Inflation
Welcome to this section on inflation! We will explore various aspects of inflation, including its definition, measurement, causes, effects, recent trends, and how policy makers tackle it. So, let's dive into the world of inflation and monetary policy!The SQA Higher Economics specification for this section
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What is Inflation?
Inflation refers to the change in prices for goods and services over time (ONS). Put simply, if a loaf of bread costs £1 but then costs £1.05 one year later, then the annual bread inflation rate is 5%
Since rising inflation means that goods and services become more expensive, we say that inflation causes the cost of living to rise for households.
When inflation increases, the real value of debt decreases, making it easier to repay loans. Lets consider an example that you have taken a £1000 loan. As inflation rises, the £1000 you have borrowed can buy fewer goods. If inflation is 5%, then one year later, the same loan’s value will have decreased to £950! As a result, the financial burden of the debt decreases and you spend a smaller portion of your income to pay off the debt.
A point to remember! When inflation decreases, it does not mean that prices are falling, but means the rate at which prices are increasing, is decreasing. In July 2023, the United Kingdom’s inflation rate decreased from 8.7% to 7.9%. While this is ‘good’ news, this does not indicate that prices will decrease, but they will rise more slowly.
The above graph demonstrates the UK’s yearly inflation rate in the previous 50 years. Continue reading to explored the recent inflation rise in closer detail!
Explore the data yourself:
UK Inflation 1971-2022.xlsx9.8KB
Deflation is the opposite of inflation. It is a decrease in the general price level of goods and services within an economy. When deflation occurs, a person’s spending power increases, meaning you can buy more with the same amount of money.
For example, if a bottle of milk costs £1 but then costs £0.95 the following year, this is an indication of deflation. The annual deflation rate for milk, in this case, would be -5%.
While it may sound like a good thing because goods and services become cheaper, deflation can lead to negative effects in the economy. For instance, it can cause people to delay spending in anticipation of further price drops, reducing overall economic activity. Similarly, it can increase the real value of debt, making it more difficult for borrowers to pay off their loans.
The Nominal Value vs Real Value of Money:
Nominal Value: The nominal value of money simply refers to the face value of money. Quite simply, if you hold a £10 note, it has a nominal value of £10.
Real Value: The real value of money accounts for the impact of inflation on the purchasing power of that money in terms of goods and services. We know that as inflation rises, the purchasing power of money decreases as you can buy less with the same value. For example, if you had a £10 note, and the yearly inflation rate was 5%. The real value of your £10 note in one year would be £9.50, as you can buy less than before.
Real Income: is the income of individuals or nations after adjusting for inflation. It's a reflection of the amount of goods and services that their income can buy. Inflation reduces real income as the purchasing power of money decreases, whilst deflation increases real income as the purchasing power of money increases.
Real Income Explained! If you earned a salary of £30,000 p/year 10 years, and inflation was 10% over the previous 10 years, then the nominal value remains £30,000 but the real value is £27,000. As a result, despite the nominal value remaining the same, this is felt like a 10% pay cut!
How is Inflation Measured?
The Consumer Price Index (CPI)
The Consumer Price Index (CPI) is the most widely used tool that economists use to measure inflation, the rate at which the general level of process for goods and services is rising. It is the headline inflation estimate used by economists to measure inflation.
Explore how the cost of living has been measured throughout history:
Consumer Price Index including Owner-Occupied Housing (CPIH)
The CPIH is a measure which examines the overall change in consumer prices based on a representative basket of goods and services over a period of time, accounting for housing costs associated with owning or renting a home (ONS).
Explore the data yourself:Explore the CPIH contribution chart, and identify what components contribute most to CPIH rises over the previous year. Click the arrow to find out which component made the largest upward contribution!
Figure_6__Housing_and_household_services_made_the_largest_upward_contribution_to_the_change_in_the_annual_CPIH_inflation_rate.xls10.5KB
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Check out how prices in the UK have changed over time, from 1209 to now:
Types of Inflation
Cost-Push Inflation
Cost-Push Inflation occurs as a result of what economists refer to as a supply shock. When there is a disruption in the supply of goods and services, prices rise due to cost-push inflation. As supply decreases, companies raise their prices accordingly and this leads to a rise in inflation.
Understanding Cost-Push Inflation
- Suppose there's a decrease in the supply of crude oil globally (which can be caused by a number of factors including geopolitical). This is called a supply shock.
- Since the UK is heavily dependent on oil for various sectors such as transportation and energy, the increased input costs for companies could push up the prices of goods and services they produce so that they can avoid losing profit, or in some cases, making a loss.
- This results in cost-push inflation, where the overall price level in the UK rises due to the increased costs of production.
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Example: Rising energy and fuel prices are a recent example of cost-push inflation. These costs affect consumers both directly and indirectly as they are also inputs for firms. For instance, recent increases in wholesale gas prices affected around one in five wholesale and retail trade businesses in the UK (ONS). It is however important to note that the energy crisis began at the end of 2021, following a significant rise in demand as the economy opened up following Covid-19 restrictions ending. We refer to this as demand-pull inflation!
Demand-Pull Inflation
Demand-Pull Inflation occurs when there is an increase in demand in the economy while the supply remains the same, or decreases. As supply cannot meet the growing demand, the prices for goods are pulled higher. It is a direct consequence of demand for goods and services rising faster than the supply of those goods and services.
Understanding Demand-Pull Inflation
- Imagine a situation where the UK government decides to significantly reduces taxes, resulting in people having more disposable income.
- This increase in income can lead to higher demand for goods and services while supply remains the same.
- The increased competition among consumers to acquire these goods and services then drives prices up. This is a typical example of demand-pull inflation, where an increase in aggregate demand leads to higher price levels in the economy.
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What is causing the recent cost of living crisis?
We have seen that Inflation , which is a rise in the prices of goods and services, can be driven by one of two forces: Cost-Push Inflation or Demand-Pull Inflation. Now we will explore how recent economic shocks are causing a cost of living crisis in the UK.
In early 2023, the United Kingdom has been faced with soaring prices for basic food items such as fruit and vegetables which has caused food inflation to rise to a 45 year high. By March 2023, the annual CPI inflation rate for food and non alcoholic beverages rose to 19.2%, which means higher cost of living costs for households.
The causes of the recent cost of living crisis are complex but economists have predicted that recent supply shocks causing higher production costs, as well as a significant rise in demand following the ending of Covid-19 restrictions, have led to a combination of cost-push and demand-pull inflation.
Russia’s invasion of Ukraine in February 2022 caused a significant global shortage of oil and gas and other commodities. This shortage worsened already rising energy prices following the reopening of the economy after Covid-19, making it more expensive for firms to produce goods and services. Additionally, Brexit has resulted in the UK becoming more dependent on energy imports. A combination of these factors has resulted in the UK’s inflation rate remaining very high in comparison to other nations such as the USA.
This chart uses an Index. This means that we can see how each price changes over time relative to December 2020. This technique is often used in data visualisation for .
These supply chain disruptions have contributed to the cost of living crisis in the UK, which has had a significant impact on households and businesses across the country. However, as can be seen below, the Consumer Price Index (CPI) of gas and motor fuels have started to fall below their previous peaks.
The Effects of Inflation on Households
Decreasing Purchasing Power
Inflation decreases the value of money by reducing its purchasing power. For example, if the prices of food items rise by 5% over a year, a person can buy fewer items with the same amount of money. This is referred to as a decrease in the purchasing power of the consumer, which increases the cost of living for consumers. The cost of living refers to the costs of everyday essentials such as utilities, fuel, and food, rises with inflation. This increase makes individuals worse off as rising costs decreases disposable income available.
Wage and Income Changes
Wage and income values decrease during periods of inflation. While some employers offer wage increases during periods of inflation, these increases often don't match the inflation rate, causing a real decrease in the value of wages. For example, between September and November 2022, the Office for National Statistics (ONS) reported that average wages rose by 6.4%. However, inflation grew by 10.7% in the same period. Use the below calculator to find out what pay rise you would need to receive if you were earning £40,000, £50,000 etc.
Saving and Investment Behaviour
Inflation can change the behaviour of individuals regarding investments:
- Property Investment: With high inflation, house prices may increase beyond the purchasing power of the consumer. As a result, individuals may postpone plans to purchase housing as deposits grow. A 1 bed valued at £150,000 will require a £15,000 deposit, which is a higher burden when inflation is high.
- Luxury Purchases: As disposable income decreases due to a rise in the cost of living, individuals may reduce spending on luxury goods, affecting sectors like travel and hospitality. However, recent demand for travel and tourism has not decreased due to ‘revenge spending’ on travel following the lifting of Covid-19 restrictions.
- Savings and Investment: Inflation reduces the value of savings and investments, making them less attractive to individual consumers. For example, if the saving rate is 4% while inflation is 10%, this is a 6% decrease in the real value of your savings.
Borrowers vs Lenders
Inflation can benefit borrowers as they repay loans with money that has a lower value. However, lenders may suffer as the real value of the loan repayment decreases due to rising inflation.
The Fraser of Allander Institute regularly explores the effects of inflation on consumer and firm behaviour in the economy:
The Effects of Inflation on Firms
Increased Input Costs and Decreased Profitability
A rise in inflation leads to higher costs of inputs, or raw materials. An increase in these costs, along with rising labour costs and operating expenses, can decrease a firm's overall profitability. If food inflation is 20%, then the costs of inputs for restaurants will increase significantly. As a result, firms may need to raise prices or risk significantly reduced profits.
A sharp rise in food and energy prices have threatened the profits of restaurants of late. The cost of living crisis has additionally led to a downturn in bookings in the industry due to consumer constraints. As a result, the hospitality industry has suffered significant losses.
Consumer Demand Shifts
Input cost however is not the only factor that impacts businesses as a result of a rise in inflation. Changes in consumer demand can also impact firms due to inflation. For instance, as disposable income decreases, the demand for luxury goods, such as holidays, may decline, negatively affecting firms in these sectors.
Labour Availability
With rising inflation, employees may demand higher wages to keep pace with the increase in the cost of living. This demand can lead to higher wage costs for businesses and potentially increase the likelihood of strike action.
Planning and Investment
Similarly to individuals, a rise in inflation can create uncertainty for firms and impact investment and planning decisions. If inflation rates are high, firms may choose to postpone investment and reduce costs.
This report from the FAI demonstrates clearly the impact that the recent rise in inflation has had upon Scottish businesses. It illustrates how businesses might respond to a rise in prices, and why they respond the way they do.
The effects of inflation on different groups
Group | Effect of Inflation | Effect of Deflation |
Borrowers | Benefit as the real value of debt decreases | Disadvantaged as the real value of debt increases |
Savers | Lose out as the value of savings decreases | Benefit as the value of savings increases |
Importers | As inflation rises, we typically buy more imports as goods are cheaper. However, over time, the price of imported goods will increase, decreasing profit margins. | Benefit as cost of importing goods decreases due to strong currency |
Exporters | Disadvantaged as their goods become more expensive for foreign buyers | Benefit as their goods become cheaper for foreign buyers |
Government | Debt burden decreases | Debt burden increases |
People on Fixed Incomes | Lose purchasing power as cost of living increases | Gain purchasing power as cost of living decreases |
Pensioners | Lose if their pension is not inflation-proof | May gain if their pensions are fixed and living costs decrease |
Consumers | Buying power decreases as prices increase | Buying power increases as prices decrease |
Effect of high inflation
Too much inflation can lead to uncertainty in the economy, possibly leading to less investment and higher unemployment. If the inflation rate is higher in the UK compared to other countries such as the USA and France, it could lead to a depreciation of the pound, which could affect the balance of trade.
The Wage Price Spiral: The Bank of England governor, Andrew Bailey, has stated that the United Kingdom is facing a ‘wage-price spiral’ (Financial Times). This situation is dangerous for the economy because it can cause inflation to spiral out of control.
A wage price spiral can occur in a situation where in response to rising prices, workers lobby their employers, often through striking or pay negotiations, to increase their wages. If lobbying is to be successful and lead to a rise in wages, firms respond to higher labour costs by raising their prices even higher in line with the wage increase. As firms rise prices in response, the value of consumers’ money further decreases and they may demand further wage rises. This creates the wage price spiral.
Effect of deflation
Deflation is a decrease in the general price level of goods and services. It occurs when the inflation rate falls below 0%. While it might seem like a good thing because your money can buy more, it's actually a sign of economic distress. This is because deflation discourages spending and investment, which are key drivers of economic growth.
Deflationary Spiral: a situation where decreases in price lead to lower production, which in turn leads to lower wages and demand, which leads to further decreases in price.
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The deflationary spiral played a significant role in the Great Depression of the 1930s. As prices dropped, businesses reduced production, leading to layoffs and wage cuts, which in turn reduced demand and led to further price decreases. This vicious cycle resulted in a prolonged period of economic downturn.
Monetary Policy: the 2% inflation target
We have seen how both inflation and deflation can have negative impacts on households, businesses and on the economy generally. This takes us to monetary policy, which is a set of tools and policies controlled by a central bank. According to the UK’s central bank, the Bank of England, "Monetary policy is action that a country’s central bank or government can take to influence how much money is in the economy and how much it costs to borrow”.
The Bank of England uses two main monetary policy tools to keep to its 2% target: Bank Rate and quantitative easing. Bank Rate is the interest rate that the Bank of England charges banks to borrow money from it. Quantitative easing is the process of creating money electronically and using it to buy bonds from the government and businesses. Using these tools, the bank chooses between expansionary or tightening monetary policy. The bank often has to react to economic shocks such as the 2008 Global Financial Crisis or 2020 Covid-19 Pandemic with expansionary monetary policy.
The main objective of monetary policy is to keep inflation low and stable at the Bank’s target of 2%. Low and stable inflation is good for the UK’s economy and it is the Bank of England’s main monetary policy aim. The 2% inflation target is important because it helps to maintain confidence in the value of money, avoid excessive inflation or deflation, and support economic growth and employment. If inflation is too high or too low, or if it moves around a lot, it can have negative effects on the economy and people’s welfare. If inflation is above the 2% target, the bank may choose to increase the interest rate to reduce inflation, and vice versa.
Expansionary Monetary Policy: This is when the Bank of England decreases the 'bank rate' or increases the amount of money in the economy through a process called Quantitative Easing (QE). When the bank rate is lower, it means borrowing money becomes cheaper which can help encourage spending and boost the economy, but also contributes to inflation.
Tightening Monetary Policy: This is when the Bank of England increases the 'bank rate' or reduces the amount of money in the economy through a process called Quantitative Tightening (QT). When the bank rate is higher, it means borrowing money becomes more expensive which can help slow down inflation.
The Bank of England decides what action to take based on its analysis and projections of the economy and inflation. It has a Monetary Policy Committee (MPC) that meets eight times a year (roughly once every six weeks) to set monetary policy. The MPC has nine individual members who vote on whether to change interest rates or quantitative easing.
The MPC make their decision based on the 2% inflation target. If they think inflationary pressures are high, they tend to tighten monetary policy. If they think inflationary pressures are low, they tend to expand monetary policy.
The impact of expansionary and tightening monetary policy
Expansionary Monetary Policy | Tightening Monetary Policy | |
Households | Borrowing money for things like houses can become cheaper, but money saved in the bank earns less | Borrowing money for things like houses can become more expensive, but money saved in the bank can earn more |
Businesses | Borrowing money for expansion can become cheaper, making growth easier | Borrowing money for expansion can become more expensive, making growth harder |
Government | Borrowing money for public services can become cheaper, possibly leading to more spending | Borrowing money for public services can become more expensive, possibly leading to cuts |
Savers | Money saved in the bank can earn less | Money saved in the bank can earn more |
Importers/Exporters | A weaker pound can make imports more expensive and exports cheaper. A lower interest rate weakens the exchange rate, weakening the pound. | A stronger pound can make imports cheaper and exports more expensive. A higher interest rate leads to a higher exchange rate, making the country more attractive to foreign investment. |
Employees | Faster economic growth could mean more job opportunities and faster wage increases | Slower economic growth could mean fewer job opportunities and slower wage increases |
Retirees | Lower returns on savings can negatively impact retirees. | Higher returns on savings can benefit retirees. |
Investors | Lower interest rates can lead to lower returns on bonds but could stimulate the growth of the stock market if it offers better returns. | Higher interest rates can lead to higher returns on bonds but could slow down the growth of the stock market as it may offer weaker returns. |