Question: In 2006, inflation was 7.4% and your annual salary increment was 8.5%. You persuaded your employer to guarantee a 10% hike next March. He kept his promise. In 2007, inflation was 10.2%. In which year did you have a higher purchasing power?

Answer: 2007 (That’s a no-brainer)

Remark: Wrong

Click here to see graphic: Unprofitable magic

No, this isn’t a misprint. Your purchasing power was higher in 2006. Your income after an increment of 8.5% was 1.1% more than the extra amount you had to pay for buying goods and services. In 2007, what you paid was 0.2% more than what you earned. So your purchasing power actually declined when your increment was higher. And the culprit is the higher rate of inflation.

Most people don’t realise this. They think of money in nominal terms, that is, what they get in hand. The income and value of their assets is not adjusted to inflation.

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Thus, most people are under the illusion that their net worth is higher than it actually is. Acclaimed economist John Maynard Keynes called it the money illusion. It is the perception that an increase in income increases the overall purchasing power when, in fact, a price increase of a similar or higher proportion results in the same or lower purchasing power, respectively. How much damage does money illusion cause? Cumulatively, quite a lot. The following table provides the difference in numbers.

— By Kamya Jaiswal and Sameer Bhardwaj

 

Types of inflation

Depending on its cause, inflation can be of two kinds: costpush or demand-pull inflation. When prices of raw materials “push” up the prices of goods and services, resulting in a decrease in their supply, it is called cost-push inflation. Supply chain bottlenecks can also cause a shortage of goods, leading to cost-push inflation. The current price rise in India largely falls under this category.

Demand-pull inflation is when an increase in demand for goods and services “pulls” up their prices. It is the condition of “too much money chasing too few goods”.

Developing countries like India are less prone to overall demand-pull inflation as a majority of the population is not prosperous. This phenomenon occurs more in wealthy countries. The measures to control the two types of inflation are different.

For instance, raising interest rates is more effective in economies facing demand-pull inflation as it encourages people to save more and borrow less. This sucks out excess money from the economy. Many experts believe that since inflation in India is not caused by an increase in demand but constriction in supply, monetary measures like increase in repo rate and cash reserve ratio, which in turn increase the interest rates, are unable to rein in price—and, in fact, stoke it.