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Inflation measures the annual rate of change of the general price level in the economy. Inflation is a sustained increase in the average price level.


The 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

When 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.


Hyper-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 Index (RPI)

The 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.



The 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.



Food 13.6
Catering 4.9
Alcohol 8.0
Tobacco 3.4
Housing 18.6
Fuel & Light 4.1
Household Goods 7.2

Household Services 5.2
Clothes 5.6
Personal Goods 4.0
Motoring 12.8
Fares 2.0
Leisure Goods & Services 10.6



Underlying Inflation (Rpix)

The 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.




The 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.


As 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


There is too much money chasing too few goods, therefore firms realise they can put up their prices.


An 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



This occurs when firms increase prices to maintain or protect profit margins after experiencing a rise in their costs of production.

The 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?

No, 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 be reduced.

  • 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 capital investment.
  • 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 leather!).
  • 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.



E-mail Steve Margetts