Inflation is a measure of how rapidly prices for goods and services rise. It is among the most well-known economic terms.
Inflation may have a detrimental influence on the economy by raising costs for essential needs such as food, housing goods, medical utilities, and such, driving the country into a long phase of instability.
The Reserve Bank of India monitors fluctuations in prices and manages inflation in India through monetary policies. They do so by raising bank rates, repo rates, cash reserve ratios, purchasing dollars, managing the money supply, and credit availability.
Let’s get deeper into it to see what it is and why should we care about inflation.
What is Inflation?
Inflation is the rate at which prices increase over a specific time period. Inflation is often measured in broad terms, such as the total increase in prices or the rising cost of living in a certain country.
It could additionally be measured more precisely for specific goods, including products, or services. Inflation defines how much more costly certain types of products and services have grown over a specific time period, usually a year.
In economic terms, inflation can be described as a gradual decline in purchasing power. The average price rise of a set of specific goods and services over a certain period can demonstrate the pace at which purchasing power declines.
The increase in prices, usually defined as a percentage, signifies that a unit of money now purchasing less than it did previously.
What Causes Inflation?
A variety of factors can influence pricing or inflation in a country’s economy. In most cases, inflation is caused by a rise in the cost of production or a rise in demand for goods and services.
A supply shock is an unforeseen situation that influences the supply of a commodity, leading to an unexpected price change. Supply shocks may either be negative, causing a decrease in supply, or positive, resulting in increased supply while assuming that aggregate demand remains constant.
Inflation is frequently caused by supply shocks, which occur when a key economic input is disrupted. This is also known as cost-push inflation, which happens when prices rise due to increases in production costs, such as raw materials (such as metals, oils, and energy) and wage rates.
The demand for commodities remains unchanged, while the supply of goods decreases due to higher production costs. As a result, the increased production costs are passed on to customers as more expensive finished goods.
Inflation can be caused by an increase in the money supply. Strong customer demand for a good or service can induce demand-pull inflation. When unemployment is low and incomes are growing, consumer confidence grows, leading to increased spending.
Economic growth or expansion has a direct effect on the number of consumers spending in an economy, which can result in increased demand for goods and services, and thus a decrease in the supply of those goods occurs.
Therefore, when there is a limited supply of a product, people will pay more to acquire it. As a result, prices rise owing to demand-pull inflation.
Inflation can also be induced by an unexpected rise in the money supply. This occurs when everyone anticipates that demand will rise (due to increased money flow), and supply will rise in response. This results in a wage-price spiral.
The wage-price spiral is the vicious loop of growing wages and rising prices. Rising prices boost wage demands, which increases prices more, creating a continuous cycle of inflation. An unchecked wage-price spiral leads to widespread inflation.
Lower Unemployment Rate
Unemployment is inversely related to inflation. Therefore, when inflation rises, unemployment falls. More people working means more money to spend, which triggers a rise in demand. Prices shortly follow.
When the majority of available employees are employed, they have the potential to demand greater wages, which can cause prices to rise. And there starts a lack of enough workers to meet any additional demand.
Inflation does not frequently result from low unemployment. However, when an economy is operating near or at full capacity, then there is a contradiction between low unemployment and low inflation at minimum in the short term.
The Housing Market
Home prices will grow if real estates are in high demand due to the economy’s expansion. The demand for additional goods and services that contribute to the housing sector is also affected.
Construction items such as wood and metal, as well as nails and screws used in buildings, might also experience a spike in demand as a result of increased demand for housing.
Fiscal And Monetary Policy
Governments’ expansionary fiscal policies can boost the quantity of discretionary income available to businesses and consumers. Tax savings can be used by businesses to support capital projects, employee salaries, or new recruitment. Consumers might also buy more products.
The government can potentially encourage the economy through rising infrastructure investment. As a result, demand for products and services may rise, resulting in price hikes.
Monetary policy can spur inflation too Interest rates can be reduced by central banks’ expansionary monetary policies. Central banks, for example, the Federal Reserve, can reduce the cost of lending for banks, allowing them to lend more funding to companies and individuals.
The increased availability of money across the economy leads to increased expense and demand for services and goods.
Currency Depreciation or Devaluation
Depreciation diminishes the value of a country’s currency in comparison to other nations’ currencies. It inhibits imports because imported items become more costly as the value of the currency falls. Inflation occurs as products become increasingly costly.
Money, like every other item in the market, is subject to the rule of supply and demand. The value decreases as the supply increases. When the value of money falls, so does its purchasing power, which causes goods to become more costly.
Negative effects of inflation
Inflation is neither good nor bad. Though excessive levels of inflation might cause people to assume that the purchasing power of their money is eroding, on the other hand, the economy would find itself unable to succeed if there was no inflation at all.
Positive effects of inflation include:
- Keeps deflation under control
- It lowers debt service costs
- Increases employment
- Promotes spending and investing
- Accelerates faster economic growth in the short term
- Causes investment boosts
Now let us focus on the negative effects and why we should be worried about inflation.
The negative effects of inflation include:
Decreases Purchasing Power
This is the major and most evident consequence of inflation. A general increase in prices over time decreases customers’ purchasing power since a given quantity of money allows for gradually lesser purchases.
This reduces the standard of living for ordinary people and adds to the hardships of those who have been struggling financially. This consequently reduces savings too.
Harms Bonds & Growth Stocks
Inflation increases additionally have a negative influence on bond growth since rising interest rates cause market prices to fall, reducing the return that bonds would have had earlier when inflation was lower.
Additionally, when inflation is higher, stock investments frequently yield lower rates of return.
Increases Cost of Living
The rising cost of necessities such as food, daily basic utilities, medical services, and housing forces consumers to spend more of the money they have saved each month. This might not be a major issue for individuals whose earnings adapt to inflation, but for people with lower incomes, it represents a rise in the overall cost of living.
Raises Interest Rates
Governments and central banks both keep inflation under control. When inflation threatens to surpass a central bank’s objective, the management can increase the minimum interest rate, increasing borrowing costs throughout the economy by limiting the money supply.
Therefore, inflation and interest rates tend to rise in together. Central banks may suppress the economy’s risk tolerance, and the resulting price pressures, by boosting interest rates as inflation rises.
Can Trigger Recessions
The problem with the inflation-unemployment trade-off is that continuous acceptance of higher inflation to safeguard jobs can lead inflation expectations to escalate to the point where they trigger a spiral of inflation of price rises and pay raises.
Causes Loss Of Goods And Services
Some industries perform well during periods of inflation, particularly those in which consumers cannot avoid spending at all times, such as supermarkets, transportation, and medical services.
But, some businesses struggle during that time. This is because when inflation is high, customers utilise their money on items and services that they undoubtedly require while avoiding those that are not of much importance. This leads some goods and service businesses to suffer losses during inflation.
Why Should Everyone Be Educated on Inflation?
Inflation impacts every part of the economy & consumers, including people on fixed incomes, workers, creditors, debtors, consumer spending, company investment, and employment rates, along with government programmes, tax policies, as well as interest rates.
Understanding inflation is crucial when investing since it has the potential to lower the value of investment returns. Being educated on it is highly important to plan out future steps, investments, savings and how to handle the situation when inflation happens depending on which industry or sector of the economy you belong to.
Consumers must keep the costs of the things they buy in check, and purchase products with the greatest benefits depending on the level of inflation. In addition, they have to plan on how to secure their savings from rising costs.
People will typically prefer to reduce the amount of cash they carry to keep a greater portion of it in the bank where it can generate interest because increasing inflation results in higher interest rates.
During inflation, companies must consider how much to boost prices when the cost of production rises.
Businesses must update items where their prices show greater inflation rates, these companies would need to devote more resources to adjust prices regularly, or else their pricing would be further from their intended level after considering opponent price shifts.
The impact of inflation on future claims can be especially difficult for people who live on a fixed income, which implies an income that is established by some agreement and does not alter with economic conditions.
For example, an annual payment is usually a fixed stream of money. Fixed income is sometimes generated via retirement pensions. Inflation reduces the purchasing power of such payments.
Creditors and Debtors
A further problem produced by inflation is its unpredictable nature. It cannot be predicted the degree to which inflation will occur in the future.
Interest rates indicate what inflation is estimated to be during the duration of a loan. If inflation exceeds expectations, debtors(borrowers) benefit because they return the loan with lower-value money. If inflation is lower than predicted, creditors(lenders) benefit since the loan payback is more valued since it is more valuable money.
There are other expenses linked with tax laws, that commonly do not consider inflation, particularly when determining capital gains. Even if workers get salary increases to keep up with inflation, greater earnings might increase tax responsibilities, causing their after-tax income to fall behind.
It is critical to understand, when the price of an item rises, how that price increase relates to the amounts of other price adjustments.
If the price of a particular product rises faster than that of other products, its relative price rises, and customers will replace it for cheaper alternatives. If the price adjustment is consistent with that of other products, the relative price of the product remains unchanged and will not encourage a substitute.
The more unanticipated inflation is, the more difficult it is for consumers to estimate the relative price fluctuation of goods and, consequently, the more difficult it is for them to use their money efficiently.
Inflation might benefit homeowners who have opted into long-term, fixed mortgages. Higher interest rates sometimes drive prospective purchasers out of the real estate market, so individuals in better financial standing may gain from the declining home market.
Productivity and Efficiency
Inflation has its benefits as well. For instance, when the economy is not operating at full capacity, that implies there is underutilised labour or resources, inflation might help improve productivity.
More money means more spending, which means greater aggregated demand. Increased demand, leads to greater production to supply that need.
The purchasing power of a country’s currency usually falls against other foreign currencies when inflation is high. This frequently results in downward pressure, strengthening the value of foreign currencies relative to the inflation currencies.
Those who possess foreign money can benefit from favourable currency exchange rates and may gain from a different country’s inflation.
Individuals with tenure or in more stable positions sometimes have advantages from a weakening economy and the likelihood of a recession. People in low-demand positions or new businesses/companies are more vulnerable to corporate budget reductions.
Thus, these are some of the reasons why should everyone be educated on inflation as it affects everyone in one way or another and to be prepared for worst-case scenarios.
Inflation may be both a benefit and a burden, depending on your perspective. Certain people or organisations gain from inflationary situations, while others face increased challenges.
Governments and central banks prepare for sustainable price increases by establishing inflationary goals while consumers respond by buying when prices rise effectively. But this changes when inflation goes higher. It has the potential to reduce customers’ purchasing power.
When inflation gets out of control, governments usually raise interest rates, lower the amount of money banks must keep on deposit, and restrict the money supply which is a significant concern, as it slows economic growth, and increases the possibility of further inflation.
We should be worried about inflation, though it is easy to ignore just a small amount of price rises, the fact is that even minor levels of inflation may substantially destroy your financial stability and purchasing power over time.