Inflation is a highly debated phenomenon among the media, government, policymakers and economists. While investors and consumers expect zero inflation, government and central banks need inflation to keep the economy going.
Inflation is an increase in the level of prices or increase in money supply. Due to increase in the supply of money, too much money starts chasing too few goods, which in turn results in an increase in prices.
Every major stakeholder in the economy has a different perspective to look at the inflation.
During inflationary phase, wages, salaries as well as prices of essential commodities tend to go up. Due to increased prices and wages, government’s tax revenue both direct and indirect goes up.
During inflation, the value of the currency goes down. Our government is sitting on a whopping outstanding debt of 5.5 lac crore. Hence, the government loves to see the debt getting eroded by the inflation.
Inflation causes a devaluation of the currency. Hence, if the country is a net exporter, it ends up earning more foreign currency with the same exports. But at the same point if the country is a net importer it ends up suffering losses due to devaluated currency. This widens current account deficit of that country.
The government needs to spend more on education, healthcare & security in order to offset the fall in purchasing power.
Unless compensated by higher interest rates, inflation erodes the value of money. Hence, if the investments are not compensated by a higher rate of returns, the investor will not earn a real rate of return (inflation adjusted returns). This reduces savings and investment habits of the people.
Prices of real assets like precious metals, land and houses rise in line with inflation helping the investors to increase the wealth.
Due to reduced savings & investment habits, entrepreneurs find it difficult to raise the capital from public as well as from the banks.
Also during inflation, interest rates go up. This makes borrowed capital (loans) more expensive forcing industries to pay more interest on outstanding loans which affects the profitability.
At the same to industry needs some amount of inflation as during the deflation people delay the purchases hoping that the price will go down in the future, which causes a slowdown in demand which leads to a loss of jobs as well as reduced revenues of the companies.
Due to different inflation rates across the countries, industries in countries with more inflation have more price for some product which reduces competitiveness of that industry across the globe
Inflation affects consumers the most. Rising prices reduce the purchasing power of consumers.
As people’s income tend to increase during inflation they move into a higher marginal income tax bracket – meaning they pay a higher tax rate.
Policy Makers: (RBI)
The objective of policy makers is to keep the inflation at sufficient level. Inflation doesn’t cause the growth, but it can be an indicator of excess demand, which is necessary for growth. They make sure that the inflation is at the optimum level below which the economy may slip into recession.
In rising prices scenario, people tend to buy more to avoid paying more in the future. This causes an increase in demand and spurs the economy.
The growth of GDP is always linked with an inflation. So if the GDP grows by 7% and at the same time if the inflation is 5%, actual growth in GDP is 2%.
There is no ideal inflation rate which is the best for all the stakeholders of an economy. Any inflation rate will benefit some stakeholders and hurt the others. The RBI has set the target inflation of 5% which will prevent an economy from slipping into recession as well as will help investors, savers, consumers and entrepreneurs to protect their own interests.
Chinmay Madgulkar is an Electronics & Telecommunication engineer from the University of Pune. He has completed his MBA in Finance from Xavier Institute of Management & Research and is a Management Trainee - Equity at Taurus Mutual Fund. He is also a Mutual Fund advisor.
You can connect with Chinmay on LinkedIn here.