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What is Inflation?

dateKnowledge Centre Team dateNovember 25, 2022 views178 Views
Time Value of Money | Financial Planning

Any inflation rate essentially tells us the rate at which prices have been rising in an economy and is expressed as a percentage. If the prices of potatoes rise from Rs. 45 per kg this year to Rs. 67 per kg next year, the inflation rate will be 50%. That’s because a kg of onion is Rs. 22 (~ 50%) more than the base price (Rs. 45). Inflation impacts your buying capacity.

A bar of chocolate used to cost Rs. 25 in the year 2012. The same chocolate costs Rs. 45 in 2022. Chocolate has become costlier in the last 12 years. With the same Rs. 25, one can get only almost half a chocolate in 2022. Your money seems to have eroded with time.

Therefore, inflation refers to the increase in the prices of items of daily use, such as food, housing, clothing, transportation, entertainment, etc. Inflation is measured by the average price change over a period of time. The RBI tries to limit inflation in order to keep the economy functioning smoothly. There are certain benefits as well as drawbacks of inflation.

Types of Inflation

The three types of Inflation are Demand-Pull, Cost-Push and Built-in inflation.

a) Demand-pull Inflation:

When demand exceeds supply, producers increase prices and new market equilibrium is formed. In simple terms when more money chases fewer goods, the prices increase and this is called “Demand-Pull” inflation.

b) Cost-push Inflation:

When the cost of input (such as labour, raw materials etc) increases, companies prefer passing on this hike to the customer so that their margin remains unaffected. It occurs when the cost of production increases.

c) Built-in Inflation:

Expectation of future inflations results in built-in inflation. An increase in prices results in higher wages to match the increased cost of living. These increased wages result in an increased cost of production, which in turn affect market pricing. A vicious circle is created.

How does Inflation Affect you?

Inflation, the steady rise of prices for "anything” over time, has many effects, good and bad. Some of them are listed below:

1. Erodes Purchasing Power:

This first effect of inflation is really just a different way of stating what it is. Inflation is a decrease in the purchasing power of currency due to a rise in prices across the economy. A simple example would be, suppose a kg of oranges cost Rs.100 in 2018 and it cost Rs.110 in 2019, then there would be a 10% increase in the cost of a kg of oranges.

2. Increase Expenditure:

As prices rise, you end up stocking stuff that you feel would get costlier with time. In the quest to tame inflation, you end up over-spending.

3. The Vicious Cycle:

You spend to stock up on goods so that you do not end up overpaying for those essential items. When everyone thinks alike, the stores go empty increasing demand further and putting inflation in a vicious circle.

4. Increases Interest Rates:

If you are saving money, you may earn some additional rupees in your account. If you are planning to borrow or have a floating rate of interest on your existing loans, be prepared to pay more.

If you own property, the market rate may increase, thus increasing your net worth. If you have let out your house, you can expect to earn more in rent. Even though the maintenance costs of your house will also increase, this hike will not be as steep as the increase in rent making you richer.

Your employer may also be feeling the heat of inflation and may increase product prices and also your salary. Gold is considered a natural hedge against inflation and you may notice a sudden rise in gold prices during times of high inflation.

Can you Benefit from Inflation?

Yes, you can. Provided you adopt a prudential approach while investing. Some below are a few ways to help you beat inflation:

1. Real Estate:

Your property price starts increasing during inflationary periods. By investing in real estate, you are also profiting if you have let out your property. You can let out the property at higher rents while the maintenance costs may not increase at the same pace.

2. Commodities:

As commodity prices increase due to inflation in consumer goods, you may consider investing in commodities through mutual funds.

3. Equity:

Equity exposure is a must to generate wealth. ELSS helps you fetch good returns plus the investment is deductible from taxable income. However, the returns are not exempt from tax. ULIPs have that too. ULIPs are eligible for a tax deduction (investment) and are exempt from tax (on maturity).

4. Gold:

The price of gold increases because gold is limited in supply. The gold pricing is a classic example of demand and supply and more money chasing limited goods. The underlying reason for moving to gold is because Gold is symbolically considered a safe investment that stands the test of time.

Which Factors can Affect Inflation?

Here is a list of the five primary causes of inflation:

1. Growing Economy:

In a growing economy, unemployment declines and wages increase. As a result, people have more disposable incomes, which they spend on things beyond basic necessities. This rise in demand allows suppliers to increase prices, which in turn leads to more jobs and puts more money in circulation.

A growing economy leads to an increase in consumer spending and demand. This is considered a form of demand-pull inflation.

2. Expansion of Fiat Money:

A sudden influx of money in the economy can also drive demand-pull inflation. This happens when the RBI prints money at a rate higher than the growth rate of the economy. With more money in circulation, there is more money chasing the same number of goods as earlier. The market finds its own equilibrium with an increase in prices.

3. Government Regulation:

The government can make it more expensive for companies to produce goods or import them. The companies pass on this increase in production cost to customers by increasing selling prices. This results in cost-push inflation.

Do not neglect the inflation’s impact on your money. To know more about inflation-hedging investments such as commodities, real estate and precious metals, you can check with a financial expert. The interest rates earned in savings accounts will not beat rising prices. Investing money in inflation-beating instruments is critical to keep growing your wealth.

Disclaimer: This article is issued in the general public interest and meant for general information purposes only. Readers are advised to exercise their caution and not to rely on the contents of the article as conclusive in nature. Readers should research further or consult an expert in this regard.

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