What is inflation?
Inflation is a measure of the rate of change in prices of selected goods and services. In simple terms, it is a rise in price levels of goods and services of daily use. It is expressed as a percentage. Also, it shows the fall in the purchasing power of a rupee.
The measures of inflation are the Consumer Price Index (CPI) and Wholesale Price Index (WPI). WPI measures wholesale level price changes. While CPI measures retail level price changes (retail inflation).
CPI is one of the most widely used indicators for identifying inflation or deflation in an economy. In India, the Consumer Price Index (CPI) replaced the Wholesale Price Index (WPI) in the year 2013 as a measure of inflation.
The percentage change in CPI over a period of time is the inflation over that period for consumer goods. It measures only retail inflation. CPI is determined using a basket of 299 commodities. It calculates the price change of all these 299 goods and services by taking a weighted average value of each of them.
Inflation can be better explained with an example. A litre of toned milk used to cost INR 25 in the year 2010. Now the same litre of toned milk costs INR 45 in 2020. The milk has become dearer (costlier). With the same INR 25, one can get only half a litre of milk in 2020. This is called the falling purchasing power of the currency. Purchasing power is when the same amount of money will buy less of a product as time passes.
How does inflation impact your savings?
Investors do savings and investments with an aim to grow their money. The main goal of these savings and investments are to meet future financial requirements. If one does not plan effectively, in all probabilities, there is a very high chance for the money to shrink.
It has a dual impact on one’s savings. It not only reduces the purchasing power, but also increases the financial requirements for the future.
Inflation has an impact on the prices of goods, services, and commodities, etc. In other words, with time, it can reduce the value of savings. It is because the prices go up. For example, INR 5,000 kept under your bed today is worth more than it is tomorrow. This doesn’t mean that you are losing money. However, the purchasing power of the same INR 5,000 10 years later is less.
An alternative to this is keeping money in a bank. The interest may help in balancing out some effects of inflation. However, it may not help in completely offsetting the inflation loss.
Impact of inflation on investments majorly depends on the investment type. For investments with a fixed annual return such as bonds and CDs, the same annual return may have the impact of inflation. The return that one gets this year may be sufficient to buy a commodity. However, the same returns after four years may not be enough to buy the same commodity.
For equity investments, the impact of inflation is mixed. When inflation is high, the economy is strong, and as a result, companies are in good business. However, companies also have to pay high wages and source raw materials at higher prices. This will impact the profits of the business. Therefore, the impact of inflation on a stock depends on the performance of the company.
How to overcome inflation?
The government aims to control inflation through Fiscal and Monetary policies. However, you should have your own plan to protect yourself from it. The main motive behind investing is to be able to lead a comfortable life in the future despite an increase in the cost of living. Therefore, to ensure this, you need to invest in a way that will help earn inflation-beating returns. However, such investments involve significant risk than regular saving accounts.
High growth investments such as stocks and mutual funds have good potential to earn better returns. On average, the returns from these investments have been more than the rate of inflation. Also, note that the risk associated with equity investments can turn the tables around, leading to heavy losses.
Additionally, you can also look at other investment options to diversify.
Also, it is important to invest money rather than holding in saving accounts. Investors can consider equity investments based on their risk tolerance levels. Additionally, in the long term, mutual funds have the potential to earn significant returns.
Therefore, having investments that earn significant returns in the long term is one way to overcome inflation loss. A strong investment strategy will help in minimizing the impact of inflation on long term financial plans and savings.
What is the time value of money?
Time Value of Money (TVM) is a financial concept that the money one holds now is worth more than the same money one receives in the future. This is because the money one has now had an earning capacity if invested. In simple words, it means people would instead prefer to receive the money today than in the future.
Let’s take an example of a person (Ms Aadhya) who has won a lottery of INR 10,000. She has two options to choose from. Receive INR 10,000 now or receive INR 10,500 in one year. If she opts to receive the money after one year, then she would get a 5% return. However, if she thinks if she can earn more than 5% return in one year, then she should opt for getting the money today.
The return for Ms Aadhya will be 5% or more depending on her choice. However, the real rate of return for her will be less than that. This is because inflation reduces the purchasing power and erodes the value of the money. It has to be factored in while investing to know the real rate of return on investment.
Real interest rates are calculated by subtracting the inflation rate from nominal interest rates.
One has to invest only if the return on investment is higher than the inflation rate. For example, if Ms Aadhya chooses to take the money now and invest for 8% per annum and the inflation rate is 10%, she is actually losing money in terms of purchasing power. Hence Ms Aadhya is better off spending the money now or looking for an alternative investment with returns more than the current inflation rate.
The above calculation of return is done using the future value formula. Future value is the value of an investment at a future date at an expected rate of return.
Future Value Formula
FV = PV (1+r)^n
Where FV is the future value
PV is the present value
r is the expected rate of return per annum
n is the tenure of investment
For Aadhya, the present value is INR 10,000. If she invests this for 8% per annum for a year, the future value of her investment is
FV = 10000(1+0.08)^1
FV = 10,800.
We can also calculate Present Value from Future Value.
Present Value Formula
PV = FV/(1+r)^n
The lottery offered Aadhya to choose between two payments. If Aadhya wants to know her rate of return for receiving INR 10,500 at a future date, she can use PV or FV formula for the same.
10,000 = 10,500/(1+r)^1
r= 0.05 or 5%
Formula for inflation
One can measure inflation using CPI or consumer Price Index.
Inflation = ((CPI x+1 – CPIx)/ CPIx))*100
Where, CPIx is Initial Consumer Price of Index
How is inflation calculated?
Inflation is calculated using CPI. CPI measures the price change in goods and services by taking a weighted average value of each of them.
CPI = (Cost of Fixed Basket of Goods and Services in Current Year/ Cost of Fixed Basket of Goods and Services in Base Year) *100
Once the CPI for the two years is calculated, inflation can be calculated using the formula.
What is an inflation calculator?
An inflation calculator shows what will be the worth of a quantity of money after a certain period of time. It also shows what will be the worth of the same amount of money if invested.
Below are the benefits of using the inflation calculator.
Easy to use
The inflation calculator is available online, and it’s easy to use. All one has to do is enter the amount of money to calculate the purchasing power of the same in the future.
Free to use
The calculator is available online and is free to use multiple times.
The calculator gives the worth of money in the future. It also provides the worth of the same money if invested. The inflation calculator uses historical rates to calculate the same. Hence the results are accurate.
The inflation calculator gives results within seconds and saves time for the investor. However, the same will calculation might take time if done manually.
Scripbox’s inflation calculator
Scripbox’s online inflation calculator will help in determining the worth of your spending power.
Let us understand the inflation calculator with the help of an example. Ms Harini wishes to check the value of her spending power as of 2020 in 2050. 2050 is when she wants to retire. The cost of a product is INR 5,000 in 2020. However the price of the same product in 2050 is INR 50,775. Here the inflation calculator estimates the future inflation (expected inflation) rate.
Also, had Ms Harini invested the same amount for 30 years, the value of her investment by 2050 would be INR 1,22,453 at an expected rate of return of 11.25%.
Assuming in 30 years, Ms Harini wants to retire. Scripbox’s Retire Confident plan will help in planning for a hassle-free retirement. The plan suggests a portfolio that will help in building up a retirement fund. Long term investments have the potential to earn inflation beating returns.
Therefore, one should always be careful while investing. Also, it is essential to ensure that the money saved today it’s worth something more and not less.
How to invest through Scripbox?
Investments through Scripbox are entirely online and hassle-free. Scripbox has various investment portfolios curated based on different life or financial goals. The investment corpus is determined after accounting for inflation. Also, these portfolios are monitored regularly to keep up with the changing market dynamics. Investors can also track the progress of their goal through Scripbox.
One can invest in Scripbox recommended best index mutual funds in India by following the below-mentioned steps:
- Login toScripbox
- Click on ‘ Let’s Get Started’
- Begin your investment journey with ‘Build Wealth.’
- Select the mode of investment, i.e., monthly SIP, one time or STP
- Enter the amount of investment
- Based on the amount of investment, the recommended funds will be provided. You can change the funds and the distribution of the amount.
- Select the payment mode and proceed toward the payment
What are India’s historical inflation rates?
The following inflation data has been taken from the World Bank.
|Year||Inflation Rate (%)||Annual Change|
What are the causes of inflation?
The main causes are
- Monetary Policy:It determines the supply of currency in the market. Excess supply of money causes inflation. Hence decreasing the value of the currency. The Reserve Bank of India (RBI) gives out the monetary policy in India.
- Fiscal Policy:It monitors the borrowing and spending of the economy. Higher borrowings (national debt), result in increased taxes and additional currency printing to repay the national debt. This, in turn, increases the money supply in the country.
- Demand Pull Inflation:Increase in prices due to the gap between the aggregate demand (higher) and aggregate supply (lower).
- Cost Push Inflation:Higher prices of goods and services due to increased cost of production.
- Exchange Rates:Exposure to foreign markets are based on the dollar value. Fluctuations in the exchange rate have an impact on the rate of inflation.
What are the three types of inflation?
The three types of Inflation are Demand Pull inflation, Cost Push Inflation and Built In inflation.
- Demand Pull Inflation:It occurs when the aggregate demand for goods or services is higher when compared to the production capacity. The difference between aggregate demand and aggregate supply (shortage) result in price appreciation.
- Cost Push Inflation:It occurs when the cost of production increases. Increase in prices of the inputs (labour, raw materials, etc.) increases the price of the product.
- Built In Inflation:Expectation of future inflation results in Builtin Inflation. The rise in the prices results in higher wages to afford the increased cost of living. Therefore, high wages result in increased cost of production, which in turn has an impact on product pricing. The circle hence continues.
What are the effects of the rise in inflation rate?
The rise in the inflation rate can cause more than a fall in purchase power.
- Inflation could lead to economic growth (increase in GDP growth rates) as it can be a sign of rising demand.
- It could further lead to an increase in costs due to workers demand to increase wages to meet inflation. This might increase the unemployment rate as companies will have to lay off workers to keep up with the costs. High unemployment rate further leads to a fall in GDP growth.
- Domestic products might become less competitive if inflation within the country is higher. It can weaken the currency of the country.
How do we prevent inflation?
To prevent inflation, the primary strategy is to change the monetary policy by adjusting the interest rates. Higher interest rates decrease the demand in the economy. At the same time, lower rates of interest increase demand. This results in lower economic growth and therefore, lower inflation. Other ways to prevent it are:
- Controlling the money supply can also help in preventing inflation. The money supply is the total value of money in circulation in the country. In India, the Reserve Bank of India controls the money supply.
- Higher Income Tax rate can reduce the spending, and hence resulting in lesser demand and inflationary pressures.
- Introducing policies to increase the efficiency and competitiveness of the economy helps in reducing the long term costs.
Frequently Asked Questions
What is the inflation formula?
One can measure inflation using CPI or Consumer Price Index. Inflation=((CPI x+1 – CPIx)/ CPIx))*100. Where, CPIx is Initial Consumer Price of Index
What is Deflation?
In simple terms, deflation is the opposite of inflation. During deflation, the price levels of goods and services fall. In other words, negative inflation is deflation. Deflation is also calculated using CPI.
What is zero inflation?
Zero inflation is a scenario where the prices in an economy are stagnant. The rise in the prices in the economy is zero. Low inflation in an economy is an indicator of low growth. In such an economy, the GDP growth rates are low.
What is price inflation?
Price inflation is a general increase in the prices of consumer goods and services.
What are real interest rates?
Real interest rates are adjusted for inflation. They reflect the real return an investor earns on investments. Real interest rates are calculated by subtracting the inflation rate from nominal interest rates.