You will often hear economists mentioning the power of inflation, what it can do and how it actually effects everyday life, but what does it really mean for you?

The inflation figure which you will see quoted on TV and in the financial press is produced by comparing the change in the cost of “a basket of everyday goods”  over a certain period.  The goods which are included in the “basket” are items such as mortgages, televisions, food, drink and general grocery items - basically goods which reflect everyday life, and the popularity of the item.  This “basket” will actually change over time, as some items become less popular and other items are introduced.

The end result is the inflation figure, which gives the average price increase of the “basket” over the period in question - normally twelve months.  If inflation is running at high levels, then it means that the economy may be running out of control and you would normally see the Bank of England intervene in the UK.  The UK government are currently looking to keep inflation in the 2.5% to 3% range which they believe is manageable.

What problems might inflation cause?

If inflation gets out of control as the economy grows at a pace which is probably unsustainable over the longer term, this can result in the so called “boom and bust” scenario.  In effect, as prices rise, there is pressure to increase wages, which then increases costs for business, requiring further price rises - in effect a vicious circle on increases.  At some stage the consumer will not be able to afford the items, as the rise in their income will probably be less that the rise in prices. 

This would then impact upon the profitability of industry in general, which may well push them towards saving costs, with redundancies the probable outcome.  As the number of unemployed increases, then we see spending reduce yet further, putting more pressure on not only industry, but the housing market.  Debts may spiral out of control, we may see an increase in house repossessions and a general collapse in the economy.

During the boom phase of the cycle, we may well see the Bank of England increase interest rates to cool down the situation.  This is a short term pain, long term gain scenario, which is required to bring the economy back under control.  In summary, a little bit of inflation is good, but rampaging inflation can ruin an economy for many years and have devastating effects on the population.