Sunday, May 9, 2010


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

consumer prices.

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

*Tax rises

*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

plan long-term

*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

interest rates

*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

the economy.

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.

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