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.

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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.