INFLATION is when you pay Rs 300 for Rs 200 haircut you used to get for Rs 100 when you had hair. Technically inflation is an economic term that describes a general increase in prices and a fall in the purchasing power of money.
A little inflation is normal and even good for a healthy economy. Inflation becomes a problem when it grows too quickly. Money losing value at a rapid rate can lead an entire economy to spiral out of control. All governments and central banks try and control inflation with regulation and monetary policy. Inflation is expressed as a percentage.
If in 1970 you could buy a cup of tea in a second-grade restaurant for Rs 1 while today an average cup of tea costs Rs 30 in the same place., then that is the effect of inflation over the years. In simpler terms, inflation is a rise in the costs of goods and services, and the inflation rate is a percentage increase or decrease in prices over a period of time.
What Causes Inflation
In simpler terms, inflation occurs when there’s an increase in production costs OR when demand for products and services increases faster than supply. Inflation can come about in many different ways. All these causes are most commonly classified into three main types of inflation, and they are:
- Cost-push inflation- Prices increase when the cost of production increases. If it costs more to make a product or provide a service, the companies will pass that cost on to consumers by increasing the price of products and services.
- Demand-pull inflation- Prices increase when demand increases faster than production. If everybody wants to buy the same thing that is a limited supply they will be willing to pay more money for it, and companies will charge more for the same product or service. Here are some things that can cause demand-pull inflation.
- Built-in inflation- Workers want higher wages to keep up with the cost of living. When prices rise due to cost-push or demand-pull inflation, people expect higher wages so they can keep their lifestyle and standard of living. Higher wages make companies increase the price of goods and services. This raises the cost of living and makes workers demand higher wages.
Other factors contributing to inflation:
Increase in money supply and inflation- Most people will correlate governments printing money with inflation. Ann increase in overall money supply can sometimes lead to cost-push and demand-pull inflation. The money supply creates inflation only when the money is printed faster than the economy grows. Keep in mind that the money supply is not just hard cash, but also credit, loans, and mortgages.
Monetary policy– When the central bank lower interest rates it’s cheaper to lend money. Banks will then lend more money to businesses and individuals who will spend it. More money being spent increases demand, which increases prices.
Fiscal policy– If the government cuts taxes, makes stimulus payments, or increases benefits, people will have more money to spend. If business taxes are cut, businesses can increase wages or hire more people. People will have more money, they spend more, and demand increases, which increases prices.
Exchange Rates- When there is more money in circulation the currency loses value in relation to foreign currencies. This makes imported products more expensive because now your currency has less purchasing power. The governments can also choose to lower the exchange rates to make local products more competitive. This will also lead to imports being more expensive.
Who Benefits and Who Gets Hurt by Inflation?
Inflation does impact everyone the same. Some people get hurt by the fall in the value of currency while others can benefit from it.
Winners
- Debtors-especially if their debts carry fixed rates. They pay their loans back in less valuable currency.
- Owners of the land and physical assets-These assets tend to hold their value through inflationary periods.
Break-even
- Workers whose salaries are indexed to inflation- will not be adversely affected by inflation.
Losers
- Savers- If the inflation rate is higher than the interest rate, savings are decreasing in value.
- Retirees on a fixed income- If you have a fixed pension or interest income from investments, your income will not grow with inflation.
- Workers on fixed-wage contracts- If your wage does not rise with inflation, it is effectively getting smaller.
- Borrowers with variable-rate loans- Governments often raise interest rates to try to make their currency more desirable. That can push interest rates on variable-rate loans up.
- Lenders of fixed rate loans- If you have lent money at a fixed rate, you are getting paid back in less valuable currency.
The most well-known inflation index is the Consumer Price Index (CPI). It examines the average price of a hypothetical basket of goods and services in order to see if there are any changes in the overall cost of living. Different items in the basket carry different weights. These weights reflect the varying importance of items in the consumer’s shopping basket. (having a roof over your head carries more weight than having a gym membership). The increase or decrease in prices of all items when expressed as a percentage represents the inflation rate.
What’s in the Basket of Goods– Each country can use its own methodology, define its own baskets of goods and assign different weights to each item in the basket. The basket generally consists of-
Food and Beverages (Food alcoholic and non-alcoholic beverages you consume at home outside of the home, non)
Housing (Costs associated with owning or renting a home, utilities, household furnishings and maintenance)
Apparel (Clothes, shoes, jewelry, and watches)
Transportation (New and used vehicles, fuel, parts, maintenance, public transport)
Medical care (Health insurance, drugs, physician services, dental services, eye care, hospital services, nursing homes etc)
Recreation and Entertainment ( Video and audio, pets, sporting goods, hobby supplies, toys, club memberships, books, and magazines etc.)
Education and Communication (Tuition, books, postage and delivery services, phones, computers, internet, etc)
Other goods and services- (personal care products, laundry, legal services, financial services, funeral expenses etc.)
The goods and services can vary from country to country.
Waiting for your views on this blog.
Anil Malik
Mumbai, India
14th November 2022