Inflation is a term that frequently surfaces in discussions about the economy and personal finances. It plays a significant role in shaping the purchasing power of individuals and businesses alike. In this blog, we will explore what inflation is, how it is calculated, the different types of inflation, historical inflation rates in India, and most importantly, how inflation can harm the finances of average individuals.
Understanding these aspects will empower you to make informed decisions to mitigate the adverse effects of inflation on your financial well-being.
What is Inflation and How is it Calculated?
Inflation refers to the sustained increase in the general price level of goods and services over time. In simple terms, it means that the purchasing power of money decreases as prices rise. When inflation occurs, each unit of currency buys fewer goods and services than it previously did.
Calculating Inflation
Inflation is calculated using various economic indicators, with the Consumer Price Index (CPI) being the most commonly used measure. The CPI tracks the average price changes of a basket of goods and services consumed by households. By comparing the CPI over different time periods, economists can determine the rate of inflation.
The Consumer Price Index (CPI) is calculated using a formula that compares the current prices of a basket of goods and services to their prices during a base period.
By tracking changes in the CPI over different time periods, economists and policymakers can gauge the rate of inflation and make informed decisions regarding economic policies and adjustments to wages, benefits, and government assistance programs.
Types of Inflation
- Demand-Pull Inflation: This occurs when aggregate demand in the economy outpaces the supply of goods and services, leading to upward pressure on prices. Demand-Pull Inflation. It is driven by factors like increased consumer spending, expansionary fiscal policies, or excess money supply. Businesses struggle to meet high demand, resulting in price increases.
- Cost-Push Inflation: Arising from increased production costs, such as higher wages or raw material prices, cost-push inflation results in businesses passing on these costs to consumers through higher prices. Factors like energy price hikes, government regulations, or supply chain disruptions can trigger cost-push inflation.
- Built-in Inflation: This type of inflation occurs when workers and businesses expect prices to rise and adjust their wages and prices accordingly, leading to a self-perpetuating cycle of price increases. Workers and businesses expect future inflation and negotiate higher wages and prices, leading to an upward spiral. This results in higher production costs, wages, and prices.
- Hyperinflation: Extreme and rapid inflation, typically occurring in times of economic instability, causing prices to skyrocket and rendering money almost worthless.
- Stagflation: Stagflation refers to a challenging situation of stagnant economic growth, high unemployment, and inflationary pressures. It poses difficulties for policymakers as traditional measures to stimulate growth may worsen inflation.
- Disinflation: Disinflation signifies a decrease in the rate of inflation. While prices continue to rise, the pace slows compared to the past. Disinflation brings relief from rapid price increases but differs from deflation, where overall prices decline.
Historical Inflation Rates in India
India has experienced varying levels of inflation over the years. In recent history, the average inflation rate in India has hovered around 5-6%. However, there have been periods of higher inflation, such as in 2013 when it peaked at around 10%, and periods of relatively lower inflation, like in 2015 when it dipped below 5%.
The Indian government sets the inflation target in coordination with the Reserve Bank of India (RBI). While the government establishes the target every five years, the responsibility for managing inflation through monetary policies rests with the RBI.
Inflation is the reverse of compound interest, like de-compound interest. Although each year’s inflation is increased from the previous year’s inflation, the impact is similar to compound interest. Consider the following scenario: you invest Rs.1 lakh in a deposit that earns you 8% per year. At the same time, prices are rising significantly at an annual pace of 8%. In this case, your compounding returns will keep up with inflation.
How Inflation Harms Average People’s Finances ?
Inflation can have several adverse effects on the finances of average individuals:
- Reduced Purchasing Power: As prices rise, the value of money diminishes, meaning individuals can buy fewer goods and services with the same amount of money. This can erode savings and impact the standard of living.
- Increased Cost of Living: Rising prices for essential goods and services, such as housing, food, healthcare, and education, can strain household budgets, particularly for those with fixed incomes or limited financial resources.
- Eroded Savings: Inflation diminishes the value of savings over time. If the rate of inflation exceeds the interest earned on savings, the purchasing power of those savings decreases.
- Impact on Investments: Inflation can erode the real returns on investments. If investment returns fail to outpace inflation, the actual value of investments may decline.
- Uncertainty and Planning Challenges: High inflation rates introduce uncertainty into financial planning, making it challenging to set realistic goals and anticipate future expenses accurately.
Example: Let’s say John, an average salaried individual, receives an annual salary increase of 5%. However, during the same period, inflation is running at 6%. While John’s nominal salary has increased, his purchasing power has actually decreased. His expenses on groceries, rent, and other goods and services have risen more than his income, putting a strain on his financial situation.
How do you prepare for it?
One reason many people don’t deposit all of their money in the bank is that inflation might diminish the value of those savings over time. As a result, some people prefer to keep some of their money in potentially higher-growth investments such as equities or mutual funds because these investments earn more per year than the inflation rate on average (although they also carry a risk of lower earnings or loss).
How can it impact your savings?
Inflation can lessen the value of your savings over time because prices usually rise in the future. It is self-evident when dealing with cash. If you keep $10,000 under your bed, that money may not be worth as much in 20 years. While you haven’t lost money, your net worth has decreased due to inflation eroding your purchasing power.
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