Readers Question: Why does the cost of living keep rising?
This is due to inflation – the persistent increase in the average price level. In modern economies, inflation is a common feature. In fact, most Central Banks target a low rate of inflation of 2%.
Central banks feel that a moderate rate of inflation is consistent with a steady rate of economic growth.
For various reasons, a zero inflation rate could create problems – especially if people are used to moderate inflation. See costs of low inflation and deflation.
The important thing is – are incomes rising faster than prices and the cost of living? If your cost of living rises at 2%, but average incomes are rising at 5% a year, then you’re real income is increasing by 3% – you are better off, despite the increased cost of living.
However, if prices are rising, and your income staying the same, then your real income is falling – you are effectively worse off because you cannot afford to buy as many goods.
Prices don’t always rise
Note; prices don’t always rise. In the 1920s and 1930s, the UK had a period of deflation – falling prices and the cost of living was going down. However, this wasn’t a good situation because it was also a period of high unemployment and low growth. Japan has experienced deflation in recent decades, and the EU is getting close to zero inflation
Why is inflation considered normal in modern economies?
This shows the rate of inflation in the UK. The rate of inflation has fallen from 1970 to 2000. But, prices are still rising – they are just rising at a slower rate.
Economic growth tends to cause moderate price rises. Also, a low inflation rate of 2%, makes it easier for relative prices to adjust. With inflation of 2% – some prices like services may rise by 4%, some prices like mobile phones may stay at 0%. Some goods like food may rise by 2%.
Because there is downward price and wage rigidity, it is easier to have these price adjustments with low inflation than zero inflation.
In modern economies, we see a divergence in the cost of living depending on the sector. We have seen falling prices for manufactured goods, such as TVs and clothes. These benefit from improved labour productivity and competitive imports. However, we have seen rising prices in services – the service sector tends to be more labour intensive, so with rising wages, this will lead to a rise in the price of services.
Real wage growth in UK
This graph shows nominal wage growth and inflation. Between 2008 and 2014, the UK had the experience of inflation rising at a faster rate than nominal wages. This led to a fall in living standards.
Why were real wages falling in this period?
- Weak economic growth meant firms were able to pay low wages.
- More flexible labour markets caused wage growth to remain muted
- Firms taking a bigger share of GDP in terms of profit.
- Periods of cost-push inflation – rise in the price of oil, higher taxes and the effects of devaluation (which causes import prices to rise)
The cost of living for different groups within society
Despite low wage growth, renting has increased by over 25%
In recent decades, the younger generation has seen a relatively faster rise in the cost of living. This is primarily caused by rising cost of housing and rent.
With demand for housing exceeding supply, the price of renting has gone up faster than inflation. For people who own their own homes, they are insulated from this rise in house prices/rent. But, for young people, who are not able to afford to buy, they have to pay higher rents. This is particularly a problem in cities, such as London.