I like munching mixtures and snacks by Haldiram. I am consuming it since last 12-15 years. A decade back a pack of 100 grams was costing Rs.18. Same is now costing Rs.24. As inflation rises, every rupee will buy a smaller percentage of a good. For example, if the inflation rate is 2%, then a Re.1 pack of gum will cost Re1.02 in a year. Therefore over a period of 10 years (roughly) price has increased by Rs.6 or 600%. In other words we can say 60% annually…!!
Maggie my other favorite narrates the same story in different words. Instead of increasing price it is keeping the price constant and decreasing the quantity to factor in price inflation…!! If 100 grams of Maggie was costing Rs10 a decade ago considering the same factors as Halidarm, now we should be getting just 65 grams in Rs10. But one can notice that the 10 years (roughly) Maggie was 100 grams for Rs.10 and now it’s 85 Grams for Rs.10. meaning its annual rise is just 20% as compared to haldiram’s 60%...!! (Assumption: only inflation is considered as the factor for price increase keeping all other factor constant)
During World War II, you could buy a loaf of bread for $0.15, a new car for less than $1,000 and an average house for around $5,000. In the twenty-first century, bread, cars, houses and just about everything else cost more. A lot more. Clearly, we've experienced a significant amount of inflation over the last 60 years.
Definition of Inflation:
An increase in the price you pay or a decline in the purchasing power of money. In other words, Price Inflation is when prices get higher or it takes more money to buy the same item. Inflation is measured by the Bureau of Labor Statistics in the United States using the Consumer Price Index. People on fixed incomes, such as some annuities or income from fixed interest on long-term investments, suffer most when inflation is rising, unless their pensions or incomes are fully indexed to the inflation rate. In other words according to this definition inflation is things getting more expensive. But that is really the effect of inflation not inflation itself....caused by an increase in available currency and credit beyond the proportion of available goods and services.
What is Inflation?
What is being inflated? Obviously prices are being inflated. So this is actually "price inflation".
Price inflation is a result of "monetary inflation". Or "monetary inflation" is the cause of "price inflation". So what is "monetary inflation" and where does it come from? "Monetary inflation" is basically the government figuratively cranking up the printing presses and increasing the money supply. "Monetary inflation" is the "increase in the amount of currency in circulation".
But how do we define currency in circulation? Is it just the cash in our pockets? Or does it include the money in our checking accounts? How about our savings accounts? What about Money Market accounts, CD's, and time deposits? "The Federal Reserve tracks and publishes the money supply measured three different ways-- M1, M2, and M3. These three money supply measures track slightly different views of the money supply with M1 being the most liquid and M3 including giant deposits held by foreign banks. And M2 being somewhere in between i.e. basically Cash, Checking and Savings accounts.
But back to the question of the cause of inflation. Basically when the government increases the money supply faster than the quantity of goods increases we have inflation. Interestingly as the supply of goods increase the money supply has to increase or else prices actually go down. Many people mistakenly believe that prices rise because businesses are "greedy". This is not the case in a free enterprise system. Because of competition the businesses that succeed are those that provide the highest quality goods for the lowest price. So a business can't just arbitrarily raise its prices anytime it wants to. If it does, before long all of its customers will be buying from someone else. But if each dollar is worth less because the supply of dollars has increased, all business are forced to raise prices just to get the same value for their products.
Major types of inflation:
There are three major types of inflation, as part of what Robert J. Gordon calls the "triangle model"
Demand-pull inflation: inflation caused by increases in aggregate demand due to increased private and government spending, etc. Demand inflation is constructive to a faster rate of economic growth since the excess demand and favourable market conditions will stimulate investment and expansion.
Cost-push inflation: also called "supply shock inflation," caused by drops in aggregate supply due to increased prices of inputs, take for instance a sudden decrease in the supply of oil, which would increase oil prices. Producers for whom oil is a part of their costs could then pass this on to consumers in the form of increased prices. Likewise all items that increase costs that could be passed on to consumers in the form of increased prices add to cost-push inflation. All increased costs passed on to consumers are inflationary.
Built-in inflation: induced by adaptive expectations, often linked to the "price/wage spiral" because it involves workers trying to keep their wages up (gross wages have to increase above the CPI rate to net to CPI after-tax) with prices and then employers passing higher costs on to consumers as higher prices as part of a "vicious circle." Built-in inflation reflects events in the past, and so might be seen as hangover inflation.
A major demand-pull theory centers on the supply of money: inflation may be caused by an increase in the quantity of money in circulation relative to the ability of the economy to supply (its potential output). This is most obvious when governments finance spending in a crisis, such as a civil war, by printing money excessively; often leading to hyperinflation.
Measures of inflation:
Inflation is measured by calculating the percentage rate of change of a price index, which is called the inflation rate. This rate can be calculated for many different price indices, including:
1- Consumer price indices (CPIs) which measure the price of a selection of goods purchased by a "typical consumer."
2- Cost-of-living indices (COLI) are indices similar to the CPI which are often used to adjust fixed incomes and contractual incomes to maintain the real value of those incomes.
3- Producer price indices (PPIs) which measure the prices received by producers. This differs from the CPI in that price subsidization, profits, and taxes may cause the amount received by the producer to differ from what the consumer paid. There is also typically a delay between an increase in the PPI and any resulting increase in the CPI. Producer price inflation measures the pressure being put on producers by the costs of their raw materials. This could be "passed on" as consumer inflation, or it could be absorbed by profits, or offset by increasing productivity. In India and the United States, an earlier version of the PPI was called the Wholesale Price Index.
4- Commodity price indices, which measure the price of a selection of commodities. In the present commodity price indices are weighted by the relative importance of the components to the "all in" cost of an employee.
5- GDP Deflator is a measure of the price of all the goods and services included in Gross Domestic Product (GDP). The US Commerce Department publishes a deflator series for US GDP, defined as its nominal GDP measure divided by its real GDP measure.
6- Capital goods price Index, although so far no attempt at building such an index has been made, several economists have recently pointed out the necessity of measuring capital goods inflation (inflation in the price of stocks, real estate, and other assets) separately. Indeed a given increase in the supply of money can lead to a rise in inflation (consumption goods inflation) and or to a rise in capital goods price inflation. The growth in money supply has remained fairly constant through since the 1970s however consumption goods price inflation has been reduced because most of the inflation has happened in the capital goods prices.
Causes of inflation:
In the long run inflation is generally believed to be a monetary phenomenon while in the short and medium term it is influenced by the relative elasticity of wages, prices and interest rates. The question of whether the short-term effects last long enough to be important is the central topic of debate between monetarist and Keynesian schools. In monetarism prices and wages adjust quickly enough to make other factors merely marginal behavior on a general trend line. In the Keynesian view, prices and wages adjust at different rates, and these differences have enough effects on real output to be "long term" in the view of people in an economy. There are different schools of thought as to what causes inflation. Most can be divided into two broad areas:
1-The quality theory of inflation rests on the expectation of a seller accepting currency to be able to exchange that currency at a later time for goods that are desirable as a buyer.
2- The quantity theory of inflation rests on the equation of the money supply, its velocity, and exchanges. Adam Smith and David Hume proposed a quantity theory of inflation for money, and a quality theory of inflation for production.
Related economic concepts:
1- Deflation - a general falling in price level. It is often caused by a reduction in the supply of money or credit. Deflation can be caused also by a decrease in government, personal or investment spending. The opposite of inflation, deflation has the side effect of increased unemployment since there is a lower level of demand in the economy, which can lead to an economic depression. Declining prices, if they persist, generally create a vicious spiral of negatives such as falling profits, closing factories, shrinking employment and incomes, and increasing defaults on loans by companies and individuals. To counter deflation, the Federal Reserve (the Fed) can use monetary policy to increase the money supply and deliberately induce rising prices, causing inflation. Rising prices provide an essential lubricant for any sustained recovery because businesses increase profits and take some of the depressive pressures off wages and debtors of every kind.
2- Disinflation - a decrease in the rate of inflation. Typically, this occurs during a recession as sales drop and retailers are not able to pass on higher prices to customers. Disinflation is not to be confused with deflation, where prices actually drop.
3- Hyperinflation - an out-of-control inflationary spiral. Extremely rapid or out of control inflation. There is no precise numerical definition to hyperinflation. Hyperinflation is a situation where the price increases are so out of control that the concept of inflation is meaningless. When associated with depressions, hyperinflation often occurs when there is a large increase in the money supply not supported by gross domestic product (GDP) growth, resulting in an imbalance in the supply and demand for the money. Left unchecked this causes prices to increase, as the currency loses its value. When associated with wars, hyperinflation often occurs when there is a loss of confidence in a currency's ability to maintain its value in the aftermath. Because of this, sellers demand a risk premium to accept the currency, and they do this by raising their prices. One of the most famous examples of hyperinflation occurred in Germany between January 1922 and November 1923. By some estimates, the average price level increased by a factor of 20 billion, doubling every 28 hours.
4- Stagflation - a combination of inflation and slow economic growth and rising unemployment A condition of slow economic growth and relatively high unemployment - a time of stagnation - accompanied by a rise in prices, or inflation. Stagflation occurs when the economy isn't growing but prices are, which is not a good situation for a country to be in. This happened to a great extent during the 1970s, when world oil prices rose dramatically, fueling sharp inflation in developed countries. For these countries, including the U.S., stagnation increased the inflationary effects
5- Reflation - which is an attempt to raise prices to counteract deflationary pressures. An economic policy whereby a government uses fiscal or monetary stimulus in order to expand a country's output. Possibilities include reducing tax, changing the money supply, or even adjusting interest rates
6- Agflation -An increase in the price of food that occurs as a result of increased demand from human consumption and use as an alternative energy resource. While the competitive nature of retail supermarkets allows some of the effects of agflation to be absorbed, the price increases that agflation causes are largely passed on to the end consumer. The term is derived from a combination of the words "agriculture" and "inflation". Interest in alternative energies contributes to agflation. In order to produce biofuel (such as biodiesel and ethanol), manufacturers need to use food products such soybeans and corn. This creates more demand for these products, which causes their prices to increase. Unfortunately, these price increases spread to other non-fuel related grains (such as rice and wheat) as consumers switch to less expensive substitutes for consumption. Furthermore, agflation will also affect non-vegetative foods (eggs, meat and dairy) as the price increases for grain will make livestock feed more expensive as well.
7- Stagnation - A period of little or no growth in the economy. Economic growth of less than 2-3% is considered stagnation. Sometimes used to describe low trading volume or inactive trading in securities. A good example of stagnation was the U.S. economy in the 1970s.
