Low and Stable Inflation

Key definitions

The disinflation versus deflation distinction is tested almost every year. If inflation falls from 6% to 3%; that is disinflation, the price level is still rising. Deflation means the price level itself is falling, which requires a negative inflation rate.

Measuring inflation with the CPI

The CPI tracks the cost of a representative basket of goods and services bought by a typical household.

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1. A household expenditure survey establishes what people buy.
2. Each item is given a weight reflecting its share of typical spending, housing and food carry far more weight than. Say, cinema tickets.
3. Prices are collected regularly across many outlets.
4. A weighted average price change is computed relative to a base year, which is set to 100.

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

Weighting is the key idea: a 10% rise in the price of bread affects the index far more than a 10% rise in the price of caviar, because households spend far more on bread.

Constructing a weighted index

Paper 3 asks for this directly, and it is straightforward once the method is fixed. Multiply each category's price index by its weight, add them, and divide by the total weight.

Weighted CPI = 10,950 ÷ 100 = 109.5
Inflation since the base year = (109.5 − 100) ÷ 100 × 100 = 9.5%

Notice what the weights do. Transport prices rose fastest, by 20%, but transport carries only a tenth of the weight, so it contributes less to the index than food's 10% rise across four times the weight. A large price rise in a small category moves the index less than a small rise in a large one, which is the whole point of weighting, and a favourite short-answer question.

Limitations of the CPI

A reliable source of evaluation marks:

• The basket becomes outdated. Consumption patterns change faster than the basket is revised, so the index can misrepresent what people actually buy.
• Substitution bias. When a good becomes expensive, consumers switch away from it, but the fixed basket keeps buying it, so the index overstates the true rise in the cost of living.
• Quality changes are hard to handle. A laptop costing the same as five years ago is far more powerful, a price rise recorded may really be a quality improvement.
• It is an average. Different households experience different inflation. Low-income households spend a larger share on food and energy, so when those prices spike their personal inflation rate exceeds the headline figure. Inflation is therefore distributionally uneven, not just an aggregate.
• International comparisons are difficult, because baskets and methods differ.
• Volatile components: food and energy, can swing the headline rate for reasons unrelated to underlying pressure, which is why central banks watch core inflation too.

Causes of inflation

Demand-pull inflation

Caused by excess aggregate demand relative to the economy's productive capacity, "too much money chasing too few goods".

1. AD shifts right
2. the economy is at or near full capacity
3. firms cannot expand output much
4. the extra demand bids up prices
5. the price level rises with little gain in real output.

Sources: consumer or business confidence, rapid credit growth, expansionary fiscal or monetary policy, an export boom, or a depreciation raising net exports.

On the AD–AS diagram, the crucial point is where the economy sits on the AS curve. Extra demand with plenty of spare capacity raises output with little inflation; the same increase near full employment is almost purely inflationary.

Cost-push inflation

Caused by rising costs of production, shifting SRAS left.

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1. Input costs rise
2. firms' costs per unit rise at every price level
3. SRAS shifts left
4. the price level rises and real output falls.

Sources: wage rises above productivity growth, imported raw material and energy prices, a currency depreciation raising import costs, higher indirect taxes, or supply-chain disruption.

Cost-push inflation produces stagflation, rising prices with falling output and rising unemployment, which is uniquely hard for policymakers, because demand-side tools improve one problem only by worsening the other.

Why the distinction matters

It determines the correct policy:

• Demand-pull responds to contractionary monetary or fiscal policy.
• Cost-push does not. Raising interest rates does nothing about the price of oil; it simply suppresses demand, deepening the output loss while the cost shock passes through anyway. The appropriate responses are supply-side: raising productivity, improving competition, reducing dependence on the affected input.

Real-world examples

• The 1970s oil shocks are the standard cost-push case: a sharp rise in the price of a universal input raised costs across every economy that imported it, producing inflation and rising unemployment together.
• Hyperinflation in Weimar Germany, and more recently in Zimbabwe and Venezuela, illustrates the monetary extreme, governments unable to raise sufficient tax revenue financing spending by creating money, until confidence in the currency collapses and people abandon it for foreign currency or goods.
• Japan from the 1990s is the deflation case, and the reason economists stopped regarding falling prices as harmless: persistent weak demand, an ageing population and a damaged banking system produced years of falling or flat prices alongside stagnant growth.

Use an example to illustrate a mechanism you have explained, not as a substitute for explaining it.

Costs of inflation

• Loss of purchasing power, especially for those on fixed incomes and for savers whose nominal interest rate is below inflation (a negative real interest rate).
• Uncertainty, which discourages long-term investment because firms cannot forecast costs and revenues reliably.
• Loss of international competitiveness if domestic inflation exceeds trading partners', worsening the current account.
• Menu costs (repricing) and shoe-leather costs (time spent minimising cash holdings).
• Redistribution: it benefits borrowers (the real value of debt falls) and harms lenders and savers. This is a transfer, not a straightforward loss.
• Wage–price spirals, where workers bargain for higher wages in anticipation, which raises costs and validates the inflation, the reason central banks care so much about anchoring expectations.

Anticipated versus unanticipated inflation is worth separating. If inflation is correctly expected, lenders build it into nominal interest rates and workers into wage bargains, so much of the redistribution does not occur. It is unanticipated inflation that transfers wealth from lenders to borrowers, and volatile inflation that does most of the damage to investment.

Why not target zero? Central banks typically target a low positive rate, commonly around 2%, rather than zero. A small positive rate keeps a safety margin above deflation, allows real wages to adjust downwards without nominal pay cuts that workers resist, and leaves room to cut interest rates in a downturn. Being able to explain why the target is positive rather than zero is a strong evaluative point.

Costs of deflation

Deflation sounds beneficial, things get cheaper, and is in fact more dangerous than moderate inflation:

• Deferred consumption. If prices are expected to fall, households postpone purchases, reducing AD and causing further price falls, a self-reinforcing deflationary spiral.
• The real burden of debt rises. Nominal debts stay fixed while incomes and prices fall, so borrowers are squeezed and defaults rise.
• Monetary policy loses traction. Nominal interest rates cannot fall far below zero, so real interest rates stay high exactly when stimulus is needed, the liquidity trap.
• Falling profits and rising unemployment as firms cut costs to survive falling revenues.

It matters why prices are falling. Demand-side deflation, caused by collapsing AD, is damaging. Supply-side deflation, caused by improved productivity shifting LRAS right, comes with rising output and is benign. Distinguishing the two is a strong evaluative point.

Worked example

A country's CPI rises from 120 to 126 over one year.

Inflation rate = (126 − 120) ÷ 120 × 100 = 5%

The following year the CPI reaches 129.

Inflation rate = (129 − 126) ÷ 126 × 100 = 2.4%

Prices are still rising, so this is disinflation, not deflation. A student who calls it deflation has misread the whole scenario.

Now diagnose the cause. If the 5% inflation coincided with rapid credit growth and unemployment below the natural rate; it is demand-pull, and contractionary monetary policy is appropriate. If it coincided with a global energy price spike and rising unemployment; it is cost-push, and raising interest rates would worsen the output loss without addressing the cause.

Then check what it did to real values. If nominal wages rose 3% during the year inflation was 5%, real wages fell by roughly 2%, workers are worse off despite a pay rise. That calculation, and the sentence explaining it, is the difference between quoting a statistic and interpreting one.

Common exam mistakes

• Confusing disinflation with deflation.
• Saying inflation means "prices are high", it means prices are rising.
• Explaining demand-pull inflation without reference to spare capacity.
• Shifting AD for a cost shock, or SRAS for a demand shock.
• Averaging price indices without applying the weights.
• Presenting inflation as purely a loss, ignoring that it redistributes from lenders to borrowers.
• Forgetting that anticipated inflation does much less damage than unanticipated inflation.
• Treating deflation as good news.
• Recommending interest-rate rises for cost-push inflation without qualification.

Exam technique

Diagnose the type before analysing or recommending. The stimulus almost always contains the clue, an energy shock, a wage settlement, a credit boom, a confidence surge.

Draw the correct diagram: AD shifting right for demand-pull, SRAS shifting left for cost-push. Label the axes price level and real output, and note that the cost-push diagram shows output falling as the price level rises, that simultaneous movement is the analysis.

In index calculations, always show the weighting step. Writing the weight × index column earns method marks even if the final division slips, and it is the step the question is actually testing.

For evaluation: the type of inflation, whether expectations are anchored, distributional effects across income groups, the CPI's measurement limitations, and the trade-off with unemployment.

Quick revision

• Inflation = sustained rise in the general price level; deflation = sustained fall; disinflation = a slower rise.
• CPI = weighted basket; weights reflect spending shares, so a big rise in a small category moves the index little.
• Weighted index = Σ(weight × index) ÷ Σ(weights).

Demand-pull: AD right near capacity

prices up, output little changed.

Cost-push: SRAS left

prices up and output down (stagflation).

• Monetary policy works on demand-pull, not cost-push.
• Inflation redistributes from lenders and savers to borrowers, mainly when unanticipated.
• Central banks target a low positive rate, not zero, to keep a margin above deflation.
• Deflation risks a spiral, raises the real burden of debt, and disarms monetary policy.

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