How do we measure inflation?

Inflation is the sustained increase in the average price of goods and services in an economy. As price begins to increase, consumers' purchasing power begins to fall - meaning we can no longer buy the same value of goods for the same amount of money. 

The UK targets a stable rate of inflation of 2% through the Bank of England. They use the CPI (Consumer Price Index) to measure this rate. The Index uses the concept of a “Basket of goods” to calculate the change in price of commonly used household items which are picked based on a family expenditure survey. The goods are then weighted based on their percentage of consumer spending with a greater weight given to items that make up a bigger percentage of household income. This basket is updated annually to account for changes in spending patterns. They use the percentage changes in price of the basket to decide the rate of inflation that year.

However, there are limitations to this system. The CPI may measure a national average, but in reality spending patterns vary across different demographics, making it not reflective of all consumers. For example, lower income households who spend a higher proportion of their income on necessities such as food and transport costs may face higher inflation as these goods are more vulnerable to fluctuations in price. Additionally, the CPI excludes housing costs and council taxes - payments which typically account for large portions of household expenditure. 

Another way we can measure inflation is through the RPI (Retail Price Index). Unlike the CPI, the RPI includes housing costs which means it tends to report higher inflation rates than CPI. It began to be used as a form of measurement in 1956, making it useful for measuring changes in inflation over time; although the RPI is unique to Britain so it is limited in allowing cross-country comparisons. The mathematics behind it is also different: the RPI formula uses the arithmetic mean rather than the geometric mean which is generally known to produce a higher figure. This has led to it falling out of favour as the main method of measuring inflation. 

But why is it important to know the inflation rate? Measuring inflation allows governments, businesses and households to monitor changes in the purchasing power of money. For households, this allows them to understand how changing prices affect their real income. This means they can make more informed decisions on whether to spend or save. It is also important for the government. Knowing the inflation rate can help them adjust pension benefits and the minimum wage to prevent their real value from falling (value adjusted for inflation).  

By Freya Brolly