What Is Inflation and How It Works

Inflation is a general rise in prices over time in an economy. When the general price level goes up, each unit of currency can buy fewer goods and services. As a result, rising inflation mean that each unit of money has less buying power. This means that the medium of exchange and unit of account in the economy has lost some of its real value.

 

Although it is simple to measure the price variations of particular products over time, human demands are not limited to just a few items. Individuals must have access to a vast array of items and services to live a comfortable life. They consist of commodities such as food grains, metal, and fuel, utilities such as power and transportation, and services such as healthcare, entertainment, and labor. Inflation tries to quantify the aggregate effect of price fluctuations on a diverse range of goods and services. It permits a single value to express the rise in the price level of goods and services in an economy over time. Inflation tries to quantify the aggregate effect of price fluctuations on a diverse range of goods and services. It permits a single value to express the rise in the price level of goods and services in an economy over time.

 

 

What Are The 3 Types Of Inflation?

 

• Cost-Push Inflation

 

Cost-push inflation happens when the prices of inputs like labor, raw materials, etc. go up, because the cost of the things that goes into making goods have gone up, and the number of these goods on the market has gone down. Even though demand stays the same, the prices of goods go up, which makes the overall price level go up. In essence, this is cost-push inflation. In this case, the overall price level goes up because the cost of production goes up, which shows up in the prices of goods and commodities that use these inputs the most. This is inflation caused by less supply also referred to as supply side bottleneck. 

 

Supply-side inflation can also be caused by things like natural disasters or the depletion of natural resources, monopolies, government regulations or taxes, changes in exchange rates, etc. Most of the time, cost-push inflation happens when the demand curve is inelastic, which means that the demand can’t easily change as prices go up. For example when oil prices go up.

 

• Demand-Push Inflation

 

When aggregate demand exceeds aggregate supply for an item or service, demand-pull inflation exists. The first step is an increase in consumer demand. The rise in supply matches the growth in demand. When more supply is scarce, however, merchants raise their prices. The result is demand-pull inflation, sometimes known as “price inflation.”

 

• Build-in Inflation

When there is a spike in the prices of goods and services, labor expects and demands higher costs and wages to maintain their standard of living. This spirals into further price increases for commodities, resulting in inflation.

 

Related Article: Inflation & Real Returns

 

What Causes Inflation?

 

• Expanding Economy

 

When families are confident, they spend more as opposed to saving. They anticipate salary increases and promotions. They are confident that the value of their homes and other investments will rise. They believe that the government is appropriately guiding the economy. Additionally, they will borrow more, whether through vehicle loans or home loans, or credit cards. If they refrain from borrowing excessively, this is a healthy cause of inflation. It results in gradual and consistent price hikes.

 

• Expectation of Inflation

 

Once people anticipate inflation, they will purchase goods now to avoid higher prices in the future. This raises demand, resulting in demand-pull inflation. Once the anticipation of inflation takes hold, it is difficult to eliminate.

 

• Expansionary Monetary Policy

 

When there are too many rupees chasing too few products. This happens when the government and the reserve bank of India print excessive amounts of money. This is done to repay its debts. The basic cause of hyperinflation is a surplus of currency. It may also arise if the RBI provides an excessive amount of credit to the banking system at a low-interest rate.

 

• Fiscal Policy

 

Keynesian economic theory says that when the government spends, demand goes up. For example, spending on the military drives up the price of military equipment. When the government lowers taxes, it also makes more people want to buy. Consumers have more money to spend on goods and services that they don’t have to. When that goes up faster than the supply, inflation happens. For instance, lower tax rates boost consumer spending.

 

• Monopoly

 

Cost-push inflation can be caused by monopolistic firms in an industry. Monopolies decrease supply to maximize profits. The Organization of Petroleum Exporting Countries (OPEC) is a prime example of a group that sought exclusive control over oil pricing. Prior to the formation of OPEC, its members engaged in price competition with one another. They were not compensated enough for a non-renewable natural resource. OPEC the member nations held almost 80% of the world’s proven oil reserves. We are currently experiencing the brunt of high oil prices in our pockets.

 

• Natural Disasters

 

The depletion of natural resources is a type of natural disaster. It has the same effect, by limiting supply and causing inflation in the short term. For example, Covid 19 pandemic disrupted the global supply chain which resulted in high prices of computer chips, electronics, pharmaceutical products, etc.

 

• Government Regulation

 

These regulations can decrease the supply of numerous products. For instance,  The purpose of high tobacco and alcohol taxes was to reduce demand for these unhealthy items.

 

• Exchange Rate

 

A country that allows a drop in the value of its currency relative to a foreign currency (devaluation) will incur greater import costs, which will lead to an increase in the overall price level.

 

What Happens When Inflation Goes Up?

 

Positive Impact:

 

• Increased Profit for Producer

 

In most situations, inflation is beneficial to producers. They earn more money because they may charge higher prices for their goods.

 

• Increased Investment Returns

 

During periods of inflation, investors and business owners are provided with additional incentives to participate in productive endeavors. Consequently, they get greater profits.

 

• Increase in Production Output

 

When producers obtain adequate investment, they generate a greater quantity of goods and services. As a result, inflation increases the production of goods and services.

 

• Increased Employment

 

As output increases, so does the need for labor and other production components. Consequently, employment and income increase as a result of inflation.

 

• Shareholders Income Increases

If a company’s profits rise due to inflation, it may distribute dividends to its shareholders. As a result, dividend income for shareholders may grow during periods of inflation.

 

• Borrowers’ Advantages

 

Money loses some of its purchasing power due to inflation. As a result, the borrower gains from the process if the interest rate he pays is lower than the rate of inflation. This is because the amount that the borrower returned was worth less than the amount that was borrowed.

 

• Government Tax Revenue Improves

 

As the price of goods and services grows, individuals must pay more ad valorem indirect taxes (on value). As individuals move into higher tax brackets, their direct taxes increase (but not in actual terms), a phenomenon known as bracket creep.

 

Due to a delay in tax collection, the government’s tax revenue increases, but the real value does not keep pace with the current rate of inflation.

 

Negative Impact

 

• Purchasing Power erosion

 

The purchasing power of an individual’s income represents his or her genuine income. Real Income is defined as money income divided by price level. As a result, those with fixed incomes, such as pensioners and salaried employees, will experience a decline in real income, or to put it another way, they will have less spending power.

 

• Income Disparity

 

Inflation increases profits for business owners and entrepreneurs. On the other hand, those in fixed-income groups experience a decline in real income. As a result, during this time, there is an increase in income disparity.

 

• Disturbs The Planning Process

 

Prices for goods, raw materials, and factor services increase as a result of inflation. As a result, any investment projects started during the period will cost the government extra money to execute. Planning as a whole is disrupted if the government is unable to increase its financial resources through taxation or savings.

 

• Increase In Speculative Investment

 

Assume that prices are rising alarmingly quickly. How much prices will increase in the coming weeks or months is unknown to the public. In such circumstances, many start making speculative investments. They might start investing only in shares, diamonds, real estate, and other such items. The goal of doing this is to make rapid money. Such investments don’t help the economy build any new productive capital.

 

• Impact On Capital Accumulation

 

Assume that price increases become a recurrent characteristic of an economy. People begin to choose objects over money during these periods since the future worth of the money will decline. In addition, individuals begin to favor immediate consumption above consumption in the future. Consequently, the desire to save begins to weaken. As people’s inclination and capacity to save diminishes, so does the amount of available capital for additional investment. As a result, the effect on the economy’s capital accumulation is negative, as capital accumulation is dependent on investment growth.

 

• Impact on Lenders

 

Borrowers benefit when inflation has a beneficial impact. Consequently, lenders risk losing money during these periods. This is because the amount they get has less purchasing power than the amount they borrowed.

 

• Rupee May Depreciate

 

Due to a decrease in purchasing power parity, the demand for the rupee rises, causing the Indian rupee to depreciate. This will benefit exporters at the expense of importers.

 

• Poverty

 

High inflation tends to exacerbate inequality and poverty because it has a greater impact on the income and savings of low and middle-income households than on those of wealthy households. By increasing inflation, households that have just left poverty may be pushed back into it.

 

Who Benefits From Inflation?

 

While individuals don’t benefit much from inflation, investors can profit if they have investments in markets where inflation is a factor. For instance, if energy costs are rising, investors in energy businesses may experience a boost in the value of their stocks. If they can raise the price of their products in response to a spike in demand, some businesses profit from inflation. Building businesses can charge more for selling homes when the economy is doing well and there is a great demand for housing.

 

Inflation can therefore give companies more pricing power and boost their profit margins. If profit margins are increasing, this indicates that product prices are rising faster than increases in production costs.

 

What Measures Can You Take To Limit The Effect Of Inflation?

 

• Stock Market

 

Typically, stock returns outperform inflation rates. Taking into account the rising costs of goods and services might result in increased earnings for businesses. Better prices result in increased share prices. Occasionally, this may not be the case, but historically, the stock market investment has delivered returns that are above inflation.

 

• Equity Mutual Funds

 

For many investors, it can be challenging to track daily changes in the market or certain equities. After deciding which mutual fund seems to be most suited to their particular needs and aspirations, they can invest in equities mutual funds. Equity mutual funds come in a variety of subcategories that can accommodate different types of investors’ needs. There are a variety of equity funds available, including sectoral, market capitalization-based, investing strategy-based, tax-saving, and more. Historically, top equity funds have consistently maintained returns above the inflation rate.

 

• Gold

 

Indians have historically invested in gold since doing so does not require market expertise. People view gold as a secure hedge against the cyclical volatility of the stock market. It is regarded as an effective inflation hedge because its price increase has been able to balance inflation. To conclude, When inflation rises, the demand for gold increases.

 

Gold is a commodity and not an asset. According to research by the World Gold Council, for every 1 percent increase in inflation, gold demand increases by 2.6%, and an increase in demand leads to a price increase.

 

• Real Estate

 

In India, real estate investments have outperformed inflation, although they demand a substantial amount of capital, typically in lakhs or crores. In most instances, investors must account for the interest they pay on home-buying loans. Since the value of real estate is greatly dependent on the geography of the place, it typically generates a greater return than inflation.

 

According to the House Price Index compiled by the RBI from real estate prices in ten cities, the average return on real estate owners over the past ten years has been approximately 11.6%. (as of Oct 2020). This is the national average rate of return. Realistically, returns may vary from city to city due to differences in property prices.

 

• Real Estate Investment Trusts (REIT)

 

REITs are available to investors who find it difficult to invest in real estate because of its high capital requirements. Real estate investment trusts (REITs) are corporations that own and/or manage properties such as apartment complexes, office buildings, retail malls, and warehouses. They are a collection of real estate that pays investors dividends.

 

When inflation increases, property prices and rental revenue also increase. REITs perform well during periods of inflation due to their capacity to increase rents and then distribute the additional money to shareholders.

 

A downside of REITs is their vulnerability to the market for other high-yield assets. Treasury assets are typically more desirable as interest rates rise. This can divert capital away from REITs, hence decreasing their share prices. REITs must also pay property taxes, which is an additional expense.

 

• Inflation-Indexed Bonds

 

Inflation-indexed bonds are among the safest and most efficient strategies to hedge against inflation. Inflation-indexed bonds are one of the numerous types of government bonds issued by the RBI. The principal amount of this bond is modified to reflect changes in inflation, and interest is paid on the adjusted principal.

 

FAQs

 

• How does high inflation affect money?

 

Inflation erodes the average person’s purchasing power. It is one of the main factors that reduce the value of your money over time. It means that the money you have at the beginning of the year has a lesser value at the end of the year in terms of purchasing goods and services.

 

• Is debt good during inflation?

 

Money loses some of its purchasing power due to inflation. As a result, the borrower gains from the process if the interest rate he pays is lower than the rate of inflation. 

 

• What are the three negative effects of inflation?

 

Three negative effects are as follows:

 

• • Higher Interest Rates: Long-term inflation results in higher interest rates. When the government raises the money supply, the increased availability of money initially reduces interest rates. However, higher equilibrium prices and a decrease in the purchasing power of money owing to an increase in the money supply prompt banks and other financial institutions to boost interest rates to compensate for the loss of purchasing power. Increased long-term interest rates discourage company borrowing, resulting in reduced investment in capital goods and technology.

 

• • Lower Exports: Foreign nations will be less inclined to purchase our goods if their prices are increased. This will result in decreased exports, decreased productivity, and increased unemployment in our nation.

 

• • Lower Savings: Inflation promotes consumption rather than saving. Higher prices motivate consumers to buy more things now before they become more expensive in the future.

 

• How to calculate the inflation rate?

 

CPI is used to calculate inflation. CPI estimates the price change of goods and services by averaging their weighted average prices.

 

CPI = (Cost of the Fixed Basket of Goods and Services in the Current Year / Cost of the Fixed Basket of Goods and Services in the Base Year) *100

 

After calculating the CPI for the two years, inflation may be estimated using the formula.

 

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