Inflation: measurement, causes and effects

The CPI and weighted baskets, calculating inflation from index numbers, demand-pull and cost-push causes and who wins and loses. Through 2022’s 11.1%.

11.1%: the highest for over 40 years.

UK consumer price inflation reached 11.1% in October 2022, driven by soaring gas and electricity prices and rising food prices. The Bank of England’s target is 2%. Prices kept rising after that, but more slowly: inflation fell back over 2023 and 2024, then rose again to 3.5% in September 2026.

How is inflation measured, why does it happen and why does it matter who it hits?

Source: Office for National Statistics, Consumer price inflation (November 2022).

Measuring inflation.

Inflation is a sustained rise in the general price level. Deflation is a sustained fall. Disinflation is a fall in the rate of inflation: prices still rise, but more slowly.

The UK measures it with the Consumer Prices Index (CPI): the ONS tracks the prices of a basket of over 700 goods and services, weighted by how much households spend on each, using surveys of household spending. The government’s target for CPI inflation is 2%.

Two other measures: CPIH adds owner-occupiers’ housing costs and council tax, and is the ONS’s preferred measure; the older Retail Prices Index (RPI) includes mortgage interest payments and is usually higher, because of the way it is calculated.

An index number shows prices relative to a base year set at 100. If the index rises from 100 to 104, prices have risen by 4%.

The effects of inflation.

• Savers lose if interest rates are below inflation: their money buys less. Borrowers gain: inflation shrinks the real value of their debts.
• People on fixed incomes, or whose wages rise slower than prices, lose: their real income falls.
• Poorer households are often hit hardest, because food and energy, which rose fastest in 2022, are a larger share of their spending.
• Firms face uncertainty, which can cut investment, and menu and shoe-leather costs of changing prices and managing cash.
• UK goods can become less internationally competitive if UK inflation is higher than elsewhere.

Deflation can be harmful too: people delay spending if they expect prices to fall, which cuts AD.

Think first

Inflation falls from 10% to 4%.

What happens to the prices people pay in the shops?

Inflation is the rate at which prices rise. Falling inflation means prices are rising more slowly, not falling. Only deflation, negative inflation, means prices are falling.

Step by step

1. A weighted basket. Each item’s price change counts in proportion to how much is spent on it. Here energy prices rise 30%, but energy is only 10% of spending, so it adds 3 percentage points. Add all the weighted changes: inflation is 7.3%.

2. To find inflation from index numbers, use the percentage change, not the change in points: (new − old) ÷ old × 100. Only when the old index is 100 are the two the same.

   Check: A price index rises from 120 to 126. What is the rate of inflation?

   (126 − 120) ÷ 120 × 100 = 5%. Not 6%: the index rose 6 points, but from 120, not 100.

3. Causes. Demand-pull inflation: AD rises faster than the economy can supply, for example from strong consumer spending or low interest rates. The price level is pulled up as output rises.

4. Cost-push inflation: rising costs, such as energy, wages or imported goods after a fall in the pound, shift SRAS left. Prices rise while output falls. 2022 was mainly cost-push. Expectations matter too: if workers expect high inflation, they bargain for higher wages, which raises costs again: a wage-price spiral.

   Check: Which is most likely to cause cost-push inflation?

   Higher costs shift SRAS left. The others raise AD.

5. Inflation does not hit everyone equally. Start with savers.

   Check: Inflation is 5%. A saver’s account pays 2% interest a year. What happens to the real value of the savings?

   The real interest rate is roughly the interest rate minus inflation: 2% − 5% = −3%. The savings buy about 3% less each year.

6. Low, stable inflation, around 2%, is the goal: it is predictable, leaves room for interest rates to be cut and avoids the risks of deflation.

A common mistake

Falling inflation (disinflation) means prices are rising more slowly. Prices only fall with deflation, when inflation is negative.

Exam question

Explain how the Consumer Prices Index is used to measure inflation.

Model answer

Inflation is a sustained rise in the general price level. In the UK it is measured by the Consumer Prices Index.

The Office for National Statistics tracks the prices of a representative basket of over 700 goods and services that households buy, collected each month from shops and online. Each item is given a weight according to the share of household spending that goes on it, based on spending surveys, so a price rise in something people spend a lot on, such as housing costs or food, counts for more than one in something they rarely buy.

The weighted prices are combined into a single index number, with a base year set at 100. The rate of inflation is the percentage change in the index over twelve months: for example, if the CPI rises from 120 to 126, inflation is (126 − 120) ÷ 120 × 100 = 5%.

However, the CPI is an average, so it may not match the inflation any one household faces: poorer households, who spend a larger share on food and energy, faced higher inflation than the CPI showed in 2022. The basket is also updated only once a year, so it can be slow to pick up new spending patterns and quality changes.