Inflation: We can simply say about is an increase in the price of a basket of goods and services that is representative of the economy as a whole.
Inflation is defined as a sustained increase in the general level of prices for goods and services. It is measured as an annual percentage increase. As inflation rises, every dollar you own buys a smaller percentage of a good or service.
The value of a dollar does not stay constant when there is inflation. The value of a dollar is observed in terms of purchasing power, which is the real, tangible goods that money can buy. When inflation goes up, there is a decline in the purchasing power of money.
The effect of inflation is the prices of everything going up over the years.
Inflation and the Money Supply
We can also have inflation and deflation by changing the amount of money in the system. If the government decides to print a lot of money, then dollars will become plentiful relative to oranges, just as in our drought situation. Thus inflation is caused by the amount of dollars rising relative to the amount of oranges (goods and services), and deflation is caused by the amount of dollars falling relative to the amount of oranges. Thus, as shown by the article “Why Does Money Have Value?”, inflation is caused by a combination of four factors:
1. The supply of money goes up.
2. The supply of other goods goes down.
3. Demand for money goes down.
4. Demand for other goods goes up.
How is inflation measured?
In India there are two broad measures of inflation: the Consumer Price Index (CPI) and the Wholesale Price Index (WPI). Of the two the latter has a higher profile because it is measured more frequently, that is, every week. When you read about inflation rising to 7 per cent in the newspaper it’s probably referring to the WPI.
The WPI is based on the wholesale prices of 435 items ranging from agricultural commodities like wheat, rice, groundnuts etc to manufactured products like steel, cement etc. A single index number is calculated based on those prices and the inflation rate is calculated by comparing the most recent index number with that of a year ago.
Why are prices rising?
A number of factors, actually, many of them global in nature but the chief among them is the rise in the price of oil above $100 per barrel. Petroleum is used to make fertilizer and also as fuel in transportation so naturally when oil prices rise it affects food and other prices as well.
How inflation pinches your wallet
Strong growth in big, developing countries like China and India has also contributed to inflation by boosting demand for many commodities like cement and steel. Finally weather-related problems have reduced agricultural output in some countries like Australia further putting an upward pressure on the price of wheat.
What is the government going to do about inflation?
Inflation is a major political concern for the government because of upcoming state elections and a general election soon afterwards. Inflation and rising food prices in particular tend to hurt the masses the most and therefore is a major issue at election time.
The bottom line is that we can expect a range of policy measures to fight inflation.
The government has already taken some quick steps like trying to curb exports in sensitive commodities and reduce the cost of imports. The idea is that exports reduce domestic supply adding to the pressure on prices; therefore the government has already banned the export of cement and non-basmati rice and may ban other commodity exports later.
Don’t get foxed by returns on your investments
Similarly cheaper imports help keep prices low and the government has reduced import duties on edible oils as well.
Further action may be taken by the RBI: for example raising interest rates which will reduce liquidity � money floating in the system — and the total demand in the economy which will reduce the pressure on prices.
Another option is to allow the exchange rate to appreciate (let rupee rise in value against the US dollar). If the rupee rises in value, imports will become less expensive which will help moderate inflation further.
Adjusting for inflation
It’s important to learn how to adjust for inflation when evaluating the rate of return on an investment.
Dear FM: Is the price rise not affecting you?
For example suppose you put your money in a one year fixed deposit which pays a return of 8 per cent. If inflation is around 7 per cent for the year, your inflation-adjusted return is just 1 per cent (8 – 7). Similarly if your salary rises by 5 per cent and inflation is 7 per cent your inflation-adjusted salary has actually fallen by 2 per cent (5-7).
Inflation and investing
You may have to modify your investment strategy in order to cope with inflation. Generally speaking commodities including gold are considered a good hedge against inflation as also are stocks. Investments that should be avoided are long-term fixed deposits whose inflation-adjusted value may be seriously eroded if inflation remains high.
Posted on May 12th, 2009 by admin
Filed under: What
Leave a Reply