February 12, 2010

Inflation ke Reason kya hai?

I love my grandfather's stories. Who doesn't? We won't get into the ones that my grandma loves to scoff at. Like his brave encounters with tigers. Or the one about the milk that needed boiling.  But you must listen to this one. My dear grandpa used to buy 10l of milk for 50p and 40kg of rice for Re1 a good fifty years ago! 
Don't believe me? Then sample this. In those days, there were coins of 1p and even less! Incredible, eh? But I have seen those with my own eyes in my father's collection of old coins.
What more, I also remember seeing and transacting in 5p and 10p coins in my childhood. Alas! my friends won't get to see those currencies. Except in an collection of old coins perhaps! 
Wondering why I am rambling about 1p coins and getting into the generation business? 
This is not a "Kal Aaj aur Kal" story. Or maybe it is. 
If you have an eye for detail you will have noticed the common thread that runs through these anecdotes. The point that I have been trying to make is how expensive things have become over the years. 
My grandfather used to buy 40kg of rice for Re1 and today a kilo of rice costs Rs20! 10l of milk cost 50p in his days but today you need at least Rs120 to purchase the same amount.

See what the passage of time has done. It has eroded the value of money. Having Rs800 today is equivalent to having Re1 fifty years ago! 
Economists call it a decline in the purchasing power of money. Remember we encountered this term while getting acquainted with saving, borrowing and investing? The 'purchasing power of money' is the amount of merchandise that a unit of money (say a rupee) can buy. 
And the term 'inflation' has its roots right there. When the purchasing power of money dwindles with time, the phenomenon is called 'inflation'. This is manifested in a general rise in prices of goods and services.

But why do prices rise?

Let us understand why this happens with the help of a simple example:  Onions are an integral part of any food preparation in our country. Can you think of having a meal without having a dish that contains onion? Why, onion and chapattis constitute the staple diet for many people.
Let us assume the onion crop fails in a particular year, for whatever reasons.
What happens then? The supply of onions in the market drops. However, people still need onions. Inevitably, the price of onion shoots up as people scramble to buy the limited supply of onions. 
Remember November 1998? Such a situation actually happened in several parts of the country.  It nearly brought down the government! The price of onions rose to as high as Rs40 per kg or  more. 
But how does a simple thing like a one-off drop in onion supply cause prices to rise across the board in sustained fashion?. 
In the winter of 1998, the dabbawallas and restaurants were forced to hike their prices in response to the rising prices of onions. Even your local barber and maidservant demanded a higher pay to meet their higher daily expenses. All thanks to the (mighty?) onion. And this  set off a chain reaction. 


Think again. It is not only onions that we consume in the course of a day. There is a whole basket of products and services that we draw on, on a day-to-day basis. Hence, some of you decide to use more of garlic to make up for the lack of onion. The demand for garlic goes up. A few who eat raw onions decide to substitute it with more of tomato and cucumber. The local sabjiwala senses this shift in consumption happening. The smart businessman that he is, he hikes prices of all vegetables. He starts earning more money. Now his children demand that he should get them a new 21" TV with 100 channels.
And with all sabjiwalas rushing to the nearest TV shop, the sales for TV picks up. The TV company makes more money. Noticing the ballooning profits, the employees of the company demand a hike in their salaries. You are lucky to be working for one such company. You have more money in your pocket. And you have always wanted to buy a car...
We could go on and on, but you get the idea,don't you? The price rise is here to stay. Any guesses on who actually benefits and who loses from this rise? Can 'inflation' lead to prosperity? 
We are posing a lot of questions. Do not worry we will come back to answer them later. Write in at school@sharekhan.com to tell us. Maybe we will use your response itself!
But, for now we just need to understand the concept of inflation. After all, the main objective is to figure out how inflation affects the three friends we met last time - saver, borrower and investor.
Last time we understood how important it is for all of us to save. We all need to save for the day when we will not be earning but will still need to spend money on food, clothing and the occasional movie. 
What would have happened if my grandfather had saved a rupee fifty years back to buy rice now? Oh boy! It would have been a total rip-off. He would receive a few grains of rice in exchange for that amount.
In short, inflation is one BIG enemy of savers.

So, why should we save?

A good and important question. But we will come back to it later. We need to find out how this monster they call 'inflation' impacts our two other friends. We have already discovered that 'borrowing is the opposite of saving'. So if the saver is losing, our borrower must be winning.
Yes, of course. After all, the borrower borrows to spend today and repay later. Imagine if my grandfather had saved a rupee fifty years ago and my grandfather's neighbour had borrowed it from him. The neighbour could have bought 40kg of rice then and had a feast. In case he repaid the money to my grandfather now, all that my grandfather would have been able to buy is a few grains of rice!
To top it all, the borrower spends NOW and adds to the inflation effect, doesn't he? And compounds the misery of our saver.

What about our last friend, investor, the slightly difficult one to understand? 
Imagine once again (just one last time, we promise) that my grandfather's friend had invested a rupee in a paddy field, that is bought a paddy field with a rupee. The smart guy would have been raking in money today, selling a kg of rice at Rs20! 
Our investor friend seems a lot better off than even our borrower who benefits from inflation.
No wonder investing is always considered as a good thing to do to beat inflation. It is what textbooks call 'hedging inflation'.
Hey, but what is happening? Last time we understood that the saver, borrower and investor are good friends who complement each other. The saver meets the needs of the borrower and the investor. Life is in perfect harmony.
Now you are saying that 'inflation' upsets this balance completely. That the 'saver' is at a complete disadvantage while the other two benefit from this poor guy.
Is life so very unfair? Should we all stop saving? Or have we missed something very fundamental?
Well, life is never unfair. We have a leveler who comes to the aid of the saver - interest.
Next time, i'll  discover how interest offsets inflation and puts our saver on an equal footing with the borrower and the investor.

Source:share khan,Icici direct.

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