It was a fine morning at the Singh household when suddenly this happened.
Lily: Mom, I want some money.
Mrs. Singh: Okay, how much?
Mrs. Singh: Why? You took money yesterday for books and stationery.
Lily: I am going out for a movie with my friends. I’ll need money to travel till the theatre, buy the ticket and who doesn’t enjoy a bucket of popcorn during a movie, right?
Mrs. Singh: You need ₹1000 for that? When I was your age, I could do all of these within ₹100 and have much more fun.
Lily: Mom, inflation! Duh!
Mrs. Singh: Do you even know what inflation is?
Lily: Uhh..yes! They taught about it briefly in our class. It has something to do with the rise in prices of goods, right?
Mrs. Singh: Inflation is not just an increase in the price of a particular good or service. It refers to an increase in the average price level of a large volume and variety of goods and services that are available in the economy over a period of time. Now the variety of goods may cover groceries, electronics, petroleum or even getting a haircut. In simpler terms, what you spend ₹1000 on now, I could get all those expenses covered in just 10% of the amount, say 25 years back.
Lily: So yesterday when we went to buy groceries, the price of mangoes had suddenly shot up. Is it because of inflation?
Mrs. Singh: Not necessarily. The increase in the price of mangoes might be because of a general shift in the tastes and preferences of the consumers. It might so happen that people are preferring mangoes over other fruits. Inflation is not a shift in tastes or rise in prices of a single commodity. Rather, it is a rise in the price level prevalent in the economy in general over some time.
Lily: So if there is inflation, what my ₹100 note can get me today, it cannot get me the same things two years later?
Mrs. Singh: Exactly! The real value of money gets depreciated. Money remains money but its purchasing power reduces. One unit of currency buys less than what it did during earlier periods.
Lily: So how does inflation get created in the economy?
Mrs. Singh: There are three ways in which inflation can rise in the economy. One of those reasons is the availability of more money in the hands of the people.
Lily: Isn’t it good that people have more money?
Mrs. Singh: It is good for people to have money, no doubt. The economy runs on a mechanism called the demand-supply relationship. When people have more funds in their hand, they tend to consume more, i.e., create a high demand for goods and services in the market. Now, supply and production are still limited. Thus, demand exceeds supply in this case. This raises the price level in the economy, triggering a rise in inflation.
There are other reasons for rising inflation. There could be a surge in the cost of raw materials which in turn gets reflected in the increasing prices of goods and services. Another reason could be rising labour costs. Labours can demand a hike in wages to adjust to the higher cost of living.
Lily: I see. It is a paradoxical situation. You spend more money and the value of your money decreases over time. To what extent does inflation affect us? And, how do we bridge this gap between inflation and the value of our money?
Mrs. Singh: There are various ways in which inflation affects us. There is uncertainty in the future. No matter how much we earn, it might never be enough. It can also lead to scarcities. In the threat of prices going extremely high in the future, people tend to hoard up, thus, creating a shortage of supply. It can give rise to a situation called stagflation; which happens when there is inflation, slow economic growth and high unemployment. Different people react to inflation in different ways. In fact, not all inflation is bad. Spending is as necessary as savings for the nation’s economy. With the lack of adequate spending, the economy will have a painfully slow growth which ultimately would lead to hundreds of additional difficulties. Low or controlled inflation can do good for the economy. Low inflation can help in reducing the severity of economic recessions. Property or stock owners might reap benefits from it since the value of their assets increase over time. Although, this can harm the cash holders since their purchasing power is getting compromised.
Lily: More questions! How can stock owners be benefited? I mean if companies face issues in taking big investment decisions due to the uncertainties posed by inflation, then how can our investment in their stocks grow? Also, what about fixed income groups? How do they cope up with inflation?
Mrs. Singh: Wait! I’ll answer your queries. No need to blow up your mind. Inflation might help in promoting investments. Rise in prices of goods and services lead to more revenue generation, which in turn yields better returns for the investors. Although, this highly depends upon the performance of a company and the economy. So smart investing might be able to help you in warding off the ill effects of inflation.
About fixed income groups, yes, it is a severe issue for them. To maintain a standard of living, the growth in your income should be greater than the growth in inflation rates. This is why, fixed income securities and investments like treasury bills, do little for aiding you against inflation. True that they help you gain a fixed amount of money over time, but the real value of that money decreases as well. Savings take a hit too. Consider this. Banks provide us with say, 3% interest on our deposits, but in a given year if the inflation rises to say 4%, then the money that we have deposited cannot help us in doing away from the inflationary effect on the market. With an increase in the inflation rate, the interest rate on debts available also rises. It makes debt costlier.
Lily: So how do we deal with this? How are you planning to save for your retirement?
Mrs. Singh: Smart planning and correct knowledge. That is all required to manage most of our financial decisions. Invest in options that will multiply over time and can act as a back up after retirement. Real estate and property seem to be wise decisions. These are high-value assets and generally generate good returns. Invest in quality healthcare and insurance policies that can protect you during unfortunate events. Investing smartly with proper risk analysis can help in growing our money exponentially. Portfolio diversification is vital. This will help you in safeguarding yourself when a particular asset or sector takes a hit. Investing and saving in the correct places can help us yield better returns. If you are not confident with the stock market, you
can begin little with mutual fund investments or index funds. Agreed that these measures require more risk than putting your savings into a savings account, but they are going to benefit you more as well. Risk is inevitable, but with proper understanding and analysis, it can be minimised. Similarly, there is no end to inflation, but there are ways to protect and maximize your wealth in an inflationary economic setup. If you don’t start planning early, you will have to face the brunt of it during your retirement.
Lily: I get what you are saying, Mom. I am well-versed with inflation for now. Can I have that ₹1000, please? I still want to go out for that movie. I will consider about inflation and its effects later.
Mrs. Singh: Okay, fine. Here you go.
Lily: Thanks, Mom. Bye. See you later.
Mrs. Singh: Bye, dear. Take care.