changes for each item and averaging them based on their average weighed in the whole basket.
Formula to calculate the inflation rate using CPI:
(Initial CPI – Final CPI/Initial CPI) x 100
The Producer Price Index (PPI)
The PPI measures the average change in the prices that companies receive on selling goods and services each month. It can be influenced by producer facing an increase in tariffs, oil and gas prices, or other issues such natural disaster, environmental changes, etc. Anyway, the index captures average weighted price change which may apply to economy, sector or commodity level.
Other indexes include:
Wholesale Price Index (WPI)
Commodity price indices
Core price index
Gross Domestic product (GDP)
How RBI’s monetary policy controls Inflation?
Monetary policy is implemented by Reserve Bank of India (RBI) to control the inflation. The RBI formulates, implements, and monitors India’s Monetary policy. It ensures the price stability considering the economic growth of the country.
- Repo Rate
Repo rate or Repurchase rate decides the interest rate at which the RBI lends credit to all other banks for a short term. When the Repo rate increases, the credit borrowing becomes expensive. Eventually, the customer or public has to face high interest rates.
So, when the inflation is on the rise, RBI implements repo rate policy to reduce the liquidity in the Economy. Eventually, the purchasing power of the public will decline.
- Reverse Repo Rate
To decrease the inflation, RBI borrows the funds from the other banks for short term it is called Reverse repo rate. This happens whenever there is excess of money with the banks.
Fiscal policy deals with the revenue and expenditure policy of the government. Government implements fiscal policy, to adjust its spending level and tax rates to monitor and influence a nation’s economy. Eventually, it curbs Inflation, increases employment, and maintains a healthy value of money
For Example, an economy has slowed down. Unemployment levels are up, consumer spending is down. A government decides to improve the economy by decreasing taxation. Which will give the consumer the power to spend more money.
Government decides to increase the budget, buying services from the market to build the infrastructure. This is turn, will create employment and liquidity will run into the economy.
Is Inflation Good or Bad?
Inflation is harmful whether it is higher or lower. Many economists consider the low to moderate, which is around 2-3% a year.
What is Deflation?
When there is a downfall in the economy, it is called deflation. Economists warn about deflation as it is more harmful than the unnoticed inflation.
Prices of goods and services are reducing day by day. One gets the opportunity to buy with low prices, but they stall for prices to get even lower in the future. If it is not fixed, Deflation can diminish or freeze economic growth, which can decrease wages.
What is Hyperinflation?
Hyperinflation takes place, when the economy faces rapid increase in inflation, prices of goods and services increases, purchasing power of the consumer decreases and the value of currency diminishes.
An economy faces Hyperinflation when certain situation takes place. Such as an economy in the middle of a war, Civil war, etc.
What is Transitory Inflation?
Transitory inflation occurs, when the rise or fall of the inflation is temporary and will not impact the economy permanently.
What is Core Inflation?
Core inflation occurs when there is movement in the Non-Volatile aspects of the economy. This is more useful to predict long-term effect.
The goods and services in the “basket of Goods” can show difference month to month.
What is Stagflation?
When the economy going through a high inflation, but the unemployment rate is decreasing and the economy is stagnant, it is called Stagflation.
Generally, when unemployment rate is high, the purchasing power of the consumer decreases. Which decreases the price of the goods and services. However, when stagflation occurs, prices of goods and services does not budge.