Inflation: All that you wanted to know

Inflation influences so much around us. Our food, our choices, our work, and even our politics are all around inflation. We all might know that inflation is an increase in prices, but there is much more to it. This piece will explain what influences inflation, and it will also cover some terms that you might have come across in financial newspapers.

What is Inflation?

Inflation is actually an increase in the general price level of our goods and services. If a basket of goods and services today costs ₹100 today and it costs ₹104 the next year, it means that inflation has been 4% in this one year. Therefore, inflation can be called a change in the price level of goods and services.

How is it measured?

In India, inflation is measured in two ways. One is the 'Wholesale Price Index.' The price of goods and services is calculated for a basket of goods based on prices charged by wholesalers. It is released by the Ministry of Commerce.

Another method is called as 'Consumer Price Index.' This calculates the price of basket based on the value paid by a normal consumer. It takes into account the tax paid by the people as well. Hence, it becomes a better indicator of inflation for the public. Moreover, this is called 'Headline Inflation,' perhaps because this number tends to occupy the heading of our newspapers. Central Statistical Office releases it.

However, have you ever thought what the figure of, say 5% inflation means? Prices increased by 5%, but 5% of what? This 5% increase is on the price of the basket of goods of the base year. The current base year in India is 2012. This means that if a basket of goods cost ₹100 in 2012, it costs ₹105 today. The base year is proposed to change to 2018 in FY 2020.

What moves the price?

A simple concept of ‘Demand and Supply’ determines the prices of goods and services. If more people want a good, supplier would increase the price for more profit. In another way, if more people want a good, some people would pay a higher amount so that they get the good.

If a good were more in supply than demand, the supplier would reduce the price to attract more customers. In another way, if people see a good available in plenty, why would they pay more prices for it?

Hence, many factors influence inflation. Increased income or cheap loans push up the demand because every person has money to buy. This is why the government cannot print notes endlessly. This is called as 'Demand-Pull Inflation.'

Black marketing or exports change supply dynamics. If hoarding happens, supply will reduce, pushing up the prices. If exports increase, Indian goods would go out of the country. Hence, those goods would become expensive in India. This is 'export-boom inflation.'

Conversely, if imports increase, more goods would come in India and prices would fall. This happens in India, mostly for food products. This is 'imported inflation.'

Sometimes, due to the above factors, the cost of production itself increases. For example, diesel price increase affects transportation. Spending more on employees or hiring better talent too cost the company. This makes the final product expensive. Hence, such inflation is called as 'Cost-Push Inflation.'

What does the Government do to counter this?

India has a Price Stabilization Fund under the Department of Agriculture, Cooperation & Famers Welfare (DAC&FW). It is a corpus of ₹500 crores. When prices of food products fall below a sustainable level, the fund is used to buy those goods. When prices rise beyond a level, they sell the goods so that prices may come down.

In June 2016, the Monetary Policy Committee (MPC) was established under RBI. Its mandate is to keep inflation between 2% to 6% until 2021.

Why can RBI not keep Inflation target 0%?

Inflation is unavoidable. If inflation is too low, it means people do not have enough money to buy things! The prices are too low because suppliers are not getting customers. They have no option but to sell at whatever price they get. While a rise in prices is called 'inflation,' the fall in prices is called 'disinflation.'

It happened in September 2014 when food inflation once reached 1.3%. It actually translated that farmers are unable to recover the cost of production. This was a classic case of 'disinflation.'

There is another term called 'deflation.' It is a specific case when the inflation index falls below 0%. This is detrimental to the economy. It means there is no economic activity. While at low inflation, at least some economic activity is happening, but deflation means people have no money in hand to buy anything. Negative inflation, in one way, tells that people are paying you to buy their product!

Fiscal Policy Inflations

Several fiscal policies, i.e., government policy, induce inflation. An increase in tax rates causes 'tax inflation.' If excessive money is pumped in the economy, it is called as 'credit inflation.' Sometimes, in order to repay the debt, the government risks printing more money to finance this debt. Since more money would come in the market, prices would rise. This is called as 'deficit-push inflation.'

The Closure

Inflation has such influence in our lives that our awareness can help us understand the price movements around us. In a democratic country like India, such information would help a citizen keep track of the government policies and also, hold leaders accountable.

One thing we must understand that in developing countries like India, there will be some inflation. Hence, the goods you can buy with ₹100 today, you would not be able to do it next year because its price would rise. One of the ways you can beat the price rise is by increasing your money. Returns on your investments should beat the inflation rate.

Wondering how to do it? Pranjal Kamra has explained the trick in detail in his investment guide 'Investonomy.' Get your copy here.