EFA (15): Inflation

Inflation is a key concept in economics. But what exactly is inflation and how is it measured? This is the subject of the 15th item in our Economics for Amateurs (EFA) series. You can find this series here every Monday.

If the price of cars goes up, is that inflation? Strictly speaking, it isn’t. Inflation is defined as a “sustained rise in the general price level”, rather than as an increase in the price of any particular good or service. A sustained fall in the general price level is called deflation, which is what many people are worried about at the moment.

Inflation is normally expressed in percentage terms at an annual rate. So, inflation of five per cent means that, on average, prices are five per cent higher than in the same month of the year before. The increase in the price level within a particular month is also often reported, as is the increase in the average price level from one calendar year to the next.

A rise in the general price level means a fall in the value of money. In periods of extreme inflation, called hyperinflation, money becomes almost worthless. Higher inflation normally goes hand in hand with booming economic activity and low unemployment. However, a dramatic increase in the prices of key inputs (such as oil) can lead to stagflation, a combination of high inflation and high unemployment (stagnation). The reason is simple: the rise in the price of oil causes not only a general price rise but also a reduction in the demand for other goods and services.

The most common measure of inflation is a consumer price index (CPI). This measures the changes in the retail prices of a typical basket of goods and services, weighted according to the share of their income that consumers spend on each good or service. An increase in the CPI is called the “headline” rate of inflation because it is often reported in the media.

An alternative measure is "core inflation", which leaves out goods with volatile prices, such as food and oil. This may understate or overstate inflation at any given moment, but it can be a better measure of the underlying trend. Another inflation measure is the GDP deflator (or “implicit price deflator for GDP”). Unlike the CPI, which includes import prices, the GDP deflator compares only the prices of goods produced and services offered within the domestic economy in any given year.

Other inflation measures are producer price indices (PPI). The “factory gate prices” or “wholesale prices” are the prices of firms’ output, and are useful indicators of future consumer inflation. There are also inflation measures for the input prices paid by firms. Wage inflation is the increase in the employees' wages and salaries.

When we talk of wages (or GDP) increasing “in real terms”, this means that they are rising faster than prices. Also, the real rate of interest is the nominal rate minus the rate of inflation.

Many central banks have explicit inflation targets, usually for consumer prices. But price stability does not normally mean a target of zero inflation. The European Central Bank, for example, aims to keep inflation “below but close to” two per cent a year. At present, however, it is zero. The Bank of England, on the other hand, allows inflation to be slightly over or under two per cent. At present, it is 2.3 per cent.