Measuring inflation, its causes and consequences, and deflation

Last time

Before we start: last time, in Economic growth and unemployment, you learned these points. Here they are again on one card. Keep them in mind, because today builds on them.

Rising and falling prices

Inflation is a sustained rise in the general price level; deflation is a sustained fall. Both affect everyone, but in different ways. This lesson covers how inflation is measured, its causes, its consequences, and deflation.

Price indices

A consumer price index tracks the price of a representative basket of goods and services bought by households. Each item has a weight, from a household expenditure survey, showing its share of spending. A base year is set to 100. The inflation rate is the percentage change in the index over a year.

A weighted index, worked

Food has a weight of 0.5 and an index of 120; housing 0.3 and 110; transport 0.2 and 105. The weighted index is 60 plus 33 plus 21: 114. Prices have risen 14 per cent since the base year.

Limitations of price indices

The basket may not match every household's spending, such as pensioners or the poor. Quality improvements and new products are hard to measure. Consumers switch to cheaper substitutes, which a fixed basket misses.

Causes of inflation

Demand-pull: AD grows faster than the economy's capacity, so firms raise prices. Cost-push: rising costs, such as wages, raw materials or a weaker currency raising import prices, shift SRAS left. Monetary: the money supply grows faster than output, according to the quantity theory.

Consequences of inflation

Menu costs of changing prices, and shoe-leather costs of managing cash. Redistribution: savers and those on fixed incomes lose; borrowers may gain. Uncertainty reduces investment. Exports become less competitive if inflation is higher than abroad. But mild, stable inflation can encourage spending.

Is inflation always a concern?

Low, stable, predictable inflation, such as around 2 per cent, causes few problems; many central banks target it. High or unpredictable inflation, and hyperinflation, are damaging. And demand-pull inflation from strong growth may be less worrying than cost-push inflation with falling output.

Deflation

Benign deflation comes from rising productivity and lower costs: output grows as prices fall. Malign deflation comes from falling AD: consumers delay spending, firms cut output and jobs, and real debt burdens rise. So deflation can be good or bad, depending on its cause.

Mistakes that lose marks

Mistake one: defining inflation as high prices. Mistake two: confusing demand-pull with cost-push. Mistake three: saying all deflation is harmful. The fix: precise definition, type, and evaluation by cause.

The full-marks tip

The full-marks tip: explain inflation by its type, with an AD/AS diagram. Evaluate its consequences by its rate, stability and cause.

On one card

So, on one card: inflation and deflation. Keep it for revision.