What is inflation?
Inflation relates to the general increase in the prices of goods and services in an economy over time.
The rise in prices, which is often expressed as a percentage, means that a unit of currency effectively buys less than it did in prior periods, so inflation can be translated as a reduction in the purchasing power of money over time.
Typically, inflation is officially calculated based on the price of a whole range of items in a ‘basket’ of goods and services. In the UK, this is determined by the Office for National Statistics (ONS) who, every month, record the cost of over 700 things that people regularly buy. The basket includes everyday items, from a loaf of bread to a bus ticket, to much larger purchases like a car and a holiday.
The price of that basket tells us the overall price level. This is known as the Consumer Prices Index or CPI.
Inflation is conventionally quoted as an annual price change. To calculate the rate of inflation, the ONS compares the cost of the basket – the level of CPI – with what it was a year ago. The change in the price level over the year is the rate of inflation.
For example, if a bottle of milk costs £1 and that rises by 5p compared with a year earlier, then milk inflation is 5%.
A moderate level of inflation is healthy for the economy as it helps drive economic growth. Price stability allows consumers to make decisions with some level of certainty that inflation will not erode the value of money.
Inflation can be contrasted with deflation. Deflation occurs when inflation is negative, i.e. when prices decline over time. In this instance, purchasing power improves, meaning that your money can buy more goods and services.