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What is inflation?

What is inflation?
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What is inflation, anyway? It’s a word we hear pretty often, but it’s not always clear what it means. Here’s a rundown of the basics – and why inflation matters to us all.

What is inflation?

It’s basically just an increase in the price of goods and services over time. For example, maybe you’ve noticed you’re paying £1 for a pint of milk now rather than, say, £0.98 a few months ago.    

It has a few causes: 

  • Demand exceeding supply (i.e. there’s not enough of a product or service to go around. Consumers are willing to pay more, so businesses can raise prices)
  • Raw materials increasing in price, which means it costs more to manufacture a product
  • The government being in debt and printing more of its own money to cover its spending  

The main problem? If wages don’t keep pace with the rate of inflation, people can’t afford to shop the same, and there’s a drop in living standards.

On the other hand, if prices go down over time, it’s called deflation. While deflation can drive prices down, it suggests there’s less demand for goods and services, which isn’t a sign of a healthy economy.

How is it measured?

To measure inflation in the UK, we usually rely on the Consumer Price Index (CPI) produced by the Office for National Statistics.

The CPI compares the price of thousands of common items, from chicken to alcohol. To make the result as accurate as possible, the CPI gives more weight to popular commodities like fuel than it gives, for example, to seasonal items. 

The number generated by the CPI is the rate targeted by the Bank of England. It’s the institution responsible for keeping inflation as stable as possible.

What’s the UK’s inflation rate?

The UK government sets a 2% target for inflation, but right now, the UK inflation rate is only 0.7%. Why? Well, it’s mainly down to the impact of the coronavirus pandemic and lockdown restrictions

For example, retail prices fell as customers stayed away from the high street, and huge shopping chains like Debenhams closed. What’s more, fuel prices dropped as more of us stayed home, and fare income fell dramatically across the transport network.

It’s a challenging time for the UK economy, and we can see this reflected in the inflation rate. 

How does inflation affect me?

Okay, so that’s what inflation is and how it works. But how does it affect you, in real terms? Let’s take a look. 

  • Do you have a savings account? When inflation’s low, you earn less interest on your money than when rates are higher. It doesn’t mean you shouldn’t save (because you should), but your money’s worth a little less when inflation is low.
  • Low inflation can drive down prices, which is good news if you’re making purchases. That said, the longer the inflation rate stays low, the likelier it is to result in redundancies.   
  • When inflation rates are low, it can make it cheaper to get a loan. However, you should still stick to a budget – don’t take out more credit than you can afford.

Takeaway

Some inflation is a good thing because it encourages people to spend money which keeps the economy going. On the other hand, if it’s too low, it’s a sign that there’s less demand for goods and services, which can lead to unemployment in the long run.

Should you care about inflation? Yes, absolutely. It affects how much your money is actually worth. In the meantime:

  • Try to keep saving money where you can.
  • Where possible, ensure the interest rate on your savings account is the same as or higher than the inflation rate. Otherwise, the value of your money falls over time.

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