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What is Inflation?
My take on why inflation is a misleading indication of the cost of living, taken from the forum:
Inflation (in economics) is the declining purchasing power of money. This is caused by the increase of available money (see M4 Lending) into the economy. This leads to an increase in the cost of goods as there is a greater amount of money competing for a limited number (finite) of products.
Many people/goverments state inflation is the rise in prices of goods, whereas this is still correct, it is the SYMPTOM of inflation not the CAUSE.
How is Inflation Measured?
Because the increase in the money supply is distributed unevenly into different assets/commodities it is extreamly difficult to measure inflation by monitoring the symtoms (rising prices).
There are different methods to monitor inflation, e.g. RPI/RPIX/CPI.
RPI/RPIX/CPI is and has been a completely misleading statistic for a long time. It is supposed to measure the rate of change in the cost of living, but the way it is calculated completely ignores several factors that have a bearing on this, making it next to useless. It is calculated by taking the average price of a typical persons weekly expenditure, and measuring the change in these same items. There are several reasons why this gives completely misleading figures, here are just two:
- It ignores the quality/durability of goods. Electrical goods have come down in price hugely over the last 20 years, but the length of time they are expected to last and their quality has decreased accordingly. For example, a kettle which would have last 10 years and cost £100 these days can be bought for £20 but it will only last 1 year. Therefore it's actually twice as expensive, but the inflation figures will say it's 1/5th of the price. Similarly a loaf of bread 10 years ago may have cost X amount, and it may be cheaper now, but the bread now is far less nutritious. If you want the same nutritional value as the bread of 10 years ago, you have to buy the "tesco finest" or whatever rather than the normal bread that CPI measures.
- The measure of typical mortgage repayments, which accounts for a significant amount of the typical income, is calculated on the average house price. The average house price has risen by X per year, but the average size of a house has gone down significantly at the same time! Because the rate at which 1/2 bed flats and small houses have been built is far higher than larger houses which were more typical 20 years ago. The average house price might have been a 3 bed house then, whereas now it's probably a 2 bed flat, because there's more smaller houses around.
For wage how the average wage is calculated (and thus wage inflation) see AWE.
Impact of Inflation
Poeple often miss-understand/ignore the impact of inflation. Often at a dinner party people will say that they bought a house in 1995 for £100,000 and sold it for £200,000 in 2005, thus making a whopping profit of £100,000! However, this statement ignores the effect of inflation ( not to mention the purchase and sale costs). For example if during these ten years inflation had been running at 7% per annum then the profit would be zero! If a loaf of bread cost 50p in 1995, then in this example, its price in 2005 would be £1! The way to measure inflation is the subject of much debate, at present the government uses the CPI however, the governer of the Bank of England has suggested that he would prefer it to be measured using RPI, the latter being significantly higher. In summary, take care when people state that they made a hugh profit when selling a house as they often ignore the effect of inflation.
Concerns about Inflation
Recently the CPI has fallen below 2% however, this is thought to be a temporary blip as both the oil prices and food prices are thought likely to increase significantly. This may prevent the Bank of England from decreasing interest rates and may even force them to increase interest rates (see Money week inflation article ).
Deflation
Instead of prices going up they go dowm. This has the problem that people will save money as they think it will be cheaper to buy the item tomorrow. This results in low sales and thus redundancy as companies cannot sell their produce.
Stagflation
Stagflation is stagnation with inflation. This means we have high inflation with low GDP resulting in low employment and recession.
See also:
- difference between CPI and RPI
- ONS
- Wikipedia page on Inflation
- Money illusion
- National Statistics Office Inflation
- Why a house price boom is not good for homeowners
- Forecasting
- Food prices
- Oil prices
-- TomR