Inflation is the progressive increase in prices over time. For example, if the average prices of goods and services increase by 3%, the rate of inflation is 3%.
As a result of inflation, the money in your pocket buys less, because you will need 3% more to buy the things you did in the past.
Here are two popular theories about the causes of inflation:
- There is too much money chasing too few goods. If there is more demand for goods than supply, the prices will increase.
- Where businesses are faced with increased cost, they must increase prices to meet their cost
Inflation is measured by the consumer retail price index, which is an official measure of the average price of goods and services purchased by ordinary households. It is
measured by government statisticians, who take a basket of goods and services and quite literally mark off the current prices of goods and services against their list,
adding up the total. This is then compared with the total cost of the same basket in the previous month, to work out a percentage change in prices.
Inflation affects people as well as the economy. For older people who rely on their savings to live, high inflation can be devastating. As inflation increases, the spending
power of savings they are living on will decrease, unless their savings are earning a return at as high as the rate of inflation.
Likewise, if inflation increases, but salary or wages do not, your relative standard of living goes down. Inflation can also work to your advantage if you have borrowed money.
Provided your income goes up in line with inflation, the relative value of your mortgage or personal debts goes down, making it easier to pay them off, but inflation can go
hand in hand with high interest rates.
The opposite of inflation is deflation. This occurs when the general level of price falls.
Why Inflation & Exchange rates are important
How much your money buys this year compared with last year is determined by the rate of inflation. If inflation is high, which means that the average price is rising faster
than the pound in your pocket is worth, you will eventually buy less. If interest rates are high, which may go hand in hand with high inflation, people from overseas may
want to invest more money in the UK.
That in turn can increase the value of the pound in relation to other countries’ currency, which helps people in the UK to buy imported goods. At the same time, it makes it
more difficult for our exporting businesses to sell overseas because their prices are already higher. This can result in people losing their jobs and having less money to spend.
If the pound falls in value, importing raw materials and other goods become more expensive, which has the effect of fuelling inflation.
The Bank of England tries to influence our inflation by increasing or lowering the interest rate; everyone is affected by the effect of the changing interest rate.
To Summarise
Inflation is simply the increase in price levels over time. This makes money you earn worth less and can make paying off your debts easier.