Inflation, who isn’t scared by this word. From common men to expert economists everyone is scared of this term.
Why? Because it causes loss of money. Both countries and individuals have to lose money during it.
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In this article, we will discuss Inflation and Inflation premium. We have explained these topics in the simplest words possible. Therefore stay with us till the end of the article.
It is the rise of the price of several goods and services for common use. Such as food, housing, transportation, etc.
In India, it is measured by the central Government authority which is the Ministry of Statistics and Programme Implementation.
It is caused by high demand or increased cash flow in the market. It has a decelerating effect on the country’s economy.
Deflation is the opposite. It means a fall in the price of several commodities due to a decrease in demand.
How are Inflation and Deflation caused?
The inflation gap is caused when the aggregate demand of a product or service increases than the aggregate supply of the same.
Therefore due to the rise in demand the prices of the goods or services rises steeply.
There is also another reason for this, high cash flow in the market.
The high cash flow increases the purchasing power of the citizens which thereby increases the demand and hence prices followed by inflation.
The deflationary gap is caused by a decrease in aggregate demand of a product than the supply.
Law of Demand and Supply
To understand it clearly, let us first understand price, demand and supply.
# Law of Demand states the relationship between the price and demand. It states that as the demand increases, price increases and vice versa.
# Law of supply states that as supply increases price decreases and vice versa.
It is different from the regular tax we pay to the government.
It is a penalty for holding excess cash during a high inflation period. Though the government does not charge it directly.
During this period, the value of cash decreases. People holding cash with them will eventually lose some of it.
The purchasing power of the cash will decrease and hence the value decreases.
Inflation Premium – Important Topic for UPSC
It is a method by which an investor calculates the normal rate of return on assets or investment during an inflation period.
In simple words, it is a part of the prevailing interest rate which results from investors pushing the nominal interest rates to a higher level to compensate for the expected inflation.
The actual rate of interest is calculated by deducting the premium from nominal interest rates.
The primary cause of this is the expectations.
When an investor understands the money they will receive will be of lower value.
Therefore they increase the interest rate to compensate for the loss caused by inflation tax.
Moreover, borrowers are ready to take loans at higher interest rates. They believe the price will rise further. They take loans at higher interest to buy different goods and services
Inflation premium includes three components:
# Risk-free return
# Risk-free rate
# Offset Credit risk
Effects of Inflation Premium on Investment
Inflation causes a negative impact on Investment’s return rate.
This has a big impact on the value of an investment over time, especially government bonds.
Suppose a government bond that uses 5% of return on the investment in one year, will yield 1% less because of the 1% of inflammation premium over there.
Inflation plays a catastrophic impact on investment especially with a very long horizon before maturity.
A government bond that will take 25 to 30 years to mature can result in being worth less than the initial investment due to the premium.
Therefore predicting the inflation rate over time is important for financial investing.
This can result in a negative rate of yield for investors investment.
It is important for long term security like bonds to factor in inflation before investing in it. They can consider trying government bonds based on the coupon rate.
The coupon rate is the percentage yield on the bond based on current interest rates.
How to Calculate Inflation Premium
To calculate risk premium we must compare the yields of bonds, which are otherwise identical, but only one of them is protected by it.
Some government bonds are protected by high prices, that is the coupon payments of face values are adjusted based on the supplies index.
Therefore the formula to estimate this is:
Inflation Premium = Yield on Treasury bond – The yield on treasury inflation protected security.
If you try to calculate it according to nominal rating and interest rate, then the formula would be
Inflation premium =
(1 + Nominal rate/ 1 + Real rate) -1
Difference between Inflation Premium and Tax
# Inflation premium is the rise in interest rate by investors while inflation tax is the decrease in cash value held by rich people.
# Inflation premium is directly charged while inflation tax is not directly charged.
# The tax is a penalty by the government for rich people to hold cash with them.
# While a premium is an increase in interest rate by investors to prevent themselves from loss.
Fiscal drag happens when a government fiscal position isn’t enough to fulfil the net savings desire of a private economy.
In simple words, where existing taxpayers move into higher tax brackets due to high price or income growth.
This helps the government to increase its revenue without in reason tax.
It helps in decrease in overall demand because of higher tax and because of it, price lowers down.
Chapter at Glance
It is a steep rise in the price of several commodities.
It is caused when aggregate demand increases aggregate supply. This causes rise in prices due to increased demand for goods and services.
It is also caused by excess cash flow in the market.
The tax is an indirect tax that is caused during inflation. It is not charged directly by the government. It is the decrease of cash value during this period.
It is referred to as the method to the rise in the prevailing interest rate. Investors pushes the nominal interest rates to higher levels to compensate for the expected increase in price.
Fiscal drag refers to situations where normal taxpayers are moved to higher tax brackets during higher prices.
We hope you have a better understanding of the topic.
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