Inflation in simple words is one of the most commonly talked about elements of the economy.
Whether you are planning your retirement or you are discussing markets, inflation finds mention in every single discussion.
It will not be wrong to say that this is decidedly one of the most talked elements about the economy.
It is in many ways one of the most tracked economic indicators as well.
Almost every discussion about economic growth, slowdown, revival and worries are punctuated with a mention about inflation.
So no one it is one of the economy’s biggest obsession and necessitates a detailed discussion on it.
One of the most explanations is that of the rising process all around.
The price rise, though a function of inflation, is only one of the elements associated with it.
There are several other factors too that impact inflation.
Inflation is also one of the earliest indicators of the changing economic scenario.
In many ways, the inflation can often be the best gauge of economic progress or slowdown.
It highlights the core problem areas and the pockets of advantage.
In short, it is your ready measure of both economic and market imbalances.
Be it currency fluctuation or commodity prices, inflation often explains most of these elements and the changes therein.
Therefore, inflation is no doubt a crucial trigger to follow.
It often gives you important clues about the state of the economy and how you need to go about it.
It is also an important factor to consider when you are deciding future investments.
In many ways, it gives you a realistic picture of your future savings and liabilities as well.
But first, it is important to understand what inflation is?
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What Is Inflation in Simple Words?
The definition of inflation in simple terms is the increase in the price of goods.
It can also refer to the use of more money to buy the same product.
So you can see the inflation as the rise in prices of goods or decrease in purchasing power.
On an average when the price of goods and services increase, the term inflation starts recurring in the daily lingo.
Therefore inflation is often defined as per the cause that triggers it.
It usually exists when the money supply exceeds the available goods and the services.
Also, it may be a function of the budget deficit that necessitates money creation in the system.
It is measured as an annual percentage change.
So as the inflation rises, every dollar gets you less of the same product compared to earlier instances.
As prices rise and inflation rises, the value of money decreases.
This is because the value of money defines the purchasing power of an individual.
Once you start needing more money to buy the same goods, it is called inflation.
This is the actual worth of a good or service at the current rate.
So when inflation rises, purchasing power declines.
When inflation falls, it increases.
You may often have heard your grandfather or father talk about the ‘good old days’ when they could buy a packet of gum for just $0.05.
But at the current rate, you need more than $1 for the same packet.
You can read this in two ways, prices have risen or the value of money has fallen.
The percentage by which this inflation increases or decreases is often the crucial factor.
Governments and economies, in general, account for a specific percentage change.
The problem starts when the rise or fall is more than this.
What Causes Inflation?
Before we proceed any further, it is essential to understand what causes inflation?
That is often the key determinant in how the inflation situation is handled.
It also gives cues to the Government and economies about how they can work towards limiting it.
Most importantly, the question is does it really need to be limited.
However, the world over, economists haven’t been able to pinpoint that one single cause which triggers inflation.
Though it is a universal truth, there are many factors that lead to inflation.
As a result, it is very important to carefully study the cause of inflation.
1. Monetary Inflation in Simple Words
Monetary inflation in simple terms is the oversupply of money in the economy.
This is primarily a function of demand-supply mismatch.
When supply increases, prices go down.
So if you have an oversupply of money, the valuation decreases.
As a result, the price of everything rises in dollar terms.
In other words, you need a higher amount of money for same value.
2. Increase in Demand
This is also known as Demand-Pull inflation.
In this case, the inflation is triggered by higher demand for a good.
As the demand for a specific product increases, the prices rise as well.
So, it is technically a case of a lot of money chasing a limited or handful number of objects.
So, in this case, you see demand growing at a faster rate than the supply.
This is normally seen in economies that are growing very fast.
3. Higher Cost of production
This is another popular cause of rising inflation rate.
This is, therefore, often described as cost-push inflation as well.
The increase in cost can be due to higher raw material cost or increased labor charges.
Certain times, increase in taxes too can result in this kind of inflation.
Price Inflation vs. Monetary Inflation
So that brings into light another fundamental question about inflation.
It is all about paying additional money for the same service or the good.
It is about the value of money decreasing or the price of a good increasing.
Either way, the same thing is happening.
So the question that springs up is why we differentiate this phenomenon between price inflation and monetary inflation.
If you notice, the fundamental change in both cases is same.
So price inflation is a situation when the prices rise, or you need more money to buy the same product.
But monetary inflation is a technical issue where the money supply increases.
Often that is what triggers lowering the value of money.
Rather monetary inflation results in price inflation.
Or monetary inflation causes price inflation in a holistic fashion.
So monetary inflation results when the Government increases the money supply.
More money is printed by the Government for a variety of reason.
But one of the side effects is the monetary inflation that you see.
But this phenomenon happens gradually.
As the market is flush with money, it slowly eats away the value of money.
This process may continue for good 18 months to 2 years to completely unfold.
Therefore neither monetary inflation nor price inflation happens overnight.
It takes time and unfolds gradually.
Of course, the economy will offer some indicators, but these are not radical changes.
So when the final unraveling happens, consumers realize that they may have more money, but it will buy less than earlier.
This spurs demand as well.
The situation results in inflationary trends across the economy.
The demand-supply matrix is what triggers the final price differentiation and fundamental changes.
That is why it is important to understand how inflation is calculated comprehensively.
How to Calculate Inflation?
The inflation rate is a function of the inflation index.
In most economies, this inflation index is often divided into two primary forms of Index.
The Consumer Price Index or the CPI is the most dependable source for calculating inflation.
This is a basket of consumer products like food, clothing and the like.
Now the individual cost determines the average cost of this basket of products.
The cost of this Index is then compared over a point of time.
That creates the price index and gives you the percentage change in prices.
This forms a vital component of the final inflation measure.
There is another element that is considered for calculating the Inflation rate.
This is known as the Product Price Index or PPI.
The PPI records the percentage change in the selling price of the domestic good.
The final inflation rate is a combination of the PPI and the CPI.
Together they bring about the final pricing quotient.
That will give you a realistic assumption of the inflation rate.
You will notice every month you have a host of economic data that is released.
From monthly car sales to weekly retail sales, there are many data points.
All of these together go on to give you the actual inflation number
If you notice, over an extended period the PPI and CPI converge to similar levels.
But in the immediate future or as per current studies, there can be a huge difference between the CPI and the PPI
These subtle changes make them such an accurate measure of changes of the current economic condition.
For example, if vegetable prices are rising every week, that signals a definitive trend in the economy.
Experts often deduce long-term term inference about the state of the economy based on these factors.
Understanding the Cost of Inflation
The reason why inflation is an essential economic measure is the long-term implications.
Depending on the kind of industry or product you deal with, inflation impacts differently.
It is not just a measure of rising prices; it is also an indicator of the state of the economy.
So changing economic situation affects different stakeholders differently.
This is because the cost of inflation is different for different players.
Some may benefit from the higher cost associated with inflation.
At the same time, there are others who may benefit from the declining cost.
The interest rates, lending rates, deposit rates are in many ways a function of all these factors.
For example, if you are a lender, you will lose if inflation increases.
This is because the cost of the money decreases as inflation rises.
So if you offered a loan for a fixed rate of interest, the value of the same amount of money would continue decreasing as inflation rises.
But if you are a borrower who took the loan, this will mean a positive development for you.
As the inflation rises, the value of money decreases.
That means every dollar that they owe continues to be devalued in absolute terms.
That will be good news for the borrowers.
They will have to now pay less for the same loan.
For those who are saving money, rising inflation is never good news.
The money that they are saving will be worth lot less than its current value.
Also, the money that they are saving will have a lot less purchasing power on the whole.
This is of course if the interest rate is not adjusted as per the inflation rate.
This is also known as cash drag.
Why Is Uncontrolled Inflation Not Good News for Economy?
Understanding the cost of inflation is a crucial factor.
This is what makes it such an outright devil for the middle class and any person with reasonable savings.
The rising inflation is not good news for those who salaries do not adjust to the changing rate of inflation.
They may end up in a situation where their money will be worth a lot less and their purchasing power also decreases as a result.
Even for retirees and annuitants, who depend on a fixed income, inflation often erodes their purchasing power.
The rate of increase in the money available is not at par with the rise in inflation.
As a result, their purchasing power decreases at a much faster rate.
Consequently, their standard of living suffers to a large extent.
Consumers, as a result, start spending less than what they would have.
That means the demand for products reduces.
This, then, has a domino effect on the businesses.
That often leads to a slowdown in the economy over the long run.
There is cost repricing at every level.
The slowdown in the economy then goes on to affect the international markets too.
This is why the rising inflation scenario does not augur well for the economy.
At the same time, don’t think a deflationary situation is good either.
Deflation signals prices moving in the reverse direction.
If goods start selling at a lower price, it will no doubt affect the profit margins and the economy in general.
Therefore an uncontrolled pace of inflation is not good in either direction.
A sudden or fast slowdown is as severe as a steep rise in inflation.
This is why you have Central Banks across the world tackling inflation in a big way.
Inflation & Interest Rates
So the question is how Central Banks and Governments tackle the inflation data?
The interest rate is one of the most popular vehicles to control the interest rates.
This is why you will see the interest rates is a big monitorable element in most monetary policies across the world.
The interest rates is used as a speed breaker or accelerator depending on the state of the economy.
The idea is to use it as a means to spur growth or contract growth.
This then works indirectly to rein in the existing inflation situation.
Often interest rate is used to cut down money supply in the system.
Once the money supply reduces, the price of the goods and services adjust on its own.
World over, you will see Monetary experts and Governments raising interest rates to achieve this end.
The exact opposite happens in case there is a deflationary trend or slowdown in the economy.
As you would have noticed in the US policies post-Lehman, there was an all-around easing of policies.
The result of this was that it gradually kickstarted growth and helped in the revival of the economy in a gradual fashion over a point of time.
Just like the entire economy bears the brunt of the cost of inflation, it works in tandem to restore the balance in the economy too.
The rate of inflation impacts your financial affairs in many ways.
From deciding the valuation of savings to determining your purchasing power, it is one of the most critical factors to watch out for.
This is exactly why there is a massive rise in inflation-adjusted opportunities.
The idea is to work towards maintaining the gradual economic balance constantly.
It is this balance that ultimately seeks to maintain the overall economic poise in the market.
So if you want to identify one major catalyst for economic growth, it is decidedly inflation.
It is the one factor that affects all your savings, retirement funds and wage outlook.
So watch out for the trend and direction of inflation data for long-term gains.