Understanding Inflation

See also: Long-Term Financial Planning

Inflation is the rise in the prices of goods over time. You can also think of it as the fall in the value of money over time. In practice, inflation means that the same amount of money buys less if you hold onto it to spend ‘later’. This sounds bad—and indeed, if it happens too fast, it is certainly damaging to the national economy, and to individual purses.

However, inflation is also what leads to wage increases, and to your assets increasing in value. It is, therefore, not all bad or all good. Governments generally seek to control it to avoid big changes, but actually want a certain level of inflation to happen. This page provides more information about inflation, including how it is measured, the types of inflation, its causes, and how governments try to control it—but can never completely do so.

What is Inflation?

Inflation is defined as “the decline in the purchasing power of money over time”.

This means that your money loses value and/or that prices increase over time. Inflation does not happen at the same rate all the time, or around the world. Sometimes some countries will experience much higher or lower rates of inflation than others—and inflation will also intrinsically be higher sometimes.

Measuring Inflation

Inflation is generally measured by looking at either the price of one single product or service, such as property, or fuel prices, or a ‘basket’ of goods, and how this changes over a period of time, usually one year.

There are various indexes that use slightly different groups of products.

For example, in the UK the Consumer Prices Index uses the price of a basket of goods that are considered to be household essentials. The specific items included in the basket are updated over time, but it always includes transport, food and medical care.

Inflation is not necessarily the same for every product or basket of products. For example:

  • In January 1970, the average price of a house or flat in the UK was £3,920. By January 2000, 30 years later, that had risen to £84,620. Fifteen years after that, in January 2015, it was £190,665. The overall rate of inflation in property prices over that 45-year period was 4,700%.

  • The Retail Prices Index, the price of a basket of ‘household goods’ including the cost of the house itself, also increased over the same period—but by a different amount. It had a value of 70.6 in January 1970, rising to 1,012.7 in January 2015. This was a rate of inflation of 1,333%: high, but not as high as the rate of inflation seen in property prices.

There is a parallel concept, deflation, which means that the price of goods goes down relative to the value of money. Your money therefore buys more, rather than less.

Inflation matters because as prices increase, people can afford to buy less. We call this an increase in the cost of living—and this slows down economic growth.

Causes of Inflation

Generally, economists agree that inflation is caused by the supply of money in a given country growing faster than the economy.

This concept is known as monetarism.

It suggests that governments (or central banks) can control inflation by controlling the supply of money: for example, by printing more, or by reducing the amount that is printed. They can also do things like sell or buy back government bonds, which effectively changes the amount of money in circulation.

This works to control inflation—but only to some extent.

Increasing the supply of money will certainly increase the rate of inflation, because having more money floating around means that each unit of it is worth less. When there is an increase in the supply of money, this stimulates demand for goods and services within the economy. In other words, when people have more money, they are more inclined to spend it. This increases demand—and therefore prices go up. This is known as demand-push inflation.

However, it is much harder to slow down inflation by controlling the money supply.

This is partly because there is another cause of inflation. Increases in the prices of raw materials and intermediate goods can also cause rising prices of end products. For example, an increase in the price of oil may result in higher prices for many goods—and an individual government that is not an oil-producing country will not have much control over that. This is known as cost-price inflation.

There is one further cause of inflation, and that is expectation. When there has been steady inflation over time—and many governments try to create this state, because it is thought to be good for the economy—people come to expect that. They therefore expect that their wages will increase to match prices. This is called a wage–price spiral, as wages and prices increase to match each other.

Inflation is not intrinsically bad or good

To hear some politicians talk, you would think that inflation is always a bad thing. Certainly, excessive inflation (sometimes known as hyperinflation) is very much seen as bad.

However, for some people, inflation is good. People who have borrowed money favour higher inflation because the amount that they have borrowed will be easier to pay back as wages rise.

Governments generally try to maintain a low but steady rate of inflation. The precise level varies between countries, because it depends on the underlying rate of economic growth, but around 2% is considered ‘normal’.

This is because deflation is generally also seen as bad. When prices are falling, people tend to delay making purchases, because they know that prices will fall further. This therefore prevents money from circulating round the economy—and can stop economic growth.

Controlling inflation

Governments—or rather, financial regulators—take action to control inflation to prevent it from getting out of hand.

Case study: Hyperinflation in Weimar Germany

What happens when governments lose control of inflation? This can cause hyperinflation, where the price of money falls extremely fast and a very long way.

In the 1920s, Weimar Germany was expected to pay massive reparations for the First World War. The country simply could not afford these reparations. The government already needed to borrow money, and decided that it would print more paper money, use the notes to buy foreign currency, and then use that currency to pay its reparations.

The huge increase in the supply of money led to a massive reduction in its value. The price of a loaf of bread went from 120 Marks in 1922 to 200,000,000,000 Marks by late 1923. There were stories of people papering rooms with bank notes because that was cheaper than trying to buy wallpaper or paint, and more or less all the notes were worth. People tried to spend money quickly—and that just increased the amount of money in the economy, reducing its value still further.

This was only (eventually) resolved through revaluation and a new currency.

Governments have a variety of mechanisms that they can use to control inflation. However, as should already be clear, these may not always work. These include:

  • Controlling the supply of money, and especially adding more money (known as quantitative easing), which encourages people to spend more and prevents demand from stagnating; and

  • Controlling interest rates, which also affects demand within the economy. Low interest rates encourage people to borrow and spend, rather than save, which stimulates demand.

Both these tend to work by stimulating demand, and therefore encouraging growth in the economy. The received wisdom is that economies that are growing faster can tolerate higher levels of inflation. Some of the control is therefore more about damage limitation than actually controlling inflation: that is, it reduces the effect of higher inflation, rather than the inflation itself.

Real vs nominal prices

There is one other issue worth discussing in the context of inflation: real and nominal prices.

Inflation means that money is worth less, and prices increase over time. When comparing prices over time, therefore, you can either compare actual (nominal) prices, or adjust for inflation (real prices).

This may sound trivial, but it is actually very important. For example, growth in an economy is generally given in real terms. However, returns on an investment are usually given in nominal terms. This means, for example, that if your money is in an account paying 0.5% interest per year, but inflation is 2% per year, you will actually be losing money over time. However, the bank will be suggesting that your money is growing by 0.5% per year.

There is more about how to calculate interest in our page on Understanding Interest.

In Conclusion

It is important to understand inflation, because it affects all kinds of choices about what you do with your money: spend, save, or invest, for example.

It is also important to understand that governments and central banks cannot entirely control inflation. They can try, but economies—and people—sometimes behave in peculiar ways. In a global world, national or even regional governments do not fully control the environment in which they operate, and therefore unexpected inflation does sometimes happen.