Study notes

Inflation - Measuring 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

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 steep 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.

CPI Inflation Rate

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 there are two measures, the Retail Price Index (RPI) & the Consumer Price Index (CPI).
  • RPI includes the costs of housing (mortgage interest costs and council tax for example) while CPI does not
  • The RPI is an arithmetic mean – the prices of everything to be included in it are simply added up and divided by the number of items.
  • The CPI is a geometric mean. It is calculated by multiplying the prices of all the items together and then taking the nth root of them, where 'n' is the number of items involved

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%.
CPI weights

Limitations of the Consumer Price Index as a measure of inflation

  • The CPI is not fully representative:
  1. Since the CPI represents the expenditure of the 'average' household, inevitably it will be inaccurate for the 'non-typical' household, for example, 14% of the index is devoted to motoring expenses - inapplicable for non-car owners.
  2. Single people have different spending patterns from households that include children, young from old, male from female, rich from poor and minority groups.
  3. We all have our own 'weighting' for goods and services that does not coincide with that assigned for the consumer price index.
  • Housing costs: The 'housing' category of the CPI records changes in the costs of rents, property and insurance, repairs. It accounts for around 16% of the index. Housing costs vary greatly from person to person.
  • Changing quality of goods and services: Although the price of a good or service may rise, this may also be accompanied by an improvement in quality as the product. It is hard to make price comparisons of, for example, electrical goods over the last 20 years because new audio-visual equipment is so different from its predecessors. In this respect, the CPI may over-estimate inflation. The CPI is slow to respond to the emergence of new products and services.
UK consumer price index
A selection of inflation rates by country

New items added to the consumer price index in 2014

Items removed from the consumer price index in 2014

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