Did you know your Money is losing its value every year? if you got money stacked up in your Savings account or FD for your kid’s future, or if you are planning to save your money for your retirement, then your money might be at risk.
Why I am stressing this point is the majority of people are unaware of the term Inflation. At least they have heard it, but they do not know exactly what that means.
It is our responsibility to know about the term Inflation because everyone will be affected by it. The inflation rate around the world is 3%, now is it safe to stack up your money on FD and savings? Absolutely not. Instead, take out your money from FD and savings and invest your money other than them.
Although our topic is not about investing, this point is worth mentioning, we will talk about Investing in our later posts. First of all, let’s try to understand what Inflation actually is.
What Is Inflation:
“The increase in general price value of goods and services in an economy when the general price level rises each unit of currency buys fewer goods and services.
Consequently, Inflation corresponds to the reduction in the buying power of money.” This seems like a bookish definition, right?
Let’s understand the concept in simple words, Inflation means “The prices of day-to-day goods and services increase where the value of money decreases, which results in more money having to be spent for buying fewer goods.
In short, the value of money decreases while goods and services prices go up.
You will get a clear understanding once you go through the article. First of all why Inflation occurs?
Why does Inflation Occur?
Inflation occurs when a government tries to print more and more money. Why does the government need to print more money?
Let’s understand with the help of a scenario, suppose you want to buy a relatively cheap product, consider a pen which is around 10 Rs, the demand for this pen is huge because it is cheap and anyone can afford it.
The customers kept coming in to buy the product, and it came to a point where the stock of pens was exhausted but the customers still came to buy the pens.
Now the shopkeeper decides to increase the price to 50, now the customers who can really afford buys the pen, remaining customers cannot afford that pen and eventually back off.
The price of the pen goes up because there is enough money in people’s hands because the government is printing the money whenever they want.
The government prints money because of a financial factor called Fiscal Deficit. Which is explained below.
What is a Fiscal Deficit:
The term Fiscal is a government policy that is carried out to impose taxes on the general public for sustainable growth of the economy, and Deficit means the amount that is not enough to pay off.
A Fiscal Deficit means when the government spends more than its total revenue, Hence the name Fiscal Deficit. It is calculated using the below formula.
Fiscal Deficit = Total Expenditure – Total revenue.
So, the next obvious question is, how is it related to Inflation?
How Fiscal Deficit Related to Inflation:
Suppose the government spends 100 crores, but the actual revenue of the government is 90 crores the government is in the Fiscal Deficit. Conversely, the government prints more money to fill the deficit, This is the main cause of inflation.
The Problem of Inflation started when the government incorporated using Currency as an exchange. There are two types of exchange methods. In the below points, we will go through a brief introduction to exchange systems.
Barter System:
During the early stages of civilization, when there are no means of exchange like gold or paper currency people used to exchange one item for the other.
Suppose if one party wants rice and another wants wheat they exchange those items without the involvement of money.
Currency Exchange:
Currency exchange came into existence when the governments of the world abandoned the concept of gold standard which means there is no physical backing up of gold for money.
When people wanted to buy goods and services they used to give paper currency to the shopkeepers which was issued by the government.
Again currency exchange causes inflation, there are many factors that cause Inflation but the
They are divided into 3 categories, They are:
Demand-Pull Inflation:
In short Demand-pull Inflation means “When the demand is high and the supply is low the prices go up”. Let us understand this in a bit of detail.
When people have enough money to buy goods and services, then the buying power of people increases, they can buy more, and when they buy more the supply becomes less and the shopkeepers are likely to increase the prices. This leads to inflation.
Cost-Push Inflation:
The simple definition of Cost-push Inflation is “Increase in cost of goods and services results to cost-push inflation” In other words when people try to purchase more because of adequate money to buy a product, then the shopkeepers are likely to increase the prices of goods and services because the supply is low. Again this leads to Inflation.
Built-in Inflation:
Built-in Inflation occurs when any one of the above-mentioned inflations continues over a period of time, suppose the demand-pull inflation persists over a period of long-term then it leads to built-in inflation.
In the upcoming section, we will discuss the advantages and disadvantages of inflation, what measures the governments take to balance inflation, and finally some extreme examples of inflation.
Advantages of Inflation:
Although inflation seems kind of a negative term, it is not, there are some advantages as well.
1. If people have adequate money then people’s buying power decreases because the prices of goods and services increase.
2. This increases in prices, when prices of goods and services increase, the businesses are into more profits.
3. When profits are high then the revenue for the government increases.
4. Resulting in more job opportunities for the general public.
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Disadvantages of inflation:
1. If people have less money to buy goods and services, they can buy more goods and services for the same price.
2. This results in prices going down, Then the purchasing power increases.
3. When prices go down businesses are in losses.
4. Then the revenue for the government decreases.
5. This eventually leads to the loss of jobs and Deflation – which means the prices of goods and services decrease when the money’s value increases.
6. Deflation can lead to unemployment and recession which is not good for the country.
So far we learned about all the aspects of inflation fine, but who operates it, who manages all this stuff, like if inflation increases or decreases who stabilizes it?
The answer is the centralized bank the bank that gives guidelines to all banks and eventually, it prints the money.
The precautionary steps for balancing Inflation like Hyper Inflation, Deflation, etc:
When inflation increases above the permissible level, then the prices skyrocket, this is termed HyperInflation, what the government does is, reduce the prices of goods and services.
On the contrary when the inflation rate decreases which is Deflation in this case, then the prices of goods and services drop then the government increases the prices of goods and services.
The government also increases REPO rates which is the interest rate at which the central bank lends money to the small banks in the country.
The other way to control the money flow in the economy is by increasing the interest rates during high inflation and decreasing the interest rates during Deflation.
Worst Economic Collapses in History Due to Extreme Inflation, Deflation:
Now that we know about Inflation and its types, here we are going to talk about the worst economic collapses in the history of mankind these are the extreme examples of how Inflation/deflation skyrocketed, which is in this case called Hyperinflation where the Inflation rate has gone to a percentage of more than 50-100%.
Zimbabwe’s HyperInflation:
It started in the year of 2007 February, we have seen that the yearly inflation rate around the world is 3-7% but when this incident happened in Zimbabwe the inflation rate was 98% daily. It came to a point where the inflation rate for Nov 2008 was 79,600,000,000%.
Imagine that we are unable to withstand a marginal inflation rate of around 6% compared with Zimbabwe’s Hyperinflation, it is huge.
Germany’s HyperInflation:
This happened way back in 1923, it is so bad that the exchange rate between the dollar and mark was one trillion marks to one Dollar. With a monthly inflation rate of 29,500% in October 1923 which is equal to a daily inflation rate of 20.9% that means it took 3.7 days to double the prices.
Here is an example of Deflation - This occurred due to an increase in production, rather than a decrease in demand. Between the years 1930 and 1933, the prices of goods and services dropped at a rate of 7% every year. This is termed as the great depression. The main cause of the great depression was to collapse of financial sectors and bank failures.
What we discussed so far:
We learned what is inflation – The loss of the value of money in an economy is called Inflation.
Then we talked about why inflation occurs - When the government prints money and due to Fiscal Deficit.
Then we learned about the Fiscal Deficit – Which means debt owned by the government.
We also learned about how the fiscal deficit is related to inflation.
How fiscal deficit related to exchange systems.
The 2 Exchange systems:
1. Barter System – Exchanging of goods between two parties.
2. Currency Exchange – Using paper currency to buy goods and services.
We also saw that currency exchange also causes inflation and it leads to three types of inflation, namely:
1. Demand-pull Inflation: When demand is high supply is low prices go up.
2. Cost-push Inflation: An increase in the cost of goods and services causes cost-push inflation.
3. Built-in Inflation: When any one of the above-mentioned two inflations occurs and persists over the long term then there will be a built-in inflation.
We also learned about the advantages and disadvantages of inflation.
We also saw the precautionary steps taken by the government to stabilize inflation/deflation.
We have also seen the worst economic collapse in world history due to inflation/deflation.
These are the main aspects that you want to understand about Inflation, I hope you are now familiar with the term Inflation.
