Till now we have discussed assets and liabilities and their classes. But what is the need for these assets? What if we don’t have assets what will be the problem?
In this post, we are going to answer these questions and see why it is advisable to accumulate assets even if you don’t think it’s necessary.
“The Grimreaper for Money” what is that supposed to mean?
The Grimreaper is a popular personification of death in movies and cartoons. It follows people whose death is near and once the time comes, the game is over.
So what is referred to as the grimreaper for money? What could kill the money?
The answer is Inflation. You see inflation chases money and with time destroys the value it holds.
What is Inflation?
Inflation is the rate at which the price of goods and services increases in the economy or the rate at which the currency of that economy loses its purchasing power.
What is Purchasing Power?
Purchasing Power of a currency describes the amount of currency required to purchase a defined basket of goods. If you don’t know these baskets don’t worry it is explained later on.
How does inflation destroy Purchasing Power?
Inflation is created due to an extra supply of money in the economy or a decrease in the supply of the goods in the basket used to measure inflation in the economy. These can occur due to a variety of reasons as described hereafter.
Causes of Inflation
Inflation can occur due to a variety of reasons.
- Increase in Public Spending: Government spending significantly impacts the economy. When the government spends more than it collects in taxes, it injects additional money into circulation. This excess demand can lead to inflation.
- Deficit financing of Government Spending: Sometimes, government spending exceeds tax revenues. To cover the deficit, the government resorts to deficit financing, which involves printing more money. This extra money supply contributes to inflationary pressure.
- Increased velocity of Circulation: the total use of money in an economy depends on both the money supply and the velocity of circulation. During economic booms, people tend to spend money rapidly, increasing the velocity of circulation and potentially causing inflation.
- Population Growth: As the population grows, the overall demand for goods and services increases. if supply doesn’t keep pace, prices rise, leading to inflation.
- Hoarding: When people hoard goods or money, it reduces the availability of those items in the market. Scarcity drives up prices, contributing to inflation.
- Genuine Shortage: Actual shortages of essential goods can lead to higher prices. For example, supply disruptions due to natural disasters or geopolitical events can cause inflation.
- Exports and Trade Unions: Price rises in international markets and the bargaining power of trade unions can affect production costs and, consequently, consumer prices.
- Tax Reductions: While tax cuts stimulate economic activity, they can also increase demand and contribute to inflation.
The above causes can be broadly included under demand-pull inflation or cost-push inflation. These factors interact in complex ways, impact the overall price level in an economy.
How do we measure inflation?
So we know how inflation eats our money. But how do we measure the amount of inflation?
Measuring Inflation is necessary for setting a benchmark for measuring our returns from our assets.
Inflation is measured by tracking the price changes of a basket of goods and services over time. To understand how inflation is measured, we should first get familiar with two terms: Consumer Price Index and Wholesale Price Index.
Consumer Price Index
This index measures the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.
In India, there are several CPI indices for different segments of the population, such as CPI for Industrial Workers (CPI-IW), CPI for agricultural Labourers (CPI-AL), and CPI for rural Labourers (CPI-RL). The RBI uses the all-India CPI to target inflation under its monetary policy framework.
You can read more about Consumer Price Index here.
Wholesale Price Index
This index measures the price of a representative basket of wholesale goods. In India, WPI is used to measure the price level changes at the wholesale market.
You can read more about the Wholesale Price Index here.
Each of these indices uses a base year to compare current prices and is calculated by taking a weighted average of the prices of the items in the basket, where the weights reflect the item’s importance in the spending patterns of the population segment the index represents.
The inflation rate is calculated as follows:
Inflation Rate = [ (CPI in current year – CPI in the base year)/ CPI in the base year] x 100
So the change in the price of these baskets gives us inflation in the economy. Now the inflation number can be easily manipulated by changing the items in the basket or changing the base year.
So there is always some ambiguity to the inflation numbers given by the government and it is up to us to verify these numbers. But still all in all this inflation number by the government gives us a benchmark to compare our returns from our assets.
There is one more measure to measure inflation known as the GDP deflator, which reflects the prices of all domestically produced goods and services in the economy. it measures the amount that the real value of an economy’s total output is reduced by inflation. You can read more about it here.
Now we know what inflation is and how it affects us. As a bonus let’s see some special cases of inflation.
Hyperinflation
It is an extreme form of inflation in which the prices in an economy increase at a very rapid pace and the inflation goes out of control. The increase becomes exponential, typically measuring more than 50% per month.
It is caused by a significant rise in the money supply in the economy that is not supported by economic growth. This can happen when the central bank prints excessive amounts of money, usually to cover government budget deficits or in response to a crisis.
Image Credit – Netsuite.com
The rapid increase in prices can lead to a surge in the cost of essential goods, such as food and fuel. As the local currency’s value plummets, people may rush to exchange it for more stable foreign currencies or invest in durable goods to retain value.
It can lead to a vicious cycle where the demand for goods increases, further driving up prices. it can severely disrupt the economy, potentially leading to a switch to a barter system if the currency becomes worthless.
Stagflation
It is an economic condition that combines the challenges of stagnation and inflation. It’s characterized by slow economic growth, high unemployment, and rising prices.
Image credit – vectormine.com
This combination is particularly problematic because the usual tools to combat inflation, such as raising interest rates, can worsen unemployment and slow growth even further. It results from a combination of adverse supply shocks and inappropriate policy responses.
Disinflation
It refers to a slowdown in the rate of inflation. It’s not a decrease in the overall price level that would be deflation- but rather a reduction in the rate at which prices are rising.
This is caused by various factors, including tighter monetary policy by the central bank, a contraction in the business cycle, or a recession. During a recession, businesses may avoid raising prices to attract more customers, leading to disinflation.
A moderate amount of disinflation is generally not problematic and can even be good, however, if the inflation rate falls too close to zero, it raises concerns about deflation and can negatively impact the economy.
This is all for this post. Don’t forget to follow my Facebook and Instagram Page for regular updates. See you all in the next post. Till then keep learning.