A basic explanation of inflation

A basic explanation of inflation

What is inflation?

Inflation is the rate at which the prices of goods and services rise.

It is one of the fundamental indicators of our country’s financial welfare. The higher inflation is, the less consumers get for their money.

Inflation is articulated as a percentage. The percentage represents the increase or decrease in the general price of goods and services. If wages don’t keep up with inflation, standard of living falls.


Wages vs. Inflation

A small amount of inflation can encourage consumers to spend more from fear of prices continuing to rise. This enables companies to increase wages. Both acts contribute towards economic growth. 

Most countries have an inflation target of between 2 and 2.5%. In the UK our target is 2%. In July 2019, inflation sat at 2.1%, while wage growth was 3.9%.


How is inflation measured?

Inflation is measured by the Office for National Statistics (ONS).

The ONS uses various measures to calculate inflation:

  • The Consumer Prices Index (CPI) – a measure of the average cost of a ‘basket’ of goods and services, such as transport and food. It is used to calculate the increase or decrease of the general cost of living.
  • The Consumer Prices Index including owner-occupiers’ housing costs (CPIH) – this measure includes the CPI but also costs surrounding owning and living in a house.
  • The Retail Prices Index (RPI) – this measures identifies the cost of a sample of retail goods and services.

The CPI is the most commonly used figure.


What is inflation used for?

Inflation is a key influence for the Bank of England when deciding the “base rate”. The base rate effects the interest rates that banks can implement for mortgages, loans and savings.

If the Bank of England estimates that the interest rate will be below 2%, it will likely decrease interest rates to encourage people to borrow money, therefore increasing spending.

Inflation also can have a direct effect on some people’s income. Many occupational pensions and state benefits rise in accordance with CPI.

Inflation can also influence the cost of some train tickets, repayment rates for student loans and government issued bonds.


Emma Richardson