The cost of living has a habit of rising. Each year, the amount we pay for goods and services typically goes up, increasing our expenditure and eroding the spending power of our cash. This effectively leaves us worse-off – especially if wages don’t climb at the same rate.
The name of this phenomenon, which has seen the price of a can of Coke surge from about 20p in 1982 to about 85p today, is inflation.
What causes inflation?
The reason prices jump is usually linked to there being more demand than supply – or too much money chasing too few goods and services.
In economic terms, the two key drivers are:
- Demand-pull inflation: When demand for goods and services exceeds the total industry-wide amount that can be feasibly produced, suppliers will recognise that it’s possible to get away with hiking prices without jeopardising sales.
- Cost-push inflation: Goods and services cost money to produce and these expenses can rise to the point that the only way for the companies behind them to make a reasonable profit and stay in business is to charge their customers more.
How is inflation measured?
The UK government keeps tabs on the fluctuating price of goods and services and shares its findings in the form of an inflation rate once a month. This is a percentage that tells us how much more things cost today compared to a year ago. It’s not possible to monitor everything, so research is narrowed down to a basket of about 180,000 prices covering roughly 700 different items that a typical household buys, such as bread, electronic devices, energy, and petrol.
Each month, the Office for National Statistics (ONS) collects this information, “weights” it according to what people spend more on – petrol, for example, tends to impact the inflation rate more than stamps – and then puts it all together to produce two main estimates of inflation: the Consumer Prices Index (CPI) and the Consumer Prices Index including owner occupiers’ housing costs (CPIH), which, as its name implies, also factors in various household expenses, such as council tax.
What is the inflation rate used for?
Inflation has a big bearing on how the Bank of England (BOE), the body responsible for safeguarding the UK economy and financial system, sets its base rate. This is a national interest rate that influences what consumers and businesses are charged for taking out a loan or paid for depositing their cash in savings accounts.
Broadly speaking, if the BOE thinks inflation is too low it will cut interest rates, reducing the cost of borrowing, and the returns on savings accounts to encourage spending. Conversely, when inflation is too high, the bank will encourage the public to limit their expenditure by raising rates.
What is a good inflation rate?
Some inflation, believe it or not, is actually a good thing.Increased consumer spending and demand for products may cause prices to rise, boosting company earnings, job opportunities, wages and the potential for the economy to grow.
The UK government’s goal is for prices to climb 2% each year and not fluctuate wildly, so that businesses can charge fairly and consumers are able to budget. When inflation is too low, or negative (deflation), there’s a risk that people reduce their spending, in anticipation of prices falling further, which could hurt companies and prompt them to make job cuts.
UK inflation has averaged 2.9% a year since 1990, according to the BOE.
Very high inflation is also unwelcome. Rapid price increases may tempt people to immediately spend all the money they have before it falls further in value. This can eventually lead to hyperinflation – a nasty situation where even the most basic goods become unobtainable.
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