Inflation for Beginners

Written by Fraser Stewart
Reading time 9 minutes
Inflation for Beginners image

Inflation is a term that often makes headlines, especially when the cost of living rises or when the economy faces challenges. But what exactly is inflation, and how does it impact the UK? Inflation is more than just a buzzword; it's a phenomenon that affects our daily lives, from the price of a loaf of bread to the interest rates on mortgages.

In this guide:

What is Inflation?

At its core, inflation represents the rate at which the general level of prices for goods and services rises, leading to a decrease in the purchasing power of money. In simpler terms, when inflation is high, each pound in your pocket buys a smaller percentage of a good or service than it did previously.

Key Terminology for Understanding Inflation

The table below summarises the key terminology with a definition and explaination. Don't worry if these do not make sense straight away, as we'll go through them in more detail through this article.

Term Definition & Explanation
Inflation The rate at which the general level of prices for goods and services rises, leading to a decrease in the purchasing power of money.
Deflation The decrease in the general price level of goods and services, leading to an increase in the purchasing power of money.
Purchasing Power The value of a currency expressed in terms of the amount of goods or services that one unit of money can buy.
CPI (Consumer Price Index) A measure that tracks the average change in prices over time that consumers pay for a basket of goods and services. Excludes housing costs.
RPI (Retail Price Index) An older measure of inflation that tracks the change in the cost of a fixed basket of retail goods. Includes housing costs.
Basket of Goods A collection of products and services used to measure and compare price changes over a specific period. Represents typical items consumed by households.
Demand-pull Inflation Occurs when demand for goods and services exceeds their supply.
Cost-push Inflation Arises when the production costs of goods and services surge.
Built-in Inflation A cyclical type of inflation where workers demand higher wages, leading to increased prices.

The Concept of Purchasing Power

Purchasing power is the value of a currency expressed in terms of the amount of goods or services that one unit of money can buy. As inflation rises, the purchasing power of a single unit of currency decreases.

Example: Imagine a scenario where the inflation rate is 2%. If a loaf of bread costs £1 this year, it will cost £1.02 the next year. So, if you had saved that £1 and didn't earn any interest on it, you wouldn't be able to buy the loaf of bread the following year. This illustrates the eroding nature of inflation on purchasing power.

Causes of Inflation

Note to Readers: The scenarios provided below are simplified examples to help illustrate the basic concepts of the causes of inflation. In reality, inflation is influenced by a myriad of factors interacting on a macroeconomic scale. These factors can include global events, government policies, international trade dynamics, and more. The scenarios are meant to serve as a starting point for understanding, but the real-world causes and effects of inflation are often more complex and multifaceted.

Demand-pull inflation Explaination: Triggered when demand for goods and services surpasses their supply. Factors like increased consumer confidence, government expenditure, or a booming economy can lead to demand-pull inflation.

Scenario: Imagine a popular new gaming console is released, and everyone wants to buy it. The demand is so high that stores run out of stock quickly. Seeing the high demand, the manufacturer might increase the price, knowing people are willing to pay more to get their hands on it. This is a simple example of demand-pull inflation, where increased demand leads to higher prices.
Cost-push inflation Explaination: Arises when the production costs of goods and services surge. This can be due to factors like rising wages, increased prices of raw materials, or geopolitical events affecting supply chains.

Scenario: Let's say there's a sudden increase in the price of oil due to geopolitical tensions in major oil-producing regions. This means transportation costs for goods will rise. A company that delivers fresh fruits might then increase the price of their fruits to cover these higher transportation costs. This is cost-push inflation in action.
Built-in inflation Explaination: This is a cyclical type of inflation where workers demand higher wages, and when they receive them, companies raise their prices to cover the higher wage costs, leading to a cycle.

Scenario: Workers at a large factory unionise and negotiate a significant wage increase. To compensate for the increased wage bill, the factory then increases the prices of its products. As these products are widely used, their price increase can lead to a general rise in prices, contributing to inflation.

How is Inflation Measured?

Inflation, often described as the "silent thief" of purchasing power, is a critical economic indicator that reflects the rise in prices over time. But how do economists and policymakers quantify this elusive concept? The answer lies in a tool called the Consumer Price Index, or CPI. The CPI provides a snapshot of the average change in prices that households pay for a specific basket of goods and services over time. By tracking the cost of this basket, the CPI offers a tangible measure of inflation, helping governments, businesses, and individuals understand the economic landscape and make informed decisions. 

What is a "Basket of Goods"?

A "basket of goods" refers to a collection of products and services that are used to measure and compare price changes over a specific period. This basket represents typical items consumed or used by households and is used as a benchmark to track inflation.

Selection of Items: The items in the basket are selected based on their significance and relevance to average consumer spending. They are meant to represent a wide range of products and services that a typical household might purchase, from food and clothing to entertainment and transportation.

Periodic Updates: The composition of the basket is not static. It is updated periodically to reflect changes in consumer habits, technological advancements, and the introduction of new products or services. For instance, with the rise of digital technology, items like smartphones might be added, while outdated items like VHS tapes would be removed.

Price Tracking: To measure inflation, statisticians track the price changes of each item in the basket over time. By comparing the total cost of the basket from one period to another, they can determine the overall price change and, consequently, the rate of inflation.

Representation: It's important to note that while the basket aims to be representative, it might not reflect the spending habits of every individual or household. Different people have different consumption patterns based on factors like age, income, location, and personal preferences.

Example: Consider a simplified basket of goods that includes a loaf of bread, a pint of milk, a pair of jeans, and a cinema ticket. If the combined cost of these items was £50 last year and is £52 this year, then the inflation rate, based on this basket, would be 4%. This is a very simple explanation, with the basket of goods now incorporating over 750 different items. 

CPI vs RPI: What's the Difference?

Consumer Price Index (CPI) and Retail Price Index (RPI) are both measures used to track the rate of inflation in the UK. However, they differ in their methodology and the basket of goods and services they consider.


Consumer Price Index (CPI) Retail Price Index (RPI)
Definition CPI measures the average change in prices over time that consumers pay for a basket of goods and services. RPI is an older measure of inflation that tracks the change in the cost of a fixed basket of retail goods.
Coverage It covers a broad range of household expenditure, including goods and services like food, clothing, health, transport, and recreation. It covers a broader range of goods and services than CPI, including housing costs like mortgage interest payments and council tax.
Exclusions It does not include costs associated with housing, such as mortgage interest payments and council tax. RPI uses a different formula than CPI, which can lead to a formula effect difference between the two measures.
Usage CPI is the measure used by the Bank of England to set its inflation target, which influences monetary policy decisions. RPI was traditionally used for wage negotiations and index-linked gilts. However, its use has declined in favour of CPI due to concerns about its methodology.

Key Difference: The primary distinction between CPI and RPI is the inclusion of housing costs in RPI. Additionally, the different formulas used can lead to variations in the reported inflation rate.

Inflation: Benefits and Disadvantages

Benefits of Inflation

  1. Debt Relief: For borrowers, moderate inflation can reduce the real value of debt. If wages rise with inflation, it becomes easier to repay loans taken in the past.
  2. Stimulates Spending: When consumers expect prices to rise in the future, they are more likely to spend now rather than later, boosting economic activity.
  3. Adjustment of Relative Prices: Inflation allows for relative price adjustments. If some prices need to rise while others need to fall, inflation can facilitate this without the need for nominal price decreases.
  4. Avoidance of Deflation: Moderate inflation prevents the economy from falling into deflation, which can have detrimental effects, as discussed earlier.

Disadvantages of Inflation

  1. Reduced Purchasing Power: High inflation erodes the purchasing power of money, meaning consumers can buy less with the same amount of money.
  2. Uncertainty: High and unpredictable inflation can lead to economic uncertainty, making businesses hesitant to invest and consumers to delay spending.
  3. Interest Rate Hikes: To combat high inflation, central banks might raise interest rates, making borrowing more expensive and potentially slowing economic growth.
  4. Savings Erosion: The real value of savings can decrease if the interest earned doesn't keep pace with inflation, discouraging saving.
  5. Income Redistribution: Fixed income earners, like pensioners, can suffer if their incomes don't adjust to rising prices. Conversely, borrowers can benefit if their incomes rise faster than the interest rates on their debts.

Understanding Deflation

Deflation is the opposite of inflation. It refers to the decrease in the general price level of goods and services, leading to an increase in the purchasing power of money. In other words, when deflation occurs, each pound in your pocket can buy more of a good or service than it did previously.

Causes of Deflation

  1. Decreased Consumer Spending: When consumers cut back on spending, demand for goods and services drops. This can lead to a surplus, causing prices to fall.
  2. Increased Production: Technological advancements or increased efficiency can lead to an oversupply of goods, pushing prices down.
  3. Reduction in the Money Supply: Central banks might reduce the amount of money in circulation, leading to decreased demand and lower prices.

Effects of Deflation

  1. Increases Real Value of Debt: As prices drop, the real value of debt rises, making it harder for borrowers to repay loans.
  2. Consumer Delay: Expecting prices to fall further, consumers might delay purchases, leading to decreased economic activity.
  3. Wage Reductions: Businesses might cut wages or lay off workers to reduce costs, leading to decreased consumer spending.
  4. Economic Stagnation: Prolonged deflation can lead to economic stagnation or depression, as decreased spending and investment can hurt economic growth.

Note: While deflation might seem beneficial because it increases the purchasing power of money, prolonged deflation can have detrimental effects on an economy. It can lead to reduced consumer spending, increased unemployment, and economic stagnation.

Historical Overview: Inflation in the UK (1960-2023)

The graphic will depict the inflation rates in the UK from 1960 to 2022, with a commentary of 2023 so far explained below.

(Source: Macrotrends)

Here's a brief overview of the data:

1960s: The inflation rate started at a modest 1.00% in 1960 and saw a gradual increase throughout the decade, reaching 5.45% by 1969. This period was characterised by post-war economic recovery and growth.

1970s: This decade witnessed significant fluctuations, with inflation soaring to an all-time high of 24.21% in 1975. Factors such as the oil crisis and global economic challenges played a role in these high rates.

1980s: Inflation remained relatively high in the early 1980s, peaking at 17.97% in 1980. However, by the end of the decade, it had moderated to below 6%.

1990s: The 1990s saw a consistent decline in inflation rates, starting at 8.06% in 1990 and dropping to a low of 1.75% by 1999. This can be attributed to economic stability and policy measures.

2000s: The new millennium began with relatively low inflation rates, hovering around the 1-2% range. However, the 2008 financial crisis led to a spike, with the rate reaching 3.52% in 2008.

2010s: This decade saw moderate inflation rates, with a notable dip to 0.37% in 2015. Economic recovery and global factors influenced these rates.

2020s: The data shows a significant jump in 2022, with inflation reaching 7.92%. This could be attributed to post-pandemic economic challenges, supply chain disruptions, and other global events.

Inflation in 2023: Navigating Record Highs

The year 2023 has witnessed inflation rates in the UK reaching unprecedented highs, with monthly rates consistently hovering around the 10% mark in the early months. January and February saw rates of 10.10% and 10.40% respectively, with a slight dip in July to 6.80%. But what has been driving these soaring numbers? The root causes can be traced back to a series of significant shocks to the UK economy.

  1. Aftermath of Covid pandemic
  2. Russia's invasion of Ukraine
  3. Labour and workforce shortages

Firstly, the aftermath of the Covid pandemic reshaped consumer behaviour. As lockdowns forced people indoors, there was a marked shift towards purchasing goods over services. However, supply chain disruptions meant that sellers struggled to meet this heightened demand, especially for imported goods, leading to price surges.

The geopolitical landscape further exacerbated the situation. Russia's invasion of Ukraine triggered substantial hikes in gas prices, directly impacting energy bills and indirectly pushing up the cost of food. This was compounded by poor harvests in various regions, resulting in food prices in June being a staggering 17% higher than the previous year.

Lastly, the labour market faced its own set of challenges. The pandemic's ripple effects led to a significant reduction in the workforce. With fewer people available for jobs, employers found themselves in a position where they had to offer higher wages to attract candidates. This wage inflation inevitably trickled down to consumers, as businesses, especially in the service sector, raised their prices to offset increased wage costs.

In essence, the inflationary trends of 2023 are a testament to the interconnectedness of global events, consumer behaviour, and economic policies. The year stands as a vivid example of how multiple external factors can converge to influence the financial landscape of a nation.

Conclusion

Inflation, while a complex economic concept, has tangible effects on everyday life. By understanding its causes and consequences, individuals can make more informed decisions about saving, investing, and spending. In the context of the UK, being aware of historical inflation trends can also offer insights into the nation's economic health and future prospects.


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