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Inflation Explained

by kraju

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Consumer Prices Index

It forms the basis for the Government’s inflation target that the Bank of England’s Monetary Policy is required to achieve. It is an internationally comparable measure of inflation, published in U.K until December 2003 as the Harmonised Index of Consumer Prices (HICP), the CPI looks at the prices of hundreds of items we spend our money on such as food, transportation, entertainment and other daily necessities but excludes housing costs and interest payment costs. The CPI is calculated based on a formula which works on the assumption that when prices rise, some people will switch to lower priced goods. The calculation of CPI is show below by an example:

Calculating the CPI Index

In this example, let us say 2000 is our base year with an index value of 100. In 2001 the same basket of goods costs $ 1.25 and the price index for the year 100 is 125, similarly for 2002 the same basket of goods would cost $ 1.31 and the price index has a value of 131. We do this for every year














Calculating the inflation rate

In order to calculate the inflation between any two years we calculate the percentage change between two years. The formula is    

F-I/ I x 100

Where F is the final value and I is the Initial value

Now, to find the inflation rate between 2003 to 2004, in this example the final value is the index value for 2003 which is 137. The initial value is the index value for 2003, so when calculated

137 – 133/ 133 x 100

This gives an inflation rate of approximately 3 percent for 2003-04.

Retail Prices Index

RPI is used to index various prices and incomes including tax allowances, state benefits, pensions and index linked gilts. Like CPI, it includes the prices of items that we spend our money on and also includes housing costs such as council tax and mortgage interest payments. The RPI and CPI are both measures of the price of goods and services in the U.K, the policy of the U.K. government is to use the CPI for the indexation of benefits, pensions, and tax credits and it would use the  RPI for uprating the index linked gilts and revalorisation of excise duties. The RPI shows the changes in the cost of living and reflects the movement of prices in a range of goods and services used regularly such as transportation expenses, household goods and petrol which are given a higher weighting in the overall index, while items, such as tobacco are given lower rating in the overall index. RPI includes some components in CPI such as mortgage interest payments. 

The Office for National Statistics announced in January 2013 that a new inflation index would be used as the existing system is flawed. Former Bank of England Governor had described the existing system as “outdated” and proposed a new index called RPIJ, the new index will replace a current formula for calculating RPI known as “carli” with a different formula called Jevons.

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