Inflation

Meaning and measurement

General price level - the average level of prices across the economy, not the price of one product.

Inflation - a sustained increase in the general price level over time.

Deflation - a sustained decrease in the general price level over time.

Consumer Prices Index (CPI) - an index that tracks changes in the weighted average prices of a representative basket of consumer goods and services.

Weight - the importance given to an item in the CPI according to its share of typical household spending.

To construct the CPI, statisticians select a representative basket, collect prices regularly, give larger weights to items on which households spend more, and combine the price changes into an index. The basket and weights are updated as spending habits change.

Inflation-rate formula: Inflation rate = ((new CPI - old CPI) / old CPI) x 100

Worked CPI example

The CPI rises from 125 to 130.

Find the change. 130 - 125 = 5 index points.

Divide by the old CPI and multiply by 100. (5 / 125) x 100 = 4% inflation.

Interpret correctly: A 4% inflation rate means the weighted average price level is 4% higher than a year earlier. It does not mean every price rose by 4%.

Causes of inflation

Demand-pull inflation - inflation caused by total demand growing faster than the economy's ability to produce.

Cost-push inflation - inflation caused by rising production costs that lead firms to increase prices.

Cause	Full chain	Typical triggers
Demand-pull	Total demand rises -> firms receive more orders -> when spare capacity is limited, shortages and competition for resources develop -> wages and prices rise.	Lower interest rates or taxes, higher government spending, investment, confidence or export demand.
Cost-push	Wages, energy, raw-material, import or tax costs rise -> profit margins are squeezed -> firms raise prices and may reduce output.	Currency depreciation, supply disruption, wage increases above productivity or higher indirect taxes.

Consequences of inflation

Real value - purchasing power—the quantity of goods and services that a sum of money can buy.

Group	Possible effects
Savers	Lose real value when the interest earned is below inflation; may gain if interest exceeds inflation or savings are inflation-protected.
Lenders	Fixed repayments buy fewer goods and services, so lenders lose in real terms when inflation is unexpected.
Borrowers	Repay fixed debts with money of lower real value, so borrowers may gain; variable interest rates may rise and offset this.
Consumers	Purchasing power falls if incomes rise more slowly than prices; uncertainty makes budgeting harder.
Workers	Real wages fall if money wages lag behind prices; wage demands and industrial disputes may increase.
Producers / firms	Revenue and profit may rise if selling prices rise faster than costs, but planning, menu costs and uncertainty increase.
Economy	Exports may become less price-competitive, imports more attractive, investment less certain and income distribution less predictable.

Low and predictable inflation may be less harmful than rapid or unstable inflation. The effect also depends on whether inflation was expected, how quickly incomes and interest rates adjust, and whether a person is a saver, lender or borrower.

Policies to control inflation

Policy	Anti-inflation chain	Main drawback / condition
Contractionary monetary policy	Higher interest rates or tighter money supply -> borrowing and spending fall -> total demand and demand-pull pressure fall.	Time lag; can reduce growth, investment and employment.
Contractionary fiscal policy	Higher taxes or lower government spending -> disposable income and total demand fall.	Politically difficult; may worsen public services or unemployment.
Supply-side policy	Higher productivity and lower unit costs increase productive capacity and reduce cost pressure.	Slow and uncertain; may require costly public investment.
Exchange-rate policy	Appreciation makes imports cheaper, reducing imported cost pressure.	Exports become less competitive and the rate may be difficult to control.

Choose by cause: Demand-reducing policy is better suited to demand-pull inflation. Supply-side measures are better suited to persistent cost pressure, although they normally take longer.

Deflation

Cause	Cause-and-effect chain	Important distinction
Demand-side deflation	Total demand falls -> firms face weaker sales -> they cut prices, output and employment.	Often harmful because falling prices occur alongside recession and unemployment.
Supply-side deflation	Productivity rises or production costs fall -> firms can supply more at lower prices.	Can be beneficial when output, real incomes and employment rise.

Affected group	Possible consequences of deflation
Consumers	Purchasing power may rise, but buyers may postpone spending if they expect lower prices; job or income losses can outweigh cheaper goods.
Workers	Real wages rise if money wages are unchanged, but firms may freeze wages, cut hours or reduce employment.
Savers and lenders	The real value of money and fixed repayments rises, so they may gain.
Borrowers	The real burden of debt rises because repayments buy more goods and services.
Producers / firms	Selling prices and revenue may fall; debt becomes harder to repay; profit and investment may decline.
Economy	Demand-side deflation can create a cycle of delayed spending, lower output, unemployment and further price falls.

Policy	How it may counter harmful deflation	Limitation
Expansionary fiscal policy	Higher spending or lower taxes raises total demand, sales and price pressure.	May create a larger budget deficit and can take time.
Expansionary monetary policy	Lower interest rates or more money/credit encourages borrowing and spending.	Weak confidence can make households and firms unwilling to borrow.
Supply-side / confidence measures	Investment support and measures that strengthen expected income can increase spending and productive activity.	Some supply-side improvements lower costs further, so they do not directly stop demand-side deflation.