What is Inflation?
Inflation or price inflation is a rise in the price level in an economy which results in a sudden drop in the purchasing power of money. It is a loss of real value in the medium of exchange. The measure of inflation is the inflation rate and is measured in percentage. The purchasing power of currency decreases as goods and services become dearer. This impacts the cost of living and gets higher. However, a certain level of inflation is required in the economy
Types of Inflation
There are different types of inflation to get an analysis of distributional and other effects of inflation. There are mainly four types of inflation. Experts say that demand-pull and cost-push are more two types of inflation not yet categorized. There are various other types of inflation like asset inflation and wage inflation. The main types of inflation are listed below by their speed levels namely:
On The Basis of Speed and Intensity
Creeping inflation is when the price rise is 3% or lower and is scheduled to rise in all coming years. This type of inflation is beneficial for the economy as it promotes demand among consumers. According to The Federal Reserve, the price rise of 2% or less benefits the economy. The consumers are prepared for the price rise and hence buy the product now to beat future higher prices.
This inflation is between 3 to 10% a year. This is harmful to the economy as it heats up the cycle. People are willing to buy more and more to beat future high prices which affect supply as well. Suppliers can’t keep up the supply drive among people.
This inflation rises to 10% or more and is absolute havoc to the economy. Money loses its value very fast and businesses can’t keep up with cost and prices. Investors avoid the country, the government loses its credibility, and the economy becomes unstable. This inflation at any cost should be avoided at any cost.
It is when prices skyrocket more than 50% a month and this situation is infrequent. This usually happens when the government prints money to pay for wars.
On The Basis of Causes
1. Currency Inflation
It is caused by the printing of currency notes.
2. Credit Inflation
Commercial banks sanction loans and advances to people in large numbers when the economy needs. This situation leads to rising in the price level
3. Deficit-induced Inflation
When expenditure exceeds revenue, the budget of the government reflects a deficit. To meet the gap, the government may ask the central bank to print additional money. Any price rise during this period is called deficit-induced inflation.
4. Demand-pull Inflation -
An increase in demand over available output leads to this type of inflation and leads to a rise in price.
5. Cost-push Inflation -
Inflation may arise from an overall increase in the cost of production. The cost of production rises from an increase in the prices of raw material, wages, etc.
The above part was a brief discussion on inflation, types and causes of inflation, and how it affects the overall economy. How consumers and producers play their role when prices rise.
Inflation is contrasted by deflation, where the purchasing power of money is increased and prices of commodity decrease
How is Inflation Measured?
The well-known indicator of inflation is the Consumer Price Index (CPI), which measures the percentage change in the prices.
For example, We calculate inflation for a basket that has two items in it - books and childcare. The formula for calculating inflation is as below:
Inflation = Price ( year 2) - Price ( year 1 ) / Price ( year 1 ) * 100
This has certain limitations as well. These are discussed in below pointers:
CPI is not an indicator of the price level. It measures the rate of change of price but not the price level.
Quality changes over time of the products. CPI intends to only calculate pure price changes.
CPI measures price changes in metropolitan cities and does not cover regional, rural, or remote areas.
CPI does not often adjust for changes in the household spending pattern.
CPI does not immediately introduce new product prices as soon as the product is introduced in the market.
CPI does not measure the cost of living. Although it is used to measure the same but is not often categorized as an ideal indicator.
Pros and Cons of Inflation
Inflation is taken as both positive as well as negative depending upon which side one takes and how constructively the situation gets managed.
For example, People owning tangible assets would want to sell their assets as they will get a higher price for the same. This will not go accordingly with the buyer as they would not want to buy the assets at a higher price.
It enables growth
Allows adjustment of wages
It allows adjustment of prices
It creates uncertainty and lowers investment.
Leads to lower growth and instability
Reduces international competitiveness
Leads to recession
Fall in value of savings.