How inflation works

Inflation is the general rise in prices over time — or, viewed from the other side of the till, each unit of money buying slightly less. Those are the same fact described twice. A note in your pocket does not shrink; the shopping it commands does. Everything else in this article is measurement and arithmetic.

Measured with a basket

Nobody can track every price, so statisticians track a basket: a fixed shopping list — bread, rent, haircuts, bus fares — priced again and again over time. Turning the basket's total cost into an index lets the same list be compared across years, and the percentage change over twelve months is the inflation rate you hear quoted. Purely hypothetical arithmetic: if the basket cost 100 last year and 103 now, inflation ran at 3%. Which items go in the basket, and in what proportions, is a judgement call — which is why the official rate can feel wrong to any household whose own shopping list differs from the average one.

Real versus nominal

Nominal is the number printed on a statement; real is what that number buys. Hypothetically, money earning 5% while prices rise 3% gains roughly 2% of purchasing power. Roughly, because the subtraction is an approximation: the exact answer is 1.05 divided by 1.03, a gain of about 1.9%. At modest rates the shortcut is close enough; at high rates the gap widens. Either way, the real figure is the one that describes what actually changed.

The mattress case

Cash earning nothing makes the arithmetic stark. With prices rising 3% a year — hypothetical, as ever — an item costing 100 today costs 103 in a year. The 100 under the mattress still says 100, but it now buys 100/103 of the item: a loss of about 2.9% of purchasing power. Nothing was stolen. The note stood still while prices walked on.

Small rates compound

Inflation applies each year to prices already raised the year before, so it compounds — the same mechanism as compound interest, run against you. Hypothetically, 3% a year for ten years does not add up to a 30% rise; it multiplies to about 34%. Modest annual rates become large decade-long ones, quietly.

What central banks do

Central banks aim to keep inflation low and steady, and their main lever is the interest rate. Raising rates makes borrowing dearer and saving more rewarding, which tends to cool spending and, with it, price rises; cutting rates works the other way. The lever is blunt and slow: the effects arrive with a lag and touch markets along the way. Deflation — prices falling — sounds pleasant and brings its own problems, which is why the usual aim is low inflation rather than none.

What this is not

None of this says what inflation will be next year. No article knows, and the forecasters with better funding miss it regularly too. Nor does it say what anyone ought to do about rising prices — that depends on circumstances this page cannot see. What the mechanics establish is narrower and more certain: whatever the rate turns out to be, the real figure, not the nominal one, is the one doing the telling.