Inflation, Put Simply

Economics terms such as inflation are thrown about by those in-the-know all too regularly. Frankly, it’s baffling for those of us without expert knowledge in the subject, and “put simply” explanations are infrequent, to say the least. #LetsTalkPolitics and challenge this.

Inflation can be defined as a sustained or persistent increase in the average price level of goods and services in an economy, or a fall in the purchasing power of a currency. The CPI or consumer price index measures the level of inflation; essentially it is a statistical estimate of prices in the economy constructed by using the prices of sample or representative goods such as butter, cars or soap.

Whilst the government does maintain a target of 2% the current level is lower at 1.2% (Nov 2016). This means that a basket of sample goods and services that would have cost £100.00 in November 2015 would have cost £101.20 in November 2016.

Inflation can be derived from both the demand side of the economy (us as consumers, buying goods and services) or from the supply-side of an economy (high prices of raw materials, increases in labour costs, import prices such as oil).

For example in reference to the demand-side – An increase in total demand in an economy at an unsustainable level will lead to the average price level rising. Causes of this demand-pull inflation could be a fall in the interest rate (the percentage rate charged on a loan or paid on savings), lower taxes (Income or VAT) or depreciation of the exchange rate. This will lead to demand for services and goods increasing, as consumers will be earning more. Hence suppliers will not have increased their output to match demand in the short-run and consequently they have the ability to rise prices of goods overall, hence leading to higher inflationary pressures.

On the supply-side inflation can be caused by a variety of factors. Cost-push inflation is a situation where the average costs for firms rise. This could be due to:

  1. Prices of imported products a firm needs to manufacture a good rising (Bolts or microchips)
  2. Wage increases (Trade unions may demand a rise in pay – London underground 2016)
  3. The average price level of raw materials rising (Oil per barrel)

There are an array of costs inflation has on an economy:

  • Millions of people face a freeze in their wages or lower-real wages as costs increase and their wages don’t hence they have falling real incomes
  • Workers may demand wage increases as they want to protect their incomes and hence this can lead to higher labour costs and lower profits for businesses
  • Businesses become less competitive on the global markets if inflation stays persistent for a long period of time and hence less of their services or goods are bought (can also lead to a worsening trade balance)
  • If there is high and volatile inflation, business confidence can fall as firms are unsure of their costs and prices – this can lead to less investment in the economy

Ultimately it’s interesting to see how inflation affects a substantial portion of the economy and has knock-on effects elsewhere.

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