Blog

Understanding Inflation

Inflation reflects the general rise in price of a basket of goods and services. In India the price of onions is reflective of the level of inflation prevailing in the market. Sometimes even potatoes come forward to share the responsibility. Inflation reduces the purchasing power of money. The hundred rupees note 20 years back had much more  purchasing power than the hundred rupees now. For the month of Oct 2019 the CPI inflation stands at 4.62%, which means the that the price of the goods and services in Oct 2018 have increased by 4.62% in Oct 2019.

Causes of Inflation

There are three major causes of Inflation:

When the demand for the goods or services is high but the supply is limited. People have the money to buy but the product is in short supply gives rise to Demand Pull inflation.  The prices of the products increase because more money is chasing limited products or services.

Sometimes the prices of products increase even though there is no increase in the demand, this is due to increase in the cost production of the goods or services. This is called cost push inflation. There are five factors that impact the cost push inflation:

1. Rise in the price of petroleum products: The rise in price of oil impacts the price of every commodity and service. Nobody is immune from the impact of rise in price of petroleum products. 
2.  Rise in wages: Countries where unions are strong, the rise in wages of the workers leads to an automatic rise in the price of the products and services.
3.  Agriculture produce: The agriculture in India is still heavily dependent on the monsoon, a bad monsoon can lead to poor harvest which will push the prices of farm products.
4.  Government regulation and taxes: The govt increases the taxes on certain products to make them costly and deter people from buying these products. The products like cigarettes and liquor have high taxes to discourage their consumption. The govt also provides subsidies on certain products that it wants the people to use.
5.  Exchange rate fluctuation: Rise or fall in the exchange rate also impacts the prices of many goods and services. 

Structuralist Inflation: This is more relevant to the developing economies  where there are structural imperfections. Lack of infrastructure is one such factor. In India the farmers do not get the rightful value of their produce because of lack of proper means of transport, lack of rural godowns, lack of cold storages etc. A lot of the farm produce also gets wasted due to lack of proper storage facilities. 

How is Inflation measured?

There are basically four indicators used for measuring inflation- the Wholesale Price Index(WPI), Producer Price Index(PPI), Consumer Price Index(CPI) and GDP Defaltor. 

Wholesale Price Index(WPI): This index takes into account the rise in prices primary articles at the wholesale level, fuel price set by govt and ex factory price of manufactured products . The index consists of  Primary articles that constitute 20.12%, fuel and power that constitute 14.91 % and manufactured products that constitute 64.97%. There are 676 items in total in the WPI. In India it is published by the Ministry of Commerce and Industry.

Consumer Price Index(CPI): In India this index consists of 448 items for rural areas and 460 for urban areas.  In India RBI makes use of the Consumer Price Index published by the central statistics office as a key measure of inflation. The  CPI consists of the below broad categories :

foods and beverages – 45.86%, 

Pan, tobacco and intoxicants 2.38%

Clothing and footwear – 6.53%

Housing – 10.07%

Fuel and Light – 6.84% 

Miscellaneous – 28.32%

Producer Price Index(PPI): This index focuses on the whole output of the producers within the country, it does not include imports. The index has not been made use of in India.

GDP Deflator: This is a more comprehensive measure of inflation. The GDP deflator measures the change in prices of all the goods and services produced in an economy. It is the ratio of GDP at current prices to GDP at constant prices. The data is published quarterly by the Central statistical organisation.

Is Inflation bad for the economy?

A certain amount of inflation is good for the economy especially in a developing economy like India. It is required to stimulate the growth of the economy. The Reserve Bank of India endeavors to maintain the fine balance of price stability and economic growth.  The RBI has set an inflation target of 4% with lower and upper tolerance level of 2% and 6% respectively. A higher inflation is likely to impact the common people adversely, hence a balance is required to be maintained.

Some general terms

Few terms to know that are intricately connected with inflation

Deflation: It’s the exact opposite of inflation, general fall in prices of goods and services. Deflation is not good for a developing economy like India. Although deflation increases the purchasing power of money and people can buy goods and services at a cheaper rate but the overall impact on the economy will not be positive.

Stagflation: This is term used to denote high inflation and high unemployment. A very undesirable situation to be in for any economy.

Hyperinflation: Steep rise in prices is referred to as hyperinflation. An excess supply of money leads to hyperinflation, remember the hyperinflation in Zimbabwe. The govt of Zimbabwe printed more money to solve their economic crisis instead of increasing productivity. The result was too much money chasing too little goods and the result was hyperinflation.

Headline inflation: This is the total inflation in the economy, in India consumer price index is considered for ascertaining headline inflation.

Core Inflation: This measure of inflation excludes food and fuel sectors whose prices are relatively more volatile.

Conclusion

A certain inflation is necessary for the growth of the economy, however excess of it is bad. Inflation reduces the purchasing power of money. The value of money has been progressively decreasing and in order to beat inflation one can invest in deposits that offer guaranteed returns or invest in Mutual funds or any other instrument that offers reasonably good returns. There are many instruments available in the market, please read the offer documents carefully. Make your decision only after understanding the risks involved in the investment. If you cannot understand a product stay away from it, preserve your hard earned money.