Definitions & Measurement

Inflation and Deflation

Inflation and Deflation

• Inflation is the sustained increase in the general price level of goods/services in an economy

  • The general price level is measured by checking the prices of a 'basket' of goods/services that an average household will purchase each month

  • This basket of goods is turned into an index and it is called the consumer price index (CPI)

  • The UK has an inflation target of 2% per annum

    • Low inflation is better than no inflation as it is a sign of economic growth

• Deflation occurs when there is a fall in the general price level of goods/services in an economy

  • Deflation only occurs when the percentage change in prices falls below zero %

Using the Consumer Price Index (CPI) to Measure Inflation and Deflation

Using the Consumer Price Index (CPI) to Measure Inflation and Deflation

• Inflation is the sustained increase in the general price level of goods/services in an economy

• The inflation rate is the change in general price levels in a given time period

  • The inflation rate is calculated using an index with 100 as the base year

  • If the index is 100 in year 1 and 107 in year 2 then the inflation rate is 7%

• The consumer price index (CPI) is used to measure inflation

The consumer price index (CPI)

• A 'household basket' of 700+ goods/services that an average family would purchase is compiled on an annual basis

  •  A household expenditure survey is conducted to determine what goes into the basket

  • Each year, some goods/services exit the basket and new ones are added

• Goods/services in the basket are weighted based on the proportion of household spending

  • E.g. More money is spent on food than shoes, so shoes have a lower weighting in the basket

• Each month, prices for these goods/services are gathered from hundreds of locations across the country

  • These prices are averaged out

• The price x the weighting determines the final value of the good/service in the basket

  • These final values are added together to determine the price of the 'basket'

• $\mathrm{CPI} =\frac{\mathrm{Cost} \mathrm{of} \mathrm{basket} \mathrm{in} \mathrm{year} \mathrm{X}}{\mathrm{Cost} \mathrm{of} \mathrm{basket} \mathrm{in} \mathrm{base} \mathrm{year}} \mathrm{x} 100$
  

• The percentage difference in CPI between the two years is the inflation rate for the period