What is inflation?

Will Hodges explains this key economic concept

Stick or twist? It's the conundrum which faces the Bank of England's Monetary Policy Committee (MPC) every time they decide whether or not to raise interest rates, currently at an all-time low of 0.5 per cent. A rise could place the UK's economic recovery in jeopardy as it would make borrowing money more expensive for businesses. But keeping interest rates unchanged could put the country at risk of an equally unattractive outcome: inflation.

What is inflation?

In the crudest terms, inflation is a rise in the price of goods or services stemming from an imbalance between supply and demand. Prices rise when there are too many people chasing too few goods. Why? People will typically pay over the odds for something when there is not enough of it to go around, which causes retailers to ramp up prices.

Inflation could be described as the biggest economic ill of the 20th century. A quick scan of the history books will reveal a lengthy list of the governments and economies it has devastated, among them the Weimar Republic, Hungary, and more recently, Zimbabwe and Venezuela.

But broadly speaking, the past 20 years have seen low rates of inflation across much of the world. Rapid advances in technology have made manufacturing and trade cheaper and more efficient than ever before. Machines have limited the need for manual labour, keeping wage inflation (rises in salaries) low, while the trend towards smaller electrical components has reduced expenditure on transportation and fuel, keeping the cost of goods and services down. Furthermore, the arrival of the internet has given us tools of communication that are now instantaneous and largely free.

What causes inflation?

Economists have identified two main sets of circumstances that lead to inflation of two different kinds: demand-pull inflation and cost-push inflation.

Demand-pull inflation can loosely be described as the effect on prices when an economy reaches its full capacity and is no longer able to produce enough goods to meet the demands of businesses or citizens. For example, in a fast-growing economy like China's, there may be a higher demand for steel to build new roads or houses than the economy is able to meet given its present capacity. With steel in short supply, the price of steel-based goods is likely to rise as producers are able to push up prices knowing that most people have little option but to pay them, however inflated. Often the situation will resolve itself naturally as some buyers, rather than paying over the odds, are able to wait until prices return to normal levels, which causes demand to subside. When the goods in question are essentials, for example, food or clothing, prices may continue to rise indefinitely until the government, or someone else, intervenes.

Cost-push inflation, the other main type of inflation, has invariably carried more negative connotations. An economy does not necessarily have to be growing for cost-push inflation to occur. Rather, all that is needed is for there to be a shortage of goods. For example, a shortage of oil stemming from political unrest in the Middle East would be likely to result in raised fuel prices globally and to have a knock-on effect on the cost of transport and manufacturing. For example, the 1973 Yom Kippur War between Israel and its Arab neighbours led to an embargo on the export of oil to the west. Due to lack of supply, fuel prices in Europe and the US surged and in the UK inflation was as high as 25 per cent in 1975.

How can governments manage inflation?

Governments' main weapon against inflation is their ability to control interest rates, though in most states this power has been deferred to central banks, which are technically independent. By raising the base rate of interest, the cost of borrowing throughout the economy is increased. This measure serves to limit people's access to money. With cash less readily available to consumers, demand for goods falls, reducing the previous excess of demand over supply and (in theory) bringing price increases back down to stable levels. But as history has shown, interest rate manipulation to counter inflation is often a hit and miss affair - there is considerable scope for governments or central banks to overshoot the mark, causing demand to fall further than intended leading to an economic slowdown or even recession.

Alternatively, the government may look to tame inflation by artificially stimulating the supply of goods available to potential buyers in an economy. For instance, should India have a problem with food price inflation, its government might take the decision to introduce export quotas on rice, grain and other major food groups. The government would hope that this step would inflate domestic supply, thereby reducing the shortfall in goods and curbing price rises.

Governments which have a steadfast anti-inflation policy are described as "hawkish," while those with a more relaxed approach, preferring to keep interest rates low to stimulate economic growth, are known as "dovish."

Can there be benefits to inflation?

Despite invariably being criticised in the media, low and stable inflation is generally considered to be a good thing for an economy, though generally only if its origins are demand-pull rather than cost-push. A steady rise in the price of goods (say 1 to 3 per cent a year) will encourage an increase production, leading the economy to grow and encouraging the recruitment of more staff, which will keep unemployment low. Likewise, a stable increase in wages will ensure workers are motivated to work and will remain contented even if the increase in their salary is eroded by the rise in the cost of goods they can buy with this income.

A lesson from history: Zimbabwe

History is littered with examples of governments making a hash of economic policy, leading to inflation and even hyperinflation (the economic term given to inflation which is deemed extremely high or out of control).

From the late 1990s, Zimbabwe served as a textbook case of how not to run an economy with the rate of inflation peaking at an incredible 89,700,000,000,000,000,000,000 per cent a year in November 2008 before the government took the drastic step of abandoning the country's currency, the Zimbabwean dollar, and replacing it with the US dollar.

The origins of Zimbabwe's inflation crisis it can be traced back to President Robert Mugabe's attacks on the country's white farming community at the end of the 1990s. Until then Zimbabwe had been known as the "bread basket of Africa" with an extraordinarily productive agricultural sector that provided the bulk of the country's export revenues. Through his policy of "repatriating" white-owned land to veterans from the war of independence, Mugabe crippled the country's farms and the country's exports. Without the essential revenues from exports balancing the books, the government was left struggling to pay its foreign creditors and was forced into printing more money to raise the cash required. Doing so diluted the value of the Zimbabwean dollar to the extent that it was almost worthless against foreign currencies so imported staples such as flour and rice (which were no longer being produced domestically) sky-rocketed. With no option but to pay the extortionate fees being demanded, citizens were forced to raise prices of other essential services such as medical fees and transportation. The result was a vicious circle that would last the best part of a decade.

While Zimbabwe's experience represents the exception rather than the norm, several other governments in recent decades have wrestled against wayward inflation, including Brazil, Argentina and, most recently, Venezuela.

Basket case: how is inflation measured?

Only the most vigilant of us are likely to know the price of a loaf of bread or a can of baked beans from one month to the next. Luckily, government bods are busy behind the scenes keeping record of the cost of everyday goods and services from which it can determine an official rate known as the Consumer Price Index (CPI). Every so often, statisticians carry out surveys on thousands of households throughout the UK to determine the most popular items bought on a regular basis by families, creating what is known as a "basket of goods." These items are then divided into categories including food and beverages, transport, and clothing, and are given a weighting to reflect the proportion they comprise of an average household spend. Thousands of price quotations for the goods in the basket are then sourced from a spread of retailers resulting in an average price for each product. This process is repeated every month to track shifts in the price of each good. Each individual shift will have a smaller or larger impact on the overall price of the basket depending on its weighting within its category and then on the basket as a whole. By comparing the current price of the basket with the month's price, a measure of inflation is given. For example, if the basket costs $100 one month and $105 the next, then the monthly rate of inflation is 5 per cent.

Since the CPI was first introduced in 1996, the average UK shopping basket has been constantly changing. Some products such as mortgage payments and council tax which aren't included in the index are instead picked up by other inflation indexes such as the Retail Price Index (RPI).