Inflation is a way to measure the rate of increase in the price of goods and services, which gradually increases with time. You cannot buy goods and services of the same value with the same amount of money due to inflation. The primary cause of inflation is the devaluation of money. Devaluation of money refers to the phenomenon where money’s purchasing power diminishes. For example, Rs.100 could buy you ten apples ten years ago, but the same amount can only buy you two or three today.
There are two primary ways in which inflation works. The first is when the price of goods and services goes up due to any reason. The second is when the supply cost of a product or service increases. Let us take the example of an apple to understand this better. There are two ways the price of apple could increase – it could increase due to the price hike of the product (apple) itself or due to the transportation charge of the same.
Governments and a nation’s central bank are equipped with the duty of trying to control inflation. This is because a higher rate of inflation could cause economic tensions and make lives easier for the public. The authorities use five main methods to control inflation, including monetary policy, money supply control, etc.
Governments often hike interest rate to control inflation. Due to higher interest costs, people tend to spend less when debt becomes costlier. Lesser spending leads to lesser inflation. Experts believe that curbing the supply of money can curb inflation to an extent. Hence, money supply changes are a way governments try to control inflation. But money supply changes are rarely used as they could also have other effects on the market.
The government may introduce policies that increase competitiveness in the market. The companies will be forced to price competitively when there is stronger competition. Competitive prices can lead to lower inflation rates.
Governments could also tinker with the income tax rates to control inflation. A higher income tax rate could stop people from spending more. But increasing income tax could have adverse effects, and hence, the step is rarely used.
Price control is another method governments can use. The idea of price control is that the government will have set prices for each commodity, and the suppliers and sellers will have to follow that. Price control is an adverse measure, but it can control inflation rates.
What is Inflation?
Inflation is the change of price or the decrease in purchasing power of money over a certain period of time. The inflation rate is usually measured on a yearly basis. The inflation rate of a country can also be defined as the rate of devaluation of a country’s currency on a yearly basis. One of the primary causes of the devaluation of the currency of a country is the increase in the Consumer Price Index (CPI). The consumer price index is a scale that tracks the increase in the price of goods in a country. Inflation rises when the consumer price index rises.
The effects of inflation primarily affect the commoners. People will be able to only purchase a smaller amount of goods with the same amount of money. Moreover, higher prices will lead to higher spending. Higher spending can decrease the amount of savings commoners have. Higher spending can affect both current savings and people’s savings plans as well.
Consumerism will also decrease due to inflation. People will only buy goods that they require when the price is higher. Decreased purchases can lead to the wastage of goods and loss of business for companies.
How does inflation work?
The basic principle of inflation is related to the theory of supply and demand. The price of goods and services increases when the demand is higher and supply is unable to cope with the increased demand. Similarly, when more goods and services are supplied by the economy than people want or need, the price tends to fall.
Inflation is measured by a scale called the inflation index. It might get difficult to track the price changes of an economy individually, and the inflation index helps here as it tracks the price of top goods and services. The inflation index is helpful in identifying how much is the rise in inflation every year.
What are the causes of inflation?
Inflation is the general rise in the price of goods and services in the economy. Inflation can be caused by several economic factors.
The various causes of inflation are given below,
Devaluation is a downward adjustment of the value of a country’s money relative to a foreign currency or standard. The trade imbalance is the main reason why countries devalue their currency.Countires lower the cost of a country’s exports using devaluation, ultimately making it more competitive globally.
For example, if a government needs to pay Rupees4 million each month in interest on its current debt, nominal interest payments will decrease if it devalues its currency. For example, The interest payment in real dollars is only Rupees2 million, if the currency’s value is devalued by half
2. Cost-push Inflation
Cost inflation is a type of inflation that is caused by increases in the price of labor and materials throughout the supply chain. When cost inflation occurs, it causes the prices of goods and services to rise, resulting in a decrease in supply. As a result, cost inflation can lead to lower economic growth and often causes a decline in living standards.
For example, during the oil crisis example of the 1970s, OPEC countries increased the price of oil while the demand for the commodity remained the same. The cost of finished products rose as the prices continued to rise, leading to inflation.
3. Demand-pull Inflation
Demand-driven inflation is a type of inflation that occurs when there is an increase in demand for goods and services. Demand-driven inflation is caused by overall economic growth, technological innovation, etc. Demand-driven inflation may increase jobs and stimulate the economy, but it drives up commodity prices.
For example, some mainstream companies create intensive brand royalties through highly effective marketing campaigns. These royalty campaigns lead to high demand for their products and allow the company to charge a higher than the market rate for their products.
4. Rising wages
An increase in wages results in an overall increase in the price of goods. Employers must raise the prices they charge for the goods and services they provide in order to maintain a profit after wage increases. Rising wages and the resulting price increases create a circular effect on wages, as higher wages will be needed to offset the increased prices of goods and services.
For example, the company must pay its employees Rupees 20 if the state raises the minimum wage from Rupees 5 to Rupees 20. But now the company’s cost of producing goods and services has increased because of the labor price increase. The firm has to increase the prices of its products in the market, and this could slowly lead to inflation in order to compensate for the increase in costs.
5. Policies and regulations
Some policies can also cause inflation. The demand for products increases when the government issues tax subsidies. Costs may increase if demand is more significant than supply. Strict building codes and even rent stabilization policies could create an inflationary environment through the increase in costs and will pass those costs on to residents or artificially reduce the housing supply.
An example of policies and regulations is monetary policy. Inflation occurs either because the Federal Reserve sets the interest rate too low or because it increases money growth too quickly.
6. Increased money supply
The money supply is defined as the total amount of money in circulation, which includes cash, coins, balances, and bank accounts, according to the Federal Reserve System. It can result in inflation if the money supply grows faster than the rate of production. For example, imagine an economy with 100 dollars and 100 apples. If everyone took their money and bought all the apples, the average price per apple would be Rupees1. Now imagine that the government increased the money supply by 10% to Rupees110, but this fictitious economy could only increase apple production by 5% to 105 apples. Since the amount of money has increased more than the number of apples, the average price of an apple has now increased to about Rupees1.05.
What is an example of Inflation?
The most evident example of inflation is the price rise of everyday groceries. An example of this is the price of wheat. Economic times reported that the price of wheat rose more than 21% rise in wheat in the financial year 2023.
The petrol price hike is another example. The petrol price hike has also caused an increase in several commodities that depend on transportation.
We can take an example from the U.S. to understand how much inflation has affected in the longer time frame. A gallon of milk cost approximately 36 cents in 1913. A gallon of milk cost $3.53 in 2013, roughly ten times more than it did one hundred years earlier.
How to calculate inflation?
There is no fixed scale that measures the amount of inflation in an economy. Consumer Price Index (CPI) is one of the scales that give you a better idea about inflation, though. The CPI takes the price of certain goods and services, similar to how a stock index lists the top stocks and calculates the average price change of the same.
CPI can be used to calculate inflation levels of certain specific periods. For example, the difference between the CPI of this year and last year will show the inflation rate of the current year. The difference between last year’s CPI and this year’s CPI is then expressed in percentage terms. Below is the equation used for the same
Inflation = (consumer price index of the current year – consumer price index of the current year) / consumer price index of the current year
Let us see how you can calculate the inflation rate using the equation.
Step 1: The first step is to pick the goods and services for those price hikes you want to gauge. For example, it could be groceries, fruits, or even electronics. Once the choice is made, find the CPI of the same. CPI data is available on multiple online resources, including government websites.
Step 2: Specify the years you want to calculate the change for. For instance, you may select the current year and the past year if you want to know the data for the past year. Similarly, you can select the current year and the fifth year before if you want to know the inflation rate of the selected items in the past five years.
Step 5: Apply the equation
(Inflation = (consumer price index of the current year – consumer price index of the current year) / consumer price index of the current year
) to the values found, and you will have your rate of inflation calculated.
It is important to ensure that you use accurate data while calculating inflation using CPI data. Ensure you take the equation from government sites for best rests.
What are the effects of inflation on the economy?
Inflation has both positive and negative effects on the economy. The flow of money in the economy is affected by inflation since the price of goods and services tends to increase more than usual. When the flow of money is disrupted, the economy suffers as businesses incur more costs and consumers are left with lesser money to spend.
Inflation can affect a person’s income due to unemployment. Businesses tend to cut off employees to stay profitable during inflation due to increases in the price of goods and services.
It can also affect the production of various goods and services due to the increase in the price of raw materials and labor changes.
Certain experts believe that inflation can have a positive effect on the economy as well. The positive effects of inflation include higher profits, better returns, etc.
What are the positive effects of inflation on the economy?
Higher profits – Businesses benefit from inflation as they will be able to take advantage of the price hike and charge more from the customers. The increased cost of production for the businesses should also be taken into consideration here, though.
Better return on fixed-income investments – Central banks hike interest rates during periods of high inflation. Interest hike during inflation is done to facilitate higher investment and lower spending. This also means that investors can earn more from their lower-risk investment options.
Increase in competition – Inflation often leads to an increase in the competitiveness of the market. This is because the business will try its best to retain customers even as they hike the prices, and it means that it will produce high-quality products and services to remain competitive.
What are the negative effects of inflation on the economy?
Fixed income groups experience a fall in income – For those belonging to the fixed income group, such as salaried individuals, pensioners, etc., this means that they will experience a fall in real income. In other words, their purchasing power will decrease.
Inequality in the distribution of income increases – During inflation, traders and businessmen experience an increase in profits. On the other hand, a large group of people experiences a decline in their real income. Thus, inequality in income distribution becomes acute during this period.
Disrupts the planning process – During inflation, prices of goods, raw materials, and factor services rise. The government, therefore, has to spend more money to complete any investment project started during the planning period.
Speculative investment increases – let’s say price levels rise very quickly. People are not sure how much prices will increase in the coming weeks or months. In such cases, many people start speculative investments. For example, they may start buying stocks, gems, land, etc., just for speculative purposes. This is done to get quick profits. Such investments do not help create productive capital in the economy.
Lenders Face Losses – Under the positive effects of inflation, we mentioned that borrowers benefit from inflation. Lenders, therefore, stand to lose in such periods. This is because they receive an amount with a lower purchasing power than the amount borrowed.
Negative impact on export earnings – During inflation, the prices of export items also increase when the prices of raw materials increase. Their demand in foreign markets could thus decrease, leading to a decrease in the country’s export earnings.
How can we control inflation?
The central bank and government manage inflation through different policies and strategies.
There are several ways to control inflation which are as follows:
The interest rate– Governments often hike the interest rate to control inflation. People tend to spend less when debt becomes costlier due to higher interest costs. Lesser spending leads to lesser inflation.
Money supply changes – Experts believe that curbing the supply of money can curb inflation to an extent. Hence, money supply changes are a way governments try to control inflation. But money supply changes are rarely used as they could have other effects on the market as well.
Increasing competitiveness – The government may introduce policies that increase competitiveness in the market. The companies will be forced to price competitively when there is stronger competition. Competitive prices can lead to lower inflation rates.
Income tax controls – Governments could also tinker with the income tax rates to control inflation. A higher income tax rate could stop people from spending more. But increasing income tax could have adverse effects, and hence, the step is rarely used.
Price controls – Price control is another method governments can use. The idea of price control is that the government will have set prices for each commodity, and the suppliers and sellers will have to follow that. Price control is an adverse measure, but it can control inflation rates.
How can we prevent inflation?
The government plays a vital role in preventing inflation, but the rate at which it is preventable is unsure. Inflation often occurs as a side effect of the growing economy. When the economy grows, people will invariably start earning more money. People will start spending more when they earn more, and this causes inflation. Governments can intervene in multiple ways to ensure the rate of inflation doesn’t harm the living of the normal. One common action governments take here is hiking the interest rate. An interest rate hike will decrease the amount of spending from credit. Furthermore, an increased interest rate will also incentivize investors to interest more, and this, in turn, can also curb spending.
What is causing inflation in 2022?
Pandemic – The covid pandemic has had a significant impact on the economy. Lockdowns, working from home, and physical distancing have seen people spend more of their household budgets on food and housing while fewer people buy non-essentials such as flights and clothes. And it can lead to inflation, with incomes falling as millions lose their jobs.
Russia vs. Ukraine War – Increased geopolitical risks triggered by Russia’s invasion of Ukraine will have an adverse impact on global economic conditions throughout 2022. According to our model, such impacts will reduce GDP and significantly boost inflation, exacerbating the policy trade-offs facing central banks worldwide. While these effects are significant, they are not significant enough to affect the global recovery from the pandemic.
Is there a way that consumers can combat inflation?
Consumers can also fight inflation in their own rights. Consumers’ action against inflation could only have a minimal effect unless the action is repeated in bulk. But the lack of coordination and difference of opinion can make consumers’ actions against inflation ineffective. Below listed are a few actions that consumers can take.
Reduce shopping costs – Consumers can do this by comparing the price of food products by weight in different stores to find out which option is the best and by purchasing goods at a discounted price.
Reduced transportation costs – Consumers can use modes of transportation that can save more money and reduce transportation costs. The use of public transport could be preferred over private transport.
Debt Reduction – With the cost of almost everything going up, it can be tempting to rely on credit cards to help you afford your expenses. However, going into debt can stretch your budget. In the fight against inflation, central banks raise interest rates, and in the process, credit card debt can become even more expensive and harder to repay.
Does having a high inflation rate means the economy is going to be in recession?
Yes, inflation can be one of the causes of the recession. Other causes of recession can include high-interest rates, a drop in confidence, a decline in bank lending, and a decline in investment all contribute to an economic downturn. Cost-push inflation has the potential to cause a recession, particularly if it exceeds nominal wage increases.