Inflation Demystified


What is inflation?

In simple terms, inflation is the increase in the price of goods and services, and the inflation rate is the rate at which such increase takes place. Let’s say, the price of apple increases from Rs. 100 per kg to Rs. 110 per kg. It is inflation. The inflation rate of apples is (110-100)/100= 10%. Inflation decreases the worth or value of money. 100 rupees could buy 1 kg of apples previously, but now 100 rupees can buy less than 1 kg of apples, as 1 kg of apples cost 110. Hence, the purchasing power/ worth of money declines if there is inflation.

But, in an economy, there are many goods and services. So, how is inflation in the economy calculated?

Inflation is defined as the increase in prices of goods and services over time. It is usually calculated by the rate of increase in Consumer Price Index (CPI).

Consumer Price Index is the weighted average of the prices of selected goods and services consumed by people. It is also called retail price index. The basket includes those goods and services in the retail market which are representative of expenditure by a typical consumer. In India, CPI is published on monthly basis and yearly basis.

Another way to calculate inflation is to use Wholesale Price Index (WPI). This index measures the price level of goods traded in the wholesale market. Presently, in India, it includes prices of 676 commodities. It is published weekly and monthly.

What are the causes of inflation?

There are two main reasons for inflation or price rise.

The first is when the demand for goods increases. It is because people have more money to spend i.e. the money supply in the economy increases and so they start buying more of goods and services.  This leads to price rise. This is also called demand-pull inflation.

Money Supply ↑ ⇒ demand ↑ ⇒ price ↑ ⇒ inflation ↑

RBI tries to reduce the rate of inflation by reducing demand. It increases interest rates. This leads to a reduction in borrowings because the cost of borrowing (interest rates) increases. It leads to decrease in money supply. People have less money in their hands, so they demand less of goods and services. Hence, prices decrease.

Interest rate ↑ ⇒ borrowing ↓ ⇒ money supply ↓ ⇒ demand ↓ ⇒ price ↓ ⇒ inflation ↓

The second is when the cost of production of goods increases leading to an increase in price. The reasons for this could be: excise duty/ other tax increase, wages increase or a price of raw materials increase. This is also called cost-push inflation.

Excise duty ↑ ⇒ cost of manufacturing ↑ ⇒ price ↑ ⇒ inflation ↑

Apart from other factors, the reason why inflation rate has come down in India is because prices of crude oil in the world market has decreased. Oil is used as raw material in certain industries and also oil affects the transportation cost of goods as the price of petrol etc declines.

Oil price ↓  ⇒ transportation cost ↓ ⇒ cost of manufacturing ↓⇒ price ↓ ⇒ inflation ↓

What is headline inflation and core inflation?

The measure of inflation that includes the prices of all types of goods is called headline inflation. In core inflation, we exclude the prices of food and fuel. The reason is the prices of food and fuel are volatile and makes the measure of inflation unstable.

Is inflation always bad?

No. A moderate inflation is a sign of a healthy economy. It signifies robust growth, investment and demand. Most countries target an inflation rate of 2 to 3% because if there is deflation in the economy, it indicates there is very little consumer demand. Also, consumer demand falls further as people stop buying goods expecting a fall in price. This sets off a vicious cycle.  People do not invest in a deflating economy.

There are signs that India has entered a deflationary stage. Headline inflation rate based on the Wholesale Price Index (WPI) lowered to -4.95% (negative) in August 2015. CPI inflation eased to 3.66%. Read more about it in this Hindu article.

If you want to give feedback on this article, you can use the comments section below.

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Have any Question or Comment?

7 comments on “Inflation Demystified

Priti Aggarwal

Simply beautiful! The sheer simplicity of this article makes it worth reading.

Reply
Mridusmita

Thank you so much:) Keep reading and sharing your feedback

Reply
Anshika Agarwal

Very good explanation of every concept. Worth reading. Keep going.

Reply
Mridusmita

Thank you so much:-) Please keep reading and sharing your feedback on the blog

Reply
Varun Bhandari

I just want to add following lines in your explanation.

Although Wholesale Price Index (WPI) is used extensively as a measure of inflation in India but it has several limitations:
(a) non-inclusion of services
(b) following a fixed weighting scheme while the economy is undergoing major structural changes, and
(c) use of gross transactions data rather than data on final purchases.

Hope it helps in further elaborating the concept of WPI.

Reply
Mridusmita

I agree with you. Also, it is the CPI that affects the consumers directly. But, in the Indian context historical data for CPI is not easily available as we have started computing it since 2010 only. Earlier we had 3 different measures of CPI calculated separately for agricultural workers, industrial labourers and rural labourers. Also, CPI is highly susceptible to change in food prices.

Reply
Rajeev Upadhyay

Nice post Mridusmita. You have covered most of the things in the write. Well done and keep it up.

Reply

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