How often have you heard your elders say, “In my days, milk was available at Rs 2 per liter? Now, it costs Rs 42.” So, what has changed over the years? Has the milk become more nutritious than before? The answer is No because the milk is the same, but the prices have increased. One can also put it this way. “The purchasing power of the Indian currency has gone down. So, the items you purchased for Rs 2, around 50 years ago, are now available at Rs 42.” This statement defines inflation for us. This article discusses inflation, its types, causes, and effects.
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What is inflation?
Investopedia defines inflation as the decline in the purchasing power of the nation’s currency over a period. In simple words, it translates into ‘Price Rise.’
What are the different types of inflation?
Economists define different types of inflation.
- If you categorize inflation by its speed or the rate it increases, the four primary inflation types are ‘Creeping,’ ‘Walking,’ ‘Galloping,’ and ‘Hyper-inflation.’
- If you concentrate on specific assets, you can classify inflation asset-wise. For example, ‘Asset inflation – Food,’ ‘Asset Inflation – Gold,’ ‘Asset Inflation – Real Estate,’ ‘Asset Inflation – Fuel,’ etc.
- Some economics experts classify the inflation types as ‘Demand-Pull,’ ‘Cost-Push,’ ‘Built-in inflation,’ ‘Money supply expansion,’ etc. However, they qualify as inflation causes rather than inflation types.
- Other types of inflation include wage inflation, stagflation, core inflation, etc.
We shall look into each of these inflation categories to understand the concept better.
Creeping inflation is mild inflation where the price rise is nominal (around 3% or less). Consumers expect prices to increase gradually. Thus, they tend to prepone their purchases. As a result, it boosts demand. This type of inflation is good for the economy.
Compared to creeping inflation, walking inflation is more potent and destructive. Generally, economists consider price rise statistics between 3% and 10% annually as walking inflation. It can harm the economy because it induces people to buy more goods and stock them, fearing abnormal price rises in the future. As a result, demand increases further that the supply position cannot keep up. Besides, wages do not grow in the same proportion, and prices go out of reach for most people.
The very name suggests that inflation rises at high speed. Generally, an increase of more than 10% constitutes galloping inflation. Such inflation can cause immense damage to the nation’s economy. It becomes unstable, and the government loses the people’s confidence. Business levels and employee wages do not increase at such massive rates. Galloping inflation can discourage foreign investors and thus, affect the country’s balance of payments position. It presents an undesirable situation.
Generally, hyper-inflation is rare. During war times, governments spend money on fighting wars rather than boosting the economy. However, the present Russia-Ukraine conflict can result in Ukrainian hyper-inflation. Previous examples included Germany in 1920. More recently, Zimbabwe and Venezuela witnessed hyper-inflation in the first decade of the 21st century.
Asset inflation can occur when a specific asset witnesses an unprecedented price rise. For example, the prices of particular assets, including oil, housing, gold, food, etc., fluctuate wildly to cause asset inflation. If left unchecked, such a price rise can spill over to other sectors. For example, in the initial decade of the 21st century, the subprime mortgage crisis resulted from an unprecedented hike in real estate prices. Similarly, high fuel prices affect the transportation sector, affecting food prices and the economy.
Food prices rose substantially in India in 2008 and 2011. Today, you have fuel prices rising abnormally. Gold is another asset that seldom witnesses a price fall. The price keeps growing steadily almost daily.
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Stagflation is a unique economic phenomenon where it witnesses price rise despite the economic growth remaining stagnant. Such situations can be dangerous because it leads to high unemployment. Generally, consumer demand increases, but people oversee their spending. As a result, the demand decreases, but the prices do not. For example, the US experienced stagflation in the 1970s when it abandoned the gold standard and delinked the dollar’s value from gold. As a result, the gold price rose to tremendous highs. In addition, the OPEC oil embargoes simultaneously drove inflation higher, resulting in recession and increased unemployment.
Wage inflation can occur when the worker’s wages rise faster than the cost of living. For example, it can happen during a labor shortage when unemployment goes below 4%. It can also occur when labor unions negotiate higher pay for their members. At times, you can also find workers controlling their pay structure. For example, CEOs of companies control their pay scales. Such a situation can result in wage inflation. As a result, the cost of the company’s products and services goes up. It is a classic case of ‘Cost-Push’ inflation.
We have discussed various types of inflation. So, let us see what causes inflation?
Generally, the two types of inflation causes in India are the Demand-Pull and the Cost-Push inflation.
Demand-Pull inflation is seen when the demand for goods and services increases, but the supply does not change. This mismatch in the demand-supply position causes a price rise, leading to inflation. There can be various reasons for demand-pull inflation. One is the demand for the products exceeds its production capacity. Under such circumstances, the market can experience a shortage of products leading to hoarding or black-marketing. Simultaneously, prices increase because people become willing to pay more for the product. This situation spills over to other sectors and causes a corresponding inflationary rise.
Cost-push inflation can occur when the demand for a specific commodity remains the same, but the supply reduces. As a result, the prices go up. Usually, such a situation can arise during a natural disaster. For example, during COVID-19, we witnessed that the production suffered due to various reasons resulting in low supplies. But the demand remained the same. As a result, they could not keep up with consumer demand, leading to inflation and a price rise.
Another example is the rise in fuel prices. The increase in the international crude oil prices pushes the fuel prices further. Similarly, the gas supply reduces during war or disasters, causing a mismatch in the demand-supply equation.
Other causes of inflation
Generally, the Demand-Pull and Cost-Push are the primary inflation types and causes. However, other factors can also cause inflation. We shall look at them in brief.
The country’s monetary policy also affects inflation because it determines the currency supply in the market. If there is excess money in the market, the individual’s purchasing power increases, leading to inflation.
The fiscal policy helps the government slow down the economy by increasing taxes to suck out the liquidity from the market. It also helps dictate a reduction in government spending, leading to a decrease in money circulation. Thus, it can cause inflation.
International market forces define the country’s exchange rate. Therefore, heavy fluctuations in the currency’s exchange rate can cause inflation.
We have discussed inflation types and causes. We should now understand the effects of inflation on the economy.
Effects of Inflation on the economy
Inflation has positive and negative effects on the economy. Let us look at the positive features first.
Positive Effects of Inflation
Though inflation appears to have a negative connotation, it has its plus points.
Increased investment and Spending
Inflation offers consumers incentives to increase their purchases. People love to buy their things immediately rather than wait for a year and pay more. So an average consumer buys new smartphones, electronics items, cars, etc. Automatically, it increases productivity, and the economy grows.
Similarly, inflation encourages a person to invest in higher yield instruments. For example, you have Rs 1 lakh in your savings account. The inflation rate is higher than what the bank offers as savings bank interest. Therefore, it encourages you to invest in avenues like the stock market, where the returns can be higher. You can also invest in reliable chit funds platform like moneyclubber.com and earn higher interest than banks offer.
Increase in asset prices
Generally, inflation causes asset prices to rise rapidly. For example, real estate prices have grown considerably in India during inflation. As a result, consumers tend to take advantage of inflationary trends and invest in assets like housing, gold, stocks, etc. For example, an investment in gold gives higher returns on investment than a bank FD. As a result, gold offers an excellent resale value compared to other assets.
Reduces Effective Debt
Surprisingly, higher inflation levels are beneficial to people with significant debt, especially if the interest rate charged on their debts is less than the inflation rate. So, it results in effectively reducing the debt burden. Under such circumstances, corporates with massive debt portfolios benefit more than individuals. However, banks lose out because they receive lower interest rates than inflation rates.
The Negative Effects of Inflation
While inflation has its positives, the adverse effects of inflation are significant.
The value of money goes down.
As the prices of products, goods, and services increase because of inflation, the value of money goes down. For example, the value of a Rs 500 note in 2022 is not the same as in 2018. In 2018, you could purchase much more with Rs 500 than you can do today.
India’s government and bank employees get Dearness Allowance at regular intervals to offset inflation. Though the DA rate might not equal the inflation rate, it provides sufficient cushioning. However, the private sector employees and the unorganized sector do not have such facilities. Therefore, they face the brunt of rising inflation. Such a situation introduces a sense of inequality in society. Inflation affects the lower and middle-income groups the most because it considerably reduces their disposable income and purchasing power.
Exchange Rate Fluctuations
Inflation can cause exchange rate fluctuations because the increase in money supply and prices can drive the country’s currency to decline. As a result, the imports become costlier, leading to a higher cost of the end product. Thus, while inflation affects the exchange rate, the fluctuations in the exchange rate result in higher pricing and thus fuel inflation. Therefore, it is a cyclical process.
Increased cost of living
Inflation results in a price rise. So, consumers end up paying more for their necessities and luxuries. In addition, with the wage levels not increasing proportionately, people spend more of their income on the same goods. So, the higher the cost of essentials, the higher the cost of living.
How has inflation affected the Indian economy?
While inflation has affected the final Indian consumer, it has also affected the Indian economy greatly.
The COVID-19 pandemic and inflation together have brought industrial growth to stagnation levels. The YoY industrial development in India is negligible. The rising prices increase raw material and labor costs. As a result, it has affected their profit margins. Finally, the Indian consumer has to bear the brunt of rising inflation as companies pass on the burden to the consumer.
Methods to Control Inflation
Generally, creeping inflation is good for the country’s economy. However, if inflation starts growing faster than 3%, it can prove detrimental to the economy. Under such circumstances, controlling inflation becomes crucial. The following steps might not always be the best, but they can control inflation.
- The Monetary Policy – Increasing interest rates can reduce the demand for products and services, leading to slower economic growth and thus lower inflation.
- Money Supply Control – Controlling the money supply can effectively control inflation.
- The Fiscal Policy – One way of reducing inflation is to have a higher taxation regime. It can reduce spending and thus, reduce demand and inflationary pressures.
- Supply-Side Policies – The government can introduce competitiveness in the market to increase the supply. As a result, it can reduce the pressure on long-term costs.
- Wage Controls – Though controlling wages is never an advisable option, it can theoretically help reduce inflationary pressures.
We have discussed the various inflation types and causes. We conclude our discussion by stating that inflation in small surges is always good for the economy because it boosts growth. However, one should prevent inflation from going out of hand. Otherwise, it can have disastrous repercussions.