The famous former baseball player Sam Ewing once hilariously said, “Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair.”
Are increasing prices the only effect of inflation? Well, no. Inflation leads to a slew of other consequences as well.
Inflation has been the subject of infinite conversations these days. Globally, economies are aggressively raising interest rates to battle rising inflation, which has led to erratic risk sentiment.
So, what are the main reasons for inflation, and what are its types? Let’s read on!
What is Inflation?
Inflation has always been a significant factor for consumers and investors in various markets, including used vehicles, the housing market, the stock market, and others. This is due to the gradual loss of purchasing power of the rupee as prices gradually increase over time.
A broad rise in the cost of goods and services across an economy is referred to as inflation. Each unit of rupee purchases fewer products and services as the general price level rises. Hence, inflation is associated with a decline in the purchasing power of money.
The annual inflation rate in India surged to 6.95 percent in March 2022, above market expectations of 6.35 percent and reaching a high not seen since October 2020.
Is inflation restricted to rising costs?
Consumers with lower salaries typically spend a greater percentage of their total income on their needs than those with higher incomes, leaving them with less safety net against the erosion of purchasing power brought on by inflation.
Governments and central banks regulate and monitor inflation through effective financial policies and reforms. Hence, the minimum interest rate can be increased when inflation threatens to surpass a central bank’s target.
Individuals with fixed-rate mortgages and other loans gain from repaying these with inflated money, cutting their debt service costs after accounting for inflation. In contrast, new borrowers will likely incur higher interest rates when inflation rises.
What are the Types of Inflation?
There are 3 types of inflation:
1. What are the Types of Inflation?
Demand-pull inflation happens when an economy’s overall demand for goods and services grows faster than its ability to produce them. This happens when the supply of money and credit increases. This raises demand, which causes price hikes. A positive consumer mood increases spending when people have more money, which further raises prices because of greater demand for goods and services.
Higher demand and less supply lead to a demand-supply gap, which raises prices. The high increase in vegetable prices in India is an example of demand-pull inflation when vegetable storage elevates the prices.
2. Cost-Push inflation
Cost-push inflation happens when overall prices rise due to rising labor and raw material costs. The total amount of production in the economy may decline as a result of higher manufacturing costs.
Cost-push inflation results from the manufacturing price increases being passed on to consumers because the demand for goods hasn’t altered. The most common example of cost-push inflation is the oil and natural gas prices. Everyone needs a certain amount of fuel for their vehicles.
3. Built-In inflation
The notion that individuals anticipate the current inflation rates to persist in the future is related to built-in inflation. The cost of goods and services is increasing, and as a result, workers and other people begin to demand higher costs or wages to maintain their quality of living. The cost of goods and services rises because of their increased earnings, and this wage-price spiral keeps going as one element drives the other and vice versa.
What Leads to Inflation?
Here are 5 main causes of inflation:
Over-Expansion of the Money Supply
In addition to cash, the money supply also includes credit, loans, and mortgages. The rupee’s worth decreases as the money supply grows. The cost of imports increases when the rupee’s value falls in relation to other currencies. The overall economy’s prices go up consequently.
Government Regulation
Demand rises when the government provides tax subsidies for particular goods. Further, costs could increase if supply is less than demand.
Also, strict property norms and rent laws may unintentionally raise prices and foster inflation by passing those costs forward to citizens or decreasing the availability of housing.
Managing the National Debt
The government has two basic alternatives when the debt is out of control. One is to increase taxes to pay off the debt. If taxes are increased, businesses will probably pass the cost onto consumers through higher pricing.
The government can also print more money as a backup plan. This may lead to demand-pull inflation. Therefore, if the government employs both strategies to address the national debt, it may impact both cost-push and demand-pull inflation.
Devaluation
Devaluation is a downward adjustment to the exchange rate of a nation, which lowers the value of that nation’s currency.
A currency’s depreciation lowers the cost of exports, which encourages other countries to purchase more of the devalued items. Devaluation also raises the price of domestic goods in the depreciating country, encouraging its inhabitants to favor native goods over imports.
Rising wages
Wages are a manufacturing cost. Businesses will have to pass on the expense of a significant wage increase or accept weaker profit margins. The only exception is if they can balance pay increases with increased production.
How to calculate inflation?
The inflation rate is calculated using the following inflation rate formula:
(B – A)/A x 100, where A is the starting number and B is the ending number
Subtract the prior price of a certain good or service in a year in the past from the current price of the same good or service that is needed for the formula. You will get a decimal as a result. Multiply by 100 to convert this amount to a percentage. You will receive the inflation rate from this.
Let’s understand with an example:
Assume that 5L of milk costs 300 INR in 2020 and 320.85 INR in 2022. 320.85 minus 300 equals 20.85. Divide 20.85 by 300. The result is 00695. Multiply it by 100. The inflation rate on 5L of milk between 2020 and 2022 is 6.95%
The Financial Takeaway
All prices are expected to rise as a result of inflation. Price levels increase when overall demand outpaces the supply of items available at current pricing. Several things, including government intervention, can bring on inflation.
Through financial reforms and regulations, governments worldwide have been attempting to moderate inflation to a certain extent. It should be remembered, nevertheless, that the economy needs a certain amount of inflation to encourage spending and discourage money hoarding through savings.
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