Inflation, though not a new term, remains unfamiliar to many, leaving them unsure about its meaning and workings. Understanding inflation is essential because it affects our daily lives and the overall health of the economy. It refers to the gradual increase in the prices of goods and services within an economy. As a result of inflation, the purchasing power of money decreases, meaning that the same amount of money can buy fewer goods and services than before. Let’s explore this important concept further.

Did you know that in the 1990s, 10 gm of gold was worth 3,200 rupees? Now, even 1 gm of gold is more costly than Rs. 3200. This rise in the prices of gold is an example of inflation. 

By definition:

“Inflation is a progressive increase in the price of goods and services within the economy.”

It means that an increase in inflation lowers your ability to buy more things. You can buy lesser commodities in the same amount over time. The purchasing power of money goes down with time due to inflation.  Here the concept of time value of money becomes extremely important since inflation impacts the worth of money over the period of time. To further understand this, you can enrol in online finance courses for detailed information.

In this article, you will learn about the various aspects of it, such as how it is calculated using different methods and its disadvantages and advantages.

Table of Content

• Why does inflation happen?
• What are the pros and cons of inflation?
• Measurement of Inflation: How is it calculated?
• Inflation in India
• Why do you need to learn about inflation?

Why Does Inflation Happen?

The following reasons cause inflation:

1. Excess printing of currency

When government prints too much money, each dollar becomes less valuable. Imagine a rare baseball card - if only 10 exist, each one is very valuable. Suddenly thousands are printed, each card will lose its worth. Similarly, whenever authorities orubrexcessive currency, people hold more currency but can buy the same amount of goods, causing prices to rise. This has happened in countries like Zimbabwe and Venezuela in the past where governments printed money rapidly to pay debts, leading to devastating hyperinflation.

2. Production cost increases

When businesses pay more to make their products, they typically pass these costs to consumers. For example, if the price of wheat rises, bakeries pay more for flour and charge more for bread. Similarly, when oil prices increase, transportation costs rise, making nearly everything more expensive. Companies must either absorb these higher costs (reducing their profits) or raise prices. Most choose to raise prices, pushing inflation through the economy.

3. Increase in demand for goods and services

When more people want to buy something while supplies remain limited, sellers can charge higher prices. Consider housing in popular cities - as more people move in seeking limited apartments, landlords raise rents. During economic booms, consumers often have more money to spend and businesses struggle to keep up with demand. Economists call this "demand-pull inflation" since higher consumer demand will pull up the  prices across the economy.

4. Lack of supply of commodities

Shortages drive prices higher. When farmers experience poor harvests, food prices rise. When factories shut down, product supplies dwindle and prices increase. Supply chain disruptions create similar effects. The COVID-19 pandemic demonstrated this clearly - factory closures, shipping delays, and worker shortages reduced available goods while demand remained strong. The resulting scarcity allowed companies to charge premium prices for available merchandise.

5. When workers demand increased salaries

As workers receive higher wages, their spending power increases, and they buy more goods and services. Meanwhile, businesses face higher labor costs and often raise prices to maintain profit margins. This can create a "wage-price spiral" where rising wages and rising prices continuously feed each other. When unemployment falls very low, workers gain bargaining power to demand higher wages, which can accelerate this inflationary cycle if productivity doesn't increase at the same rate.
Each of these factors may or may not trigger inflation independently, but in most cases, these factors together contribute to inflation. For example, supply shortages might prompt workers to demand higher wages, while excess money printing can amplify demand-driven inflation. Understanding these mechanisms helps explain why controlling inflation requires addressing multiple economic factors simultaneously.

What are the Pros and Cons of Inflation?

You might believe that inflation is bad for the economy. However, it is an inevitable part of the economy with both advantages and disadvantages. Let us discuss both.

Advantages

1. A moderate rate of inflation is a sign of a healthy economy. 
2. Theoretically, a higher rate facilitates production, which requires more labour. This leads to more manufacturing opportunities as well as more employment.
3. Debtors can easily repay loans with money that holds less value in comparison with the money that they borrowed

Disadvantages

1. High inflation rates cause uncertainty which reduces the influx of investment. Usually, countries with higher inflation rates have lower investment rates and, thus, lesser economic growth.
2. Higher inflation reduces exports and reduces the current account balance of payments. With higher inflation, unemployment also increases. 
3. It can also impact people’s lives, such as senior citizens who rely on savings. 

Measurement of Inflation: How is it Calculated?

Let us now discuss the different methods of measuring inflation:

The basic method for calculating the inflation rate is to find the difference between the indices and divide it by the previous period’s index. Let us understand this with the help of an example. 

For example, you want to calculate thecrate for biscuits in March 2021 concerning March 2014. Suppose the price of 100 gm biscuits was 52 rupees in March 2014; in March 2021, it is 60 rupees. Then the rate will be:

Start date: March 2014. Price: ₹ 52 = A

End date: March 2021. Price: ₹ 60 = B

Inflation Rate = ((B – A) / A) x 100 = ((60 – 52) / 52) x 100 

= (0.153) x 100

= 15.3%

Worldwide, different indices are used for calculating the inflation rate. Let us discuss the following globally adopted indices:

• Consumer Price Index
• Producer Price Indices
• GDP deflator 

1. Consumer Price Index

Inflation is measured by the consumer price index (CPI), which is the change in the price of a basket of goods and services purchased by households. Following is the method of calculating CPI:

To calculate the rate using this index, you need to find the difference between CPIs of two time periods. After that, you need to divide it with the CPI of the year for which you need to find the rate. Let us take an example:

Suppose, in January 2007, the CPI of a country was 202.416, and in January 2008, it was 211.080. Now, the rate for the time period will be:

2. Producer Price Indices

It is a price index to measure the average change in the selling prices that the domestic producers receive for the output. It measures the prices of commodities before they reach the customers. Currently, PPI is not used in India. The formula for calculating the PPI is:

You will calculate the inflation rate similar to the method used in CPI.

3. GDP Deflator

It is the measure of prices of domestically produced commodities in a period of one year. The GDP deflator is used for measuring the rate with respect to the base year. It is the ratio of current price (nominal) GDP to the real GDP. The GDP deflator for the base year is equivalent to 100. 

Real GDP is calculated on the basis of the base year’s prices. The GDP deflator in India is calculated quarterly but only released annually. 

Inflation in India

In India, this rate increased from 4.91% to 5.59% in December 2021, below the market expectations of 5.80%. It is still within the RBI’s 2-6% target range consecutively for the sixth time. 

Prices increased at a faster pace, including:

• Food items: from 1.87% to 4.05% 
• Clothing and footwear: from 7.94% to 8.30% 

Prices went down for:

• Fuel and light: from 13.35% to 10.95% per cent), 
• Housing: from 3.66% to 3.61%
• Pan, Tobacco and Intoxicants: from 4.05% to 3.22%
• Miscellaneous items: from 6.75% to 6.65%
• Consumer prices: went down for the first time in 11 months by 0.36% in December

Learn about the power of compounding

Why do you Need to Learn About Inflation?

It is an important concept because it affects every aspect of the economy, including the customer. It has a direct impact on your finances since it reduces the purchasing power of your money. As the rate increases, you must pay more for basic necessities such as groceries and utility bills. When you start understanding the concept, you can set a practical budget for the time period. According to that, you will be able to manage your finances in the long run better.