measures the annual rate of change of the general price level in the economy.
Inflation is a sustained increase in the average price level.
British economy has experienced inflation throughout the last thirty years -
but the rate at which prices have been rising has not been stable. The chart
below tracks the annual rate of inflation for the British economy in each
year since 1968.
Inflation and the Price Level
prices rise, the value of money falls. There is an inverse relationship
between the price level and the purchasing power of money. When there is
inflation money buys less in real terms. People can protect themselves
against the effects of inflation by investing in financial assets that give a
rate of return at least equal to the rate of inflation.
is extremely rare, although some countries experience it. In fact even when
the rate of inflation is rising, the prices of some goods will be falling.
Deflation is also fairly
unusual although some countries such as Japan and China have experienced
price deflation in their economies in recent years.
In the United Kingdom, the main measure of inflation is done through
the Retail Price Index.
The Retail Price
Retail Price Index (RPI) measures the average change in prices of a
representative sample of over 600 goods and services. Each month, over
120,000 separate price samples are taken to compile the inflation statistics.
index is weighted according to the proportion of income spent by the average
household on categories of goods such as food and housing. These are
periodically changed to reflect changing consumer spending patterns in the
economy. For example the
weighting attached to food has fallen as average living standards have grown.
Fuel & Light 4.1
Household Goods 7.2
Household Services 5.2
Personal Goods 4.0
Leisure Goods & Services 10.6
Underlying Inflation (Rpix)
underlying rate of inflation, known as RPIX, was originally set a target of
between 1-4%. However, the Labour Government's target is for an average of
rate of growth of 2.5% over the duration of this parliament which ends in
2002. Inflation is allowed to move between 1% either side of the 2.5%
benchmark. The Bank of England
has been given the responsibility for meeting the inflation target. The chart
below tracks RPIX also known as
underlying inflation for the UK since 1988.
calculation of the RPIX is similar to the RPI, but excludes mortgage interest payments. This is because when interest
rates are increased to control inflation, the immediate effect is to increase
mortgage interest payments and, therefore, housing costs.
housing costs are a significant component of the RPI (see the table above),
inflation is artificially increased. Thus the very policy adopted to tackle
inflation actually creates a greater problem in the short run, and explains
why the Government discounts this component of the RPI.
The Main Causes Of Inflation
DEMAND PULL INFLATION
There is too much money chasing too few goods,
therefore firms realise they can put up their prices.
example of this was during the late 1980s with the so-called "Lawson
Boom". There was a sharp rise in the demand for credit and an explosion
in house prices. The amount of money in circulation grew at alarming rates
and caused a great deal of demand in the economy. By the autumn of 1990,
retail price inflation had climbed to 10.9%. A recession was needed to bring
it back down again.
Main causes of demand pull inflation:
Rapid growth of household consumption
Increases in government spending
Injections of demand from higher exports
COST PUSH INFLATION
occurs when firms increase prices to maintain or protect profit margins after
experiencing a rise in their costs of production.
main causes are:
Growth in Unit Labour Costs
Rising input costs
Increases in indirect taxes
Higher import prices (Imported inflation)
Will an increase in a firm’s costs always feed
through into inflation?
because a business can absorb an increase in costs by reducing its profit
margin. An example of this occurred after the devaluation of Sterling in
September 1992. The fall in the value of the pound caused a rise in the cost
of imported fuel and raw materials. Although input costs rose in 1993, this
increase did not fully feed through into the prices of goods.
Many firms were forced to reduce profit margins and absorb the
increase in costs or face a loss in market share. Effectively, firms were
facing elastic demand curves and any increases in price would have resulted
in a fall in demand and total revenue.
Costs And Effects Of Inflation
- Effect on UK competitiveness - if the UK has
higher inflation than the rest of the world it will lose price
competitiveness in international markets.
- The problems of a wage-price spiral – price
rises can lead to higher wage demands as workers try to maintain their
real standard of living. Higher wages over and above any gains in labour
productivity causes an increase in unit labour costs. To maintain their
profit margins they increase prices. The process could start all over
again and inflation may get out of control.
Consumers and businesses on fixed incomes will lose out. Many
pensioners are on fixed pensions so inflation reduces the real value of their
income year on year, this means that their demand for goods and services will
- Inflation can also cause a disruption of
business planning – uncertainty about the future makes planning
difficult and this may have an adverse effect on the level of planned
- Budgeting becomes a problem as firms become
unsure about what will happen to their costs. If inflation is high and
volatile, firms may demand a higher rate of return on planned investment
projects before they will go ahead with investment
- Shoe leather costs - when prices are unstable
there will be an increase in search times to discover more about prices.
Inflation increases the opportunity cost of holding money, so people make
more visits to their banks and building societies (wearing out their shoe
- Menu costs - extra costs to firms of changing
price information. This can be important for companies who rely on bulky
catalogues to send price information to customers.