Understanding inflation rate in the easiest way

Hey! Imagine if I had given you a 100-rupee note back in the year 1958. You had hidden it under your bed thinking that you will use it in an emergency, the sad part is the value of the same 100-rupee note would be Rs.1.20 today. You didn’t get that? Let’s try another angle- If you buy goods worth 100 rupees today, the value of the same goods back in 1958 would be Rs.1.20. That means today’s Rs. 100 is equal to Rs. 1.20 in 1958. This is the magic of inflation. Inflation means a general increase in prices and fall in the purchasing value of money. This applies to everyone every year. Let’s understand “inflation” through the following questions today:-

  1. Why does inflation occur?
  2. Is inflation really bad?
  3. What is the relation between inflation and unemployment? As well as other economic factors.

Why inflation happens?

The critical questions are –

Who is making inflation happen? Are the government officials in the hierarchy/pyramid system controlling inflation?

Its is not that at all!! There are 4 main reasons for inflation-

  1.  Economic Boom

When there is an economic boom taking place, we, the general public, will receive more cash in their hands. If we have more money in our hand, we will have the opportunity to spend it on various stuff and necessities. This means every product will have a higher demand in the economy. Now, if demand increases, the companies and businesses will see that they can increase the price of goods and earn more profits – hence inflation occurs. If I have to explain this phenomenon by an example- Imagine there is an aeroplane having 100 seats. Now 100 passengers can travel using that aeroplane which has 10 business class and 90 economy class seats. Seems like a real example. Right? Now if the passengers are being given more cash to spend, then everyone will try and grab those 10 business class seats (Here I am assuming both the seats are of same tariffs for the time being). But business class seats are limited. In response to this, the airline will increase business class seat prices, so that passengers who can afford to pay more can only avail the business class seats. So here we see there is an inflation in aeroplane seat pricing. This type of inflation is called Demand-pull Inflation. Demand ▲, inflation ▲well.

2. Increase in prices of raw materials

Like the price of wheat and rice increases due to a dreadful monsoon season, or like oil and kitchen gas price increase due to a tax policy change on raw materials imposed by government overnight. So, the companies which are manufacturing products using those raw materials have to increase the price to remain profitable. Due to this also inflation can take place. This is called cost-push inflation.

3. Increase in employee Salaries

Hey, I am not kidding. When companies and governments increase employee salaries, they have to increase the prices of the products to continue earning profits. This is called Wage push inflation. There can be various scenarios or factors resulting in Wage push inflation. For example, -if there is low unemployment, then it is harder for companies to replace the employees. If employees can’t be replaced then, then their wages are required to be increased, which in return leads to inflation.

4. Currency depreciation

This is the most speculated and blamed reason for inflation among commoners. This can happen due to various reasons as well as a government printing more currency notes etc. It is the most dangerous of them all as it can trigger hyperinflation as well. This currently happening in Venezuela and also took place in Zimbabwe in 2008.

In our country, even a 10% inflation rate is considered extreme, but in Venezuela, between the year 2016-2019, the inflation rate was over 50000000%. In around 2008 when Zimbabwe was rapidly losing its currency valuation, the government started printing 1 million, 1 billion and even 1 trillion Zimbabwe dollar notes. And you would be shocked to hear that the 1 trillion Zimbabwe dollars equalled 1 US dollar. This is the extent to which currency depreciation can take place when the hyperinflation crisis occurs. Hyperinflation, in itself, is a vast topic because there are many political reasons behind it apart from specific economic reasons.

Inflation is when you pay $15 for the $10 dollar haircut you used to get for $5 when you had hair

Sam Ewing

Present Day inflation

If I talk about present-day inflation, in most countries the inflation rate is falling down. Take a minute and think about it! Right from March, several lockdowns have been imposed at various times due to which the demand has decreased. We are buying fewer products, travelling lesser. People have had to close their businesses, and hence they don’t have money to spend. So, the overall demand has come down. And the first point where I mentioned demand-pull inflation- a total opposite phenomenon is taking place currently. Demand ▼, inflation ▼ Now, to arrest this phenomenon, some countries have taken a decision to transfer free cash to its citizens. Some say that as a result of this inflation rate might go up. What do you think? I shared the same logic When I wrote the blog about Universal basic income. The primary argument which people have against Universal Basic Income is that it might result in the rapid Inflation rate. Do share with me in the comments below.

What if inflation was zero?

I would like to put forward a question in front of you that is inflation necessary? What if there was 0% inflation. If we think about it, one will definitely say that it looks perfect. Prices of goods aren’t rising, and it is the best for the consumer that they can avail it at cheaper rates. We can even save more money, and if we save for a longer time, it is good for us that the value of money doesn’t decrease as well. But If we think deeply considering the reasons I stated above, then you would get the feeling that 0% inflation isn’t desirable. This directly means that companies won’t increase your salaries. Since your salary can’t go down hence inflation rate is always positive. The third scenario is that if deflation or negative inflation is occurring, i.e. prices of goods are going down gradually. People won’t be open to spending more money. We might think that we should save money, as the value of money is increasing. Subsequently, if deflation continues, the goods will be much cheaper in the next 5 years. So people will wait for 5 years to buy the same. So, Reduce Spending >>> Businesses start incurring losses >>> Unemployment ▲

This is very a long interrelation I explained here, and you must be wondering that does it really happen. But the reality is it actually happening and nothing to joke about. Relationship between inflation rate and the Unemployment rate can be explained by Philips Curve shown below.

They are inversely related to each other. This is an unexpected reality, but it does happen. The graph obviously has some extreme limits, i.e. in the case of hyperinflation. In the case of Venezuela, the issue hasn’t changed from 100% employment to 0% employment. Of course, the problem is much different there because of political factors which have resulted in hyperinflation. But in general, Philips Curve is valid in most cases.

What is the best level of inflation?

Now the argument is if inflation increases, goods will be costlier. And if inflation decreases unemployment increases. So, what is the optimum level of an inflation rate that a country should have? The ideal inflation rate for developed nations is 2% which has been decided by the government and the central banks. The idea is to maintain it around this number. For India, this rate is 4% ± 2%. If inflation is around this range, it is considered “good”. This maintains a balance between prices of good and unemployment rate.

How can the government’s control inflation?

There can be multiple ways to maintain it. Generally, this inflation rate is controlled by a central bank, in the case of India, Reserve Bank of India (RBI). RBI controls inflation with its interest rates, i.e. REPO rate. If RBI increases the repo rate for giving loans to banks, then less number of banks will want to take loans. Higher REPO rate >>> Banks Increase interest rates (so that people don’t take loans) >>>> Hence, less money is in circulation in the economy>>> inflation rate goes down. If RBI decreases the REPO rate, the opposite happens and as a result, can increase the inflation rate.

Other ways to control inflation is by printing more currency notes. Printing of more currency notes increases the inflation rate.

The government can decrease the inflation rate by applying higher taxes on goods. The government can even control inflation by spending more or less according to the scenario.

Inflation vs Recession

Till now, whatever you have read, I am sure that you understand that inflation and economic growth has a direct relation. If economic development takes place, inflation increases and vice versa causes recession. This understanding is real and very general but isn’t the cause or effect every time.  Sometimes it does happen that a country is going through decreasing economic growth and recession, but the inflation rate goes on increasing. This phenomenon is called Stagflation.

This is obviously non- desirable at all and to understand, let’s take an example. Suppose a country is going through recession internally. In contrast, the cost-push inflation factors (i.e. an increase in the price of raw materials) like oil import prices globally has increased, which causes a high inflation rate. Another exception happened in the US between 1870-1890 when the country was going through deflation and economic growth simultaneously. This period is called the great deflation. Every year about 2% decrease in the price of goods was observed, but employment was increasing, and people had more cash in hand. The reason for this is said to increase productivity due to technological progress.

Coming back to the original question that today, will free money lead to rapid inflation? In my opinion, it won’t !! Because the amount of money people receive isn’t that much that the customer buying character changes and supply of such products aren’t adequate. This will definitely increase the demand, but the change won’t be significant that inflation rate increases.

Consequences of inflation

No doubt, inflation is necessary for economic growth. Still, if we come back to personal consequences, so it obviously hurts the common man. We all save money, but over time the value goes on decreasing, the price of goods increases gradually etc. This is the sole reason why, instead of saving money in the form of cash, people invest in various assets or ventures like gold. The price of gold has increased drastically in the span of the last 4-5 months.

Similarly people invest in real estates or properties,  stocks, mutual funds or even cryptocurrencies. You must be thinking that isn’t trading bitcoin/cryptocurrency banned in India? This happened when RBI released a circular in 2018 freezing accounts which deal with cryptocurrency trading. But on 4th March 2020 Supreme court gave its judgement and overturned the verdict of RBI. Now it is legally available to invest in cryptocurrencies.

In my personal understanding or opinion: –

You must have seen that people who buy bitcoin, they preserve it rather than spending it. This is one of the reasons why the value of cryptocurrencies increases over time, just like gold as more people want to buy and preserve it. But in the case of cash, since the vale is decreasing day by day, people tend to spend it. So, if people aren’t spending cryptocurrencies, then it can’t replace currency/ cash in that sense. Hence as a future of cryptocurrency, it is turning out to be an asset than a currency – totally opposite to the thought behind it being designed or invented. Do share your opinion as well in the comments below.

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