Measure inflation
Construct and interpret index numbers, calculate inflation from a price index and explain how a consumer price index is built.
Price Stability
Price stability means keeping inflation low and reasonably predictable rather than allowing the general price level to rise or fall rapidly. This chapter explains how inflation is measured using price indices, how to distinguish inflation from deflation and disinflation, what can cause the price level to rise, and why unstable inflation can damage economic performance.
InflationCPI & index numbersDeflationCost-pushDemand-pullConsequences
What this chapter prepares you to do
Use the terms accurately
Distinguish inflation, deflation, disinflation and hyperinflation without confusing a falling inflation rate with falling prices.
Explain the causes
Use AD/AS analysis to explain cost-push and demand-pull pressures and distinguish one-off price-level changes from persistent inflation.
Evaluate the effects
Analyse how inflation can affect investment, resource allocation, income distribution, wages, transactions and economic confidence.
High-grade habit: always distinguish the price level from the inflation rate. A price index measures the level of prices relative to a base period; inflation is the percentage rate at which that index changes.
Chapter sections
10.1
Price stability and the measurement of inflation
Governments usually want a stable macroeconomic environment. Price stability does not normally mean that every price stays unchanged or that inflation is exactly zero. It means avoiding high, volatile or unpredictable changes in the general price level.
InflationA sustained increase in the general or average price level over time.
DeflationA fall in the general price level, giving a negative rate of inflation.
Why is stability important? Firms make investment decisions partly on expectations of future revenues and costs. When inflation is high and volatile, planning becomes more difficult and expected real returns on investment become less certain. This can discourage investment and therefore weaken future economic growth.
Exam warning: do not write that “inflation is a government objective”. The usual objective is low and stable inflation or price stability.
10.2
Measuring the price level and inflation
Index numbers
An index number expresses the value of a variable relative to a chosen base value. The base is normally set equal to 100. Index numbers are useful because they make changes through time easy to compare.
Index number= (current value ÷ base value) × 100
Worked example: if a product cost $80 in the base period and $84 now, its index is (84 ÷ 80) × 100 = 105. The price is therefore 5% above the base-period price.
Easy book example — from a price to an index: If a kilogram of oranges rises from $0.80 in the base year to $0.84, the price has risen by 5%. Setting the base year equal to 100 gives a new index of 105 (= 0.84 ÷ 0.80 × 100). An index tells us the level of prices relative to a base; inflation is the percentage change in that index over time.
The consumer price index (CPI)
A consumer price index is designed to measure the general level of prices faced by households. It does not simply average every price equally. Goods and services that take a larger share of household spending receive a larger weight.
Easy book example — why weights matter: A representative household spends much more on some categories than others. The book illustrates this with food receiving a much larger weight than footwear in the UK CPI basket. A 10% rise in the price of a heavily weighted item therefore affects the CPI much more than the same 10% rise in a lightly weighted item.
1. Choose a representative basketSelect goods and services typically purchased by households.
→2. Collect pricesRecord prices regularly from shops and other sellers.
→3. Apply expenditure weightsGive greater importance to items on which households spend more.
4. Calculate the weighted indexCompare the current cost of the basket with the base period.
→5. Update the basket and weightsAdjust for changing consumer spending patterns over time.
→6. Calculate inflationFind the percentage change in the index between periods.
Inflation rate= ((CPI this period − CPI last period) ÷ CPI last period) × 100
Worked example: if the CPI rises from 125 to 130, inflation = ((130 − 125) ÷ 125) × 100 = 4%.
Price level versus inflation rate
| Measure | What it tells you | Example |
|---|---|---|
| Price index | The level of prices relative to a base period. | CPI = 130 means the weighted basket is 30% more expensive than in a base period of 100. |
| Inflation rate | How quickly the price index is rising. | CPI rising from 125 to 130 gives 4% inflation. |
Why CPI measurement is not perfect
- Different households buy different baskets. Pensioners, students and high-income households may experience different price changes.
- Weights become outdated. Consumers change what they buy, so weights need regular revision.
- Substitution bias. If one product becomes expensive, consumers may switch to a cheaper substitute, but a fixed-weight index may not immediately capture this.
- New products and quality changes. It can be difficult to separate a pure price rise from an improvement in quality.
- International comparison. Comparable methodology is helpful, but spending patterns and data collection still differ across countries.
Exam tip: when a question gives two CPI values, calculate the percentage change in the index. Do not subtract the two index numbers and call the difference the inflation rate.
Inflation, deflation, disinflation and hyperinflation
Inflation
The general price level is rising.
Deflation
The general price level is falling; the inflation rate is negative.
Disinflation
The inflation rate is falling but remains positive, so prices are still rising more slowly.
Hyperinflation
Inflation has reached an extreme or excessive rate and the value of money falls very rapidly.
Why deflation can be harmful
If consumers expect prices to continue falling, they may postpone spending. Firms may also become pessimistic about future sales and reduce investment. Weaker aggregate demand can then contribute to lower output and higher unemployment. The seriousness depends on why prices are falling and how expectations respond.
10.3
Causes of inflation
A rise in the general price level can begin on either the supply side or the demand side of the economy. It is important to distinguish a one-off rise in the price level from a continuing process of inflation.
Cost-push inflation
Cost-push inflation begins with higher costs of production. Examples include a rise in wages not matched by productivity, higher energy or raw-material prices, or other increases in firms' costs. Firms become willing to supply less output at each price level, shifting aggregate supply left.
A decrease in long-run aggregate supply
A permanent rise in a major production cost, such as oil, can reduce productive capacity. LRAS shifts left from LRASFE0 to LRASFE1, real GDP falls from YFE0 to YFE1, and the price level rises from P₀ to P₁. This is the book's AD/AS illustration of cost-push pressure.
Adapted from Cambridge International AS & A Level Economics, Second Edition, by Peter Smith (with Adam Wilby and Mila Zasheva).
Demand-pull inflation
Demand-pull inflation begins with an increase in aggregate demand. Higher consumption, investment, government spending or net exports can shift AD to the right. Tax reductions may also increase disposable income and spending. If the economy is close to full capacity, the effect on the price level can be particularly strong.
Adjustment following an increase in aggregate demand
An increase in AD first raises real GDP and the price level in the short run. As costs rise, SRAS shifts left and output returns to YFE, leaving a higher price level. The diagram is useful for distinguishing a one-off rise in the price level from continuing inflation.
Adapted from Cambridge International AS & A Level Economics, Second Edition, by Peter Smith (with Adam Wilby and Mila Zasheva).
Persistent inflation
The textbook stresses that a single demand or supply shock produces a one-off change in the price level unless the process continues. In its framework, persistent inflation requires the money stock to grow persistently faster than real output. Continued growth of spending power can repeatedly shift aggregate demand to the right and sustain price increases.
| Cause | Initial change | Typical short-run result |
|---|---|---|
| Cost-push | Costs rise / SRAS shifts left | Higher price level and lower real output |
| Demand-pull | AD rises / AD shifts right | Higher price level and higher real output initially |
| Persistent excessive money growth | Spending power repeatedly increases faster than real output | Continuing upward pressure on the general price level |
Important distinction: the AD/AS diagram can show a higher price level after a shock, but that alone is not proof of continuing inflation. Inflation is a rate of change through time.
One-off price rise versus persistent inflation: A single leftward shift of aggregate supply or rightward shift of aggregate demand can raise the price level once. Persistent inflation requires repeated upward pressure over successive periods. This distinction matters in an exam: a diagram showing one shift does not by itself prove a continuing inflation process.
10.4
Consequences of inflation
A small, stable and predictable rate of inflation is not necessarily harmful. The textbook notes that many governments choose positive inflation targets rather than zero because moderate inflation can allow relative prices to change while avoiding widespread falls in money wages and prices. Problems become more serious when inflation is high, volatile or unexpected.
Uncertainty and investment
Unpredictable future prices make it harder for firms to estimate costs, revenues and the real return on investment. Investment may fall.
Resource allocation
If inflation makes price signals harder to interpret, firms and consumers may make poorer decisions, causing resources to be misallocated.
Income distribution
People on fixed money incomes or with savings that do not keep pace with prices may lose purchasing power, potentially worsening inequality.
Wage pressure
Workers may seek higher money wages to protect real incomes. If this raises firms' costs, it may add further inflationary pressure.
Real wages
What matters for purchasing power is the change in money wages relative to inflation. For small percentage changes, a useful approximation is:
Approximate real wage growth≈ nominal wage growth − inflation
Example: if money wages rise by 3% while prices rise by 5%, real wages fall by about 2%. Workers can buy less even though their money wage has increased.
Menu costs and shoe-leather costs
Menu costs
Costs to firms of changing quoted prices, catalogues, labels, systems and contracts more frequently when inflation is high.
Shoe-leather costs
Costs created when people try to minimise cash holdings because inflation and high nominal interest rates increase the opportunity cost of holding money.
Transactions and confidence in money
At very high rates of inflation, people may become reluctant to hold or use money for ordinary transactions. This raises transaction costs and can reduce the effectiveness of markets. The problem can be worsened if taxes, benefits or pensions are not adjusted for inflation.
Who gains and who loses?
The effects depend on whether inflation was expected and whether incomes, interest rates and contracts adjust. People with fixed nominal incomes are vulnerable. Borrowers may benefit from unexpected inflation if they repay debt in money that has lost purchasing power, while lenders may lose. However, the chapter's main emphasis is that high and volatile inflation increases uncertainty throughout the economy.
Evaluation point: the consequences depend on the rate, stability and predictability of inflation, whether incomes and contracts are indexed, and the cause of the price increase. A low, stable rate is very different from hyperinflation.
Chapter 10 revision checklist
Define inflation accurately.
Explain why price stability matters.
Distinguish the price level from the inflation rate.
Construct and interpret an index number.
Explain why CPI uses a representative basket.
Explain why expenditure weights are used.
Calculate inflation from CPI data.
Explain why CPI weights need updating.
Explain substitution bias and household differences.
Distinguish inflation and deflation.
Distinguish deflation and disinflation.
Define hyperinflation.
Explain why deflation can weaken demand.
Explain cost-push inflation with AD/AS.
Explain demand-pull inflation with AD/AS.
Distinguish one-off price-level changes from persistent inflation.
Analyse effects on investment and resource allocation.
Analyse effects on income distribution and real wages.
Explain menu and shoe-leather costs.
Evaluate why low, stable inflation differs from high, volatile inflation.
20 questions. Each answer is marked immediately with a short explanation of why it is correct or incorrect.