Study notes

Inflation - Measuring Inflation

What is inflation?

Inflation is a sustained increase in the cost of living or the general price level leading to a fall in the purchasing power of money

How is the rate of inflation measured?

  • The rate of inflation is measured by the annual percentage change in consumer prices.
  • The British government has set an inflation target of 2% using the consumer price index (CPI)
  • It is the job of the Bank of England to set interest rates so that aggregate demand is controlled, inflationary pressures are subdued and the inflation target is reached
  • The Bank is independent of the government with control of interest rates and it is free from political intervention. The Bank is also concerned to avoid price deflation
Inflation Rate in the UK Economy in Recent Years

Falling inflation does not mean falling prices!

  • Please remember that a fall in the rate of inflation is not the same thing as a fall in prices!
  • In 2009 there was a drop in inflation from 5 per cent to 1 per cent over the course of the year. Inflation was falling – but the rate remained positive – meaning that prices were rising but at a slower rate!
  • A slowdown in inflation is not the same as deflation!
  • For this to happen, the annual rate of price inflation would have to be negative.

How is the rate of inflation calculated?

  • The cost of living is a measure of changes in the average cost of buying a basket of different goods and services for a typical household
  • In the UK the main measure of inflation is the consumer price index (CPI)

Calculating a weighted price index

  • CPI is a weighted price index. Changes in weights reflect shifts in the spending patterns of households in the British economy as measured by the Family Expenditure Survey.

The following hypothetical example shows how to calculate a weighted price index.

Category Price Index Weighting Price x Weight
Food 104 19 1976
Alcohol & Tobacco 110 5 550
Clothing 96 12 1152
Transport 108 14 1512
Housing 106 23 2438
Leisure Services 102 9 918
Household Goods 95 10 950
Other Items 114 8 912
100 10408

Weights are attached to each category; we multiply these weights to the price index for each item of spending for a given year.

  • The price index for this year is: the sum of (price x weight) / sum of the weights
  • So the price index for this year is 104.1 (rounding to one decimal place)
  • The rate of inflation is the % change in the price index from one year to another.
  • So if in one year the price index is 104.1 and a year later the price index has risen to 112.5, then the annual rate of inflation = (112.5 – 104.1) divided by 104.1 x 100. Thus the rate of inflation = 8.07%.
Weighting the Consumer Price Index in the UK

Limitations of the Consumer Price Index as a measure of inflation

Few households are average – the published figure for inflation is rarely the actual rate of inflation experienced by different people

  1. The CPI is not fully representative - it will be inaccurate for the ‘non-typical’ household, e.g. 14% of the CPI index is devoted to motoring costs - inapplicable for non-car owners.
  2. Spending patterns: e.g. Single people have different spending patterns from households that have one or more children
  3. Changing quality of goods and services: Although the price of a good or service may rise, this may also be accompanied by improvements in quality / performance of the product
  4. New products: The CPI is slow to respond to new products and services – the CPI basket is changed each year but only a few items fall out / come in
Contributions to CPI Inflation in the UK

New items added to the consumer price index in 2014

Items removed from the consumer price index in 2014

Have you seen the tutor2u YouTube channel? Subscribe now and never miss a revision video!

Wake up with today’s latest teaching resources & student support

Subscribe to our daily digest and get today’s content delivered fresh to your inbox every morning.

Or follow us
Close

Explore tutor2u

Close

Economics