Inflation is one of the most familiar words in economics. It’s often used to describe the impact of rising oil or food prices on the economy.
For example, if oil prices go up by $25 per barrel, then input cost of business and transportation costs will increase. In response, the cost of many other products and services will rise.
Inflation may plunge countries into a long period of instability.
Prices are like market air supply. It tells businesses or consumers when to produce more or consume less. High inflation is like contamination to this air supply. It creates difficulty among businesses to interpret price signals. Therefore they defer their investment decisions until prices are settled.
Inflation and unemployment rates are considered as two economic indicators that help to determine an average citizen’s financial health.
In this article, you will learn what inflation is and how it is measured.
What is Inflation?
Inflation is an economic term which means it increases your cost of living.
Inflation is the rate of increase in prices over a given period of time. It’s a continuous price rise of almost everything such as food, clothing, housing, recreation, transport, consumer staples, etc, thereby decreasing the purchasing power of your money. it increases the cost of living in a country.
Inflation is expressed as a percentage. It’s a rate at which prices of goods and services rise over a period. This means, a unit of money or currency effectively buys less than what it was capable of buying in prior periods. In other words, one unit of money buys fewer goods and services due to inflation.
For every month, inflation rates are calculated both on a year-on-year basis to know how prices have changed over the past year and on a month-on-month basis to know how prices have changed over the past month.
Don’t think of inflation as a price rise in one or two items or services. It refers to the broad increases in prices of almost everything across the economy.
Due to high inflation many middle and lower class people will watch their income and savings get wiped out.
Hyperinflation is where prices rise by 50% or more per month.
A retired employee who bought fixed deposits @5.3% per year will be worried by seeing inflation jump to 7.1% as his purchasing power gets clobbered.
However a home buyer who bought a house at a low interest before rising in inflation will be happy seeing the price rise in real estate by 50%.
Government tries its best to control inflation by monitoring money supply, prices, and controlling interest rates.
What is the cause of inflation?
Inflation is not automated. It’s created due to certain circumstances. It can be good or bad depending on how the rise in prices impacts your pocket.
For instance, a rise in real estate value can increase the price of property you hold, which can be sold at a higher rate to make more money. However, buyers of the property will not be happy with the rise in price as they have paid more.
There are generally two causes of inflation: Demand pull effect and cost push effect.
Demand pull effect
Printing and giving away more money to citizens, increase in supply of money and credit stimulates the overall demand for goods and services. If it increases more rapidly than the economy’s production capacity, then such increases in demand leads to price rises.
When people get more money, it leads to higher spending. This higher demand for goods and services pulls prices higher. Due to this a demand-supply gap is created, which results in higher prices.
Excess circulation of money leads to inflation as money loses its purchasing power. With people having more money, they also tend to spend more, which causes increased demand.
Cost push effect
When there is a negative sentiment to the supply of key commodities, cost for these commodities increases. These developments lead to higher costs for the finished product or services. For instance, recent increase in oil and energy costs due to global uncertainty contributed to rising consumer prices, which reflects in various measures of inflation.
As the price of goods and services rise, people demand an increase in salary and wages to maintain their standard of living. This increase in wages results in higher cost of goods and services.
High demand and low production or supply of multiple commodities create a demand-supply gap, which leads to a hike in prices.
Type of price indexes to measure inflation
Inflation is measured by the government using two indices.
Most commonly used inflation indexes are the consumer price index and the wholesale price index. Now let us learn what is consumer price index (CPI), what is wholesale price index (WPI),and how these are measured.
Consumer price index – CPI
Cost of living of consumers depends on the prices of many goods and services. In order to measure the cost of living of consumers, the government agencies conduct various surveys to track over time the cost of purchasing those goods and services.
The cost of this basket of goods and services expressed relative to a base year is consumer price index (CPI).
The percentage change in Consumer price index (CPI) over a period of time is consumer price inflation.
For instance if a base year Consumer price index (CPI) is 100 and the current year Consumer price index (CPI) is 115, then consumer price inflation is 15% over the year.
The biggest cost of inflation is erosion of real income due to rising prices which inevitably reduces the purchasing power of certain consumers.
For instance, pensioners may receive a 5% yearly increase in their pension. If inflation is higher than 5%, the purchasing power of these pensioners falls.
Consumer price index (CPI) is a measure that examines the weighted average of prices of a basket of goods and services which are of primary consumer needs.
Change in consumer price index used to assess the rise or fall in price associated with the cost of living. Every country reposted their Consumer price index (CPI) on a monthly basis.
Formula used to measure inflation;
Percentage inflation rate = (Final CPI Index Value / Initial CPI Value) x 100
Wholesale price index (WPI)
In India, inflation is measured by taking the wholesale price index (WPI) and consumer price index (CPI). These two indices measure changes at the retail and wholesale price levels, respectively.
Wholesale price index (WPI) measures changes in the price of goods in the stages before the retail level. This means it measures price change in items at wholesale or producer level.
Formula to calculate inflation;
[(WPI in month of current year-WPI in same month of previous year) / WPI in same month of previous year ] * 100
What is Stagflation, deflation and hyperinflation ?
Stagflation means the inflation is at a high, the country’s economy is not growing and the unemployment is rising.
When price declines throughout the entire economy and purchasing power increases, it’s referred to as deflation. It’s the opposite of inflation.
When prices are falling, most of the consumers delay their purchases expecting prices to fall further. This will lead to less economic activity, lower economic growth and lower income for producers.
Hyperinflation takes place when prices rise by at least 50% each month. It occurs when inflation rises rapidly and the value of currency of the country tumbles rapidly.
A moderate rate of inflation of 2% or 3% is considered as beneficial for an economy. Due to this reason government agencies and RBI will always strive to achieve a limited level of inflation.
The most powerful way to protect yourself from inflation is to increase your earning ability and income.
For better return on your investments you can go for stocks or any other investment which will give you a year-on-year increased rate of return to beat inflation. You need to consult your financial advisor before taking any decisions that can impact your financial goals.
What is Stagflation and when it’s triggered
Stagflation is derived from two words stagnation and inflation. Stagflation is an economic term used to describe a condition that describes slow growth, high unemployment and rise in prices of goods and services.
In other words, stagflation is a combination of three negatives: slower economic growth, higher unemployment and high inflation.
Inflation refers to a sustained increase in prices of all goods and services in an economy over time. Inflation can occur due to many factors. One of the most impact factors is when the money supply grows faster than the rate at which goods and services are products in a country.
In 1965, British politician Lain Macleod used the term Stagflation to describe the time of economic stress in the United kingdom. He describes the effects of inflation and stagnation as a “stagflation situation”.
Many economists argue that the combination of slower economic growth, higher unemployment, and higher prices isn’t supposed to occur in the logic of economics. They argue that unemployment fell as inflation rose, and rose when inflation fell. Therefore, this combination is not possible. However, in the 1970s the United States faced stagflation due to the oil crisis.
Stagflation is harmful to the economy. For end consumers it means people are earning less and spending more on almost everything.
When end consumers spend less due to higher costs, consumer spending slows down and corporate revenue decreases. This affects the overall economic activity, resulting in slow growth and unemployment.
As discussed above, stagflation occurs when there is a high inflation, higher unemployment and decrease in economic activity.
Here are few factors that may cause stagflation;
Poor fiscal policy and monetary policy decisions.
Increase in cost of oil and energy prices and decrease in economic productivity.
Reaction of consumers and producers to the economic behavior such as rising prices, monetary policy changes and unemployment may create stagflation.
Economists closely watch the trends in growth, rise in prices, unemployment and other measures to assess if stagflation will be triggered. If the price rise and economic slowdown is temporary, economists don’t fear stagflation.
Deflation: Definition, Causes and is it good or bad for us
In economics, deflation occurs when there is a general decline in prices for goods and services across all segments of the industry. As prices decline, the purchasing power of money rises over time.
Deflation benefits the end consumer as their purchasing power increases. They can buy more goods and services due to lower prices with the same income over time.
Purchasing power means the value of one unit of money that can buy the number of goods or services. During inflation, rising prices decrease the value of one unit of money that can buy the number of goods and services.
Purchasing power means your home currency’s buying power.
During deflation, purchasing power increases, which means the value of your home currency increases. Thus, you can buy more goods and services for the same amount of money.
Deflation is the opposite of inflation. To put it another way, deflation is negative inflation.
A borrower who is bound to pay his debt will not be happy as the money he paid is worth more than the money he borrowed. Deflation has a negative impact on the economy.
What triggers deflation?
Decrease in supply of money and credit without a corresponding decrease in economic production of goods and services causes deflation. When the supply of money comes down, the prices of all goods and services tend to fall.
A decline in prices can be caused due to a number of other factors such as decrease in demand of all goods and services, increase productivity with decrease in money supply.
A decrease in demand for goods and services subsequently forced the businesses to lower their prices.
When the output of the economy grows faster than the money supply, prices fall due to lower production costs and lack of demand for goods due to decrease in money supply.
Here is a list of causes that triggers deflation;
- Stagnant economic growth;
- Restriction of the central bank in money supply. When the central bank increases interest rates for an extended period of time, credit becomes expensive due to which money supply decreases leading to lesser demand of goods and services, ultimately falling in prices.
- More supply of goods and services but lesser demand;
- Due to unemployment and low wages end consumers have less money in hand. They spend less and save more for rainy days. Due to this problem demand decreases as a result prices fall. Negative sentiment in the economy may discourage people to spend more and increase their savings, which leads to decrease in demand for goods and services.
- Excessive production due to technology advancement reduces cost of production and increases supply of goods. With lesser demand and higher supply, prices of goods and services fall.
Above causes of deflation can be classified under two heads: (1) downfall in demand of goods and services with increase in supply, and (2) mismanagement in money supply by the central banks.
Is deflation bad or good?
Due to the decrease in prices of all goods and services, businesses will not be interested to invest more money. When owners of assets saw their asset prices fall, they postponed their investment with an expectation of further fall in prices, resulting in lower economic activity.
Deflation is considered bad for the economy even though it increases the purchasing power of money.
If deflation is not controlled then it may lead us to depression. It causes negative effects on the economy, increases unemployment, increase in the real value of debt, lower production, and lower wages.
Many economists think that deflation is more dangerous than inflation as economic activity falls with a fall in the aggregate demand, wages, employment and investments.
Example of deflation
In the 1930s the United states experienced significant deflation. The period between 1930 and 1933 is referred to as the Great Depression.
In the 21st century, deflation occurred between 2007 and 2008, this period is referred to by economists as the Great Recession.
In the 1990s Japan experienced deflation. Japan experienced a period of economic stagnation and price deflation from 1991 through 2001. This period is known as Japan’s “Lost Decade”.
Inflation vs. Deflation: Comparison
Here is a table showing the comparison of inflation with deflation in economics;
| Particulars | Inflation | Deflation |
|---|---|---|
| Definition | Inflation is an economic term which means there is a rate of increase in prices over a given period of time. | Deflation is the opposite of inflation. It means an economic slowdown, where prices of goods and services decline. |
| Cause | Lack of demand;Higher supply of goods and services with low demand;Contraction of money supply;Low investment | Increase in demandIncrease of money supplyLow interest ratesHigher investments |
| Effect | Decreases the purchasing power of money. Increases the cost of living. | Increases the purchasing power of money and decreases the cost of living. |
Companies with less debt and more cash reserves are generally considered as an attractive investment during deflation.
Shrinkflation: What is it and why is it used by producers
Shrinkflation is a process of items shrinking in size or quantity, or even sometimes reformulating, while their prices of the product remain the same or slightly increase. It is a tactic used as an alternative to raising prices in line with market inflation.
Shrinkflation is also known as package downsizing. This means your everyday products shrink in size and quantity with the same price tag.
The term “shrinkflation” is derived from two separate words: shrink and inflation. Pippa Malmgren, a British economist, is often credited with coining shrinkflation. It is a practice generally followed in the fast moving consumer goods (FMCG) industry.
What causes shrinkflation?
Shrinkflation helps FMCG companies to increase their operating margin and profitability by reducing costs whilst maintaining sales volume, and is often used as an alternative to raising prices in line with inflation.
If a fast moving consumer goods company (FMCG) thinks that the product at a price will not be acceptable by many customers due to inflation or rise in cost, then instead of increasing the price of a product, then they prefer to reduce the size of the product while maintaining the same price. In this way, the actual price of the product does not increase but the price per unit of weight has increased to maintain the profit margin.
FMCG companies follow this practice during high inflation or when they think that the cost of raw material will be higher for a longer duration. If they don’t follow this practice, then customers might look for a substitute product at the same or lower price offering similar features. In this case, getting back customers will be very difficult.
Increase in production costs is the main reason for shrinkflation.
Rise in raw material costs, energy, salaries and wages, and other production costs due to high inflation is the main reason for following the practice of shrinkflation. To maintain profitability, they reduce the size to lower the cost per unit and sell it at the same price. Please note, it’s not illegal as these FMCG companies clearly show the weight and other details in the product that they sold. However, the customer does not pay much attention to it as he is paying the same price for the product.
Market competitors can be another factor why companies use these tactics to maintain market share at a price that is affordable to the customers.
Shrinkflation is a very common practice followed by companies.
Example of shrinkflation
A beverage company which is selling 2 liters of cold drinks at Rs 100, may charge you the same price by offering 1.75 liters at the same price of Rs 100 instead of offering 2 Liters.
A company selling 100 items in a pack at Rs 500, may charge you the same price by offering 90 items in that packet.
Price of a notebook has not changed but pages of the notebook have been reduced from 100 pages to 80 pages.
Fewer potato chips in the bag at the same price of Rs 10.
If not managed properly, then shrinkflation tactics might backfire badly.
