Whether you are a business owner or a private employee, you need to understand what is inflation and how it affects your income. Inflation is generally considered a buzzword that many people have heard of, but only a few understand it deeply. When you feel like your currency’s value isn’t going as far as it used to, then the most obvious reason behind it will be inflation. So, inflation describes the gradual increase in prices and a slow decline in the purchasing power of your currency over time.
The impact of inflation may seem to be small in the short term, but it can drastically affect the purchasing power of your savings in the long term. Besides, you may know that inflation has much to do with the cost of goods and services, but you might not be sure how they are related. So in this article, we will dig deeper into this topic and understand what is inflation and why does it occur. We will also see its effects, causes, and measurements.
What is Inflation?
Inflation is the persistent rise in general prices of most goods and services of common or regular use such as food, housing, clothing, fuel, transport, recreation, consumer staples, etc. It measures the average price change of commodities and services over time, which ultimately results in an increase in the cost of living.
Inflation generally indicates a fall in the purchasing power of a unit of a nation’s currency as the services and products get more expensive. It is basically the difference between aggregate demand and aggregate supply of services and products. So when the aggregate demand surpasses the supply of services and products at current prices, there is an increase in the price level. A certain level of inflation is needed in the economic sector to ensure that the expenditure is increased and money hoarding through savings is discouraged.
Contrarily, the rare decline in the price index of commodities and services is called ‘deflation.’ It indicates the decline in the purchasing power of a unit of any country’s currency. The deflation is measured in percentage.
Effects of Inflation:
Inflation drops the purchasing power of a currency unit as the commodities and services get expensive. It also impacts the cost of living in the country. So when the inflation is high, the cost of living increases as well, which ultimately leads to a decrease in economic growth. And as money loses its value over time, it becomes essential for people to invest their money. This investment makes sure that there is economic growth in the country. Thus it is evident that inflation affects the economy in both positive and negative ways.
Positive effects of inflation on the economy :
- Reduction in unemployment because of nominal wage rigidity.
- Encouraging investments and loans instead of money hoarding
- Allowing the central bank freedom to carry out monetary policy.
- Avoiding the inefficiencies related to deflation.
Negative effects of inflation on the economy :
- Increase in the alternative cost of holding money.
- Uncertainty over inflation in the future can discourage savings and investment.
- With rapid inflation, there will be a shortage of commodities as consumers start hoarding out of worries that costs will rise in the future.
Causes of Inflation:
Once you understand what is inflation and what are its effects, it will be easy for you to understand its causes. There are commonly two causes of inflation, such as:
Demand pull inflation :
The demand pull inflation occurs when there is a rise in the aggregate demand, which is categorized by four parts of the macro economy like businesses, households, governments, and foreign buyers. When the simultaneous demand for output surpasses what the economy can produce, these four sectors compete to buy a limited amount of products and services. It means the buyers ‘bid prices up’ and cause inflation.
Cost pull inflation :
The total quantity of products and services produced by an economy at any given price level is called the aggregate supply. When this aggregate supply of products and services decreases due to a rise in production costs, it results in cost-push inflation. It means the prices have been ‘pushed up’ by an increase in the price of any of the four factors of production, like capital, land, labour, or entrepreneurship, when the companies are already producing at full capacity. The companies cannot maintain their profit margins by producing the same quantity of products and services when their prices are higher, and their productivity is maximized.
How is inflation measured?
Primarily there are two main indices to measure inflation, such as WPI (Wholesale Price Index) and CPI (Consumer Price Index). These two indices measure the wholesale and retail level cost changes, respectively.
The CPI tracks the difference in the retail price of goods and services that are consumed by households across the country, such as medical care, education, food, electronics, etc. In short, it calculates the changes in price level at the consumer level.
On the other side, WPI tracks the average change in the price of goods and services at the wholesale level, where businesses sell them to smaller businesses for selling further. It considers the price of products and services traded only among the corporations, not goods bought by the consumers. Thus, the aim of WPI is to track the price change that reflects the demand and supply in manufacturing, construction, and industry.
The basic formula to measure the inflation rate is as follows:
(Current Price – Former Price)/ Former Price
Is inflation bad?
Everyone views inflation differently, depending on the kinds of assets they have. For instance, people with cash may be adversely affected by inflation because the value of their cash will erode over time. On the other hand, people with investments in real estate or stock commodities will benefit as the prices of their assets are set for a hike.
We hope now you are aware of what is inflation and everything else related to it. Lastly, you can protect yourself from inflation by increasing your earnings, ability, and income.