Inflation

The text book definition of inflation might be 'a trend of rising prices caused by demand exceeding supply'. Over time, even a gentle annual increase in prices of say 2% will tend to affect our 'purchasing power'.

In other words, if prices are rising steadily, after a number of years, we will be able to afford to buy significantly less goods and services - this assumes of course our income doesn't increase in line with inflation. For example, inflation at even a relatively benign 2% a year means that prices would double in 36 years.

The economic effects of a little inflation can be positive and often be taken as a sign the economy is in an expansionary phase. But when inflation is accompanied by a contracting economy (this is known as stagflation - a sort of stagnation combined with inflation), it is not healthy at all. In such circumstances, prices in the shops will be increasing but the economy will be in the doldrums. In such circumstances, it is likely pay rises might not be keeping pace with prices and jobs will be lost as firms slow down output and shut down production.

The effect of inflation on our lives can be profound, if not always immediately visible. Our savings in a bank or building society may be eroded in real terms - this happens when the interest rate on offer from the bank or building society is less than the annual inflation rate.

Another symptom of inflation is that it is normally interpreted by foreigners as 'bad management' of the economy by the government and can affect the value of the currency and your spending power abroad.

See also: UK Inflation history Inflation and your Savings RPI Index Rossi Index

Last Updated: November 2007 © Moneyextra.com

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