What is inflation?

Inflation is an increase in the general price level of goods and services over time. A rise in one product’s price alone is not general inflation. When prices rise faster than income, the same money buys less. Understanding inflation requires distinguishing the price level from the rate at which prices increase.

How is inflation measured and what causes it?

1. Price indices and the consumption basket The consumer price index combines prices of different goods and services using weights based on household spending. Food, rent, transport and other groups receive different weights. It is an average measure: personal experiences differ because households do not buy the same products in the same proportions. 2. Monthly and annual rates Monthly inflation compares prices with the previous month; annual inflation compares them with the same month a year earlier. An index rising from 100 to 125 increases by 25 percent. Monthly changes compound, so simply adding monthly percentages does not calculate annual inflation correctly. Base effects arise when the earlier comparison period was unusual. 3. Demand, costs and expectations Demand exceeding productive capacity can create price pressure. Energy, imported inputs, transport and production costs also affect prices. Exchange rates and expectations of future inflation can influence wage and pricing decisions. Several forces may operate together; explaining every episode with one cause is misleading.

Effects of inflation and commonly confused concepts

4. Income and debt People whose fixed incomes do not keep pace with prices lose purchasing power. Effects on debt depend on fixed or variable interest rates, income adjustments and the currency of borrowing. Inflation does not affect everyone equally. 5. Disinflation and deflation Inflation falling from 40 to 20 percent does not mean prices have fallen: their rate of increase has slowed. This is disinflation. A decline in the general price level is deflation. A discount on one product is not evidence of general deflation. 6. Interpreting the figures Headline inflation should be considered alongside components, underlying measures and seasonal effects. Lasting price stability is related to monetary policy, fiscal policy, expectations and production conditions. One monthly observation cannot establish a long-term trend.