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Level 2 Business and Economics: The Economic Context of Business

Inflation

Inflation is a rise in the general price level over a period of time.

In any economy, prices are rising and falling all the time - some rise by quite a lot and others will fall. This is not just the prices in shops for food but also prices of things like insurance for both individuals and businesses, the prices of raw materials like oil, copper and steel, tuition fees for education at university and the price we pay for different sorts of entertainment like the cinema.

Inflation affects businesses and individuals in different ways. Changes in inflation invariably make the news but what is it and how is it calculated? Copyright: Kay Pat, from stock.xchng.

The government give the responsibility for collecting information about what is happening to prices throughout the economy to the Office for National Statistics (ONS). Every month representatives from the ONS go around the country collecting information about prices of 650 different goods and services from 150 areas of the UK in different sales environments resulting in around 120,000 different pieces of price information.

The above is a selection of items added to the CPI basket in 2006. Other items are removed. Source: Crown Copyright. [PDF, 256KB]

From this, they compile a picture of how prices are changing on average. They publish the information every month through what is called the Consumer Price Index (CPI). The CPI gives us an idea of what is happening to price changes throughout the economy. The CPI is used to measure the rate of inflation.

A CPI figure of 2.5% means that prices on average rose by 2.0% compared to the same period a year before. An item priced at £1.00, therefore will now be £1.02.

It is important to remember that this is an average and that it does not mean that every good and service has increased by that amount.

In the UK, the government has set a target for the rate of inflation at 2.0%. This, they believe, is a rate that is consistent with a growing and dynamic economy. Businesses need to have some incentives to expand and if prices are rising then it provides such an incentive to keep growing and seeking out profits and good returns on investment.

If inflation rises too quickly, however, it can cause problems. How quick is 'too quick' is not easy to specify. In the UK a rate of inflation over 3% might give cause for concern. In the mid 1970s, inflation in the UK reached 25%. In other countries such as Germany between the two World Wars and in the former Yugoslavia in the 1990s, inflation rates of thousands and even millions of percents were recorded. Such cases are extreme but the danger of letting inflation get out of control is something that most governments want to avoid.

The dangers of inflation are as follows:

• Difficulties for businesses to plan ahead - especially when inflation starts to get out of control. This affects not only the amount the business receives from sales but also the prices of inputs - raw materials and so on
• Businesses may face pressure from employees organisations for pay awards to keep up with inflation and this can affect costs of production
• It affects spending power if wages do not rise by the same rate as inflation
• It especially affects those who may be on certain types of fixed incomes like company pensions
• Savings can fall in value if the rate of interest is lower than inflation
• Inflation in the UK at a higher rate than in other countries affects businesses who try and sell abroad. It makes it harder for them to sell goods and services because they are less competitive

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