Decoding the complex terms inflation, purchasing power and average income

Inflation: This is an economic concept that simply means the rise in prices of goods and services over time. For example, you can find out the current price of apples per kilogram and see how it’s changed since 1980. Inflation occurs when prices go up due to rising production costs such as wages, raw materials, transportation, storage facilities and so on.

Several factors that can cause inflation:

  • Increase in demand: There is a direct relationship between inflation and the demand for a product. The surge in demand for a particular product leads to inflation. That means the consumer is ready to pay more for that product and there are not enough of the products to meet the demand. For example: If there is a surge in demand for housing in the city, the prices of houses will go up and that will cause inflation.
  • Low supply: Inflation is also caused when there is a decrease in the supply of goods and services because the requirements are not met. For example: if a flood destroys a large part of the harvest of a specific crop, this will lead to a decrease in the supply, causing inflation.
  • Rise in production costs: When the cost of manufacturing goods and services goes up, inflation occurs. This is caused when manufacturers pass on the rising production costs to consumers in the form of high prices. For example: If there is an increase in the cost of oil, it will affect many industries where oil is used to produce goods and services.
  • Inflation expectations: The rate at which people expect prices of goods and services to rise in the future leads to hoarding of products. People start to buy products now, expecting them to be more expensive in the future, leading to higher demand and higher prices.

Inflation can have various adverse effects, such as decreased purchasing power, increased costs for businesses, reduced savings and uncertainty.

Purchasing power: This refers to how much a person can buy with a unit of currency. For example: If you have a 100 Euro banknote that was printed 10 years ago, the note’s worth will still be the same today, but you can probably buy a lot less than you could back then.

Multiple economic factors have a significant influence on purchasing power:

  • Inflation and deflation: The main culprit of decreasing purchasing power is inflation. Inflation causes an increase in prices that in turn leads to a reduction in people’s purchasing power at the current income level. At the same time, deflation results in price drops, so relative purchasing power increases.
  • Currency exchange: Fluctuation in exchange rates greatly influences purchasing power. If a country’s currency gets devalued in comparison to that of another country, the prices of commodities from the second country will be higher in the first country’s currency. Although this does not have a direct impact on domestic products, businesses that depend on suppliers in the second country end up paying higher prices for imported goods. All these factors result in inflation and subsequently low purchasing power.
  • Supply and demand: Supply increases when companies produce more goods and services than are required. An increase in supply often leads to a decrease in prices. On the other hand, demand increases when there is less production than consumption. Increase in demand results in an increase in prices.
  • Increasing taxes: Consumers are left with less money to spend in case of higher taxes, which ultimately reduces purchasing power.
  • Price fluctuation: There is an inverse relationship between price and purchasing power. When the price drops, purchasing power increases, and when there is a surge in the price, purchasing power decreases.

Average income: This is the income earned by an individual in a specific location over a period of time. It is calculated by dividing the total income of the region by the entire population of that region. It is often called ‘per capita income’.

Written by Parul Sachdeva