Contents: 13 sections
Cambridge IGCSE Economics 0455
Definitions
| Term | Meaning |
|---|---|
| Inflation | A sustained rise in the general price level |
| Deflation | A sustained fall in the general price level |
| Disinflation | Inflation is still positive but the rate is falling: prices rise more slowly |
The disinflation trap catches many students. If inflation falls from 6% to 3%, prices are still rising; that is disinflation, not deflation. Deflation needs a negative inflation rate.
Inflation is about the price level rising, not about prices being high.
How inflation is measured
The Consumer Price Index (CPI) measures the change in the price of a "basket" of goods and services a typical household buys.
How it is built:
- A survey of household spending finds what people actually buy.
- Each item is given a weight reflecting how much of the household budget it takes. Food and housing carry far more weight than. Say, cinema tickets.
- Prices are collected regularly from many shops.
- A weighted average price change is calculated against a base year set at 100.
Inflation rate = (this year's CPI − last year's CPI) ÷ last year's CPI × 100
Limitations of the CPI:
- The basket becomes out of date as spending habits change.
- It is an average, so it does not match any individual household. Poorer households spend more on food and energy, so when those prices spike their personal inflation is higher than the headline rate.
- Quality changes are hard to handle, a phone costing the same as five years ago is far better.
- Different countries build their baskets differently, making comparison difficult.
Causes of inflation
Demand-pull inflation, too much demand chasing too few goods.
Total demand rises → the economy is near full capacity so firms cannot produce much more → they raise prices instead → the price level rises.
Causes: rising consumer confidence, cheap credit, tax cuts, high government spending, an export boom.
Cost-push inflation, rising costs of production.
Costs rise (wages, raw materials, imported goods, energy) → firms' costs per unit increase → they raise prices to protect profits → the price level rises.
Causes: wage rises above productivity, higher oil or commodity prices, a weaker exchange rate raising import costs, higher indirect taxes.
Why the difference matters: demand-pull inflation responds to higher interest rates or contractionary fiscal policy. Cost-push does not, raising interest rates does nothing about the world oil price, and just reduces output and jobs.
Consequences of inflation
- Falling purchasing power, especially for those on fixed incomes such as pensioners.
- Savers lose if the interest rate is below the inflation rate; borrowers gain, because the real value of their debt falls.
- Uncertainty discourages firms from investing, because future costs and revenues are unpredictable.
- Loss of international competitiveness if domestic inflation is higher than in other countries, exports become dear and imports cheap, worsening the current account.
- Menu costs: the time and money spent changing prices.
- Wage–price spirals, where workers demand higher pay to keep up, raising costs and driving prices up further.
Some inflation is normal. Most countries target around 2% rather than zero, because very low inflation risks slipping into deflation.
Consequences of deflation
Deflation sounds good, everything gets cheaper, but is usually more damaging:
- Spending is postponed. If prices are expected to fall, people wait to buy, so demand falls further and prices fall again, a deflationary spiral.
- The real burden of debt rises. Debts stay the same while incomes and prices fall.
- Firms' profits fall, so they cut jobs and investment.
- Monetary policy loses power, because interest rates cannot fall far below zero.
Worked example
The CPI rises from 120 to 126 over a year.
Inflation = (126 − 120) ÷ 120 × 100 = 5%
The next year it reaches 129.
Inflation = (129 − 126) ÷ 126 × 100 = 2.4%
Prices are still rising, so this is disinflation, not deflation.
Now diagnose the cause. If the 5% coincided with a consumer spending boom and very low unemployment; it is demand-pull, and raising interest rates is appropriate. If it coincided with a jump in world energy prices and rising unemployment; it is cost-push, and raising interest rates would deepen the downturn without touching the cause.
Common exam mistakes
- Confusing disinflation with deflation.
- Saying inflation means prices are "high" rather than rising.
- Explaining demand-pull inflation without mentioning capacity.
- Presenting inflation as purely bad, borrowers gain, and low positive inflation is the aim.
- Treating deflation as good news.
- Recommending interest-rate rises for cost-push inflation without qualification.
Exam technique
Identify the type of inflation before suggesting a policy, the stimulus almost always tells you, through an energy shock, a wage settlement or a spending boom.
Show the calculation when given CPI figures: formula, substitution, answer with a % sign.
For consequences, cover groups who lose and groups who gain, savers and fixed-income households lose, borrowers gain. That balance is what evaluation marks reward.
Building an answer
4 marks, "Explain the difference between demand-pull and cost-push inflation."
Demand-pull inflation occurs when total demand grows faster than the economy's ability to supply, so buyers bid prices up; it is caused by too much spending chasing too few goods.
Cost-push inflation occurs when firms' costs rise, wages, imported raw materials, energy, and firms pass those costs on as higher prices, even though demand has not changed.
6 marks, "Analyse the consequences of high inflation."
Real incomes fall for anyone whose pay does not keep pace, so living standards decline even though money incomes may be rising.
Savers lose, because interest rates rarely keep up with inflation, while borrowers gain as the real value of their debt falls, an arbitrary redistribution nobody voted for.
Exports become less competitive as domestic prices rise relative to trading partners', worsening the balance of trade.
Uncertainty rises, so firms delay investment, which harms long-run growth. Menu costs and shoe-leather costs add further inefficiency.
Much depends on whether inflation is anticipated and whether incomes are indexed, anticipated inflation is far less damaging than a surprise.
Why deflation is not simply "good news"
Falling prices sound like a benefit to consumers, and this is the trap.
| Problem | Why it bites |
|---|---|
| Delayed spending | If prices will be lower next month, buyers wait: demand falls further |
| Rising real debt | The money owed stays fixed while incomes and prices fall, so debt gets heavier |
| Falling profits | Firms cut output and jobs, deepening the fall in demand |
| Policy runs out | Interest rates cannot fall far below zero to stimulate demand |
Japan's experience from the 1990s is the standard reference: deflation combined with stagnant growth for the better part of two decades.
How it is measured, and why the measure is imperfect
The Consumer Price Index tracks the price of a fixed basket of goods, weighted by how much households spend on each. The rate of inflation is the percentage change in that index.
Its limitations are worth two marks in themselves: the basket is average and matches no actual household; quality improvements make a price rise look worse than it is; and new goods enter the basket only after a delay.
A real case to quote
Zimbabwe, 2008. Inflation reached figures so large they ceased to be meaningful, money stopped functioning as a store of value or medium of exchange, and the economy reverted substantially to barter and foreign currency. It is the extreme case, and it is useful precisely because it shows what money is for by showing what happens when it fails.
Check you have it
What would be a cause of cost-push inflationary pressure in an industry which supplies mobile (cell) phones?
More questions on inflation →Quick revision
- Inflation = sustained rise in the general price level; deflation = sustained fall; disinflation = a slower rise.
- CPI = weighted basket; weights reflect spending shares.
- Demand-pull: too much demand near full capacity. Cost-push: rising production costs.
- Interest rates work on demand-pull, not cost-push.
- Inflation harms savers and fixed incomes, helps borrowers, and damages competitiveness.
- Deflation risks a spiral of postponed spending and raises the real burden of debt.
- Most countries target about 2%, not zero.