Lesson preview · Prices, inflation and interest
Inflation: measuring it, and who it hurts
~8 min · Free to read
Imagine you leave 1,000 dollars in a drawer for a year. When you open it, every note is still there. But the shopping you usually buy now costs 10% more. Your 1,000 dollars buys only what about 910 dollars bought a year ago. Nobody took your money. Rising prices shrank what it can buy.
Savers saw this happen in 2022. In June, prices in the United States were 9.1% higher than a year earlier. In October, they were 10.6% higher in the euro area and 11.1% higher in the United Kingdom. In the United States and the United Kingdom, these were the fastest rises in about 40 years.
Key Term
Inflation
Inflation is a rise in the general price level: prices across the whole economy going up, on average, and continuing to rise over time.
One price rising isn’t inflation. If petrol jumps but other prices stay still, petrol has become dearer compared with other things. The average rises only a little, and only once.
When prices across the whole economy fall, on average, that is the opposite: deflation.
To measure inflation, a statistics office uses a basket: a list of what households buy, and how much of each, from bread and bus fares to rent. It prices the same basket in both years it compares, so any change in its cost comes from prices alone. Every so often, the office updates the basket as spending habits change.
Say the basket costs 500 dollars in the first year. That is the base year, the year that later years are compared with. The office gives the base year a score of 100. This score is the price index: the basket’s cost compared with the base year. The next year, the same basket costs 525 dollars, so the index is 105 (525 ÷ 500 × 100). Prices rose 5%, so inflation was 5%.
An index like this, built from what households buy, is called a consumer price index (CPI).
Divide the change in the index by the earlier index, then multiply by 100 to get a percentage.
Every household faced the same price rises. Yet in this example the car commuter’s inflation was 6.5% and the student’s was 4.6%, because they spend their money differently. The official figure is built from the spending of all households added together, so your own inflation can be higher or lower.
Key Term
Interest, and what your savings can buy
Interest is the price of borrowing money. For a saver, it’s the reward for waiting instead of spending now.
Say your savings earn 3% a year, so 200 dollars grows to 206. But prices rise 5%, so shopping that cost 200 dollars now costs 210. You have more dollars, but they buy about 2% less. The number of dollars is the nominal amount. What they can buy is the real amount.
Key Term
Unexpected inflation: who loses and who gains
Leo borrows 1,000 dollars from a bank for one year, at a fixed 4% interest rate that can’t change. He and the bank expect prices to rise about 2%, but they rise 8%. Leo repays 1,040 dollars, which buys only what about 963 dollars bought when he borrowed. Leo gains, and the bank gets back less buying power than it lent.
If both had expected 8%, the bank would have charged more interest. So it is unexpected inflation that moves buying power from lenders and savers to borrowers with fixed-rate loans.
Cash loses either way, because it earns no interest.
Trap · Common Misconception
Falling prices aren't good news either
Deflation sounds great, but central banks worry about it. When prices keep falling, some people may put off buying because they expect things to get cheaper. If many do, firms sell less and may cut jobs. Economists still debate how strong this effect is in real economies, so the evidence on it is mixed.
Debts also get heavier: the amount owed stays the same while prices, and often pay, fall.
So many central banks (the banks that look after a currency, such as the euro or the yen) don’t aim for zero. In 2026, the central banks of Canada, Japan, the United Kingdom, the United States and the euro area all aimed for inflation of 2% a year. That leaves a safety margin: a bad year can pull inflation down without tipping prices into falling.
Check yourself · no marks
Why would you rather have 100 dollars today than 100 dollars in a year’s time, even if prices stay exactly the same?
Commit to one first. Guessing and being wrong beats reading the answer cold.
Check yourself · no marks
Inflation falls from 8% one year to 3% the next. Have prices fallen?
Commit to one first. Guessing and being wrong beats reading the answer cold.
Worked Example
A country’s price index was 100 in the base year. Two years later it was 120. One year after that, it was 126. What was the inflation rate in that last year?
Practice · 1 / 6
Which of these is an example of inflation?
Next
Like what you read?
Sign up free to save your progress, get spaced reviews tuned to you, and work through the whole course with interactive graphs and adaptive practice.