What is Inflation?

Have you ever asked yourself “What is inflation?” If you have, you aren’t alone. It is one of the most popular questions I receive from new investors.

In simple terms, it can be defined as either a rise in prices or a fall in the value of money. That means if someone asks you, “What is inflation?” the short answer is, “An increase in the cost of things that are necessary for humans to live and enjoy life, such as bread, butter, milk, cheese, coffee, oil, shelter, clothing, medical services, chicken, cotton, electronics, etc.

“Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair.”

Costs of Inflation:

Almost everyone thinks it is evil, but it isn’t necessarily so. It affects different people in different ways. It also depends on whether it is anticipated or unanticipated. If the inflation rate corresponds to what the majority of people are expecting (anticipated inflation), then we can compensate and the cost isn’t high. For example, banks can vary their interest rates and workers can negotiate contracts that include automatic wage hikes as the price level goes up.

Problems arise when there is unanticipated inflation:

• Creditors lose and debtors gain if the lender does not anticipate inflation correctly. For those who borrow, this is similar to getting an interest-free loan.
• Uncertainty about what will happen next makes corporations and consumers less likely to spend. This hurts economic output in the long run.
• People living off a fixed-income, such as retirees, see a decline in their purchasing power and, consequently, their standard of living.
• The entire economy must absorb repricing costs (“menu costs”) as price lists, labels, menus and more have to be updated.
• If the inflation rate is greater than that of other countries, domestic products become less competitive.

People like to complain about prices going up, but they often ignore the fact that wages should be rising as well. The question shouldn’t be whether inflation is rising, but whether it’s rising at a quicker pace than your wages.
Finally, inflation is a sign that an economy is growing. In some situations, little inflation (or even deflation) can be just as bad as high inflation. The lack of inflation may be an indication that the economy is weakening. As you can see, it’s not so easy to label it as either good or bad – it depends on the overall economy as well as your personal situation.

Inflation is measured by two indicators

1- Wholesale Price Index (WPI)

2- Consumer Price Index (CPI)

WPI index reflects average price changes of goods that are bought and sold in the wholesale market. WPI in India is published by the Office of Economic Adviser, Ministry of Commerce and Industry.

In contrast, CPI is computed by executing a weighted average on a particular set of goods and services. The computation of CPI takes into account price changes and the actual inflation that affects the end consumer. CPI is thus a reflection of changes in the retail prices of specified goods and services over a time period which are traded by particular consumer group

Below is the chart on historic Inflation in India from 1958 to 2013.

(Chart source : www.inflation.eu)

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