Explain what the CPI is and how it’s used to measure inflation.

Inflation is a continuous or persistent rise in the price level, or can be seen a fall in the value of money (if bread goes from costing £1 a loaf to £1.10, it means £1 becomes less valuable with the increase in the price of bread). Deflation is the decrease in price level or a rise in the value of money (if bread falls to 90p, then £1 can buy you more than it did before, increasing its value), but is much less common. Inflation can be measured in various ways, which differ across countries.

  The CPI is the Consumer Price Index, which lies central to the Bank of England’s (the UK’s central bank) monetary policy, which seeks to monitor and control inflation levels. Most central banks try to limit inflation in their economy, many of which use inflation targeting, the UK’s being 2%, to prevent major falls in the value of money within that country. The CPI is measured by looking at the change in price levels of a ‘typical basket’ of goods and services, such as food, transport and clothing, that people typically spend their money on, which aims to indicate the cost of living.

 Price quotations from thousands of sources are gathered for nearly 700 consumer goods and services in the UK on a monthly basis, which are used to generate the CPI. Alongside these, an annual Living Costs and Food Survey (LCFS) is distributed to around 7000 households, which includes questions on households fortnightly spending, as well as larger purchases made throughout the year, to give an indicator on how ‘average’ families spend their income. The answers are collated and goods are then chosen and weighted to reflect their importance in a family’s expenditure, creating the ‘average basket of goods and services’ households buy in the UK. These items are then combined with the average prices found from the price quotations to create the UK’s CPI. The CPI is used as an indicator of the overall cost of living as it measures changes in the price of day to day living expenses. CPI levels are compared across months and years to monitor changes. Any movements in the price of this basket of goods correspond to movements in the CPI, and therefore, cost of living and the price level in the economy- which is the economic indicator for inflation.