Inflation is an increase in the money supply which results in rising prices for goods and services. Too much money chasing too few goods debases(makes it worth less) the value of our money and causes prices to rise. That means that the money in your pocket buys less and less stuff during periods of inflation.
Many things in the economy are priced off the current rate of inflation. The Bank of England sets interest rates based on current inflation levels, which in turn affects the amount the government pays to state pensions, benefits etc. The interest amount banks pay to savings accounts as well as the amount of money you need to pay for your mortgage is also affected by the current levels of inflation. Did you know that the Bank of England(BoE) currently has a 2% a year inflation target ? That means that the BoE intends to debase the currency by at least 2% a year.
How is it measured?
The Office of national statistics collects a ‘basket of goods’ and tracks any price changes. There are 700 items in the basket and these items are updated/reviewed regularly to reflect changes in technology as well as their relevance/necessity to the general public.
The most commonly used measures of inflation in the UK are the Consumer prices index (CPI) and the Retail prices index (RPI). Each of these measures looks at the prices of many things we tend to spend our money on. The CPI basket of goods includes things like cinema tickets, bread, alcohol etc, whilst the RPI basket includes things like mortgage interest payments, council tax etc. These indexes represent inflation as a percentage. For example, if the CPI was reported as being 4%, that means that generally speaking, the amount we pay today for goods and services is 4% higher than a year ago.
Both these indexes calculate inflation using different formulae and the RPI is generally larger than the CPI figure. The UK government uses the CPI as the de facto measurement and some employers use either of these measures to set annual pay increases.
Infographic by Office for National Statistics (ONS)
Difference between consumer and asset prices
There are 2 types of prices you need to bear in mind when thinking of inflation, consumer prices and asset prices. Consumer prices are the cost of items such as tv’s, fridges, food, energy etc. Asset prices are the cost of items such as property, stocks and shares, land, precious metals etc. When the economy is experiencing periods of inflation, it’s important to remember that prices in different sectors of the economy may not rise at the same time or by the same amount. For example, the CPI is currently at 1.6% yet UK house prices increased by 9.1% this year to February 2014.
To easily get a feel for just how much inflation there has been over the years, why not visit the Bank of England’s inflation calculator page. You are able to choose a start and end year as well as a fixed amount of cash to work with. The inflation calculator then works out how much more money you’d need in today’s money to buy the same goods and services.
For instance, I used a ten year period with a start year of 2002 and end year of 2012 as well as an amount of £100. I.e. What would goods and services costing £100 in 2002 have cost me in 2012? The answer is £137.76. That’s a 37.8% increase over the 10 years averaged out at 3.2% a year ! Another way of looking at this is, if you had stuck £100 in your mattress for those 10 years, that same hundred pounds would actually be worth £62.20 in real terms in 2012.
What would you add?
Soti Coker is the founder and editor of smartMoneytree. Learn more about him here and connect with him on Twitter.