‘Back in the day, we could buy so-and-such goods for under ₹100, and today these products are so expensive’ you could have heard this comment from your parents or grandparents at least once. For that, we can thank inflation. A secure financial future depends on being aware of and keeping up with inflation.
What Is Inflation?
Inflation is the rise in prices of different commodities and services over a predetermined period (usually one year). In other words, inflation is indicated by a decline in the purchasing power of money. For instance, imagine that the same amount of milk you paid $55 for a year ago now costs you $58. This indicates a 5.45% annual loss in the purchasing power of money to buy milk. This is a prime instance of price inflation.
The rate at which the cost of goods and services rises or the purchasing power of money falls is known as the inflation rate.
Similarly, lifestyle inflation is when your expenditure rises due to increased income. When something previously a luxury has changed from being a need, this is called lifestyle inflation. For instance, if your pay increases and you decide to go out for elegant dinners more frequently—say, twice a week instead of once every two weeks—this is an example of lifestyle inflation.
What’s Behind Inflation?
1. An excessive supply of money
When more money is circulating in an economy than things are being produced, which means more money is chasing the same amount of goods, the money supply is considered excessive. In turn, this causes money’s value to decline, which leads to inflation.
2. Inflation is driven by demand
An ample money supply could lead to inflation driven by demand. Demand for products and services rises to a level that the supply side cannot keep up, which is called demand-pull inflation. Businesses might need help to grow output swiftly shortly.
For instance, in 2020, the pandemic severely impacted company operations. When the economy began to recover, the commodity demand rose significantly, but there wasn’t enough to satisfy the demand, leading to inflation.
3. Price-driven inflation
Businesses may raise the prices of their products to pass on rising manufacturing costs to final customers. Cost-push inflation is the term used to describe price increases for items due to rising production costs.
For instance, the geopolitical conflict between Russia and Ukraine contributed to the increase in the price of oil and petroleum products, which impacted many enterprises and raised the cost of many products.
How to Measure Inflation?
There are various methods for measuring inflation. The Consumer Price Index (CPI) and the Wholesale Price Index are two (WPIs).
Consumer Price Index (CPI)
The retail industry uses the Consumer Price Index (CPI) to measure inflation. It is estimated using a basket of 260 goods for food, transportation, education, electronics, healthcare, and other categories. The price change of the basket is contrasted with a reference base year.
Here is the formula for CPI.
CPI = (Cost of the basket / Cost of the basket in the base year)*100
Wholesale Price Index (WPI)
As its name suggests, the Wholesale Price Index (WPI) tracks wholesale inflation. It is computed using 697 commodities, including cement, metals, chemicals, crude oil, minerals, and oil. WPI is also evaluated in comparison to a standard base year.
WPI = (Current price / Base period price)*100
How to Protect Your Income against Inflation?
Although managing your finances is under your control, you cannot control inflation. You should consider reviewing your spending plan and making the necessary changes to protect your income from inflation. You may also consider using these financial strategies to beat inflation or protect yourself from it.
Invest in the stock market
Although inflation may reduce your returns, investing in savings accounts or fixed deposits is good. As a result, consider investing in financial instruments like stocks, mutual funds, exchange-traded funds, etc., that provide compounding returns. They can give you returns that outpace inflation even though they cannot guarantee returns.
Diversify your portfolio geographically
If you want to lessen the adverse effects of inflation on your portfolio, consider investing in different financial products across different nations. Your investment returns may be less impacted, for example, if you have equities in both India and the United States and India experiences severe inflation while the United States is doing well.
Invest in gold and real estate
You should consider investing in non-traditional channels. These alternative investments, which can hedge against inflation, include gold, real estate, and others. They have frequently provided returns more significant than the inflation rate in the past.
You can also invest in financial assets that mirror the performance of tangible assets like gold and real estate, such as digital gold, gold exchange-traded funds (ETFs), real estate investment trusts (REITs), etc.
Buying inflation-indexed bonds (IIBs)
By purchasing inflation-indexed bonds, you could protect your capital from the damaging effects of inflation. The principal amount and coupon payments on these bonds are modified to reflect changes in the inflation rate.
Living in an inflationary economy
The secret to long-term success is planning. Although you have no control over the economy, you have power over how much money you spend and save.
Although moderate inflation may initially appear scary, some economists view it as a sign of an expanding economy. It’s hardly likely that inflation will stop. As a result, considering inflation when making financial decisions rather than avoiding it may help you accumulate long-term wealth.
