Theme 2.2: Measuring Inflation

Question 1

The two ways to define inflation

Answer 1

Inflation is the sustained rise in the average price of goods and services over a period of time. Keep in mind that:

• The prices of some goods may be rising faster than the average
• Some prices may be rising more slowly
• Some prices may even be falling

Inflation can also be seen as a fall in the value of money. This means that:

• A fixed amount of money (e.g. £10) buys less than before.
• The purchasing power of money has fallen

Question 2

What does +/- inflation mean?

The difference between inflation / disinflation / deflation / hyperinflation

Answer 2

Inflation (or positive inflation) is when the average price of goods and services is rising

Sometimes the average price will actually be falling. This is called negative inflation, or deflation.

Other times, a country may experience hyperinflation. This is when prices rise extremely quickly and money rapidly loses its value.

If the rate of inflation is slowing down, e.g. from 6% to 4%, this is called disinflation. Prices are still rising but at a slower speed.

Question 3

What are the two main measurements for inflation?

Answer 3

RPI (Retail price index)

CPI (Consumer price index)

Question 4

Calculating the RPI - Living costs and food survey

Answer 4

The first survey is called the Living costs and food survey.

This is used to find out what people spend their money on, e.g. petrol, apple and haircut. The survey also shows what proportion of income is spent on items. This is used to work out the relative weighting of each item (this will be important in a second) - for example, if 20% is spent on transport, then a 20% weighting will be given to transport.

Question 5

Calculating the RPI - Basket of goods

Answer 5

The second survey is based on prices - it measures the changes in price of around 700 of the most commonly used goods and services (these goods are often referred to as the basket of goods).

The items are chosen based on the living costs and food survey. what is in the basket of goods changes over time, because technology, trends and taste change (see the diagram below for some examples). This ensures that the basket of always reflects what the average household might spend it’s money on.

The price changes changes in the second survey are multiplied by the weightings from the first survey. These are then converted to index numbers.

Question 6

The Consumer Price Index (CPI)

Answer 6

The CPI is calculated in a similar way to the RPI, but there are three main differences:
- Some items are excluded from the CPI, the main ones being:
Mortgage interest payments
Council tax
- A slightly different formula is used to calculate the CPI
- A larger sample of the population is used for the CPI

These differences mean that the CPI tends to be a little lower than the RPI - the exception is when the interest rates are very low. However, they both tend to follow the same long-term trend.

The CPI is the official measure of inflation in the UK. Many other countries collect data on inflation in a similar way to the CPI, so it’s used for international comparisons.

Question 7

Limitations of the CPI and RPI

Answer 7

The RPI and CPI can be really useful but also have their limitations:

• The RPI excludes all households in the top 4% of incomes. The CPI covers a broader range of the population, but it doesn’t include mortgage intrest payments or council tax.
• The information given by the households in the Living costs and food survey can be inaccurate
• The basket of goods only changes once a year - so it might miss some short term changes in spending habits