4.7. Inflation
- Syllabus
- 0455–2027–2028
- Topic
- 4.7
- Level
- —
Learning objectives
4.7.1Definitions of inflation and deflation• Definitions of inflation and deflation4.7.2Measurement of inflation• measurement of inflation using the Consumer Prices Index (CPI)4.7.3Causes of inflation• demand-pull• cost-push4.7.4Consequences of inflation• how inflation affects savers, lenders and borrowers• consequences of inflation for consumers, workers, producers/firms and the economy4.7.5Policies to control inflation• the range of policies available to control inflation and their effectiveness
Distinguish inflation and deflation
Inflation is a sustained rise in the general price level, so each unit of money buys fewer goods and services. Deflation is a sustained fall in the general price level, so money's purchasing power rises.
| Change | Price level | Purchasing power of money |
|---|---|---|
| inflation | rises over time | falls |
| deflation | falls over time | rises |
A fall in the inflation rate is disinflation: prices are still rising, but more slowly. Deflation occurs only when the general price level falls; a fall in one product's price is not enough.
Measure inflation with the Consumer Prices Index
The Consumer Prices Index (CPI) measures how the price of a representative basket bought by households changes over time. A base year is assigned an index value, usually 100.
| Step | What happens |
|---|---|
| 1 | choose a representative basket from household spending surveys |
| 2 | collect current prices for the basket |
| 3 | give each item a weight based on its share of household expenditure |
| 4 | combine the weighted price changes into the CPI |
| 5 | update the basket and weights as spending patterns change |
\text{inflation rate}=\frac{\text{current CPI}-\text{previous CPI}}{\text{previous CPI}}\times100%
If the CPI rises from 125 to 150, the inflation rate is (150−125)/125×100=20%. The weight shows the item's importance in household spending, not how quickly its own price rises.
The CPI is an average: individual households may experience a different inflation rate because their spending patterns differ from the representative basket.
Distinguish demand-pull and cost-push inflation
Diagnose inflation from the first causal link. Demand-pull inflation starts with rising total demand; cost-push inflation starts with rising production costs or falling total supply.
| Type | Causal chain | Typical triggers |
|---|---|---|
| demand-pull | total demand grows faster than productive capacity → firms cannot expand output enough → general price level rises | higher consumption, investment, government spending or net exports; pressure is stronger near full employment |
| cost-push | production costs rise or total supply falls → firms raise prices and may reduce output | wages rising faster than productivity, dearer energy/raw materials, higher indirect taxes or currency depreciation |
Both causes can operate together. For example, stronger demand may raise wages while an energy-price shock raises firms' costs. State each mechanism separately before judging which is more important.
Borrowing that raises consumer spending can create demand-pull pressure. A rise in oil prices that increases transport and production costs is cost-push, even if consumer demand is unchanged.
Trace the consequences of inflation
Inflation redistributes real purchasing power and changes decisions. Its effect depends on whether income, interest and prices adjust as quickly as the general price level.
\text{approximate real income growth}=\text{nominal income growth}-\text{inflation rate}
| Group | Likely consequence and condition |
|---|---|
| savers and lenders | lose purchasing power when interest received is below inflation; unexpected inflation makes fixed repayments worth less in real terms |
| borrowers | may gain because fixed debts are repaid with lower-value money, unless interest rates rise enough to offset this |
| consumers and workers | purchasing power falls if prices rise faster than wages, pensions or benefits; workers whose wages keep pace are better protected |
| firms | face uncertain costs, planning and menu costs; exporters may lose competitiveness, although demand-led inflation can raise revenue and real debt burdens can fall |
| economy | high or unstable inflation can reduce saving, investment and export competitiveness; mild demand-pull inflation may accompany rising output and employment when spare capacity remains |
The outcome depends on the rate and duration of inflation, whether it was expected, how incomes and interest rates respond, and inflation relative to trading partners. Deflation reverses some redistribution but can delay spending and increase the real burden of debt.
Choose policies to control inflation
The most effective anti-inflation policy targets the cause. Measures that reduce total demand are suited to demand-pull inflation; measures that lower costs or expand productive capacity are better suited to persistent cost-push pressure.
| Diagnosis | Policy and transmission | Main limitation |
|---|---|---|
| demand-pull | contractionary monetary policy: higher interest rates or slower money growth reduce borrowing and spending, and may strengthen the currency | time lags; weak response; lower growth and higher unemployment |
| demand-pull | contractionary fiscal policy: higher taxes, lower government spending or compulsory saving reduce total demand | political difficulty, time lags and weaker public services/investment |
| cost-push | supply-side policies: training, infrastructure, competition and productivity growth reduce unit costs or expand capacity | costly and slow; cannot quickly remove an imported energy shock |
A policy mix may be needed when both causes operate. Judge effectiveness by the cause, spare capacity, expectations and credibility, interest sensitivity, time lags, import costs and the trade-off with output and employment.
Reducing demand may lower the inflation rate but does not directly remove a supply shock. Likewise, supply-side reform is not an immediate answer to excessive current spending.