In the modern world the monster which scares our finances the most is a word we call “inflation”. In very simple words, Inflation is the rate at which the prices of the things we use increase year by year. So if we are told that the current inflation is 6 %, it means that the prices of goods or services worth 100 rupees we used last year has risen by 6 rupees this year, so it costs 106 now.
Now inflation in itself is not a bad thing as it is made out to be. It is as necessary as the pain you get in your muscles after a good workout. To increase the size of your biceps, you need to put it through the pain. Similarly a growing economy will always have the rate of its goods and services increase. That is exactly what it makes an economy grow; the increase in prices.
So let us take an example of a local town. The town has a farmer, a grocer, a baker, a hotel owner and a doctor. So the farmer grows wheat and sells it to the grocer at 5 rs per kg with some profit. This grocer now sells it to the baker who bakes cakes and then sells it to the restaurant owner at 10 rupees per kg making a rupee of profit from it. Now this hotel owner sells the cake to the doctor at 20 rupees per kg making some profit out of it. Finally the doctor treats the farmer in exchange of some fee, making money too. So we can see in this system everyone makes a little money irrespective of the cost of the material or service taken. But complexities are added later on.
Suppose this year and there is no good yield of wheat, so the farmer is forced to sell this wheat at 7 rupees now. Since the grocer is now forced to buy this wheat at a higher price, he will have to sell it to the baker at a much higher price, to maintain his profit. So this has an effect on the prices of every good and service that is exchanged in the town. Now this is a simple example of how economy works.
Now let’s consider how growth of the economy affects inflation. Let us take an example of Pune city and how inflation has affected the local economy of Pune. The growth of the city in general is credited to the education and the information technology sector. So this is how the growth in IT sector contributes to the cascading effect of local inflation. Since the IT industry depends on the payments by the west based organisations. The business model is based on the labour arbitrage, which in simple words means that we can do the same computer work done by the foreigners in much lesser wages. Even then the salary provided to the IT workers is still much higher than the industry standards of the Indian companies. So this caused high demand for IT jobs and flocking of skilled engineers to Pune. Now these people flush with disposable income look for ways to spend it. Now this is where they start spending and looking for a better lifestyle. This caused huge demand of various services, be it land and apartments to restaurants and education. Now for example when there is a huge demand for homes, it is natural for the land prices to increase, which the builder will quote to buy from the local land owners. Now this brings two sects, the IT people and now the past owners of the land to the economy. Both spend freely, thus bidding the price of daily services even higher. The construction of buildings will invite raw materials, skilled and semi-skilled workers to the city. The high demand will again increase the cost of the raw materials and labour. The money then given to the contractor will be spent into the services he consumes. Suppose he requires warehouse to keep his material, the warehouse owner will quote the rent higher sensing the demand of warehouses. The same warehouse owner will go eat out in a restaurant, which has increased the prices of his food since the costs of owning a hotel have increased. So this was just an example of how inflation works and how growth requires a healthy inflation rate to be maintained.
But then when exactly does inflation turns into a villain? It happens when it increases at a rate faster than the income growth rate of people increase. For example suppose the rent costs of a city have increased by 10 percent per year. So suppose the person making 10 lac per year paid 1 lac as rent will have to pay 1 lac 10 thousand this year. But if his income has grown just by 5 thousand per year means his spending power has decreased. This will be a sorry situation for him since he soon will have to either shift to a lower lifestyle or work more, both of which have psychological effects.
How inflation affects our savings is also important. We all know savings return us from anything between 6%. So if inflation has increased by more than 6%, then it means our idle money has actually lost its value this year. So it is important for inflation to remain in a desired level.

So since we have learned a bit about inflation, how it occurs and how it works, we will learn more about it in the later series of our blogs.

Thank you
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