First read this article to understand nature of Indian economy and National income calculation. In this article we are going to concentrate on Basic economics concept.Definition first: What is economics? It is the study of allocating merger resources efficiently.Almost all of the Resources are limited. So we should efficiently distribute it to the needy. That is what economics is all about.
What is inflation? For a ordinary people it is increase in price of everyday item. For a economist it is a decrease in the value of money. Why economy faces inflation? There are lot of reasons associated with inflation. One of the simple method to explain it is demand and supply method. In a simple situation,If a item has more demand and a supplier cannot meet the new demand ,then inflation occurs. Monetary theory says more money circulation in the economy causes inflation.How more money causes inflation? If salary of everyone in India is increased by 5000, everyone will demand something preferably food because many people people in India are below poverty line. So cost of food will increase. As food cost increases, labour cost too increases to meet new cost of food. Hence every item’s cost will increase so Inflation is a vicious circle. RBI uses Monetary tool to control inflation. Inflation is good, when it is around 2% of GDP because when there is zero inflation, it means zero economic development. Inflation is like a drug that needs to be taken in very small quantity for nation’s development.
What is Deflation? It is the decrease in price of items. It often means low economic activity. It may lead to recession. Recession may be defined as a economic situation in which there is lot of unemployment in the society ,demand for item becomes low and income of everyone in the is reduced.So deflation is very bad for economy.
How to handle inflation: RBI increases repo rate (interest rate at which RBI gives loan to private banks) ,Cash reserve ratio (percentage of amount needed to be deposited by every bank with RBI for which bank receives no interest)and statutory liquidity ratio(percentage of amount needed to be deposited by every bank in Government securities with RBI for which bank receives interest) and decreases Reverse repo(interest rate at which RBI takes loan from private banks) rate to contain inflation by absorbing more money from the economy.
How to handle Deflation:RBI decreases repo rate,Cash reserve ratio and statutory liquidity ratio and increases Reverse repo rate to contain deflation and to simulate more money in the economy(Just opposite strategy that was done to contain inflation).Note: Reverse repo rate in India is 1% less than repo rate. So you can independently decrease/increase repo and reverse repo rate. Tomorrow more banking terms will be discussed. If you are preparing for banking or Civil service in 2015. Please regularly visit this site for updates.