Price Inflation

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21 Aug, 2024

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Price Inflation Meaning

Price inflation is the rate of increase in the prices of a broad range of essential goods and services across a specific time period, generally a year. It is an important financial measure to ascertain the fluctuations in the cost of living in a country. A low level of predictable inflation boosts economic activity in an economy and hence is considered desirable.

Inflation occurs due to an increase in demand (demand-pull inflation) or a rise in the cost of production (cost-push inflation). Either way, rising prices decrease a currency's purchasing power and erode its value. Consumer price Index (CPI) is the most popular indicator of inflation. Since inflation promotes economic growth, central banks try to maintain a stable rate of inflation by adjusting interest rates and monetary policies.

Price Inflation Meaning

Price inflation refers to a steady increase in the prices of goods and services over a certain period.
High price inflation decreases purchasing power and reduces the value of money.
Consumer Price Index (CPI) is the most widely used measure to gauge consumer price inflation in the US.
Excessive demand with a shortage of supply leads to price inflation.

Price Inflation Explained

Price inflation shows how costly a basket of pertinent goods and services has become over time, typically a year. For instance, the price of a kilogram of butter last year was $3, while the same butter is available for $3.5 this year. This price rise can be attributed to inflation.

Similarly, inflation explains the upward trend in the prices of a wide range of items. This surge reduces the purchasing power of people. This is because people have to shell out more money to purchase the same amount of product that was available at a lower price before. As a result, the value of money depletes.

Reduced purchasing power affects the cost of living or living standards of a nation. It affects both the working class and pensioners. Since inflation is closely related to interest rates, it also impacts the lending rates on savings and homeowner’s loans, along with pensions and additional benefits.

Inflation - Video Explanation

Calculate Price Inflation

Let’s first understand the Consumer Price Index (CPI) in order to calculate the inflation rate. Government agencies administer household surveys to determine the components of an average consumer basket. Then, they track the purchase price variations of this basket during a definite timescale. Though normally kept unaltered to ensure stability, the basket is adjusted infrequently according to variable consumption patterns.

The basket’s cost at a certain time concerning the base year is called the Consumer Price Index (CPI). Moreover, the percentage change in CPI across a fixed duration is named consumer price inflation. Note that the consumer basket keeps replacing obsolete commodities with brand new ones.

Price Inflation Formula

The inflation rate formula indicates the percentage rise in the price of goods and services in an economy within a year or a specific period of time.

For instance,

Base year CPI = 250

Current CPI = 200

= 25%

Furthermore, core consumer inflation is a significant concept for legislators covering basic and repetitive inflationary trends. It excludes government-set rates and more erratic prices of items influenced by supply situations due to seasonal changes.

An index with wider coverage like GDP (Gross Domestic Product) deflator is required to determine the complete inflation rate for a country. Due to frequent product price variations, GDP deflator contents vary per year. Hence, it displays a more current percentage change than a usually fixed Consumer Price Index basket. Nonetheless, it is not an accurate cost-of-living calculator due to the inclusion of non-consumer items.

Example

Let’s discuss a hypothetical example to understand how to calculate the inflation rate. Suppose an average household in a country makes the following purchases in a week in 1995 and 2022:

Items	Rate 2015	Rate 2022	Quality Purchased	Total Price (1995)	Total Price (2022)
Milk	$3	$5	4	$12	$20
Bread	$2	$4	5	$10	$20
Butter	$3	$5	3	$9	$15
Cost of Basket				$31	$55

Cost of basket (1995) = $31

Cost of basket (2022) = $55

Therefore, the inflation rate is 77%, meaning the prices for these items have risen by 77%.

A recent Bloomberg article predicts a surge in the US inflation rate due to the ongoing Russian-Ukraine war. The stand-off between the countries has impacted global supplies, driving up food and oil prices. According to the article, the average annual CPI in 2022 will likely increase by 5.1%.

Furthermore, a CNBC report reports a growth of 7.5% in annual inflation since last year. CPI for all products witnessed a 0.6% increase in January 2022. Even the core consumer inflation recorded a staggering growth of 6%. This is the highest inflation figure since February 1982.

This increase is likely to cause considerable hikes in interest rates. This news has especially hit the stock markets hard. However, the government bond yields were up to 2%, the best since August 2019.

Causes

Inflation is based on the laws of demand and supply. Excessive demand with a supply shortfall is the major cause of price inflation. Such inflation is referred to as demand-pull inflation. High demand leads to more production, reduced unemployment, and higher wages leaving more money in the hands of consumers.

If continued, a point reaches where the demand outpaces supply driving up the prices of scare products. In such a scenario, central banks intervene and increase the interest rates to reduce the money supply. With reduced money, consumers curtail spending, pulling the prices down.

Inflation can also ensue when the cost of production increases for certain goods. It is called cost-push inflation. Higher cost of inputs or raw materials usually pushes the production cost up. Consequently, producers recover this additional cost from the consumers in the form of higher prices, resulting in inflation.

Effects

Since inflation promotes economic activity, it is considered beneficial in propelling the economy forward. However, if inflation continues to rise unprecedently, the value of the national currency declines steeply.

Over the years, several nations have faced annual hyperinflation of at least 1000%. This results in a severe financial dilemma, sometimes even relinquishing the national currency. One such instance is when Zimbabwe surrendered the legal tender in 2008 due to almost 500 billion percent annual inflation.

Inflation is an omen whose virtuosity or wickedness depends upon the consumer’s available funds and situation. For instance, if the debtor borrows some money before the inflation, he would benefit as the value of money he owes is less than what it was when he received it. But, at the same time, the lender will suffer.

The term contrasts with “deflation,” meaning a fall-off in the prices of goods and services. Contrary to popular belief, neither inflation nor deflation is desirable for a country’s economic health. Rather, a perfect balance between both ends of the financial spectrum ensures a prosperous nation.

Frequently Ask Questions (FAQs)

Q#1 – What is the major reason behind price inflation?

A – Inflation is caused due to excessive product demand with supply shortages. The in-demand goods or services available in a limited quantity give rise to more competition among buyers. Consequently, they agree to pay more for acquiring them.

Q#2 – Is price inflation or deflation good for a country?

A – Neither price inflation nor deflation is good for a country’s financial health. Inflation creates a surge in product prices, while deflation causes major price reductions, having adverse long-term effects. Thus, it is essential to sustain the balance between both extremities.

Q#3 – How does price inflation impact the product rates?

A – Inflation boosts product prices leading to a decline in buying power. It also decreases the value of treasury notes, savings, and pensions. However, inflation does not strongly affect the rates established through contracts.

Q#4 – Who benefits from price inflation?

A – Borrowers benefit the most from price inflation. It allows them to repay the lent money with a capital value less than the original one. However, higher costs due to inflation boost the demand for credit, resulting in enhanced interest rates. Lenders are the beneficiary in such a situation.