Unit 2 Macro: Measuring Inflation in the UK

Inflation is a sustained increase in the cost of living or the average / general price level leading to a fall in the purchasing power of money. The opposite of inflation is deflation which is a decrease in the cost of living or average price level.

How is the rate of inflation measured?

The rate of inflation is measured by the annual percentage change in consumer prices.

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 aggregate demand is controlled, inflationary pressures are subdued and the inflation target is reached. The Bank is independent of the government with control of interest rates and it is free from political intervention

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.

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.

In the UK there are two measures, the Retail Price Index (RPI) & the Consumer Price Index (CPI).

The major difference between the two measures, is that CPI calculations excludes payments on mortgage interest (It’s thought that by excluding mortgages, the CPI is a better measure of the impact of macroeconomic policy

The CPI is a weighted price index. Changes in weights reflect shifts in the spending patterns of households in the British economy as measured by the Family Expenditure Survey

CPI for goods and services

Data from Timetric.

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Bank of England Target 2.0 from Timetric

Limitations of the Consumer Price Index as a measure of inflation

The CPI is a thorough indicator of consumer price inflation for the economy but there are some weaknesses in its usefulness for some groups of people.

The CPI is not fully representative: Since the CPI represents the expenditure of the ‘average’ household, inevitably it will be inaccurate for the ‘non-typical’ household, for example, 14% of the index is devoted to motoring expenses - inapplicable for non-car owners. Single people have different spending patterns from households that include children, young from old, male from female, rich from poor and minority groups. We all have our own ‘weighting’ for goods and services that does not coincide with that assigned for the consumer price index.

Housing costs: The ‘housing’ category of the CPI records changes in the costs of rents, property and insurance, repairs. It accounts for around 16% of the index. Housing costs vary greatly from person to person.

Changing quality of goods and services: Although the price of a good or service may rise, this may also be accompanied by an improvement in quality as the product. It is hard to make price comparisons of, for example, electrical goods over the last 20 years because new audio-visual equipment is so different from its predecessors. In this respect, the CPI may over-estimate inflation. The CPI is slow to respond to the emergence of new products and services.

Data from Timetric.

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Bank of England Target 2.0 from Timetric

Deflation

Price deflation is the opposite of inflation and happens when the rate of inflation becomes negative. I.e. the general price level is falling and the purchasing power of say £1,000 in cash is increasing. Some countries have experienced bouts of deflation in recent years; perhaps the most well-known example was Japan during the late 1990s and in the current decade. In Japan, the root cause of deflation was slow growth and a high level of spare capacity in many industries that was driving prices lower.

Hyperinflation

Hyperinflation is extremely rare. Recent examples include Yugoslavia Argentina, Brazil, Georgia and Turkey (where inflation reached 70% in 1999). The classic example of hyperinflation was of course the rampant inflation in Weimar Germany between 1921 and 1923. When hyperinflation occurs, the value of money becomes worthless and people lose all confidence in money both as a store of value and also as a medium of exchange. The recent hyperinflation in Zimbabwe is a good example of the havoc that can be caused when price inflation spirals out of control. It has made it virtually impossible for businesses to function in any kind of normal way.

UK Retail Price Inflation

Data from Timetric.

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Bank of England Target 2.0 from Timetric

Reforms to the RPI measure of inflation (BBC news, January 2013)