Too embarrassed to ask: what is inflation?
While coming up with a precise definition for inflation is tricky, for most of us it boils down to one simple question.
As with almost every important concept in economics, finding a technical definition of inflation that everyone agrees upon is impossible.
But for most of us, inflation boils down to one simple question: “how fast are prices in general rising compared to this time last year?”
That makes sense. There are two main reasons for most of us to worry about inflation, and both concern the impact of rising prices on our standard of living.
Subscribe to MoneyWeek
Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE
Sign up to Money Morning
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
Firstly, if your cost of living is rising more rapidly than your income, then your standard of living will deteriorate, potentially quite rapidly.
Secondly, if prices generally are rising more rapidly than your savings are growing, then the value of your savings is in fact falling in “real” terms. This might not be obvious in the short term, but in the long run, it could really ruin your retirement plans.
So, how do we measure inflation? The main inflation gauge in the UK is the Consumer Prices Index, or CPI for short.
Every month, the Office for National Statistics checks the prices of more than 700 goods and services in an imaginary shopping basket. This is meant to roughly represent the sorts of things that the average UK consumer buys regularly.
Clearly, some people will have a higher rate of personal inflation than others. A 75-year-old pensioner will have a very different shopping basket to a 20-year-old student.
But the CPI methodology is widely accepted around the world as being the most practical way to measure price inflation.
One of the jobs of a central bank is to keep inflation hovering around a specific level, usually around 2%.
This is because rapidly rising prices – as happened in the UK in the 1970s – are economically and socially disruptive.
However, central banks also want to avoid deflation – where prices are consistently falling.
Contrary to popular belief, this is not because falling prices make consumers less likely to buy goods in the hope of getting them cheaper in future.
No one would ever buy a new TV or mobile phone if this was genuinely true.
The real problem is that deflation makes the real cost of debt go up, which is something that our debt-fuelled economies are not set up to cope with.
However, that’s a story for another day.
To learn more about how inflation affects your investments, see our previous video on “real returns” – and don’t forget to subscribe to MoneyWeek magazine.
Sign up to Money Morning
Our team, led by award winning editors, is dedicated to delivering you the top news, analysis, and guides to help you manage your money, grow your investments and build wealth.
-
Best funds to add to your ISA or SIPP before the Budget
With Labour expected to increase taxes, ISAs and SIPPs could be a great way to protect yourself from any CGT hikes. We look at the best funds to buy now
By Katie Williams Published
-
Starling Bank slapped with £29 million fine over ‘shockingly lax’ financial crime controls
The Financial Conduct Authority has fined Starling Bank £29 million over failings related to financial crime and its financial sanctions screenings
By Kalpana Fitzpatrick Published
-
What is a dividend yield?
Videos Learn what a dividend yield is and what it can tell investors about a company's plans to return profits to its investors.
By Rupert Hargreaves Published
-
High earners to pay nearly £2000 more in tax due to fiscal drag
Videos The government froze tax thresholds, which will drag employees into higher tax bands as wages rise with inflation. We explain what fiscal drag is, and how to avoid it.
By Nicole García Mérida Last updated
-
What is a deficit?
Videos When we talk about government spending and the public finances, we often hear the word ‘deficit’ being used. But what is a deficit, and why does it matter?
By MoneyWeek Published
-
Too embarrassed to ask: what is moral hazard?
Videos The term “moral hazard” comes from the insurance industry in the 18th century. But what does it mean today?
By MoneyWeek Published
-
Too embarrassed to ask: what is contagion?
Videos Most of us probably know what “contagion” is in a biological sense. But it also crops up in financial markets. Here's what it means.
By MoneyWeek Published
-
Too embarrassed to ask: what is a marginal tax rate?
Videos Your marginal tax rate is simply the tax rate you pay on each extra pound of income you earn. Here's how that works.
By MoneyWeek Published
-
Too embarrassed to ask: what is stagflation?
Videos Traditionally, economists and central bankers worry about inflation or recession. But there is one thing worse than both: stagflation. Here's what it is
By MoneyWeek Published
-
Too embarrassed to ask: what is the metaverse?
Videos The term “metaverse” sounds like something out of a science fiction novel (and it is). But what does it actually mean?
By MoneyWeek Published