Tuesday, May 17, 2022

Causes of Inflation Essay: Best and Easy Concept of Inflation PDF

Inflation is the term used to describe a decline in purchasing power evidenced in an economic environment of rising prices.

Inflation exhibits a loss in the purchasing power of money over time. Inflation means that the cost of an item tends to increase over time or put it in another way, the same dollar amount buys less of an item over time.

Inflation causes prices to rise and the decreases the purchasing power
of a unit of money with the passage of time.

Inflation and Deflation

Deflation has the opposite effect. Deflation is the opposite of inflation in that prices usually
decrease over time, hence, a specified dollar amount gains in
purchasing power.

Inflation and deflation are terms that describe changes in price levels in an economy. Inflation is far more common than deflation in the real world. Prior to this chapter, we have assumed that prices for goods & services in the marketplace are unchanged over extended periods of time.

Unfortunately, this is not generally a realistic assumption. General
Price Inflation is defined as the phenomenon of a general increase in
the prices paid for goods and services bringing about a reduction in the
the purchasing power of the monetary unit is a business reality that can
affect the economic comparison of alternatives.

Inflation is difficult to measure because the prices of different goods
and services do not increase or decrease by the same amount, nor do
they change at the same time.

Inflation rates are measured by the Wholesale Price Index (WPI), Producer’s Price Index (PPI), and Consumer’s Price Index (CPI).

Consumer’s Price Index (CPI)

CPI is based on a typical market basket of goods & services required
by the average common consumer. The market basket normally
consists of items food, housing apparel, transportation, medical care,
entertainment, personnel care and other goods & services.

CPI is a composite price index that measures price changes in these items.
CPI is a good measure of the general increase in prices of consumer
products. However, it is not a good measure of the industrial price

In performing engineering economic price indexes must be
selected to estimate the price increase of raw materials, finished
products, and operating costs.

To measure historical price-level changes for particular commodities, it
is necessary to calculate a price index.

Price Index (PI)

A price index is a ratio of the historical price of some commodities or services at some point in time to the price at some earlier point.

Suppose an individual can invest Rs. 100 at the present time with the
expectation of earning 15% annually for the next 5 years. At the end of
5 years, the accumulated amount will be FW = (1.15)5 = Rs. 201.10.

At present, an individual can purchase a commodity for Rs. 100, but
suppose that cost of that commodity increases at an annual rate of 10%.
At the end of 5 years, the same commodity will cost FW = (1.10)5 = Rs.

It may have a false impression that if the invested now, he can
purchase two commodities at the end of 5 years if he ignored the
changes in prices.

Purchasing Power of Money

Actually, he can purchase only 1.25 commodities. If earning power is 10% and the increase in commodity price is 15%, actually he can purchase only 0.80 commodities.

Thus, when considering the time value of money, one must include the impact of changes in prices (i.e. changes in purchasing power of money) as well as the effect of the earning power.

When incorporating changes in price levels in the engineering economic studies the index selected should measure those changes that are pertinent to the individual or organization
undertaking the study.

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