Description of Inflation in detail

Inflation is the rate at which average price level of services and goods rises in a given time period. In UK the Office for National Statistics uses two major indices to measure inflation: Consumer Prices Index (CPI) and Retail Prices Index (RPI).

The role of inflation expectations in influencing future inflation was an area of economic analysis established by Professor Milton Friedman in the 1970s. Friedman argued that firms and workers' pay careful attention to their past experiences when developing expectations about future inflation. If they have experienced inflation in the past workers would expect prices to go up in the future and will make pre-emptive wage demands on the ground which without an inflation-adjusted pay rise they will experience a pay cut in real terms. This behaviour will actually create the conditions for inflation. Confronted with increased wage demands and accepting inflationary record of the past, firms will give in to higher wage demands and pass on cost increases to consumers in form of higher prices.

Changes in costs of production will also affect inflation. In the summer of 2008 UK experienced increased inflation as price of energy raised in world markets. In July 2008 price of oil broke $100 a barrel mark for the first time though it did fall sharply after financial crisis. It has, though, risen steeply again because of the high levels of demand from emerging markets that may well see the price of a barrel of oil break the $200 mark in the subsequent few years. The British economy is dependent upon oil as a main source of energy so when oil prices increase, costs of production of almost all firms increase either indirectly or directly. This feeds into the inflation indexes.

Cost-push inflation is illustrated on the aggregate demand and supply diagram below. Initially, macroeconomic equilibrium is at point X with real output and price level correspondingly at y1 and P1. Firms' money costs of production rise - for instance since money wages or price of imported raw materials increase - that causes the SRAS curve to move upward and to left from SRAS1 to SRAS2. The cost-push inflationary process increases price level to P2 however higher production costs have reduced the equilibrium level of output which firms are willing to produce to y2. The new macroeconomic equilibrium is at point Z.