Inflation is best defined as a sustained increase in the general price level leading to a fall in the value of money. In this section we will concentrate on the measurement of inflation in the UK.

The UK consumer price index since 1930 – notice the effect of the high rates of inflation during the 1970s and the 1980s.

The consumer price index (CPI) is a weighted price index which measures the monthly change in the prices of goods and services.  The spending patterns on which the index is weighted are revised each year, mainly using information from the Family Expenditure Survey. The expenditure of some of the higher income households, and of pensioner households mainly dependent on state pensions, is excluded. As spending patterns change over time, the weightings used in calculating the CPI are altered. The consumer price index is now used as the main official measure of inflation in the UK. It is a weighted price index. The current weights used in the calculation of the price level are summarised in the table below:

Weights used in the consumer price index

	Food & Non-Alcoholic Drinks	Alcohol and Tobacco	Clothing & Footwear	Housing, water & fuels	Household furnishings	Health	Transport
1988	184	67	84	134	76	5	159
2004	106	46	62	103	75	22	151
	Transport	Communication	Recreation & Culture	Education	Hotels, Cafes	Miscellaneous goods & services
1988	159	20	94	9	118	50
2004	151	26	150	16	137	106

 

The changes in these weights reflect significant shifts in spending patterns of households in the British economy. The weighting attached to food and non alcoholic drinks has declined from 184/1000 in 1988 to just 106/1000 this year. In contrast families are spending proportionately more of their budgets on recreation and cultural activities, hotels and cafés!

Calculating a weighted price index

The following hypothetical example shows how to calculate a weighted price index for a number of categories of consumer spending.

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 and then 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%.

The inflation target for the UK

The inflation target for the UK economy is consumer price inflation of 2.0%. This inflation target is set each year by the Chancellor and it is the task of the Bank of England (BoE) to meet this target. There is a permitted band of fluctuation of +/- 1%. The inflation target was changed in December 2003. Between May 1997 and December 2003 the inflation target was for CPIX (retail price inflation excluding mortgage interest rates) and the target was 2.5%.

The progress of the UK economy in keeping to the 2% inflation target since the millennium

Limitations of the Consumer Price Index as a measure of inflation

The retail price index is a thorough indicator of consumer price inflation for the British economy but there are some weaknesses in its usefulness for some groups of people.

• The CPI is not fully representative: Since the CPI represents the expenditure of the ‘average’ household, it may be inaccurate for the ‘non-typical’ household. 14% of the index is devoted to motoring expenses - inapplicable for non-car owners. Single people have different spending patterns from households that include children, young from old, male from female, rich from poor and minority groups. We all have our own ‘weighting’ for goods and services that does not coincide with that assigned for the retail price index.
• Housing costs: The ‘housing’ category of the CPI records changes in the costs of rents, mortgage interest, property and insurance, repairs. It accounts for around 16% of the index. Housing costs vary greatly from person to person, from the young house buyer, mortgaged to the hilt, to the older householder who may have paid off his or her mortgage.
• Changing quality of goods and services: Although the price of a good or service may rise, this may be accompanied by an improvement in quality as the good. 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.