Inflation is a general increase in prices and fall in the purchasing value of money. The inflation rate is the percentage change in the price index from one month to the next.
The Retail Prices Index (RPI) is the best measure of inflation as it covers a wide range of typical household items, including food, clothing, housing costs, mortgage interest payments, car purchases and gas and electricity bills.
It is also used to calculate inflation-linked benefits, such as the state pension and certain components of Jobseeker’s Allowance.
The Consumer Prices Index (CPI) does not include some important items such as housing costs, so it tends to be lower than the RPI.
In order to reduce inflation, the government can raise interest rates which will make it more expensive for businesses to borrow money for investment, and discourage consumer spending.
Another option is for the government to reduce its own spending in order to leave more money available for households and businesses to spend themselves. Reducing spending can lead to increased unemployment, however, so this option is usually only adopted as a last resort.
Quantitative easing (QE) is another tool that can be used by central banks to help stimulate economic activity and reduce inflation. QE involves central banks buying financial assets from commercial banks with newly created electronic money. This increases the amount of money in circulation and reduces lending rates, making it cheaper for businesses to borrow money and stimulating investment and consumer spending. There are drawbacks to QE, however, as it can lead to asset bubbles forming and increasing levels of government debt.