Inflation

Inflation and Deflation

Inflation is a sustained increase in the general price level over time — the average prices of goods and services rise, reducing the purchasing power of money. If inflation is 5%, a basket of goods costing £100 now costs £105 a year later.

Deflation is a sustained decrease in the general price level. Although lower prices may seem desirable, deflation can be economically damaging — consumers delay purchases expecting further price falls, reducing demand, output, and employment.

The Bank of England targets 2% CPI inflation per year — low and stable inflation is considered optimal for economic planning and growth.

Causes of Inflation

• Demand-pull inflation — caused by aggregate demand growing faster than the economy's productive capacity. Excess demand "pulls" prices up. Typical in booms, when consumer spending is strong and unemployment is low.
• Cost-push inflation — caused by rising production costs (energy, raw materials, wages). Firms pass higher costs on to consumers through higher prices. Examples: oil price shocks, rising import costs following currency depreciation.
• Imported inflation — if the pound falls in value, imports become more expensive, directly raising prices of imported goods and production costs for firms using imported inputs.
• Excess money supply — if money supply grows faster than output, too much money chases too few goods, generating inflation (the monetarist explanation).

Consequences of Inflation

• For consumers: lower real purchasing power (wages may not rise as fast as prices); people on fixed incomes (pensioners) are disproportionately harmed; savings eroded in real terms.
• For producers: uncertainty about future costs and prices makes planning difficult; international competitiveness falls if UK inflation is higher than trading partners' (UK exports become relatively more expensive).
• For the government: higher nominal tax revenues (fiscal drag — inflation pushes workers into higher tax bands); higher benefit costs if benefits are inflation-linked; increased cost of index-linked debt.
• For borrowers and lenders: unexpected inflation benefits borrowers (real value of debt falls) and harms lenders/savers (real value of savings falls).

The Consumer Price Index (CPI)

The CPI measures inflation by tracking the price of a representative basket of goods and services purchased by a typical UK household. The basket contains hundreds of items across categories including food, housing, transport, clothing, and recreation. Items are weighted according to their importance in household spending — if households spend 10% of their budget on food, food prices have 10% weight in the index.

CPI = (Cost of basket in current year ÷ Cost of basket in base year) × 100

Inflation rate = ((CPI this year − CPI last year) ÷ CPI last year) × 100