Demystifying Everyday Economics: Inflation (Part-I)

Each one of us must have come across this term in one way or the other - Inflation. For some of us, it could be part of our job, for some of us part of our curriculum, but for all of us most certainly part of our lifestyle. Since it is so coupled with our everyday lives, why not take a moment to understand to the core?

Urban Definition

Inflation measures how much more expensive a set of goods and services has become over a certain period, usually a year.

In oversimplified terms, Inflation means increase of prices of things around us, or alternatively decrease of value of the money we have in our hands. Let's take an example to understand it better, Ram, a farmer from Rural India produces certain amount of crops and sells his output grains in a maandi or a farmer's market. In certain day, he brought 100 kg or rice. Now, to produce this rice, he had to spent around 30,000 INR for all the rice paddies, fertilisers, tractors and other operational costs. And being generous that he is, he decided to keep profit margin only 10 INR per kg. So he sat on the market selling his rice for 40 INR per kg. Now fast forward that to next year, in which he had to spent 5000 INR extra because of some maintenance work in the machinery he was using for production. And rest of the cost being same for him, he decided to keep the profit margin same as before. Hence, he is selling his rice at 45 INR per kg making price each kg of his rice increase by 5 INR or 12.5% as compared to last year.

Cause of Inflation

Inflation can cause due to numerous reasons and for most part might not be concerning to the general public. However, long-lasting inflationary period is often dictated by lax monetary and economic policy. In this section, we will look at two broadly classified strategies that causes inflation and how central reserve bank plays role into this.

Cost Push Inflation

Price of any item at any point can be thought as an agreement between buyers (demand) and sellers (supply). And as such, inflation is just an increase in their agreed upon value for the exchange of goods or services. If production those goods or services become costly for some reasons, like we have seen in our earlier example, it is obvious that the seller will ask for more. And more common this is the case among sellers, harder it will be for a buyer to get a price lower than that. This situation will overall push the price of that item higher than before. This is known as Cost Push Inflation and usually caused by lesser production power or higher cost of production per unit in suppliers end. In laymen terms, the supplier failed to keep up with the demand.

Demand Pull Inflation

Now let us take a look at the opposite side of the agreement, buyers. If buyers have more amount of disposable income, i.e., higher purchasing power, they will try to outbid others for the same number of goods or services. In this scenario, the production power remains the same and so does production cost for each unit. It is now upto the buyers to decide how high they can go for a price in exchange of the value created. This is known as Demand Pull Inflation and caused by money supply becoming bigger than the size of the production economy. In general, this is common among growing economy and usually thought as a good thing as long as the sizeable difference is within reasonable limits. But given how convoluted today's finance and economy is, it well can go beyond reproach very quick and that is where a Monetary Policy by Central Reserve Bank come into play.

Effects in Everyday Lives

I think it goes without saying, the biggest effect inflation has in our every day life is that the living cost gets higher and higher, no matter where you live (urban or rural). To more microscopic level, this effect might differ from household to household and to institutions to institutions. There are certain group of items that we call essentials such as food item, health services and maybe education, which we all depend upon so heavily. Any increase in cost of affording this means a greater cost to the whole economy of a nation. A movie hall, or restaurant, on the other hand if gets costly, only effects a certain segment of the population.

Budget

The detailed plan and execution of expenses and revenues of an individual, or a family household, or an institution or even a nation is described in its Budget. Focusing right at inflation only, there are certain things a budget creator might decide to do. The most obvious is to cut expenses on non-essential goods and services, followed by reallocation of purchases. For example, a family with a fixed budget when faced by inflation might decide to drop Movie Friday and have more indoor family time. If there is some uncertainty with supplies of grocery, the family might decide to stock up, eventually beating inflation in a short-term.

Cash

The primary cost of inflation comes from the fact that the money gets devalued. So whatever amount of cash an individual or institution holds will less valuable the very next day in an inflationary economy. This makes holding onto a lot of cash a bad investment. But also one must have cash in some form to pay for utilities and bills. This forces people to look for short-term low-risk investments that might not give an attractive rate of return but would enough to protect wealth from inflation. For an individual, this ranges from investing into Liquid Funds, to lock into Term Deposits in reputable banks and financial institutions or simply owning an asset that has higher return than inflationary loss. For an institution, this could mean buying short-term Government Debt (also called Treasury Bills) or as mentioned for individuals, park it into some small assets just to beat inflation. This decisions often influenced by the immediate requirements of cash, time horizon for such investments and availability of cash either via sale or credit in the economy.

Invention

The influence of an inflationary economy into invention is often overlooked. Quite frequently it so happens in an inflationary economy is a better efficient tool or solution come into play to match the production need with current amount of resource and hence causing inflation to come around. This can also be attributed to new industry formation, creation of new jobs and even relocation of certain industries.

Effects in Global Economy

Gross Domestic Product

The relationship between a country's GDP and it's currency is a very delicate matter and often misunderstood by policy makers. This is often believed and pursued for is that a slightly inflationary economy is better for nation's GDP. It forces people to purchase goods and service and advises them to save them as cash for near future, as it's purchasing power will erode with time. It is true that a surreptitious bout of inflation can temporarily fool an economy into growing faster than it otherwise would. But afterwards, you pay a penalty--long-term losses that may swamp the temporary gains.

Global Trade

Integration into the world economy has proven a powerful means for countries to promote economic growth, development, and poverty reduction. Over the past 20 years, the growth of world trade has averaged 6 percent per year, twice as fast as world output.

If we look closely to our everyday items that we consume, we will hardly find a single item that has been accured, extrated, produced, manufactured and then soled in domestic market. To our luxury, we living in a intertwind market of global and international trade where anything from anywhere is up for sale. And that inherently complicates our day to day economy in multiple ways. For the limitation of discussion we will only focus on inflation, i.e., purchasing power of a currency to buy a product domestic or otherwise. Now we must already be knowing that the only currency treated as Global Reserve is the almighty Dollar (US). If a currency looses it's value in the face of USD, it will loose it's purchasing power in global market and will be able to less than earlier. This might have moderate to dire consequences in the nations economy and so it's GDP.

Imagine you live in a Oil-rich country, but unfortunately you don't have the infrastructure to refine Petrolium. So for everyday use of Gasoline, Kerosine and many other products, you are dependent on one of your neighbourhood country. Let's say you gave them $1000 worth of Petrolium at a cost of 10% for refinery, so under this agreement they are expected to give you back $900 worth of Petrochemical products. If your currency was valued at 10 per Dollar at the begining of this trade and later it lost value to 20 per dollar, you will be paying 18000 to import the refined products in your local currency for the sale of raw material at 10000 in same currency, including the intermediary fees.

And the opposite can also be illustrated similar way. Let's say a country has a production of an exclusive material that a lot of consumers across multiple countries want. Those country will try to get a hold of the local currency to buy that product to meet their demands and in the process appreciating the value of the currency, increasing it's purchasing power.

In the next part, we will look at how Central Reserve Banks take a part in it and how their monetary policies influence nation's inflation.