Inflation refers to the gradual rise in the prices of goods and services over time, which lowers the purchasing power of money. In simple terms, the same amount of money buys fewer items than before. For example, something that cost Rs. 100 a few years ago may now cost Rs. 120 or more.
Economists measure inflation by tracking changes in the prices of a basket of commonly used goods and services, including food, fuel, housing, healthcare, and transport. When the overall cost of this basket increases, inflation is said to occur.
Inflation affects consumers, businesses, investors, and governments. While moderate inflation can support economic growth and encourage spending, high or unstable inflation can reduce savings and create financial uncertainty.
This article explains inflation, its effect on investments, and how it influences different asset classes. It also explores ways investors can manage inflation risks and make informed financial decisions during inflationary periods.
Key takeaways
- Inflation reflects the rate at which investments lose real value and how prices increase over time.
- It signals the required returns on investments to sustain a certain standard of living.
- Inflation arises when the money supply expands more rapidly than the economy’s productive output.
- An increase in the price of a single product is not inflation; it’s a relative price change caused by shifts in supply or demand.
What is the meaning of inflation?
Inflation refers to the continuous rise in the prices of goods and services over time within an economy. It is an important measure of a country’s economic health and is usually shown as a percentage increase over a specific period. Inflation mainly occurs when the demand for goods and services becomes higher than their supply, causing prices to increase.
A moderate level of inflation is generally considered beneficial because it encourages spending, investment, and economic growth. However, high inflation can reduce the purchasing power of the rupee and create financial instability.
As prices increase over time, the same amount of money may buy fewer goods and services in the future. This affects everyday items as well as major purchases such as property. Therefore, it is essential for income, savings, and investments to grow at the same pace as inflation, or faster, in order to maintain a comfortable lifestyle and financial security.
Inflation rate meaning and formula
The inflation rate represents the percentage change in the overall price level of goods and services over a specific time period—usually monthly or yearly. It indicates how quickly prices have risen or fallen during that time.
Formula to calculate inflation:
The inflation rate is calculated using the change in the Consumer Price Index (CPI). The formula is:
Inflation Rate = ((Final CPI – Initial CPI) / Initial CPI) × 100
Where:
- CPI stands for Consumer Price Index, a measure used to track changes in the price level of a basket of consumer goods and services.
Steps to calculate inflation:
- Identify the price of a product or index value in the past (Initial CPI).
- Identify the current price or index value (Final CPI).
- Apply the formula:
((Final CPI – Initial CPI) / Initial CPI) × 100 - The result gives you the percentage increase or decrease in price, which reflects the inflation rate over the chosen period.
Also read: What is Inflation Risk
Types of inflation
Inflation can arise from various sources and affect the economy in different ways. Understanding the types of inflation helps investors, policymakers, and consumers make informed financial decisions. Below are the major types of inflation explained in simple terms:
- Demand-pull inflation
This occurs when the demand for goods and services exceeds supply. It’s typically seen in a growing economy where consumers and businesses have more money to spend, leading to price rises. - Cost-push inflation
This happens when the production cost of goods increases due to factors like rising raw material prices or wages. As companies pass these costs onto consumers, overall prices rise. - Built-in inflation
Also known as wage-price inflation, this type occurs when workers demand higher wages to keep up with the cost of living, and businesses raise prices to offset increased wage costs—creating a cycle of inflation. - Hyperinflation
An extremely rapid and uncontrollable increase in prices, often exceeding 50% per month. It usually occurs due to economic collapse, war, or excessive money printing by governments. - Deflation
Although the opposite of inflation, deflation is sometimes discussed in this context. It refers to a sustained drop in prices, often linked to reduced consumer demand and economic slowdown. - Stagflation
A rare and troubling condition where inflation and unemployment rise simultaneously, often accompanied by stagnant economic growth. - Creeping inflation
A mild and manageable form of inflation, typically ranging from 1–3% annually. It's considered normal in a stable economy.
Advantages of inflation
- Encourages Spending and Investment
Moderate inflation motivates people and businesses to spend and invest instead of saving money for long periods. This increased economic activity can support business growth and create more opportunities in the market. - Reduces Debt Burden
Inflation lowers the real value of money over time, making it easier for borrowers to repay loans. Individuals and businesses with existing debt may benefit as future repayments become less expensive in real terms. - Supports Higher Lending
During periods of stable inflation, banks and financial institutions are generally more willing to provide loans. Improved access to credit can help businesses expand operations and encourage entrepreneurship. - Promotes Wage Growth
Inflation often results in higher nominal wages. If salary increases match or exceed inflation levels, workers can maintain or improve their standard of living. - Encourages Investment in Assets
People may invest in stocks, mutual funds, and similar assets to protect their wealth from inflation, which can increase long-term investment growth.
Disadvantages of inflation
- Reduced Purchasing Power
As prices increase, the value of money decreases. Consumers are able to buy fewer goods and services with the same income, which can negatively affect their overall standard of living. - Difficulty in Financial Planning
High or unpredictable inflation creates uncertainty in the economy. Consumers may find it harder to manage budgets, plan future expenses, make long-term investments, or purchase essential items because future costs become difficult to estimate accurately. - Decline in Savings Value
Inflation can reduce the real value of savings over time, especially when interest rates on savings accounts are lower than the inflation rate. People with fixed incomes, such as retirees and pensioners, may also face financial pressure as the cost of living continues to rise while their income remains unchanged.
How does inflation affect investment?
Inflation affects investments by reducing their real value over time. If inflation is high, the money you earn from investments will have less purchasing power. For instance, if you earn a 4% return on an investment but inflation is 5%, your real return is negative because your earnings do not keep up with rising prices.
Inflation occurs when the money supply grows faster than the economy's production. This results in more money chasing the same amount of goods, driving prices up. As an investor, you need to seek returns that at least match inflation to preserve your wealth. For example, if a stock returns 6% but inflation is 3%, the real return is 3%. Understanding inflation helps you choose the right assets to protect and grow your investments.
Also read: How to Invest During Inflation
Can inflation be suitable for your investment portfolio?
While you cannot control inflation, you can adopt strategies to protect your investment portfolio from its effects:
Optimum diversification
Diversify your investments across different types of funds, such as equity, debt, and hybrid funds. This helps balance your portfolio and reduces the risk of any one investment performing poorly during high inflation.
Regularly review and make adjustments
Monitor your portfolio and make adjustments as needed. If inflation leads to high interest rates, consider reducing debt fund investments. Conversely, when inflation is low, you might increase your exposure to debt funds and equities. Building a resilient portfolio is like constructing a sturdy house – it requires a solid foundation and a balanced mix of investments to withstand economic changes.
What causes inflation?
Inflation arises from three main sources: demand-pull inflation, cost-push inflation, and built-in inflation.
Demand-pull effect
Demand-pull inflation occurs when increased money supply and credit boost overall demand for goods and services beyond the economy's production capacity, causing prices to rise. When people have more money and are optimistic, they spend more, driving up demand and prices.
Cost-push effect
Cost-push inflation happens when production costs rise, leading to higher prices for finished goods and services. This can occur when the money supply increases and flows into commodity markets, causing prices to spike. For example, if oil prices rise due to increased money supply, the cost of energy goes up, leading to higher prices for various goods and services.
Built-in inflation
Built-in inflation is driven by expectations that current inflation rates will continue. When people expect prices to keep rising, they demand higher wages to keep up with the cost of living. Higher wages then lead to increased production costs, perpetuating the cycle of rising prices.
Effects of rising inflation rate
- Reduced purchasing power: Consumers need more money to buy the same goods and services.
- Higher cost of living: Essentials like food, fuel, and housing become more expensive, straining household budgets.
- Impact on savings: Inflation erodes the real value of money saved, lowering future purchasing power.
- Increased borrowing costs: Central banks may raise interest rates to control inflation, making loans costlier.
- Business challenges: Rising input costs can reduce profit margins and limit expansion.
- Investment shifts: Investors often move funds into assets that can outpace inflation, such as equities or real estate.
Inflation and asset classes
Inflation affects liquid and illiquid assets differently. Liquid assets, like cash, appreciate slowly and are more vulnerable to inflation. High inflation leads people and businesses to hold fewer liquid assets. Illiquid assets, like property or stocks, may appreciate or generate interest, providing some defence against inflation. Investing in mutual funds, stocks, and bonds can help protect savings. Inflation-protected securities, like Treasury Inflation-Protected Securities (TIPS), offer returns that adjust with inflation, safeguarding purchasing power.
How inflation impacts prices
Inflation measures the overall rise in prices of goods and services over time. People rely on a wide range of products and services in daily life, including food, fuel, electricity, transport, healthcare, entertainment, and labour. Inflation combines the price changes of these items into a single figure to show how the cost of living changes within an economy.
When inflation increases, the purchasing power of money falls, meaning people can buy fewer goods and services with the same amount of money. This can affect living standards and slow economic growth. Economists generally believe that long-term inflation happens when the growth of a country’s money supply is faster than its economic growth.
To control inflation, central banks manage money supply and credit levels to maintain economic stability. Inflation is the opposite of deflation, where prices fall below 0%. It should not be confused with disinflation, which refers to a slower rate of inflation.
Impact of inflation on mutual funds
Inflation can reduce the real returns of mutual funds, affecting their performance. As prices rise, the purchasing power of returns decreases. It’s crucial to adopt strategies to mitigate inflation’s impact on investments.
How to combat the impact of inflation on mutual funds?
To combat the impact of inflation on mutual fund schemes, diversify your portfolio across various asset classes, including equities, bonds, and commodities, to balance risk and returns. Regularly review and adjust your investments based on market conditions and inflation trends. Additionally, focus on high-quality, dividend-paying stocks, as they tend to perform well during inflationary periods. Maintaining a well-diversified and actively managed portfolio can help cushion the effects of inflation and protect your investment returns over time.
Optimum diversification
Diversify your portfolio across various funds to balance performance during inflationary periods. Include equity, debt, and hybrid funds to spread risk and enhance returns.
Regularly review and make adjustments
Keep an eye on your portfolio and make necessary adjustments. If interest rates rise due to inflation, reduce debt fund investments. When inflation is low, increase debt fund exposure and equity allocation to optimise returns.
How to protect your portfolio against inflation
Here are some investment options that provide inflation-adjusted returns:
- Inflation-indexed securities: These bonds have their principal indexed to inflation, offering returns higher than the inflation rate, protecting your investments from inflation.
- Floating interest rate products: These products adjust coupon payments with changing interest rates, offering protection against inflation.
- Commodity prices: Investing in commodities can hedge against inflation, as their prices rise with inflation.
- Equity income funds: These funds invest in dividend-paying companies, providing income and protection against inflation.
Also read: Cost Inflation Index (CII) for FY 2024-25
Methods to control inflation
Governments and central banks use several measures to keep inflation under control and maintain price stability.
1. Monetary policy measures
Central banks, such as the Reserve Bank of India (RBI), control inflation by adjusting interest rates and regulating money supply. Increasing policy rates like the repo rate makes borrowing more expensive, which reduces spending and slows inflation.
2. Fiscal policy measures
The government can control inflation by reducing public expenditure or increasing taxes. These steps help reduce excess demand in the economy and ease upward pressure on prices.
3. Supply-side measures
Improving production, removing supply bottlenecks, and strengthening supply chains can increase the availability of goods. When supply rises to meet demand, price pressures tend to reduce.
4. Price control and regulation
In certain cases, the government may impose price controls or regulate essential commodities to prevent sudden price spikes.
5. Import policies
Reducing import duties or increasing imports of essential goods can increase supply in the domestic market and help stabilise prices.
These measures work together to maintain economic stability and prevent prolonged periods of high inflation.
What are the difference between inflation today and historical inflation?
The difference between inflation today and historical inflation lies in the drivers, management strategies, and the economic environment. Historically, inflation was often triggered by tangible factors such as wars, crop failures, or sudden increases in resource demand. For example, the oil crisis in the 1970s led to high inflation due to the sudden spike in energy prices, impacting nearly every sector of the economy. Governments at that time had fewer tools to monitor and control inflation, relying more on restrictive monetary policies to curb price increases.
In contrast, modern inflation is influenced by complex global factors, including digital advancements, global supply chains, and expansive fiscal policies. Recent inflationary periods, such as the one following the COVID-19 pandemic, have been driven by supply chain disruptions, labour shortages, and large-scale government stimulus efforts. Central banks today possess more sophisticated tools to measure, predict, and manage inflation, including interest rate adjustments, quantitative easing, and improved economic data analysis.
Additionally, historical inflationary periods were often prolonged and difficult to control. Today’s inflation, while still challenging, can sometimes be addressed more quickly due to real-time data and targeted policies. However, the globalised economy makes inflation more interconnected; an economic disturbance in one region can rapidly affect prices worldwide.
Overall, while inflation remains a persistent economic challenge, modern economies possess better mechanisms to mitigate its effects. Yet, the interconnectedness and complexity of today’s economy mean inflationary pressures can arise more unpredictably than in the past.
Final Words
Understanding inflation is important for making informed financial decisions. It measures the rate at which investments lose value and prices rise, affecting purchasing power and living standards. Inflation results from an increase in the money supply relative to productive output. While a price increase in one product is not inflation, a general rise in prices across the economy is.
While cash and fixed-rate bonds tend to underperform during inflationary periods, diversifying your portfolio and opting for investments with inflation-protected returns can help mitigate these effects. Platforms like Bajaj Finance make this process more accessible and efficient. With over 1,000 mutual funds available on the Bajaj Finance Platform, you have a diverse range of options to build a robust investment portfolio and compare mutual funds. With extensive research from in-house specialists and a wide array of mutual fund options, including tools like a mutual fund calculator, Bajaj Finance ensures a seamless and informed investment experience. By leveraging such resources, you can build an investment portfolio capable of combating the impacts of inflation.
