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4.6 Price stability

Syllabus
9708–2026–2027
Topic
4.6
Level
AS

Inflation, deflation and disinflation describe different price paths

Inflation is a sustained rise in the general price level; deflation is a sustained fall; disinflation means the inflation rate is falling while prices are still rising.

Use the rate and the price level together. A fall from 8% to 3% inflation is disinflation, not deflation. Deflation can raise the real burden of debt and encourage delayed spending, but its effects depend on expectations and causes.

If an index moves from 100 to 108 and then to 111, inflation has slowed from 8% to about 2.8%; prices have not returned to 100.

A fall in the inflation rate is not a fall in prices. Only a negative inflation rate indicates a general price-level decline.

Build, calculate and question the CPI

A consumer price index estimates how the cost of a representative household basket changes. A spending survey selects goods and services and assigns expenditure weights; prices are sampled regularly, combined into a weighted index and compared with a base period, usually set to 100.

\text{weighted price change}=\sum(\text{expenditure weight}\times\text{item price change})\text{inflation rate}=\frac{\text{CPI}{t}-\text{CPI}{t-1}}{\text{CPI}_{t-1}}\times100

Suppose spending weights are food 20%, clothing 10%, housing 40% and transport 30%. If their prices change by −2%, +4%, +10% and 0%, the weighted change is −0.4+0.4+4+0=4%. If CPI rises from 106.53 to 111.74, inflation over the interval is about 4.89%, not 5.21%.

Measurement difficulty Why CPI may misrepresent experience
Spending changes and substitution Fixed weights become outdated as households switch products
New products and quality change A higher observed price may partly buy improved quality, while new goods enter late
Household diversity Income groups, regions and family types buy different baskets
Informal, illegal or subsistence activity Prices and expenditure may be missing or unreliable
Sampling and data collection Outlets, items and reported prices may not represent all purchases

CPI is an estimated average price-level index, not every household’s inflation rate. An index of 125 means the basket costs 25% more than in the base period; it does not mean inflation is currently 25%.

Turn money values into real purchasing power

A nominal or money value is stated in the prices of that period. A real value adjusts for a price index so that amounts from different periods are compared in constant-price purchasing-power terms.

\text{real value in base-period prices}=\frac{\text{nominal value}}{\text{price index}}\times100\text{approximate real growth}=\text{nominal growth}-\text{inflation}\text{approximate real interest rate}=\text{nominal interest rate}-\text{inflation}

Nominal information Price information Real reading
Salary rises from 20,000to20,000 to25,000 CPI rises from 100 to 110 2023 salary in base prices is 25,000/110×100≈25,000/110×100 ≈22,727: real pay rose
Wage rises 4% Prices rise 6% Real wage falls by about 2%
Interest rate is 14% Inflation is 48.7% Real interest rate is about −34.7%

Keep the sign: inflation above nominal growth produces a real loss. The subtraction rules are approximations for percentage rates; index deflation gives the direct level comparison. Real data still depend on the chosen price index and basket.

Inflation can begin with excess demand, rising costs or expectations

Demand-pull inflation occurs when aggregate demand grows faster than the economy’s ability to supply output. Cost-push inflation follows higher unit costs, such as wages, energy or imported inputs.

Expectations can make either process persistent: workers and firms adjust wages and prices when they expect inflation. Imported inflation depends on exchange rates and foreign prices. Identify the initiating shock before naming the mechanism.

A consumer-spending boom can move AD right and raise the price level. A sudden energy-price rise can shift SRAS left, creating higher prices with weaker output—the pattern called stagflation.

Not every price rise is economy-wide inflation, and a one-off tax change may raise the price level without creating a continuing inflation process.

Evaluate the domestic and external effects of inflation

Inflation changes purchasing power and relative prices, so it creates winners and losers rather than one identical effect. Its seriousness depends especially on whether it is anticipated, high or low, stable or accelerating, and above or below inflation abroad.

Channel Possible costs Possible benefits or limits
Income and wealth redistribution Fixed-income groups and unindexed savers lose purchasing power; unexpected inflation hurts lenders Fixed-rate borrowers gain as debt falls in real terms; indexed incomes/assets may be protected
Household and firm decisions Shoe-leather and menu costs; inflationary noise and uncertainty can reduce saving and investment Low, stable demand-led inflation can accompany stronger sales, output, profit and employment
Taxation Fiscal drag can move nominal incomes into higher tax bands Government nominal tax receipts may rise
International competitiveness If domestic inflation exceeds competitors, exports become less competitive and imports relatively cheaper, risking a weaker current account The effect depends on relative inflation, exchange-rate changes and demand elasticities

With a fixed nominal interest rate of 4%, inflation of 6% gives a real return of about −2%: the lender or saver loses purchasing power while the borrower gains. If inflation falls to 3%, the real return becomes about +1%, even though prices are still rising.

Judge the cause, size, duration and predictability of inflation; indexation and bargaining power; how open the economy is; competitors’ inflation; exchange-rate movement; and the price elasticity of exports and imports. High, unexpected and prolonged inflation is usually more disruptive than low, stable inflation.

Inflation does not imply every price rose or every person became poorer. A balanced conclusion must compare domestic and external effects and include gains as well as costs where the mechanism supports them.