Tuesday, September 27, 2011

Suppose you are purchasing some goods worth Rs.100/- today. We all know that in a year’s time, you would require more than Rs.100/- to purchase the same goods as you have done today. This is due to the “Rise in Prices”. This phenomenon is observed constantly in almost all the economies, though the degree of increase would depend upon so many factors and hence it differs from time to time and country to country.

This “increase” in prices is due to the fact that at any given time, more money chases less goods and services. This means that there exists a gap between “Supply” and “Demand” of goods and services and the degree of price rise directly depends upon the extent of gap. The more the gap the higher the price rise and vice-versa. This general increase in prices of goods or services with the passage of time is called “Inflation”.

Inflation in India as a Developing Country:

All Developing Countries experience a fair to heavy dose of Inflation depending upon the Current Growth Rate of the Economy. Usually, when the economic activity is at its peak in the growth phase in any country, the rate of Inflation tends to be high, as money in circulation increases appreciably and growth in terms of economic activity requires a little time to catch up with.

India, as a developing country is no exception to this phenomenon of “Inflation”. At present, it is indicated that the rate of Inflation as per “Wholesale Prices Index (WPI) ” is around 9%.

However, in all Developed Economies, the rate of Inflation is measured in terms of “Consumer Prices Index”, which is the correct measure, as consumers do not buy at wholesale prices and that in a country like India, there are any number of intermediaries between wholesale trade and retail trade; usually, the average consumer gets his goods from the retail trade and not the wholesale trade.

What do you mean by “Rate of Inflation of 5%”?

This means on a comparative basis, the difference between prices of a basket of Commodities last year and this year works out to 5%. Hence, in case there is a reduction in the rate of Inflation, it does not mean that the prices have come down in an absolute sense. It only means that the rate of increase in price rise of a basket of selected commodities has come down.

What is the difference between inflation in a Developing Country and a Developed Economy?

Inflation in a Developing Country appears due to the gap between “Supply” and “Demand” of goods and services, whereas, in a Developed Country, this is not the case.

Developed Countries experience, what is known as “Cost Pushed” Inflation. This essentially occurs because of “high levels of income”, which pushes up the “Cost of Production”, resulting in Inflation. This does not necessarily indicate that there is a gap between “demand” and “supply”.

Inflation and Interest Rates:

In any Economy, there is a 4-tier Structure for Rates of Interest as under:

Tier No. I – Rate of Inflation;

Tier No. II – Rate of Interest on Deposits, i.e., Rate of Inflation + Certain % loading depending upon the degree of compensation expected by the Depositors;

Tier No. III – Rate of Interest on Loans, i.e. Rate of Interest on Deposits + Certain % loading depending on the risk perceived in the lending activity by the lender which could be borrower specific and the profit margin of the lender and

Tier No. IV – Rate of return expected by a promoter from Investment in a project = Rate of Interest on Loans + Certain % loading as a reward for the risk incurred by the promoters in the project.

What is “Time Value of Money”?

That with the passage of time, the value of “Present Money” reduces due to “Inflation”is clear to us and this phenomenon is referred to in finance as “Time Value of Money”.

Interest is in fact primarily a Compensation for the loss in value of money due to passage of time. Hence we should familiarize ourselves with terms associated with “Time Value of Money”such as “Compounding and Discounting”.

Compounding: It is a process by which given a specific present value, at a fixed rate of interest and depending upon the frequency of compounding, the future compounded value can be determined for a specific period.

All of us know this formula to be

F.V. = P.V. (1+ r /100) rose to “n” times, “n” representing the period in number of years.

This presupposes that the periodicity of compounding is yearly.

In case the periodicity of compounding is half-yearly, then the formula would change as follows: F.V. = P.V. (1+ r /200) raised to “2n” times. Similarly, the formula could be amended for quarterly compounding or monthly compounding.

Discounted value: This is converse to the process of “Compounding”. Just as we know the present value for compounding, we should know the future value for discounting.

This value, when discounted at a given rate of discount, which is usually the rate of return expectation, by a promoter or an investor gives us the present value.

This again depends upon the period for which the discounting is done. Just as in the case of compounding, in the case of discounting also, the formula which is given below needs amendment for adjusting for a more frequent periodicity of discounting than 1 year. P.V. = F.V./(1+r/100) raised to the power of “n”, wherein “n” is the number of years.

This discounting is useful for saving a fixed sum at a future date and for evaluating projects, whose cash flows can be determined now for a future date.

Types of Inflation & its Basics

There are two theories in the economics that are generally accepted as the causes of inflation.

  • Demand pull inflation – Happens when too much Money chases too few Goods.

This situation mostly exists in a Growing economy (Like India), where there are huge expansions from the Government and Private Sector, leading to increase in employment, which in turn will increase the purchasing power of the consumer.

This leads to an environment, where people have got too much money to buy goods and/or services, but the supply of goods and services are not growing at the same rate, resulting in a supply and demand mismatch. To adjust this, producers will increase the price of goods.

  • Cost push inflation – Happens when the aggregate cost of resources goes up, for the companies due to decrease in supply or increase in taxes. This situation primarily exists in Developed Economies such as US or UK.

Companies pass this increase on to consumers in the form of increased prices. For example, Crude oil prices have gone up sharply in past few months on account of decrease in supply. The economy sectors where oil is the part of their cost element, will pass on this increase to customers by increasing prices of their goods and services.

It is not necessary that only one type of inflation exists in an economy at a time. They can co-exist.

For instance, in India right now we have both types of Inflation, Oil and Metal prices have gone up to record highs, giving rise to Cost Push Inflation. At the same time, purchasing power has also increased due to increases in employment, wages, and easy availability of money, creating Demand Pull Inflation. This combined effect has taking inflation to the 13-year high that we are experiencing right now.

Inflation is not always an Evil.

Within limits, Inflation is required for an Economy to grow. It’s very well said that inflation is the sign of a growing economy. Imagine an environment where there is no price increase; in fact prices are falling (this situation is opposite of inflation known as deflation). There will be no increase in wages. Nobody would like to have that environment.

But when inflation is too high it adversely affect the consumer and the economic conditions of the nation as well:

  • In a fixed interest rate environment the Creditor will lose money, if he has not properly estimated the inflation and accordingly fixes the interest rate. High inflation can sometime result in negative real interest rates. This can be currently seen in India as the inflation is touching 11.4% and the interest rate on fixed deposit is 9% it is actually giving negative return of 2.4%
  • It decreases the savings of the individuals. As the prices increase, the consumer has to shell out more money from his pocket to buy the same products but his income has not increased. Therefore he has to eat up his savings.
  • As savings get reduced, automatically investments will reduce, affecting the economy negatively.
  • If the inflation in one country is greater than another, the products and services of the former will become less competitive due to the increase in its prices.

To control inflation Central Banks, take Monetary actions and government takes fiscal measures. But individuals should also take some steps to get over it. They should invest their money in the investment avenues which gives better return, should try to minimize unwanted expenses, reduce the consumption of the commodity that has become very expensive, and find out some substitute that will help them in managing their own inflation.

Relation between Inflation and Bank Interest Rates: How does Inflation affect rates?

“Inflation is the overall or specific increase in the cost of goods or services.”

Inflation is an increase in the price of a basket of goods and services that is representative of the economy as a whole.

Inflation is basically a rate of increase in the price of goods and services which in economics defined as “The overall general upward price movement of goods and services in an economy, usually as measured by the Consumer Price Index (CPI).”

In India, however, it is measured using the wholesale price index (WPI).

The CPI is based on a basket of goods and services with different weights, reflecting the expenditure of a typical consumer. The weighted average of price rises of these goods and services gives the inflation figure.

Inflation simply reduces the worth of our money. For example: the same 1 kg of apples you used to buy at Rs. 100 will cost you Rs. 110 next year, if the inflation remains at 10%.

Inflation is when our Mom or Dad complains about the prices they have to pay nowadays compared to what they paid when they were younger. “I remember when a roll of Poppins only cost 20 paise.” “I used to buy Tur dal at Rs.14/Kg.” “When did milk get so expensive?” My Great Grandfather used to get a salary of Rs. 5 per month!!

Most people look at their present living standards and estimate how much they will need to accumulate to survive. They don’t even take a second look at inflation. India’s Inflationrate is currently above 9%. There are no Fixed Deposits which give such high returns. This means that for every year that your money is in the bank you are actually losing money!! Inflation is Eroding the value of our money lying idle in Savings Accounts in Banks, as it is fetching us only 4% ROI.

The best way to beat inflation when planning for the future is to include it in your calculations. The biggest problem we see with a lot of long-range financial planning, especially retirement planning, is that people forget to factor in the effect of inflation on their investments and savings.

Another quick way to account for the effect of inflation is to subtract the inflation rate from any rate of interest you will be receiving on an investment. So if you are going to assume a 10% inflation rate and the assumed rate of return is 11%, do the projection with only a 1% rate of return. This will give you a more accurate picture of the value (not the amount) of the investment at its maturity!!!.

If inflation is high, interest rates are increased. If repo, ie rates at which banks borrow from RBI, is increased, such borrowing will become costly and banks would thus either borrow less or pass on this increased cost to their borrowers. Again if reverse repo is increased, banks would divert more funds towards RBI and excess liquidity will be absorbed by RBI rather than going at cheaper cost in the economy. In either of the cases, actual lending will be less and demand for goods and services will be less

In the case of CRR, if the rate is increased, it affects in two ways. First, immediate liquidity in the system is absorbed to the extent CRR is increased as more money needs to be placed with the regulator. Second, in the incremental lending, potential capacity of banks to lend is curtailed. This again leads to less lending by banks.

How is inflation calculated in India?

India uses the Wholesale Price Index (WPI) to calculate inflation. Most developed countries use the Consumer Price Index (CPI) to calculate inflation.

What is Wholesale Price Index (WPI)?

Wholesale Price Index (WPI) is the index that is used to measure the change in the average price level of goods traded in the wholesale market. In India, a total of 435 commodities data on price level is tracked through WPI which is an indicator of movement in prices of commodities in all trade and transactions. WPI is published on a weekly basis in India.

What is Consumer Price Index (CPI)?

CPI is a statistical time-series measure of a weighted average of prices of a specified set of goods and services purchased by consumers. It is a price index that tracks the prices of a specified basket of consumer goods and services, providing a measure of inflation. In India, CPI is published on a monthly basis.


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