Inflation

Inflation is, in short, when prices rise. Inflation can be caused by demand-side factors (which is more common) or supply-side factors.

Measuring Inflation
Inflation is measured by the Consumer Price Index (CPI) and Retail Price Index (RPI). These take a "basket of goods", full of commonly bought items, and measure how their price changes.

The CPI just measures the basket of goods, and the RPI takes into account the costs of the home as well, for example mortgage payments, rents and council tax. They also use a slightly different method for determining the average. As such, the RPI is usually higher than the CPI.

Supply-Side Factors
An increase in the costs of production will force the producer to raise prices to cover those costs. This can be due to a raise in the price of the raw materials or taxes.

Demand-Side Factors
An increase in demand can lead to excess demand (demand higher than supply) which raises prices due to people competing for scarce resources.

Disinflation and Deflation
Disinflation is a reduction in the rate of inflation (i.e. falling prices). When disinflation happens to a level where inflation goes negative, it is called deflation.

Disinflation occurs due to the inverse of the factors listed above - so, for example, a decrease in demand will cause disinflation.

Impacts of Inflation
Inflation is generally bad for the consumer because the price of the products they buy is increased, and their savings become worth less. Inflation will also be bad for firms who have to pay increased prices for their raw materials.

Short-term disinflation or deflation can be beneficial for an economy as the falling prices boost demand, however sustained deflation can reduce demand (and therefore be harmful) as consumers constantly wait for prices to fall further before buying what they want.

Controlling Inflation
The UK government aims to keep inflation at around 2%. This target is a similar number across the developed world.

The interest rate is the primary method of controlling inflation. Quantitative easing (artificially injecting money into the economy) can be used to rapidly boost inflation if it falls below the target.