Inflation is the increase in prices of the things over a period of time.

This price increase occurs when there is more demand than the supply i.e. more money is chasing a certain commodity (or pool of commodities), which leads to increase in the price.

From where this extra money comes which leads to increased in demand more than the increase in supply over a period of time (in most cases supply is not constraint, leaving some exceptions!) ?

Answer is simple, only one institution can increase or decrease the supply of the money i.e. Government through the RBI. Whenever government needs money (for spending on the economy), it has two ways – First, collect it from the public in some or other way i.e. Tax, and there is only so much tax government can collect from the public so 2nd means is – Print new money through RBI to spend it on economy.

So, inflation increase with the additional new printed money floating in the economy and it reduces the value of the money which we have in our account/ pocket, like – a bag of vegetables for which you may have paid 100 rupees in last year may need 107 rupees in this year.

Did you noticed, ever though you and me did not pay any extra taxes to the government but indirectly the value of our money reduces due the extra money printing, which is equivalent to the more taxes (i.e. government got the money by printing it and automatically the value of money in our hand reduced!).

Most important thing to understand is, the inflation increases year on year on the last year price, so you just do not pay taxes at fix rate, it keeps on compounding. (refer – Difference between Simple interest and compounding)

Example – Lets assume, Inflation rate in Year 1, 2 and 3 was 7% Per annum. Lets see what was real increase in price of the goods (or decrease in the value of your money)

1st Year – 7%

2nd Year – 7.49% (i.e. 7% of (1.07%)

3rd Year – 8.01% (i.e. 7% of (7% of (1.07%)))

Even if you are not required to pay any tax, you do pay tax in terms of inflation!

It is also important to understand the impact of Inflation of how you save and where you invest. Just imagine you saved 6 lakh rupees every year (your current annual expense) for 30 year assuming that you will retire at 60 and will need money till 90 years of life but when you retired at 60, you realized that in last 30 year inflation has changed your cost of living to 10 lakh and in next 30 years it will increase to 15 lakh.

Please refer – Inflation and investing here