Inflation. This article will explain the basic principles of CPI inflation and will define basic terms such as inflation, deflation, and disinflation. Furthermore, the article will expound upon why inflation is important and how it is manipulated.
Welcome to Simply Economics. This article is the second in a series to explain economics to those who want to broaden their scope of the subject. Click here to find out more about the series.
INFLATION, DEFLATION AND DISINFLATION
- Inflation – Inflation is a rise in the average price level. The average price level is measured using an index such as the consumer price index (CPI). An index is used because it allows gives each item a ‘weight’ which makes the comparison 2 goods fairer. More of this will be explained later in the article.
- Deflation – Deflation is the fall in the average price level (negative inflation). Deflation is bad for an economy because it stops firms investing because the value of a good will fall at a later date if an economy is experiencing deflation i.e. why would a person buy a good now if they know the price will drop later?
- Disinflation – It is important not to confuse deflation and disinflation. Disinflation is a decrease in inflation. For example, the inflation may go from 4% to 2%. This is known as disinflation and shows that the average price level is increasing at a slower rate than it was previously. Disinflation is a good indicator that the economy is slowing down and the central bank and may need adopt various fiscal and monetary policy to combat this.
CONSUMER PRICE INDEX (CPI)
The CPI is the average price of the most common household items in an economy.
In order to calculate it 2 values are needed. Firstly, you need to know what people are buying and so a sample would be taken of around 7000 households (in the UK) in which the households record what items they buy. Then a ‘weight’ is assigned to each item depending on how much income is spent on the good. For example, if 5% of income is spent on clothes, then clothes would be given a 5% weight.
Secondly, a survey is carried out of the prices of the 650 most bought goods across various shops and locations. This is because prices can vary in different shops.
The prices are multiplied by the ‘weight’ assigned in the first survey and it gives a price index.
By calculating the percentage change in the index, you can measure inflation.
CONS OF THE CONSUMER PRICE INDEX (CPI)
- It does not consider housing costs – One of the main limitations of the CPI is that it does not take into account housing costs such as mortgages or rent. However, these payments are extremely common in today’s economies across the globe. Therefore, if interest repayments rise on mortgages, or if rent payments increase it would not affect the CPI which would make it seem as though inflation is under control, when in fact consumers are experiencing increased living costs.
- The CPI is for ‘average households’ – The CPI measures is measured using the ‘average household’. The sending habits of the top and bottom 4% is not recorded which can affects the rate of inflation.
- It does not take into account for the quality of goods – If the quality of good being sold is higher, then the CPI does not measure accurately because you are not comparing the same good. For example, if someone bought a more expensive laptop than last year, the price would change but not necessarily due to inflation. They may be paying more due to better technology.
The 650 goods are changed once a year – The list of 650 goods is changed only once a year. This would cause inaccurate CPI inflation data because fashions and trends change much quicker than that. For example, the fidget spinner trend last less than a year and therefore, the CPI may indicate there has been deflation but because the fidget spinner should no longer be part of the top 650 items it would be inaccurate.
WHY IS INFLATION IMPORTANT?
A small percentage of inflation (around 2% a year) is important because it protects the economy from deflation. Deflation is when the average price of goods in an economy is falling. This causes a fall in consumer expenditure because no one would want to buy a good today if the price is lower tomorrow. Furthermore, it causes a decrease in investment because investors would see their asset value increase over time rather than increase.
In conclusion, inflation is crucial for the growth of an economy as hedges against deflation. The CPI is an index of the most commonly bought goods in an economy and economists use the percentage change in price of this index to find the inflation rate.