AS Macro Key Term: Inflation

Inflation is a sustained increase in the general price level leading to a fall in the purchasing power of money. The rate of inflation is measured by the annual percentage change in consumer prices.

CPI inflation in the UK economy

Bank of England Target 2.0 from Timetric

The British government has set an inflation target of 2% using the consumer price index (CPI). It is the job of the Bank of England to set interest rates so that AD is controlled, possible inflationary pressures are subdued and the inflation target is reached.

The process of calculating the rate of inflation in the UK

The cost of living is a measure of changes in the average cost for a household of buying a basket of different goods and services. In the UK there are two published measures, the Retail Price Index (RPI) and the Consumer Price Index (CPI). Price data is used in many ways by the government, businesses, and society in general. They can affect interest rates, tax allowances, wages, state benefits, pensions, maintenance payments and many other ‘index-linked’ contracts.

The CPI is a weighted price index. Changes in weights reflect shifts in spending patterns of households in the British economy.

The rate of inflation is the % change in the price index from one year to another. So if in one year the price index is 104.1 and a year later the price index has risen to 112.5, then the annual rate of inflation = (112.5 – 104.1) divided by 104.1 x 100. Thus the rate of inflation = 8.07%.

The main causes of inflation

The main causes of inflation

• Inflation can come from both the demand and the supply-side and also from internal and external economic events.

• Some inflationary pressures direct from the domestic economy, for example the decisions of the utility businesses providing electricity or gas or water on their tariffs for the year ahead, or the pricing strategies of the food retailers based on the strength of demand and competitive pressure in their markets. A rise in the rate of VAT would also be a cause of increased inflation in the short term because it increases a firm’s production costs.

• Inflation can also come from external sources, for example a sustained rise in the price of crude oil or other imported commodities, foodstuffs and beverages.

• Fluctuations in the exchange rate can also affect inflation – for example a fall in the value of the pound against other currencies might cause higher import prices for items such as foodstuffs from Western Europe or technology supplies from the United States – which feeds through directly or indirectly into the consumer price index.

CPI and RPI inflation for the UK

Bank of England Target 2.0 from Timetric