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The cost of living is a measure of changes in the average cost for a household of buying a basket of different goods and services. In the UK there are two published measures, the Retail Price Index (RPI) and the Consumer Price Index (CPI). Price data is used in many ways by the government, businesses, and society in general. They can affect interest rates, tax allowances, wages, state benefits, pensions, maintenance payments and many other 'index-linked' contracts. The consumer price index (CPI) is a weighted price index, which measures the monthly change in the prices of over 600 different goods and services. The weights are revised each year, using information from the Family Expenditure Survey. The expenditure of some higher income households, and of pensioner households dependent on state pensions, is excluded.
Selected Weights in the UK Consumer Price Index
Total weights for the CPI = 1000. Source: Office of National Statistics
140 130 120 110 100 90
Housing, water and fuels
120 110 100
90 80 70
80 70 60 50 40 30 20 10 0 01 02 03 04 05 06 07 08 09 10 Education Alcohol, tobacco and narcotics Clothing and footwear
60 50 40 30 20 10 0
Source: UK Statistics Commission
Calculating a weighted price index
Category Food Alcohol & Tobacco Clothing Transport Housing Leisure Services Household Goods Other Items Price Index 104 110 96 108 106 102 95 114 Weighting 19 5 12 14 23 9 10 8 100 Price x Weight 1976 550 1152 1512 2438 918 950 912 10408
Weights are attached to each category and then we multiply these weights to the price index for each item of spending for a given year. • • The price index for this year is: the sum of (price x weight) / sum of the weights So the price index for this year is 104.1 (rounding to one decimal place)
1 and a year later the price index has risen to 112.5 Percent 5. This target is set each year by the Chancellor and it is the task of the Bank of England to meet this target. Indeed the expectation is that inflation in the UK is set to fall further in 2009 renewing fears of price deflation. Macroeconomic policymakers were looking for a way of introducing transparency and credibility into monetary and fiscal policy by having a clear final target or objective – namely price stability at a low (positive) rate of inflation. The government has not signalled any official change to the inflation target but. The hope was that an inflation target would provide an anchor for inflation expectations.0 1.0 3.0%.1 x 100.5 1.1%.5 3.0 2. So if in one year the price index is 104. There is a permitted band of fluctuation of +/.5 CPI Inflation target = 2% 2. as far as monetary policy is concerned.5. In the early years of this decade inflation stayed comfortably within target range but this changed from 2007 onwards.0 97 98 99 00 01 02 03 04 05 06 07 08 09 10 Source: UK Statistics Commission Since 2004.5 0.The rate of inflation is the % change in the price index from one year to another.0 0.0 4. the inflation target for the UK has consumer price inflation of 2. then the annual rate of inflation = (112. In respect of the .0 3. The target was breached for the first time in the spring of 2007 when inflation edged over 3% before falling back. the inflexible nature of targets has come under growing criticism in the last few years.5 1.5 5.5 2.5 – 104.0 4. The UK Inflation Target Consumer Price Inflation for the UK Economy Annual percentage change in the Consumer Price Index 5.0 1.0 0.07%.5 4. Criticisms of the inflation target Setting inflation targets came into fashion in the early 1990s.1) divided by 104.0 2. Whilst inflation targets seemed to work well during a period of global macroeconomic stability. But in 2008 there was a renewed surge in consumer prices that caused CPI inflation to spike up above 5%. the Bank of England has interpreted the inflation objective flexibly given the highly uncertain economic situation both at home and in the global economy. Thus the rate of inflation = 8. Less than a few months later disinflation had set in and CPI inflation fell back towards the target level.5 4. giving businesses and employees the confidence that the purchasing power of money would be protected and encouraging long term planning and higher levels of investment.5 0.5 5.0 3.
One city economist talked about the “real product wage” – i. This time. this may be accompanied by an improvement in quality. Thus some economists believe that a narrow inflation-targeting framework has introduced a "stopgo" element into the British economy that has made our cycle more volatile. people have been able to log on to the Office of National Statistics website to use their own personal inflation calculator! . it will be inaccurate for the ‘non-typical’ household. property and insurance. It is hard to make price comparisons of electrical goods because new audio-visual equipment is so different from its predecessors. huge levels of personal sector debt. A few years back when many businesses were outsourcing and off shoring and China and other emerging markets were making big inroads into world trade. what goods and services could be bought with £100 of wage income. in themselves were not the result of whether UK policy interest rates were at the right level. Housing costs: The ‘housing’ category of the CPI records changes in the costs of rents. Changing quality of goods and services: Although the price of a good or service may rise. to the older householder who may have paid off his or her mortgage. and an unsustainable housing boom. But this heralded a period when official CPI inflation was below the 2% target. In this respect. Fast forward to 2006-08 when booming emerging market countries were contributing to a sudden and sharp rise in world commodity prices. In the short term this boosted aggregate demand and GDP growth but at the expense of causing big imbalances – shown by a falling savings ratio. for example. Since 2007. We all have our own ‘weighting’ for goods and services that does not coincide with that assigned for the consumer price index. Cheaper interest rates encouraged consumer borrowing and also acted as a stimulant to the UK property market. The response of the Bank of England was to ‘tighten’ policy by raising interest rates and this did much to bring down the housing market. kettles and iPods. from the young house buyer. Housing costs vary from person to person.UK. and 14% of the index is devoted to motoring expenses . To prevent this from happening required a boost to domestic spending through a combination of lower-than-necessary interest rates and an expansionary fiscal policy. The CPI is slow to respond to the emergence of new products and services. one criticism has been that the chosen inflation measure and target (CPI inflation of 2%) was not designed to deal with inflation shocks from abroad which. Perhaps monetary policy in particular should be guided less by a narrow measure of inflation but a broader assessment of inflationary pressures including data on what is happening to asset prices such as property? Limitations of the Consumer Price Index as a measure of inflation The CPI is a thorough indicator of consumer price inflation for the British economy but there are some weaknesses in its usefulness for some groups of people. repairs and accounts for around 16% of the index. there was a collapse in the price of manufactured goods from DVD players to freezers. This has become an important issue both when CPI inflation was rising well above target in 2008-09 and more recently as the risks of a deflationary recession have become more apparent. indeed policy-makers focussed their attention on preventing price deflation.inapplicable for non-car owners.e. Single people have different spending patterns from households that include children. leading to a burst of cost-push inflationary pressures in the UK. • • Inflation affects different people in different ways and few of us experience the same rate of inflation. the CPI may over-estimate inflation. mortgage interest. This led to a fall in consumer prices fell relative to wages and profits boosting people’s spending power. • The CPI is not fully representative: Since the CPI represents the expenditure of the ‘average’ household. CPI inflation surged above the target but once more for reasons that were not to do with what was happening domestically – inflation was being driven by external rather than homegrown headwinds.
they are unlikely to accept pay rises less than their expected inflation rate because they want to protect the purchasing power of their incomes. The diagram below summarises some of the key influences on inflation. RPI inflation became negative for the first time since the 1960s. If people expect prices to continue rising. Prices also increase when businesses decide to increase their profit margins. productivity bonuses and other supplements to earned income. or output per person hour. oil. commodity prices (e. . They are more likely to do this during the upswing phase of the economic cycle. The wage price spiral – “expectations-induced inflation” Rising expectations of inflation can be self-fulfilling. A rise in productivity helps to keep unit costs down.Retail Price and Consumer Price Inflation in the UK Annual percentage change in the retail price index and CPI 11 10 9 8 7 6 Percent 11 10 9 8 7 6 5 4 3 2 1 0 -1 -2 90 91 92 93 94 95 96 97 All items retail price index (RPI) 5 4 3 2 1 Consumer price index 0 -1 -2 98 99 00 01 02 03 04 05 06 07 08 09 10 Source: UK Statistics Commission One of the big issues in recent times has been the difference in measured inflation between the Consumer Price Index (CPI) and the Retail Price Index (RPI). In 2009. Reading from left to right: o o o o o Average earnings comprise basic pay + income from overtime payments. Productivity measures output per person employed. Conversely inflationary pressures decline in a recession when businesses have far more spare capacity and may decide to offer deep price discounts to their customers to get rid of unsold stock. The latter includes mortgage interest costs in its calculation. When workers are looking to negotiate higher wages.g. Additional pressure on prices comes from higher import prices. The growth of unit labour costs is a key determinant of inflation in the medium term. copper and aluminium) and also the impact of indirect taxes such as VAT and excise duties. there is a danger of a ‘wage-price spiral’ that then requires the introduction of deflationary policies such as higher interest rates or an increase in direct taxation.
Basic Pay Bonuses + overtime Import Prices Exchange rate / profit margins + Commodity Prices Average Earnings Unit labour costs + + Productivity Taxes + Economic Cycle Secular Influences (e. ICT impact) Fiscal Policy Consumer price inflation Profit Margins Economic Cycle Consequences of Inflation High and volatile inflation is widely viewed by economists to have economic and social costs. Households may be able to switch savings into accounts offering a higher nominal rate of interest or into other financial assets where capital gains might outstrip price inflation. it becomes difficult for individuals and businesses to correctly predict the rate of inflation in the near future. many airlines buy their fuel several months in advance in the forward market as a protection or ‘hedge’ against fluctuations in world oil prices. The impact of inflation depends in part on whether inflation is anticipated or unanticipated: o Anticipated inflation: o When people are able to make accurate predictions of inflation. Actual inflation may end up well below or above expectations causing losses in real incomes and a redistribution of income and wealth from one group in society to another. businesses and governments make errors in their inflation forecasts. Unanticipated inflation occurs when people. Businesses can adjust prices and lenders can adjust interest rates. o o o o Unanticipated inflation: o o When inflation is volatile. Businesses may also seek to hedge against future price movements by transacting in “forward markets”. they can take steps to protect themselves from its effects. . Trade unions may exercise their collective bargaining power to negotiate for increases in money wages to protect the real wages of union members.g. For example.
Inflation Expectations and Wage Demands: Price increases lead to higher wage demands as people try to maintain their real living standards. Tax revenues: The government gains from inflation through what is called ‘fiscal drag effects’. a worker might experience a 6 per cent rise in his money wages – giving the impression that he or she is better off in real terms.g. However if inflation is also rising at 6 per cent. e.for example people in low paid jobs with little or no trade union protection may see the real value of their pay fall. so does the amount of tax revenue flowing into the Treasury. Benefits of inflation Can inflation have positive consequences? The answer is yes although much depends on what else is happening in the economy. in real terms there has been no growth in income. Some of the potential advantages of benign inflation are as follows: 1. since low and stable inflation is less damaging than hyperinflation where prices are out of control. the . 1.and this may reduce planned investment spending. 3. Avoiding deflation: Perhaps one of the key benefits of positive inflation is that an economy can manage to avoid some of the dangers of a deflationary recession (discussed in the next chapter) 2008 – The return of rising inflation to the UK economy 2008 was a year when rising inflation came to dominate the newspaper headlines and TV news bulletins almost on a daily basis and the UK economy was not alone in that! In May 2008. leading to a loss of international competitiveness and a subsequent worsening of their trade performance. Money illusion is most likely to occur when inflation is unanticipated. This process is known as a ‘wage-price spiral’. Impact of Inflation on Savers: When inflation is high. Savers will lose out if nominal interest rates are lower than inflation – leading to negative real interest rates. Inflation can also favour borrowers at the expense of savers as inflation erodes the real value of existing debts. Arbitrary Re-Distributions of Income: Inflation tends to hurt people in jobs with poor bargaining positions in the labour market . For example many indirect taxes are ad valorem in nature.Money Illusion People often confuse nominal and real values because they are misled by the effects of inflation. 4. This can provide a psychological boost and might lead to rising investment and productivity. Cutting the real value of debt: Low stable inflation is also a way of helping to reduce the real value of outstanding debts – there are many home owners with huge mortgages who might benefit from a period of inflation to bring down the real burden of their mortgage loans.so as prices rise. 4. Business Planning and Investment: Inflation can disrupt business planning. 5. For example. so that people’s expectations of inflation turn out to be some distance from the correct level. Competitiveness and Unemployment: Inflation is a possible cause of higher unemployment in the medium term if one country experiences a much higher rate of inflation than another. Costs of Inflation We must be careful to distinguish between different degrees of inflation. 3. whilst at the same time workers can expect to see an increase in their pay packers. revenues and profits. Budgeting becomes difficult because of the uncertainty created by rising inflation of both prices and costs . 2. 2. Higher revenues and profits: A low stable rate of inflation of say between 1% and 3% provides a situation where businesses can raise their prices. VAT at 15% . people may lose confidence in money as the real value of savings is severely reduced.
6 per cent having being negative for four months in a row. higher wholesale and retail prices e. Average inflation in developed countries in 2010 is 1. has fallen compared to where it was a year ago. A depreciating exchange rate (leading to higher import prices) 3.5%) and Turkey where prices have risen by 8. 2010 Update: Inflation in the World Economy The global recession of 2009 has led to a reduction in average rates of consumer price inflation in many parts of the world.” • The main cause of the pick-up in inflation was the unexpectedly large rise in world prices of many commodities including oil and foodstuffs. This topic is covered in more depth in the next chapter. an inward shift of the SRAS curve). . increased petrol prices and energy bills. The RPI takes account of changes in mortgage interest payments and in June 2009 it was standing at minus 1. Throughout most of 2007 the Bank of England was raising policy interest rates to control inflation – interest rates stayed fairly high at 5% or above for most of 2008 – but then the inflation outlook changed because of recession.g.6%) the Ukraine (9. That means the absolute level of prices.8% in 2008 and -0. Higher indirect taxes The Bank of England feared a return to stagflation and 2008 was a year when real wages fell as inflation out-paced the growth of pay. Indeed in some nations there has been a period of price deflation.4% in 2010. not just their rate of increase. Prices there are expected to continue falling through 2010 and into 2011 partly as a result of the strong Yen which has made imports cheaper.9%.9% in 2009 and it is forecast to move up to 3. 2009 – The return of deflation In the spring of 2009 the annual rate of retail price inflation became negative heralding many headlines that the British economy was on the verge of a period of sustained deflation. “global inflation had re-emerged as a major threat to the world economy due to soaring energy and food prices. This led to an increase in cost-push inflation (i.4% in 2008 to 1.3% in contrast to emerging nations where the mean inflation rate is 5. rising production costs. Rising input costs. Developed economies have experienced the brunt of the recession and have seen average inflation fall close to zero. notably in Japan where CPI inflation was -1.5 per cent. But falling gas and electricity prices have also played a role.6%) Vietnam (9. World inflation dipped from 5. An increase in actual inflation led to an upward shift in inflation expectations and the Bank of England feared a return of inflation and a wage-price spiral • • Inflation also increased because of: 1.e.9% in 2009. Strong GDP growth / consumer spending 2. Much of the onset of inflation could be explained by the was due to the drop in mortgage repayments after the Bank of England slashed interest rates from more than 5 per cent to 0.0% during 2010.International Monetary Fund (IMF) warned. Countries where inflation is noticeably higher in 2010 include India (13.
Source: Tutor2u Economics Blog. In Ukraine inflation is 30%. What is fuelling the dramatic acceleration in inflation? As always in macroeconomics the causation is complex. Consumers. June 2008 Since this blog was written. Most of the danger is coming from fast growing emerging market countries. And with rising prices come increased demand for welfare assistance and other forms of government financial support that many countries simply do not have the resources to provide. governments and central bankers have been able to enjoy a period of price stability –.indeed the biggest fear for many countries have been the threat of price deflation along the lines of that suffered by Japan in the 1980s and late 1990s – but the days of low inflation seem to be coming to an end.5%) and India (7.International Inflation Annual % change in consumer prices 11 10 9 8 7 6 5 4 3 2 1 0 Jan May Sep 04 World Inflation Dveloping Countries 11 10 9 8 7 6 5 4 3 United Kingdom 2 1 0 Jan May Sep 05 Jan May Sep 06 Jan May Sep 07 Jan May Sep 08 Jan May Sep 09 Jan May 10 EU25 Source: International Monetary Fund Mini Case Study: Inflation takes-off in more than half the world For well over a decade. gas and other energy sources is not the only explanation. household spending on food is a much higher percentage of the basket used to calculate inflation than in richer developed nations – but food and the rising cost of oil. inflation has fallen back – can you think of reasons why this has happened? .6%). The danger is that accelerating inflation in emerging market countries will cause problems such as greater exchange rate and international investment volatility and also impart an inflationary shock to the richest advanced nations. With nominal interest rates lagging behind inflation. Vietnam (25%). Wage inflation has taken off as workers look to protect their real incomes against an increasingly uncertain economic backdrop. Many nations have been enjoying super-charged growth rates and their central banks may have been at fault in not doing enough to dampen down domestic demand and control demand-pull inflationary pressures. the IMF estimates that nearly two thirds of the inflation shock has come from the steep rise in food prices – remember that for many poorer countries. and Pakistan (17%) Russia (14%) China (8. Latvia (18%). the real cost of borrowing has been negative – hardly the right monetary policy stance for countries struggling to bring under control rampant growth of the supply of money and credit. the IMF’s measure of consumer price inflation for the world economy has been stable at or around 2 to 3%.
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