Inflation and its causes in simple terms by Finlessons

The lesson ‘ Inflation and its causes’ explain Inflation and its reasons in simple terms.

A general rise in the prices of goods and services is called ‘Inflation.’ In a developing country like India, it is a significant concern. Let’s explore the causes of it.

To know more about Inflation, click here.

Inflation and its causes

The significant causes of Inflation are Demand-Pull Inflation and Cost-Push Inflation. However, we have covered a few other reasons also in simple terms.

Demand-Pull Inflation

More demand for goods and services causes Inflation. And, It is one of the primary causes of Inflation.

To understand it with an example, suppose a greengrocer had 20 bunches of Radish, and he was selling it for Rs 25.00 per bundle. Due to religious sentiment, 50 people jumped to buy all of that. What do you think the price of Radish will go up or down?

It must go up.

The opposite is also exact. In a recent case, Maharastra’s farmers threw away tomatoes frustrated by low prices due to lesser demand during the Covid-19 lockdown. To read the news, click here.

You can observe that the prices of goods and services go up during an increased demand and vice-versa.

 Cost-Push Inflation

Another major cause of Inflation is the rise in production cost. It is also a primary cause of Inflation.

To understand it with an example, suppose Roshan is working in a paint company. They agitated to raise their wages or salaries, and the company also raised it after a lot of hustle-bustle.

The paint company uses crude oil as raw material. Suppose, the prices of crude oil jumped up 30% per barrel. What do you think the cost of paint will go up or down after these two incidents?

It must go up as the cost of production has increased.

An increase in the prices of services like transport, warehousing, etc. and utilities like electricity and water can also increase production cost, causing Inflation.

Government Spending

Many times the government of a country increases its expenditure higher than its income. It causes Fiscal Deficit.

To meet its expenditure, the government may print more money. It floods up the economy with cash and causes Inflation.

The best example of it is the present situation of Covid-19. The world economy is struggling for existence. India plans to inject Rs 20 lakh crore around 10% of its GDP (Gross Domestic Product). Its tax and revenue have come down due to lockdown.

Thus, such a massive amount of money will cause Inflation as the production of goods and services has gone down in the same period.

Inflation Expectation

We expect that the prices of goods and services will increase over time, causing ‘Inflation.’

To cite an example, when people think that property prices will rise, they tend to buy it as soon as possible. It creates more demand for properties, and the price goes up.

Someone who is on the sideline feels that the price of properties is going up. He suffers from FOMO (Fear of Missing Out) and joins the party causing Inflation.

Population Growth

The population growth is another also an essential cause of Inflation. More people mean more demands for goods and services.

To take an example, India has limited resources to meet the growing demands of its people. More people mean more houses, more food, more luxuries, more dresses, more lands, etc.

At the same time, more people mean more producers and more suppliers, which can control Inflation. Thus, it is not the people; but the balance in the demand and supply system responsible for Inflation.

Hoarding

In economics, hoarding means obtaining and keeping commodities in quantities higher than needed. That creates an artificial scarcity of products. Thus, it causes Inflation.

People who hoard are called hoarders. They do it to make a profit when the prices of the commodities go up. Hoarding is illegal, but it is common practice.

Sometimes, ordinary people also make this mistake. They believe in a hoax circulating in social media about the shortage of a particular commodity and hoard it. Though it is smaller in size, it is a sufficient cause for Inflation.

Imports 

Sometimes, when there is a rise in the overall spending capacity of people of a country, and the country is unable to meet the demands for goods and services, it imports.

The government now has to spend a lot on importing, causing Inflation.

Further, more import means depreciation of the exchange rate of the currency. As a result, the country has to pay more with each imported goods or services. It also causes Inflation.

Similarly, an increase in the prices of commodities in the international market also causes Inflation. The best example is raising the prices of Petrol and Diesel when the costs of crude oil increase in the Gulf countries.

An increase in the prices of Petrol and Diesel also makes transportation costlier causing widespread Inflation.

Remember – We use Crude oil as a critical raw material in several industries.

Income Tax Deduction

A reduction in Income Tax means more disposable income in the hands of people. If people feel that the economy will continue to grow, and they prefer to spend rather than save, Inflation occurs.

To cite an example, suppose Mr. Amit gets a salary of Rs 12 lakh per annum. He is in the 30% tax bracket. Therefore, his take-home (post-tax) salary is Rs 8.4 lakh (assuming no other deductions).

Suppose, after a few years, the government reduces it to 20%. Even if Mr. Amit has the same amount of salary, his take-home salary now will be Rs 9.6 lakh. Thus, an increase of Rs 1.2 lakh in his take-home salary.

There might be lakhs and crores of people like Mr. Amit, whose income will be soaring due to that tax reduction. If they plan to spend it, then Inflation is bound to rise.

Indirect Tax 

An increase in Indirect taxes like GST (Goods and services tax), Customs duty, etc. that is levied on the manufacture of goods and services within the country as well as coming from outside of the country, increase the price of products and services also.

Let’s understand it with an example; the current customs duty on gold is 12.5% and GST 3%. Therefore, it is 15.5% in total (12.5%+3%).

That means we bought gold for Rs 30,000 (not the exact price), then it becomes Rs 34,650 after adding customs duty and GST.

To your surprise, the customs duty was only 2% in 2012, and there was no GST at that time.

As you can see, the taxes on gold has been increased by 675% in just eight years.

Non-economic causes of Inflation

There may be some other causes of Inflation that non-economic. It may be a flood, a drought, an epidemic, a pandemic, a natural disaster, war, etc.

Let’s take an example, in a drought condition, the output from agriculture goes down, but demands may not drop; less food for the same number of people. Consequently, the price of agricultural products goes up, causing Inflation.

Inflation and its causes – Notes

  • The significant causes of Inflation are demand-pull Inflation and cost-push Inflation
  • Demand-pull Inflation occurs due to more demand for goods and services
  • Cost-push Inflation occurs due to an increase in the production cost
  • When the expenses of a government are higher than its income, it is called fiscal deficit
  • Government spending also causes Inflation
  • Inflation expectation also causes Inflation
  • Population growth can cause Inflation in some conditions
  • Hoarding creates an artificial shortage and causes Inflation
  • Uncontrolled import depreciates currency, and that causes Inflation indirectly
  • A lowered income tax means more disposable income in the hands of people, and that causes Inflation
  • Indirect taxes like GST causes Inflation
  • Some non-economic events like war, drought, flood, etc. can also cause Inflation

Inflation & Its causes – Sum up.

In personal finance, Inflation plays an important role. It has a long-lasting impact on you and your money. Therefore, an investor should master the topic.

The causes of Inflation are high in numbers. It is impossible to cover all the reasons and sometimes may be irrelevant to my target audience. Therefore, I have presented you with only those causes of Inflation that matters to you as an investor.

There are more things in store for those persons who seek more.

I hope you enjoyed the post. Do share this post with your loved ones, please. Further, I would like to hear from you in the form of comments and suggestions.

Thanks and regards,

finguru@finlessons.com

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