What is Inflation: Definition, How It Is Measured, Effect and Causes of Inflation

Whether we like it or not inflation has been a very important aspect of financial life and will continue to be so. in this post we provide information about Inflation: Definition, How It Is Measured and Causes of Inflation

What is Inflation:  Definition, How It Is Measured, Effect and Causes of Inflation

What is Inflation?

Introduction: Whenever we go back to memory lane about the prices of various goods/items important in our daily life 10 years ago following things may pop up in our mind:

Whether we like it or not Inflation is an integral part of our lives.

Item

Price 10 years back in 2010

Present price in 2020

% increase

Sugar per kg

25

40

60%

Edible oil per litre

60

100

66%

Petrol per litre

55

80

45%

Doctor’s average consultation fee

300

500

66%

School fee per month

2000

3500

75%

Total

2440

4220

72%

 

The above list is not exhaustive and the prices may be slightly different than the actual prices. However, each one of us will acknowledge the phenomenon of an upsurge in the prices of everything(goods or services) in our life whether essential or luxury. This increase in prices over a period of time is known as inflation.

According to Wikipedia, in economics, inflation is a sustained increase in the general price level of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation reflects a reduction in the purchasing power per unit of money.

To illustrate, let’s assume an average middle-class family of four persons could easily purchase the essential grocery items which are sufficient for the entire month in Rs. 1000/- in the year 2010. Whereas now the same essential items will cost around Rs.1700/- approximately in 2020. This increase in prices refers to inflation.

Inflation is measured by the Inflation rate. For common man, the inflation rate is the annualized percentage change in consumer price index or CPI.

Whether we like it or not inflation is very deeply embedded in the ecosystem of every family. It is the sole reason why we find ourselves crippling every now and then of price rice in everything.

1) Causes of Inflation

Demand and supply are the major factors behind inflation.

Inflation occurs when prices increase due to increases in production costs, such as raw material and wages. For example, if a company uses any metal for making its’ final product, and if the price of raw metal increases the company will pass on the same to the consumer. The same is true when there is an increase in wages.

Similarly, when there is greater demand for any product or services than its’ supply, people are willing to pay more to get the product or service this also results in price rise.

Also, governments can affect the amount of income for both businesses and consumers. If a government cuts taxes, businesses may spend it on capital expenses, employee compensation, or new hiring. Consumers are inclined to purchase goods and services. The result could be an increase in demand for goods and services, leading to price increases.

2) Effects of Inflation

Common men have always been at the receiving end of effects of inflation

The purchasing power of the rupee falls -- an Rs. 50 note, which you could use to buy a kilogram of rice, will now fetch only half a kilogram.

Wholesaler dealers may try and hoard essential commodities like food grains on hopes of reaping profits when prices increase further on dwindling supplies.

Fixed income groups are hit the hardest because their salaries are generally not revised to include the cost of living even as prices of items soar.

Household savings drop because there is less money to save now as everybody uses a greater part of their disposable income to pay for daily use essential items.

 

3)  Inflation & Investment and Mathematics to beat inflation:

We have observed that inflation affects purchasing power very badly. Anybody who is now able to buy goods or services for a definite sum will not be able to buy the same goods or services with that amount some years hence.

Therefore it becomes of paramount importance for each one of us to take into consideration inflation while taking every financial planning. This calls for putting a methodological approach for doing savings and investment planning for beating inflation.

However high or low sources of income one may have in their life, each one of us tries to save some part their income for the future. This becomes even more important when you are in the early stage of your career or have just started earning. According to the basic rule of financial planning, everybody must at least save(Invest) 10%-20% of their net income. This saving and Investment should always factor inflation whenever we talk of return from them. This can be illustrated by the following example:

The average annualized rate of inflation in India for the last 10 years is around 7%, which means any article which is costing Rs. 100/- today will be costing Rs. 107/- after one year due to inflation. So when one is saving must always keep in mind that the rate of return on his savings (Investments) should be greater than or equal to the 7% per annum in order to stay afloat and safeguard against the dwindling purchasing power due to inflation.

Summary

As we have seen above inflation has been a very important aspect of financial life and will continue to be so. Hence our investment tool must be able to beat inflation for not only protecting our capital but also for wealth creation. There are various investment options available for us to park our savings and generate returns.

In our next article, we will examine each one of them in detail and also will talk about the power of compounding interest.