Written by Jyotsna Iyer, a second-year undergraduate student.
The word ‘inflation’ is one that is commonly thrown around in conversations about finances and the economy. Hence, it is important to understand the definition and the working of this word in order to understand its practical impacts.
So, what does the term ‘inflation’ mean?
It broadly refers to the increase in prices of goods and services during a given period of time. It also indicates an increase in cost of living for the population and a decrease in the purchasing power of the currency of the nation(s) in question.
‘Cost of living,’ in simple terms, is the approximate amount of money one needs in order to live a basic life in a particular region (country, city, etc.) during a given period of time. It refers to the expenses one needs to cover to have access to the basic necessities such as food, housing, healthcare, etc. The ‘purchasing power of currency,’ refers to the quantity of goods and services that can be bought by one unit of a currency. When inflation occurs, the prices of goods and services increase, hence the quantity of these that one unit of currency can purchase is lower than what it previously was. This indicates that the purchasing power of the currency has decreased.
How do you measure inflation?
Inflation is measured using numerous tools, one of the most widely used ones being the Consumer Price Index (CPI). The CPI is calculated as the average cost of a collection of numerous goods and services that form the basic necessities of a person. This collection of goods and services is often referred to as a ‘basket of goods.’ The inflation rate is calculated using the new and old CPIs for a given period of time, usually a year. The precise formula for inflation rate is: [(New CPI – Old CPI)/ (Old CPI)]*100. If inflation rate is greater than 50% a month, it is known as hyperinflation.
Why does it happen?
The cause of inflation is often associated to an increase in the flow of money in any economy. This can be understood through a simple series of events. An increase in the flow of money would mean that there is more wealth in the hands of the public. This, in turn, would lead to an increase in the public’s capability to afford goods and services, creating an increase in the demand for said goods and services. This demand often surpasses the production capability of the industry, hence, creating a supply- demand gap. Due to a paucity of supply in comparison to the increasing demand, the prices of these goods and services increase. Such an increase in the prices of a significant amount of goods and services adds up to cause a surge in the overall cost of living and a fall in the purchasing power of currency – resulting in inflation.
This particular chain of events is known as ‘demand- pull’ inflation. In addition to this, there also exists a ‘cost- push’ inflation, which occurs due to an increase in the production costs of certain goods and services, which causes an increase in the cost of the final product, and hence the CPI.
It has been established that inflation is caused and affected by an increase in the flow of money in an economy. Hence, in order to control inflation, the central monetary agencies of countries regulate the flow of wealth through monetary policies. In the case of India, this agency is the RBI (Reserve Bank of India). These policies are aimed at preventing hyperinflation, while also maintaining a steady rate of inflation which is healthy for the economy.
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