Inflation and deflation | IGCSE Class 10 Economics Notes

This note covers the definitions of inflation and deflation, how inflation and deflation are measured using the Consumer Prices Index (CPI), the demand-pull and cost-push causes of inflation, the demand-side and supply-side causes of deflation, the consequences of both for consumers, workers, savers, lenders, firms and the economy as a whole, and the range of policies used to control inflation and deflation and how effective they might be.

What is inflation and what is deflation?

Inflation is a sustained rise in the general (average) level of prices in an economy over a period of time, usually measured over a year.

It does not mean that every price is rising; some prices may fall while others rise faster, but the overall price level moves upward. The opposite process, deflation, is a sustained fall in the general level of prices over time.

Both are usually expressed as a percentage change in a price index from one period to the next.

A related idea is disinflation, which is a fall in the rate of inflation (prices are still rising, but more slowly than before). This is different from deflation, where prices are actually falling.

A very rapid and out-of-control rise in prices is called hyperinflation; this can occur when a government prints large amounts of money to finance its spending, causing the value of money to collapse.

Definition: Inflation. A sustained increase in the general level of prices in an economy over a period of time, usually measured as an annual percentage change.

Definition: Deflation. A sustained decrease in the general level of prices in an economy over a period of time.

Economists distinguish inflation and deflation from a single price change. A rise in the price of fuel alone is not inflation; inflation occurs only when the average of all prices, weighted by how much consumers spend on each item, is rising.

This is why inflation and deflation are measured using a price index rather than by watching one product.

How is inflation and deflation measured?

The most widely used measure of inflation is the Consumer Prices Index (CPI). Statisticians construct the CPI by first identifying a representative "basket" of goods and services that a typical household buys, based on household expenditure surveys.

Each item in the basket is given a weight according to the proportion of total household spending it represents; for example, housing and food usually carry heavier weights than items bought rarely, such as furniture.

The cost of the whole basket is calculated every month or year and compared with its cost in a chosen base year, which is given an index value of 100. The CPI in any other year shows how the cost of the basket has changed relative to the base year.

Definition: Consumer Prices Index. A weighted index number that measures changes in the average price level of a representative basket of goods and services bought by households, compared with a base year of 100.

CPI = (cost of basket now ÷ cost in base year) × 100

Once the CPI values for two periods are known, the rate of inflation (or deflation, if negative) between them can be calculated.

Inflation rate = (CPI this year − CPI last year) ÷ CPI last year × 100

Worked example 1. The CPI in a country was 120 last year and 126 this year. Calculate the rate of inflation.

Answer: Inflation rate = (126 − 120) ÷ 120 × 100 = 6 ÷ 120 × 100 = 5%. Prices rose by 5% over the year, so the country experienced inflation of 5%.

Worked example 2. The CPI fell from 110 to 104 between one year and the next. Calculate the rate of change in prices.

Answer: Rate of change = (104 − 110) ÷ 110 × 100 = −6 ÷ 110 × 100 = −5.45%, approximately. A negative figure shows that the general price level fell, so the economy experienced deflation of approximately 5.45%.

The CPI has limitations as a measure. It is based on an average household, so it may not reflect the experience of particular groups, such as pensioners or low-income households, whose spending patterns differ from the average.

The weights are also usually updated only occasionally, so the basket can become out of date as spending habits change, for example as households spend more on digital services.

Index numbers and the base year

An index number expresses a value in one period as a percentage of its value in a chosen base period, which is always set at 100.

Index numbers make it easy to compare changes over time without needing to know the actual prices involved; a rise from 100 to 108, for instance, always represents an 8% increase, whatever the underlying currency amounts are.

What causes inflation?

Inflation is generally explained by two broad causes: demand-pull and cost-push.

Demand-pull inflation

Demand-pull inflation occurs when total (aggregate) demand in an economy rises faster than total (aggregate) supply.

If consumers, firms or the government spend more, and businesses cannot increase output quickly enough to meet this extra demand, firms respond by raising prices rather than increasing output.

Rising demand can result from, for example, an increase in consumer confidence and spending, a rise in investment by firms, higher government spending, increased export demand, or a cut in interest rates that encourages more borrowing and spending.

Definition: Demand-pull inflation. A rise in the general price level caused by total demand in an economy growing faster than total supply, so that "too much money is chasing too few goods".

Cost-push inflation

Cost-push inflation occurs when the costs of producing goods and services rise, forcing firms to raise their prices to protect their profit margins, even though demand has not increased.

Causes of rising costs include higher wages that are not matched by higher productivity, rising prices of imported raw materials or fuel, a fall in the value of the exchange rate (which makes imports more expensive), and indirect taxes imposed by the government, such as a sales tax, which raise the price firms must charge.

Definition: Cost-push inflation. A rise in the general price level caused by increases in the costs of production, such as wages, raw materials or taxes, which firms pass on as higher prices.

When both demand-pull and cost-push pressures act together, inflation can accelerate quickly, as rising prices lead to demands for higher wages, which in turn raises firms' costs further and pushes prices up again. This wage-price spiral can make inflation difficult to bring under control.

What causes deflation?

Deflation can arise from the demand side or the supply side of the economy.

Demand-side deflation

Demand-side deflation occurs when total demand in the economy falls, for example because of a fall in consumer confidence, a rise in interest rates that discourages spending and borrowing, a cut in government spending, or a fall in export demand.

With weaker demand, firms struggle to sell their output at existing prices and may cut prices to attract customers, so the general price level falls.

This type of deflation is often associated with rising unemployment and a shrinking economy, because falling demand also reduces firms' output and the number of workers they need.

Supply-side deflation

Supply-side deflation occurs when the costs of production fall, allowing firms to lower their prices while maintaining or even increasing their profit margins.

Causes include falling wage costs, cheaper raw materials or energy, improvements in technology that reduce production costs, or increased competition between firms that forces prices down.

Unlike demand-side deflation, this type of deflation is not necessarily linked to a shrinking economy; it can occur alongside rising output, because firms are producing more efficiently at lower cost.

What are the consequences of inflation?

Inflation affects different groups in different ways, and some groups can even benefit from moderate inflation.

Borrowers can gain from inflation, since the real value of the money they must repay falls over time, which is the reverse side of the loss to lenders described above.

Workers in strong bargaining positions, such as those in essential industries, may also be able to secure wage rises that keep pace with or exceed inflation, protecting or even improving their real income.

Governments can also gain from inflation, as fixed-value tax allowances lose real value and pull more income into tax (fiscal drag), and because tax revenue generally rises as money incomes and spending rise.

At very high rates, inflation imposes extra costs on the whole economy. Menu costs are the costs firms face in constantly updating price lists, labels and advertising as prices change frequently.

Shoe leather costs describe the time and effort people spend shopping around or moving money between accounts to avoid losing value as prices rise quickly.

What are the consequences of deflation?

Deflation also has mixed effects, but it is often viewed as more harmful to an economy than mild inflation, especially when caused by falling demand.

Borrowers lose out from deflation, since the real burden of their debt increases as the money they repay is worth more than when they borrowed it.

This can discourage households and firms from borrowing and spending, reinforcing a fall in aggregate demand.

Supply-side deflation caused by falling production costs or improved technology tends to be viewed more positively, as it can occur alongside economic growth, rising real incomes and increased competitiveness, rather than falling output.

What policies can be used to control inflation?

Governments and central banks have a range of policies available to control inflation, with differing degrees of effectiveness.

1. Monetary policy: raising the interest rate makes borrowing more expensive and saving more attractive, reducing consumer and firm spending and so reducing demand-pull pressure on prices.
2. Fiscal policy: the government can reduce its own spending or raise taxes, both of which reduce total demand in the economy and ease demand-pull inflation.
3. Supply-side policy: measures that increase the economy's productive capacity, such as improving education and training or investment in infrastructure, allow supply to grow in line with demand, reducing inflationary pressure without needing to cut demand.
4. Incomes policy: the government may try to limit wage increases, for example by agreement with trade unions, to prevent a wage-price spiral driving cost-push inflation.
5. Exchange rate policy: allowing or encouraging the currency to appreciate makes imports cheaper, which can reduce cost-push inflation caused by expensive imported raw materials.

The effectiveness of these policies depends on the cause of the inflation. Monetary and fiscal policy mainly tackle demand-pull inflation by reducing total demand; they are less effective against cost-push inflation, since raising interest rates does not directly lower the cost of imported fuel or raw materials.

Reducing demand too sharply can also slow economic growth and raise unemployment, so there is often a trade-off between controlling inflation and maintaining growth and employment.

Supply-side policies tend to work more slowly, since improving education, skills or infrastructure takes time, but they avoid this trade-off because they raise supply rather than cut demand.

What policies can be used to control deflation?

Policies to control deflation generally aim to boost aggregate demand, since demand-side deflation is linked with weak spending and rising unemployment.

1. Monetary policy: cutting the interest rate makes borrowing cheaper and saving less attractive, encouraging consumers and firms to spend and invest more, raising demand and prices.
2. Fiscal policy: the government can increase its own spending or cut taxes, both of which raise total demand and help to reverse falling prices caused by weak demand.
3. Quantitative easing and other measures: if cutting interest rates close to zero is not enough to raise spending, central banks may use other measures to increase the amount of money available in the economy, aiming to encourage lending and spending.
4. Supply-side policy: where deflation is caused by falling costs and rising productivity rather than falling demand, policy may focus less on raising demand and more on ensuring the benefits of lower costs, such as lower prices and higher real incomes, are shared across the economy.

These policies also have limits. If consumers expect prices to keep falling, they may continue to delay spending even if interest rates are cut, reducing the effectiveness of monetary policy.

Government spending to boost demand can increase government borrowing, which some governments may be reluctant to allow.

Distinguishing whether deflation is demand-side or supply-side is important for choosing the right policy, since stimulating demand is of little use if the real problem is falling production costs rather than weak spending.

Glossary

• Inflation — a sustained rise in the general level of prices in an economy over time.
• Deflation — a sustained fall in the general level of prices in an economy over time.
• Disinflation — a fall in the rate of inflation, while prices are still rising, but more slowly than before.
• Hyperinflation — an extremely rapid and uncontrolled rise in prices, often caused by excessive money creation.
• Consumer Prices Index (CPI) — a weighted index number measuring changes in the average price of a representative basket of goods and services, relative to a base year of 100.
• Base year — the chosen reference year in an index number, always given a value of 100.
• Index number — a figure that shows how a value has changed compared with a base period, which is set at 100.
• Demand-pull inflation — a rise in prices caused by aggregate demand growing faster than aggregate supply.
• Cost-push inflation — a rise in prices caused by rising costs of production being passed on by firms.
• Wage-price spiral — a cycle in which rising wages push up firms' costs and prices, leading to further wage demands.
• Real income — income measured in terms of the goods and services it can actually buy, after adjusting for price changes.
• Nominal income — income measured in current money terms, without adjusting for changes in prices.
• Menu costs — the costs firms incur in frequently updating prices, price lists and advertising during high inflation.
• Shoe leather costs — the time and effort spent by households and firms trying to avoid losing value during fast inflation.
• Supply-side policy — government measures aimed at increasing the economy's productive capacity, such as education, training or infrastructure spending.

Common errors and misconceptions

• Misconception: inflation means every single price is rising. Correct: inflation refers to the general, average level of prices rising; individual prices can rise, fall or stay the same.
• Misconception: deflation and disinflation are the same thing. Correct: deflation is prices actually falling, while disinflation is simply a slower rate of rising prices.
• Misconception: all borrowers and lenders are harmed by inflation. Correct: borrowers can gain from inflation because the real value of their debt falls, while lenders tend to lose out in real terms.
• Misconception: deflation is always good for an economy because prices are falling. Correct: demand-side deflation is usually linked with falling output and rising unemployment, so it can be harmful, whereas supply-side deflation from falling costs can occur alongside growth.
• Misconception: raising interest rates is equally effective against all types of inflation. Correct: raising interest rates mainly reduces demand-pull inflation, but is less effective against cost-push inflation caused by rising import or raw material prices.
• Misconception: the CPI measures the price of one product, such as fuel. Correct: the CPI is a weighted average of the prices of a whole basket of goods and services bought by a typical household.
• Misconception: a rising CPI number means prices have risen by that percentage since last year. Correct: the CPI is compared with a base year set at 100; the rate of inflation must be calculated from the change between two CPI values, not read directly from a single CPI figure.

Exam-style questions with model answers

Q1. Define the term "deflation". [2 marks]

1. Deflation is a sustained fall in the general level of prices in an economy over a period of time.
2. It is the opposite of inflation and is usually measured as a negative percentage change in a price index such as the CPI.

Q2. The CPI in a country was 150 in one year and 159 in the next year. Calculate the rate of inflation between the two years, showing your working. [2 marks]

1. Inflation rate = (CPI this year − CPI last year) ÷ CPI last year × 100, so (159 − 150) ÷ 150 × 100.
2. = 9 ÷ 150 × 100 = 6%, so the rate of inflation between the two years was 6%.

Q3. Identify two groups who may gain in real terms from a period of deflation. [2 marks]

1. Savers, because the real value of their savings rises as prices fall.
2. Lenders, because the money they are repaid is worth more in purchasing power than the money they originally lent.

Q4. Explain two causes of cost-push inflation. [4 marks]

1. One cause of cost-push inflation is a rise in wage costs.
2. If wages rise faster than worker productivity, firms' costs of production increase, forcing them to raise prices to protect their profit margins.
3. A second cause is a rise in the price of imported raw materials or fuel.
4. This increases firms' costs of production, and firms often pass these higher costs on to consumers in the form of higher prices.

Q5. Distinguish between demand-side and supply-side causes of deflation. [4 marks]

1. Demand-side deflation occurs when total demand in the economy falls, for example due to a rise in interest rates or a fall in consumer confidence, leaving firms unable to sell output at current prices.
2. Supply-side deflation occurs when the costs of production fall, for example due to cheaper raw materials or improved technology, allowing firms to lower prices while keeping or improving their profit margins.
3. Demand-side deflation is usually associated with falling output and rising unemployment.
4. Supply-side deflation can occur alongside rising output and growth, since it comes from firms producing more efficiently rather than from weaker spending.

Q6. Analyse the consequences of inflation for workers and for firms in an economy. [6 marks]

1. Workers may see their real income fall if their wages do not rise as quickly as prices, reducing their purchasing power and living standards.
2. Workers with strong bargaining power, such as those in essential industries, may be able to negotiate wage rises that keep pace with or exceed inflation, protecting their real income.
3. Firms face rising costs of production during inflation, such as higher wages and raw material prices, which can squeeze their profit margins if they cannot pass these costs fully onto consumers.
4. Uncertainty over future prices during periods of inflation can discourage firms from making long-term investment decisions.
5. Firms selling goods abroad may become less competitive internationally if domestic inflation is higher than inflation in other countries, since their goods become relatively more expensive to foreign buyers.
6. Overall, both groups can be harmed by inflation, but the extent of harm depends on their bargaining power and ability to pass on or protect against rising costs and prices.

Q7. Discuss whether raising the interest rate is always an effective policy to reduce inflation. [6 marks]

1. Raising the interest rate makes borrowing more expensive and saving more attractive, which reduces consumer spending and firm investment, lowering total demand in the economy.
2. This fall in total demand eases demand-pull inflation, where prices were rising because demand was growing faster than supply.
3. However, raising the interest rate is less effective against cost-push inflation, since it does not directly reduce the price of imported raw materials, fuel or other rising costs of production that are pushing up prices.
4. Higher interest rates can also slow economic growth and raise unemployment, since firms may postpone investment and consumers may spend less, which is a cost of using this policy.
5. If a wage-price spiral is driving inflation, a rise in the interest rate alone may not stop workers demanding higher wages to keep up with living costs, so cost-push pressures can continue.
6. Overall, raising the interest rate can be effective against demand-pull inflation, but on its own it is not a complete solution when cost-push factors are the main cause, so a combination of policies is usually more effective.

Q8. Explain two reasons why a government might be concerned about a period of demand-side deflation in its economy. [4 marks]

1. One reason is that falling aggregate demand can cause firms to cut output as they are unable to sell their existing stock at current prices.
2. This reduction in output often leads firms to reduce the number of workers they employ, raising unemployment, which is a serious concern for government.
3. A second reason is that consumers may delay purchases if they expect prices to fall further.
4. This reinforces the fall in demand, output and prices, creating a downward spiral that can be difficult for policy to reverse.

Key takeaways

• Inflation is a sustained rise, and deflation a sustained fall, in the general level of prices across an economy, not a change in any single price.
• The Consumer Prices Index measures price changes using a weighted basket of goods and services compared with a base year set at 100.
• Demand-pull inflation is caused by total demand growing faster than total supply; cost-push inflation is caused by rising costs of production.
• Deflation can be demand-side, linked with falling demand and output, or supply-side, linked with falling costs and often rising output.
• Savers and lenders tend to lose out from inflation but gain from deflation, while borrowers tend to gain from inflation but lose out from deflation.
• Demand-side deflation is often associated with rising unemployment and falling output, making it potentially more damaging than mild inflation.
• Monetary policy, fiscal policy and supply-side policy can all be used against inflation, but their effectiveness depends on whether the cause is demand-pull or cost-push.
• Policies to reverse deflation generally aim to raise aggregate demand through lower interest rates or higher government spending.

Test yourself

What is the difference between inflation and disinflation?

Inflation is a sustained rise in the general price level; disinflation is a fall in the rate of inflation, so prices are still rising but more slowly than before.

How is the Consumer Prices Index constructed?

A representative basket of goods and services is chosen, each item weighted by its share of household spending, and the basket's cost each year is compared with its cost in a base year set at 100.

Give one cause of demand-pull inflation.

A rise in consumer spending or firm investment that increases total demand faster than firms can increase output can cause demand-pull inflation.

Give one cause of cost-push inflation.

A rise in wage costs or in the price of imported raw materials and fuel can increase firms' production costs, causing cost-push inflation.

Why might demand-side deflation be more harmful than supply-side deflation?

Demand-side deflation is linked with falling spending, output and employment, whereas supply-side deflation can occur alongside falling costs and rising output and growth.

Who gains and who loses in real terms from inflation among savers and borrowers?

Savers tend to lose, as the real value of their savings falls, while borrowers tend to gain, as the real value of their debt falls.

Name one monetary policy tool used to reduce inflation.

Raising the interest rate, which discourages borrowing and spending and encourages saving, reducing total demand in the economy.

Why is a supply-side policy sometimes preferred to reduce inflation rather than cutting demand?

Supply-side policy raises the economy's productive capacity so it can meet demand without raising prices, avoiding the trade-off of lower growth and higher unemployment from cutting demand.