What is Inflation? – Meaning & Types

What is Inflation and what are its Causes ?

Inflation is the phenomenon of a sustained increase in the general price level of goods and services within an economy over a period of time. It essentially means that, on average, prices are rising, and each unit of currency can purchase fewer goods and services than it could previously. Inflation is measured as an annual percentage increase in the Consumer Price Index (CPI) or the Wholesale Price Index (WPI), which tracks the price changes of a basket of goods and services.

Several factors can contribute to inflation, and understanding its causes is crucial for policymakers, businesses, and investors:

Demand-Pull Inflation

This occurs when the demand for goods and services exceeds their supply. Increased consumer spending, government expenditure, or investment can lead to higher demand, putting upward pressure on prices.

Cost-Push Inflation

When the costs of production, such as raw materials or labour, rise significantly, businesses may pass these higher costs onto consumers in the form of higher prices, causing cost-push inflation.

Built-In Inflation

Also known as wage-price inflation, this occurs when workers demand higher wages to keep up with rising prices. In response, businesses raise prices, creating a cycle of inflation.

Monetary Policy

Central banks play a critical role in controlling inflation. Central banks can influence borrowing and spending by adjusting interest rates and money supply, impacting inflation rates.

Fiscal Policy

Government policies, such as tax cuts or increased government spending, can stimulate demand and potentially contribute to inflation.

Exchange Rates

Changes in exchange rates can influence the prices of imported goods. A weaker domestic currency can lead to higher import costs and inflation.

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Inflation Rate Meaning and Formula

The inflation rate is a crucial economic indicator that measures the percentage change in the general price level of goods and services in an economy over a specific period, typically on an annual basis. It provides insight into the rate at which prices are rising, reflecting the erosion of the purchasing power of a currency.

The formula to calculate the inflation rate:

Inflation Rate (%) = [(Current CPI – Previous CPI) / Previous CPI] × 100

Here’s a breakdown of the components:

Current Consumer Price Index (CPI): represents the average price level of a basket of goods and services in the current period.

Previous CPI: This represents the average price level of the same basket of goods and services in the previous period (typically a year ago).

The result of this formula expresses the inflation rate as a percentage, indicating how much prices have increased (positive inflation) or decreased (negative inflation or deflation) relative to the base period.

Types of Inflation

Inflation can be categorised into several types based on its causes, severity, and impact on an economy. Here are the main types of inflation:

Demand-pull inflation

This type of inflation occurs when aggregate demand in an economy exceeds aggregate supply. It is typically the result of increased consumer spending, government expenditure, or investment.

Cost-Push Inflation

Cost-push inflation arises when the costs of production, such as wages or raw materials, increase significantly. This forces businesses to pass on these higher costs to consumers through higher prices. Supply disruptions, like those caused by natural disasters or geopolitical events, can trigger cost-push inflation.

Built-In Inflation (Wage-Price Inflation)

Also known as wage-price inflation, this type occurs when workers demand higher wages to keep up with rising prices. In response, businesses raise prices to cover increased labour costs, creating a cycle of inflation.

Monetary Inflation

This type of inflation is primarily caused by an increase in the money supply in an economy, often due to expansionary monetary policies by central banks. When there is more money in circulation relative to goods and services, the result is rising prices.

Hyperinflation

Hyperinflation is an extreme form of inflation characterised by an exceptionally rapid and uncontrollable rise in prices, often exceeding 50% per month. It can result from factors like a collapse in the value of a currency, excessive money printing, or severe economic crises.

How does it work?

Inflation fundamentally revolves around the interaction of supply and demand dynamics, and it works through the key cycle that includes:

1. Increase in Money Supply

One of the primary mechanisms for causing inflation is an increase in the money supply. When a central bank prints more currency or introduces it into the economy through various monetary policies, there is more money available to be spent.

2. Rising Demand

With more money in circulation, consumers and businesses have increased purchasing power. This leads to higher demand for goods and services.

3. Imbalance of Supply and Demand

As demand rises, producers may struggle to keep up with the increased demand. This can lead to shortages of goods and services in the market.

4. Price Adjustments

When demand exceeds supply, producers often respond by increasing prices. They can do this to optimise profits and control demand.

5. Wage and Cost Pressures

Workers may demand higher wages to maintain their purchasing power in an inflationary environment. If businesses grant these wage increases, they often compensate by raising prices.

6. Repeat Cycle

This process can become cyclical. Higher prices can lead to increased revenue for businesses, leading to more spending and higher demand.

7. Expectations and Behavior

Over time, if individuals and businesses expect prices to continue rising, they may adjust their behaviour. This can include purchasing goods and assets sooner or negotiating higher wages and prices, contributing to further inflation.

It’s important to note that inflation can be influenced by a variety of factors, including changes in government policy, shifts in international trade, and supply chain disruptions.

Effects of rising inflation rate

The effects of a rising inflation rate include:

Purchasing Power Erosion

Consumers can buy less with the same amount of money.

Increased Costs

Businesses may face higher production and operating costs.

Uncertainty

Investors and consumers may become uncertain about future prices.

Interest Rate Hikes

Central banks may raise interest rates to curb inflation, impacting borrowing costs.

Income Redistribution

Debtors may benefit as debt becomes less valuable, while savers may lose out.

Impact on Fixed Incomes

Retirees on fixed pensions may find it challenging to cover living expenses.

International Trade

A high inflation rate can affect a country’s competitiveness in international markets.

How is inflation measured?

Inflation is measured using various indices that track the changes in the prices of a selected basket of goods and services over time. These indices provide a quantitative representation of how much the cost of living has risen within an economy. The most commonly used indices for measuring inflation include the Consumer Price Index (CPI) and the Producer Price Index (PPI).

The Consumer Price Index (CPI) is a widely recognised measure of inflation that reflects the average change in prices paid by urban consumers for predetermined goods and services. This includes items such as food, housing, clothing, transportation, healthcare, and entertainment.

On the other hand, the Producer Price Index (PPI) measures the average change in selling prices received by producers of goods and services over time. PPI is crucial in understanding inflation at the production level. It provides insights into businesses’ cost pressures, which can impact consumer prices downstream.

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Ways to get prepared for inflation

To prepare for inflation, consider the following –

Invest Wisely

High Returns

Diversify your investment portfolio to include assets that historically performed well during inflation, such as stocks, real estate, and commodities.

Save and Budget

Increase your savings and create a budget to manage expenses efficiently during rising prices.

Pay Down Debt

Reduce high-interest debt, as interest payments can become more burdensome in an inflationary environment.

Asset Allocation

Consider inflation-protected securities like Treasury Inflation-Protected Securities (TIPS) to preserve purchasing power.

Adjust Income

Negotiate for inflation-adjusted wages or seek income sources with built-in inflation protection.

Monitor Investments

Stay informed about economic trends and regularly review and adjust your financial strategy to align with changing inflation rates.

How does it impact the stock market?

Inflation can significantly impact the stock market, influencing investor sentiment, corporate profitability, and overall market dynamics. Some major impacts are –

Purchasing Power Erosion

As inflation increases the purchasing power of money, investors may seek assets that offer a better hedge against rising prices. This can lead to increased demand for stocks, driving up prices.

Interest Rates

Central banks often raise interest rates to combat high inflation. Higher rates can make bonds and fixed-income investments more attractive than stocks, potentially leading investors to shift their portfolios away from equities.

Corporate Profits

Inflation can affect a company’s profitability. Rising input costs like raw materials and labour can squeeze profit margins. Companies may pass these cost increases onto consumers, potentially reducing sales or market share.

Investor Sentiment

Inflation can create uncertainty in the market. Investors may become more risk-averse and cautious about the future, leading to increased market volatility and fluctuations in stock prices.

Sector Performance

Inflation can impact sectors differently. Some sectors, like commodities, energy, and real estate, may benefit from rising prices, while others, like technology and growth stocks, may face challenges due to higher borrowing costs and reduced demand for their products.