Whenever there is a new monetary policy introduced people will talk about inflation. We hear this word from many economists in their interviews or any articles written by them. What does inflation mean and how does that impact a common man is what you must be wondering. Let’s look at what is inflation and its effects.
The term “inflation” originally referred to increase in the amount of money in circulation. Today the term “inflation” is used to refer to a rise in the price level.
Inflation means an increase in the general price level of goods and services in a country over a period of time. When the price level increases each unit of that currency purchases fewer good and services. This can also be termed as the reduction in the purchasing power of a common man. Example: Say in the year 2000 a person is able to buy 1 kg of onions for Rs.5 and now same 1kg of onions has to be bought for Rs.15-20. With same Rs.5 the person can buy 300gms of onions. This means rupee has lost its purchasing power.
Inflation has some negatives and positives as well. One of the drawback is that there will less investments due to the uncertainty of future inflation rates. Due to high inflation people tend to hold money with them as they might think the inflation rate might decrease in the future. Due to this circulation of cash in the country will reduce. Positive effects include reducing the real burden of public and private debt, keeping nominal interest rates above zero so that central banks can adjust interest rates to stabilize the economy. One of the main advantage of having a stable inflation in the economy is that it reduces unemployment in the country.
High rates of inflation and hyperinflation are caused by an excessive growth of the money supply and are dangerous to a country’s economy. Hyperinflation has been seen in Zimbabwe where Zimbabwe’s peak month of inflation is estimated at 79.6 billion percent in mid-November 2008. Due to this the currency of Zimbabwe lost its value completely and post November 2008 Zimbabwe stopped printing its currency and adopted US dollar as their official currency.
A measure of price inflation is the inflation rate, the percentage change per year in a general price index, usually the consumer price index.
Consumer Price Index: A consumer price index (CPI) measures changes in the price level of basket of common consumer goods like milk, rice, sugar etc. and services purchased by households. The CPI is a statistical data tool constructed using the prices of a sample of representative items whose prices are collected periodically. A CPI can be used to identify the real value of salaries, pensions, for regulating prices. Let’s see how CPI is calculated.
Current item price = base year price * (current year CPI/Base year CPI).
For example, data is collected by surveying households to determine what proportion of the consumer’s overall spending is spent on specific goods and services, and weights the average prices of those items. Those weighted average prices are combined to calculate the overall price. To better relate price changes over time, indexes typically choose a “base year price” and assign it a value of 100. Index prices in subsequent years are then expressed in relation to the base year price.
Even though there are a few negatives due to inflation, it gives an opportunity to reduce unemployment in the country. The country’s external debt and internal funds will be improved. Due to the reduction of unemployment the productivity of that country will also improve. Having a stable inflation will be beneficial for the country.