Have you seen recently in the news that we will have to pay more for the same amounts of gas to fill our cars’ tanks and that heating is becoming more and more expensive? This is due to inflation. But, what is inflation and how does it affect our income? Can it be controlled? You will find answers to these questions in what follows and you will learn how inflation impacts the economy.
What is Inflation?
Inflation is the situation when the general price levels of goods and services increase and the value of money decreases in the economy. As a result of inflation, one may require more money to buy goods or services compared to what one would have paid in the past. Basically, it means that the same amount of money can now get you fewer units of a good or service than before.
These goods and services include:
- Essential goods (such as food items, hygiene products, housing supplies, clothing, etc.).
- Housing and cars.
- Rental services (car, accommodation, etc.).
- Luxury goods.
When the prices of goods and services go down in the economy and the comparative value of money increases, it is called Deflation.
There are two major forces that impact the economy and increase the price level of goods and services:
Cost-Push Inflation
Cost-push inflation occurs when the cost of production increases. This results in an increase in the final price of goods and services.
As a result of the rising price of wheat flour in the UK, the cost of wholemeal wheat loaves of bread has increased. Hence, the increase in the cost of wheat pushes the prices of loaves of bread to increase too.
Demand-Pull Inflation
Demand-pull inflation occurs when there is a high demand for goods and services but not enough aggregate supply. When aggregate supply and aggregate demand for goods and services don't match, there is a rise in the price of those goods and services.
When the demand for the new iPhone is very high but the rate of supply is comparatively low, the price of the new iPhone will increase causing demand-pull inflation.
The Three Different Measures of Inflation
The rate of inflation is measured in many different ways in different countries. The three most commonly used methods to measure the inflation rate are described below:
RPI: The Retail Price Index of Inflation
The RPI is now an old method of inflation calculation. The RPI is calculated using the arithmetic mean. It includes housing costs, mortgage interests, council taxes, and rent.
The RPI method is based on two surveys to collect the data.
- The first survey is the survey of households, which is called the living cost and the food cost. This survey helps to understand the people’s spending on day-to-day costs like vegetables, fruits, gas, transport, etc. Each item is given relative weightage as per the spending.
- The second survey is based on the prices of the most commonly used goods and services, which are also called the ‘Baskets of goods.’ The items in the basket may change over time.
The RPI is calculated by measuring the changes in the prices of items in the baskets of goods.
CPI: The Consumer Price Index of Inflation
The most commonly used method of inflation calculation across the globe is the CPI. The CPI is calculated using a geometric mean. CPI measures the percentage change in the prices of a basket of goods and services of household goods.
It takes into account the prices of primary consumer goods that include transportation, medical care, and food. The CPI is calculated in a similar way to the RPI. However, it has a few differences:
- It does not include council tax and mortgage interest.
- It surveys a larger population compared to the RPI.
WPI: The Wholesale Price Index of Inflation
The WPI takes into account the wholesale prices of the goods and services. This method calculates the goods’ rate of inflation at the wholesale stage and before they reach retail. The goods considered here are sold in bulk and are between business to business.
The WPI usually takes into account commodity prices. It is also calculated as the percentage change in the prices of goods and services compared to the base year.
Figure 2. Consumer and Retails Price Indices in the UK 200-2021, Source: Office for National Statistics, ons.gov.uk, StudySmarter Original
Measuring Inflation with the CPI
Most governments in the world use the CPI method to measure inflation. The CPI measures the percentage change in the prices of a basket of goods and services of household goods.
These goods and services are divided into eight categories: housing, apparel, transportation, medical, recreation, food and beverages, education, and other goods and services.
Method to calculate the CPI
- Survey. In the UK, the expenditure survey is carried out by the ONS (Office for National Statistics). This survey includes questions about what the families buy, the prices of goods and services, the quantity they buy, where they bought, and what amount of their income they spend on goods and services.
- Definition of all the goods and services in the basket. Once the details of surveys are collected, the baskets of most common goods and services are formed. These baskets help the government understand the average buying capacity of a family in the country in a given period. In the UK, the government forms about 700 baskets of goods and services.
- Weightage of all the goods and services baskets. All the goods and services in the baskets are weighted as a percentage of income spent on the particular goods or services between 0 and 1. After finding the total price of the basket, the base year is selected with the index value of 100. To calculate the index, items that are included in the shopping basket are weighted according to their importance. The more people spend on it, the higher the importance and thus the weight of the item.
- Calculation of the CPI. After finding the value of the basket and establishing the base year, the CPI is calculated using the following formula:
CPI = Cost of Market basket in the given year X 100
Cost of the market basket in the base year
The baskets are regularly updated to calculate the CPI, as there are changes in the trends, technology, etc.
Problems with the CPI Method
Although the CPI index is the most common way of calculating inflation, it has a few problems and disadvantages.
- The CPI method may miss out on some of the goods and services consumed as they may not be included in the basket.
- Since the data is generated by the survey method, there are opportunities for inaccuracies in the data.
- Comparisons with the other countries' inflation indexes may be difficult as every other country may be using a different method.
- If the baskets of goods and services are changed and are not constant, it gets difficult to compare the data over a period of time.
- The rate of inflation may differ from individual to individual. The goods and services bought in the basket may differ as well.
Measures to Control Inflation
As we already saw, inflation can be caused by cost-push inflation and demand-pull inflation. Inflation can be controlled with the following measures:
- Monetary policies: when inflation goes up, the central banks usually raise the rate of interest. The increase in interest rates reduces demand, which results in low economic growth and reduces demand-pull inflation. Sometimes, the government may resort to extreme measures like the demonetisation of currency or the issue of new currency. Demonetization helps to curb black money in the market.
- Fiscal policy: fiscal measures help the government to a large extent to control inflation. These are some measures a government can take to control inflation: Increasing taxes: the government may resort to increasing the tax rates to control inflation. With the higher tax rate, the rate of personal expenditure reduces or is controlled. Also, the people who save and invest may receive incentives. Tax evaders should also be heavily penalized to get the money back into the economy. Increasing savings: encouraging savings will reduce personal expenditures. In fact, in developing countries, to encourage people to save more, the central banks offer higher interest rates on savings and fixed deposits. Budget control: governments aim to spend less compared to the revenue generated, which helps them to create a budget surplus. This helps the government to reduce the deficit financing.
- Supply-side policies: these increase the competitiveness in the economy. The government may opt for providing tax reliefs to get more investments. This may result in more firms entering the market, which will increase supply in the economy and help to control units so eventually the price rise will decrease.
- Wage control: sometimes a trade union’s bargaining power may be very high to bargain for higher wages. At such times, limiting the wage rates can help to control inflation. However, this can be a short-term solution as such policies may hurt the workers and affect the level of production eventually leading to lower production and less supply.
- Increasing production: increasing the rate of production for consumers' goods and raw materials can as well be an adaptive measure to reduce inflation. Better technology, subsidies on products and raw materials, and fewer import duties on raw materials can help increase production.
Measures of Inflation - Key Takeaways
- Inflation is the situation when the general price levels of goods and services increase and the value of money decreases in the economy.
- Cost-push inflation occurs when the cost of production increases, which results in an increase in the final price of goods and services.
- Demand-pull inflation occurs when the aggregate demand for goods and services rises, but the aggregate supply does not match it. This leads to a rise in the prices of goods and services.
- The increase in interest rates reduces demand resulting in low economic growth and finally reducing demand-pull inflation.
- The three most commonly used methods to measure the inflation rate are:
RPI - Retail Price Index
CPI - Consumer Price Index
WPI - Wholesale Price Index.
The RPI is calculated using an arithmetic mean. It includes housing costs, mortgage interests, council taxes, and rent.
The CPI measures the percentage change in the prices of a basket of goods and services of household goods.
The WPI calculates the rate of inflation at the stages of wholesale and before they reach retail.
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