• What is Inflation?
Simply put, Inflation is the term used to define the general
rise in level of the price of goods and services in any
economy which subsequently reduces the buying power of a
currency. For example, if you were able to buy two cricket
bats at Rs. 500 in 1990, you would only be able to buy one
bat at Rs. 500 in 2010. Basically, each unit of currency buys
fewer goods and services.
• How is inflation calculated?
Inflation is usually estimated by calculating the inflation rate of a price
index, usually the Consumer Price Index (CPI). The Consumer Price Index
measures prices of a selection of goods and services purchased
by a "typical consumer". The inflation rate is the percentage
rate of change of a price index over time.
The formula for calculating the annual percentage rate inflation
in the CPI over the course of two years is:
[ ( Current Year's CPI - Previous Year's CPI ) / Previous
Year's CPI] = Rate of Inflation
India uses a different price index called the wholesale Price Index (WPI) to
calculate the rate of inflation in our economy. It is quite similar to
Consumer Price Index, but uses whole sale prices instead of retail
• What are the causes of Inflation?
The following factors can lead to inflation:
*Loose or expansionary monetary policy — If there is a lot of money going
around, then supply is plentiful compared to the products you can
buy with that money. The law of supply and demand therefore
dictates that prices will rise.
*Increases in production costs
*Declines in exchange rates
*Decreases in the availability of limited resources such as food or oil
*War or other events causing instability
• What are the effects of Inflation on an economy?
Though Inflation sounds like a very negative thing that can happen in an
economy, it has some positive aspects as well. These include:
*Add inefficiencies in the market, and make it difficult for companies to budget or
*Can impose hidden tax increases, as inflated earnings push taxpayers into
higher income tax rates
*Cost-push inflation — Rising inflation can prompt employees to demand higher
wages, to keep up with consumer prices. Rising wages in
turn can help fuel inflation.
*Hoarding — People buy consumer durables as stores of
wealth in the absence of viable alternatives as a means of
getting rid of excess cash before it is devalued, creating
shortages of the hoarded objects.
*Hyperinflation — If inflation gets totally out of control (in
the upward direction), it can grossly interfere with the
normal workings of the economy, hurting its ability to supply.
*Price inflation has immense effect on the Time Value of Money (TVM).
*Labor-market adjustments — Inflation would lower the real wage if nominal
wages are kept constant, Keynesians argue that some inflation is good for the
economy, as it would allow labor markets to reach equilibrium faster.
*Debt relief — Debtors who have debts with a fixed nominal rate of interest will
see a reduction in the "real" interest rate as the inflation rate rises.
• What measures can be taken to control Inflation?
The central banks, monetary authorities or finance ministries of most
nations have the authority to take economic measures to control rising
inflation by regulating the following factors:
*Reducing the central bank interest rates and increasing bank
*Regulating fixed exchange rates of the domestic currency
*Controlling prices and wages
*Providing cost of living allowance to citizens in order to create
demand in the market.
• Different schools of thought on causes of inflation
Different schools of thought emphasize different factors as the root cause
of inflation. However, there is a consensus on the view that economic
inflation is caused either by an increase in the money supply or a decrease
in the quantity of goods being supplied, and that the effects
of either high inflation or deflation are extremely damaging to
Also, on a personal level, you need to look at investing in
avenues which can take the impact of inflation. The rate of
return is how much you make on an investment. If you invest
Rs. 100 in the market today and you make money at a 3%
"rate of return" in one year you will have Rs.103.
But for example, since the rate of inflation is at 4%, an item costing Rs.
100 today will cost Rs.104 a year from now. So what you can buy with
today's Rs.100, you will only be able to buy with Rs. 104 a year from now.
So in conclusion, the rate of return on your investments, have to be higher
than the rate of inflation.