Inflation: Cause & Impact

Before we delve into understanding inflation, picture this: you walk into your favorite store, excited to purchase that item you’ve been eyeing for a while.

But then you look at the price tag and your heart sinks. The price has gone up significantly since six months ago when you started saving up for it.

What sorcery is this? Well, my friend, it’s the work of a sneaky thief called inflation.

Inflation is a common economic term we often hear when discussing finance. But, did you also know inflation has a profound impact on our daily lives?

It’s like a silent force that gradually reduces the value of our hard-earned money.

In this blog, we unravel the mysteries of inflation, explore its causes, and understand its effects on the Indian and US economies.

We’ll also share strategies to control inflation and plan for this crafty culprit.

What is Inflation?

Inflation, in its essence, is the financial phenomenon that causes prices to rise over time.

It’s as if our money loses its superpowers. Over time, it becomes weaker and less able to purchase the same goods and services it once could.

This relentless rise in prices is measured using an inflation rate, which quantifies the percentage increase in prices within a specific period.

Understanding Inflation

Let’s say you’re a fan of cricket. Imagine you’re going to buy a ticket to watch a cricket match in your favorite stadium.

In the year 2022, you bought a ticket for Rs. 1000, and you were able to enjoy the match with your friends.

The next year, in 2023, you decide to go to another match, but you notice something different. The ticket prices have gone up due to inflation.

Now, the same ticket that cost ₹1 000 in 2022 costs ₹ 1300 in 2023. This increase in ticket prices is an example of inflation. You can no longer buy as many tickets as before with the same amount of money.

Say, in 2022 you paid ₹ 3,000 for three tickets. But in 2023, you can only buy around 2 tickets with ₹ 3000. (rounding down to 0 or 1 depending on the rules of the ticket seller).

This means that inflation has reduced the purchasing power of your money. Your ₹ 1000 can’t buy as much as it used to, and you need more money to afford the same ticket(s).

In the real world, this happens with many things we buy, such as groceries, clothes, and other goods and services.

It’s important to keep track of inflation because it affects how much we can afford and how far our money can go.

To calculate Inflation, we compare the prices of the things from the current year to the base year.

To do that, we use a special formula called the Consumer Price Index (CPI). It helps us measure the change in prices over time.

In our example, there has been a ₹ 300 increase, which shows that the prices have gone up by 30%.

This inflation is also called Consumer Price Inflation. Every month, inflation data is analysed when studying the country’s economy. According to Forbes, the RBI projects FY24 inflation at 5.2%, and is optimistic that CPI inflation will moderate this fiscal.

Causes of Inflation

To unmask the true culprits behind inflation, we must examine its causes. There are several key factors that contribute to this phenomenon:

Demand-Pull Inflation

This happens when a lot of people want to buy something, but there isn’t enough of it available. When the demand for something is higher than the supply, sellers can raise the prices.

For example, if there’s a new video game that everyone wants to buy (high demand), but there are only a limited number of copies (less supply). This might cause the price of the game go up (which is the demand-pull inflation).

Cost-Push Inflation

This happens when it becomes more expensive to produce goods or provide services. When the cost of things like raw materials, labor, or energy goes up, companies may increase the prices of their products to cover those extra costs.

For example, if the cost of fuel used to transport goods increases, the prices of those goods may also rise.

If you order a Rajasthani saree from Jaipur to Hyderabad, the shipping costs will be included in the amount you pay. But if there is a hike in fuel prices, there’s a high possibility that the shipping cost might increase too, in return increasing the price you pay for the saree. This increase in price is Inflation.

Monetary Policy

Central banks, such as the Reserve Bank of India and the Federal Reserve Bank in the United States, utilize monetary policy tools to influence inflation.

They adjust interest rates, such as the repo rate or federal funds rate, to regulate the borrowing costs for banks and consumers.

By raising interest rates, they aim to reduce borrowing and spending, curbing inflationary pressures. Conversely, lowering interest rates stimulates borrowing and spending during periods of low inflation or economic downturns.

Fiscal Policy

Governments can also play a crucial role in managing inflation through fiscal policy measures. They can adjust taxation levels or government spending to influence aggregate demand in the economy.

For instance, increasing taxes or reducing government expenditure can help decrease the overall level of spending, leading to a moderation in inflationary pressures.

Supply-Side Policies

To address cost-push inflation, governments can implement supply-side policies aimed at increasing the economy’s capacity to produce goods and services efficiently.

These policies may focus on enhancing productivity, improving infrastructure, reducing regulatory burdens, and promoting competition.

By strengthening the supply side of the economy, businesses can operate more efficiently and keep production costs in check, ultimately mitigating inflationary pressures.

Strategies to Safeguard Against Inflation

Now that we understand the impact of inflation, it’s time to prepare ourselves to outsmart the sneaky thief and safeguard our finances.

Diversify Your Investments

• One of the most effective ways to protect your wealth from the effects of inflation is by diversifying your investment portfolio.
• Allocate your funds across different asset classes, such as stocks, bonds, real estate, and commodities.
• Historically, these assets have shown the potential to outpace inflation over the long term, preserving and growing your purchasing power.

Invest in Inflation-Indexed Products

• Consider investing in financial instruments specifically designed to combat inflation, such as inflation-indexed bonds or mutual funds.
• These products adjust their value in line with changes in inflation rates, ensuring that your investments keep pace with rising prices.
• For example, in India, the government issues inflation-indexed bonds known as the “RBI Retail Direct” scheme, providing a hedge against inflation for retail investors.

Save and Budget Wisely

• Inflation may tempt us to splurge and enjoy instant gratification, but it’s crucial to adopt a disciplined saving and budgeting approach.
• Set aside a portion of your income for savings and prioritize expenses wisely. By maintaining a financial cushion, you can better withstand inflationary pressures and preserve your long-term financial goals.

Stay Informed and Seek Professional Advice

Keep a close eye on economic trends, inflation rates, and market conditions. Stay informed about investment opportunities and consult with financial experts, through platforms like Vittae, who can provide tailored guidance based on your specific circumstances.

A well-informed approach ensures that you make sound financial decisions in the face of inflationary challenges.

Conclusion

Inflation has a significant impact on individuals, businesses, and investors. Rising prices decrease purchasing power, strain budgets, and affect profitability.

To mitigate the impact of inflation, individuals can focus on saving, budgeting wisely, and exploring investment options that outpace inflation.

In India, it is important for consumers to be mindful of their spending habits, prioritize savings, and explore investment avenues that offer protection against inflation.

Additionally, the government plays a crucial role in implementing monetary and fiscal policies to control inflation and stabilize the economy.

In the USA, trhe Federal Reserve Bank closely monitors inflation rates and adjusts monetary policy accordingly to maintain price stability and support economic growth.

While inflation may seem like an unavoidable force, individuals, businesses, and governments can take proactive steps to mitigate its impact.

By understanding the causes and effects of inflation we can navigate the challenges and maintain financial stability in an ever-changing economic landscape.

In conclusion, inflation affects everyone in society. It diminishes the value of money, impacts consumers’ purchasing power, creates challenges for businesses, and poses risks for investors.

However, by staying informed, adopting prudent financial practices, and taking advantage of various investment opportunities, we can mitigate the negative effects of inflation and secure our financial well-being.

Remember, knowledge and proactive planning are key to weathering the storm of inflation and achieving long-term financial resilience.