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What is inflation? Inflation Explained

Inflation for most tends to bring a sense of dread as inflation means an increase in the general cost of goods and services. Inflation can be defined as an increase in the price of a defined group of goods and services and the subsequent reduction in the true value of money.

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In simple terms, as the cost of goods go up, the amount of goods you can buy is reduced. Imagine a seesaw; Inflation is the opposing balance of the Value of Money. Let's look at a simple example of inflation.

Inflation Example

Jenny buys 100 sweets for £1.00 in 1980. In 2017 she purchases the same sweets but this time only receives 50 sweets for £1.00.

The cost of the sweets has doubled meaning that the value of her money has been reduced, in this instance by half. That example may seem extreme but take a look at the inflation calculator, enter a few figures and see how your £1.00 compares to previous years, it truly is surprising. £1.00 just a few years ago is now worth less than 90 pence.

Inflation is benchmarked as a percentage figure, showing increases typically from Year-to-Year though inflation is measured Month-on-Month due to the significance of inflation in modern economics. Inflation can be measured in diverse ways, drawing samples from different markets, goods and services.

CPI and RPI

The most commonly used measure and benchmark for inflation is the Consumer Prices Index (CPI) and the Retail Prices Index (RPI). Whilst RPI includes housing costs (mortgages, council tax etc.) CPI does not, instead draw data purely based on the services and goods samples. This is an important consideration as, anyone living in the UK can testify to, housing prices have rocketed since the early 1980s with most needing large mortgages to secure a foot on the property ladder. The sample methodology is clearly important in any Inflation calculation but the key difference between RPI and CPI is that they are calculated differently. CPI includes an assessed equation that assumes that consumers will switch to lower priced goods when their counterparts become more expensive. A key factor given the range in quality and cost of the same products within the UK and Global economy. Toiletries are a prime example where an individual could spend £1,000.00 on toiletries or £10.00 and have the same products (albeit at a lower quality). An individual who made that switch due to changes in their economic situation can influence economic trends (albeit slightly, it takes thousands of instances like this example to translate in to hundredths of a percent). The net result is that CPI provides a more robust inflation benchmark which allows for spending trend fluctuations., as such the CPI method is now considered best practice though the RPI inflation figure is still calculated by the Office for National Statistics each month.

Why publish the RPI inflation?

All inflation calculations are simply a snapshot of an economic segment. They are never wholly accurate but they do serve as a good benchmark on which to build an assessment. Whilst the CPI provides more stable and balanced inflation calculations the RPI method is still valid, it simply provides a wider scope of accuracy due to the volatile increase and decrease of large cost items, mainly housing costs.

How is inflation used?

As inflation calculations have increased in accuracy, so has the understanding of the economic trends that go hand in hand with inflation. Too much inflation can makes the cost of living very expensive and create poverty, drive increasing salaries and dampen business growth (as operational costs exceeds sales Sales falling as higher costs reduce demand).

Too little inflation and economists become worried, inflation suggests economic growth as the demands for goods and services facilitates rises costs as supply chain and manufacturing costs increase.

Negative inflation is called deflation, deflation results in a reduction of the cost of services and goods and increases the value of money. Deflation can be positive in the short term as it increases spending capability though long term deflation can result in significant economic challenges.

Leveraging Inflation

Given the potential economic impact that extremes of inflation can have, fluctuations in inflation are carefully monitored by the Bank of England who leverage interest rate figures to control inflation. Interest rates directly affect most UK consumers who typically have large mortgages. Increasing interest rates mean higher monthly mortgage repayments and less money to spend on the high street. Decreasing interest rates on the other hand means more spare cash so increased consumer spending.

Next: Deflation Explained

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