Inflation is a situation of rising prices in the economy.

A more exact definition of inflation is a sustained increase in the general price level in an economy. Inflation means an increase in the cost of living as the price of goods and services rise.

The rate of inflation measures the annual percentage change in the general price level.

Inflation and value of money

Inflation leads to a decline in the value of money. “Inflation means that your money won’t buy as much today as you could yesterday.”

If the prices of goods rise. the same amount of money will purchase a smaller quantity of goods.

This diagram shows how inflation in the US has eroded the purchasing power of the dollar. The biggest decline in the purchasing power of the dollar occurred in the 1970s when inflation was highest.

Purchasing power of the Pound Sterling (1920=100)

1920 1930 1940 1950 1960 1970 1980 1990 1998 100 125 129 98 66 46 133 6.8 5.33

This table shows us that £100 buys fewer goods in 1998 than 1920, (approx 78% of its value)

Types of inflation

Cost-push inflation – when a rise in prices is caused by a rise in the cost of production, such as higher oil prices

Demand-pull inflation – when a rise in prices is caused by rising aggregate demand and firms pushing up prices due to the shortage of goods

Definition Hyper-Inflation

Hyperinflation is generally considered to occur when inflation is greater than 1000%. With hyperinflation, money loses its value so rapidly that nobody wants to use it as a medium of exchange.

In 1920s Germany had inflation of 100 billion %

In 1946 Hungary had inflation of 42,000 billion per cent

See: Hyperinflation

Graph showing UK inflation rate

UK inflation in the post-war period.

In 1974, the inflation rate peaked at 25%. This was due to rising oil prices and rising wages.

In the late 1990s and early 2000s, the inflation rate fell to less than 2% in 2004.

This fall in the inflation rate means prices were increasing at a slower rate.

UK Inflation since 2000

Inflation was close to the governments target of 2% between 2000-2007

In 2008, inflation peaked at 5%, primarily because of a surge in the price of oil.

Inflation fell in 2009, because of the recession and fall in demand.

In mid-2015, there was a short period of deflation (negative inflation rate – falling prices)

Definition of Deflation

Deflation is a fall in the price level of the economy. It means there will be a negative inflation rate.

See more on deflation

Measuring inflation

To calculate inflation, the statistics authority (ONS)

Measure the price of 1,000 goods every month

Gives a weighting to different goods depending on how important they are in a typical basket of goods.

An index is created with calculates the weighting of good * price change.

See more on Measuring inflation

Costs of inflation

Inflation is seen to have economic costs. These include:

A decline in value of savings Uncertainty for business leading to less investment. A decline in the competitiveness of exports (if inflation higher than in other countries.)

See also: Costs of inflation

Causes of inflation

Inflation can be caused by:

Excess demand. Rapid economic growth causes firms to put up prices Rising costs. For example, rising price of oil/commodities causes rise in price of goods.

See also: Causes of inflation

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