What Is Inflation?
Inflation is when prices rise over time. It means the money in your pocket buys less than it did before.
Think of it this way: if a loaf of bread costs £1 today and inflation is 2%, that same loaf will cost £1.02 next year. The bread hasn’t changed – your money just doesn’t stretch as far.
We measure inflation by tracking a “basket” of common items people buy – everything from milk and bus tickets to cars and holidays. When the overall price of this basket goes up compared to last year, that’s the inflation rate.
Important to understand: When inflation falls from 5% to 3%, prices aren’t going down. They’re just going up more slowly. Your shopping still costs more than last year – just not as much more as it would have.
A bit of inflation is actually good. Low, steady inflation around 2% keeps the economy healthy. It encourages people to spend and invest rather than sit on their money. Most central banks, including the Bank of England, target 2% inflation as the sweet spot.
How Inflation Affects Your Money
Purchasing Power
This is the real impact of inflation. When prices rise faster than your income, you can afford less. Your money loses value sitting in your wallet or bank account.
If you earn £30,000 a year and inflation is 5%, but your salary only goes up 2%, you’re actually £900 worse off in real terms. That’s because everything costs more, but you don’t have much more money to pay for it.
The Ripple Effect
Inflation touches everything:
- Your weekly food shop costs more
- Heating your home gets pricier
- Transport and fuel bills climb
- Clothes and entertainment become more expensive
Even small inflation adds up. At 3% inflation, prices double every 24 years. What costs £100 today would cost £200 by then.
Why Do Prices Rise?
There are two main reasons prices go up:
Demand-Pull Inflation
When everyone wants something but there isn’t enough to go around, prices rise.
Imagine a popular toy at Christmas. If stores can’t get enough stock but parents are desperate to buy, the price goes up. The same happens across the whole economy – when people have money to spend and want to buy things, but there aren’t enough goods or services, everything gets more expensive.
Cost-Push Inflation
When it costs more to make things, companies pass that cost to you.
Picture a chocolate company that gets cocoa from abroad. If storms destroy cocoa crops, cocoa becomes scarce and expensive. The chocolate company now pays more for ingredients. To stay in business, they charge more for chocolate bars. You end up paying the difference.
This happens with energy too. When oil or gas prices spike, it costs more to heat factories, transport goods, and run shops. All these extra costs end up in the price you pay.
Real Impact on Your Life
Mortgages and Debt
If you owe money, moderate inflation can actually help you. Your debt stays the same number, but that number becomes easier to pay off as wages typically rise with inflation.
But there’s a catch. When inflation rises, the Bank of England (the UK’s central bank) often increases interest rates to control it. If you have a variable-rate mortgage, your monthly payments shoot up. A mortgage that cost £800 a month might jump to £1,200 when rates rise.
Savings
Savers often lose out. If your savings account pays 1% interest but inflation is 3%, your money loses 2% of its value each year. £1,000 in savings will still be £1,000 next year, but it won’t buy as much.
Wages
Everything depends on whether your pay keeps up. If inflation is 4% and your pay rises 4%, you break even. If your pay rises less, you’re worse off. If it rises more, you’re ahead.
Many workers find their wages don’t keep pace with inflation, especially during sudden price spikes. This creates the “cost of living crisis” – when everyday essentials eat up more and more of your income.
Winners and Losers
Who Benefits from Inflation?
- Borrowers with fixed-rate loans: Your debt gets easier to pay off as money becomes worth less
- Property owners: House prices often rise with or above inflation
- People with inflation-linked incomes: Some pensions and benefits rise automatically with inflation
Who Loses from Inflation?
- People on fixed incomes: Pensioners with set pensions see their buying power shrink each year
- Savers: Money in the bank loses value unless interest rates beat inflation
- People with variable-rate debt: When inflation rises, so do interest rates and loan payments
- Low-wage workers: Often the last to see pay rises that match inflation
The Bottom Line
Moderate inflation is a normal, even necessary part of a healthy economy. When it sits around 2% annually, it keeps money moving and the economy growing.
But when inflation runs too high or changes unpredictably, it creates real hardship. It eats into savings, makes planning difficult, and can push struggling families into poverty.
Understanding inflation helps you make better financial decisions. When you know prices will likely be higher next year, you can plan accordingly – whether that means asking for a pay rise, choosing the right mortgage, or rethinking how you save.
The key is that inflation affects everyone differently. Your personal inflation rate depends on what you buy and how you live. A family with a big mortgage and car loans faces different pressures than a renter who cycles to work. Knowing how inflation impacts your specific situation is the first step to managing its effects.