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14/10/2022

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5 mins read

What is inflation?

What is inflation?

Inflation refers to the hike in the prices of goods and services in an economy over time. The hike in prices signifies that purchasing power of the currency reduces or fewer goods and services can be purchased with the same amount of money.

Consumer demand and money supply affect inflation in the long run. Consumer demand may arise due to factors like an increase in population, an increase in money supply, etc. A rise in consumer demand means a rise in inflation.

Money supply can affect inflation too. Increased money supply means people in an economy have increased spending power leading to more demand than supply. To meet the increasing demand, prices rise, and inflation occurs. Other factors affecting inflation are cheap monetary policy, deficit financing, and a rise in black money.

How to Stop Inflation from Eating your Money?

Rising inflation is a painful reality. It hurts whenever the shopkeeper asks to pay a few extra bucks for the same thing. Surprisingly, the annual Inflation rate in India has surged to 7.79% in April 2022. Food inflation raised to 8.38%, a new record since November 2020. Retail inflation has been rising since September 2021 and reached 6.07% in February 2022.

But what exactly is inflation? Is inflation bad for an economy? How can inflation eat up your money? Most importantly, what can you do about it when it is not in your hands? Is it possible to generate wealth in times of rising inflation?

Let’s seek answers to all these questions in the blog.

How can inflation eat up your money?

Rs 1,00,000 saved in your locker today won’t be equal to Rs 1,00,000 at the end of the year because inflation eats a part of your money.

If you keep your money in bank FDs or savings accounts, you get returns that'll cover some effect of inflation, but your money won’t grow to the level that it outgrows inflation.

Investments with fixed annual interest rates, such as bonds, get affected by inflation adversely. Since you earn fixed returns every year, rising inflation will erode the value of returns each passing year. Investments with market-linked returns, such as equities, can outgrow inflation when markets are rising. But inflation rises as the market grows, and company's profits decline as they have to pay more wages. Hence, it depends on the company's performance.

How do you plan for inflation?

You can not control inflation because it's not in your hands. But you can plan your finances so that your money doesn't lose its value as inflation rises.

Due to the negative impact of inflation, experts advise not to keep all your money in bank FDs or saving accounts. When the inflation is higher than the returns, the returns that you get on Rs 100 investment will not be equal to Rs 100 tomorrow. This is because the 3-4% returns won't cancel the effect of 6% inflation.

Instead, plan to invest in investments that generate good returns over time, like equity mutual funds through SIP. These funds help beat inflation due to the compounding effect if you keep investing monthly, quarterly or yearly for several years. Moreover, these funds lead to wealth accumulation over time.

Investors who can't take the high risks that come with equity investment can invest in debt mutual funds. If one stays invested in a debt fund for more than three years, the capital gains from the debt funds are taxed after indexation.

Indexation is a method of adjusting an investment's purchase price to account for inflation. A greater purchase price implies lower profits, resulting in a lower tax rate.

Indexation allows you to reduce your long-term capital gains, lowering your taxable income. Compared to traditional fixed deposits, debt funds are an excellent fixed-income investing alternative because of indexation.

The solution lies in the diversification of assets. Investing in a mix of different assets such as equities (domestic and international), debt, and gold to match the investor's risk profile can help decrease the risk and optimise returns, thus beating inflation.

Conclusion:

Inflation isn't a curse for a country. However, investors should reconsider their investment portfolio and invest in various assets across different types, industries, and countries when inflation rises beyond expectations. Hence, diversification is the only solution.

This blog is purely for educational purposes and not to be treated as personal advice. Mutual fund investments are subject to market risks, read all scheme-related documents carefully.

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