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Global demand

We have to buy goods and services from other countries so that we can enjoy things we do not produce, such as coffee etc.

Global trade makes companies from different countries compete with each other and this tends to mean lower costs and prices than if countries produced most things for themselves.

The industries in some countries might decline over time, as other countries become better or cheaper producers of the same product (the UK textiles industry for example).

In the longer term, the effects of more trade are generally positive. Costs and prices are lowered and, as other countries become richer, they import more of what we produce. However, international trade links are not without risks. Problems in one part of the world can have a big impact on the rest.

Rising prices

Some prices will be going up and some prices will be going down in the economy at anyone time, depending on all the factors that influence the prices of individual goods and services.

When most prices start to rise, this is a sign that inflation is on the rise too.

The rate of inflation is a measure by which prices are rising overall and is measured on a monthly basis. It takes into account the prices of things bought by most people, including bread, clothes, petrol, electricity bills, insurance and holidays.

The UK government has decided that an inflation rate of 2% is manageable and if it rises any higher, then the Bank of England need to make alterations to bring it down.

Inflation has the affect of reducing our income, because the items we bought last year now cost more and therefore, we need to earn more to maintain our lifestyle, let alone improve it.

Keeping things stable

The Bank of England wants to avoid this kind of sudden change in economic fortunes. It wants to maintain a balance in the economy so inflation remains stable. It wants demand to grow at a steady pace so inflation stays low.

To stop prices rising as fast, demand might have to reduce, which often leads to companies producing less and reducing the workforce.

Setting interest rates

The Bank of England has the job of meeting this 2% target. It has to ensure that total demand in the economy increases gradually rather than too quickly or too slowly.

It does this by setting an interest rate for banks that influences the interest rates they set for everyone's savings and borrowing.

If the Bank thinks demand might rise too much - putting upward pressure on prices - and it expects inflation to be above 2%, it raises the interest rate.

People have to pay more interest on what they have borrowed. Their mortgage and other interest payments rise. Saving also becomes more attractive as interest rates increase.

The general premise is that this leads to people spending less, which eventually lowers inflation.

On other occasions, if demand looks too low - perhaps because global demand for our exports has fallen - and the Bank expect inflation to be lower than 2%, it can reduce the interest rate.

This makes borrowing cheaper and saving less rewarding, and so encourages more spending and raises inflation.

The Bank does not want inflation to be so low that there is a risk of prices falling across the economy - deflation. This can be damaging and result in falling demand as people stop spending as much as they wait for prices to decline further.

Looking ahead It takes time for interest rates to affect inflation, so the Bank has to judge what might happen to the economy in the future. It looks for early signs that demand might be rising too fast and for pressure on costs and prices. It watches spending in the shops, how much companies can produce and are investing, demand for UK exports, the cost of materials, wages and inflation itself.

Hindsight

Inflation in the UK used to be higher than it is now. In the 1970's, it averaged 12.7% a year. In 1975, it averaged 24% and the peak was 27%. In the 1980's, inflation averaged 7.5%. Goods and services costing £100 in 1970 would have cost around £680 by 1990. Ideally, we want inflation to be low. In the decade since the mid 1990's, inflation has averaged around 2.5%.

Even with the figures above, many investors continue to wish they had bought property and shares during these times.