Type: Study notes Levels: AS, A Level Exam boards: AQA, Edexcel, OCR, IB, Other
Inflation is a sustained increase in the cost of living or the general price level leading to a fall in the purchasing power of money
How is the rate of inflation measured?
- The rate of inflation is measured by the annual percentage change in consumer prices.
- The British government has set an inflation target of 2% using the consumer price index (CPI)
- It is the job of the Bank of England to set interest rates so that aggregate demand is controlled, inflationary pressures are subdued and the inflation target is reached
The Bank is independent of the government with control of interest rates and it is free from political intervention. The Bank is also concerned to avoid price deflation
F alling inflation does not mean falling prices!
Please remember that a fall in the rate of inflation is not the same thing as a fall in prices . In 2009 there was a steep drop in inflation from 5 per cent to 1 per cent over the course of the year. Inflation was falling – but the rate remained positive – meaning that prices were rising but at a slower rate! A
slowdown in inflation is not the same as deflation! For this to happen, the annual rate of price inflation would have to be negative.
CPI Inflation Rate
How is the rate of inflation calculated?
- The cost of living is a measure of changes in the average cost of buying a basket of different goods and services for a typical household
- In the UK there are two measures, the Retail Price Index (RPI) & the Consumer Price Index (CPI).
- RPI includes the costs of housing (mortgage interest costs and council tax for example) while CPI does not
- The RPI is an arithmetic mean – the prices of everything to be included in it are simply added up and divided by the number of items.
- The CPI is a geometric mean. It is calculated by multiplying the prices of all the items together and then taking the nth root of them, where 'n' is the number of items involved
Calculating a weighted price index
CPI is a weighted price index. Changes in weights reflect shifts in the spending patterns of households in the British economy as measured by the Family Expenditure Survey.
The following hypothetical example shows how to calculate a weighted price index.