The Truth Behind Inflation: (Economy)
If I gave you a hundred rupee note in the year 1958 and you kept it hidden under your bed for 60 years and if you took out that note today and used it in the market, then the value of that note would have reduced to a mere 1 rupee 20 paise in comparison to 1958.
Let me explain it to you from another angle, if you did not understand If you buy something worth 100 rupees today it would have cost 1 Rupee 20 paise back in 1958 That is 100 rupees today is equal to 1 rupee 20 paise in 1958 this is because of inflation.
Inflation means dearness of things that makes things costlier for all of us every year. Why does inflation occur and what are the reasons behind this?
Is it a bad thing? and How is inflation related to unemployment and other economic factors?
First of all, an important question- Why does inflation happen and who is causing it to happen? Are some Government officials increasing the prices of things arbitrarily?
It is not so There are several reasons for inflation but I’d like to discuss 4 main reasons for inflation.
An Economic Boom:
The first reason is very simple an economic boom That is, good economic growth
When the economic growth is good, then there’s more money in the hands of the people who can spend it on different items. When there’s more money in the hands of the people, they can spend it on different items That is, the demand for everything would go up in the economy.
When demand goes up, the businesses and companies that manufacture these products seek to increase the prices in a bid to earn more profit since so many people are willing to buy So they increase the price of the goods which will then lead to inflation.
So basically there is inflation This type of inflation is called “demand-pull inflation” A demand-pull inflation is when the inflation rises with the rise in demand.
The increase in the prices of raw materials is due to different reasons:
The second reason is the increase in the prices of raw materials due to different reasons for example, if the prices of wheat and rice rise due to a bad monsoon season, the prices of oil rise, or a new tax imposed by the government leads to a rise in the price of one of the raw materials
Then the companies that manufacture products using these raw materials have to hike the prices of the products to make profits since manufacturing them would become costlier which would ultimately lead to inflation This inflation is called “cost-push inflation“.
Increase in Salaries:
The third reason is an increase in salaries No, I’m not joking: When companies or governments raise the salary of their employees then they have to increase the price of their products as well to be able to still make profits.
This inflation is called “wage push inflation” There could be other reasons for this as well If unemployment levels are at low levels in a country, then it is difficult for the companies to replace their employees and if they aren’t replaced, their salaries would have to be raised and this again, triggers inflation.
Currency Depreciation:
Finally, the fourth reason is currency depreciation This can happen due to several different reasons, of which one of the most important reasons is the printing of more notes by the government which leads to the currency losing its value
And this is a very dicey reason This could also potentially trigger hyperinflation which is happening in Venezuela today and happened in Zimbabwe in 2008 If the inflation rate touches even 10% in our country, then it would cause people to comment that things are becoming extremely dear very fast but in Venezuela, between 2016- 2019, the inflation rate was more than 5 crore percent!
Taking the example of Zimbabwe,
Around 2008, the currency of Zimbabwe was losing its value at such a rapid pace that the government began printing 1 million dollars and 1 billion dollar notes! And there existed even a 1 trillion dollar note in Zimbabwean dollars.
And do you know what the value of that 1 trillion Zimbabwean dollar note was? Just 1 US dollar! This is the extent to which money can lose its value in a case of hyperinflation because there are several political reasons behind it, apart from the economic ones.
What if Inflation was Zero?
What if there was 0% inflation? Observing superficially, you could think that this would be great as things would stop becoming costlier and that it is good for you as you will be able to afford it for cheap You would be able to save up more and over, the value of money would not depreciate either So this would be another great thing!
Analyzing deeply the reasons that lead to inflation then you would understand that 0% inflation is not a good thing This would mean that companies would not raise your salaries Your salary would remain constant and since salaries never go down, therefore, in general, inflation always stays in the positive.
And there is a third reason as well If there is deflation, that is, the prices of things keep decreasing every year, then the people would not want to spend money. They would want to save up First of all, the value of money is increasing,
If deflation continues to happen, then five years on, the item that one wishes to buy would come for cheaper So they would want to buy it five years later instead of buying it now This would cut down the overall public expenditure Lesser expenditure would mean that the businesses would start incurring losses.
The businesses incurring losses would translate to people losing their jobs which would then cause unemployment to rise I’ve told you about a very long and convoluted connection- You might wonder if it happens so Yes it does There is a very interesting relation between unemployment and inflation This graph is called the “Phillips Curve”
This shows us the inverse relation between unemployment and inflation If there’s economic growth, there will be an increase in inflation and unemployment would go down and unemployment will rise if inflation goes down this is a very interesting explanation because one would not expect this to happen, but it does in reality but as obvious, there are some extreme limits where this graph is not valid
For example, in the case of hyperinflation, it isn’t that Venezuela today has 100% employment and 0% unemployment Some other factors come into play there. For instance, political factors cause inflation to spike but generally, this graph is valid.
What is the Optimum Level of Inflation?
A question arises- Excessive inflation is bad because it would cause hyperinflation and increase dearness Nominal inflation is also bad because it would cause unemployment to rise So, what is the optimum level of inflation that a country should maintain? What could it be?
This figure is 2% for the developed countries The central banks and the governments of the developed nations have decided that they should maintain an inflation rate of about 2% If it is more, then they would try and reduce it and if it is less, they will try and increase it for India, this rate is 4% with a margin of ±2%.
So the ideal inflation rate in India should be around 2-6% This keeps the prices stable and keeps the levels of unemployment at their lowest It ensures maximum employment So, if a government wants to control inflation, how can it do that?
There can be several ways to do this Generally, the central bank of a country is responsible for controlling the inflation rate, and normally, the central bank- RBI, in the case of India- controls the inflation rates by increasing/decreasing its interest rates If RBI increases in interest rates (which are called repo rates) which is charged on loans given to other banks.
Then fewer banks would want to take loans and these banks in turn, would increase their interest rates as well which would reduce the number of people wanting to take loans This would result in less money being circulated in the economy and if this happens so, then inflation would go down.
And if RBI slashes its interest rates, then indirectly, through other banks, more people would want to take loans and this would push inflation up. So inflation rate can mainly be controlled by increasing or decreasing the interest rates But there are other ways as well- Inflation can also be controlled by printing of more notes Printing of more notes would obviously cause inflation to rise The government can control inflation by imposing more taxes The government can also control inflation by spending more or by spending less.
If I gave you a hundred rupee note in the year 1958 and you kept it hidden under your bed for 60 years and if you took out that note today and used it in the market, then the value of that note would have reduced to a mere 1 rupee 20 paisa in comparison to 1958.
Let me explain it to you from another angle, if you did not understand If you buy something worth 100 rupees today it would have cost 1 Rupee 20 paisa back in 1958 That is 100 rupees today is equal to 1 rupee 20 paisa in 1958 this is because of inflation.
Inflation means dearness of things that makes things costlier for all of us every year. Why does inflation occur and what are the reasons behind this?
Is it a bad thing? and How is inflation related to unemployment and other economic factors?
First of all, an important question- Why does inflation happen and who is causing it to happen? Are some Government officials increasing the prices of things arbitrarily?
It is not so There are several reasons for inflation but I’d like to discuss 4 main reasons for inflation.
An Economic Boom:
The first reason is very simple an economic boom That is, good economic growth
When the economic growth is good, then there’s more money in the hands of the people who can spend it on different items. When there’s more money in the hands of the people, they can spend it on different items That is, the demand for everything would go up in the economy.
When demand goes up, the businesses and companies that manufacture these products seek to increase the prices in a bid to earn more profit since so many people are willing to buy So they increase the price of the goods which will then lead to inflation.
So basically there is inflation This type of inflation is called “demand-pull inflation” A demand-pull inflation is when the inflation rises with the rise in demand.
The increase in the prices of raw materials is due to different reasons:
The second reason is the increase in the prices of raw materials due to different reasons for example, if the prices of wheat and rice rise due to a bad monsoon season, the prices of oil rise, or a new tax imposed by the government leads to a rise in the price of one of the raw materials
Then the companies that manufacture products using these raw materials have to hike the prices of the products to make profits since manufacturing them would become costlier which would ultimately lead to inflation This inflation is called “cost-push inflation“.
Increase in Salaries:
The third reason is an increase in salaries No, I’m not joking: When companies or governments raise the salary of their employees then they have to increase the price of their products as well to be able to still make profits.
This inflation is called “wage push inflation” There could be other reasons for this as well If unemployment levels are at low levels in a country, then it is difficult for the companies to replace their employees and if they aren’t replaced, their salaries would have to be raised and this again, triggers inflation.
Currency Depreciation:
Finally, the fourth reason is currency depreciation This can happen due to several different reasons, of which one of the most important reasons is the printing of more notes by the government which leads to the currency losing its value
And this is a very dicey reason This could also potentially trigger hyperinflation which is happening in Venezuela today and happened in Zimbabwe in 2008 If the inflation rate touches even 10% in our country, then it would cause people to comment that things are becoming extremely dear very fast but in Venezuela, between 2016- 2019, the inflation rate was more than 5 crore percent!
Taking the example of Zimbabwe,
Around 2008, the currency of Zimbabwe was losing its value at such a rapid pace that the government began printing 1 million dollars and 1 billion dollar notes! And there existed even a 1 trillion dollar note in Zimbabwean dollars.
And do you know what the value of that 1 trillion Zimbabwean dollar note was? Just 1 US dollar! This is the extent to which money can lose its value in a case of hyperinflation because there are several political reasons behind it, apart from the economic ones.
What if Inflation was Zero?
What if there was 0% inflation? Observing superficially, you could think that this would be great as things would stop becoming costlier and that it is good for you as you will be able to afford it for cheap You would be able to save up more and over, the value of money would not depreciate either So this would be another great thing!
Analyzing deeply the reasons that lead to inflation then you would understand that 0% inflation is not a good thing This would mean that companies would not raise your salaries Your salary would remain constant and since salaries never go down, therefore, in general, inflation always stays in the positive.
And there is a third reason as well If there is deflation, that is, the prices of things keep decreasing every year, then the people would not want to spend money. They would want to save up First of all, the value of money is increasing,
If deflation continues to happen, then five years on, the item that one wishes to buy would come for cheaper So they would want to buy it five years later instead of buying it now This would cut down the overall public expenditure Lesser expenditure would mean that the businesses would start incurring losses.
The businesses incurring losses would translate to people losing their jobs which would then cause unemployment to rise I’ve told you about a very long and convoluted connection- You might wonder if it happens so Yes it does There is a very interesting relation between unemployment and inflation This graph is called the “Phillips Curve”
This shows us the inverse relation between unemployment and inflation If there’s economic growth, there will be an increase in inflation and unemployment would go down and unemployment will rise if inflation goes down this is a very interesting explanation because one would not expect this to happen, but it does in reality but as obvious, there are some extreme limits where this graph is not valid
For example, in the case of hyperinflation, it isn’t that Venezuela today has 100% employment and 0% unemployment Some other factors come into play there. For instance, political factors cause inflation to spike but generally, this graph is valid.
What is the Optimum Level of Inflation?
A question arises- Excessive inflation is bad because it would cause hyperinflation and increase dearness Nominal inflation is also bad because it would cause unemployment to rise So, what is the optimum level of inflation that a country should maintain? What could it be?
This figure is 2% for the developed countries The central banks and the governments of the developed nations have decided that they should maintain an inflation rate of about 2% If it is more, then they would try and reduce it and if it is less, they will try and increase it for India, this rate is 4% with a margin of ±2%.
So the ideal inflation rate in India should be around 2-6% This keeps the prices stable and keeps the levels of unemployment at their lowest It ensures maximum employment So, if a government wants to control inflation, how can it do that?
There can be several ways to do this Generally, the central bank of a country is responsible for controlling the inflation rate, and normally, the central bank- RBI, in the case of India- controls the inflation rates by increasing/decreasing its interest rates If RBI increases in interest rates (which are called repo rates) which is charged on loans given to other banks.
Then fewer banks would want to take loans and these banks in turn, would increase their interest rates as well which would reduce the number of people wanting to take loans This would result in less money being circulated in the economy and if this happens so, then inflation would go down.
And if RBI slashes its interest rates, then indirectly, through other banks, more people would want to take loans and this would push inflation up. So inflation rate can mainly be controlled by increasing or decreasing the interest rates But there are other ways as well- Inflation can also be controlled by printing of more notes Printing of more notes would obviously cause inflation to rise The government can control inflation by imposing more taxes The government can also control inflation by spending more or by spending less.