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What is Inflation and How it Works?

Inflation is an economic indicator that indicates the rate of rising prices of goods and services in the economy. Ultimately it shows the decrease in the buying power of the rupee. It is measured as a percentage.

This quantitative economic measures the rate of change in prices of selected goods and services over a period of time. Inflation indicates how much the average price has changed for the selected basket of goods and services. It is expressed as a percentage. Increase in inflation indicates a decrease in the purchasing power of the economy.

This percentage indicates the increase or decrease from the previous period. Inflation can be a cause of concern as the value of money keeps decreasing as inflation rises. 

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What are the 3 Types of Inflation?

The three types of Inflation are Demand-Pull, Cost-Push and Built-in inflation.

Demand-pull Inflation: It occurs when the demand for goods or services is higher when compared to the production capacity. The difference between demand and supply (shortage) result in price appreciation.

Cost-push Inflation: It occurs when the cost of production increases. Increase in prices of the inputs (labour, raw materials, etc.) increases the price of the product. 

Built-in Inflation: Expectation of future inflations results in Built-in Inflation. A rise in prices results in higher wages to afford the increased cost of living. Therefore, high wages result in increased cost of production, which in turn has an impact on product pricing. The circle hence continues. 

What are the Main Causes of Inflation?

Monetary Policy: It determines the supply of currency in the market. Excess supply of money leads to inflation. Hence decreasing the value of the currency.

Fiscal Policy: It monitors the borrowing and spending of the economy. Higher borrowings (debt), result in increased taxes and additional currency printing to repay the debt.

Demand-pull Inflation: Increases in prices due to the gap between the demand (higher) and supply (lower).

Cost-push Inflation: Higher prices of goods and services due to increased cost of production.

Exchange Rates: Exposure to foreign markets are based on the dollar value. Fluctuations in the exchange rate have an impact on the rate of inflation. 

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Who Benefits from Inflation?

Inflation being a cause of concern for the economy, doesn’t affect everyone in a bad way. It is a boon for a certain set of people. While consumers lose a part of their purchasing power to inflation, investors gain from it.

Investors investing in assets affected by inflation, if held on for a long time will certainly benefit from it. For example, an increase in housing prices might affect consumers. However, those who have already bought a house will benefit from capital appreciation.

How Do We Prevent Inflation?

To prevent inflation, the primary strategy is to change the monetary policy by adjusting the interest rates. Higher interest rates decrease the demand in the economy. This results in lower economic growth and therefore, lower inflation. Other ways to prevent inflation are:

Controlling the money supply can also help in preventing inflation.

Higher Income Tax rate can reduce the spending, and hence resulting in lesser demand and inflationary pressures.

Introducing policies to increase the efficiency and competitiveness of the economy helps in reducing the long term costs. 

What are the Effects of a Rise in the Inflation Rate?

A rise in an inflation rate can cause more than a fall in purchase power.

  • Inflation could lead to economic growth as it can be a sign of rising demand.
  • Inflation could further lead to an increase in costs due to workers demand to increase wages to meet inflation. This might increase unemployment as companies will have to lay off workers to keep up with the costs.
  • Domestic products might become less competitive if inflation within the country is higher. It can weaken the currency of the country. 

What is the Inflation Rate Formula?

Inflation rate formula is the difference between initial CPI and final CPI divided by initial CPI. The result then multiplied by 100 gives the inflation rate.

Rate of Inflation = (Initial CPI – Final CPI/ Initial CPI)*100

CPI= Consumer Price Index

How to Calculate Inflation Rate?

Inflation is calculated using the Consumer Price Index (CPI). Inflation can be calculated for any product by following these steps.

  • Determine the rate of the product at an earlier period.
  • Determine the current rate of the product
  • Use the inflation rate formula (Initial CPI – Final CPI/ Initial CPI)*100. Here CPI is the rate of the product.
  • This gives the increase/decrease percentage in the price of the product. One can use this to compare the inflation rate over a period of time.

Here we used only one product to calculate inflation. However, the Ministry of Statistics calculates inflation using a basket of selected goods and services. 

Frequently Asked Questions

What is India’s inflation in 2023?

India’s Inflation rate in 2023 is around 6.77%. The inflation rate of an economy is determined by the increase in the price of the product basket. The product basket consists of the services and goods on which an average consumer spends through the year. For example, rent, power, clothing, groceries, telecommunication, domestic needs (oil, gas), recreational activities, and taxes, etc. In 2020, India’s inflation was around 3.34%.

Does gold protect against inflation?

Yes, gold is considered a hedge against inflation. As inflation rises, rupee tends to lose value, and gold tends to become more expensive

Is inflation bad or good?

Inflation isn’t always bad for the economy. To an extent is healthy for the economy. Too high or too low inflation is bad for the economy. When inflation is low and the economy is struggling, the government would lower the interest rates to increase the money supply in the market. On the contrary, if the inflation is too high, it erodes the purchasing power and lowers cash value.

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