Inflation means an increase in the level of prices of goods and services in an economy and the subsequent fall in the purchasing power of money. Simply put, it means that something costs more today, then it used to in the past. What I buy for Rs100 today will cost me Rs110 a year later if the inflation rate is 10%. This means that I would need increasing amounts of money to buy the same basket of goods as time goes on.
How is it calculated?
There are two popular indices of inflation. The Whole Price Index (WPI) measures the price at a wholesale level and the Consumer Price Index (CPI) works more as a cost of living index.
How does it affect you?
Inflation affects different people in different ways. For a salaried person, who sees an annual salary increment, inflation does not really reduce purchasing power since increments build in the current annual inflation rate. For a retired person on a fixed interest income, inflation has a nasty bite. They face higher prices year-on-year while their income stays the same. Inflation works well for borrowers. Suppose you borrow Rs1 lakh that you are to pay back after one year. If prices rise by 15%, you would pay back Rs85,000 in terms of purchasing power, though the nominal value would remain Rs1 lakh. Salaries, rents and dividends are incomes that work well as inflation hedges. Interest income suffers from regular hits on purchasing power year-on-year.