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Inflation – What, Why and How? Unraveling the Mystery

INFLATION.

Everyone has heard about inflation. From what everyone has heard, it really seems to be a devil. It is responsible (we think) for increased cost of living, for a decrease in our real income, decrease in value of our investments, for bad Indo-Pakistan relations…

OK. I made up the last one – Inflation cannot be blamed for bad relations between India and Pakistan!

My point is – we tend to blame inflation for this and that, when all we are doing is to shoot the messenger. Everyone likes to speak about the ills of inflation, when very few actually understand what inflation is. Inflation is NOT, repeat, NOT a bad thing in itself.

It is just a manifestation, an outer sign, so to speak, of something that can be bad (or not), depending on a number of factors. So, what does that mean?

Before we proceed further, let me ask you a question – What is the current inflation, or more correctly, the rate of inflation, in India? Newspapers tell that the rate of inflation in February 2010 was about 9.9%. Is that very high? What about 5.5%? Will that be good enough? What about 0%? Will that be the best situation? Common wisdom would suggest yes, though economics, not surprisingly, says no! Economics even goes to the extent of saying that ‘some amount’ of inflation is actually good for economy! Howzzat!!

Inflation - An Increase in Prices

Inflation - An Increase in Prices

What is Inflation?

At its simplest, inflation is

i) an increase ( an upward movement, it should be positive. Deflation results when the rate becomes negative, that is, falls below zero)

ii) in the general level of prices (measured by CPI – Consumer Price Index, or COLI – Cost of Living Index)

iii) of goods and services

iv) in a particular economy (Indian, US, Chinese and so on..)

v) over a defined period of time. (Mothly/Weekly/Annual)

It can also be understood as an erosion in the purchasing power of money. With an increase in the rate of inflation, the purchasing power of money is reduced further.

Very Important Fact – When the rate of inflation decreases, it does NOT mean that things are becoming cheaper, it only means that they are getting more expensive at a LESSER rate. Conversely, when inflation rate increases, it simply means that things are becoming expensive at a FASTER rate. This is a VERY crucial fact in understanding inflation.

Causes of Inflation

Now, for the most important part – the causes of inflation. So what are the culprits behind the devil, that is, inflation?  Here are some of them -

  1. Too much money chasing too few goods – This is actually a ‘super cause’, as it explains a number of causes simultaneously. For example, if the wages of every worker (blue collar/white collar/every-other-color collar) is increased by, say, 20% tomorrow morning, what do you think will happen? Some will want to purchase new refrigerators, some will want new houses, while some will need new cars. Production will take some time, so what happens in between? The ‘demand vs supply’ equation will come into play, with an increase in prices of things demanded. Yes, you guessed it right – that is inflation! This also explains a popular fantasy – why doesn’t the government simply print more money, and make everyone rich? Because that will mean excess money in system – without a corresponding increase in the amount of goods produced or services rendered. In other words, you have to work before you will get paid anything. What a revelation!
  2. Increase in Production Costs – Let us take the above example once again. The workers demand a wage increase, and actually get it. This means that the labor cost per unit will increase for the manufacturer, and you can trust that it will be passed to the ultimate consumer. The customers will have to shell out more to purchase the same amount of goods, leading to inflation in prices.
  3. Taxation – Indirect taxation, such as VAT, sales tax, excise tax etc, has the effect of increasing the cost of goods for the eventual consumers, leading to increased inflation. On the other hand, a decrease in Income Tax rate will mean more disposable income for consumers – again leading to higher inflation.
  4. Increase in Price of Imported Raw Materials – The best example for India would be petroleum – almost all of our requirement in petroleum is imported. An increase in prices, as during the summer of 2008, can really accelerate inflation in India.
  5. Depreciation in Exchange Rates – This increases the price of imports into the country, and decreases the price of exports abroad.
  6. Decrease in Interest Rates – This leads to an increase in money supply, leading to inflationary pressure. In other words, the monetary policies adopted by the RBI can affect inflation rates, at least to a certain extent
  7. Rapid Economic Growth – Especially if take place in the markets to which the country exports.money

How is Inflation Measured?

So how is the inflation measured? When we say that the current inflation rate is 9.9%, then 9.9% of WHAT?

Inflation is measured by using the CPI – Consumer Price Index. The CPI consists of an index comprising the goods ‘used by an average customer’. The CPI figure at the beginning of the period is taken, then the CPI figure at the end of period is taken, and then the percentage change is calculated. This gives the rate of inflation.

For example,

CPI figure on March 1 = 100

CPI figure on March 7 = 110

Rate of inflation for the week ended March 7 = (110-100) / 100

= 10%

Now, this gives a lot of legroom to the government to ‘manage’ the rate of inflation. How? Simple – it can simply change, and it does change, the basket of goods used by the consumer. For example, the basket of goods, as defined by the Indian government, comprise of ‘vanaspati ghee’. Now, how many people are still using vanaspati ghee? Not many.

Effects of Inflation -

The following are the effects of inflation -

  • Increase in prices of goods and services – the most visible effect for the general public.
  • Decrease in real income.
  • It encourages hoarding – as people anticipate further increase in prices.
  • Decrease in the value of investments – especially affecting people with fixed income – such as pensioners.
  • It can lead to a wage spiral – people will demand higher wages to cope with increased prices, and increased wages will push the prices further up.
  • Lowers the domestic saving rate – since people prefer to spend the money rather than watch it diminish in value.
  • When inflation becomes very acute, hyperinflation may result – a very dangerous situation for the economy.

Well, there is a twist in the tail – inflation has some positive effects too. What? Inflation? Positive effects? Well, here they are -

  • Relief from Debt – If you had taken a loan at a fixed rate of interest, you will continue to pay the same interest to your creditor, with the result that the real rate of interest, that is, the nominal rate minus the inflation rate, will decrease.
  • Increase in Investments – Also known as the Tobin Effect – when people realize that money decreases in value, and it would be better if it is invested in an asset which can yield higher income – such as real capital assets.

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5 Responses

  1. when the GDP is growing at a rate of 6.5% then the prices should at least get controlled rather than getting inflated ?

  2. Thanks for the good article.

  3. It was a very indebth article….

  4. Hi Anita,

    Well, fiscal deficit is often linked to high inflation, but that may not always be the case. If the public expenditure results into a substantial increase in production, there would be little, or none, imbalance between money supply and production – that means modest inflation, or very little. For example, during the last few years, the fiscal deficit in India has been climbing very high every year, while the inflation remained within 5-8% for a very long time. This was made possible by real economic growth over the last many years.

    But yes, in India there is always a chance of public expenditure not being very productive, and leading to some inflationary effect.

  5. Inflation is a neccessary evil in developing economies like India, where fiscal/budgetary deficit is one big cause of inflation. But fiscal deficit is an essential till a country has developed all it’s basic infrastuctural requirements upto a certain (take-off) standard.Besides, there is lot of corruption too in our country leading to undue pressure on the economy.It is a tricky situation for the government to manage the fiscal deficit, corruption, global rise in prices, all together.Every effort has to be made to check a situation of run-away inflation.The world has learnt many lessons from the great depression of the 1930s.