2.10 Economy: what is inflation?

The goings on in the economy influence our lives in many different ways, even though we are not always immediately aware of this. One of these phenomena that often go unnoticed is inflation, or the depreciation of money. Inflation means that prices go up and that the same amount of money buys you less goods and services than before.

Inflation may be due to various reasons:

Price rises happen in different areas and in different parts of society in different ways. In Finland, as elsewhere, there are countless products in the marketplace: the product classification adopted in 1995 contains more than 2,500 categories, each of which includes large numbers of products and product names. Furthermore, goods are sold in thousands of different places. For these reasons, the measurement of inflation is an extremely demanding task. The prices of individual products develop unpredictably: some prices get cheaper, others become more expensive, and the rate of price change varies.

Average prices in 1983-2008 (euros): the cost of selected products in 1983, 1993, 2003 and in September 2008

In order to find out just how much prices have gone up, data need to be systematically collected each month. The rise in prices is described by the consumer price index (CPI), which indicates the average increase in prices compared to the base year. For purposes of price monitoring a new basket of representative products is selected once every five years, making use of data on Finnish people's consumption expenditure and retail trade. Price data are collected from a number of sources, but primarily from retail outlets. In order to make sure there is a representative sample of different kinds of shops in the survey, target municipalities are first selected from different parts of the country. Then, different kinds of shops, department stores, bargain shops, specialist outlets, etc., are included. Each month this machinery produces data on some 44,000 prices.

CPI weight structure

Source: OSF: Statistics Finland, Consumer Price Index, 2008

Goods can have a very different meaning to the consumer or producer. For example, households spend on average 1.8 per cent of their total outlays on electricity and 0.04 per cent on carrots. The weight of electricity in the consumer price index is 45 times greater than the weight of carrots. In other words, changes in the price of electricity have a greater impact on household consumption expenditure than changes in the price of carrots. This must also be reflected in index changes.

Inflation is an integral part of market economy. A small increase in prices indicates that the economy is moving forward: product improvements are one factor that drives up prices. Rising standards of living also act to increase wages, which in turn pushes up prices.

Excessive inflation is not good for the economy, however. Those who suffer most from inflation are those who have saved money, because that money will no longer buy them the same amount of goods as earlier. Inflation is particularly bad news for the economy's international competitiveness because it is much harder to sell products on foreign markets where prices have increased more moderately. Secondly, it is harder to make economic predictions if prices are galloping ahead.

As a rule, prices go up. It is only in exceptional circumstances, usually in conditions of economic decline, that prices may fall. This is known as deflation. In this situation the same money will buy you more goods and services than before.