what is inflation?

Inflation measures the annual rate of change of the general price level in the economy. Inflation is a sustained increase in the average price level. We focus here on the overall level of prices throughout the economy rather than prices in one particular market or industry. It is quite possible for prices to be falling, for example in audio-visual equipment or textiles, but for there to be general price inflation across a wide range of goods and services.

Inflation and the Price Level

When prices rise, the value of money falls.  There is an inverse relationship between the price level and the internal purchasing power of money. When there is inflation money buys less in real terms. People can protect themselves against the effects of inflation by investing in financial assets that give a rate of return at least equal to the rate of inflation.

Hyperinflation is extremely rare, although some countries experience something approaching it. Recent examples include Argentina, Brazil, Georgia and Turkey (where inflation reached 70% in 1999). The classic example of hyperinflation was of course the rampant inflation in Weimar Germany between 1921 and 1923.

When hyperinflation occurs, the value of money becomes worthless and people lose all confidence in money both as a store of value and also as a medium of exchange. Often drastic action is required to stabilize an economy suffering from high and volatile inflation - and this leads to political and social instability. The International Monetary Fund is often brought into the process of implementing economic reforms to reduce inflation and achieve greater financial stability

The economy is continuously experiencing changes in relative prices as demand supply conditions alter in individual markets. For example the relative price of hi-tech goods including PCs and Multi-Media equipment is falling whilst the relative price of cigarettes and fuels has increased in recent years not least because of rising levels of indirect taxes applied on these goods by the government in successive budget announcements.

Deflation is also fairly unusual although some countries such as Japan and China have experienced price deflation in their economies in recent years.

In the United Kingdom, the main measure of inflation is done through the Retail Price Index.