Inflation or the erosion in the purchasing power of money is a constant and global phenomenon. For instance, the basket of goods and services that we can acquire with Rs 1,000 is considerably smaller than what we could have acquired with the same amount of money 10 years ago. Inflation tends to be a self-fulfilling activity that can go out of control. In anticipation of high inflation, suppliers of raw materials and providers of labour services will demand higher payments for their contribution. Producers who have to absorb these higher costs will pass it on to their consumers in the form of higher prices for their output. The final result will be an increase in the prices of the end products.
If the economy is in the throes of a recession, unemployment levels will be high and wages will be low. In fact, in a deep recession, wages may actually decline. In such a situation, inflation will be low. However, when the economy is on a high growth trajectory, production may not be able to keep pace with demand.
Impact on fixed income
Inflation can be devastating for people like retirees who have a fixed income. In India, such people generally park their surplus funds in fixed deposits with banks, and the rate of interest from these deposits usually lags the prevailing rate of inflation. In some countries, the federal or central governments have responded with inflation adjusted bonds.For instance, the US government issues TIPS—Treasury Inflation Protected Securities. Such bonds give higher cash flows when inflation is high and lower cash flows when it is low. Thus the purchasing power of the returns from these bonds remains fairly steady.
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There are two ways of adjusting the payments from a bond for inflation. In a principal-linked bond (P-Linker) the principal is indexed to a price index and every period, interest is paid at a constant rate on the adjusted principal. The alternative is a coupon-linked bond or C-Linker where every period, the rate of interest is adjusted based on the inflation experienced, and this adjusted rate is applied to a constant principal.
Inflation could be induced by demand related effects or due to higher costs of factors of production. In demand-pull inflation, it is a case of excess demand which is outpacing the level of production. In cost-push inflation, the resultant rise in prices is due to higher costs of raw materials and increasing wage levels.
Market-power or profit-push inflation is a kind of cost-push inflation. When the output is controlled by a monopolist, it could dictate terms which could cause the prices of all related products to get inflated. In the case of wage-spiral inflation, a strong trade union can negotiate a substantial wage hike for its members causing a hike in price by employers.
Sunil K. Parameswaran
The author is visiting faculty at various business schools including IIMs