What is inflation?

3 July 2008

Inflation is a measure of the average rise in prices of goods and services over time. In the UK, it is measured once a month by the Office of National Statistics (ONS), who compile a ‘basket’ of approximately 650 goods and services that represent the average buying habits of the public, and calculate the average rise in prices based on this.

There are two main measures of inflation that take different factors into account: the Consumer Price Index (CPI), which the Government use officially, and the wider-ranging Retail Price Index (RPI).

Many critics argue that as measures of costs of living, CPI and RPI are not all that accurate – neither seem to reflect the fast rise in essential costs of living (e.g. housing, groceries, taxes, utilities etc.). But regardless of whether the official inflation rate reflects real-life experience, it is taken very seriously and has a significant knock-on effect on the rest of the economy.

How does inflation affect me?
The Bank of England aim to keep inflation at around 2% each year – which they believe maintains safe and steady economic growth. If inflation raises above or falls below this figure, they will attempt to steady it, normally by altering their base rate (which tends to affect the interest rates that banks, building societies and other lenders offer to consumers).

Low inflation

If inflation is below target, the Bank of England tend to lower their base rate, which usually lowers interest rates available to consumers. This makes saving money less worthwhile, and encourages more consumer spending. This increased demand for goods and services pushes average prices up, which in turn raises inflation.

Homeowners and other borrowers will benefit from this, as they will not have to pay as much in interest – their loans will effectively be cheaper. But lower interest rates will hit people with existing savings – they will not gain as much in interest as they may be used to.

High inflation

If inflation is above target, the Bank of England are likely to raise the base rate (and interest rates will usually rise with it). This encourages more people to save more and spend less, and the decreased demand means average prices fall, lowering inflation.

This benefits savers and some investors, as they will gain more money back in interest. But it is not such good news for homeowners and other borrowers – the increased interest could make their loans a lot more expensive, which could lead to trouble with repayments.

Back to debt consolidation blog home