Inflation Explained

In today’s world the inflation rate of India is 4.87% measured by the consumer price index (CPI) in October 2023 that is much less than the last year which is around 7.79%. Before we understand about the other things related to the inflation we have to first understand about what is Inflation?

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Definition of Inflation

Inflation is simply defined as the “Too much money chasing too few goods” or we can also define it into this way “General rise in the price of goods and services.”

For Example: During the COVID 19 pandemic the rise of a price of a oxygen cylinder is not a inflation because it is not a general rise of price rather it is a specific rise of a price.

Now the question emerge the it is all Good or Bad?

Contrary to the notion that inflation is entirely detrimental, the Phillips Curve suggests that inflation serves a crucial and even desirable role for a country. According to this economic concept, there exists an inverse relationship between inflation and unemployment. When inflation occurs, it prompts increased production demands from factories, leading to a higher demand for labor. In response, companies hire additional workers, thereby reducing unemployment rates and fostering overall economic growth in the country.

Classification of Inflation

There are various types of inflation, classified based on their causes, effects, and other characteristics. Here are some common types of inflation:

Inflation is the rate at which the general level of prices for goods and services is rising, leading to a decrease in purchasing power. There are various types of inflation, classified based on their causes, effects, and other characteristics.

Here are some common types of inflation:

Demand-pull:

Cause: This type of inflation occurs when aggregate demand (the total demand for goods and services in an economy) exceeds aggregate supply.
Effect: It often leads to an increase in prices as consumers and businesses compete for a limited supply of goods and services.

Cost-push:

Cause: Cost-push inflation is driven by an increase in the cost of production, such as rising wages or higher costs for raw materials.
Effect: When production costs increase, businesses may pass on these higher costs to consumers in the form of higher prices.

Built-in inflation (also called wage-price inflation):

Cause: This type of inflation occurs when workers demand higher wages, and businesses, in turn, raise prices to cover the increased labor costs.
Effect: It can create a cycle where higher wages lead to higher prices, and vice versa.

Hyperinflation:

Characteristics: Hyperinflation is an extremely high and typically accelerating inflation. It often occurs when a country experiences a collapse in its currency and a loss of confidence in the monetary system.
Effect: Prices can rise uncontrollably, leading to a breakdown in the normal functioning of the economy.

Stagflation:

Characteristics: Stagflation is a situation where there is a combination of high inflation, high unemployment, and stagnant economic growth.
Effect: This is an unusual scenario as inflation and unemployment are often seen as having an inverse relationship.

Open:

Characteristics: Open inflation refers to a situation where the prices of goods and services are rising openly, and people are aware of the inflation rate.
Effect: It is the opposite of suppressed or repressed inflation, where the actual inflation rate is not reflected in the reported or official figures.

Creeping:

Characteristics: Creeping inflation is a gradual and mild increase in prices over time.
Effect: While it may not have immediate severe consequences, persistent creeping inflation can erode purchasing power over the long term.

Galloping:

Characteristics: Galloping inflation is a rapid and accelerating increase in prices, but it is not as extreme as hyperinflation.
Effect: It can still have significant negative effects on an economy, leading to uncertainty and a loss of confidence in the currency.

Measurement Methodology

There are three measure ways to measure Inflation:

Consumer Price Index (CPI)
Wholesale Price Index (WPI)
Producer Price Index for Manufacturing (PPIM)

Consumer Price Index (CPI):

The Consumer Price Index (CPI) is a measure that tracks the average change in prices paid by urban consumers for a basket of goods and services over time. It serves as a key indicator of inflation, reflecting the cost of living for consumers. The CPI is widely used by economists, policymakers, and central banks to monitor inflation trends and make informed decisions.

Wholesale Price index

The Wholesale Price Index (WPI) is an economic indicator that measures average price changes for goods at the wholesale level. It includes products like food, fuel, metals, and manufactured goods. Calculated based on a chosen base year, the WPI serves as a leading indicator of inflation, helping policymakers assess cost-of-production fluctuations. The index comprises three main groups: Primary Articles, Fuel and Power, and Manufactured Products. Despite its utility, the WPI has limitations, focusing on wholesale rather than retail prices and needing periodic updates to stay accurate.

Producer Price Index for Manufacturing (PPIM)

The Producer Price Index for Manufacturing (PPI-M) is an economic gauge tracking the average change in selling prices for goods produced in the manufacturing sector over time. It offers insights into cost fluctuations at the wholesale level for manufacturers, serving as a key indicator of inflation in the industry. The PPI-M is part of the broader Producer Price Index, which covers prices at various production stages for all industries. It is a valuable tool for businesses, policymakers, and economists to assess cost pressures specifically within the manufacturing sector.

Conclusion

Hence, inflation is a persistent rise in the general price level of goods and services over time. While moderate it is considered a normal part of a healthy economy, excessively high inflation or deflation can have adverse effects. It erodes the purchasing power of money, impacts savers and fixed-income earners, and introduces uncertainty into financial planning. Central banks and policymakers aim to maintain price stability, balancing the need for economic growth with the goal of avoiding runaway inflation. A comprehensive understanding of inflation dynamics is crucial for effective monetary policy and informed decision-making by individuals, businesses, and governments alike.

Frequently Asked Questions

Q1. How does inflation affect the economy?

Inflation can impact various aspects of the economy. Mild inflation may encourage spending, while high or unpredictable inflation can harm investment, savings, and long-term economic planning.

Q2. What role does the central bank play in controlling inflation?.

Central banks use monetary policy tools, such as interest rates and open market operations, to control inflation. They aim to achieve a target inflation rate that promotes economic stability.

Q3. How does inflation impact interest rates?

Central banks may raise interest rates to combat high inflation and lower them to stimulate economic activity during periods of low inflation or deflation.