Saturday, January 9, 2010

The monster of Inflation

Inflation has been a big cause of concern world over in the recent past, especially in India. So, I thought to present a crash course on this topic today. My source is obviously the ever-expanding Internet.

In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time. When the price level rises, each unit of currency buys fewer goods and services; consequently, inflation is also an erosion in the purchasing power of money – a loss of real value in the internal medium of exchange and unit of account in the economy. A chief measure of price inflation is the inflation rate, the annualized percentage change in a general price index (normally the Consumer Price Index) over time.[source]

Inflation is a world problem. Here is a view of inflation all over the world.

 So, what causes Inflation? Why do prices rise? Many people mistakenly believe that prices rise because businesses are "greedy". This is not the case in a free enterprise system. Because of competition the businesses that succeed are those that provide the highest quality goods for the lowest price. So a business can't just arbitrarily raise its prices anytime it wants to. If it does, before long all of its customers will be buying from someone else.

It is actually the supply on money in the market that increases the prices!!! Yes! Prices of comodities rise because people have more money to spend and hence are willing to pay more for the same thing. In other words, with more money supply or monetary inflation (govt printing/minting more Rupees), everyone has more money in their pockets and that results in buying more. Basically when the government increases the money supply faster than the quantity of goods increases we have inflation. Interestingly as the supply of goods increase the money supply has to increase or else prices actually go down. The basic Demand and Supply theory we read in class 12!!

How does India calculate Inflation? Well, that is for the next post!!! Keep checking this space...


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