What is Inflation and Why Does It Matter?

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You see it daily in news reports. Economists and other financial experts talk about it in serious tones. Its impact is felt throughout the financial sector – from banking institutions to household budgets. We’re talking about inflation.
But what is it, and why is it so important?

What is inflation?

Simply put, inflation is the rate in which the cost of goods and services increase. Or, to put it another way, the value of your money decreases. So, what cost you £1 last year might end up costing you £1.03 this year. Usually inflation will rise by about 2-3% each year, meaning you’ll be spending more, the more inflation rises.
A certain level of inflation is a sign of a healthy economy, and keeps it growing – although too much inflation can be disastrous for a country. Just look at Zimbabwe in the late 2000s. There, inflation doubled every day, forcing the government to print more and more money as the value of each bank note spiralled downward to the point where it was all but worthless.

Inflation is pretty handy when, for instance, you take out a mortgage at a low interest rate prior to a financial ‘boom’. Let’s say you’re paying £1000 a month – well, you’ll continue paying that rate, even when £1000 is technically worth less year-on-year. In effect, you’re saving money., or at the very least, reducing your costs. Inflation, then, can be seen as a good thing for those in debt.
Increasing inflation is usually not so good for savers, however, since that money you’ve stashed away one year isn’t worth as much the following year. You might have £100 saved, but that £100 will buy significantly less if inflation has risen.

Inflation also affects the pay in your pocket; if the cost of living is higher than the wage you’re earning, and your wages aren’t rising in line with inflation, you’ll feel a whole lot poorer. Ok, this doesn’t happen a whole lot – most workers find their salaries do increase as inflation increases, but it’s one to watch out for, since its impact has serious consequences for your living standards.

How is inflation measured and calculated?

There are a lot of different ways that inflation can be measured, but the two main measurements for assessing inflation are the Retail Prices Index (RPI) and the Consumer Prices Index (CPI). These track the prices of the most common, everyday items, to see how much inflation is really costing us over a period of time. But while CPI is concerned with typical purchases like bread and milk, among other things, RPI also takes into account how much we’re spending on things like houses and council tax.

This data is then used by the government and the Bank of England to work out how much interest rates should be. If the Bank believes that CPI will likely be too high, it can up interest rates to maintain an even economic keel; if CPI is too low, interest rates can also be cut. It’s all about finding a balance.

What causes inflation?

Although there’s no single reason for the cause of inflation, economists generally agree that there are three causes: Demand-Pull Inflation, Cost-Push Inflation and Monetary Inflation.

Demand-Pull inflation: In a nutshell, this relates to supply and demand. Let’s say there’s a huge demand for dictionaries. The response is for dictionary sellers to increase the cost of their product, since the demand outstrips the supply, i.e. there’s more money chasing the product than there are products available.

Cost-Push inflation: This relates to how much it costs to produce certain goods. A company might find they need to spend more on manufacturing costs, employee salaries or even paying increased taxes. And since companies keep their eyes on the bottom line, they may have to increase the prices to maintain their profits. Cue rising inflation.

Monetary inflation: Put simply, monetary inflation occurs when there’s too much money in an economy. Sounds odd, right? How can you have too much money? Well, just like everything else in the economy, it’s all down to supply and demand; if there’s too much of something – even money, prices fall since it’s more common and therefore less valuable. And when it’s your chosen currency that’s losing value, the price of everything in that currency rises.

So, is inflation a bad thing? Well, yes and no. There are plenty of pros, but also cons-particularly if you’re saving and trying to make your money work harder for you.

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