Measuring Inflation

Defining Inflation, Disinflation, and Deflation

Inflation is defined as a sustained increase in the average price levels of an economy, over a period of time.

Disinflation is defined as a slowdown in the increase in the inflation rate. For example, if prices rose from 2018 to 2019 by 5% and then by 3% in 2020, the economy is experiencing disinflation. The rate of inflation is still positive, but a lower increase compared to before.

Deflation is defined as a sustained decrease in the average price levels of an economy, over a period of time. Deflation is far less common due to a number of factors in an economy. Firstly, workers wages do not tend to fall due to factors such as labour market rigidities (e.g.Trade unions, National Minimum Wage legislation). Therefore lower prices would see a decrease in a firms revenues, whilst costs remain constant, thereby reducing firms profits. Similarly, markets that are dominanted by oligopolistic firms tend to have relatively stable prices, due to firms wishing to avoid price wars. Both these factors mean that wages/prices do not tend to decrease, so experiecing deflation is less likely (but not impossible)

Measuring Inflation - Consumer Price Index (CPI)

The Consumer Price Index is the most common method to measure the rate of inflation in an economy. A price index measures the average prices at a moment in time to a reference point or "base year". The changes in prices for these goods then represent the rate of inflation.

Statistical agencies within a country construct a hypothetical basket of goods, containing common goods and services that are typically consumed by households in that country. The value of this basket is measured by multiplying the price of the goods and the quantity of the goods. The same basket of goods and services and quantities are then taken with the changes in prices used to compare the changes to the base year and measure the inflation or deflation.

Constructing a weighted price index

In the example to the side we can see how we calculate the value of a hypothetical basket of goods within an economy.

Now that we have the value of the hypothetical basket of goods, we need to create our Price Index. In order to calculate a price index for the specific year:

=value of basket in a specific year /value of same basket in the base year x 100

So to calculate the weighted indices for 2017, 2018,2019:

We will take 2017 as the base year.

2017 = (186/186) x 100 = 1 x 100 = 100

2018 = (205/186) x 100 = 1.10 x 100 = 110.21

2019 = 220/186) x 100 = 1.18 x 100 = 118.27

Using a weighted price index to calculate the Inflation Rate

The inflation rate is the percentage change in the price index. It is also the change in the value of the basket of goods.

To calculate a percentage change:

Final Value - Initial Value / initial value x 100

Therefore to calculate the rate of inflation.

Between 2017 and 2018

((110.21 - 100) / 100) x 100 = 10.2%

Between 2018 and 2019

((118.27 - 110.21) / 110.21) x 100 = 7.31%

As we can see the inflation rate for 2017-2018 was 10.2% and for 2018-2019 was 7.31%. (This is an example of disinflation we mentioned earlier, as there is a decrease in the rate of inflation).

Issues with using the CPI Index

Different Inflation Rates for different income earners

Different income groups may purchase different goods compared to the "Typical" basket of goods. As such, different income groups may face different rates of inflation, which is not reflected in the CPI figures.

Different Rates of Inflation depending on regional or cultural factors

Similar to income earners, different regions of a country may purchase different goods not reflected in the typical basket due to cultural or regional factors.

Changes in price and substitute goods

In order to calculate the CPI index, we take the price of the good and times that by a quantity to weight the items. However, this measure does not take into account the fact that when prices rise of one good, consumers may begin to purchase substitute goods instead due to them being cheaper. For example, the price of a branded bag of ground coffee increases, therefore consumers switch to buying cheaper non branded bags of ground coffee. In terms of the CPI index, the branded bag of ground coffee would still be included in the measure, despite consumers switching to substitute goods.

Changes in Product Quality

Firms may improve the quality of their products over time. This may also increase the price of the good. However, CPI only measures changes in the price and not the increased quality of the good.

International Comparisons

As every country has a different "typical" basket of goods. As a result of this, this makes comparing inflation rates of countries is difficult and limits the effectiveness of comparing them. The European Union was presented with this problem with those countries that use the Euro. To solve the problem, the EU created the Harmonised Index of Consumer Prices (HICP). This measure aims to harmonise inflation figures for the entire eurozone and make comparisons more accurate.

Comparing Inflation over time

Countries review the basket of good regularly and change it when they need (see case study below). This means that price index figures are good measures in the short term, in the longer term, they become less effective as the basket of goods changes or the weightage of particular items is changed.

The RPI Measure of Inflation and its use in the UK

The Retail Price Index (RPI) is one of the key measures of inflation in the UK, reflecting the rate at which the prices of a basket of goods and services commonly bought by households are rising. RPI includes a wide range of products, such as food, clothing, housing costs, transport, and household goods, providing a comprehensive picture of consumer price inflation. It is often used to track the cost of living and inform various economic decisions.

The RPI is calculated by measuring the change in the cost of a fixed basket of goods and services over time, using data collected from various outlets and retailers. The basket is updated periodically to reflect changes in consumer spending habits and the introduction of new products or services. Unlike other measures of inflation, such as the Consumer Price Index (CPI), RPI also includes certain costs not captured in the CPI, such as housing costs (e.g., mortgage interest payments and rents) and council tax, making it a more comprehensive measure of the costs faced by households.

RPI is used for a variety of purposes in the UK, particularly in setting wages, pensions, and social security benefits. For example, index-linked pensions and some welfare payments are adjusted in line with RPI, ensuring that they keep pace with inflation and maintain their purchasing power. Additionally, RPI is often used by businesses to adjust rental agreements and determine price changes for long-term contracts, ensuring that payments remain aligned with the rate of inflation. However, RPI has been criticised for its methodology and is no longer considered an official national statistic by the UK government. As a result, the Consumer Prices Index (CPI) has become the primary measure of inflation used for monetary policy and inflation targeting by the Bank of England. Despite this, RPI remains widely used in practice for certain financial and contractual adjustments.

In recent years, the government has moved towards CPI, particularly for adjustments to public sector wages, pensions, and benefits, but RPI still plays a crucial role in the financial and housing sectors.

How Changes in World Commodity Prices Affect Domestic Inflation

Changes in global commodity prices, including oil, metals, and agricultural products, have a direct impact on domestic inflation in the UK. When the prices of essential commodities rise on the global market, the cost of producing and transporting goods increases. This often results in higher prices for consumers, driving inflation. For example, the global oil price surge in 2021 due to supply chain disruptions and increased demand as economies reopened after the pandemic led to higher fuel costs in the UK. This increase in energy prices not only raised transportation costs but also contributed to higher prices for goods and services across the board. Additionally, changes in commodity prices like wheat, which saw price hikes in 2022 due to the Russia-Ukraine war, impacted food prices in the UK, contributing to a cost-of-living crisis for consumers.

Another example is the global copper price fluctuations that have affected manufacturing costs in the UK, particularly for electronics and vehicles. As copper prices rise due to increased demand from countries like China, costs for manufacturing goods in the UK also rise, leading to higher prices for end consumers and fueling inflation.

How Changes in Other Economies Can Affect Inflation in the UK

Changes in other economies, especially major global players like the United States, China, and the Eurozone, can influence inflation in the UK through trade links, currency fluctuations, and global financial trends. For instance, the US Federal Reserve's monetary policy decisions (such as interest rate hikes) often have a ripple effect on global inflation. When the US raises interest rates to curb inflation, it strengthens the US dollar, which in turn makes imports into the UK more expensive. This increase in import prices can lead to higher costs for consumers in the UK, driving up inflation.

Similarly, the economic slowdown in China can affect global supply chains, reducing demand for UK exports and leading to reduced economic growth. For example, during the COVID-19 pandemic, China’s lockdowns disrupted global manufacturing and shipping, creating shortages of goods and materials. This caused a rise in prices for items like electronics and machinery, which had a knock-on effect on inflation in the UK, as manufacturers faced higher input costs, leading to higher prices for consumers.

Another example is the Eurozone’s economic performance and its impact on inflation in the UK. As the UK shares close trade ties with EU countries, economic instability in the Eurozone—such as a recession or financial crisis—can lead to reduced demand for UK exports, creating economic pressure. For instance, the Eurozone debt crisis in 2009 caused inflationary pressures in the UK as weak demand from European markets led to lower growth and rising prices domestically.

These examples show how global economic conditions, from commodity price changes to the economic policies of other nations, can significantly influence inflation in the UK, affecting everything from consumer prices to wage growth and economic stability.

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