Inflation Why do the items in your shopping basket cost more (or less) than they did the day before? Sally Bolton explains Friday January 18, 2002 What is inflation? Inflation is a sustained rise in prices across an economic area - literally "the cost of living". In Britain it is calculated by measuring the monthly percentage rise in price of a weighted sample, or basket, of goods and services that a typical household buys. Why are there different types of inflation rate? The above rate is called the Retail Price Index (RPI) and includes the cost of mortgage inflation rates. This is the most prominent inflation rate and is quoted frequently by the media, so it is also called the headline rate. The second-most important rate of inflation is the underlying rate, or RPIY. This is RPI minus the cost of mortgage interest rates, so, since mortgage interest rates stem from the rate set by the Bank of England, it is preferred by some as a purer measure of the actual trend in prices. A third, less commonly quoted and even purer rate is RPIX - this is RPI minus mortgage interest rates and consumer taxes. What causes inflation? In classical economic terms, it is caused by demand exceeding supply: in other words, too much money is chasing too few goods and services, so the goods and services begin to command higher prices. This situation can arise in several ways. Rising public expectations of the standard of living may increase demand; supply may be constricted during war or through external shocks such as the 1970s oil crises; union activity may increase wages and hence both stimulate demand and restrict supply; or government policies, such as printing paper money in a bid to pay back debt, can be directly inflationary. But inflation is a relatively new phenomenon that appears to be endemic in modern industrial economies. One of the earliest notable appearances of inflation was in 1800, when restricted supply during the Napoleonic wars drove up prices. At the time, this comparatively modest inflation was considered highly unusual and alarming to people used to an environment of very stable prices. Why is it considered to be bad? Inflation is not necessarily bad - at least not for everyone. Borrowers don't usually mind inflation because, as long as interest rates aren't too high, it brings down the cost of their debt. But inflation does reduce the buying power of money, so unless wages keep up with inflation, people become worse off. Those dependent on savings or fixed-rate pensions are severely affected by high inflation that exceeds interest rates, because it makes serious inroads into their capital. But a moderate amount of inflation simply shows that a country is on the upswing of its economic cycle. Only if inflation is increasing rapidly or is at a permanently high level does it become a problem: it could indicate that the economy is overheating and heading for a crash. Permanently high inflation indicates instability and weak economic fundamentals, discouraging saving and investment. It erodes confidence in the country's currency, causing the exchange rate to drop, and ironically, causing more inflation through import price increases. What is deflation? Very low inflation, or negative inflation (ie deflation - a sustained fall in prices) is not necessarily good either. Falling or low inflation can indicate a country's position along the economic cycle. And with inflation in Britain currently standing at around 0.7% - its lowest level since 1960 - it is pretty clear that we are on the curve of a downturn, despite what market analysts and Christmas shopping figures may suggest. What is stagflation? Stagflation is a freak economic phenomenon where prices rise despite stagnating economic growth - the worst of both worlds. It notably occurred in Britain and elsewhere during the 70s, due to the tripling of world oil prices by the Organization of Petroleum Exporting Countries (OPEC) in the aftermath of the 1973 Arab-Israeli War. These oil-price shocks drove up production costs, hence prices, during a world recession. What is hyperinflation? Hyperinflation is another unusual phenomenon, where prices spiral upwards uncontrollably and extremely rapidly with devastating economic consequences. It is usually defined as inflation in excess of 50% a month. In 1922-23, Germany's short-lived interwar democracy experienced hyperinflation of 3.25m% a month, partly because it had borrowed heavily, then printed massive amounts of paper money in an attempt to manage the cost of war reparations and other debt. With prices increasing by the second, people began to be paid as often as three times a day, in wheelbarrows full of nearly worthless notes, and rushed to spend wages that couldn't buy enough to eat. The chaos continued until a new currency, the Rentenmark, was introduced. What can be done about inflation? No one can get rid of inflation permanently. It will always rise and fall with the economic cycle, but government policies to manage this will also affect inflation. Increasing interest rates, taxes and cutting back public spending to take the heat out of a boom will also damp down inflation, to an extent. However, in the long term, sound economic policies may reduce a country's average rate of inflation. Creating the conditions for investment, long-term growth and currency stability, so that the economy cannot overheat easily and so that confidence in the currency remains high, are the best ways to achieve the goal of low average inflation.