What is Inflation? Definition, Causes, Effects, and Control Measures
Inflation is the increase in the prices of goods and services over time. It reduces purchasing power, which means you can buy less with the same amount of money. A moderate level of inflation is common and often signals a healthy economy. However, when inflation rises too quickly, it can increase costs for consumers and businesses, which could be a negative sign for the economy. In this article, we’ll explain inflation, its causes, and its effects. We’ll also discuss how it’s measured and ways to manage its impact.
What is Inflation?
Inflation is when prices rise over time, reducing the value of money. For example, if a product that cost ₹100 last year now costs ₹105, that 5% increase reflects inflation. The higher the inflation rate, the less you can buy with the same amount of money.
A small amount of inflation is expected in any growing economy. But when inflation accelerates too fast, it can lead to instability. Inflation can affect consumers, businesses, and the overall economy of a country.
What is the Inflation Rate?
The inflation rate shows how much prices rise within a specific time frame, usually a year. If the inflation rate is 5%, it means prices have increased by 5% compared to the previous year. Policymakers, like central banks, keep an eye on inflation to control its effects and maintain price stability.
Current Inflation Rate in India
India tracks inflation using the Consumer Price Index (CPI) and Wholesale Price Index (WPI). The CPI measures price changes for goods and services consumers buy, while the WPI tracks changes in prices at the wholesale level. The Reserve Bank of India (RBI) monitors inflation and adjusts policies to manage it.
Note: In June 2025, India’s inflation rate dropped by 2.10%, the lowest in six years, due to a drop in food prices. This shows that for now, inflation is under control and within the acceptable range.
What Are the Effects of Inflation?
The inflation impacts everything we buy, be it goods or services. As inflation rises, the value of money falls, making it harder to afford everyday goods. With high inflation, purchasing power also decreases.
Inflation also impacts investments, as fixed-return options like savings accounts and bonds lose value if they don’t give a higher return than the inflation rate.
Central banks manage inflation through interest rates. They increase interest rates when inflation is high so that people would spend less, and high interest rates also make borrowing costlier. When inflation is too low, the central banks lower interest rates, which can lead to increased spending and investment.
How is Inflation Measured?
Inflation is measured using the Consumer Price Index (CPI) and Producer Price Index (PPI). The CPI tracks price changes for a basket of goods and services, reflecting the cost of living, and the PPI measures price shifts at the wholesale level, showing how much producers are paid for their goods. Both help gauge inflation trends and guide economic decisions.
How to Calculate Inflation?
To calculate inflation, use this formula:
Inflation Rate = (Ending Value – Starting Value) / Starting Value x 100
- Starting Value (A): CPI from a past period
- Ending Value (B): Current CPI for the same goods
Subtract the starting value from the ending value to get the difference. Then divide by the starting value and multiply by 100 to find the inflation rate.
How Does Inflation Work?
Inflation happens when the prices of goods and services rise, which means the value of money falls. For example, if something that cost ₹100 last year now costs ₹105, you’ve experienced 5% inflation. Inflation generally happens when demand outpaces supply. So if there is a higher demand for something than the supply, prices go up.
What Are the Causes of Inflation?
There are three main causes of inflation:
- Demand-Pull Inflation: This happens when demand for goods or services exceeds supply. For example, think of a product everyone wants, but there isn’t enough supply of it, so the price of that product increases.
- Cost-Push Inflation: This occurs when the cost of producing goods or services increases. For example, if prices of raw materials go up, businesses raise prices of their products to cover the costs.
- Built-In Inflation: When workers demand higher wages to keep up with rising costs, businesses raise their product prices to pay the wages. This again leads to more wage demands, so the cycle continues.
Types of Price Indexes
When we talk about tracking inflation, there are a few ways to measure it.
- Consumer Price Index (CPI): This index tracks the average change in the price of goods and services that consumers buy, like food, housing, and healthcare. It’s the most common metric to calculate inflation.
- Producer Price Index (PPI): The PPI tracks price changes that businesses get in return for their goods and services. It’s a good early indicator of inflation because if producers face higher costs, those costs often get passed down to consumers.
- Personal Consumption Expenditures Price Index (PCE): The PCE tracks the changes in the prices paid by consumers for goods and services. The key difference from CPI is that the PCE tracks a basket of goods that updates based on consumer spending patterns.
Types of Inflation
- Mild/Moderate Inflation: Moderate inflation, also known as creeping inflation, is the gradual rise in prices for goods and services. Central banks make changes in their policies to support moderate inflation to ensure economic stability and growth.
- Hyperinflation: Hyperinflation or Stagflation is when there is an extreme rise in prices. During hyperinflation, prices may double or even quadruple in a short time, which can lead to a loss of purchasing power for people and cause economic instability.
- Deflation: During deflation, prices of goods and services fall over time. Deflation may seem good for consumers as they have to pay less. But in reality, deflation can lead to a negative cycle, where people spend less, businesses make lower profits, and unemployment rises.
- Disinflation: Very slow growth in price rise leads to disinflation. It can be a sign of a healthier economy, though its impact depends on the overall economic conditions.
Impact of Inflation on the Economy
Inflation can have both positive and negative impacts on the economy, depending on the market conditions and the rate of inflation.
- Impact on Purchasing Power: With rising prices of goods and services, the value of money decreases. Due to this, each unit of currency buys fewer goods and services. It forces consumers to spend more on necessities and leaves them with very little scope for savings.
- Aid in Economic Growth: People tend to spend more when prices rise slowly. This is because they expect prices to continue rising. This increase in spending leads to economic growth and also supports job creation and higher business activity.
- Income Redistribution Effects: Inflation doesn’t have an impact on all groups equally. For example, people on fixed incomes struggle more with rising prices and losing purchasing power. But people with assets that increase in value will see their wealth grow.
- Effects on Savings and Investments: When the returns on investments and interest rates on savings accounts are lower than the inflation rate, it can decrease the real value of savings over time.
Factors That Influence Inflation
- Monetary Policy: When central banks increase the money supply or lower interest rates, demand for goods and services rises, which leads to inflation. Similarly, reducing the money supply or raising interest rates can curb consumer spending and reduce inflation. This is how central banks make changes in the monetary policy to control the inflation rate.
- Fiscal Policy: Governments can influence inflation through spending and taxation as well. When the government spends more or cuts taxes, it leads to higher consumer spending and demand, which can lead to inflation. Similarly, reducing spending or raising taxes can help control inflation.
- Supply Shocks: When there are supply disruptions, prices increase due to high demand for raw materials. This can happen for various reasons, such as natural disasters, geopolitical events, or supply chain issues. For example, a disruption in oil supply can lead to higher energy costs.
- Expectations of Future Prices: People’s expectations about future prices can also have an impact on inflation today. If consumers expect prices to rise, they may spend more now, which leads to higher demand. Similarly, businesses may raise prices in anticipation of higher future costs. Central banks work to manage these expectations to control inflation.
What’s the Role of the Central Bank in Managing Inflation?
Central banks, like the RBI, play a big role in managing inflation. They do this by adjusting interest rates and controlling the money supply.
- Interest Rate Adjustments: When inflation rises, the central bank raises interest rates. This makes borrowing costlier, which helps reduce demand and lower prices of products. When inflation slows down too much, the bank lowers rates to increase borrowing and spending.
- Open Market Operations: This is when central banks buy or sell government securities to control the money supply. If they want to raise demand and inflation, they buy securities, adding money into the economy. If they need to reduce inflation, they sell securities, pulling money out of circulation.
- Exchange Rate Policies: Central banks can also impact inflation through exchange rate policies. A strong currency makes imports cheaper, reducing inflation. A weaker currency makes imports more expensive, leading to higher inflation.
How to Deal with Inflation?
- Strategies for Individuals: Investing in assets that can withstand inflation is key. In this case, diversification can help by spreading investments across different assets and regions to minimise risk. Also, budgeting and cutting back on non-essential expenses can make a real difference when costs rise.
- Impact on Businesses: For businesses, inflation means higher production costs, including labour and materials. To cope, some businesses might raise prices, but that can lead to less demand. Businesses also focus on becoming more efficient and cutting costs where possible to stay profitable.
- Government Policies and Interventions: Governments have a few tools to tackle inflation. They can adjust interest rates to control the money supply, change tax rates, or change spending to manage demand. Also, they might focus on increasing production efficiency or introducing price controls and social support programs to protect those who are highly impacted.
Historical Instances of Inflation in India
- The Great Inflation (1970s): In the 1970s, India faced high inflation due to food shortages, disrupted supply chains, and rising global oil prices. It created economic instability and a sharp rise in inflation rates.
- Post-Liberalisation Inflation (1990s): After India’s economic liberalisation in the 1990s, inflation became a persistent issue. Structural shifts and rising consumer demand created new dynamics that increased prices.
- Surge in Food Inflation (2000s): Between 2007 and 2008, food prices increased due to global price hikes and supply shortages. This put pressure on household budgets and led to policy changes aimed at controlling the situation.
- Recent Trends in Inflation (2020s): In the 2020s, the COVID-19 pandemic played a major role in higher Inflation trends. The pandemic led to supply chain issues, which in turn caused price instability, with inflation rates fluctuating.
Inflation’s Role in the Economy
Inflation is something that touches everyone, from the groceries we buy to how our investments perform. But have you ever stopped to think about its role in the economy? Let’s break it down in simple terms.
- Importance of Controlled Inflation: A little inflation means the economy is moving, and things are being bought and sold. If inflation stays moderate, it encourages people to spend instead of hoarding cash. Also, when inflation is under control, borrowing becomes easier because interest rates are usually higher than inflation rates. This benefits lenders since they get a return on their money that outpaces inflation.
- Inflation and Economic Growth: A small rise in prices signals that the economy is growing, which is good for business. But when inflation gets too high, it makes a negative impact on the economy. The cost of living increases, making everyday things more expensive. This can slow down consumer spending, which is a negative sign for businesses and the economy at large.
To Wrap It Up…
To conclude, when it comes to inflation, balance is crucial. Inflation can make things more expensive, but it also keeps the economy moving by encouraging spending and investment. Factoring in inflation is key to understanding the true value of your investment returns. If you’re thinking about long-term financial strategies, it’s important to figure out how inflation can make a difference.
Investing in the right assets is the best way to beat inflation. You can explore ready-made model portfolios of stocks on smallcase based on various sectors and themes, or conduct research about the best stocks using Tickertape stock screener with more than 200 built-in filters for your financial planning.
Frequently Asked Questions About Inflation
The definition of Inflation is the rise in the average price of goods and services in an economy over time. For example, if the price of a product was ₹1000 in 2023 but it’s now ₹1200, then the 20% rise in price is a sign of inflation.
There are many reasons behind inflation, but the three main causes are demand-pull inflation (when demand exceeds supply), cost-push inflation (due to increased production costs), and built-in inflation (wage-price spirals).
The four types of inflation are mild/moderate inflation, hyperinflation (rapid and extreme price increases), deflation (a slowdown in price rises) and disinflation (a decrease in the rate of inflation).
Retail inflation refers to the rise in the cost of everyday goods and services that individuals typically purchase.
The highest inflation rate in India over the last decade has been 6.06% in 2020. One of the major reasons behind the high inflation was the COVID-19 pandemic and lockdown, which created disruption in terms of demand and supply.
Purchasing power risk, or inflation risk, happens when inflation reduces the value of the money you’re getting from your investments.
Inflation can actually help people with big debts. As prices go up, the value of their debt decreases, making it easier to repay. But it’s not helpful for those with fixed incomes or cash savings. Their purchasing power drops, and they can’t buy as much as they used to, which hurts their financial stability.
All About Investment Concepts on smallcase –
smallcase offers you a quick view to the different finance related concepts to help you on your investment journey to achieve the financial freedom you have always dreamt of –
