2.1.1 - Inflation, deflation and CPI

Changes in the general price level

The price of one product can change without the general cost of living moving in the same direction.

Inflation is a sustained increase in the general price level of goods and services. Deflation is a sustained decrease in that general price level. “General” matters: cheaper mobile phones do not establish deflation if other prices raise the overall price level. “Sustained” distinguishes a continuing general change from an isolated fluctuation.

Inflation reduces money's purchasing power. If an unchanged basket costs £100 and later £105, the same £100 buys less of that basket. This does not mean every price rises by 5%, or that every household experiences exactly the same cost increase. Deflation means money buys more of the measured basket; it is different from prices merely rising more slowly.

Disinflation means a fall in the inflation rate while it remains positive. A rate falling from 8% to 3% means prices are still rising, but at a slower rate. A rate of −3% indicates deflation. A government seeking low and stable inflation seeks a slow, predictable rise in prices rather than repeated large swings; it is not necessarily seeking a price level that never changes.

The basket, weights and CPI

A consumer price index combines price changes across a representative basket instead of tracking just one shopping receipt.

The Consumer Price Index (CPI) is an index of the prices of a representative basket of consumer goods and services. A reference period is assigned 100; later values compare the measured price level with that reference. In a simple unchanged-basket illustration, a basket costing £200 in the base year and £220 later gives $220\div200\times100=110$. CPI 110 means the measured price level is 10% above the base, not that inflation is 110%.

Statistical offices collect many price observations and combine categories using weights reflecting their shares in household expenditure. A category taking a larger budget share has more influence on the overall index. Representative items and weights are reviewed as spending habits change. This describes the principle; real CPI compilation is more detailed than our small fixed-basket example.

For identical apples sampled at £1.20, £1.40 and £1.60, an illustrative arithmetic average price is $(1.20+1.40+1.60)\div3=£1.40$. That average describes the sample. Combining unlike categories requires appropriate expenditure weights, rather than averaging their money prices as if food and a bus ticket were the same product.

The weighted index is $0.50\times110+0.30\times100+0.20\times120=109$. The weights total 100%. An unweighted mean of the three category indices would be 110; it would wrongly give every category the same influence despite their different budget shares. A household spending much more than average on the fastest-rising category may face a larger personal cost increase than CPI suggests.