Inflation 101: The Basics!

If you're reading this, it's likely that you've come across the term 'inflation' through news reports or advice from financial experts. You may have heard about inflation rising or falling or been advised to invest in assets that beat inflation (generate more return than inflation). But what exactly is inflation? How is it measured? And what are the factors that cause inflation? Let's delve into these questions and gain a better understanding.

What is Inflation?

Inflation refers to the general rise in prices for goods and services within an economy, leading to a gradual erosion of purchasing power. Ummm....Purchasing power? What? To understand purchasing power, let's consider an example. Suppose you have Rs. 100 today, which you plan to use for buying a mango. However, instead of purchasing one immediately, you decide to put the money in your tijori to buy a mango next year. When you go to buy the mango next year, you discover that its price has increased to Rs. 110 (Because inflation you know). As a result, your Rs. 100 can no longer buy a whole mango but only 90.9% (100/110) of it. In other words, your Rs.100 note has lost its ability to purchase a complete mango due to a 10% inflation rate for the year. That’s why it’s important to save your money in a financial product which gives return more than inflation and preserves your purchasing power.

Reasons for it.

In simple terms, inflation occurs when there is an imbalance between demand and supply. So, Demand > Supply = Inflation. There are various factors that contribute to Demand > Supply.

1) More disposable income: When consumers have more money available for spending, their disposable income rises.

More disposable income ➡ More money in the hands of consumers ➡ More money demands more goods ➡ Demand > Supply ➡ Inflation.

2) Printing machine goes brrrrrr: If the government decides to print more money and inject it into the economy, it results in an increase in the amount of money in the hands of consumers.

More money supply in an economy ➡ More money in the hands of consumers ➡ More money demands more goods ➡ Demand > Supply ➡ Inflation.

3) Supply crunch: When there is a shortage of goods due to factors like bad weather conditions which decreases crop yield, it creates a scarcity of supply.

Same amount of money in the hands of consumers ➡ Same demand for goods and services ➡ Demand > Supply (Since supply is less but demand is same) ➡ Inflation.

How is inflation calculated?

Imagine it's the year 2012, and an economist comes to visit you to ask about your spending habits. She carefully listens to everything you share and creates a list of the things you typically buy. To keep things simple, let's say you earn Rs. 100, and you use it to buy three things: Rs. 30 for your housing (rent), Rs. 50 for food, and Rs. 20 for Wi-Fi. The economist calls this list the "Basket” of goods and services.

The following year, she visits the market to find out the current prices of the items on your list. Let's say the prices have increased to Rs. 35 for housing (rent), Rs. 60 for food, and Rs. 25 for Wi-Fi. When she adds up the new prices, the total comes to Rs. 120. She then calculates the percentage increase compared to the previous year and calls you to let you know that the things you spend your money on have become 20% more expensive, meaning the yearly inflation for you is 20%.

The example mentioned above is, in a rough sense, what the NSO (National Statistical Office), a department under the Ministry of Statistics and Programme Implementation (MoSPI) in India, does. They create a list of goods that the average Indian, both in rural and urban areas, typically spends money on. This list is referred to as the "basket" of goods. In 2012, which is called the base year, they assigned a value of 100 to this basket.

To calculate the rate of inflation or the percentage change in prices over time, the NSO compares the value of this index between different periods. For example, they compare it month to month to determine the monthly rate of inflation or year to year to calculate the annual rate of inflation. This helps them track how prices are changing over time and measures the impact on people's purchasing power.

You can visit this (https://shorturl.at/nDFS5) link to check out the CPI numbers released every month.