Inflation is a measure of how much the value of currency depreciates each year. For example, if prices for a loaf of bread rise by 3% in a year, you would have to earn that extra 3% to continue to purchase bread, so your extra earnings would have no extra value.
According to the Bank of England, average price inflation rose by an average of 5.2% a year between 1950 and 2020. £10 in your purse or wallet in 1950 would now need to be £350.42 to have the same purchasing power.
The process is pernicious. As prices increase there is a tendency to try and buy now before prices increase. This increase in demand can further outstrip supply and push up prices even more.
The reverse applies if prices fall; this is known as deflation. There is a tendency to defer buying decisions in the hope that prices will fall further. This is a disaster for businesses as they must lower prices to win sales, become unprofitable, and if the process continues, become insolvent and forced to liquidate.
While earning keep pace with inflation the increasing number of £s in your pocket will help you maintain your purchasing power, but the increased earning will not allow you to buy more stuff.
If inflation outstrips earnings, then you will have less purchasing power.
Inflation is a recent phenomenon. Between the seven hundred years 1200 and 1900, average inflation was low, only 0.4% per annum. In the next one hundred years, as the effects of industrialisation and increases in money supply took effect, average inflation was 4.4%.
If the Bank of England manages to keep inflation at the target rate of 2%, we should suffer no ill effects. The danger is if rates climb above 2% the BOE may need to increase interest rates – their prime instrument for reducing inflation – which means that we will all have to pay more to borrow money or finance our debts.
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