Inflation is the name given to an increase in price levels generally. It is also manifest in the decline in the purchasing power of money

Inflation does not mean that the price of every good and service increases, but that on average the prices are rising.

Inflation reduces the value of money

Governments aim to control inflation because it reduces the value of money and the spending power of households, governments and firms.

Measurement of inflation

Inflation erodes the real value of money. In order to measure changes in the real value of money as a single figure, we need to group all goods and services into a single price index.

Consumer price index

A consumer price index is based on a chosen 'basket' of items which consumers purchase. A weighting is decided for each item according to the average spending on the item by consumers

Stages in constructing consumer price indices.

Selecting a base year:

This is usually a relatively standard year in which nothing unusual has occurred. It is given a value of 100. The base year is changed on a regular basis.

Carrying out a survey to find people’s spending patterns:

A sample of the population’s households are asked to keep a record of what they buy. The products purchased are placed into categories such as food and clothing and footwear.

Attaching weights to the different categories:

Weights are based on the proportion of total expenditure spent on the different categories. For instance, if on average households spend $500 of their total expenditure of $2,000 on food, the category will be given a weight of ¼ or 25%.

Finding out price changes:

Prices in a range of retail outlets and from a number of other sources such as gas companies and train companies are recorded.

Multiplying weights by price changes:

The total will give the change in the consumer price index but it can go much higher.

The CPI versus the RPI

Both the consumer price index and the retail price index (RPI ) can be used to calculate the rate of inflation.

There are three key differences to these price indices:

The items included in the calculations

The main difference is that the RPI includes the cost of housing, such as mortgage interest payments and other housing costs. The RPI also includes overseas expenditure by domestic. households. The CPI includes costs paid for financial services.

The population base

Both price indices try to measure changes in the cost of living for the average household. However, the RPI excludes low-income pensioner households and very high-income households, as it is argued that these do not represent the 'average' household or the expenditure of the average family.

The method of calculation

The RPI is calculated using the arithmetic mean whereas the CPI uses the geometric mean. What this means is that the RPI tends to be lower than the CPI (unless interest rates for mortgage repayments are extremely low).