Mommy what's inflation?

["Ian Murray" <seamus2001@xxxxxxxxx>]

Inflation

Why do the items in your shopping basket cost more (or
less) than they did the day before? Sally Bolton explains

Friday January 18, 2002

What is inflation?
Inflation is a sustained rise in prices across an economic
area - literally "the cost of living". In Britain it is
calculated by measuring the monthly percentage rise in
price of a weighted sample, or basket, of goods and
services that a typical household buys.

Why are there different types of inflation rate?
The above rate is called the Retail Price Index (RPI) and
includes the cost of mortgage inflation rates. This is the
most prominent inflation rate and is quoted frequently by
the media, so it is also called the headline rate.

The second-most important rate of inflation is the
underlying rate, or RPIY. This is RPI minus the cost of
mortgage interest rates, so, since mortgage interest rates
stem from the rate set by the Bank of England, it is
preferred by some as a purer measure of the actual trend in
prices.

A third, less commonly quoted and even purer rate is RPIX -
this is RPI minus mortgage interest rates and consumer
taxes.

What causes inflation?
In classical economic terms, it is caused by demand
exceeding supply: in other words, too much money is chasing
too few goods and services, so the goods and services begin
to command higher prices.

This situation can arise in several ways. Rising public
expectations of the standard of living may increase demand;
supply may be constricted during war or through external
shocks such as the 1970s oil crises; union activity may
increase wages and hence both stimulate demand and restrict
supply; or government policies, such as printing paper
money in a bid to pay back debt, can be directly
inflationary.

But inflation is a relatively new phenomenon that appears
to be endemic in modern industrial economies. One of the
earliest notable appearances of inflation was in 1800, when
restricted supply during the Napoleonic wars drove up
prices. At the time, this comparatively modest inflation
was considered highly unusual and alarming to people used
to an environment of very stable prices.

Why is it considered to be bad?
Inflation is not necessarily bad - at least not for
everyone. Borrowers don't usually mind inflation because,
as long as interest rates aren't too high, it brings down
the cost of their debt. But inflation does reduce the
buying power of money, so unless wages keep up with
inflation, people become worse off. Those dependent on
savings or fixed-rate pensions are severely affected by
high inflation that exceeds interest rates, because it
makes serious inroads into their capital.

But a moderate amount of inflation simply shows that a
country is on the upswing of its economic cycle. Only if
inflation is increasing rapidly or is at a permanently high
level does it become a problem: it could indicate that the
economy is overheating and heading for a crash. Permanently
high inflation indicates instability and weak economic
fundamentals, discouraging saving and investment. It erodes
confidence in the country's currency, causing the exchange
rate to drop, and ironically, causing more inflation
through import price increases.

What is deflation?
Very low inflation, or negative inflation (ie deflation - a
sustained fall in prices) is not necessarily good either.
Falling or low inflation can indicate a country's position
along the economic cycle. And with inflation in Britain
currently standing at around 0.7% - its lowest level since
1960 - it is pretty clear that we are on the curve of a
downturn, despite what market analysts and Christmas
shopping figures may suggest.

What is stagflation?
Stagflation is a freak economic phenomenon where prices
rise despite stagnating economic growth - the worst of both
worlds. It notably occurred in Britain and elsewhere during
the 70s, due to the tripling of world oil prices by the
Organization of Petroleum Exporting Countries (OPEC) in the
aftermath of the 1973 Arab-Israeli War. These oil-price
shocks drove up production costs, hence prices, during a
world recession.

What is hyperinflation?
Hyperinflation is another unusual phenomenon, where prices
spiral upwards uncontrollably and extremely rapidly with
devastating economic consequences. It is usually defined as
inflation in excess of 50% a month.

In 1922-23, Germany's short-lived interwar democracy
experienced hyperinflation of 3.25m% a month, partly
because it had borrowed heavily, then printed massive
amounts of paper money in an attempt to manage the cost of
war reparations and other debt. With prices increasing by
the second, people began to be paid as often as three times
a day, in wheelbarrows full of nearly worthless notes, and
rushed to spend wages that couldn't buy enough to eat. The
chaos continued until a new currency, the Rentenmark, was
introduced.

What can be done about inflation?
No one can get rid of inflation permanently. It will always
rise and fall with the economic cycle, but government
policies to manage this will also affect inflation.
Increasing interest rates, taxes and cutting back public
spending to take the heat out of a boom will also damp down
inflation, to an extent.

However, in the long term, sound economic policies may
reduce a country's average rate of inflation. Creating the
conditions for investment, long-term growth and currency
stability, so that the economy cannot overheat easily and
so that confidence in the currency remains high, are the
best ways to achieve the goal of low average inflation.