INFLATION.

 Inflation is a measure of changes in the cost of living. Inflation is measured by using a weighted basket of goods and looking at the changes in price. However, in practice, there are many practical difficulties for measuring inflation.

1. Family Expenditure Survey does not include everybody. E.g pensioners are excluded. Pensioners have different spending habits e.g. heating / bus travel account for a higher % of their expenditure. Young people will benefit more from falling prices of mobile phones and electronic goods. Therefore, the basket of goods may not be representative. Also, as it is updated once a year, it may soon become outdated for changes in spending habits.
2. Changes in Quality of goods. Changes in the quality of goods mean that price rises may not reflect inflation, but just the fact it is a different good. For example, computers have many more features than 10 years ago, so it is difficult to compare prices because they are effectively different goods. This is similar situation for many goods such as mobile phones and cars.
3. One off shocks may give a misleading impression. For example, a rise in oil prices will lead to higher inflation. But, this rise in prices may just be temporary. Tax changes have a similar effect.
4. Which Measure to Use? – CPI, RPI or RPIX. RPI includes mortgage interest payments. CPI doesn’t. In 2009, with falling interest rates, RPI gave a negative inflation rate, whilst CPI was positive. Therefore, it is important which measure is used. The government’s preferred measure is currently CPI.
5. People have different inflation rates. Rising electricity and gas prices may effect old people more than young people. Therefore, old people could have a higher inflation rate than the national average. This is important if pensions are index linked because their cost of living may rise more than prices causing a decrease in living standards.

Different Types of Inflation Measures

ü  RPI  – old headline inflation rate

ü  RPIX  – RPI less mortgage payments this is the underlying rate.

ü  This is used because interest rates are increased to reduce inflation but this higher interest rates increase the cost of mortgage repayments

ü  RPIY = RPIX less taxes (This is sometimes known as the harmonized rate)

ü  CPI – Consumer Price Index