Inflation - Part 3 of 3

Inflation rate refers to a general rise in prices measured against a standard level of purchasing power. The most well-known measure of Inflation is the CPI which measures consumer prices.

The Consumer Price Index is a measure prices of a list of goods and services purchased by a 'consumer'. The inflation rate is the percentage rate of change of a price index over time (typically 1 year). The list of items which are part of CPI are
• Food (this group has 8 sub items)
• Non Food like Pan, Supari, Tobacco and Intoxicants
• Fuel & Light
• Housing
• Clothing
• Miscellaneous

Due to excessive money in the system (‘Quantitative Easing’ in US, the printing of free money in US and EU) costs of basic items of consumption have increased. Also, due to the economic growth of India, levels of affordability of Indian consumers has also increased (look at the crowd at Indian malls!!!). Today more and more Indians are willing to spend higher as compared to few years ago on consumption items which are both a necessity and luxury.

The ‘young, working population’ of our country (now seen as the biggest asset of India) spends more than it saves. ‘Saving’ for a rainy day was more a habit of my parents’ generation.

Today the motto is ‘Have Money, Will Spend’. So RBI can continue to increase interest rates but if people refuse to save more than they spend, inflation is not going to come down.

PS: Inflation will ease post January 2012 because of the base effect. That’s what all policy makers in India are hoping for (fingers crossed).

Inflation - Part 2 of 3

Inflation reduces the purchasing power.

To control, inflation the RBI (Central Banks) increases interest rates. But how does increasing interest rates help reduce inflation.

Here’s how it works:
One pays interest on loans taken and receives interest on deposits made. To allow lending and borrowing, banks also borrow from / deposit with RBI.

By increasing interest rate, RBI achieves the following:
• Banks need money to lend so they borrow from RBI; if borrowing rate increases, they have to increase lending rates
• Loans become expensive and lesser people take loans
• Deposit rates become attractive so people save more and spend less
• Lesser ‘free money’ in the system
• Cost of items reduces as demand for the item falls (assuming supply is constant)

High inflation in India is not an exception though due to some India specific issues (supply side issues in agriculture) inflation is higher than other emerging countries.

Main reason for the inflation has been high globally is due to the loose monetary measures (keeping interest rates low and QE 1 & QE 2) by countries like US and the EU.

Next part: How’s inflation measured and why is not reducing even after interest rates have been increased by RBI many a times in the last 2 years.

Inflation - Part 1 of 3

With so much of talk about inflation and RBI’s monetary policy, so here’s the low down and again in a multi-part series.

We all know that inflation makes things more expensive, reduces purchasing power, gives enough headaches to governments all around (including being the cause for governments to fall), etc.

Inflation in simplest terms is got to do with ‘supply of money’. It is more money chasing limited items; it’s about people spending more than they are saving.

Here’s an example:
There are 3 friends (Alpha, Beta, Gamma), of different socio-economic backgrounds.
All of them make purchases needed for living (all these items are finite and limited in quantity and are impacted by economies of demand-supply) – fruits, vegetables, fuel, etc.

Let’s take petrol as the item they would like to buy. All 3 friends, by virtue their socio-economic backgrounds will be willing to pay different amounts for the same item.
Alpha has Rs. 3,000/-, Beta has Rs. 5,000/- and Gamma has Rs. 10,000/- of ‘money power’ they are willing to spend. Since the supply of petrol is limited, Gamma has the maximum power of ‘affordability’. The other 2 guys will possibly chose to use public transport :-).

The sheer power of ‘affordability’ makes items expensive for many people.

And why will petrol be an ‘unreasonable’ price in the first place? Remember, a producer of an item (in this case Organization of Petroleum Exporting Countries aka OPEC) will always want to sell at the maximum possible value as long as there are consumers to pay for it.