Inflation is the rate at which the average price level of goods and services in an economy increases over a period of time which reduces the purchasing value of money.
Causes of Inflation:
There can be 2 main reasons that cause inflation. They are:
1. Cost-push Inflation
Cost-push inflation is something that occurs when the price level is pushed up due to the increase in the cost of production. If firms incur higher costs, they usually increase their prices to sustain their profit margins. There might be a number of reasons for increase in costs.
One is labour costs. As labour costs contribute to a major proportion of the total costs in a lot of firms, such a hike can have a significant influence on the price level. The initial increase in the price level is likely to cause workers to pressurize the management for even higher wages, which might lead to a wage-price spiral.
Another important reason may be increase in the cost of raw materials. Some raw materials, most importantly oil, can change the price by significant amounts. The other causes of cost-push inflation may be higher cost of capital goods, increases in indirect taxes etc.
2. Demand-pull Inflation:
While cost-push inflation is due to a supply-side issue, demand-pull inflation is on account of high demand that results in increase in prices.
Demand-pull inflation is something that occurs when the price level is pushed up by excess demand. The Aggregate demand for a country’s products can rise due to increase in consumption, investment, government’s expenditure or net exports. Such an increase in the aggregate demand will not necessarily lead to inflation, unless the aggregate supply fails to match it.
The other reasons that can cause inflation are:
1. Rising house prices
Increasing house prices may not directly cause inflation, but they lead to a positive wealth effect which encourages consumer led economic growth. This indirectly causes demand-pull inflation.
2. Printing more money
If the Central Bank (RBI) prints more money, one would expect to see a rise in inflation. This happens because the money supply has an important role to play in determination of prices. If there is more money behind the same amount of goods, then prices will increase. An extreme increase in the money supply may cause Hyperinflation.
An inflation index is an economic tool that is used to measure the rate of inflation in a country.
There are different methods to measure inflation, which results in more than one inflation index with different economists and investors who prefer one method over another.
Few of the Popular Inflation Index Reports are:
- Consumer Price Index:
Consumer Price Index (CPI) is an inflation index that measures the change in prices that regular consumers pays to live their day to day life like food, transportation etc..
- GDP Deflator (Gross Domestic Product Deflator)
This index measures the increase in costs that are experienced by end consumers and also the government or institutions that provide goods and services
- Producer Price Index:
Producer Price Index (PPI) is used to measure the change in prices that manufacturers or producers experience on materials that are required for conducting their business.
- Employment Cost Index
Employment Cost Index (ECI) measures the increasing cost of hiring employees in various sectors.
Why is it important to beat Inflation?
Under normal circumstances, one can assume that moderate inflation is good for an economy as the overall consumption of an economy might be increasing. However it is to be noted that neither excessive inflation nor deflation is good. Excessive inflation means that goods have become very expensive, which might reduce the aggregate demand for goods and services in the economy. This will lead to decrease in the profits of companies, which would, in turn, lead to reduction in wages of workers or even layoffs. On the other hand, deflation has a similar effect. Deflation looks good from a consumers’ point of view but it has many other considerations to look into. There will be deflation in an economy when Supply is greater than Demand. As a result, companies might not be willing to produce goods, which might cause a fall in the wages and ultimately a reduction in aggregate demand (as the purchasing power of people might fall on account of fall in wages.) This again leads to a shrink in the economy.
Few Ways to Beat Inflation:
Investing in Equity or Mutual Fund
Investing in stocks that do not have debt but have lot of surplus in cash can be considered. These stocks are not influenced by the increase in cost of interest due to higher borrowing cost.
To invest in equity, one can either directly invest in equity stocks or through equity mutual funds.
Gold is considered as a hedge against inflation. Whenever there is uncertainty in global markets, investors can take refuge in gold. This is because, in times of inflation, investing in gold helps in preventing diminution in the purchasing power.
Real estate is another preferred investment during inflationary times as property prices tend to increase in accordance with the cost of construction. The biggest barrier is that the minimum amount one needs to invest in Real Estate is higher and beyond the financial reach of a common man.
By considering investments that can provide steady returns during inflation, one will be able to protect the value of money. Although, there are investment avenues that could beat inflation, it is important to ensure that portfolios are well diversified.