Musing On Inflation

Hola amigos, I am Suraj here with my bestie Roshni. She is a first year management student who wants to specialize in finance. She is very curious about finance, economics and hundred other things. When we were sipping up coffee in the café, she suddenly popped up with a question “what is inflation?” Being from an engineering background Roshni is very good with technical and technological stuff, but she wasn’t so clear with the concept of inflation but fortunately I had some idea about the topic and so I started sharing what I knew.

Firstly I gave her the basic definition of inflation which goes as follows,

Inflation is a general rise in the price levels of the goods and services. Example: consider you were buying 1 kg of sugar for ₹40 last year, and this year you are paying ₹45 for 1 kg of sugar then there is a rise in the price level of sugar, this is nothing but inflation.

After explaining, I took a great sigh of relief as I thought I had managed to quench her thirst for knowledge. After understanding the definition, my innocent friend nodded her head and said confidently “Oh so inflation is not good for an economy”. And I corrected her “No, not really”.  She asked me “Why not, Can you elaborate dear?” I looked at her, smiled and continued…. moderate inflation is actually boon for an economy…

There is positive correlation between inflation and interest rates. If inflation is moderate between 3-4 % then it incentivizes the people who are hoarding money to purchase goods or services or to invest in assets, as moderate inflation signifies moderate rise in the prices of goods, services and assets. Generally banks have savings interest rates slightly above inflation, so if inflation is moderate, say between 2-4% then banks may give interest of 5-6% to its customers who are depositing money in the banks. Through banks this deposited money can be lent to entrepreneurs or businesses to invest in businesses or to households for their personal needs, this in turn gives a necessary push to the economy and money keeps flowing in the economy itself. As businesses invest more money in their business, it creates more jobs and helps in raising the wages and salaries of existing employees. This helps to increase the buying power of consumers, which causes demand to increase and as the demand increases, there is rise in the prices of the commodities and the cycle continues. Hence moderate inflation is a necessary catalyst which is essential for sustained growth of economy.

Note:  Currently inflation in Europe and USA is nearly zero, hence interest rates in those economies is also nearly zero. So there is no incentive as such for the people there to keep money in the banks, which creates problem in the smooth flow of money in the economy and ultimately results in slow growth.