What Is Inflation? Definition, Causes, and Impact

calendar 23 May, 2025
clock 10 mins read
what is inflation

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Picture this: Your favourite cup of coffee that cost ₹50 last year now costs ₹60. That extra ₹10 you're paying? That's inflation in action. As an investor or someone managing your finances, understanding inflation isn't just helpful - it's essential for protecting your money's purchasing power.

Inflation affects everything from your daily expenses to your long-term investment strategy. Whether you're a seasoned investor trading on platforms like FYERS or just starting your financial journey, grasping inflation's impact will help you make smarter money decisions.

Meaning of Inflation

Inflation is the sustained increase in the general price level of goods and services in an economy over time. Simply put, it means your money buys less tomorrow than it does today.

Think of inflation as your money slowly losing its strength. If inflation runs at 5% annually, something costing ₹100 today will cost ₹105 next year. This isn't about temporary price spikes during festivals or due to supply shortages—inflation represents a consistent, long-term trend.

The Reserve Bank of India (RBI) defines inflation as the rate at which the general level of prices for goods and services rises. When inflation increases, each unit of currency (like the rupee) purchases fewer goods and services than before.

Key Characteristics of Inflation

  • Sustained increase: Not a temporary price rise

  • General price level: Affects most goods and services, not just specific items

  • Measured over time: Usually calculated annually or monthly

  • Currency's purchasing power declines: Your money's value decreases

Consider this practical example: In 2010, the average price of petrol in India was around ₹50 per litre. By 2023, it had risen to approximately ₹100 per litre. This represents an inflation rate of roughly 5.5% annually for petrol alone.

Types of Inflation

Understanding different types of inflation helps you recognise what's driving price increases and adjust your investment strategy accordingly.

1. Demand-Pull Inflation

This occurs when demand for goods and services exceeds available supply. It's like too many people chasing too few products.

Example: During the post-COVID economic recovery, pent-up consumer demand led to higher prices for cars, electronics, and real estate. The automobile sector saw waiting periods extend to several months, driving up prices.

2. Cost-Push Inflation

This happens when production costs increase, forcing businesses to raise prices to maintain profit margins.

Real-world scenario: When crude oil prices spike, transportation costs rise, affecting prices across sectors—from groceries to manufactured goods. India imports about 85% of its oil, making it vulnerable to global oil price fluctuations.

3. Built-in Inflation

Also called wage-price inflation, this creates a cycle where workers demand higher wages to cope with rising prices, leading businesses to raise prices further.

Example: If living costs increase by 6%, employees negotiate for wage hikes. Companies pass these increased labour costs to consumers, creating an inflationary spiral.

4. Hyperinflation

An extreme form where prices rise uncontrollably, often exceeding 50% monthly. While India hasn't experienced hyperinflation, countries like Zimbabwe and Venezuela have faced such situations.

5. Deflation

The opposite of inflation - when general price levels fall. Japan experienced deflation in the 1990s, leading to economic stagnation.

Type of Inflation

Cause

Example

Impact on Investments

Demand-Pull

Excess demand

Post-pandemic recovery

Growth stocks benefit

Cost-Push

Rising production costs

Oil price increases

Energy sector volatility

Built-in

Wage-price spiral

Annual salary increments

Bonds lose value

Hyperinflation

Economic instability

Currency collapse scenarios

Flight to hard assets

Deflation

Falling demand

Economic recession

Cash gains purchasing power

Main Causes of Inflation

Inflation doesn't happen in isolation - multiple factors contribute to rising prices. Understanding these causes helps you anticipate inflationary periods and adjust your investment portfolio accordingly.

1. Monetary Policy and Money Supply

When central banks increase the money supply (printing more money), it can lead to inflation. More money chasing the same goods naturally drives prices up.

Indian context: The RBI's monetary policy decisions directly impact inflation. During the 2020 pandemic, the RBI cut repo rates to historic lows and increased liquidity, contributing to asset price inflation.

2. Government Fiscal Policy

Increased government spending, especially deficit spending, can drive inflation by boosting demand without corresponding supply increases.

Example: Large infrastructure projects or welfare schemes inject money into the economy, potentially increasing demand for construction materials, labour, and services.

3. Supply Chain Disruptions

Any break in the supply chain can create shortages, driving prices higher.

Recent example: The Suez Canal blockage in 2021 disrupted global trade, affecting prices of imported goods in India. Similarly, semiconductor shortages impacted automobile and electronics prices.

4. External Factors

India's economy is significantly influenced by global factors, which can in turn affect inflation.

  • Oil prices: Given India's high oil import dependency

  • Food grain imports: Weather conditions in exporting countries affect domestic prices

  • Global commodity prices: Metals, chemicals, and other raw materials

  • Exchange rate fluctuations: A weaker rupee makes imports costlier

5. Sectoral Bottlenecks

Specific sector constraints can drive inflation:

  • Agricultural: Monsoon failures, crop diseases

  • Manufacturing: Raw material shortages, labour issues

  • Services: Skills shortage, regulatory changes

6. Speculation and Hoarding

When traders expect prices to rise, they may hoard goods, creating artificial scarcity and driving prices up.

Example: Onion prices in India often spike due to hoarding by traders anticipating supply shortages.

Effects of Inflation on the Economy

Inflation impacts every aspect of the economy, affecting individuals, businesses, and the government differently. As an investor, understanding these effects helps you position your portfolio strategically.

Impact on Different Economic Groups

For You as an Individual:

  • Reduced purchasing power: Your ₹1,000 buys less than before

  • Eroded savings: Low-interest accounts lose value (₹1 lakh at 3% interest vs 6% inflation = -3% real return)

  • Fixed debt advantage: Repay loans with "cheaper" money

For Businesses:

  • Higher input costs squeeze margins

  • Pricing power determines success

  • Asset-heavy companies benefit from appreciation

For Government:

  • Increased tax revenues from higher nominal incomes

  • Reduced real debt burden

  • Higher program costs and political pressure

Sectoral Impact Analysis

Sector

Impact

Explanation

Banking

Mixed

Higher interest rates boost margins, but loan defaults may increase

FMCG

Negative

Margin compression if unable to pass costs to consumers

Real Estate

Positive

Property values typically rise with inflation, but higher interest rates on home loans may play a spoilsport

Technology

Neutral to Positive

Often maintains pricing power, benefits from asset appreciation

Pharmaceuticals

Mixed

Input cost pressures vs. the essential nature of products

Energy

Positive

Oil & gas companies benefit from higher commodity prices

Long-term Economic Consequences

Moderate inflation (2-4% annually):

  • Encourages spending and investment

  • Indicates healthy economic growth

  • Allows for wage adjustments

High inflation (above 6%):

  • Discourages savings in traditional instruments

  • Creates uncertainty in business planning

  • May lead to social unrest

  • Forces central bank intervention through higher interest rates

Real-world impact: During India's high inflation period of 2010-2012 (averaging 8-10%), the RBI raised repo rates to 8.5%, slowing economic growth but eventually controlling inflation.

How Inflation Is Measured? (With Formula)

Accurately measuring inflation helps policymakers, businesses, and investors make informed decisions. India uses several methods to track inflation, each providing different insights.

Consumer Price Index (CPI)

The CPI measures changes in prices that consumers pay for a basket of goods and services. In India, the CPI is the primary inflation measure.

Formula:

Inflation Rate = ((CPI in Current Year - CPI in Base Year) / CPI in Base Year) × 100

Example calculation:

  • CPI in 2022: 125

  • CPI in 2023: 132

  • Inflation Rate = ((132 - 125) / 125) × 100 = 5.6%

Wholesale Price Index (WPI)

WPI measures price changes at the wholesale level, reflecting producer costs.

Key differences from CPI:

Aspect

CPI

WPI

Perspective

Consumer/Retail

Producer/Wholesale

Coverage

Goods + Services

Primarily Goods

Weight

Urban + Rural

Manufacturing heavy

Policy Focus

Primary for RBI

Secondary indicator

Core Inflation

This excludes volatile items like food and fuel to show underlying price trends.

Why it matters: Food and fuel prices can be affected by temporary factors (weather, global events), while core inflation reflects fundamental economic conditions.

Step-by-Step Inflation Calculation

Let's work through a practical example:

Step 1: Define the basket of goods

  • Rice: 10 kg

  • Petrol: 20 litres

  • Mobile bill: 1 month

  • Clothing: 2 pieces

Step 2: Calculate prices for two periods

Item

2022 Price

2023 Price

Weight

Rice (10 kg)

₹300

₹330

25%

Petrol (20 litres)

₹2,000

₹2,100

40%

Mobile bill

₹500

₹520

15%

Clothing (2 pieces)

₹2,000

₹2,200

20%

Step 3: Calculate weighted price change

2022 Total Cost = (₹300 × 0.25) + (₹2,000 × 0.40) + (₹500 × 0.15) + (₹2,000 × 0.20) = ₹1,475

2023 Total Cost = (₹330 × 0.25) + (₹2,100 × 0.40) + (₹520 × 0.15) + (₹2,200 × 0.20) = ₹1,545

Step 4: Apply formula Inflation Rate = ((₹1,545 - ₹1,475) / ₹1,475) × 100 = 4.75%

Official Indian Inflation Data Sources

  • National Statistical Office (NSO): Publishes monthly CPI data

  • Office of Economic Adviser: Releases WPI figures

  • Reserve Bank of India: Provides comprehensive inflation analysis

Understanding Inflation Data

When you see headlines like "Inflation touches 5.8% in March", here's what it means:

  • Year-over-year comparison: Prices in March 2024 vs March 2023

  • Month-over-month: March 2024 vs February 2024 prices

  • Core vs headline: With or without food and fuel

How to Protect Yourself From Inflation?

Inflation can erode your wealth, but smart planning and investment strategies can help you not just survive but thrive during inflationary periods. Here's your practical guide to inflation-proofing your finances.

1. Build a Diversified Portfolio

Balancing different asset classes helps mitigate inflation risks:

  • Equities
    Stocks tend to beat inflation in the long run. Focus on sectors like FMCG, commodities, and banking that thrive in inflationary times.
    Example: ₹1 lakh in Nifty 50 in 2010 grew to ₹4.5 lakhs by 2023.

  • Real Estate & REITs
    Property values and rental income usually rise with inflation, offering long-term protection.

  • Gold & Commodities
    Physical assets like gold preserve value. Gold has delivered ~13% annual returns from 2000 to 2020.

  • Debt Instruments
    Use short-term debt funds and floating rate bonds to stay responsive to interest rate changes.

  • Cash
    While offering no inflation protection, cash is necessary for liquidity and emergencies.

2. Invest Regularly with SIPs

Systematic Investment Plans (SIPs) help manage market volatility. Mutual funds are one of the easiest and safest ways to invest in equities.
Example: ₹10,000/month for 10 years at 12% returns grows to ₹23.23 lakhs. Adjusted for 6% inflation, its real value is ₹12.97 lakhs.

3. Manage Debt Wisely

Fixed-rate loans become easier to repay as inflation rises and your income grows, but EMIs remain constant.

4. Pick Inflation-Resilient Sectors

Focus on:

  • Beneficiaries: Energy, materials, banks, real estate

  • Defensive sectors: Consumer staples, utilities, healthcare

5. Short-Term Protection Tools

  • High-yield savings accounts for emergency funds

  • Short-term debt & liquid funds to beat fixed deposit returns

6. Long-Term Wealth Strategies

  • Invest in your skills to boost income potential.

  • Create passive income via rentals, dividends, or side hustles.

  • Go global with international funds and  ETFs

7. Review & Rebalance Regularly

Track your:

  • Real returns (after inflation)

  • Emergency fund adequacy

  • Debt levels

  • Portfolio performance (monthly, quarterly, annually)

8. Use Tax-Efficient Investments

  • ELSS funds for tax savings and equity growth

  • PPF and NPS for long-term wealth building with tax benefits

Conclusion

Understanding inflation and its impact on your finances is crucial for building long-term wealth. By recognising inflation's causes and effects, you can make informed investment decisions that protect and grow your money's purchasing power.

Remember, inflation is a reality you need to plan for, not fear. With proper asset allocation, regular monitoring, and a long-term perspective, you can not only beat inflation but also use it to your advantage. Whether you're trading on sophisticated platforms like FYERS or just starting your investment journey, keeping inflation in mind will make you a more successful investor.

FAQ

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FAQ

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FAQ

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Inflation means things become more expensive over time. If your groceries cost ₹2,000 this month and ₹2,100 next month for the same items, that's inflation—your money buys less than before.

No. Moderate inflation (2-4% annually) signals healthy economic growth. The RBI targets 4% inflation with a ±2% tolerance band. Problems arise with high inflation (above 8%) or deflation, which can indicate economic trouble.

Inflation erodes purchasing power. A savings account earning 3.5% loses value when inflation runs at 6% (real return: -2.5%). That's why diversifying into equity mutual funds, real estate, or gold helps maintain wealth over time.

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