What Is Inflation And How To Tackle It

By BankBazaar | June 22, 2018

Does rising inflation give you sleepless nights? This article will give you the low-down on inflation and tips on how to tackle it.

What Is Inflation And How To Tackle It

The cost of living is increasing with each passing year. With each successive year, you have to pay more to buy products or avail services. What you could afford for Rs. 1,000 a few years ago will perhaps cost you Rs. 1,200 today. This phenomenon of rising costs and changing value of money is called inflation.

According to the rule of economics, inflation is an increase in the average level of prices for goods and services. A sample basket of goods and services is used to get an estimated figure of the change in prices because it is not plausible to calculate the change in prices of each and every product and service separately.

If you really want to understand the impact of inflation on prices of goods and services then have a chat with your grandparents about money. They’ll regale you with stories about how they could buy a whole lot of stuff for a few paisas or annas and how spending even one rupee was a luxury. But what can you get for a rupee today? Absolutely nothing. These days we talk in hundreds, thousands and even lakhs. This difference is called inflation.

Additional Reading: Protect Your Paycheque From Inflation

Inflation & Investments

Many people assume that inflation is a macro-economic term and reflects the bigger economic picture of the country. This is true, but it’s also true that inflation affects us on a micro-economic level too. The cost of things you purchase on a regular basis is also affected by inflation.

Inflation also has a strong impact on your investments as well. This makes it all the more important to understand the mechanics of the concept so that you can make smart investments. If the percentage of returns on your investments is smaller than the inflation rate then your money is losing value. This is one reason why many discerning investors are moving to Mutual Funds. Mutual Funds have acquired a reputation for giving inflation-beating returns and if held for long they help you ride out market volatility.

Let’s look at an example. An investment of Rs. 1 lakh giving annual returns of 5% will translate to Rs. 1.05 lakhs. But if inflation is at 6% then your gains will be consumed by the rising prices of goods and services. By investing in Mutual Funds, you can expect an annualised return of 10%.

Additional Reading: How To Beat Inflation

What Causes Inflation?

There are multiple factors that can cause inflation, but for the sake of simplicity they can be categorised into three broad concepts.

  • High Demand

A product or a service costs more when the demand for it is higher than supply. This scenario is called demand-pull inflation. For example, let’s say one year ago you had Rs. 1,000 to buy 100 products available in the market assuming you are the only person to buy these products. One year later you have Rs. 5,000 to buy the same 100 items available in the market.

What do you think the price of these items will now be?  The prices of these items will now be 5 times more on an average. This phenomenon is termed as demand-driven inflation i.e. when too much cash chases too few products. That is to say, the demand outstrips the supply.

  • Limited Supply

While high demand is on one side of the spectrum, limited supply lies on the other end of it. In this case, the demand for products and services remains the same but the cost of it goes up due to supply constraint. Inflation caused due to this reason is called cost-pull inflation.

This usually happens with products you use regularly such as farm produce. The cost of farm produce is determined by the yield. Though demand remains the same, the cost of fruits and vegetables goes up when the yield is low. The produce can also get affected due to bad monsoons or sub-par warehousing conditions and can send the cost of produce higher.

Limited supply driven inflation can also happen during natural calamities when demand for daily need products remains the same but the supply gets curtailed due to events like a roadblock, floods, landslide etc.

  • Minting Money

Another factor that triggers inflation is excessive printing of money. When excessive printed money flows in the economy it reduces the value of money. Due to this reason, the prices of goods and services go up, leading to high inflation.

These are three factors that broadly impact inflation

Why Women Need To Me More Cautious Of Inflation

It is even more important for women to understand inflation because of two reasons.

1) Their life expectancy is higher

2) They are more likely to contract medical complication with age. So women need to make sure that they pick their investment portfolio wisely.

We have written generously about women grabbing the reins when it comes to managing their money. This article will help them understand where and how to invest money to get returns that will comfortably account for inflation and more.

Additional Reading: Drama Lama Learns About Inflation

Cost Inflation Index

The cost inflation index (CII) is a means to measure inflation, which is used in the computation of long-term capital gains with regard to the sale of assets. Cost inflation takes into account the Consumer Price Index (CPI) for a given year for urban non-manual employees for the preceding year. As the price of a capital asset is likely to rise in the years between the purchase and its sale, selling the asset would net the owner a significant amount.

Since the government levies a tax on such transactions, the owner would be required to pay a hefty sum as tax. In order to avoid paying a large sum towards tax, the sale price of the asset can be indexed to demonstrate the asset’s value as per its current value, taking into account inflation reducing its value. In this manner, the profit derived from the sale would be lower, thus reducing the capital gains payable.

Thus, indexation helps reflect the actual value of the asset at present market rates, taking into account the erosion of value due to inflation.

When selling an asset, the purchase price is referred to as the indexed cost of acquisition. The cost inflation index (CII), therefore, is the indexed price that the asset is purchased at. The CII for a particular year is fixed by the government and released before the accounting year ends, for the purpose of tax computation.

Additional Reading: How do Interest Rates Affect Inflation?

Inflation-friendly Investments

We are sure you are keen to invest in inflation-beating options now. We have a few suggestions for you.

Equities & Equities Mutual Fund

This is one of the top options when people talk about inflation-beating investments. You can either invest in Mutual Funds that are heavy in equities or trade in stocks directly, if you have experience. If you are a stock market novice then it’s better to go with Mutual Funds as they are managed by experts. This option is also good for those who have a small capital to invest and want to take the SIP route.

But, if you are investing in Mutual Funds then look for a period of at least three years. The longer your tenure, the higher your rewards will be.

Dividend Paying Stocks

If you have a soft corner for stocks then consider dividend-paying stocks. They are known to give better returns than bank deposits such as Fixed Deposits and Recurring Account. But do your research before investing in a stock. Study the financial details of the company, compare with peers and take guidance from experts before picking your favourite lot.

Gold & Real Estate

Gold has always been a favourite with people in India. The shiny metal has so far lived up to its reputation. Barring a few declines, the price of gold has historically always been on a rise. Gold is definitely a great hedge against inflation.

You can also look at real estate. Investing in the right property can offer returns to the tune of 25-100%.

Inflation-indexed Bonds

These bonds are an excellent shield against inflation. They work in a manner that protects both the principal amount invested and also the interest earned on it.

Additional Reading: Investments That Protect You From Inflation

Other than picking the right investment options it’s also important to diversify your funds into multiple investments. This will save your profits in case one of your investments doesn’t perform as expected. Another secret to making smart investments is starting early. We have Mutual Funds you might like.

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