What Is Inflation?

The inflation rate is the rate at which general price levels are rising. This includes goods such as what you buy in a supermarket, purchases such as cars, electronics, and services such as getting your car washed or getting your nails done.

Inflation happens when there is too much money chasing too few goods. Normally, there is a moderate level of inflation in the economy, therefore prices increase slowly over time. However, inflation becomes a problem when the rate increases dramatically.

How is it measured?

The Office for National Statistics (ONS) is responsible for measuring inflation in the economy. The department keeps an eye on prices for everyday items bought by the public. Each month, they collect data on prices of about 700 items. These items are called the “basket of goods” which is constantly being updated due to changes in the public’s spending habits.

An example of this is hand sanitiser and exercise equipment being added to the basket of goods. This happened after spending habits changed during the lockdown. Each item in the basket of goods is given a 'weighting'. Items that we spend more money on are given more 'weights' e.g., petrol. Price rises on items with bigger weightings will have more influence on the rate of inflation.

This measure of inflation is released each month showing how much prices have risen in comparison to the same date in the previous year. This is what is called the Consumer Price Index (CPI).

Inflation target

The Bank of England has an inflation target of 2%. This means that they hope to keep the inflation rate at around 2% as some inflation is good for the economy. This is because it is healthy for prices to increase over time. However, when the inflation rate increases above 2%, this indicates that prices are rising too quickly. This is a sign that demand in the economy is greater than the supply of goods and services in the economy.

If the inflation rate increases or decreases by 1% point on either side, then the Governor of the Bank of England has to write a letter to the Chancellor explaining why this has happened. They will then discuss the actions they will undertake to get the rate back to 2%.

How does the inflation rate affect us?

The rate of inflation is used as a guide for a whole range of decisions such as how much pension payments will increase and the price of train fares. Economists also pay attention to the inflation rate as it’s a sign of what is happening in the economy.

Rising inflation will also affect your savings if interest rates are lower than the rate of inflation. Therefore, in real terms, your savings are depreciating in value.

What people can buy with their wages is called their purchasing power. When inflation increases, your purchasing power decreases. Rising inflation could reflect an effective wage cut for some people, as it decreases your purchasing power. Therefore, your income may be able to buy less than what it was previously able to buy.


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