AQA A-Level Economics · Revision notes

4.2.3.3 Inflation and Deflation

Inflation is a sustained rise in the general price level. It is one of the main measures of macroeconomic performance, and in the UK it is the one the Bank of England is given an explicit numerical target for: 2% a year, measured by the Consumer Prices Index. This topic covers inflation, deflation and disinflation, the causes of inflation including the Quantity Theory of Money, and the consequences of both inflation and deflation.

Inflation, deflation and disinflation

These three terms are easy to confuse, and they describe very different situations.

• Inflation is a sustained rise in the general price level. The rate of inflation is the percentage change in a price index over a year.
• Deflation is a sustained fall in the general price level. The rate of inflation is negative.
• Disinflation is a fall in the rate of inflation while it stays positive. Prices are still rising, just more slowly.

Key distinction: If inflation falls from 6% to 3%, that is disinflation, not deflation. The price level is still 3% higher than a year earlier.

How the CPI is calculated

The CPI tracks the cost of a representative basket of goods and services bought by UK households.

1. Build the basket. The Office for National Statistics chooses several hundred items that represent typical household spending, from bread and rent to streaming subscriptions. The basket is reviewed every year so that it keeps up with what people actually buy.
2. Weight the items. Each item is weighted by its share of household spending, using data from a household spending survey. A 10% rise in the price of something households spend a lot on moves the index far more than the same rise in something they rarely buy.
3. Collect prices. Prices are collected every month from shops and online sources across the country.
4. Calculate the index. Weighted price changes are combined into a single index number relative to a base year, where the index equals 100.
5. Calculate the rate. The inflation rate is the percentage change in the index over twelve months.

Rate of inflation = (index this year − index last year) / index last year × 100

If the CPI rises from 125.0 to 128.5, inflation is (128.5 − 125.0) / 125.0 × 100 = 2.8%.

Limitations of the CPI

• It is an average. No household buys exactly the average basket. Pensioners, students and families with young children all face different inflation rates.
• Housing costs are largely excluded. Mortgage interest payments and council tax are not in the CPI, though they are a large part of many households' spending.
• Quality changes are hard to measure. A phone that costs 10% more but does far more is not simply 10% more expensive. Adjusting for quality is necessary but imprecise.
• New products enter with a delay. The basket is updated annually, so new goods and services take time to appear.
• Substitution. When a price rises, people switch to cheaper alternatives. A fixed basket can overstate the true rise in the cost of living.

The RPI as an alternative measure

The Retail Prices Index is an older measure that is still published.

• It includes housing costs such as mortgage interest payments and council tax.
• It uses a different averaging formula, which tends to give a higher figure than the CPI even for the same price changes.
• It is no longer a national statistic and is not used for the inflation target, though it is still used in some contracts and index-linked bonds.

The RPI usually exceeds the CPI. The gap widens when interest rates rise, because mortgage interest payments feed directly into it.

Causes of inflation

Demand-pull inflation occurs when aggregate demand grows faster than the economy's capacity to produce. With spare capacity used up, firms respond to extra demand by raising prices rather than output. Causes include rising consumer confidence, cuts in interest rates, tax cuts, and strong growth in export demand.

Cost-push inflation occurs when firms' costs rise and they pass them on as higher prices. Causes include rising wages not matched by productivity, higher prices for imported raw materials and energy, a depreciation of the currency, and higher indirect taxes. It shows as a leftward shift in short-run aggregate supply.

Growth of the money supply links to demand-pull. If the quantity of money grows faster than the quantity of goods and services produced, more money chases the same output and prices rise. The quantity theory of money puts this formally, with the money supply multiplied by the velocity of circulation equal to the price level multiplied by real output.

In practice causes interact. A wage rise that starts as cost-push raises incomes and so feeds demand as well.

The equation of exchange and the Quantity Theory of Money

Fisher's equation of exchange is MV = PQ, where M is the money supply, V is the velocity of circulation, P is the price level and Q is real output. PQ is nominal national income. The equation is true by definition, because total spending equals the value of output. Monetarists turn it into the Quantity Theory of Money by assuming that V is stable and that Q is set by supply-side factors in the long run. A rise in M then leads to a proportionate rise in P.

Effects of inflation

Consumers

• Real incomes fall if prices rise faster than wages or benefits.
• Savers lose if interest rates are below inflation, because the real value of savings falls.
• People on fixed incomes are hit hardest.

Firms

• Uncertainty about future prices makes investment planning harder.
• Menu costs: the cost of repeatedly changing prices.
• If UK inflation is higher than in competitor countries, UK exports become less price competitive.

Government

• Fiscal drag: if tax thresholds are frozen, rising nominal incomes pull more people into higher tax bands, raising tax revenue.
• The real value of government debt is eroded.
• Spending on index-linked benefits and pensions rises.

Workers

• Workers with strong bargaining power may secure wage rises that keep pace. Those without lose out.
• Expectations of future inflation can feed into wage demands, creating a wage-price spiral.

Evaluation: Moderate, stable inflation is generally seen as less harmful than either high, volatile inflation or deflation. Deflation can cause consumers to delay spending in expectation of lower prices, and it raises the real burden of debt.

Effects of deflation

Deflation caused by rising productivity or cheaper imports can raise real incomes and is less of a concern. Deflation caused by weak demand is more damaging. Consumers delay purchases, firms cut output and jobs, and the real value of debts rises, so borrowers cut spending further. Note that deflationary policies, such as higher interest rates, aim to reduce aggregate demand. They usually cause disinflation rather than deflation.

Key terms

Common mistakes

• Confusing disinflation with deflation. A falling inflation rate does not mean prices are falling.
• Calculating inflation from index points. A rise from 125 to 130 is 5 points, but inflation is 4%. Always divide by the earlier value.
• Treating all inflation as bad. The target is 2%, not zero. Deflation carries its own risks.
• Naming a cause without the mechanism. "Oil prices rose" is incomplete until it is linked to firms' costs, a shift in SRAS and higher prices.
• Treating effects as the same for everyone. Borrowers can gain and savers lose; the effect on each group depends on whether incomes keep pace.

How this has been examined

In the AQA papers indexed on this site, this topic has appeared in five formats:

• 25-mark "Evaluate" essay — asked twice across 2 series (2019 to 2025)
• 15-mark "Explain" essay — asked once (2019)
• 9-mark "Explain" data response — asked 3 times across 3 series (2022 to 2025)
• 2-mark calculation — asked once (2017)
• 1-mark multiple choice — asked 6 times across 6 series (2019 to 2025)

Where this goes next

The way the CPI is used as a macroeconomic indicator is covered in 4.2.1.2 Macroeconomic indicators and 4.2.1.3 Uses of index numbers. Demand-pull inflation is analysed using the AD curve in 4.2.2.4 Aggregate demand and the level of economic activity, and cost-push inflation through 4.2.2.5 Determinants of short-run aggregate supply. The trade-off between inflation and unemployment appears in 4.2.3.4 Possible conflicts between macroeconomic policy objectives, and the Bank of England's use of interest rates to hit the target in 4.2.4.3 Central banks and monetary policy. The companion measure of labour market performance is 4.2.3.2 Employment and unemployment.