2.1.2 Inflation

A) Understanding Inflation, Deflation, and Disinflation

1. Inflation

  • A sustained increase in the general price level over time

  • Must be long-term, not a one-off rise

  • Refers to many goods/services, not just one

  • Leads to a fall in purchasing power of money

2. Deflation

  • A sustained decrease in the general price level

  • Increases purchasing power

  • Can discourage spending and investment (people delay purchases)

3. Disinflation

  • A fall in the rate of inflation

  • Prices are still rising, but more slowly

B) Calculating the Rate of Inflation Using CPI

1. Consumer Price Index (CPI)

  • Main measure of inflation (UK)

  • Based on a weighted basket of goods and services

  • Represents spending of an average household

  • Weights reflect importance of items

2. CPI Formula

CPIt=CtC0×100CPI_t = \frac{C_t}{C_0} \times 100CPIt​=C0​Ct​​×100

  • CtC_tCt​ = cost of basket in current period

  • C0C_0C0​ = cost of basket in base year

3. Inflation Rate Formula

Inflation Rate=CPIcurrent−CPIpreviousCPIprevious×100\text{Inflation Rate} = \frac{\text{CPI}_{current} - \text{CPI}_{previous}}{\text{CPI}_{previous}} \times 100Inflation Rate=CPIprevious​CPIcurrent​−CPIprevious​​×100

4. Key Notes

  • Everyone experiences different inflation rates

  • Government target: ~2% ± 1% (not 0%)

5. Real vs Nominal

  • Real = adjusted for inflation (true purchasing power)

  • Nominal = not adjusted (just the number)

C) Limitations of CPI

1. Population Average

  • Same basket for everyone

  • Ignores individual differences in spending

2. Substitution Bias

  • Assumes people buy the same goods every year

  • In reality, consumers switch to cheaper alternatives

    • e.g. pasta → rice

  • Leads to overestimation of inflation

3. Quality Changes

  • Doesn’t fully account for improvements in products

  • Higher prices may reflect better quality, not inflation

  • Causes overestimation

4. Time Lag

  • Consumer habits change faster than CPI updates

D) The Retail Price Index (RPI)

1. Definition

  • Alternative measure of inflation

2. Key Features

  • Includes housing costs (e.g. mortgages)

  • Uses a different calculation method

  • Usually shows higher inflation than CPI

3. Uses

  • Pensions

  • Index-linked bonds

  • Wage negotiations (sometimes)

E) Causes of Inflation

1. Demand-Pull Inflation

  • Occurs when aggregate demand (AD) > aggregate supply (AS)

  • AD shifts outwards

Causes:

  • Higher consumer spending

  • Increased investment

  • Government spending

Example: Economic boom

2. Cost-Push Inflation

  • Caused by rising costs of production

  • SRAS shifts inwards

Causes:

  • Higher raw material prices (e.g. oil)

  • Rising wages

  • Supply chain issues

Effects:

  • Higher prices

  • Lower output (bad for GDP)

3. Growth of Money Supply

  • Too much money chasing too few goods

  • Leads to excess demand → inflation

F) Effects of Inflation on Economic Agents

1. Consumers

  • Reduced purchasing power

  • Savings lose value

  • Fixed-income earners worse off

  • Pensioners struggle to maintain living standards

2. Firms

  • Rising costs of production

  • Lower profit margins

  • May increase prices to compensate

3. Government

  • Higher cost of servicing debt

  • Less money for public services

  • Bracket creep → higher taxes without real income increase

4. Workers

  • Nominal wages may rise

  • But real wages may fall

  • Trade unions may push for higher wages

✅ Final Summary

Inflation is a key macroeconomic issue affecting:

  • Living standards

  • Business costs

  • Government policy

Understanding:

  • How it’s measured (CPI/RPI)

  • Its causes (demand-pull, cost-push, money supply)

  • Its impacts