What is meant by inflation, how is it calculated?

Question

From the beginning of this year I am hearing the words called inflation in all indian news channels,what is it? what effects does it have on common man? how is it calculated? what does industrial growth have to do with it?

How is industrial growth calculated?Please explain these things to me in a way so that I and any layman can understand.

Answer 1

You ask several questions. I'll try to answer them all, but it will take a little time to walk through.

Inflation, strictly defined, is the rise in prices over time due to the growth of money supply relative to money demand. Think of it as the difference in prices between economies that are identical, except in one there is twice as much money as in the other.

However, most of the time, when people talk about inflation, they describe it as the general rise in prices over time regardless of the reason. However, there are factors other than excess money supply that cause prices to rise.

One is market forces. The price of anything will rise if demand suddenly increases or supply is decreased. Take rice prices - these are not rising because of excess money being printed, but rather because four of the world's major rice exporters (Egypt, India, Vietnam and Cambodia) have restricted the export of rice, and a fifth exporter (the U.S.) is suffering heavy flooding.

Another is the foreign currency exchange rate.  This has to do with the price of imported goods, which you must pay for in foreign currency and so you must trade domestic currency in order to get the foreign currency to buy them. This is what importers do - if an Indian company wants to import steel from Japan, it must exchange rupees for yen to pay the steel exporter. If trade is somewhat lopsided, that exchange rate will depreciate so that as time goes on it takes more rupees to get the same amount of yen to buy the same steel. The price in Japan hasn't changed, but the effective price the Indian company pays has.

It is important to note the differences. If inflation is caused by printing too much money, then the obvious solution is to reduce the rate at which money is printed (or, otherwise, devalue all currency, as Mexico and other countries have painfully done). However, if inflation is caused by a supply crunch, then reducing the amount of money available in the economy may compound the problem by making it difficult for businesses (which need financing) to borrow money.

The easiest way to tell the difference is this: if inflation has a monetary cause, all prices rise by roughly equal rates. If inflation has a market cause or a foreign exchange cause, then only certain products will experience a price rise. Technically, the latter isn't even inflation (it's the expected result of market forces) but this is the term the media use.

You ask about the effects on the common man. Where inflation is monetary and hence widespread, it makes it more difficult for the common person to get by, since all prices are higher. However, it does help debtors, who end up repaying less actuall purchasing power (since debts are established in units of currency and not indexed for inflation). Where inflation is market-driven, the common person may be able to shift consumption to those products that are not experiencing price increases. In the U.S., as the price of gas increases, people are changing their habits to use less gas. The price of a used SUV has plunged as drivers trade these behemoths in for smaller, fuel-efficient vehicles.

I should note that while economists can tell the difference between inflation from monetary causes and from market forces, if market-driven price increases continue upward on key products for long periods of time, they will eventually drive up related prices as well. Consider the price of corn, which is a staple food in the U.S. as well as necessary for making most processed foods, animal feed and ethanol. Due to factors of demand (increased beef consumption) and factors of supply (flooding in the corn-growing regions), the price of corn has skyrocketed. As such, the price of other meats that are fed corn (poultry, pork) has gone up, as has the price of many processed foods. Thus, while the source of inflation here is market-specific to corn, the effect appears much more like that of general inflation.

This is why economists differentiate "core" inflation from food and energy inflation.

Now you asked about calcuation. Simply, you subtract the price of a good at some earlier starting point from the price of a good today, and divide the difference by the price at the earlier starting point. It is a percentage, and when inflation as a rate is calculated it is generally in reference to a specific year.

For instance, right now the U.S. Bureau of Economic Analysis calculates inflation since the year 2000 - the average price level for 2000 is the benchmark. So the formula would look like:

[(Price in 2008-Price in 2000)/Price in 2000]*100

You can then graph the results and these will be on scale from 0 to infinity, but with most results between 80 and 200.

A score of 100 means that things cost exactly as much as they did in 2000. A score of 125 means they are, on average, 25% higher.

But what are we measuring the price of? Good question - a "basket" of goods. The basket includes a representative sample of what Americans consume in a given month. It isn't perfect - so many gallons of gas, pounds of beef, quarts of milk, square feet of living space to rent or pay mortgage on, etc. That basket eventually changes due to tastes and lifestyle, but the idea is to get an apples-to-apples comparison. Consider that the 1910 basket included mutton, something which I don't think most supermarkets carry today.

You ask what industrial growth has to do with inflation. There is not a simple answer to this. Industrial growth can feed inflation through market forces- and India currently is a good example of this. Industrial production requires tremendous amounts of raw materials and energy, and thus industrial growth increases the demand for steel, iron, coal, oil, concrete, gypsum, tar, etc. Also, industrial growth can contribute to monetary inflation. Since industrial growth often requires expansion of productive capacity, industries generally have to borrow money to finance that expansion. If many industries borrow at once, the interest rate goes up as a natural and expected result. If the government wishes growth to not be hampered by high interest rates, it lowers the central bank rates by making more money available (either by printing new money, or more often by buying securities on the open markets, which places more reserves out for use). If government manages the levels poorly and allows too much money out there, it may drive inflation.

Industrial growth is calculated as all rates of growth are:

(How much now - How much then)/How much then

What goes into growth - ie, what is the "how much" of? That is up to the one doing the calculation! But I would think it safe to measure either total revenue collected by industry, or total production in some homogenous unit (tonne of output, value of output, including inventories that are new but not yet sold).

You ask very many questions! I hope you enjoy learning!

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In response to your email about currency printing:

A nation generally holds sovereignty over its own monetary policy, including money supply. It may do as it wishes unless it has entered into agreements that restrict its behavior.

One example of this is the European Monetary Union, in which member nations share a common currency (the Euro) and agree to maintain their interest rates and inflation rates within a strict range of tolerance. While this does not expressly dictate how much the money supply may change, it does present an agreed range of monetary growth rates. Much of the discord within the EU comes from the larger member nations using expansionary monetary policy to improve their own situations at the expense of another member nation - indeed, early on Germany and France were both accused of these actions.

Another example of an agreement that restricts currency printing is a foreign exchange regime, such as the Bretton Woods accord under which member nations agreed to maintain currency exchange rates at a certain level, and held sway from after WWII until 1973. Again, the United States was often accused of "exporting inflation" because it would use an expansionary monetary policy (ie, print extra money) to pick itself up out of recessions, which would force other nations to do the same in order to maintain the exchange rate.

Finally, many nations have some mechanism to prevent excessive printing of the money supply. The example of 1930s Germany (with 6-digit inflation rates) is not forgotten. Indeed, where an independent entity is in control of the money supply (Federal Reserve Bank in the U.S., for one), the spectre of hyperinflation is very low because there is no political incentive to print excess money. Contrast this with Zimbabwe, where dictator Robert Mugabe simply printed extra money any time he needed to buy something.

Finally, it is possible for a nation to legislate the rate at which money should grow. I am not aware of any current legislation that does so, but it is not out of the question. At the same time, I am loathe to give such economic authority over to a group of lawyers with a self-interest in economic growth.

Now, there is a fine line between reckless printing of extra money (sometimes called "seigniorage") and inaccurate monetary policy. In the latter, there is no intent of causing inflation - it is simply a bad calculation or a misunderstanding of the situation. If you read Joseph Stiglitz's "Globalization and its Discontents", it describes what happens when a bad prescription is made for a developing economy's monetary policy.

The primary impact of excessive currency printing is quite vivid: rapid inflation across the board. The classic example is in the Veimar Republic, when waiters would stand on tables in restaurants to announce the new prices every few hours. More re

Answer 2

Zehra: The common man's income is not even close to $100,000 and if you're paying $10 for Fries, those better be the best fries in the world !

Answer 3

inflation is when prices increase, if McDonalds start selling fries for $10 that does not mean that inflation has taken place however if generally prices for all commodities have increased then inflation has happened.

its bad for a common man as now with the same income of $100,000 a person would be able to buy less than before... this would be so because generally incomes do not rise together with prices, however if someone is a businessman selling stuff so this situation would be good for him as now he can make extra profits but even costs would have increased too.

is it calculated by the use of CPI consumer price index, 1600 goods and services are taken on average these are such goods that people use the most such as petrol, food, housing, school education, etc... the recorded change is then calcuated in percentage, more than 5% is regarded as critical for the economy.

intially demand increases with inflation but then things start going downhill... industrial growth goes negative as firms find it expensive to set up however some might be benefitting but overall it is thought to be undesirable for the economy.

hoping that i explained it well enough for you... i love economics! =]