Inflation: Measurement and Causes

Inflation — a sustained increase in the general price level — is one of the most important macroeconomic phenomena. Maintaining low and stable inflation (the UK target is 2%) is a primary objective of the Bank of England's Monetary Policy Committee (MPC). This lesson examines how inflation is measured, the main theories of its causes, and the UK's recent inflationary experience.

---

Defining Inflation, Deflation, and Disinflation

Term	Definition	Example
Inflation	A sustained increase in the general price level over time	UK CPI inflation of 11.1% in October 2022
Deflation	A sustained decrease in the general price level	Japan experienced deflation for much of the 1990s and 2000s
Disinflation	A fall in the rate of inflation (prices still rising, but more slowly)	UK inflation falling from 11.1% in October 2022 to 4.6% in October 2023
Hyperinflation	Extremely rapid and out-of-control inflation, typically exceeding 50% per month	Zimbabwe 2008 (approximately 79.6 billion % per month); Weimar Germany 1923

Exam Tip: Students often confuse deflation with disinflation. Deflation means prices are falling; disinflation means they are rising more slowly. A question that says "inflation fell from 5% to 2%" describes disinflation, not deflation.

---

Measuring Inflation in the UK

The Consumer Prices Index (CPI)

Key Definition: The Consumer Prices Index (CPI) measures the average change in prices of a representative basket of approximately 730 goods and services purchased by households, weighted by their share of total consumer spending.

How CPI is constructed (ONS methodology):

1. Select the basket — the ONS updates the basket annually to reflect changing spending patterns. In 2023, additions included e-bikes and air fryers; removals included coal.
2. Collect prices — around 180,000 price quotations are collected each month from approximately 140 locations across the UK, plus online retailers.
3. Assign weights — each item is weighted by its share of average household expenditure (from the Living Costs and Food Survey). Housing costs have a large weight; niche products have a small weight.
4. Calculate the index — the weighted average price change is expressed as an index number relative to a base year (currently 2015 = 100).
5. Derive the inflation rate — the annual inflation rate is the percentage change in the index over 12 months.

CPI vs RPI vs CPIH

Feature	CPI	RPI	CPIH
Includes mortgage interest payments?	No	Yes	No
Includes owner-occupier housing costs?	No	No (but includes mortgage interest)	Yes (via rental equivalence)
Formula	Geometric mean (Jevons)	Arithmetic mean (Carli)	Geometric mean (Jevons)
Population coverage	All private households	Excludes top 4% by income and pensioner households mainly dependent on state benefits	All private households including owner-occupiers
Used for	Bank of England inflation target (2%); international comparisons	Some index-linked gilts; student loan interest; some pension uprating	ONS preferred measure since March 2017
Typical relationship	Usually lower than RPI	Usually 0.5–1.0 percentage points above CPI	Usually close to CPI; sometimes slightly higher

Key Definition: CPIH is the ONS's preferred measure of inflation. It extends CPI by including owner-occupiers' housing costs (OOH), estimated using rental equivalence — the rent a homeowner would pay for an equivalent rented property.

The RPI was stripped of its "National Statistic" status in 2013 by the UK Statistics Authority because the Carli formula has a known upward bias. However, it remains influential because many contracts, index-linked gilts, and rail fare increases are still tied to RPI.

Exam Tip: If asked to evaluate measures of inflation, always mention the formula effect (Carli vs Jevons) and the treatment of housing costs as key differences between CPI and RPI.

---

Limitations of CPI

Limitation	Explanation
Basket may not reflect individual experience	A non-driver gains no benefit from falling petrol prices; a vegetarian is unaffected by meat prices
Quality improvements are hard to capture	A smartphone costing the same as last year's model but with better features represents a fall in the "quality-adjusted" price. The ONS uses hedonic adjustment, but this is imprecise
New products	There is a lag before new goods are included in the basket
Substitution bias	When prices rise, consumers switch to cheaper alternatives; CPI may overstate the cost-of-living increase (though the Jevons formula partially addresses this)
Housing costs	CPI excludes owner-occupier housing costs; CPIH is preferred but still uses rental equivalence, which may not capture actual mortgage-cost pressures

---

Causes of Inflation

1. Demand-Pull Inflation

Key Definition: Demand-pull inflation occurs when aggregate demand grows faster than aggregate supply, pulling up the general price level. It is associated with a positive output gap.

Possible causes of rising AD:

• Consumer confidence and wealth effects (e.g., rising house prices)
• Loose monetary policy (low interest rates, quantitative easing)
• Expansionary fiscal policy (tax cuts, increased government spending)
• Export growth or a weaker exchange rate
• Credit expansion by banks

On an AD/AS diagram, demand-pull inflation is shown by a rightward shift of the AD curve along an upward-sloping SRAS curve, causing a higher price level and higher real output.

2. Cost-Push Inflation