Inflation-The Silent Killer
You might have heard your dad, grandfather and other people from Gen X saying that a certain good or service costed very less in their era. A bottle of Coca-Cola then costed 5 paise, a movie ticket would cost 3 rupees, your favorite Cadbury Dairy Milk mere 5 rupees and finally the Amul butter that adds flavor to any food at 6.5 rupees. What phenomenon causes such a contrast in prices between generations? It’s inflation.
Inflation is the term given to rise in prices of a basket of goods and services over time. It reduces the purchasing power of currency. It basically increases your cost of living and thus reduces your standard of living.
The interest you receive on fixed deposits, PPFs, etc. doesn’t account for inflation. For example, if you are earning an interest rate of 7% on your fixed deposit and the prevailing inflation rate in the country is 3%, you are basically only earning 4% interest on your fixed deposit.
What is inflation rate?
Inflation rate is the percentage increase in price over a period of time, which is usually a year. For example, if the inflation rate for 1 liter of milk is 4% per annum and it costs for 50 rupees today, then 1 yr down the line it will cost 4% higher i.e. 52 rupees.
Here are few types of inflation that can be observed in an economy ……
When inflation rate is extraordinarily high i.e. 50 % or more per month, it is known as hyperinflation. Many countries have faced hyperinflation in the past like Germany during 1921-1923 and Zimbabwe during 2007-2008. The most recent example of hyperinflation can be seen in Venezuela which began in the early 2017 and is still prevailing, an outcome of socioeconomic and political instability.
ZIMBABWE: INFLATION RATE TABLE 2007-2008
VENEZUELA: INFLATION RATE 2017-2020 (MONTHLY)
When inflation rate is decreasing over time, but remains greater than zero it is known as disinflation. In the given graph below, there is a dip in inflation rate from 7.59% in January 2020 to 6.58% in February 2020 to 5.84% in March 2020, this dip represents disinflation.
INDIA: INFLATION RATE 2019-2021
3. Asset Inflation
When prices of assets such as houses, stocks and commodities like gold rise over time it is known as asset inflation. This phenomenon was currently witnessed during Covid-19 when the price of 10g gold went from around 42k during mid-March to around 50k in the month of July.
Source: Google Finance
When inflation rates are high, along with high unemployment and stagnant economy, it is known as stagflation. Stagflation was witnessed in the US during 1970s. In the US the inflation rates are usually in the range of 1-5 %, but it the 1970s it soared above 5% along with unemployment rate hitting whopping 9% and negative GDP for five quarters.
USA: INFLATION RATE 1965-1975
USA: UNEMPLOYMENT RATE 1960-1980
How is inflation measured?
Price indices are used to measure the ongoing inflation rate in an economy. In India, Consumer Price Index (CPI) and Wholesale Price Index (WPI) are used to determine inflation rate. Globally, CPI is considered to be the best barometer for calculating inflation.
CPI takes the average of prices of a basket of goods to come up with inflation rate. CPI basket of goods covers the following sectors- Education, Health, Clothing, Transportation, Communication, Housing, Fuel & Light, Food, Household Goods & Services and Personal care.
WPI on the other hand computes inflation rates based on average prices of manufacturing goods. It is used by few nations apart from India.
CPI INFLATION IN INDIA (YOY%)
Source: RBI, IMF
INDIA: CPI & WPI INDICES 2000-2019
What causes inflation?
The two major drivers for inflation are cost-push inflation and demand-pull inflation. There are many other factors that trigger inflation like money supply and currency exchange rates.
Cost-push inflation is the rise in price of goods and services due to increase in the prices of factors of production (labor, wages), which leads to low aggregate supply while aggregate demand remains constant.
For example, Hike in oil prices can be caused by cost-push inflation.
Demand-pull inflation is the rise in price of goods and services when aggregate demand surpasses aggregate supply.
For example, increase in property prices can be an outcome of demand-pull inflation.
The phenomenon opposite to inflation is known as deflation i.e. prices of a basket of goods and services fall over time. It usually takes place when deep recessions take place. When there is a negative inflation rate it is basically deflation in an economy.
It increases the purchasing power of consumers and leads to better standard of living. So, it’s good for consumers who love shopping, but it can be bad for the economy is some scenarios as it could lead to recession.
For example, Japan has witnessed deflation many a times since the boom of housing sector in the late 1980s. In the graph below, you will notice a dip in inflation below 0% i.e. the deflation phase of Japanese economy.
JAPAN: INFLATION RATE 1986-2020