Inflation is a very common term nowadays. Even the maid, auto driver talks about it. So What is Inflation? How does it affect me ? What causes inflation? How to calculate it ? How to protect myself from inflation ? Let us try to understand the answers for these questions. These are some of the questions you must know the answers to. If not, watch your money lose its value over time . We will cover about deflation, stagflation in another post. Let us just stick to inflation here..
What is Inflation Rate ?
Investopedia defines inflation as “Inflation is defined as a sustained increase in the general level of prices for goods and services”. Quite a simple definition. Let us make it even simpler with some examples.
- You must have heard your father say he bought milk for you at Rs 6 per liter when you were born. What is the cost of per liter of milk now in 2014? Nearly Rs 30. Prices have risen for same 1 liter of milk. That’s Inflation.
- Petrol used to cost around Rs 45-50 per liter in 2007 . Now they cost you around Rs 75-80. One liter petrol is same. But its value has increased.
- I bought my 1st TVS Scooty for Rs 32,000 in 2005. The same vehicle costs above Rs 45,000 now. Damn you, inflation !
All the above examples define ‘What is inflation’. Something which you buy today is likely to get costlier tomorrow. The same item cannot be bought for the same cost in future in an inflating economy. You need to shell out extra money. Why? Answer: Inflation. Inflation in one sentence means ‘decreasing value of money‘ and ‘increasing value of goods‘. The purchasing power of money goes down and same amount of money buys lesser products/goods/services.
Also Read: Most common mistake by investors
What causes Inflation ?
The economy and capitalism has structured goods/services such that it increases in value over time. Will you like to take lower salary in the future? Will you sell your house for less after 10 years? Even if there is deflation (prices decreasing over time) , the human mind considers it a social stigma to get lower salary in future. Logically, if prices decrease we can take a salary cut and buy the same products and maintain same standard of living. This human stigma is the main/core cause of inflation. Enough with philosophy? OK 🙂
- Inflation is always and everywhere a monetary phenomenon resulting from and
accompanied by a rise in the quantity of money relative to output
- Inflation rate is essentially dependent on the growth rate of money supply relative to the growth of the economy (Wikipedia-Inflation cause)
- Demand-Supply mismatch : When there is huge demand for something, its value rockets. It does not come down as much as it went up (except stocks :-)).People are willing to pay more to make sure they get what they want.
- Perceived human value – For eg., You learn Salman Khan is moving next door or a new airport comes less than 4 kms from your house. The value of your house shoots up. Once it has gone up,even if airport or Salman doesn’t come, you do not sell at/below original price.
- Increased cost of production – As costs of raw materials increase, companies mostly pass it on. They do to maintain profits and this causes inflation.
- Unemployment/Recession – When unemployment increases, governments pump in more money by simply printing them. As more money enters the system, the value of it goes down.
These are some of the causes of inflation. There are many other views and theories and concepts. We do not want to get too technical. Basic examples above must suffice to explain what causes inflation.
Popular post: Best Tax saving mutual funds in India
How to calculate inflation rate – WPI or CPI ?
Consumer Price Index(CPI) and Wholesale Price Index(WPI) are the common indices used to calculate inflation rate. Each government uses/prefers its own index . Typically CPI is followed in US, UK and WPI is followed in India. Though with the last two Reserve Bank Governors I see the trend shifting slightly to CPI in India as well.
Consumer Price Index(CPI) – Value of a basket or collection of goods used by consumers(common man) and households. It is divided into five groups :
- Foods and beverages – Cereals,rice,milk,meat,oil,fruits,vegetables
- Fuel and power – Petrol,diesel,coal,Electricity etc.,
- Housing – Real estate, Rents, Cost of labor, Building materials
- Clothing,Bedding and footwear – Self explanatory 🙂
- Miscellaneous – Medical expense, Recreation, Transports,Communication,Others
As you can see, a common man will be more concerned about CPI as it affects him the most. The formula used for computing CPI index is as follows
CPI = (Updated cost of prices/Base price cost) *100
Updated cost is the current cost ie., present price.The base year index/price is the average prices of goods in the previous year(last 12 months).If you want over long period, then consider base price of the year from which you want.
Wholesale Price Index(WPI) – Value of basket of wholesale goods. In India, WPI is used as the primary index for inflation. In WPI we use approximately 430 items like induatrial power, manufactured goods, Services, Machines, Textile, agriculture produce etc., You can see it includes items in CPI as well.
WPI =((Cost now-Cost earlier)/(Cost earlier))*100
For eg., The WPI of rice for the year 1980 is,
(Price of Rice in 1990 – Price of Rice in 1980)/ Price of Ricein 1980 x 100
i.e. (8.10 – 6.55)/6.55 x 100 = 23.04
WPI for the base year is equated to 100. So, WPI of rice for 1990 =100 +23.04 = 123.04.
WPI is arithmetic mean of each of all such 430 items. Let us see how inflation calculated
Inflation rate = ((WPI current year – WPI base year)/WPI base year )*100
In last decade, WPI in India is around 5-7% and CPI is around 8-11%. Find out how much your money will be worth in future -FREE Inflation Rate Calculator
How does inflation affect you -the common man?
- Your purchasing power goes down. You will not be able to pay your rents, dress the same way in future if your income remains constant
- You cannot give your children the best education. Education inflation is 12-13% in India. You spent Rs 50,000 per annum for college fees in 2012. Guess how much college fees will cost for your just born child 20 years later. It’s Rs 5,00,000. Almost 10 times.
- You are living off your pension/fixed income? Your money is not growing. It’s decreasing in value. If you just retired and earn Rs 25,000 as pension. Ten years down the line it will just be enough to cover your rent. What you’ll do for food?
- You have less money to save and invest – If your salary hike % does not increase greater than inflation rate %, you can’t save. You cannot build assets or buy a home. It becomes difficult.
- Your investments/assets value go down – When inflation increases, governments increase interest rates. This brings down value of real estate, equity shares in most cases. Only sometimes, shorter inflation will lead to higher profits and increase in share value.
- Inflation fuels inflation(1) – As prices go up, businessmen start to hoard goods. Hoarding is withholding goods expecting higher prices in future. That’s how onion prices reached Rs 120 a kilo towards end of 2013.
- Inflation fuels inflation(2) – The exchange rates of Rupee gets affected. High inflation indirectly fuels itself, with currency value going down. With lesser valued currency, you can buy only lesser goods.
- Inequality in income and social disparity – Business owners and asset owners tend to get benefited the most . Poor people tend to get disadvantaged the most. After a certain period, it leads to people taking unethical routes to acquire money at any cost. This affects social stability. Think why people resort to stealing?
These are some of the ways how inflation affects individuals.
How to get protected from inflation
By now, we already know that inflation is a pain in the butt. There is nothing you can do to prevent or escape from it. In a growing economy, inflation is a necessary evil. However you can protect yourself from effects of inflation through a proper planning mechanism.
- Build assets – This is the most important part of outpacing inflation effect. When you build assets like real estate, stocks (from good business), gold (the trend now) you feel the pinch lesser. How? Assets also tend to increase in increase in value in an inflationary economy. Businesses will sell their products for more and earn more profits.You will have more money. Real estate will increase in value – again more money in your pocket.
- Reduce dependency on fixed income – Have you retired with only fixed income as income source?Or have major part of portfolio as bonds, fixed deposit ? Then inflation will eat its way through your pocket. When inflation is 7%-10% and your fixed income earns you 8-9%, your money is not growing.
- Reduce expenses – Simple way 🙂 Cut down on your unwanted expenses . Money saved is money earned. Are you a shopaholic? You are a compulsive buyer? Be ruthlessly careful on what you spend money.
- Have a proper financial plan – Knowing is half the battle. List out your expenses, income streams in a sheet. What are your future goals? How much money you want for them in future? What is the time frame? You can use our FREE Inflation Calculator to find the future value of present amount.Plan meticulously.
- Increase your income – There are multiple sources to increase income. Are you good at something ? Start consulting – properly assess what your are capable of and charge accordingly. People will not pay you if they think you are not capable. You spend hours on the internet? – check out genuine internet jobs. Great at handicrafts,tailoring – Start to sell your products on eBay.com, Amazon.com. Good at studies – Start private tutoring in subjects which you are an expert.
Also check out Tips to improve credit score for getting loans fast
If one decides that he will take control of effects of inflation rather than the other way around, there is no stopping him.Using above methods you can protect yourself from inflation effects.
Liked the article? I spent long hours getting it ready and informative. Share it with your friends, family on Facebook, Twitter, Google+. This will be useful for all and they will thank you for helping them. Let us know your comments below.