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What is Inflation ?
Let us first understand what the
term Inflation means. According to the Merriam Webster
Dictionary inflation is “a continuing rise in the general price
level usually attributed to an increase in the volume of money
and credit relative to available goods and services.” So from
this, we get to understand that inflation is a rise in the
general levels of prices of goods and services. It also goes on
to specify a cause for the inflation stating that the rise in
prices is because of an increase in the value of money and
credit. Putting these two parts of the definition, we can say
that inflation is general rise in prices intrinsically linked to
money.
Typically, when we hear the term inflation, it means that there
has been a sustained and prolonged period of increase in the
general level of prices for goods and services. It is usually
measured as an annual percentage increase. As inflation rises,
your purchasing power keeps dropping. For example, say you could
buy for a bottle of coke for a dollar a year back; the same
bottle of coke could now cost now you $1.50. In short, you pay
more for less.
Related Terms:
The following are terms related to
inflation
• Deflation is the opposite of inflation and refers to a decline
in the general level of price.
• Disinflation is a slowing down of the rate of inflation - the
general level of prices are still increasing but at a slower
rate.
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• Hyperinflation is a rapid increase
in prices over a short period of time - prices increase rapidly
even as currency loses its value. This type of economic
condition can happen during wars and political uprisings. An
example is Germany in 1923, when prices rose 2,500% in one
month.
• Stagflation is the combination of the words stagnation and
inflation. It is characterized by a period of high prices rises
combined with high unemployment and recession. This occurred in
industrialized countries during the 1970s when a poor economy
was combined with rising oil prices.
Causes of Inflation
• Demand-Pull Inflation – This situation arises when there is
the demand for goods and services is more than the supply. In
essence this means that there is more money and a shortage of
goods and services. Since more money is available for purchase,
people are willing to pay more for what they need thus driving
up the prices. |
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• Cost-Push Inflation – This
situation occurs when the production of goods falls. The reasons
for this could be scarcity of raw material or high cost of
labor. When production rates fall, the prices of good will
automatically rise leading to inflation. One major example is
the oil industry – when oil production falls, the oil prices
rise leading to a cascading increase in prices for all goods and
commodities resulting in inflation.
Measuring Inflation
How exactly is this inflation measured? How can a government
declare that there has been inflation in a particular period?
What are the criteria for declaring inflation?
Inflation is measured based on data collected by government
agencies by observing the change in the price of a large number
of goods and services in an economy. This is done by creating a
“market basket” and comparing the cost of this basket over time.
The “market basket” is a set of goods that are representative of
the economy. The prices of goods and services in this basket are
added to derive the average price level. The inflation rate is
calculated on the basis of the rate of increase in this index.
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Common
measures of inflation include
• Consumer price indexes (CPIs) measure the price of a selection
of goods purchased by an average consumer. The consumer is
typically a wage earner in an urban area.
• Producer price indexes (PPIs) measure the price received by a
producer. This is different from what the consumer pays. The
producer’s income is dependent on a number of factors including
profits, taxes, government subsidies and cost of raw material.
• Wholesale price indexes (WPI) measure the change in the
average price level of goods traded in wholesale market without
adding sales taxes. The WPI is the most widely used price index
in India.
• Commodity price indexes measure the change in price of a
selection of commodities, for example the gold standard in which
the average price level of gold is compared over a period of
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• GDP deflator measures change in
prices of all gross domestic products (GDP).
• Employment Cost Index measures wages, benefits, and the other
costs of labor in relation to the cost of the products
manufactured and sold.
Inflation and the economy
Inflation can have both positive and negative impact on the
economy:
Positive Effects
• It is considered favorable to have a small amount of
inflation. Trying to keep prices stable and achieving a zero
inflation rate can lead to deflation. Wages have to increase and
a resultant increase in prices is inevitable. This will adjust
over a period of time.
• Inflation provides an incentive for investment, rather than
have the purchasing power erode, it is better to invest the
money in the market thereby increasing the cash flow in the
market.
• Inflation also enables central banks to control the supply and
velocity of money. An inflation rate allows the banks to
stimulate the economy.
• Inflation can be seen as a sign of a growing economy.
Negative Effects
• A high inflationary rate may discourage investment and
savings.
• It impacts international trade negatively. The balance of
trade will be weakened and will adversely affect the fixed
exchange rates.
• The value of cash is eroded by inflation and as a result
people will tend to hold less cash during times of inflation.
• People living on a fixed-income, such as retirees, see a
decline in their purchasing power and their standard of living.
• Companies must deal with the cost of repricing such as price
lists, labels, menus and pass it on to the consumers.
• If inflation gets totally out of control, it interferes with
the normal workings of the economy.
• The government may seek to improve its net financial position
by allowing inflation. This is known as "stealth tax".
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Article Contributed By: Jaya Suresh
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