What is Inflation - Meaning, Working, Calculation, & How to Overcome

You must have noticed how the price of all items grows gradually. The reason behind this is inflation, a phenomenon that reduces a currency's relative value. As a result, you need to pay more to purchase a good or avail of a service year after year.

You need to know how you can beat its impact on your financial stability. However, before that, you must know what inflation is in detail, along with its types and causes.

Inflation is the rate at which goods and services prices increase over time. You can also see inflation as a relative decrease in the overall value of a currency. As a result, you need to spend more of your currency to buy a specific commodity or service.

A moderate level of this price hike is necessary for a country's economy. It is favourable for both businesses and common citizens. Under such economic conditions, individuals can easily purchase items, borrow credits and increase their economic opportunities. However, during over-inflation, prices of daily necessities increase so much that it becomes difficult for people to afford them.

To clearly understand what inflation is, you should also know how it is calculated.

What Is Inflation Calculation Using WPI?

WPI is the average price of a basket of commodities at their wholesale level. An increase or decrease in the percentage of this index against the base year shows a country's inflation rate.

In India, RBI used to leverage WPI to measure this rate until 2014. The Ministry of Commerce and Industry was responsible for calculating WPI by averaging prices of 697 particular items at their wholesale level. The basket of commodities used by the Department of Commerce included the following three groups of items:

• Manufactured Products: Accounted for 65% of the total weight of WPI
• Primary Articles (mainly food items): Accounted for 20.1% of the total weight of WPI
• Fuel and Power: Accounted for 14.9% of the total weight of WPI

In 2014, the RBI governor changed the base index for inflation calculation from WPI to CPI. Its primary reason was that the WPI does not consider price-hikes of services.

What Is Inflation Calculation Using CPI?

The consumer Price Index (CPI) measures the average selling price of both services and products at the consumer level. It includes the price of clothing, food and other commodities, along with the prices of transportation, electricity, etc. The inflation rate is the change in CPI in a particular year concerning the base year.

In India, CPI is calculated considering the price of 260 different products and services. With the help of the Central Statistics Office, the Ministry of Statistics and Programme Implementation tracks the changes in CPI.

The respective government departments collect the  price data from 1114 urban and 1181 rural markets throughout India. After data collection, they calculate the CPI by averaging prices of commodities.

Inflation is categorised into several types according to pace. Here are various types of inflation:

• Creeping Inflation: Prices rise by 2% or less
• Galloping Inflation: Prices increase by 10% or more
• Hyperinflation: Prices increase by 50%
• Deflation: Negative inflation; prices drop

The following are the different causes of inflation:

• Demand-Pull Inflation: In this case, the aggregate demand for goods and services increases concerning overall supply in the market. It occurs for several reasons, including supply shortfalls, economic booms, an increase in money supply, etc.
• Cost-Push Inflation: In cost-push inflation, prices of intermediate goods or production process inputs increase. As a result, the total cost of manufacturing items inflates. Finished products also become costly.
• Built-in-Inflation: People in an economy expect that prices of commodities and services will increase at a moderate rate, as they have previously experienced. This is why workers demand an increase in their wages to sustain their standard of living. The products or services also become costlier year-on-year.

The only possible means to beat inflation is by increasing wealth accumulation. You need to ensure that your overall earnings increase with the falling relative value of money and increasing price of goods and services. This will help you retain your purchasing power.

If you save your money in a bank account or Public Provident Fund (PPF) and earn interest lower than the inflation rate, you will not be able to keep pace with the rising price. Therefore, you need to choose investment instruments that will give you higher rates of returns than inflation. You can choose to keep your money in some mutual funds or equities as they give higher returns.

Now that you know what inflation is, you must understand that increasing earnings is also paramount. Inflation in the economy reduces the currency's value and increases the prices of products and services. As a result, you need to spend more to sustain a basic standard of living.