Understanding inflation and its pros and cons - Motilal Oswal
Understanding inflation and its pros and cons - Motilal Oswal

Understanding inflation and its pros and cons

Our grand parents often tell tales of yesteryears, thereby helping us draw a line between what’s new and what’s, sometimes, archaic. But the most commonly told tale is of how things back in the day used to cost less than they do now. The reason is the inflation in economics.

Inflation is defined as an upward movement of prices of goods and services, measured as an annual percentage increase. This is also known as the inflation rate, i.e. how fast rupee loses its value in a financial year. As inflation rises, every rupee has a smaller purchase capacity.

To illustrate, let’s assume that today you can buy a kg of onion for INR 10. With inflation rate of 2%, you will buy the same quantity of onion for INR 10.2. However,there is no guarantee that the quality will also improve with the increase in price. Also, if there’s a rise in price of a single commodity, we call this an increase in the relative price of that commodity, not inflation.

The Reserve Bank of India attempts to control inflation rate by increasing or decreasing the supply of money to the economy. And it does this gradually so that we don’t feel the pressure of a highly dynamic financial landscape. You see, most of us don’t pause to realise that the value of a rupee is always changing. So if it can go up, resulting in inflation, it can also go down. This is called deflation – a condition when every rupee is worth more in terms of real goods or property or services. In broader terms, deflation is when inflation is below zero.

Types of inflation

There is no strict categorization of ranges of intensity in price increase. But some indications are available for us to understand the severity of inflation.

Low inflation – when inflation rate is 1-2% to 5%.

Moderate inflation – its definition differs around the world,but it usually falls between 5%-30%.

High inflation – it's a situation of increase in price by30%-50% a year.

Extremely high inflation – it could range anywhere between 50% and100%.

Hyperinflation – the most extreme inflation phenomenon, it occurs when the increase in yearly prices is above 100%.

Tools for measuring inflation

Since inflation can’t be observed directly, measures of inflation index include price indexes specifically crafted for that purpose.

Consumer Price Index – this measures the change in prices we all pay for day-to-day goods and services.

Cost Inflation Index – a measure of inflation that is used for computing long-term capital gains of sale of assets like real estate, stock,mutual funds, jewellery etc.

Gross Domestic Product – it measures the rise in cost experienced by us, as well as the government or institution providing goods and services to us.

 Pros & cons of inflation

The rate of inflation usually increases due to massive printing of money, which increases supply in the economy, thus reducing demand. It may also occur when certain commodities like oil, or agricultural goods become more expensive.  

Uncompensated inflation results in reduction in savings, and thereby in consumption of goods.In response to higher prices, the rich can reduce their level of quality of purchased goods, but the poor are already purchasing low-priced, low-quality goods. Their only reaction to inflation is to stop purchasing, there by increasing the need gap. Higher inflation also leads to lower competitiveness with other countries, reduces the real value of savings, thereby affecting senior citizens who live on them.

However, not every instance of inflation is bad for the economy. In times of low inflation rate (1%-5%), it is beneficial for the economy as it encourages people to buy more, because with lower inflation rate comes lower interest rate. Governments usually target for a CPI of 2%, and a moderate inflation rate reduces the real value of debt. While on one hand, a moderate increase allows prices to adjust and update, on the other, employers and government adjust wages of employees.

All in all,a little inflation with corresponding increase in wages is healthy for the economy. It is an indicator of a prospering nation that is constantly tweaking its economic policies to meet the interests of its citizens, and its foreign counterparts. After all, a nation must keep up with the times to avert the dangers of global inflation. As far as negative effects of inflation are concerned, they can be dealt with only if we have a robust financial plan for the future. And that includes systematic investment, which we can help you with.

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