Definition of Inflation

  • Inflation is basically a rise in prices.
  • A more exact definition of inflation is a situation of a sustained increase in the general price level in an economy. Inflation means an increase in the cost of living as the price of goods and services rise.

Inflation and value of money

  • Inflation leads to a decline in the value of money. “Inflation means that your money won’t buy as much today as you could yesterday.”
  • The inflation rate is the annual percentage change in the price level.
  • Inflation is measured by government statistics such as RPI (retail price index) and CPI (consumer price index)

Graph showing UK inflation rate

annual-inflation uk

UK inflation in the post-war period.

  • In 1974, the inflation rate peaked at 25%. This was due to rising oil prices and rising wages.
  • In the late 1990s and early 2000s, the inflation rate fell to less than 2% in 2004.
  • This fall in the inflation rate means prices were increasing at a slower rate.

 

UK Inflation Since 2000

inflation

  • Inflation was close to the governments target of 2% between 2000-2007
  • In 2008, inflation peaked at 5%, primarily because of a surge in the price of oil.
  • Inflation fell in 2009, because of the recession and fall in demand.
  • In mid-2015, there was a short period of deflation (negative inflation rate – falling prices)

Definition of Deflation

Deflation is a fall in the price level of the economy. It means there will be a negative inflation rate.

See more on deflation

Measuring inflation

To calculate inflation, the statistics authority (ONS)

  • Measure the price of 1,000 goods every month
  • Gives a weighting to different goods depending on how important they are in a typical basket of goods.
  • An index is created with calculates the weighting of good * price change.

See more on Measuring inflation

Inflation and the purchasing power of money

Inflation means the prices of goods rise. Therefore, the same amount of money will purchase a smaller quantity of goods.

This diagram shows how inflation in the US has eroded the purchasing power of the dollar. The biggest decline in the purchasing power of the dollar occurred in the 1970s when inflation was highest.

 

Purchasing power of the Pound Sterling  (1920=100)

192019301940195019601970198019901998
1001251299866461336.85.33

This table shows us that £100 buys less goods in 1998 than 1920, (approx 78% of its value)

Definition Hyper Inflation

Hyper inflation is generally considered to occur when inflation is greater than 1000%. With hyper inflation money loses its value so rapidly that nobody wants to use it as a medium of exchange.

In 1920s Germany had inflation of 100 billion %
In 1946 Hungary had inflation of 42,000 billion per cent

See: Hyperinflation

Costs of inflation

Inflation is seen to have economic costs. These include:

  1. Decline in value of savings
  2. Uncertainty for business
  3. Decline in the competitiveness of exports (if inflation higher than other countries.)

See also: Costs of inflation

Causes of inflation

Inflation can be caused by:

  1. Excess demand. Rapid economic growth causes firms to put up prices
  2. Rising costs. For example rising price of oil/commodities cause rise in price of goods.

See also: Causes of inflation

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