Money that buys less
People say things have become expensive. The reason is inflation: a general increase in the price level of goods and services that erodes the purchasing power of money. Put 1,000 rupees in a drawer for a year and you still have the same note, but it buys fewer goods and services than it did, because everything has become more expensive. How much less it buys depends on the inflation rate over the period.
Two causes
To defuse inflation, policy makers reduce demand, increase supply, or do both.
A question describing a surge in consumer spending outrunning factories is demand-pull; one describing a jump in crude, wages or raw material costs is cost-push. The remedy in the options should match: cooling demand for the first, easing supply constraints for the second.
Two indices
Inflation is generally measured in two ways. At the wholesale level it is the Wholesale Price Index (WPI); at the retail level it is the Consumer Price Index (CPI). Economists define a basket of products based on general consumption and price it at wholesale prices for the WPI and at retail prices for the CPI. Statistics on both over several years give the inflation trend and feed the policy decisions of both the government and the central bank.
The link to interest rates
Interest and inflation are closely tied. Higher inflation demands higher interest rates for people to be motivated to save; as they save more they consume less. Higher rates, though, raise the cost of capital, reduce investment and may slow the whole economy. Some sectors feel it more: real estate and automobiles, where most middle-class buying happens through loans that become expensive when rates rise. Higher inflation also cuts the discretionary income people have, hurting demand for products and services across the board.
Inflation climbs, the central bank raises rates, and a car loan that cost 8% now costs 10%. The monthly instalment on the same car rises, marginal buyers postpone, and the car maker's volumes fall before anything about the car itself has changed. A property developer sees the same effect through home loans.
Unemployment
The unemployment rate is the share of the population that is eligible and willing to work but unemployed, in percentage terms. During a slowdown it rises; during an expansion it falls as rising production creates jobs. Higher employment means income, which improves people's ability to spend, which implies growth. The reverse holds for an economy in tough times with high unemployment.
- Inflation is a general rise in the price level that erodes the purchasing power of money: the same 1,000 rupees buys less a year later.
- Demand-pull inflation comes from demand exceeding available supply; cost-push inflation from rising input costs. Policy responses cut demand, raise supply, or both.
- Inflation is measured at wholesale level by the Wholesale Price Index and at retail level by the Consumer Price Index, each priced off a basket of goods; multi-year trends feed policy.
- Higher inflation demands higher interest rates to motivate saving, which cuts consumption; higher rates raise the cost of capital, cut investment and slow the economy, hitting loan-driven sectors such as real estate and autos hardest. Unemployment rises in slowdowns and falls in expansions.