The Foundations of Finance – Inflation

Inflation is the rate of increase in prices for goods and services. So, say you live in a country with 4% annual inflation – on average, the price you pay for goods and services will be 4% higher than in the previous year. This is a general increase across the board, and shouldn’t be confused with a price increase in a particular good (if there’s a huge fad for halloumi, for example, that’s not a halloumi inflation) It can be calculated in a number of ways – many countries use a market basket, which analyses a particular set of different goods and services (stuff a typical consumer will likely need or use) and their cost over time. Certain items are weighted according to how much is spent on them – in the UK, for example, fuel has more weight than stamps when calculating inflation rates.

When gold was used as currency, the government would collect gold coins, melt them down and mix them with other metals before reissuing them at the same nominal value

There has been inflation throughout history (although the term itself wasn’t really used in an economic sense until the American Civil War). When gold was used as currency, the government would collect gold coins, melt them down and mix them with other metals before reissuing them at the same nominal value. They could issue more coins without increasing the amount of gold that needed to make them – however, as the relative value of the coins was lower, customers would need to give more in exchange for the same goods and services. Thus, there was a price increase because the value of each coin was reduced.

The Mongol Yuan Dynasty spent a great deal of money fighting costly wars, and reacted by printing more money (this was a fiat currency – a money without any intrinsic value), leading to inflation. Large infusions of gold or silver historically led to inflation – after an influx of gold and silver from the New World into Habsburg Spain, widespread inflation spread throughout the previously cash-starved continent. Later on, huge increases in the supply of paper money led to a number of hyperinflations – most notably in the German Weimar Republic of the 1920s, although it is still to be found today in Venezuela (with an annual inflation rate of around 46,000%).

Inflation is very important because the government and businesses use it as a tool for setting economic policy. Consider the Bank of England, with its main priority being to keep inflation under control, and its capacity to set interest rates – most economists favour a low and steady rate of inflation nowadays, so the Bank can choose interest rates that attempt to subdue inflation (in the event of it being higher than preferable).

Because of its inherent link to interest rates, it affects both the money you have in the bank and the amount of student loan you’ll have to pay back

Now, talking theory and history is all well and good, but why does any of this matter to students? Well, inflation currently sits at 2.4% for the third month in a row, and that’s down to some price shifts in the market baskets. Clothing prices and video games saw their prices drops, but inflation remains stable because of an increase in the cost of motor fuel and energy – so if you’ve moved into off-campus accommodation, it may be worth saving to pay for the gas and electric over winter. It also influences things like the price of some train tickets (think about that when you’re contemplating that railcard) and, because of its inherent link to interest rates, it affects both the money you have in the bank and the amount of student loan you’ll have to pay back (the interest rate will rise to 6.3% in September). Some companies also use the level of inflation to set pay rises – maybe something to consider when you’re scouting for grad jobs?

Although an increase in inflation may seem bad, and certainly nobody likes having to pay more for the things they want, economists don’t really tend to worry about it too much. Don’t ignore it when it comes on the news, but if it remains steady, don’t expect it to impact particularly on your day-to-day life.