Beginner's Guide to Inflation
Reading about the economy is an excellent practice to adopt, regardless of age or situation. We all want to make sure we make the most of our money and understand why it could be worth less or more than we thought.
However, remaining informed can be a challenge, especially when it comes to understanding financial and economic terms, terms like ‘inflation’. This is why we have put together a brief guide to help truly understand what inflation is, how it’s measured and whether or not it can ever be a good thing.
What is inflation?
Simply put, ‘inflation* is the rise in the overall level of prices for the goods and services consumed by households.’ The important word here is ‘overall’. Everyone buys lots of different things and pays for a range of services throughout their day and these rise and fall by various amounts. We also don’t buy exactly the same things; these often vary by age, meaning that different price changes can affect different groups of people.
With all these variables present, it is unsurprising that inflation can be tricky to measure. The Office for National Statistics* has come up with an index based on a ‘basket of goods and services consumed by the average person’ to give us some idea of how the cost of living changes. These ‘baskets’ are kept as accurate as possible through price and spending surveys which keep them as up to date as possible.
How is inflation measured?
In the UK, ‘the two major indices are the Consumer Prices Index (CPI) and the older Retail Prices Index (RPI).’ This is not the case in most other countries where the CPI is the main calculation used. But what is the difference between the two? RPI includes housing costs (mortgage payments) and CPI does not. This usually leads to RPI inflation being higher than CPI.
The reason that there is debate over which calculation to use is because, strictly speaking, housing is an asset rather than a good, which means it shouldn’t figure in the equation and makes CPI more technically correct. However, it can be argued that CPI dangerously understates inflation if it doesn’t include housing. You can read in more detail about the two methodologies here.*
There are further issues with measuring inflation, for example, the inclusion of food and energy in the ‘basket’. One could argue that as both are so volatile, it is foolish to keep them in there. On the other hand, both food and energy are essential, so omitting them also has its pitfalls. Lastly, some countries (such as China and Argentina) are alleged to lie about inflation, leaving us to guess at the truth.
What is the difference between a ‘real’ and a ‘nominal’ price?
Inflation is all about the value of things, which is why there are such things as ‘real’ and ‘nominal’ prices. ‘Real values* are those that are adjusted for inflation, while nominal (the raw figures) are not.’ It is important to know which of these someone is speaking about, otherwise, you are vulnerable to people taking advantage of your misunderstanding.
For instance, short-to-medium term investment returns (like the ones you see in adverts) usually use nominal values, meaning that an already poor interest rate of 0.5% can look even worse once you know that the annual inflation rate is above 2%. Sudden spikes in inflation are bad for savers in this way due to the fact that your savings are essentially taxed. However, if you are the person lending the money, this can be good for debtors as it may result in them having to pay less interest and could even see the value of their debt reduced in real terms.
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Note: This article is for information only and must not be considered as financial advice. We always recommend that you seek independent financial advice before making any financial decisions. Investments can go down as well as up and you may get back less than you invested.
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