This is first post in the series All About Inflation.
Inflation: An Introduction
Remember your grandfather telling you that in his times people could get mangoes for 50 paisa per kg- something that is now available for Rs. 30-50 per kg !! This is inflation in simplest terms.
Making this definition a bit complicated, inflation can be defined as the decrease in an individual’s purchasing power. This is what your grandfather means when he makes that classic statement about mangoes. That 50 paisa coin, which once had a power of buying 1 kg of mangoes, can now only get you a haajmola candy, thus decreasing an individual’s purchasing power.
Now that we are clear with the meaning of inflation, let’s see what inflation rate means. We can define inflation rate as the rate at which prices of goods and services increase in an economy. It is an indication of the change in prices over “a given period of time”. This clearly means we need two sets of data-present and past. The past data should have a definite value or else everyone will come up with their own inflation rate. How this is done we’ll see in the coming posts.
Since it’s practically impossible to find out the average change in prices of all the goods and services traded in an economy due to the sheer number of goods and services present, a sample set or a basket of goods and services is used to get an indicative figure of the change in prices. We’ll see this in detail in the coming posts.
Types of Inflation
Now that we know what inflation means, the obvious question that should come to your mind is – why does price increases over time? The answer to this question will also tell you about the types of inflation. For this let us consider following two scenarios:
Scenario#1: We all know that demand for a particular good and its supply determines the price of that good. You all must have witnessed this concept while shopping with your mother. The price of say a kilo of sugar is decided only when the shop keeper and your mother agree at a price. This is known as equilibrium, a state where demand and supply meet each other at an agreeable price.
Now let us assume that the seller has 10 kg of sugar, and there are 10 people each demanding a kg. In this case everyone will get sugar at the price mutually agreed upon, say Rs.20/kg.
Now let there be an increase in demand of sugar. The seller has 10 kg of sugar while there are 10 customers each wanting 2 kg of sugar. In this case demand is more but the supply is less. Obviously the customers will try to outbid each other. Say one customer agrees to pay Rs.30/kg for the sugar, for which he was initially paying Rs 20/kg. Once the seller realizes that buyers would pay him any price to meet their requirements, he will start demanding more for the remaining sugar left.
In this scenario it was the demand for sugar that led to increase in its price. This is known as demand-pull inflation.
Scenario#2:The sugar that we see in shops reaches there after a lot of processing and transportation. Now if the cost of transportation increases or the cost of fertilizers used for sugarcane increases, then it will impact the cost of final product also. Say, initially 100 kg of sugar was produced by investing Rs 1500/- in production and transportation, so the cost per kg of sugar comes out to be Rs.15. To earn profit, the shopkeeper will sell it for Rs 20/kg. Now due to increase in production and transportation cost, for the same investment of Rs. 1500/- only 75 kg of sugar could be produced- thus increasing the cost per kg to Rs.20. So to protect his profits the shopkeeper will now start selling the sugar at Rs. 25/kg.
In this case the cost of production has led to an increase in the cost of sugar. This is cost-push inflation.
This completes our discussion on inflation and its types. We have understood the meaning of inflation, seen what are the two common types of inflation, namely demand-pull inflation and cost-push inflation, and also realized how price changes.
In the next post we’ll see what are the various indices (or methods) adopted by different countries to measure inflation. So stay tuned.