Inflation

What is Inflation?

Inflation is the persistent increase in the prices of the goods and services in the economy over a period of time.When overall prices rise, each unit of currency buys fewer goods and services. That means the worth of that unit of currency reduces or it can said that due to inflation the purchasing power of money is reduced.

For example:   An Amitabh Bachchan movie 30-40 years ago would cost you few Paisa’s. But nowadays it would cost you 200-300 Rs in multiplexes. Inflation basically reduces the value of money.

So if the inflation rate is around 5% for the current year, the price of a product which stood at Rs 100 for the previous year would be at Rs 105 for the current year.

How Inflation rate is 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"which is a basket of goods such as coffee, clothing, furniture, financial services, etc. The inflation rate is the percentage rate of change of a consumer price index over time.

For example in January, 2010, the CPI in India was 345.67. And in January, 2011 the CPI is 370.56 then Inflation rate in India is:

= [(CPI of the Current year – CPI of the Last year) / CPI of the last year]*100

= [(370.56-345.67)/345.67]*100 = 7.20% is the current year’s inflation rate.

Let us take another example:

Assume we are living in hypothetical world where there are only two commodities Apples and Money. Apples are picked from apple tree and money printed by the government. Now next year there is a drought and apples are scare. So the price of apples would rise because there is less number of apples but more amount of money. On the contrary if there is record amount of apples produced then prices of apple would fall because apple sellers need to reduce the prices to clear their inventory. These are the situations of Inflation and Deflation.

Now the obvious and tempting question would be:

Why can’t government print more amount of money to reduce inflation rates?

Let us take a very simple example to explain the answer of the aforementioned question-:

We assume that India decides to increase the money supply in the economy by handing over cash to and every person in the country. Most of the people would actually spend the amount whereas some amount of it would also be saved .Now, Person X goes to the market to buy a television and so the company have the option to either keep the prices at the same level and thereby not have enough Television to sell to all the customers or raise the prices? Obviously, it would raise the prices and hence would starting pushing up the inflation rate. The company can increase the production to meet the demand but it wouldn’t be possible to increase the production level after a certain limit. Thus even though the government prints more money, the inflation rate would not be lowered by it as the value of money would fall

There are few lessons to be learned from this:

1)      Do not keep your money stagnant. It will lose its value (worth) over the time. (With that same few Paisas, You won’t be able to buy the same Amitabh Bachchan movie ticket in today’s time.) So, don’t keep your money stagnant.

2)      Always invest your money. Either in bank or stocks or government bonds or Mutual funds or any such schemes so that the returns so generated are more than the inflation rate so as to get actual increase in the value of money.