INFLATION

Definitions of inflation

1) A rise in the prices of goods and services which occurs when economic
demand exceeds supply. The economy may grow so fast demand for
products and services are greater than the available supply. This situation
causes prices to rise. Over time, even with a relatively low inflation rate, the
purchasing power of a dollar is reduced. Things cost more; your dollar buys
less.

2) An increase in the general price level of goods and services; alternatively,

a decrease in purchasing power of the dollar
The increase in the cost of living (prices for goods and services). Inflation is
measured as an annual average by the CPI (Consumer Price Index.)

3) A rise in prices of goods and services, as measured by the Consumer Price

Index, which is based on a "market basket" of about 400 goods and services.
Inflation can decrease the value of money. Therefore, money today is worth
less than money tomorrow.

4) An increase in the cost of goods and services which, in turn, decreases the
buying power of money over time. Inflation is usually measured by the
Consumer Price Index and Product Price Index.

• What Is Inflation?

Simply put, inflation is a situation in the economy where, there is

more money chasing less of goods and services. In other words, it
means there is more supply/availability of money in the economy and
there is less of goods and services to buy with that increased money.
Thus goods and services commands a higher price than actual as
more people are willing to pay a higher value to buy the same goods.
In this inflationary situation, there is no real growth in the output of the
economy per se. It’s simply more money chasing few goods and
services.

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Eg: With Rs. 100 you can buy 5kgs of apple when the inflation is say,
zero. Now when the inflation rate is 5%, then you will need Rs. 105 to
buy the same quantity of apples. This is because there is more
money chasing the same produce.

• What Are The Types Of Inflation?

While there are many types of inflation the prominent ones are:
Modest Inflation (2-3%)
Creeping Inflation (5-!0%)
Running Inflation (Over 10%)

• Is Inflation Good For The Economy?

Yes and No. Yes because Inflation helps producers realise better
margins. This incites them to do better and produce more. No
because it reduces the buying power of the consumer in real terms.
Inflation always gives rise to inequalities of income because the poor
are hit badly by the price rise. This has further increased. The gap the
between the poor and rich. The value of assets appreciates due to
this the rich becomes more rich and poor becomes poorer.

• How Do Governments/Central Banks Control Inflation?

The following are the tactics used to control inflation:
Control the supply of money in the economy; by using monetary
policy and fiscal policy.
Encourage measures to increase the productivity in the economy,
Use government borrowing programs to suckout the excess liquidity
in the economy.
Use CRR/SLR margin requirements to maintain the required liquidity
in the economy etc.
Changes in the interest rates in the economy to ensure correct
liquidity

Issue of money: Central Bank can control the supply of money by

controlling the issue of money.
Bank rate: Bank rate is a rate of interest at which the central bank
rediscounts the first class securities of other banks. Increase in bank

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rate help in contraction of credit in the country as it leads to
expensive central bank loan to commercial banks.

Open market operation: Bank can control the inflation by controlling

the credit by selling the government securities in open market. When
these securities are to be sold in market, money will come to central
bank from circulation. It will also affect the creation of credit. As the
money supply will decline, rise in price can be controlled.

Cash reserve ratio: Cash reserve is that percentage of their deposits

which the commercial banks have to deposit in cash with central
bank. Higher the cash reserve ratio, higher the amount to be kept
with central bank and lesser will be the capacity of commercial banks
too create credit. Thus, supply of money will reduce.

Statutory liquidity ratio: Statutory liquidity ratio is the proportion of

total assets of commercial banks to be kept in liquid form with them.
Higher the ratio, lesser is the capacity of commercial banks to create
credit and thus supply of money will be reduced.

All these techniques are helpful in reducing the supply of money

which will ultimately help in controlling the inflation.

• What Are the Ways of Measuring Inflation?

Consumer Price Index (CPI) – This measures the consumer prices of
a basket of commodities in different cities.

Wholesale Price Index (WPI) – This measures the different prices of

a basket of commodities in the wholesale markets. The basket is
broadly made up of Primary products, Fuel products, and
manufactured products.

• Why Do We Need To Know About Inflation?

This is necessary as it tells you what is the real return on your

investments and the real rate of growth in the company/economy.

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Eg: If you deposit Rs. 100000 @ 12% p.a., with the annual inflation
rate being 5% in the economy, then the real return on your deposit is
12%(nominal rate) minus 5%(inflation rate), i.e. 7% p.a.(real rate)
This is because after one year when your deposit matures you will
have to pay 5% more for any purchases owing to that being the rate
of interest in the economy for a year.