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Inflation: Definition, Types, Causes And How To Fight It

By April 21, 2021 No Comments
Inflation

What is Inflation?

Inflation is defined as the increase in the cost of living as the price of goods and services of daily or common use, such as food, transport, clothing, consumer staples, housing, etc., rise. This rise in the general price level in an economy results in the decline of the currency’s purchasing power over time.

As the currency loses value, prices rise, and it can buy fewer goods and services, ultimately leading to a deceleration in economic growth. Inflation is measured in percentage and is the opposite of deflation (decline in the prices of goods and services when the inflation rate drops below 0%).

Effects of Inflation

Inflation affects:

  • The purchasing power of a currency unit
  • Cost of living
  • Economic growth

When the inflation is high, the prices of commodities and services get higher, and it:

  • Decreases the purchasing power of the currency
  • Increases the cost of living
  • Causes deceleration in economic growth.

High or low inflation is bad for the economy, while a balanced level is considered healthy for the economy.

Causes of Inflation

There are 4 causes of inflation, and they include:

  1. Fiscal Policy: This policy monitors the spending and borrowing of the economy. When the borrowings are high, it results in increased taxes and increases currency printing to repay the debt.
  2. Monetary Policy: This policy monitors the supply of currency in the market. When there is an excess supply of money, it causes inflation and decreases the value of the currency.
  3. Cost-Push Inflation: Due to high production costs, the prices of the goods and services get high, too.
  4. Demand-Pull Inflation: When there is a gap between demand (high) and supply (low), there is an increase in the price of products and services, causing inflation.
  5. Exchange Rates: Fluctuations in the currency exchange rate impact the rate of inflation.

Types of Inflation

There are different types of inflations as follows:

    Based on the Factors That Drive Inflation
     

  • Demand-Pull Inflation: This type of inflation occurs when the demand for goods and services is high, but their production capacity is low. The gap between demand and supply causes the prices to shoot up.
  • Cost-Push Inflation: This inflation type occurs when the production cost increases. The increase in the prices of raw materials, labour, etc., eventually increases the price of the product.
  • Built-In Inflation: This type of inflation occurs when future inflations are expected. When prices go up, it results in higher wages for people to afford the increased cost of living. The high wages then results in increased cost of production, which in turn impacts the product pricing. Hence, the circle continues.
     
    Based on the Sector/Industry
  • Core Inflation: It is the rise in the prices of everything except food and energy. That’s because the prices of energy (power and fuel) and food are highly volatile, and therefore, they have been kept out of core inflation.
  • Wholesale Inflation: Wholesale or headline inflation is based on wholesale prices. It allows the government to spot the price rise in advance.
  • Retail Inflation: It is calculated based on the changes in the Consumer Price Index (CPI). It measures the impact of price rise, and therefore, plays a significant role in financial planning for the average investor.
  • Food Inflation: It is highly volatile and is a subset of headline/wholesale inflation. In a developed world, a rise in food prices is merely an inconvenience for the people. But when the food prices rise in the developing world, it can mean going hungry and getting just enough to eat.
  • Lifestyle Inflation: This happens when a rise of income of an individual gradually improves the lifestyle of the individual, which means a better car, branded clothes and a bigger house.
  • Housing Inflation: This type of inflation is another subset of headline inflation. In this type of inflation, the house price rises by the rate of inflation times the cost of the house.
  • Medical Inflation: This inflation type is the increase in the average or unit cost of healthcare services over a historical period of time.
  • Education Inflation: Another subset of headline inflation, education inflation, only measures the increase in education and stationery costs.
     
    Based on the Rate of Inflation
  • Deflation: It is the opposite of inflation. It’s when prices drop, and it’s caused when the asset bubble bursts. For example, the housing market crash of 2007. It’s harder to stop deflation.
  • Hyperinflation: This occurs when prices go up by 50% a month. It is a very rare occurrence.
  • Galloping Inflation: When inflation rises to 10% or more, it causes chaos. The currency loses its value so quickly that business and the employee income can’t keep up with costs and prices.
  • Walking Inflation: An inflation between 3-10% a year causes walking inflation. It’s destructive for the economy as it urges people to buy more than they need to avoid tomorrow’s higher prices.
  • Creeping Inflation: Creeping or mild inflation is when prices rise 3% a year or less. A price increase of 2% or less is known to benefit the economy. This kind of mild inflation creates demand by making the consumers expect that prices will go up. This creates demand and drives economic expansion.

How is Inflation Measured in India?

In India, inflation is primarily measured by WPI (Wholesale Price Index) and CPI (Consumer Price Index).

  • The Consumer Price Index (CPI) measures the average change in prices over time that consumers pay for a basket of goods and services. CPI measures retail inflation, and it calculates the price difference of goods and services such as food, education, medical care, electronics, etc., which the consumers buy to use.
  • A Wholesale Price Index (WPI) measures and tracks the changes in the price of goods before they reach consumers: goods that are sold in bulk and traded between entities or businesses (rather than consumers). WPI measures wholesale inflation. It captures the goods or services sold by businesses to smaller businesses for selling further.

The Current Inflation in India

The Reserve Bank of India (RBI) has kept retail inflation at 4%, plus or minus 2. It has eased to 4.1% in January this year, compared to 4.6% in December 2020.

The retail price rise in food was 1.9% in January, much lower than the 3.4% in December last year. Retail inflation has softened, but core inflation is on the rise, and that’s a concern.

Core inflation in January 2021 was at 6.5% in January 2021, notably higher than the 4.2% recorded last year in the same month. In the coming months, as the economy recovers from the pandemic, core inflation might go up.

Aditi Nayar, principal economist, ICRA, cautions, “Food prices have displayed a mixed trend so far in February 2021. The rise in onion prices, as well as higher crude oil prices and their transmission into retail fuel prices, are areas of concern that need to be monitored.”

8 Ways to Overcome Inflation

Here’s a list of things you can do to fight inflation:

  1. Diversify your investment portfolio: Your investment portfolio should have a range of asset types and classes. Restricting your investments to one type of asset can put you at risk of incurring losses due to market fluctuations. Here’s a list of the best investment alternatives you can consider to diversify your portfolio and minimise risk.
  2. Invest in high return small saving schemes: High-yield saving schemes can help you beat inflation. These savings schemes can outperform the current rate of inflation by being consistent in the face of ever-fluctuating inflation. Here’s a list of the best small saving schemes in India you can invest in to fight inflation.
  3. Invest in chit funds: Chit funds also have the ability to beat inflation and give you better returns as compared to saving accounts, FDs, and RDs.
  4. Take advantage of tax-advantaged schemes: Some government schemes offer tax benefits, and this can help you fight inflation. Read the article Best Saving Plans & Schemes In India to know more about them.
  5. Change your shopping habits: There are a few things you can do when shopping to overcome inflation:
    • Make a list of what you need and stick to it. Planning your shopping in advance will prevent you from buying unnecessary things.
    • Shop when there is a sale. With discounts and offers, you can shop for more things with less money.
    • Shed brand consciousness. Don’t fall for big brands that spend big on advertising. Rather, choose local brands or brands of large retail chains, which are comparatively cheaper.
  6. Minimise food wastage at home: Don’t buy foods like fruits and vegetables in bulk. They have a very short shelf-life and can quickly end up in the trash.
  7. Use your salary smartly to save money: Saving money from your salary every month is important to build a savings fund that can help you combat inflation. But, this habit requires sincerity and discipline, which many may find difficult to inculcate.
  8. Build an emergency fund: An emergency fund is a safety cushion you can fall back on in a crisis situation like inflation. This fund can cover your unplanned or emergency financial requirement or shortfall.

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