Inflation is among several data points that an investor or an economists or a financial journalist or even a commerce student look for very judiciously and intensively to arrive at making or rather investment decision.
It is one of the key factor which helps understand health of an economy along with consumption trend.
Let us understand the intricacies, importance and its direct impact on an individual, financial markets, currency, economy and the decision making.
Theoretically, Inflation refers to the rise in the prices of most goods and services of daily or common use, such as food, clothing, housing, recreation, transport, consumer staples, etc.
It is a quantitative measure of the rate at which the average price level of a basket of selected goods and services in an economy increases over some period of time. It is the rise in the general level of prices where a unit of currency effectively buys less than it did in prior periods. Often expressed as a percentage, inflation thus indicates a decrease in the purchasing power of a nation’s currency.
Inflation can be contrasted with deflation, which occurs when prices instead decline.
Inflation derives importance from the fact that it depicts the purchasing power. As prices rise, a single unit of currency loses value as it buys fewer goods and services. This loss of purchasing power impacts the general cost of living for the common public which ultimately leads to a deceleration in economic growth. The consensus view among economists is that sustained inflation occurs when a nation’s money supply growth outpaces economic growth.
To combat this, a country’s appropriate monetary authority, like the central bank, then takes the necessary measures to keep inflation within permissible limits and keep the economy running smoothly.
Inflation is measured in a variety of ways depending upon the types of goods and services considered and is the opposite of deflation which indicates a general decline occurring in prices for goods and services when the inflation rate falls below 0%.
Let us understand causes of inflation.
Rising prices are the root of inflation, though this can be attributed to different factors. In the context of causes, inflation is classified into three types: Demand-Pull Inflation, Cost-Push Inflation and Built-In Inflation.
Demand-pull inflation occurs when the overall demand for goods and services in an economy increases more rapidly than the economy’s production capacity. It creates a demand-supply gap with higher demand and lower supply, which results in higher prices.
Cost-push inflation is a result of the increase in the prices of production process inputs. Examples include an increase in labor costs to manufacture a good or offer a service or increase in the cost of raw material. These developments lead to higher cost for the finished product or service and contribute to inflation.
Built-in inflation is the third cause that links to adaptive expectations. As the price of goods and services rises, labor expects and demands more costs/wages to maintain their cost of living. Their increased wages result in higher cost of goods and services, and this wage-price spiral continues as one factor induces the other and vice-versa.
Now let us understand types of Inflation
Depending upon the selected set of goods and services used, multiple types of inflation values are calculated and tracked as inflation indexes. Most commonly used inflation indexes are the Consumer Price Index (CPI) and the Wholesale Price Index (WPI).
The CPI is a measure that examines the weighted average of prices of a basket of goods and services which are of primary consumer needs. They include transportation, food, and medical care. CPI is calculated by taking price changes for each item in the predetermined basket of goods and averaging them based on their relative weight in the whole basket. The prices in consideration are the retail prices of each item, as available for purchase by the individual citizens. Changes in the CPI are used to assess price changes associated with the cost of living, making it one of the most frequently used statistics for identifying periods of inflation or deflation.
The WPI is another popular measure of inflation, which measures and tracks the changes in the price of goods in the stages before the retail level. While WPI items vary from one country to other, they mostly include items at the producer or wholesale level. For example, it includes cotton prices for raw cotton, cotton yarn, cotton gray goods, and cotton clothing. Although many countries and organizations use WPI, many other countries use a similar variant called the producer price index (PPI). It is a group of indices that calculates and represents the average movement in selling prices from domestic production over time.
The PPI measures price movements from the seller’s point of view. Conversely, the CPI, measures cost changes from the viewpoint of the consumer. In other words, this index tracks change to the cost of production.
Inflation is measured by a central government authority, which is in charge of adopting measures to ensure the smooth running of the economy. In India, the Ministry of Statistics and Programme Implementation measures inflation.
Inflation is perceived differently by everyone depending upon the kind of assets they possess. For someone with investments in real estate or stocked commodity, inflation means that the prices of their assets is set for a hike. For those who possess cash, they may be adversely affected by inflation as the value of their cash erodes.
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