A background of Inflation

Inflation is the economic phenomenon where the purchasing power of the currency declines over a given period. The inflation rate for a year is the percentage fall in the currencyʼs purchasing power for the given year. A rise in the price level for a selected group of products and services is calculated to arrive at the inflation rate. Thus price rise and inflation are synonymous – as prices rise the currency loses its value and you end up buying lesser goods and services for the same amount of money.

What causes inflation?

Although there are different dynamics behind inflation, its primary trigger is an increase in the supply of money in the economy. Supply can be increased by the government through additional minting of currency notes, by devaluing the currency or by injecting cash into the secondary market. Three major types of inflation are,

Demand-Pull Inflation – The supply of money in the economy kindles demand in the market. With more demand for goods and services compared to the supply capacity, the price inevitably rises. With cash availability, the consumerism in the market increases while the supply is not able to cope with the demand surge.

Cost-Push Inflation – It happens when the production costs increase leading to a rise in the price of commodities. For instance, when the manufacturer concedes to the wage increase demands of the employees, they lose out a portion of their profit, provided the selling price is fixed. To restore their profit, the manufacturer would then raise the price of the final product. At a macro level, this would lead to a price rise which is triggered by an increase in the cost of production. With the price rise, the real income of the wage earners reduce, and the demand for wage increase repeats itself.

Built-in Inflation – With the price rise, workers and suppliers expect the rise to continue and demand more. This increases the cost of production and eventually the price. The cost rise-price rise cycle continues by bouncing off each other, keeping the inflation rate going up. This is known as built-in inflation.

Apart from the supply of money and the demand-supply dynamics, there are a host of factors that can influence the inflation rate of a country. Technology, for instance, has made production processes cheaper thus resulting in the lowering of prices of technology-driven products. The demography of a country like Japan is considered to be responsible for its persistent deflationary trends. Factors like the unemployment rate, saving propensity and velocity of money can influence the inflation rate.

The mechanics behind Inflation

The simple formula to calculate inflation involves the use of the price indices at the beginning and end of the period for which inflation is calculated. So the inflation rate for the year 2020 would be, (Price Index value on 31 December 2020/ Price Index value on 1 January 2020) X 100 As far as finding the price index value is concerned, three price indices are commonly used.

Consumer Price Index – A set of goods and services are selected based on their importance as basic consumer needs and the weighted average of their prices are monitored. Each of these items has its respective weightage in the consumer price index bucket and may include expense items like food, healthcare, transportation etc. The price considered is the price at which these items are available to the retail consumer. CPI is a good parameter to calculate the cost of living of a particular place or country.

Wholesale Price Index – It tracks the price of the goods and services in the pre-retail stages. The bulk prices of goods as sold from one business to another is the basis of WPI. In India, the Economic Advisor to the Ministry of Commerce and Industry releases the WPI numbers. Manufactured goods like sugar, oil, tobacco, textile, chemicals, cement etc. are considered. Non-food products considered include oil and fuel, minerals, oil seeds, while food products like cereals, paddy and wheat are included in the WPI bucket.

Producer Price Index – While CPI measures price rise from a buyerʼs point of view, PPI is measured from the sellerʼs point of view. The changes in the selling price of intermediate goods and services as purchased by the producer are the basis of PPI.

Can it be controlled?

A healthy rate of inflation need not be controlled, although regular monitoring of it continues at the policymaker level.

Deflation – This is because deflation or fall in prices is considered to be more harmful than inflation. It is the situation where demand falls due to consumer speculation that a product may be available for a cheaper price in the future. The interest rates fall as well, which discourages lending. Deflation leads to a reduction in wages, unemployment and even recession.

Stagflation – A galloping inflation can be just as damaging as deflation, if not worse. Also known as stagflation, it could result in large scale unemployment and a slowdown of the economy. Controlling this hyperinflation involves a paradoxical situation where opposite responses are required to control inflation-driven slowdown and unemployment, the two major symptoms of stagflation. When the inflation rate crosses a tolerable rate, the government can intervene to retain normalcy. It generally reduces the money flowing in the economy by reducing the bond prices. Interest rates are increased to reduce credit availability, thus limiting the money availability.

Is inflation necessary?

Economic growth is driven by consumer demand and an increase in consumption levels. Inflation helps this increase in demand and consumption. So inflation is coincidental to steady economic growth. This is particularly true in the case of an economy that has a scope of further production and growth. More demand would mean more production and accelerated economic growth. Lending and borrowing also receive a boost as borrowers are happy to repay the currency at a lesser than what it was borrowed for. This also increases spending in an inflationary economy.

Who benefits from inflation?

As a consumer, you tend to lose wealth during inflation, as the purchasing power of your money slides down. However, as an investor, you can benefit from inflation. Investors can invest in economies that are undergoing inflation and hold their investments during the inflationary period. The stocks of the products whose prices are rising will see a rise. Consequently, you will earn a higher yield, thanks to inflation.

Companies can also benefit from the surge in demand in an inflationary market. For instance, if there is a high demand for consumer durables, the producing companies can earn a higher profit by charging a higher price to cash in on the demand. Although it is not a fair practice, companies may use the option of withholding supplies to facilitate such a price rise. However, if the inflation is due to a hike in production costs, the companies can be at the receiving end of the inflationary pattern. They may have to offer products at a lower profit margin just to make sure that they maintain their market share and retain their existing customers.

In any case, a steady rate of inflation is considered to be much more desirable than plummeting deflation or an unprecedented rate of inflation. Inflation in India was at a one-year high of 7.61% in October 2020 and has risen in the first three months of 2021 from 4% to 5.5%.

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