Syllabus points
- Define inflation, disinflation and deflation.
- Explain how inflation is measured using a consumer price index (CPI).
- Distinguish demand-pull from cost-push inflation.
- Explain the costs of inflation and deflation.
Key definitions
| Term | Meaning |
|---|---|
| Inflation | A sustained rise in the general price level |
| Disinflation | A fall in the rate of inflation (prices still rising, but more slowly) |
| Deflation | A sustained fall in the general price level (negative inflation) |
Measuring inflation
A consumer price index (CPI) tracks the price of a representative basket of goods and services bought by a typical household. Items are weighted by their share of household spending. Inflation is the percentage change in the index:
Inflation rate = (index in year 2 − index in year 1) ÷ index in year 1 × 100
Limitations: the fixed basket lags behind changing spending patterns, may not reflect any one household, and can miss quality improvements.
Causes of inflation
- Demand-pull: AD rises faster than the economy's capacity to supply, pulling prices up — often from strong consumption, low interest rates or fiscal expansion.
- Cost-push: rising costs of production (wages, imported raw materials, a weaker exchange rate) shift SRAS left, raising prices while reducing output.
Costs of inflation and deflation
- Inflation: erodes the real value of money and savings, creates uncertainty that discourages investment, damages international competitiveness, and can trigger a wage–price spiral. It redistributes from savers and those on fixed incomes to borrowers.
- Deflation: can be worse — falling prices encourage consumers to delay spending, raise the real value of debt, and can trap the economy in recession.
Worked example
If a price index rises from 120 to 126 over a year, inflation is (126 − 120) ÷ 120 × 100 = 5%. If the next year it rises from 126 to 129 (roughly 2.4%), that is disinflation — a lower inflation rate, not falling prices.
Common exam mistakes
- Confusing disinflation (slower price rises) with deflation (falling prices).
- Assuming all inflation is demand-pull; identify the cause before choosing a policy.
- Forgetting that moderate, stable inflation is a policy target — not zero inflation.
Exam technique
Diagnose demand-pull vs cost-push using AD–AS diagrams, because the appropriate policy differs. Evaluate who gains and who loses from inflation.
Quick revision
- Inflation = sustained price rise; deflation = sustained fall; disinflation = slower inflation.
- Measured by a weighted CPI basket.
- Demand-pull (AD up) vs cost-push (SRAS left).
- Costs: uncertainty, lost competitiveness, redistribution; deflation deepens recessions.