What inflation is
- Inflation is a sustained rise in the general price level. It means money buys less (lower purchasing power).
- It is measured by the Consumer Prices Index (CPI), which tracks the prices of a typical "basket" of goods and services. The Retail Prices Index (RPI) also includes mortgage interest payments.
- Deflation is a fall in the general price level.
Causes
- Demand-pull inflation: demand grows faster than the economy can supply, so prices are pulled up.
- Cost-push inflation: rising costs of production (such as energy, wages or imported materials) push prices up.
- A fall in the value of the pound makes imports more expensive, adding to cost-push inflation.
Effects
- Savers lose if interest rates are lower than inflation; borrowers can gain because debts are worth less in real terms.
- People on fixed incomes lose purchasing power.
- Exports become less competitive if prices rise faster than in other countries.
- Uncertainty can reduce business investment. Firms face menu costs of changing prices.
Calculating price changes
- Percentage change = (new − old) ÷ old × 100. If a basket costs £200 one year and £206 the next, inflation is 3%.
Key terms
- Inflation
- A sustained rise in the general price level.
- Deflation
- A sustained fall in the general price level.
- Consumer Prices Index
- The main UK measure of inflation.
- Purchasing power
- The amount of goods money can buy.
- Demand-pull inflation
- Inflation caused by demand growing faster than supply.
- Cost-push inflation
- Inflation caused by rising costs of production.
- Real interest rate
- The interest rate minus inflation.