Inflation is a key macroeconomic concept affecting individuals, firms, and governments. Understanding how it is measured and its economic impact is vital for informed analysis.
What is inflation, deflation and disinflation?
Inflation
Inflation refers to a sustained increase in the general price level of goods and services in an economy over a period of time. As inflation rises, the value of money falls, meaning that each unit of currency buys fewer goods and services. This erosion of purchasing power affects consumers, savers, and wage earners.
Example: If the inflation rate is 3% per year, an item that cost £100 this year would cost £103 next year.
Inflation is commonly expressed as a percentage change in a price index, most often the Consumer Prices Index (CPI).
Deflation
Deflation is the opposite of inflation—a persistent decrease in the general price level. It can indicate weak demand, excess capacity, or economic stagnation.
Example: A -2% deflation rate means that a product costing £50 would cost £49 the following year.
While falling prices might seem beneficial, prolonged deflation can lead to delayed spending, reduced investment, and economic slowdown.
Disinflation
Disinflation occurs when the rate of inflation is falling, but the price level is still rising. It is a slowdown in the rate of inflation, not a fall in prices.
Example: If inflation decreases from 5% to 2%, this is disinflation. Prices are still rising, just more slowly.
Disinflation may be a desired outcome of monetary policy, especially when central banks aim to bring inflation closer to their target (e.g., 2% in the UK).
How is inflation measured? The Consumer Prices Index (CPI)
The Consumer Prices Index (CPI) is the UK’s official measure of inflation. It is used by the Office for National Statistics (ONS) and influences monetary policy decisions by the Bank of England.
Basket of goods
The CPI is based on a virtual basket of over 700 goods and services that represent typical household spending in the UK.
The composition of the basket is reviewed annually to reflect changing consumer habits (e.g., inclusion of streaming services, exclusion of DVDs).
Items are grouped into categories such as food and drink, housing and household services, transport, and recreation.
This basket is designed to reflect what the "average" UK household spends money on, although it may not match every household’s consumption exactly.
Weightings
Each item in the CPI basket is given a weight that reflects its importance in household budgets.
Products that take up a larger share of household spending, such as energy bills or food, are given higher weights.
Less frequently purchased or less important goods, like cinema tickets, have lower weights.
These weights ensure that price changes in more significant items have a proportionally larger impact on the overall index.
Price collection
Each month, the ONS collects around 140,000 prices for 700 items from approximately 20,000 retail outlets across the UK, including supermarkets, shops, and online retailers.
Prices are gathered from varied geographic locations to improve representativeness.
Efforts are made to maintain consistency by tracking identical items over time.
Price changes are then calculated and combined using the weights to produce an average percentage change in the cost of the basket compared to a base year.
Calculating inflation
The CPI inflation rate is calculated as the percentage change in the index over a 12-month period.
For example, if the CPI index was 105.0 last year and 110.0 this year, the inflation rate is:
(110.0 - 105.0) / 105.0 x 100 = 4.76%
This means prices have risen on average by 4.76% over the past year.
Limitations of CPI
Although CPI is widely used and essential for policy, it has several limitations that reduce its accuracy as a true measure of the cost of living.
Substitution bias
Consumers may change their spending patterns in response to price changes by substituting cheaper alternatives.
For example, if beef prices rise, households may buy more chicken.
CPI does not fully account for this, leading to overestimation of inflation as it assumes people continue buying the same quantities.
Sampling and representation issues
CPI data is based on samples of goods, services, and retail outlets.
These samples may not fully represent the diversity of consumer experiences across the UK.
Regional price differences, rural vs urban spending patterns, and demographic factors can all influence the accuracy of CPI.
Exclusion of housing costs
CPI excludes owner-occupier housing costs, such as mortgage interest payments and council tax.
For homeowners, these are significant monthly expenses.
By excluding them, CPI may understate inflation for large segments of the population.
Regional and lifestyle variation
CPI is based on an “average household,” which may not reflect the real experience of:
Pensioners, who may spend more on healthcare.
Students, who may spend more on rent and travel.
Residents in London, where prices are typically higher than in rural areas.
This reduces the personal relevance of the CPI rate for many individuals.
What is the Retail Prices Index (RPI)?
The Retail Prices Index (RPI) is an older measure of inflation still used in some contexts, such as index-linked pensions, student loans, and rail fare increases.
Key differences between RPI and CPI
Inclusion of housing costs: Unlike CPI, RPI includes mortgage interest payments, rent, council tax, and other housing costs.
Formula difference: RPI uses the arithmetic mean, while CPI uses the geometric mean. This results in RPI often producing higher inflation rates than CPI.
Perceived reliability: RPI is no longer a “national statistic” due to concerns over its statistical methodology, but it remains in use due to legal and contractual reasons.
For economic analysis, students should be aware of both measures and understand why CPI is preferred for official use and why RPI still matters in certain financial decisions.
Causes of inflation
Inflation can result from demand-side or supply-side pressures, or from monetary expansion.
Demand-pull inflation
Occurs when aggregate demand (AD) increases faster than aggregate supply (AS), causing the price level to rise.
Causes include:
Higher consumer confidence and spending.
Lower interest rates (cheaper borrowing).
Increased government spending.
Higher exports due to global demand.
This type of inflation is common during economic booms and reflects an economy operating close to full capacity.
Example: A surge in tourism may increase demand for hotels, restaurants, and transport, raising prices in those sectors.
Cost-push inflation
Caused by rising costs of production, which are passed on to consumers through higher prices.
Common drivers:
Wage increases without matching productivity gains.
Increases in the prices of imported raw materials (e.g., oil, metals).
Exchange rate depreciation making imports more expensive.
Higher indirect taxes like VAT.
Example: If oil prices rise significantly, transport and delivery costs rise, increasing prices of goods across the board.
Cost-push inflation can occur even when demand is weak, leading to a stagflation scenario—high inflation with low growth.
Monetary inflation
Monetarist economists argue that inflation is caused by excessive growth in the money supply.
When more money is in circulation than the economy’s output, prices rise.
Based on the equation of exchange:
Money Supply (M) × Velocity of circulation (V) = Price level (P) × Quantity of output (Q)If M increases faster than Q, then either P must rise (inflation), or V must fall (less common in the long run).
This theory forms the basis of monetary policy tools, such as interest rate changes and quantitative easing, used to regulate inflation.
Impacts of inflation
Inflation affects all sectors of the economy. Its consequences depend on its rate, predictability, and causes.
Impact on consumers
Reduced purchasing power: As prices rise, a fixed income buys less. This particularly affects low-income households who spend a larger share of income on necessities.
Savings erosion: If inflation exceeds the interest rate, the real return on savings is negative. This discourages saving and may reduce future consumption.
Increased uncertainty: Inflation makes it harder to plan household budgets. Consumers may defer spending, especially on big-ticket items, leading to lower demand.
Impact on firms
Rising input costs: Increases in raw material and wage costs squeeze profit margins. Firms may be forced to raise prices, risking competitiveness.
Menu costs: Changing prices frequently (on menus, catalogues, systems) incurs real costs for businesses.
Investment decisions: Unpredictable inflation increases the risk of long-term investment, reducing capital expenditure and productivity.
Wage demands: Workers may demand higher pay to keep up with inflation, increasing pressure on business costs.
Impact on government
Fiscal drag: As incomes rise due to inflation, people may move into higher tax brackets, raising government tax revenue without changing tax rates.
Public spending pressures: If benefits and pensions are index-linked, inflation raises government expenditure automatically.
Real debt burden: Inflation can reduce the real value of government debt, making it easier to repay. However, high inflation may increase borrowing costs, as lenders demand inflation-adjusted returns.
Impact on workers
Real wage erosion: If wage growth lags behind inflation, workers experience a fall in real income, reducing their standard of living.
Bargaining difficulties: Inflation complicates wage negotiations. If expectations of inflation are high, workers may push for higher pay, risking a wage-price spiral.
Job insecurity: If firms cannot afford higher wages or lose competitiveness, they may reduce employment, leading to redundancies or shorter hours.
FAQ
The Bank of England targets a 2% inflation rate because it balances price stability with economic flexibility. A small, positive inflation rate encourages spending and investment, as consumers and firms expect prices to rise gradually over time. This helps sustain economic activity. A 0% target may sound ideal, but it risks deflation if economic conditions deteriorate, which can be more damaging than mild inflation. Deflation discourages consumption, increases the real burden of debt, and can lead to a downward economic spiral. On the other hand, targeting a higher inflation rate (e.g., 4% or more) can create uncertainty and erode confidence in the value of money. It may also lead to a wage-price spiral as workers demand larger wage increases. Therefore, 2% is considered optimal—it provides a buffer against deflation while maintaining public confidence in monetary stability and giving policymakers room to cut interest rates in downturns without hitting the lower bound too quickly.
Inflation influences exchange rates through its impact on international competitiveness and investor behaviour. When UK inflation is higher than that of trading partners, UK goods and services become relatively more expensive. This reduces demand for UK exports and increases demand for cheaper imports, worsening the current account balance. Consequently, there is less demand for the pound in foreign exchange markets, causing it to depreciate. A weaker pound makes imports more expensive, which can further fuel inflation—a process known as imported inflation. Additionally, high inflation erodes the real returns on UK-based investments, making them less attractive to foreign investors. This can lead to capital outflows and further downward pressure on the pound. Central banks may raise interest rates to combat inflation and attract foreign capital, which could strengthen the exchange rate—but only if monetary policy is seen as credible. Thus, inflation and exchange rates are closely linked in an open economy context.
Inflation affects income groups unequally due to differences in consumption patterns, income elasticity, and financial flexibility. Low-income households are more vulnerable because they spend a higher proportion of their income on essential goods and services, such as food, energy, and housing. These items often experience above-average inflation, meaning real incomes fall more sharply for these groups. Additionally, low-income earners are less likely to have inflation-protected assets like property or stocks, which can act as a hedge. Middle and higher-income groups might better absorb rising costs or benefit from wage increases tied to inflation. Moreover, these groups may have fixed-rate loans or mortgage payments that become cheaper in real terms if inflation rises. Retirees on fixed pensions may also suffer if their incomes are not index-linked, leading to reduced purchasing power. Therefore, inflation often exacerbates income inequality, as its effects are more burdensome on those least equipped to manage rising prices.
Inflation expectations significantly influence consumer behaviour, wage-setting, and business pricing decisions. If households expect inflation to rise in the future, they may increase current spending to avoid paying more later, which can actually push inflation higher—a self-fulfilling prophecy. Similarly, if workers expect future prices to rise, they may demand higher wages to preserve their real income, contributing to wage-push inflation. Firms anticipating higher costs may pre-emptively increase prices, further embedding inflation into the economy. Central banks monitor inflation expectations closely because they can signal whether inflation will remain anchored around the target. If expectations become unanchored—e.g., people expect 5% inflation instead of 2%—it becomes harder for the central bank to maintain price stability. Effective communication and policy credibility are therefore crucial. When people trust the central bank to keep inflation near its target, their expectations remain stable, reducing the risk of runaway inflation or deflationary spirals.
CPI represents inflation based on the average spending habits of a typical UK household, but it may not reflect the actual experience of specific demographic groups like students or pensioners. For instance, students may spend a larger proportion of their income on rent, transportation, and education-related expenses. If inflation in these sectors outpaces general inflation, students will experience a higher personal inflation rate. Pensioners, on the other hand, may allocate more of their budget to healthcare, energy, and food—categories that often have volatile or above-average inflation. Additionally, the CPI excludes owner-occupier housing costs like mortgage interest, but includes rents, which can distort real experiences further. CPI also fails to account for regional price differences, which can be significant—urban areas often face higher living costs. As a result, although CPI is useful for macroeconomic policy, it may not accurately capture the inflationary pressures faced by distinct groups, leading to misinformed policy or social tension.
Practice Questions
Explain two limitations of using the Consumer Prices Index (CPI) as a measure of inflation.
The Consumer Prices Index has several limitations. Firstly, it suffers from substitution bias, as it assumes consumers purchase the same basket of goods even when prices change. In reality, they may switch to cheaper alternatives, leading to an overstatement of inflation. Secondly, CPI does not account for variations in spending patterns across different demographics and regions. For example, retirees and students have different expenditure profiles, yet CPI represents an average household. These limitations reduce the accuracy and relevance of CPI as a true reflection of inflation experienced by all consumers.
Analyse how cost-push inflation may impact firms in the UK.
Cost-push inflation increases production costs for firms, such as higher wages or raw material prices, which can squeeze profit margins if firms cannot pass these costs onto consumers. This may force businesses to raise prices, risking a loss of competitiveness, particularly in export markets. Smaller firms may struggle more than large firms due to limited pricing power. Additionally, investment decisions may be delayed due to uncertainty, affecting long-term productivity. If input costs rise rapidly, businesses may reduce output or cut staff, leading to reduced efficiency and possibly a fall in economic growth.
