Inflation

Inflation is a measure of the change in the price level. It is the rate at which prices change, typically expressed as a yearly percentage increase.

Inflation can be caused by supply and demand changes or by government policies. Inflation causes a loss of purchasing power for consumers who hold fixed incomes (such as pensions) and investors who have fixed-income assets such as bonds.

The effects of inflation on investments are that the purchasing power of an investor’s money decreases over time, causing their real investment to shrink. This means it takes more money to buy the same goods and services.

Moderate inflation is associated with economic growth, while high inflation can signal an overheated economy.

As an economy grows, businesses and consumers spend more money on goods and services. In the growth stage of an economic cycle, demand typically outstrips the supply of goods, and producers can raise their prices. As a result, the cost of goods and services rises and creates increasing inflation. If economic growth accelerates rapidly, demand grows faster than producers keep raising prices continuously. As a result, fast-moving upward prices, sometimes called “runaway inflation” or “hyperinflation,” could also occur.

During inflation, money loses value over time. It happens constantly; things become more expensive than they were a few years ago.

Example of Inflation

To see it happening, think about what you could buy with Rs 1,000 over the past few years.

We’ll look at it in terms of household items:

• 2010: Rs 1,000 = 5 Kg basket of items
• 2015: Rs 1,000 = 3 Kg basket of items
• 2020: Rs 1,000 = 2 Kg basket of items
• 2022: Rs 1,000 = 1.5 Kg basket of items

So, Rs 1,000 could buy much less in 20222 than in 2010, and it’s possible that it would buy even much less in another ten years. This is due to inflation. This also reflects the “purchasing power” of money. Rising inflation reduces the purchasing power of money.

Types of Inflation

The reasons for inflation depend on supply and demand. Depending on the type of inflation, changes in supply or demand could increase the price level of goods and services. The main types of inflation are:-

Cost-push Inflation

Economists describe cost-push inflation as when the supply of goods or services is limited, but demand remains the same, pushing prices. For example, the increased cost of labor or raw materials leads to decreased supply of these goods. While demand remains constant, the prices of commodities increase, and this causes a rise in the overall price level.

The most common example of cost-push inflation occurs in the energy sector – oil and natural gas prices. However, it may happen in other products also. For example, floods and natural disasters also cause cost-push inflation, leading to the shutdown of manufacturing units.

Demand-pull Inflation

Demand-pull inflation is the tendency of prices to increase due to increasing aggregate demand, or the number of goods and services that the entire population buys. This type of inflation is usually associated with a strong economy.

As an economy strengthens, employment tends to rise. As more people work, they make more money and spend more money. However, if goods are limited when people are willing to spend more money, competition among consumers drives prices up. Economists often refer to this type of inflation as “too much money chasing too few goods.”

Demand-pull inflation is not limited to the consumer sector of the economy. We get a similar outcome if the government puts more money into circulation or a low-interest-rate environment encourages too much borrowing.

How is Inflation Measured?

There are several regularly reported measures of inflation that investors can use to track inflation.

The Wholesale Price Index (WPI) and Consumer price index (CPI) are the two primary measures of inflation.

WPI index reflects average price changes of goods bought and sold in the wholesale market. The Office of Economic Adviser publishes WPI in India under the Ministry of Commerce and Industry.
The commodities considered for computing the WPI could be categorized into the primary article, fuel and power, and manufactured goods.

CPI is measured by computing a weighted average on a particular set of household goods and services, for example, food items, telecom services, transportation services, medical facilities, and similar items. The computation of CPI considers price changes and the actual inflation that affects an end consumer.

What is the difference between WPI and CPI inflation?

While WPI keeps track of the wholesale price of goods, the CPI measures the average price households pay for a basket of goods and services. Even as the WPI is used as a critical measure of inflation in some economies, it is no longer used in India for policy purposes, including setting repo rates.

Instead, the central bank, i.e., RBI, uses CPI, or retail inflation, as a critical measure of inflation to assess the monetary and credit policy.

The Effects of Inflation in Different Sectors

Inflation is the increase in the prices of goods and services. It is a significant economic phenomenon that can affect different sectors. Inflation is suitable for some industries but not so good for others.

The impact of inflation on different sectors is not always the same. For example, it has a different effect on the production sector and financial sector. Inflation causes an increase in demand for goods and services, which leads to a rise in price levels. This results in higher production costs and higher prices of goods and services, often leading to lower demand for these products or even their discontinuation.

Financial services are one of the sectors that can be negatively affected by inflation. Inflation has many effects on financial services, but the most important is its impact on interest rates. If you are an investor who wants to earn a return on your money, then you might want to consider investing in bonds or fixed-income securities like pension plans which do not fluctuate with inflation.

Inflation hurts the education sector. It makes education costly and sometimes unaffordable to an ordinary person. It increases college tuition fees, cost of books, travel related to schooling, miscellaneous expenses, etc.

How does Inflation Affect Borrowing, Saving, and Investing?

Interest is the price of money. During high inflation, interest rates for a new car, home loans, and credit cards rise. Even though nominal interest rates for savers rise as well, the increases do not provide “real” gains if the inflation rate is higher than the interest rate on savings accounts or certificates of deposit.

Intelligent investors recognize that the risk of inflation is higher for long-term lending, e.g., 5 or 20 years than for short-term borrowings, such as one year because the likelihood of error when estimating inflation increases when a long period is involved. Therefore, long-term interest rates are generally higher than short-term interest rates.

Suppose, if inflation is at 5 percent annually, a rupee of profit that a company will earn a year from now would be worth only 95 paise at today’s prices. If inflation were only 2 percent, that rupee would be worth 98 paise today. Such differences add up over many years. Throughout your financial life, you may need to factor in the impact of inflation on your financial decisions to avoid its adverse effects.

Conclusion: Dealing with The Realities of Inflation

Inflation is a reality of life. It comes in many forms, be it the cost of living, the price of goods, or even the value of your investments.

It is essential to understand how inflation can affect your life and investments. When you have a lot of money, you may feel inflation is not a big deal. However, it can be a huge problem when you don’t have much money, or existing monetary resources start devaluing due to rising inflation.

The best way to deal with inflation is to plan and ensure you have enough funds for your future needs. This is true whether you are an individual or a business owner.