Inflation: Definition, How it Works, Causes, and Examples

Inflation is the rate at which the general level of prices for goods and services in an economy is rising over time. Inflation is measured by the Consumer Price Index (CPI) or the Producer Price Index (PPI), which tracks price changes for a basket of goods and services. Inflation has a significant impact on an economy, as rising prices can lead to decreased buying power and a decrease in the standard of living.

Causes of inflation can include an increase in the money supply, a decrease in productivity, and rising demand for goods and services. Examples of inflation include the hyperinflation in Zimbabwe in 2008 and the inflation in the United States in the 1970s. Governments and central banks often take measures to try to control inflation, such as raising interest rates or implementing price controls.

What is the meaning of Inflation?

Inflation refers to the general increase in the price level of goods and services over time. The rise in prices, which is often expressed as a percentage, means that a unit of currency effectively buys less than it did in prior periods. Inflation is most often contrasted with deflation, which occurs when prices decline and purchasing power increases. What Rs.100 could buy you could be smaller the next year. This occurs when there is an increase in the money supply or a fall in productivity, coupled with rising demand for goods and services.

The inflation rate is the percentage change in the overall price level over a specific period, typically one year. The Consumer Price Index inflation rate has been consistently higher than the Reserve Bank of India’s (RBI) medium-term target of 6% for the past nine months in India. It is a key indicator of the health of an economy, as it reflects the rate at which prices are rising. Central banks often monitor the inflation rate to determine their monetary policies and maintain price stability.

Inflation has both positive and negative side effects to the economy. One positive impact is debt relief. Moderate inflation helps reduce the burden of debt for borrowers, as the real value of their debt decreases over time. This encourages borrowing and spending, which can stimulate economic growth. One negative side of inflation in the economy is reduced purchasing power. The purchasing power of money decreases with inflation, leading to a decline in the standard of living for consumers.

How does Inflation function?

Inflation functions as a sustained increase in the general price level of goods and services in an economy over a period of time. Let us take an example to understand that. Let us suppose you could buy two kilograms of rice for Rs.100 last year. But inflation reduces the purchasing power of the money and the same Rs.100 will not be able to buy 2 kilograms of rice this year. This affects various aspects of the economy, including employment, interest rates, and international trade.

Inflation is commonly measured using CPI or PPI. The CPI index tracks the price changes of a basket of consumer goods and services, such as transportation, food, and medical care, over time. The CPI measures the percentage change in the cost of this basket, reflecting the rate of inflation experienced by consumers. The PPI index measures the average change in the selling prices received by domestic producers for their goods and services. The PPI tracks price changes at various stages of production, offering insights into inflationary pressures in the economy.

Inflation is important because it impacts the overall health of an economy. It affects the purchasing power of a currency, consumer spending, business investment, and government policies. Central banks often set an inflation target to maintain price stability and ensure that the economy functions smoothly. But inflation hurts the economy if the levels go beyond what is predicted.

What are the causes of inflation?

The causes of inflation encompass factors including devaluation, which weakens a country’s currency and makes imports more expensive; cost-push inflation, resulting from increased production costs that lead businesses to raise prices; demand-pull inflation, caused by a surge in demand for goods and services that outpaces supply; rising wages, which contribute to higher production costs and consumer prices; policies and regulations that can directly or indirectly affect the cost of goods and services; and an increased money supply, which can dilute the value of the currency and push prices higher.

1. Devaluation

Devaluation is the deliberate reduction in the value of a country’s currency relative to other currencies. A country could decide to devalue its currency to deal with situations like debt. This causes inflation because it makes imports more expensive, leading to higher costs for domestic businesses that rely on imported goods or inputs.

Businesses increase the prices of their products to maintain profitability. For example, the cost of imported goods, such as electronics or machineries rise, contributing to inflation when a country like Argentina devalues its currency.

2. Cost-push inflation

Cost-push inflation occurs when the costs of production for goods and services rise, forcing businesses to increase their prices to maintain profitability. This is a commonly occurring cause of inflation that could affect developing and developed countries mainly. For instance, companies that rely on oil as a key input need to raise their prices to cover the higher costs if the price of oil rises significantly.

This type of inflation is also caused by supply chain disruptions or natural disasters that impact the availability and cost of key resources. For example, a major flood wipes out a significant portion of a country’s crops will cause the cost of food to increase, leading to cost-push inflation.

3. Demand-pull inflation

Demand-pull type of inflation is driven by an increase in the overall demand for goods and services that exceeds the available supply. This happened during the outbreak of covid19 when masks and sanitizers were in high demand. Businesses raise their prices to balance the market when demand outpaces supply.

During periods of strong economic growth or increased government spending, consumer demand rises rapidly, leading to higher prices and demand-pull inflation.

4. Rising wages

Businesses face higher labor costs When wages increase, which contributes to inflation. Rising wages is a common occurrence and mandated by law in certain cases. Companies pass these increased costs onto consumers through higher prices. For instance, a restaurant raises the prices of its menu items to offset the increased expenses if a minimum wage increase leads to higher labor costs for the restaurant.

5. Policies and regulations

Government policies and regulations directly or indirectly impact the cost of goods and services, leading to inflation. For example, let us assume a government introduces new environmental regulations that increase the cost of production for certain industries. Businesses in those industries will raise their prices to cover the additional expenses. Trade policies, such as tariffs, also increase the cost of imported goods, contributing to inflation.

6. Increased money supply

Money supply increase in an economy dilutes the value of the currency and push up the overall price level. This is often referred to as monetary inflation. Central banks create new money to buy government bonds or other financial assets during periods of quantitative easing, effectively increasing the money supply. it leads to inflation if this increase is not matched by a proportional rise in economic output.

The causes of inflation are complex and multifaceted, often involving a combination of factors such as production costs, supply and demand, government policies and regulations, and monetary policies.

What is an example of Inflation?

Let us take a look at some of the real-life examples of inflation. The most infamous one is the inflation in Zimbabwe. The country experienced one of the most extreme cases of hyperinflation in modern history between 2007 and 2009. The inflation rate reached an astonishing 89.7 sextillion percent per month in November 2008.

This hyperinflation was primarily caused by the government’s excessive printing of money to finance its budget deficit, leading to a rapid decline in the value of the Zimbabwean dollar. This resulted in widespread economic distress, with prices doubling every 24 hours and citizens struggling to afford basic necessities.

Another example is the Weimar Republic Hyperinflation which happened between 1921 and 1923. Germany’s Weimar Republic experienced a period of hyperinflation during this time, with the peak monthly inflation rate reaching 29,500% in October 1923.

This extreme inflation was driven by factors including the heavy reparations Germany was required to pay after World War I, a loss of industrial production in the occupied Ruhr region, and the government’s decision to print large amounts of money to finance its expenditures. The hyperinflation led to a collapse in the value of the German mark, with people using wheelbarrows of cash to buy simple everyday items.

United States Inflation in the 1970s is another notable example. The U.S. experienced a period of high inflation during the 1970s, with the annual inflation rate peaking at 13.5% in 1980. This period of inflation was primarily driven by a combination of factors, including rising oil prices due to the OPEC oil embargo, expansionary fiscal and monetary policies, and cost-push factors like rising wages.

The high inflation led to economic stagnation, high unemployment, and reduced purchasing power for consumers. The Federal Reserve, under Chairman Paul Volcker, eventually raised interest rates dramatically to combat inflation, leading to a recession in the early 1980s but successfully bringing inflation under control.

What is the Formula for Inflation?

The formula for calculating inflation is based on the percentage change in a price index, such as the Consumer Price Index (CPI) or the Producer Price Index (PPI), over a given period. The most common formula for calculating the inflation rate is as follows.

Inflation Rate = ((Price Index in Current Year – Price Index in Base Year) / Price Index in Base Year) * 100

This formula calculates the percentage change in the price index between the current year and the base year, which represents the rate of inflation over that period.

How to calculate inflation?

Calculating inflation is done using the percentage change in a price index, such as the Consumer Price Index (CPI). Here is a step-by-step process to calculate inflation using the CPI.

Select the time period

Choose the two periods for which you want to calculate the inflation rate. These could be two different years or two different months, depending on the data available and your analysis needs. Let us suppose you want to calculate the inflation between 2023 and 2022. Then that one year is the time period.

Obtain the CPI data:

Find the CPI values for both the initial period (base period) and the final period (current period). You can obtain this data from official sources like the national statistical office, the reserve bank of India, the central bank of the nation, or international organizations like the World Bank or the International Monetary Fund.

Calculate the change in the CPI

Subtract the CPI value of the base period from the CPI value of the current period to find the change in the CPI between the two periods. You subtract the CPI value of 2023 from 2022 if that is the time period of your choice.

Divide the change in CPI by the base period CPI

Take the change in the CPI value and divide it by the CPI value of the base period. This will give you a proportionate change in the price level between the two periods.

Multiply by 100 to find the percentage change

Multiply the proportionate change in the price level by 100 to convert it into a percentage. This percentage change represents the inflation rate between the base period and the current period.

Example

Let’s calculate the inflation rate between 2022 and 20213 using the following hypothetical CPI data.

• CPI in 2022 (base period): 250
• CPI in 2023 (current period): 260

1. Calculate the change in the CPI: 260 (2023) – 250 (2022) = 10
2. Divide the change in CPI by the base period CPI: 10 ÷ 250 = 0.04
3. Multiply by 100 to find the percentage change: 0.04 * 100 = 4%

The inflation rate between 2022 and 2023 is 4% in this example.

What are the effects of inflation on the economy?

Inflation erodes the purchasing power of money, as the general increase in prices means that a given amount of currency is able to buy fewer goods and services. This particularly affects people with fixed incomes, such as retirees, as their purchasing power decreases over time.

Inflation leads to a redistribution of income and wealth within an economy. Borrowers benefit from inflation if their debts are fixed in nominal terms, as the real value of their debt decreases. Lenders and savers will be negatively impacted, as the real value of the money they receive or have saved decreases.

High or unpredictable inflation creates uncertainty in the economy, making it difficult for businesses and individuals to plan for the future. This causes reduced investment and lowered economic growth.

What are the positive effects of inflation?

One of the positive effects of inflation is that it helps stimulate economic growth by incentivizing consumption and investment. Inflation erodes the purchasing power of money, which encourages people to spend and invest while prices are still relatively low. This increased demand can help to create jobs, increase production, and drive economic growth.

Inflation also makes exports more competitive by making domestic goods relatively cheaper on the international market. This is because it will be costlier to purchase international goods with eroded currency. This helps to boost a country’s trade balance and improve economic performance. But these positive effects of inflation are typically outweighed by the negative effects, particularly if inflation is too high or too unpredictable.

What are the negative effects of inflation?

Inflation causes reduced purchasing power for consumers, particularly those with fixed incomes. Redistribution of income and wealth is also affected. Inflation makes it difficult to plan for the future as a result of uncertainty. Reduced investment and economic growth due to uncertainty are also caused by high or unpredictable inflation.

Inflation also leads to higher interest rates, as lenders demand higher rates to account for the lost purchasing power of the money they are lending. This further contributes to reduced investment and economic growth. Inflation causes increased production costs for businesses, which results in higher prices for goods and services, further reducing the purchasing power of consumers.

Why does Inflation occur?

One factor is an increase in demand for goods and services, which leads to a general increase in prices. Another factor is an increase in production costs, such as wages or raw materials, which results in higher prices for finished goods. Inflation is also caused by an increase in the money supply, which reduces the value of each unit of currency. Inflation is sometimes driven by external factors, such as an increase in the price of oil or other commodities that are important for the economy.

How can we prevent inflation?

Preventing inflation or keeping it under control is primarily the responsibility of central banks and government policymakers. The Reserve Bank of India takes care of inflation control in India. Here’s a list of actions they can take to prevent or control inflation.

Monetary policy

Central banks use monetary policy tools to influence interest rates and money supply in the economy. Central banks influence the cost of borrowing and overall credit conditions, which in turn can affect inflation by adjusting key rates such as repo rates. Raising interest rates help reduce inflationary pressure by making borrowing more expensive and encouraging saving.

Open market operations

Central banks buy or sell government bonds in the open market to influence the money supply. Selling bonds helps reduce the money supply, which puts downward pressure on inflation while buying bonds increases the money supply and stimulates economic activity.

Reserve requirements

Central banks change the reserve requirements for commercial banks, which are the minimum amounts of cash that banks must hold against their deposits. Central banks reduce the amount of money available for lending, which can help control inflation by increasing reserve requirements. But this is often a last measure as it sometimes has consequences.

Exchange rate policy

Governments and central banks influence their country’s exchange rate, which affects import prices and overall inflation. The reserve bank in India intervenes in the foreign exchange market to support its currency, making imports cheaper and helping to reduce inflationary pressure.

Fiscal policy

Central governments use fiscal policy to influence inflation by adjusting their spending and taxation policies. A government reduces its spending or increases taxes to slow down economic activity and reduce demand-pull inflation during periods of high inflation.

Inflation targeting

Central banks sometimes adopt an inflation targeting framework, which involves setting a specific inflation target, usually within a certain range, and using monetary policy tools to achieve that target. This approach can help anchor inflation expectations and provide a clear framework for managing inflation.

It’s important to note that preventing inflation doesn’t necessarily mean keeping it at zero. Most central banks aim for a moderate, stable inflation rate (often around 2%) to maintain price stability and provide some flexibility for economic growth.

How can we control inflation?

Controlling inflation is a key responsibility of central banks and government policymakers. Below are the key tactics they use.

Monetary policy

Central banks can monetary policy tools to manage inflation by influencing interest rates and the money supply in the economy. This is done by adjusting key interest rates such as repo rate or reverse repo rate.

Reserve requirements

Central banks change the reserve requirements for commercial banks – the minimum amount of cash banks must hold against their deposits. Increasing reserve requirements help control inflation by reducing the amount of money available for lending in the economy.

Forward guidance

Central banks provide forward guidance, communicating their future policy intentions to the public. This can help shape expectations about future inflation and interest rates, which in turn influence current economic behavior and help control inflation. The reserve bank does this activity in India which helps individuals and businesses align their operations and plans with the current inflation scenario.

Central banks, like the Reserve Bank of India, and policymakers, like the governments, have the ability to effectively control inflation and maintain price stability in the economy.

What is causing inflation in 2023?

Inflation in 2023 is mainly caused by a combination of factors, including major shifts in the demand for housing, which has led to an increase in the cost of shelter. Geopolitical issues like the Ukraine war, tensions between China and the west and even after effects of the pandemic can contribute.

Demand-pull inflation has contributed to the persistence of inflation throughout the year, as there is a higher demand for goods and services than the economy can supply. Price gouging by corporations, who claim increased costs of labor, energy, and materials as a justification for raising prices, has also played a significant role in driving inflation. Global growth projections indicate a decline in 2023, which could contribute to inflationary pressures.

Is there a way that consumers can combat Inflation?

Yes, there are a few ways that consumers can combat inflation. Consumers could choose to shop for deals and discounts to save money on purchases. They should try to reduce overall spending and focus on necessities. Investing in assets like stocks or real estate that appreciate in value over time helps. But the onus of controlling inflation ultimately lies with the government and the central bank and only their actions could have a lasting impact.

Is it a good idea to invest during Inflation?

Yes, it is a good idea to invest during inflation. Inflation causes higher prices for goods and services, which translates into higher profits for companies. Investing in stocks or other assets that are expected to appreciate in value during inflation can help individuals protect their wealth.

Will Inflation Cause a Stock Market Crash?

There is a probability that Inflation causes a stock market crash. Inflation causes stock prices to rise, as companies increase the price of their products in response to rising costs but if the inflation rate is very high, it could lead to a decrease in demand for goods and services, which could negatively impact the stock market. Other factors such as economic growth, interest rates, and global events also play a role in determining the performance of the stock market.

Does having a high inflation rate means the economy is going to be in recession?

No, having a high inflation rate does not necessarily mean the economy is going to be in a recession. High inflation rates lead to a decrease in economic growth. But it’s important to note that inflation and economic growth are not always directly correlated.

What is the current Inflation rate?

The annual consumer inflation rate in India is 5.66%, as of March 2023 data. This is the lowest rate since December 2021 and is slightly below market forecasts of 5.8%.

Arjun Remesh

Head of Content

Arjun is a seasoned stock market content expert with over 7 years of experience in stock market, technical & fundamental analysis. Since 2020, he has been a key contributor to Strike platform. Arjun is an active stock market investor with his in-depth stock market analysis knowledge. Arjun is also an certified stock market researcher from Indiacharts, mentored by Rohit Srivastava.

Shivam Gaba

Reviewer of Content

Shivam is a stock market content expert with CFTe certification. He is been trading from last 8 years in indian stock market. He has a vast knowledge in technical analysis, financial market education, product management, risk assessment, derivatives trading & market Research. He won Zerodha 60-Day Challenge thrice in a row. He is being mentored by Rohit Srivastava, Indiacharts.