Inflation: The good, the bad, and the not so ugly
Inflation has many faces. Some you will like, and some you won’t. Here is an introduction to all of them
Inflation, a ubiquitous term used by economists and government officials worldwide, is like a double-edged sword. It also has different implications for different people.
- For consumers, it is the idea that prices of basic necessities such as food, clothing, and fuel will increase.
- For investors, inflation threatens a decline in the real rate of return on their investments.
- For policymakers (read the government) it is a crucial variable considered for policy-making to ensure economic development.
But what is Inflation exactly?
By definition, inflation is an increase in the prices of goods and services over a period of time. Basically when everything gets more expensive.
Here’s a quick video from Investopedia that explains inflation with a simple example.
Inflation is a relative concept because we say that prices have increased in comparison to last year or last week. It is generally measured by the government which chooses a particular year (free from wide fluctuations) as the base and computes the rate of inflation accordingly.
In India, there are two major indexes to measure inflation: Wholesale Price Index (WPI), which measures and tracks changes in wholesale goods and services while Consumer Price Index (CPI) computes the change in a basket of consumer goods and services.
For representing the country’s inflation, CPI is used and any reference to inflation in this article implies CPI.
What moves the inflation up or down?
Inflation occurs basically due to two main reasons — demand-driven or cost-push.
When consumer- demand increases more rapidly in comparison to the available supply, it triggers a rise in prices as the production capacity is not able to catch up with the huge influx of demand. This could be due to the government putting too much money into the public hands which leads to higher spending and therefore higher demand.
Cost-push inflation occurs when the price of input goods and services increases, say an increase in labour costs or crude oil, which puts upward pressure on the cost of production. Producers are, therefore, pushed to increase their product prices. This leads to consumers facing higher prices of goods and services in the market.
Why is inflation good?
A modest level of inflation acts as a stimulus for economic growth. When prices go up, people buy now than pay more later. This increases demand in the short-term. Firms respond to the increased demand by way of increasing production and hiring more people, if necessary.
In moderation, inflation creates a virtuous economic cycle in which consumers have an incentive to spend, companies to invest, wages to increase and employment to expand.
In contrast, deflation or a fall in prices slump economic activity. This is because when prices start falling, consumers start believing that it will fall further in the future and thus, delay expenditures. This could slow down economic activity substantially. During the Great Depression, American stock markets bottomed out, consumers started holding on to their money which pulled down consumer demand.
Because companies were unable to sell their products, they slashed prices and laid off workers. As more people lost jobs, demand dropped further, putting into motion a deflationary spiral.
When does it become bad?
A stable or manageable level of inflation, as determined by the country’s central bank and government, is necessary for economic growth. However, an exorbitantly high level of inflation or hyperinflation is not good for any economy.
Zimbabwe faced hyperinflation in the late 1990s which was triggered on account of too much money with the public, poor economic policies by the government as well as government instability. Things got so worse that Zimbabwe had to give up its national currency to bring inflation to reasonable levels. Venezuela is the current poster child of hyperinflation.
When inflation runs wild, savings are lost, businesses start to fail, investment dries up and real incomes fall.
So, what is the optimum level?
While many developed countries aim for a 2% inflation rate, there is no consensus regarding an optimal level per se. For instance, the RBI aims for a 4% medium-term inflation target. A country sets a stable inflation target and continues to take steps towards achieving the same. That stable target is influenced by a range of factors including growth levels, dynamics in the economy and expectations regarding the future movements.
“The most important thing to remember is that inflation is not an act of God, that inflation is not a catastrophe of the elements or a disease that comes like the plague.”
“Inflation is a policy.”
- Austrian philosopher and economist Ludwig von Mises.
In an ideal world, there would be no inflation. However, that may not be the case ever. There will something or the other that is falling or rising, in scarcity or in bulk which will continue to de-stabilize an economy.
As an individual, one has to accept that inflation is a fact of life and make investments that will protect them against wide fluctuations and instability.
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