Sustained increases in price are often due to rising
demand for existing production, when the former outpaces the productive
capacity of an economy. With high money circulation, one has more money to
spend and invest, but production is unable to expand in response. Prices must
now rise to bring equilibrium to the market, by incentivizing producers to
increase production.
If the economy is already at full capacity of output, employment
and production increase becomes difficult. In order to employ more workers,
wages must rise, which increases the incomes of workers, who then become better
off and contribute to a further increase in demand, and the cycle continues.
Unless the central bank intervenes, or another external factor brings in
moderation, the process is exacerbated.
However, if the economy is not functioning at full
capacity, the price rise due to excess demands puts an upward pressure on
production- supply rises to meet demand and price increases gradually. But,
this might lead to outright price decline as well. A drop in price would imply
that the demand is too little to meet the current increased output levels. This
would then result in downsizing, less money in the hands of employees, hence
less disposable income for consumers, leading to even lower demand, hence price
cuts.
So the see-saw of demand and supply keeps moving the
prices up and down!
In the short run, inflation is about the shifts in
aggregate demand with respect to aggregate supply; in the long run, inflation
is a function of the Central bank’s policy measures and discretion in
conducting fiscal policy.
By definition, inflation refers to a persistent rise
in the general level of prices in an economy. By gauging the rate of inflation
or deflation (a negative rate of inflation, referring to a decline in the level
of prices, which occurred in the previous example when supply outpaced demand,
and may culminate in depression) present or anticipated, producers and
consumers are given the means to measure the cost of production and living.
Most often, inflation refers to price inflation, as
opposed to monetary inflation which refers to the significant increase in the
money supply. Consumer Price Index (CPI) is the key measure of inflation in
India.
CPI measures the cost of consuming a standard basket
of goods and services over a particular period. Through this index, one can
evaluate the cost of living in a particular economy. For example, if the
weighted average of the basket in 2013 was 200, and 206 in 2014, the rate of
inflation in 2014 would be 3 per cent.
The standard basket includes food, clothing, shelter,
fuel, transport, healthcare and other day-to-day purchased goods and services
for rural, urban and combined groups. The weights for each component of the
Consumer Price Index basket is determined by their importance, as surveyed by
consumers’ total spending on that item (See Chart 1).
Chart 1: Components of
Consumer Price Index
CPI is a rather stable index. It is not susceptible to large changes,
and its basket items are constant, reflecting the standard items consumed by
domestic households.
As such, inflation pegs down
currency value, re-allocates resources, reduces potential economic growth and
leads to the attrition of gross domestic savings, with less capital formation
in the economy. But how are individuals really impacted by the inflation?
High inflation leads to higher
interest rates; people in need of loans and mortgages find it difficult to
borrow with increased costs of borrowing. For example, banks increase rates on
existing borrowers of home loans during times of inflation. As home loans are
mostly taken at floating rates, most customers are wont to pay more EMI per
month.
When saving for retirement,
education, housing, or any other plan in the foreseeable future, the rise in
cost is a massive risk: buying may cost more in the future than today.
Inflation distorts future goals and savings.
A bigger (if not the biggest)
risk of higher inflation is posed to the lower and fixed income families.
Prices for food and utilities such as water and fuel rise at a rapid rate. Usually, being short of cash, more people use
credit cards and get into a debt trap, having to take personal loans- more EMI
to pay; and budgets are incisively cut for most of the lower and middle
classes.
The issues associated with
inflation form a double-edged sword: while prices are higher, declining one’s
buying price, non-fixed income groups can benefit from increases in income
(however, if income increases at a rate less than the rising price rate, buying
power still declines).
This is why economically
worse-off individuals bear the most significant brunt of high inflation, as
they are less able to insulate themselves and hedge against the risks and
uncertainty posed during inflation.
Investors in debentures and
fixed-interest securities, bonds, etc. lose substantially during inflation.
Similarly, retail investors with stocks in inflation-sensitive companies such
as automobiles are likely to see stock prices decline as people prefer to not
spend discretionary money.
Inflation is known as the Worst
Tax because its effects often go unnoticed with the focus on nominal earnings
rather than real earnings. If inflation is rising at 9 per cent, and one earns
6 per cent in a savings account, one may feel 6 per cent richer, when in fact one
is 3 per cent poorer. Real incomes of wage earners sharply decrease, especially
when wages do not rise at the same pace as the general price level, thus
increasing the real cost of living.
As the value of national savings
drops with less money to save now as people spend a greater part of their
disposable income, individuals are left with little money to spend on any other
activities.
In recent years, inflation has
been perceived as a serious problem owing to public confusion about what
inflation is and how to make adjustments for it. However, what is certain is
that Inflation makes it difficult to make decisions about future expenditure,
investment, and production with respect to current prices.
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