What is Inflation? What are its Effects?

Inflation is simply the rise in the prices of goods and services offered. In India, inflation is measured based on two metrics: CPI and WPI. Retail inflation and wholesale inflation are mapped by Consumer Price Index (CPI) and Wholesale Price Index (WPI), respectively. Today, we will see how inflation really affects various participants in the economy.

Impact on the Stock Market

When inflation occurs in an economy, the Reserve Bank tries to control it by increasing the interest rates. As the interest rate increases, debt instruments become more attractive to investors. They get a higher return and that too at a lower risk. Thus, more of the investment shift from equities into the debt market.

With inflation, prices of inputs/raw materials required by companies become more expensive which adds to their expenses. Generally, this cost is passed on to the end consumer. If a company's sales decrease due to this reason, revenues and profits will take a hit. The falling financials might give a negative indication to the stock market participants.

At the same time, if the company is able to maintain a similar level of sales, and does not show any other negative effect of inflation on itself, then its share price won't take a hit.

Impact on Loans

Does inflation favour lenders or borrowers? This question has always been in the mind of people. A borrower takes money from a creditor and promises him/her to pay it back at a later date. If inflation occurs during that tenure, it will aid the debtor by decreasing the real value of the money which he has to pay.

When the prices of goods rise, you can buy a lesser number of goods at a specific amount as compared to earlier when the prices were stable. The debtor is still obliged to pay a fixed amount that was agreed upon earlier. Thus, the real value of money that a debtor is paying back is less as the creditor will be able to buy less number of goods. Thus, the burden of the debt is reduced for the lender.

If that's the case, is the bank at a loss? The answer is both a yes and no. The loan which is already credited will give lesser real money to the creditor as the amount or the interest rate is fixed. But with inflation in the economy, demand for credit will increase. Suppose an individual needs a loan to buy a ring worth Rs 50,000. Inflation has increased the prices to Rs 60,000. As the bank charges a 10% interest rate, then instead of getting Rs 50,000, he will get Rs 60,000. Thus, a creditor might face dual effects of inflation.

Impact on your Savings Account

Inflation negatively impacts your saving account interest, especially if the inflation rate surpasses your savings account interest rate. Suppose your savings account interest rate is 1.5%. That means you would earn 150 rupees if your account had Rs 10,000. Suppose the inflation rate rises to 3%, then the increase to Rs 10,150 would not mean an actual increase in your income. In real terms, you will feel like you are actually losing money.