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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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