2.1.2

What is inflation?

Inflation is a sustained increase in the general price level in an economy, which reduces the purchasing power of money.

What is deflation?

Deflation is a sustained fall in the general price level in an economy.

What is disinflation?

Disinflation is a fall in the rate of inflation, meaning prices are still rising but at a slower rate.

How is inflation measured in the UK?

Inflation is measured in the UK using the Consumer Price Index (CPI).

What does CPI measure?

CPI measures the average change in prices of a basket of goods and services purchased by households.

How is the CPI calculated?

The ONS collects prices of goods and services, combines them into a representative basket, applies weights based on household spending patterns, and calculates an index number.

How are index numbers calculated?

Index = (new figure ÷ base figure) × 100. The base year is equal to 100.

How does the ONS collect CPI data?

The ONS collects prices for around 710 goods and services from about 20,000 shops and online retailers across 141 locations, updated monthly.

What determines the weight of goods in CPI?

Weights are based on the Living Costs and Food Survey, which records household spending patterns. Goods with higher spending have a greater influence on inflation.

Why may CPI not be representative?

Different households have different spending patterns, so CPI only reflects an average rate of inflation.

Why might CPI underestimate inflation?

CPI may not fully capture rising housing costs.

Why is CPI difficult to compare historically?

Changes in methodology over time make long-term comparisons more difficult.

Why may CPI overestimate inflation?

CPI may overestimate inflation because it does not fully account for improvements in the quality of goods and services.

What is the Retail Price Index (RPI)?

RPI is an alternative measure of inflation in the UK.

What is a key difference between CPI and RPI?

RPI includes housing costs such as mortgage interest payments and council tax, whereas CPI does not.

Why is CPI usually lower than RPI?

CPI is usually lower than RPI because it accounts for substitution effects when people switch to cheaper goods.

Who is excluded from the RPI calculation?

The top 4% of income earners and some low-income pensioners are excluded from the RPI calculation.

What is demand-pull inflation?

Demand-pull inflation is inflation caused by excess demand in the economy, when aggregate demand increases faster than aggregate supply.

What is cost-push inflation?

Cost-push inflation is inflation caused by rising production costs, which push firms to increase prices.

How can growth of the money supply cause inflation?

If the money supply increases faster than output, more money chases the same number of goods and services, causing prices to rise.

What is the Fisher equation?

The Fisher equation is MV = PT, where M is money supply, V is velocity of circulation, P is the price level, and T is transactions or output.

How can banks increase the money supply?

Banks can increase the money supply through credit creation and the bank multiplier, where deposits create multiple rounds of lending.

How does inflation affect consumers?

If incomes do not rise with inflation, real incomes fall and consumers can buy fewer goods and services.

How does inflation affect savers and borrowers?

Borrowers benefit because they repay loans with money worth less, while savers lose because the real value of savings falls.

What psychological effects can inflation have on consumers?

Rising prices may make consumers feel worse off, which may reduce their spending.

How can inflation affect firms’ competitiveness?

Higher domestic inflation can make exports less competitive internationally.

How does inflation create uncertainty for firms?

Unpredictable inflation makes future costs and prices difficult to forecast.

What are menu costs?

Menu costs are the costs firms incur when changing prices, such as updating menus, catalogues, or price lists.

How can inflation affect government finances?

If tax thresholds are not adjusted, governments may receive higher tax revenues in real terms.

How does inflation affect workers?

If wages do not rise as fast as inflation, real wages fall and living standards decrease.

How can deflation affect employment?

Falling prices can reduce demand and profits, causing firms to cut jobs.

What is indexation?

Indexation is adjusting wages, pensions, or benefits in line with inflation.