Causes and Consequences of Inflation and Deflation
Inflation is a sustained rise in the general price level of an economy over time, reducing the purchasing power of a given sum of money; deflation is a sustained fall in the general price level.
Before you start
Make sure you're comfortable with these topics first:
Method
- Define demand-pull inflation (AD rising faster than AS, especially near full capacity) and cost-push inflation (a leftward shift of SRAS from rising costs) as two separate causes, and be ready to identify which one a given scenario describes.
- Learn how the CPI is constructed: a representative basket of goods and services is priced, weighted by household spending patterns, combined into a single index, and compared year on year to give the inflation rate.
- Learn the CPI's limitations: the basket may not match every household, it is updated only periodically so can lag changing habits, and it excludes owner-occupier housing costs, which the RPI partly captures.
- Learn the consequences of inflation for different groups: savers and those on fixed incomes lose out as the real value of money falls, borrowers can gain as the real value of debt falls, UK exporters can become less competitive if UK inflation exceeds that of trading partners, and menu and shoe-leather costs are incurred adjusting prices and holding less cash.
- Learn the causes and consequences of deflation: falling AD (often accompanied by recession and rising real debt burdens) versus falling costs or rising productivity (a positive supply shock), and the risk of a deflationary spiral if consumers delay spending expecting prices to fall further.
- Practise converting a CPI index into an inflation rate (the percentage change year on year) and interpreting a table of index values.
- For any essay, structure the answer around the cause, then the chain of effects on named groups or the wider economy, then an evaluation on the size and persistence of the inflation, who is affected, and the state of the economy.
Worked example
The CPI (index, January of Year 1 = 100) was 100 in January Year 1 and 104.5 in January Year 2. Calculate the annual rate of CPI inflation over this period, and explain one consequence for a saver holding cash in a bank account paying 2 percent interest.
- Calculate the percentage change in the index: (104.5 - 100) / 100 x 100.
- This gives 4.5 percent, so the annual rate of CPI inflation was 4.5 percent.
- Compare this to the saver's 2 percent interest rate: the real interest rate is approximately the nominal rate minus inflation, 2 percent minus 4.5 percent equals minus 2.5 percent.
- Since the real interest rate is negative, the purchasing power of the saver's money falls over the year even after interest is added, because prices are rising faster than the balance is growing.
- The saver is worse off in real terms, illustrating why unanticipated inflation redistributes real income away from savers and other groups on fixed nominal incomes, towards borrowers.
Practice questions
Try each question, then tap to reveal the answer.
Q1Define demand-pull inflation.Show answer
Answer: A sustained rise in the general price level caused by aggregate demand growing faster than aggregate supply, especially as the economy nears full capacity.
Q2Define cost-push inflation.Show answer
Answer: A sustained rise in the general price level caused by rising costs of production, such as wages or imported raw materials, which shifts SRAS leftward.
Q3What does CPI stand for and what does it measure?Show answer
Answer: Consumer Prices Index; it measures the average change in the price of a representative, weighted basket of goods and services bought by households.
Q4Give one limitation of the CPI as a measure of inflation.Show answer
Answer: It is based on an average household basket, so it may not reflect the true cost-of-living change for particular groups, such as pensioners or students, whose spending patterns differ from the average.
Q5State one group that tends to gain from unanticipated inflation.Show answer
Answer: Borrowers with fixed-rate debt, since inflation erodes the real value of what they owe.
Q6Give one economic risk associated with deflation.Show answer
Answer: Consumers may delay purchases expecting prices to fall further, reducing current spending and deepening a downturn, and the real value of debt rises, increasing the burden on borrowers.
Q7A price index was 108 last year and is 111 this year. Calculate the rate of inflation.Show answer
Answer: (111 - 108) / 108 x 100 = approximately 2.8 percent.
Exam-style questions
Written in the style of a A Level Economics exam paper, with a full mark scheme.
Explain two consequences of a sustained period of demand-pull inflation for a country's international competitiveness.
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Evaluate the view that cost-push inflation is more damaging to an economy than demand-pull inflation.
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See real A Level Economics past-paper questions, with official mark schemes →
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