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Guru Gyan

#BackToBasics: Understanding The Concept Of Inflation

Learning the basics of Inflation, which is one of the most important concepts in economics.

Inflation data for September has come today and here’s how it was: India’s consumer price index (CPI) inflation also known as retail inflation has surged to 7.34% in September from 6.69% in August because of a jump in food prices.

Here is a chart showing how inflation varied over the past few months and how people’s spending was affected by the pandemic.

The important thing to note here is that inflation affects everyone’s lives, even if people are not aware of it. So, in today’s article, we wanted to tell you about the basics of inflation and why is it important?

What Is Inflation?

Inflation is a sustained increase in the general price level of goods and services in an economy over a period of time, reducing your purchasing power.

Here’s an example. In Vagrants in the Valley, Ruskin Bond says a meal for 2 people cost ₹2 in the year 1960. But in 2020, you can’t even buy a candy bar for ₹2, let alone a complete meal for 2 people. This is what inflation is. Inflation is why your parents could afford many good things with less salary which you can’t, even with your 6 figure salary.

Measuring Inflation

Inflation can be measured at three levels — producer, wholesaler and retailer (consumer). At present, India doesn’t have an index to measure inflation at the producer level. Inflation at Wholesale Level is calculated using the index called Wholesale Price Index (WPI), which shows the combined price of a commodity basket consisting of 676 items.

The inflation at the retail level is the most important one because it is the actual reflection at the price hike in the country. It is calculated using the Consumer Price Index (CPI), which is based on 260 commodities, including certain services.

What Causes Inflation?

There are many reasons behind the cause of inflation but let’s try to understand the most crucial ones.

  • Too Much Money: Sometimes there is too much money in the economy. Let’s say
  • The Reserve Bank of India prints more money or
  • The economy grows stronger, which results in you getting a hike in your salary, which in turn increases your purchasing power

Whatever the reason may be, more money in the system causes inflation. But why? Because, whenever your salary increases, you can afford more and better things, resulting in you spending more money and saving less. This leads to a rise in demand for products and a rise in prices of those products.

  • Fall In The Value Of The Indian Rupee: When a country’s currency depreciates, it has to pay more for its imports. Consider a scenario where the value of $1 is equal to ₹65 and one barrel of crude oil costs $1. At this time, if India imports crude oil from the U.S, it would cost ₹65 for one barrel. But if the value of rupee falls to ₹71 for $1, we would have to pay ₹71 for the same one barrel. Since crude oil is the basic ingredient for many household products, your grocery bill will go up when rupee’s value comes down.
  • Corporate Decisions: Companies increase the price of products because they know that consumers will continue to buy them even if they become expensive. Sometimes, companies increase the price of products when the cost of raw materials go up. Both reasons lead to a rise in prices, resulting in a surge in consumer spending.

When Is Inflation Bad?

Deflation happens when prices are decreasing, as it leads to customers delaying their purchases. Deflation also discourages lending because it leads to lower interest rates. Lenders usually wouldn’t want to lend money at lower rates because it will give them a very small return.

On the other hand, too much inflation is also a problem. If inflation continues to rise, it may cause the economy to slow down swiftly and unemployment to jump. The mix of rising inflation and unemployment is called “stagflation”. It is important to learn about this concept because it is one of the important economic indicators.

Inflation is good when it is kept at the targeted level. One of the main objectives of the Reserve Bank of India is to achieve the medium-term inflation target of 4% (within a band of +/- 2%) — and the target has already been breached. How long will it take to bring back the inflation rate within the aimed range?

Head to moneyguru’s Insight section to stay updated on all major financial news updates of the day!

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