Inflation To define inflation and to explain how it is measured

Definition of inflation A sustained increase in the general price level leading to a fall in the purchasing power of money. Full definition is safest, but can be just the first – For example, from the mark scheme to January 2011 exam: Definition of inflation: an increase in the cost of living or average/general price level, or a fall in the purchasing power of £1 (2 marks) Inflation measures the increase in prices for households, not by firms

What is deflation? What is disinflation? Deflation – a decrease in the general price level (negative inflation) Disinflation – a decrease in the rate of inflation (eg inflation was 1% last month and it is now 0.5%)

How is it calculated Inflation means an increase in the general price level By the general price level we mean the cost of a basket of goods There are various different measures of inflation, but we use the Consumer Price Index (CPI) to measure the cost of a basket of goods. This is the internationally recognised measure, so inflation can be compared between countries You also need to know about the Retail Price Index (RPI)

How is it calculated -2 1.What is in the basket of goods, and how important it is (how it is weighted) is determined each year?: – The basket is based on the ONS’s (Office for National Statistics) annual Food and Living Costs Survey of spending by UK households plus foreign visitors. A few other sources as well – A few thousand households keep a record of their spending over the course of a fortnight – This leads to a typical basket of goods and services of about 700 items, representing the spending of an average household

How it is calculated - 3 Weighting means that the goods that we spend a higher proportion of income on get more importance in the basket How do we calculate changes in the cost of the basket? – Each month the prices of the 700 items representing the basket are checked, mostly by visiting, telephoning stores or checking online. About 180,000 prices are collected – A new index is then calculated by applying the increase in the price of the good to the weight of each good in the basket

Sample CPI calculation Imagine we spend our money on food, clothing and transport. Say: – 30% of our weekly basket is spent on food, and food prices rose by 5% in the last month; – 20% is spent on clothing and prices fell 10%; – 50% is spent on transport and prices rose by 2% What has happened to the cost of the basket. For each £100 we spend – Our food costs rose from £30 to £31.50 (+5%), ie +£1.50 – Our clothes costs fell from £20 to £18 (-10%), ie -£2.00 – Our spending on transport rose from £50 to £51 (+2%), ie +£1.00 – So overall spending, ie the cost of the basket, rose from £100 to £ – This can be shown in a table using index number and weights weight Index last month% change Effect on basket Food301005%= 5% x 30/1001.5% Clothing %= -10% x 20/ % Transport501002%= 2% x 50/1001.0% Overall CPI % Overall change in cost of basket0.5%

Calculation - CPI Weights Index (2005=100) ChangeWeighted Aug %contribution abcd=(dxa)/1000 CPI (overall index) % 01 Food and non-alcoholic beverages %-0.26% 02 Alcoholic beverages and tobacco %0.09% 03 Clothing and footwear %0.04% 04 Housing, water, electricity, gas and other fuels %0.05% 05 Furniture, household equipment and maintenance %0.02% 06 Health %0.04% 07 Transport %-0.39% 08 Communication %0.04% 09 Recreation and culture %-0.13% 10 Education %0.26% 11 Restaurants and hotels %0.22% 12 Miscellaneous goods and services %0.08% All goods %-1.05% All services %1.09% All items CPI excluding Energy, food, %0.77% alcoholic beverages and tobacco

Other Measures of Inflation Retail price Index (RPI). Differences are in – The households chosen RPI excludes richest households and pensioners – The goods in the basket More housing costs in RPI, particularly mortgage interest payments, housing insurance and estate agent fees Examiners expect you to know this – The method of calculation RPI is calculated with an arithmetic mean, and CPI with a geometric mean. This means CPI will better reflect changes in spending patterns as prices change (that households will spend less on goods which see price increases, and more when prices fall) Why do we need to know about RPI – Has been used in the UK for a long time – Is used to change some pensions (though not as much as in the past), so that if the RPI rises by 5% pensions are increased by 5%

Keeping the basket representative It is important that the index is representative and kept up-to-date. The basket of goods and services is therefore reviewed every year, helping to ensure that the CPI calculations more accurately reflect UK shopping and purchasing patterns. In particular – New products can be included in the basket – smart phones/tablets would not have been included several years ago – The basket can keep pace with general changes in our spending habits. Over the years people have tended to spend more of their money on electrical goods, travel and leisure while the proportion they spend on basics has fallen Footnote: the basket includes some goods which many people do not buy, eg cigarettes. – Some groups – pensioners, students – may face an entirely different rate of inflation in their monthly spending. It is possible to calculate your own inflation rate –