Introduction

Inflation means the general increase in prices of goods and services within an economy, and the corresponding reduction in purchasing power.

Inflation / deflation is often expressed as a percentage / rate over the period of a year. For example, inflation in the UK was operating at an annual rate of 4.2% using the Consumer Price Index measure as at January 2024 (see below).

This means that, compared to the same time a year ago, overall prices were 4.2% higher. Accordingly, a person will be able to acquire less with £1 than they would have one year ago, but likely more than they will in a year - this is known as the time value of money.

The rate of inflation / deflation will differ depending on the measure used, and there is variance between the price changes of different goods and services - for example, the price of petrol may have increased more than the price of staplers.

In this article, we discuss the causes of inflation, the significance and impact of inflation on an economy, and the measures of inflation.

Deflation means a general reduction in prices, and over an extended period is less likely to occur than inflation. Accordingly, we do not discuss this in as much detail.

Types / causes of inflation

There are two types of inflation:

1. Demand pull inflation - caused by an increase in aggregate demand (“AD”) - see article on AD for a reminder on what can cause an increase in AD; and
2. Cost push inflation - caused by a reduction in aggregate supply (“AS”). A reduction in AS is generally caused by a reduction in the quantities of factors of production available (which means their prices increase). It could also be caused by a reduction in the quality of the factors of production, but this is less likely to occur in the long-run due to the nature of human progression (we rarely go backwards!) - see Introduction to Aggregate Supply for a reminder on what may cause shifts in AS.

The amount by which prices increase due to an increase in AD, or reduction in AS, will depend upon:

1. The magnitude of the change i.e. how much does AD increase, or AS decrease? This itself will depend on various factors - review the articles on AD and AS and consider what factors cause changes in AD / AS; and
2. The shape and positioning of the AD and AS curves, and where they intersect. For example, do they intersect at a point where there is plenty of spare capacity within an economy? If so, changes in AD or AS may not result proportionately large changes in prices versus changes in output (GDP). Alternatively, if the AD and AS curves intersect at a point where there is no spare capacity within an economy, changes in AD or AS may result in a proportionately large change in prices compared to output.

We demonstrate this on figures 1 and 2 below.

Figure 1 shows demand pull inflation i.e. an increase in prices caused by an increase in AD.

AD1 intersects LRAS where there is plenty of spare capacity within the economy. Accordingly, an increase in AD - AD1 to AD2 - causes a disproportionately large increase in output (GDP) compared to price - O2 and P2. Despite the price increases, on average (and assuming equal distribution) people within an economy would be better off.

However, AD2 intersects LRAS where the economy is operating at close to full capacity. An increase in AD - AD2 to AD3 - therefore causes a disproportionately large increase in price compared to output (GDP) - O3 and P3. On average (and assuming equal distribution) people within an economy would be worse off due to the price increases.

Figure 2 shows cost push inflation i.e. an increase in prices caused by a decrease in LRAS.

AD intersects LRAS1 where there is plenty of spare capacity within the economy. Accordingly, a decrease in LRAS - LRAS1 to LRAS2 - has little impact on output and price - O2 and P2.

However, due to the reduced AS, AD intersects LRAS2 where the economy is close to full capacity. A further reduction of AS would therefore cause a large decrease in output and increase in price - O3 and P3. The reduction in output and increase in price means that, on average (and assuming equal distribution), people within an economy would be worse off.

In reality, changes in both AD and AS will be working in tandem to cause inflation. For example, the high inflation in recent years is attributed to a reduction in AS due to increase in costs of oil and the effects of the Covid-19 pandemic (which also resulted in a decrease in AD). However, as we came out of the pandemic, AD ramped up and intersected AS at a point close to full capacity - meaning a disproportionate increase in prices compared to GDP.

Governments and central banks will therefore use a combination of demand and supply-side policies to control inflation in the long-run and short-run - we discuss these in the following articles.

Significance and impact of inflation

An increase in prices (i.e. inflation) can cause people within an economy to be worse off, assuming that their overall level of income is not increasing.

However, as seen above, an increase in prices can also be an indicator of an increase in output (GDP) where this is caused by an increase in AD - particularly where the increase in output is proportionately more than any increase in prices. Where this happens, on average people within an economy should be better off (assuming equal distribution).

Due to this, governments and central banks often have targets for inflation that is set above 0% - they want some inflation, since this is an indicator of growth and because deflation can be a bad thing (see below). For example, in the UK, the target set by the UK government is 2% using the CPI measure (see below). See the articles on monetary and fiscal policy to understand methods that the government and Bank of England use to achieve this target.

Measures of inflation

Inflation is measured in the UK by the Office for National Statistics (“ONS”). Broadly speaking, the ONS monitor the prices of a notional shopping basket of goods and services over time and measure the change.

More specifically, each year the ONS selects over 700 goods / services to form a virtual shopping basket which is representative of what consumers typically spend their money on. Each item is given a different weighting within the basket. The shopping basket includes staples such as milk and bread, but also big ticket items such as vehicles, and services such as tickets for flights or concerts.

The ONS then obtains prices for the items in this shopping basket from a range of sources - noting that prices for a good / service are not the same across all retailers - and measures the percentage change in prices over time. The ONS continually monitors the shopping basket to ensure it is representative of UK household spending, and items and/or their weightings in the basket may change from year to year.

The exact items and their weightings within a notional shopping basket and with the methodology used to calculate inflation will differ depending on the measure of inflation which the ONS is calculating. Below, we set out key measures of inflation and the main differences between each:

Consumer  Price Index (“CPI”) - measures changes in the prices of a notional shopping basket which excludes housing costs (council tax, mortgages, rent etc). However, utilities are included in the basket as non-housing costs. The UK’s inflation target of 2% is set by reference to CPI.

Further details on the CPI shopping basket for 2023 can be found at the following link.

Consumer  Price Index with Owner Occupiers’ Housing Costs (“CPIH”) - measures changes in the prices of a notional shopping basket which includes certain costs associated with owning, maintaining, and living in one’s own home (owner-occupier costs). This includes, for example, council tax and a rent equivalence figure - this is the rent that an owner-occupier would pay to live in a home like their own. Utilities and minor repairs and maintenance costs are already included in the CPIH basket as non-housing costs.

Rent equivalence is used rather than the cost of a home or mortgage repayments. This is because home prices relate to the value of an asset, and mortgage payments may vary even for the same property depending on when it was acquired, its price at that stage, how much of the mortgage has been paid off, and interest rates. Accordingly, house prices and mortgage payments are not considered by some economists as good indicators for a standardised measure of household spending and how this increases over time (this is the general international consensus).

Accordingly, the ONS consider CPIH to be the UK’s most comprehensive measure of inflation.

Retail Price Index (“RPI”) - measures changes in the prices of a notional shopping basket which includes certain owner-occupier housing costs, including council tax, mortgage interest payments, house depreciation / appreciation, buildings insurance, ground rent, and other house purchase costs (such as estate agents’ and conveyancing fees). These housing costs are different to those included in CPIH. In addition, a few other goods included in the CPI / CPIH shopping basket are excluded from the RPI shopping basket, such as (non-exhaustively) university accommodation fees.

Note - a central bank may increase interest rates if inflation is too high (to reduce AD by lowering disposable income - see our article on Monetary Policy), which would then increase any measure of inflation that incorporates mortgage interest repayments (such as RPI). Accordingly, any such measure would not be appropriate to use as a policy target due to the circularity.

There are also other measures of inflation not mentioned here, and these will differ from economy to economy.

Uses of the measures of inflation

The above measures of inflation look at slightly different things, and so can be used differently by governments and central banks when assessing an economy and making policy decisions.

In addition, the prices of certain items are linked to measures of inflation. For example:

1. CPI - state pension and benefits increases are linked to CPI. This may also apply to prices for other goods / services, such as mobile phone contract prices;
2. RPI - student loan interest rates are linked to RPI.

Deflation

Deflation means a general reduction in prices, and over an extended period is less likely to occur than inflation.

Deflation is caused by a decrease in AD, or increase in AS. The level of deflation will vary according to the magnitude of changes to AD / AS, and the shape and positioning of the AD / AS curves.

If prices decrease, this could be a good thing to some extent since people will be able to purchase more with their money as prices go down.

However, too much deflation for an extended period could also be a bad thing. If prices are decreasing, consumers may be more likely to save than spend, since they could acquire a good or service for cheaper in future. This would mean that AD decreases, which would result in lower output (GDP) and fewer people being employed (since fewer people would be needed to produce goods / services).

Governments / Central Banks have policies to combat deflation (see articles on fiscal and monetary policy).

Conclusion

You should now understand inflation / deflation, the causes of it, its significance to an economy, and the various measures of inflation. In summary:

• Inflation is the general increase in prices over time;
• It may be caused by increases in AD (demand pull inflation) or decreases in AS (cost push inflation);
• Inflation is an important economic indicator because it shows how much people can acquire compared to previous years, which is a measure of how well-off they are;
• Governments set targets for inflation at above zero, because a small amount of inflation is an indicator that GDP is growing;
• Governments and central banks use policy in an attempt to meet this target;
• In the UK, the ONS measures inflation. There are various measures, all of which look at the price of a notional shopping basket of goods and services and measure the change in prices over time. The constituents of the shopping basket and the exact method of calculation differs depending on the specific measure of inflation;
• Prices of real-world goods and services may be linked to various measures of inflation.