Definitions and types of inflation

Inflation refers to a continuous increase in the general level of prices for goods and services across an economy over time. Alternatively, it can be viewed as a reduction in the real value of money, where the same sum purchases fewer items than previously.

Characteristics of inflation

• During inflation, prices of certain products may increase more rapidly than the overall average.
• Some prices might rise at a slower pace.
• In some cases, prices of specific goods could even decrease.

Main types of inflation

• Positive inflation - Occurs when the general price level is increasing.
• Deflation - Happens when the general price level is decreasing, also known as negative inflation.
• Hyperinflation - Involves extremely rapid price increases, causing money to lose its value quickly.
• Disinflation - Takes place when the rate of price increases slows, for example, from 9% to 6%, meaning prices continue to rise but less quickly.

The retail price index (RPI)

The retail price index (RPI) measures changes in the cost of a typical selection of goods and services purchased by households. It relies on two main surveys to gather data.

Surveys used in calculating RPI

• Living Costs and Food Survey - Involves approximately 6,000 households to determine the share of income spent on various items.
• Price survey - Tracks price changes for around 700 commonly bought goods and services.

Process of calculating RPI

Items in the selection, known as the basket of goods, are chosen based on the Living Costs and Food Survey. The basket is updated over time to reflect shifts in technology, consumer preferences, and trends.

Price changes from the second survey are adjusted using weightings from the first survey, which reflect spending proportions. These weighted changes are then turned into an index number.

The inflation rate is the percentage change in this index number over a period. For example, if the index increases from 100 to 104, the inflation rate is 4%.

Worked example - Calculating inflation rate from RPI

The RPI index number for a country rises from 100 in January to 105.2 in December. Calculate the annual inflation rate.

Step 1: Identify the values

• Initial index number = 100
• Final index number = 105.2

Step 2: Apply the percentage change formula

$\text{Inflation rate}=\frac{\text{final index number}-\text{initial index number}}{\text{initial index number}}\times 100$

Step 3: Calculate the inflation rate

$\text{Inflation rate}=\frac{105.2-100}{100}\times 100=5.2\%$

The consumer price index (CPI)

The consumer price index (CPI) is calculated similarly to the RPI but with key differences, making it the official inflation measure in the UK. It is also used for comparisons between countries, as many nations collect similar data.

Key differences between CPI and RPI

• Excluded items - CPI omits certain costs, such as mortgage interest payments and council tax.
• Calculation method - CPI uses a slightly different formula for combining data.
• Sample size - CPI draws from a larger group of the population for its surveys.

These variations usually result in a lower CPI figure compared to RPI, except when interest rates are particularly low.

Limitations of RPI and CPI

Both the RPI and CPI have drawbacks that can affect their accuracy as measures of inflation.

Main limitations

• Population coverage - RPI leaves out the highest 4% of income earners, while CPI includes a wider range but excludes mortgage interest payments and council tax.
• Data accuracy - Responses in the Living Costs and Food Survey may not always be reliable.
• Basket updates - The selection of goods is only revised annually, so it may not capture quick shifts in consumer behaviour.

Importance of RPI and CPI for government policy

The RPI and CPI influence various aspects of economic policy, particularly in areas like income adjustments and trade.

Use in wages and benefits

• Employers and trade unions refer to these indices during pay discussions to set starting points.
• Governments apply them to adjust state pensions and welfare payments.
• Certain benefits are index-linked, meaning they increase automatically each year in line with the chosen index's percentage change.

Role in international competitiveness

If a country's CPI inflation rate exceeds that of its trading partners, its products become more expensive for foreign buyers, reducing price competitiveness.

This can lead to:

• A decline in exports, as goods cost more abroad.
• An increase in imports, as foreign products become relatively cheaper domestically.