4.6 Price stability

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.

The consumer price index (CPI) estimates changes in the price of a representative basket of goods and services. Each item is weighted according to its share of household spending, then the basket cost is compared with a base period.

Weights and the basket are updated because spending patterns change. Quality changes, new products, substitution and differences between households make CPI an estimate rather than a universal personal inflation rate.

If food has a larger basket weight than cinema tickets, a 10% food-price rise contributes more to the index than a 10% cinema-price rise, even if the ticket change is more noticeable to one household.

The CPI is a price-level index, not an index of quantities or wages; an index value of 125 means the basket costs 25% more than in the base period.

Nominal income or output is measured in the prices of the period. Real data adjust for price changes, so they are better for comparing purchasing power or quantities across time.

A nominal increase can coexist with a real decrease if prices rise faster. The adjustment uses a price index or deflator; the exact formula depends on the index convention, but the economic question is always whether buying power or physical output changed.

A wage rises from 2,000 to 2,080 while prices rise 6%. Nominal pay is up 4%, but real purchasing power has fallen because the price increase is larger.

Real does not mean “inflation-free in every household”. It means adjusted using a chosen index, so the basket and base period still matter.

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.

Inflation reduces the purchasing power of money: a given income buys fewer goods and services when prices rise. Its wider effects depend on whether incomes, interest rates and expectations adjust.

Unexpected inflation can transfer real wealth from lenders to borrowers and from people on fixed incomes to those whose incomes rise faster. It can reduce international competitiveness, create menu and shoe-leather costs, and make planning harder; mild predictable inflation may be less disruptive.

A pension fixed in nominal terms loses purchasing power if prices rise 6%. A borrower with a fixed-rate loan may gain in real terms, while a saver’s outcome depends on the real interest rate.

Inflation does not hurt everyone equally, and a wage rise is not a real gain if prices rise by more.