Inflation refers to a sustained increase in the general price level of goods and services in an economy over time. When prices rise, each unit of currency buys fewer goods and services, meaning the purchasing power of money declines. This erosion of purchasing power affects households, businesses, and government decision-making and is therefore a key indicator of economic health.
Inflation can result from various factors. Demand-pull inflation occurs when aggregate demand grows faster than the economy’s productive capacity, pushing prices upward. Cost-push inflation, by contrast, arises when higher production costs - such as increased wages, raw material prices, or energy costs - force businesses to raise prices to maintain profitability. A related concept is built-in inflation, which stems from adaptive expectations: workers demand higher wages to keep up with rising prices, and businesses pass these higher labour costs back into prices.
Measuring Inflation
Most countries track inflation using consumer price indices that monitor changes in the cost of a representative “basket” of goods and services purchased by households.
United Kingdom
The Office for National Statistics (ONS) publishes the Consumer Price Index (CPI), the UK’s main inflation measure. CPI tracks price changes across a wide range of household expenditures, including food, transport, clothing, and energy.
United States
The Bureau of Labor Statistics (BLS) publishes the Consumer Price Index for All Urban Consumers (CPI-U). This measure reflects price changes for goods and services typically bought by urban households, which represent the majority of the US population.
Australia
The Australian Bureau of Statistics (ABS) publishes the Consumer Price Index (CPI), tracking quarterly changes in the cost of living for households across Australia.
These indices are widely used by governments, businesses, and financial institutions to adjust wages, pensions, contracts, interest rates, and other economic variables for inflation.
Effects of Inflation
Inflation has a mix of positive and negative impacts, depending on its level, duration, and causes.
Positive Effects
- Encourages investment and spending: Low and stable inflation allows businesses and households to plan ahead, supporting long-term investment and economic growth.
- Reduces the real value of debt: Borrowers benefit because their debt becomes easier to repay in real terms as wages and prices rise.
- Signals healthy demand: Moderate inflation often indicates a growing economy with rising demand for goods and services.
Negative Effects
- Erodes purchasing power: As inflation rises, consumers can afford fewer goods and services, reducing real income and living standards.
- Increases uncertainty: High or unpredictable inflation makes it difficult for businesses to forecast costs, set prices, and make investment decisions.
- May trigger higher interest rates: Central banks often raise interest rates to combat high inflation, which can slow economic growth and increase borrowing costs.
- Can redistribute income unfairly: Fixed-income earners and savers suffer when inflation rises faster than wages or interest returns.
Inflation is therefore a crucial economic indicator. When kept at low and predictable levels, it supports economic stability and growth. However, when inflation becomes high or volatile, it can undermine confidence, disrupt investment, and weaken an economy.
