What is Inflation ?

Inflation is an increase in the price of essential basket of goods and services that is required for a common man to survive (something like Roti, Kapda and Makhan) that is representative of a country as a whole. For example the basket of goods in India will include rice, wheat, kerosene, Dhal etc while that of the US could include corn, beef, bread etc as the eating behavior of people are very different.

To understand this better, imagine that India produces only two things namely rice and paper money printed by the Reserve bank of India. In a year when there is a drought and there is a bad crop, rice will become scarce. We therefore will tend to see the price of rice rise, as there will be more money chasing the few kilos of rice that is produced. Conversely, if there's a record crop of rice, we'd expect to see the price of rice fall, as farmers will reduce their prices in order to sell their entire crop. These 2 scenarios depict inflation and deflation respectively at a high level though in the real world inflation and deflation are changes in the average price of all essential goods and services for a country.

So in the recent past when India has been having a booming economy (measured by GDP growth) it leads to more jobs and hence more money with people. However, the output of essential items such as rice, wheat, vegetables etc did not keep pace with the growth. Thus there is more money and less items to buy and hence caused the increase in prices and thus leading to high inflation or increasing inflation.

There are multiple ways to control inflation. In this case, the government can allow import of those essential goods from abroad thus bringing in more supply of the items or release more grains from their PDS (Public distribution system or Ration shops – these are sold to the lower strata of society at a lower price) quota and thus meeting the demand of the consumers.

The government can also control the amount of money in the system. Therefore the Reserve Bank of India increases the interest rates thus trying to prevent business from borrowing money. At every increase of interest rate, there will be one section of the society that will find it difficult to borrow either for business purposes or personal loan or home loan etc. Thus when business is not able to borrow money it internally slows the growth of the companies as it does not have the necessary money to expand their business (True especially for manufacturing companies that need to borrow money for expansion). Similarly when you do not borrow money to buy a bike or car, the demand for car and bikes come down and so on and this affects the car manufacturing company and in turn the car manufacturing company needs lesser workers to produce lesser cars. Some people could lose their jobs. If the company does not scak the employees, their profits will come down and to maintain the profit growth, salary hikes wil be lower, shareholders will have lesser money as decreased profits means that the value of the share comes down etc. This has a rippling effect on the economy till such time that the prices of the essential goods adjust to the new availability of money in the system.

In a nut shell, inflation is caused by a combination of four factors:
* The supply of money goes up.
* The supply of goods goes down.
* Demand for money goes down.
* Demand for other goods goes up.