Notice the aim is not no inflation. Most central banks target around 2% a year, because a little inflation is the normal sign of a growing economy — and falling prices turn out to be far more dangerous than gently rising ones.
📚 What you need to know
Inflation is a sustained rise in the average price level. Deflation is a sustained fall. Disinflation is prices still rising, but more slowly.
Inflation is measured by the consumer price index (CPI), built from a weighted basket of typical household purchases.
Two causes: demand-pull (AD shifts right) and cost-push (SRAS shifts left). They need opposite policies.
Deflation can be demand-side (bad) or supply-side (good) — the cause decides the consequences.
The CPI has real limitations: one average basket, no allowance for quality changes, regional differences hidden.
Low, stable inflation lets firms plan investment and protects the purchasing power of consumers.
Three words students mix up
Term
What is happening to prices
Example over three years
Inflation
The average price level is rising
2%, then 3%, then 4%
Disinflation
Still rising, but the rate is falling
5%, then 4%, then 2%
Deflation
The average price level is actually falling
1%, then 0%, then −1.5%
Disinflation is the one that catches people out. If the inflation rate falls from 5% to 2%, prices are still going up — just more slowly. Nothing has got cheaper. Only a negative rate means prices are falling.
How the CPI is built
🧩 From shopping basket to inflation rate
A household expenditure survey finds out what a typical family buys.
Those items go into a basket, updated each year as tastes change.
Each item is given a weight based on its share of household spending — housing is heavy, shoes are light.
Prices are collected each month from many places and averaged.
Price × weight for every item, added up, gives the value of the basket.
The basket value is turned into an index with the base year set at 100.
The percentage change in the index between two years is the inflation rate.
Turning an index into an inflation rate
inflation rate = (CPInew − CPIold) ÷ CPIold × 100
WORKED EXAMPLE
Calculating inflation from a weighted basket
In the base year the basket cost $500 and the index was 100. This year the basket costs $560; last year it cost $525. Calculate the CPI for each year and the inflation rate for this year, to two decimal places.
Step 1: CPI for last year(525 ÷ 500) × 100 = 105.00Step 2: CPI for this year(560 ÷ 500) × 100 = 112.00Step 3: percentage change between the two(112.00 − 105.00) ÷ 105.00 × 100= 7.00 ÷ 105.00 × 100 = 6.666…Inflation rate = 6.67%Divide by the older index, not the base year value. That is the usual slip.
The two causes of inflation
The direction of output is how you tell the two apart in a data response. Prices up and output up is demand-pull; prices up and output down is cost-push.
Why the cause matters so much. Using demand-side policy against cost-push inflation makes things worse: raising interest rates cuts AD, so prices fall a little but output and jobs fall too. Say this in evaluation and you are answering like an economist.
Who loses from inflation
Group
How inflation hurts them
Consumers
Purchasing power falls; savings lose real value; worst for people on fixed incomes such as pensioners
Firms
Uncertainty delays investment; menu costs of constantly changing prices
Workers
If pay rises lag behind inflation, real wages fall and morale drops
The government
Exports lose competitiveness; fixing inflation usually means accepting higher unemployment
Deflation: good or bad?
This is where the top marks are. Falling prices sound wonderful, but you have to ask which curve moved.
Feature
Demand-side deflation (bad)
Supply-side deflation (good)
What moved
AD shifted left
SRAS or LRAS shifted right
Output
Falls
Rises
Unemployment
Rises
Falls
Consumer behaviour
Purchases delayed, waiting for cheaper prices, so AD falls further
Confidence rises with real incomes
Real burden of debt
Rises, and real interest rates rise with it
Also rises — the one drawback
The dangerous part of bad deflation is the loop. Prices fall, so shoppers wait for a better deal, so demand falls further, so prices fall again. Once that starts, cutting interest rates does not help much, because nobody wants to spend at any rate.
The limitations of the CPI
One basket, many households. Your own inflation rate depends on what you buy. Someone who spends most of their income on rent and energy feels a very different rate.
Regional differences are hidden. Prices in the capital may rise far faster than in smaller cities.
Quality changes are missed. A phone at the same price as last year is a much better phone, and the index does not see it.
The basket updates slowly. Spending habits change faster than the annual survey.
Comparison problems. Some countries use a retail price index instead, so international comparisons are less meaningful.
💡 Exam tip
Read the direction of output in the data to identify demand-pull or cost-push before you draw anything.
Never say deflation is simply good or simply bad. Ask which curve moved.
Give numbers with the words: “prices rose about 3%, then about 2%, so this is disinflation”.
Use “sustained” in the definition. A one-off price rise is not inflation.
Two or three CPI limitations make excellent evaluation in a data response.
Label the shifted curve AD₂ or SRAS₂ and mark the new equilibrium clearly.
⚠️ Common mix-up
Calling disinflation deflation. Prices are still rising during disinflation.
Saying inflation means everything gets more expensive. It is an average; some prices still fall.
Dividing by the base year when calculating a rate. Divide by the earlier of the two years you are comparing.
Treating all inflation the same. Cost-push and demand-pull need opposite policies.
Forgetting the target is 2%, not 0%. A little inflation is healthy.
Ignoring debtors. Inflation actually reduces the real value of debt, so it does not hurt everyone.
Up next: Keeping Government Debt Sustainable — the difference between a deficit and a debt, and why the debt-to-GDP ratio is the number markets watch.
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