The Truth behind Inflation | Fully Explained
Posted by
Bhat Aasim
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 of today is equal to 1 rupee 20 paise of 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 really a bad thing?
- And how is inflation related to unemployment and other economic factors?
We will talk about all of this in this Article.
where I will explain this "ghastly" inflation to you Come, let us see.
First of all, a very 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 in this Article.
The first reason is very simple.
- An economic boom. That is, a 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.
- Explaining this with an example.
Imagine an Airplane with 100 seats and 100 passengers have to board that plane.
But there are only 10 first class seats and 90 economy class seats. Now if the passengers are given more money.
If they're all given enough money to be able to afford a first class seat, they'll all want to book a first class seat. But the number of seats are only 10. Not all of them can have a first class seat.
So what would happen as a response?
In response, the airline would hike the prices of its first class seats. So that only those who have more money can afford to book a first class seat. So basically there is an inflation.
This type of inflation is called a "demand pull inflation"
A demand pull inflation is when the inflation rises with the rise in demand.
The second reason is the increase in the prices of the 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 lead to a rise in the price of one of the raw materials.
Then the companies that manufacture products using these raw materials, they'd 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"
The third reason is increase in the salaries. No, I'm not joking: When the companies or governments raise the salaries 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 very low levels in a country, then it is extremely 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.
And finally, the fourth reason is "currency depreciation"
This can happen due to several different reasons, out of which one of the most important reasons is 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 hyper inflation 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 the 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 dollar 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 hyper inflation. But this is a very long topic on its own.
Talking about the present, the inflation rate in most of the countries today is going down.
- Think about why this is happening?
It is because of the shrinking demand in the wake of the lockdowns that have been imposed around the world. People are buying fewer things and travelling less.
The people do not have money to spend because their businesses have shut down. And so, there has been a decline in overall demand.
And the opposite of the "demand pull"(which I told you about as the first reason) is happening.
Since the demand is going down, so is the inflation. As a response to this, some countries have decided to transfer cash to the people- distribute it for free.
Now, some people state that doing this would cause the inflation to increase.
- What do you think will happen?
I discussed the same logic in this Article on Universal Basic Income, that the biggest criticism of the Universal Basic Income and the free distribution of money is that, it will cause the inflation to spike.
- What do you think?
Write down your explanations in the comments below.
And I will give the answer to this question later in the Article.
I'd like to pose another interesting question before you
- Is inflation necessary?
- 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 overtime, the value of money would not depreciate either.
So this would be another great thing!
Analyzing deeply upon the reasons that lead to inflation, then you would understand that 0% inflation is actually 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 the unemployment to rise. I've told you about a very long and convoluted connection- You might wonder if it actually 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."
And 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 which cause inflation to spike. But generally, this graph is valid.
- 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 would 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 it 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 lesser 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 the 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. as I had explained in the reasons earlier in this video. The government can also control inflation by spending more or by spending less.
As seen in this Article, you might've noticed that there is a direct relation between inflation and economic growth, If the economic growth of a country increases, then so would inflation.
And if there is a recession in a country and there's no economic growth, then inflation would also decline.
This happens on a general basis, but not always. Sometimes, it also happens that a country's economic growth is going down and the country is going into recession but inflation is going up This situation is called "Stagflation". This is a disastrous thing indeed.
Why does this happen?
The reason for this is Assume that there is a recession within a country, but the cost push factors- the second reason for the rise of inflation that we talked about The cost of the raw materials is rising.
For example, the rise of oil prices all across the world, so the oil imported would then cost more, so the inflation would rise because of cost push factors but there is recession within the country.
There is another exception from the other side.
If there is deflation in a country, but simultaneously, there is economic growth in the country. This happened in the USA between 1870-1890. This period is referred to as "The Great Deflation".
The cost of the goods were falling by around 2% every year and there was deflation, but there was also an economic boom. Both the people and the businesses were making more money and employment was on the rise. The reason behind this attributed to the rise in productivity. This was a time when there was technological progress at such a rapid pace and new technologies were being developed that it compensated for the deflation.
Reverting to our original question if people are given money for free in today's times during this recession then would it lead to a rise in inflation?
In my opinion, the answer of this is No. Inflation would not rise because handing out money wouldn't amount to such a huge increase in wealth, that people become capable to buy things that are not being supplied. It would not be so. Because it would push up the demand very slightly. And demand has fallen so low that giving out paltry sums of money would not alter the demand drastically.
So I do not think that the distribution of money for free would trigger any sort of inflation. No matter how much importance inflation holds for the entire economy, but if we come down to personal consequences and how it personally affects you, then you could say that it has a negative consequence.
The money that you save up would lose value over time. The prices of the things keep going up and dearness would always be on the rise. This is why people invest their money in different things rather than stashing it under their bed
For example, they buy gold with it. Because the price of gold rises overtime.
The value of money keeps diminishing due to inflation but the value of gold keeps rising. Similarly, some people buy real estate/ Property to avoid this. And some people invest in cryptocurrencies like Bitcoin.
While talking about this, you might wonder about the ban imposed by India on cryptocurrencies. This happened in September 2018, when RBI brought out a circular banning crypto currencies in India.
But on 4th March, 2020, the Supreme Court has overturned the decision of RBI by its judgement, and the ban on cryptocurrencies on India has now been lifted. So this can be done legally and openly by everybody again.
There is one other thing that I would like to tell you about cryptocurrencies and inflation.
According to my personal observation and my personal opinion, You might have observed how the people who buy bitcoins today, buy it and merely stash it- they do not spend it.
This is the reason why the value of cryptocurrencies keeps increasing over time, because more people want to buy it and stash it- like they do with gold.
But people do the opposite with cash because they know that its value will depreciate, and so they spend it. But they do not do this with Bitcoin. This would mean that if the people do not spend the cryptocurrency, it cannot replace cash in that sense
Its future as an asset is more as compared to its future as a currency, This is my personal opinion here
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