Decoding inflation: What is it and how does it impact economy of a country?

Governments across the world bother about mostly two economic indicators – inflation and gross domestic product (GDP). The latter shows the economic might of the country; higher the GDP growth of the country, the better positioned its government is.

And with an increase in the GDP, the incomes of people in that region increases – leading to a surge in per capita consumption. As consumption increases, it jacks up the prices of various commodities in market – a phenomenon known as inflation.

What is inflation?

Inflation occurs when prices rise, decreasing the purchasing power of your dollars. In economic terms, inflation is a general rise in the price level of an economy over a period of time. When the general price level rises, each unit of currency of that country buys lesser goods and services. So, in a way, inflation reflects a reduction in the purchasing power per unit of money – a loss of real value in the medium of exchange and unit of account within the economy.

How is inflation calculated?

Inflation is calculated on an index format – where different commodities have different weightage. So, you have a base year from which you start calculating inflation. In that base year, the index stands at 100. As the price increases the index goes up – just like stock market indices. To calculate the inflation rate, we evaluate the increase in the index over the last one year. For example, let’s presume that that the index for August 2021 stood at 250, while for August 2020, it stood at 230. In this case, inflation stands at 8.7%. Had the index this year been lower than what it was last year, that would have been called deflation.

How to make sense of the Inflation data?

How many inflation indices are there?

There are three different types of inflation indices – producer price index (PPI) – formerly wholesale price index, consumer price index (CPI) and core price index. The PPI gauges average changes in prices received by domestic producers for their output. The CPI, on the other hand, examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care – basically all the prices that matter for the common consumer. The core price index removes the most volatile components (such as food and oil) from a broad price index like the CPI. It is pertinent to note that the central banks look at the CPI as measure of inflation before taking any monetary policy action.

So, is inflation good?

Now this question is very subjective in nature. The inflation can be good, bad or ugly – depending on the rate of inflation. So basically, there are four different types of inflation rates – creeping, walking, galloping, and hyperinflation. According to most experts, its only creeping inflation that is good for economy; walking and galloping inflations are bad for economy; while hyperinflation is ugly and spells doom for economy. Creeping inflation is when the inflation rate is between 1%-4% and is sign of growing healthy economy. Hyperinflation is rapidly rising inflation, typically measuring more than 50% per month – the kind of inflation Venezuela is facing right now.

Bottom Line:

Excess of everything is bad. So is the case with inflation. While inflation within a manageable range is great for economy, if it increases at a larger rate, it makes the country poorer than before.

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