An Introduction to Inflation

Inflation is the sustained increase in the average price level of goods/services in an economy
Deflation occurs when there is a fall in the average price level of goods/services in an economy
- Deflation only occurs when the percentage change in prices falls below zero %
Disinflation occurs when the average price level is still rising, but at a lower rate than before
- These figures demonstrate disinflation: Y1= 5% Y2= 4% Y3= 2%
  - Inflation is increasing but at a decreasing rate

Worked Example

How would you characterise the fall in the CPI from 2018 to 2021? Explain your answer [3]

2-1-2-inflation---worked-example_edexcel-al-economics

Step 1: Study the time period and decide if you are witnessing inflation, disinflation or deflation

Disinflation (1 mark)

Step 2: Explain your answer

According to the CPI data, prices are still rising but at a decreasing rate. For example, in 2018 prices were rising at around 3%. In 2019 this increase fell to roughly 1.8%. In 2021, they were still rising but by a much lower 0.5%

(2 marks for an answer with a correct explanation which references the data)

Measuring Inflation Using the Consumer Price Index (CPI)

Inflation is the sustained increase in the average price level of goods/services in an economy
- The average price level is measured by checking the prices of a 'basket' of goods/services that an average household will purchase each month
- This basket of goods is turned into an index and it is called the consumer price index (CPI)
- Many economies have an inflation target of 2% per annum
  - Low inflation is better than no inflation as it is a sign of economic growth
The inflation rate is the change in average price levels in a given time period
- The inflation rate is calculated using an index with 100 as the base year
- If the index is 100 in year 1 and 107 in year 2 then the inflation rate is 7%

The Consumer Price Index (CPI)

A 'household basket' of goods/services that an average family would purchase is compiled on an annual basis
- A household expenditure survey is conducted to determine what goes into the basket
- Each year, some goods/services exit the basket and new ones are added
- The number of goods in the basket varies from country to country e.g. the UK has 700 'goods' in their basket and Singapore has 4,800
Goods/services in the basket are weighted based on the proportion of household spending
- E.g. More money is spent on food than shoes, so shoes have a lower weight in the basket
Each month, prices for these goods/services are gathered from many locations across the country
- These prices are averaged out
The price x the weighting determines the final value of the good/service in the basket
- These final values are added together to determine the price of the 'basket'
$CPI = \frac{Cost of basket in year X}{Cost of basket in base year} x 100$
The percentage difference in CPI between the two years is the inflation rate for the period

Worked Example

Using the information in the table, calculate the inflation rate for 2021 if the price of the basket in the base year (2019) was $400 [3]

Good	Price 2020	Price 2021	Weight	Basket 2020 (Price x weight)	Basket 2021 (Price x weight)
Housing, water, electricity, gas	950	1200	34%	323.00	408.00
Transport	250	325	11%	27.50	35.75
Food	500	620	9%	45.00	55.80
Recreation and culture	300	340	10%	30.00	34.00
Clothing and footwear	190	210	5%	9.50	10.50
				$435.00	$544.05

Step 1: Calculate the CPI for 2020

$CPI = \frac{Cost of basket in 2020}{Cost of basket in base year} x 100 = \frac{435}{400} x 100 = 108.75$

Step 2: Calculate the CPI for 2021

$CPI = \frac{Cost of basket in 2021}{Cost of basket in base year} x 100 = \frac{544.05}{400} x 100 = 136.01$

Step 3: Calculate the percentage difference between the CPI for 2021 and 2020

$Inflation rate = \frac{New CPI - Old CPI}{Old CPI} x 100 = \frac{136.01 - 108.75}{108.75} x 100 = 25.07 %$

(3 marks for the correct answer or 1 mark for any correct working. Answers should be rounded to 2 decimal places to be correct)

The Limitations of Using the CPI

The CPI provides a level of inflation for the average basket and the basket of many households is not the average basket
- Depending on what households buy the level of inflation for each one can vary significantly
- As an average, it also ignores regional differences in inflation e.g. London's inflation may be much higher than Manchester's inflation
The CPI is one of several methods used by countries in determining inflation - another is the retail price index (RPI)
- This can make comparisons between countries less meaningful as one may use the RPI and another the CPI
The CPI does not capture the quality of the products in the basket
- Product quality changes over time and so the comparison with different time periods is less useful
The CPI only measures changes in consumption on an annual basis
- Changes in consumption can occur more frequently and the index is always behind these changes
The CPI is prone to errors in data collection
- It is based on a survey that goes to thousands of households each year, yet it is still a small sample
- The respondents have no incentive to fill in the survey carefully and accurately

The Causes of Inflation

An increase in the average prices in an economy can be caused by demand pull inflation or cost push inflation

1. Demand Pull Inflation

Demand pull inflation is caused by excess demand in the economy
Aggregate demand (AD) is the sum of all expenditure in the economy
- AD = Consumption (C) + Investment (I) + Government spending (G) + Net Exports (X-M)

2-1-2-inflation---demand-pull_edexcel-al-economics

An increase in aggregate demand (AD) raises the average price level in an economy leading to demand pull inflation

Diagram Analysis

If any of the four components of AD increase (ceteris paribus), there will be a shift to the right of the AD curve from AD₁→ AD₂
At the original price (AP₁), there is now a condition of excess demand in the economy
As prices rise, there is a contraction of AD and an extension of SRAS
Prices for goods/services are bid up from AP₁→ AP₂
Demand pull inflation has occurred
If the Central Bank lowers the base rate, there is likely to be increased borrowing by firms and consumers
- This will result in an increase in consumption and investment
- It is likely to lead to a form of demand-pull inflation

2. Cost Push Inflation

Cost push inflation is caused by increases in the costs of production in an economy

2-1-2-inflation---cost-push_edexcel-al-economics

An increase in the costs of production raises the average price level in an economy leading to cost push inflation

Diagram Analysis

If any of the costs of production increase (labour, raw materials etc.), or if there is a fall in productivity, there will be a shift to the left of the SRAS curve from SRAS₁→SRAS₂
At the original price (AP₁), there is now a condition of excess demand in the economy
As prices rise, there is a contraction of AD and an extension of SRAS
Prices for goods/services are bid up from AP₁→AP₂
Cost push inflation has occurred

The Costs of Inflation

The Impact of Inflation on Different Stakeholders

Stakeholder

Explanation of Impact

Firms

Uncertainty. Rapid price changes create uncertainty and delay investment
Menu change costs. Price changes force firms to change their menu prices too and this can be expensive

Consumers

Decrease in purchasing power
Decrease in the real value of savings (as money will be worth less in real terms)
Fall in real income for those on fixed incomes/pension
Inflation is more harmful to low income households

Government

Inflation erodes international competitiveness of export industries as the country's exports are now relatively more expensive
Economic growth may slow due to a fall in exports and a possible fall in consumption
Trade-offs involved in tackling inflation e.g reducing inflation may increase unemployment and/or reduce economic growth

Workers

Demand higher wages to compensate for reduced purchasing power
If wage increases ≠ inflation, motivation and productivity may fall

The Causes and Costs of Deflation

Deflation occurs when there is a fall in the average price level of goods/services in an economy as measured by the consumer price index (CPI)
- Deflation only occurs when the percentage change in prices falls below zero %
Deflation can be caused by either demand-side or supply-side factors
- The two different causes of deflation have very different consequences for the economy

1. Demand-side Deflation (Bad Deflation)

Demand-side deflation is caused by a fall in total (aggregate) demand in the economy
Aggregate demand is the sum of all expenditures in the economy as measured by the real gross domestic product (rGDP)
- rGDP = Consumption (C) + Investment (I) + Government spending (G) + Net Exports (X-M)
If any of the four components of rGDP decrease, there will possibly be a decrease in the aggregate demand in the economy leading to a decrease in the general price level
- Demand-side deflation has occurred

3-3-4---demand-side-deflation-1

Aggregate demand (AD) has fallen leading to a reduction in the average price level (AP)

Diagram Analysis

The initial macroeconomic equilibrium is at AP Y
Any factor which causes a reduction in one or more of the determinants of real GDP may cause the AD curve to shift left from AD₁ → AD₂
This shift causes a fall in average price levels from AP to AP₁
The new macroeconomic equilibrium is now at AP₁ Y₁
Demand-side deflation has occurred

The Consequences of Demand-side Deflation

Government Challenges	Consumers Lose Confidence	Debt
With a decrease in output, fewer workers are required and so unemployment increases Fiscal and monetary policy is less effective at combatting deflation than inflation as consumers get into a habit of waiting for lower prices prior to making purchases	With falling output and rising unemployment, households lose confidence choosing to save instead of spend Consumption falls and rGDP reduces even more Consumers delay purchasing goods/services as they believe prices will be cheaper in a few weeks or months	Debt feels more burdensome as the value of any debt is worth more The real cost of borrowing increases as real interest rates rise when the price level falls e.g. if interest rates are 1.5% and the inflation rate is –1.5%, then the real interest rate is 3%
Firms Lose Confidence	Bankruptcies	Exports
Falling output and falling prices cause firms to lose confidence and so they delay investment, further reducing rGDP	Falling output and falling prices reduce the profits of firms Some firms will be unable to continue and will go out of business	Persistently falling prices can prove attractive to foreigners and the level of exports may increase (this helps offset some of the reduction in rGDP)

2. Supply-side Deflation

Supply-side deflation is caused by increases in the productive capacity of the economy
- This is brought about by any increase in the quantity/quality of the factors of production
- It effectively creates a condition of excess supply in the economy
- Average price levels fall
- National output (rGDP) increases

Short-run aggregate supply (SRAS) has increased leading to a reduction in the average price level (AP)

Diagram Analysis

The initial macroeconomic equilibrium is at APY
Any factor which causes an increase in the SRAS will result in the SRAS curve shifting right from SRAS → SRAS₁
This shift causes a fall in average price levels from AP → AP₁
The new macroeconomic equilibrium is now at AP₁ Y₁
Supply-side deflation has occurred

The Consequences of Supply-side Deflation

Unemployment	Consumers Gain Confidence	Debt
With a decrease in costs, the output of firms increases. More workers are required and so unemployment falls	With rising output and falling price levels, households become more confident and the consumption increasing - increasing rGDP even more	Debt still feels more burdensome as the value of any debt is worth more
Firms Gain Confidence	Exports
Rising output and falling costs of production cause firms to gain confidence and increase investment, thereby increasing rGDP	Persistently falling prices boost international competitiveness and exports increase

Exam Tip

Understanding the cause of deflation is vital to analysing the consequences of the deflation.

Falling prices caused by a recession are not good for an economy. In this scenario, national output is falling which means that fewer workers will be required to produce goods/services so unemployment will increase.

Falling prices caused by an increase in supply are good for an economy. In this scenario, national output is rising which means that more workers will be required to produce goods/services so unemployment will decrease.

The Relative Costs of Unemployment Versus Inflation

Generally, there is an inverse relationship between inflation and unemployment
- When inflation increases unemployment decreases and vice versa
Each situation has consequences for the economy and governments try to limit the negative consequences

The Costs of Unemployment Versus Inflation

Unemployment

Inflation

Personal costs such as depression, suicide, marital failure, stress
Economic costs such as inefficient use of resources, increased benefit payments, less tax revenue
Social costs such as increased homelessness, vandalism, anti-social behaviour

Decrease in purchasing power leads to a worse standard of living
Reduction in the international competitiveness of exports which may be decreased AD
Loss of worker productivity when any wage increases do not equal the rate of inflation
Creates an uncertain environment which may prevent firms from investing
Erodes the real value of savings with the biggest impact on low income households and households on a fixed income (such as pensioners)

Exam Tip

When analysing inflation in data response questions, or evaluating it in longer essay questions, make certain that you consider the size of any inflation. Low Inflation is not bad but is actually a sign of a healthy economy as it is indicative of economic growth.

SL IB Economics

Revision Notes

3.3.4 Low & Stable Rate of Inflation

An Introduction to Inflation

Worked Example

Measuring Inflation Using the Consumer Price Index (CPI)

The Consumer Price Index (CPI)

Worked Example

The Limitations of Using the CPI

The Causes of Inflation

1. Demand Pull Inflation

Diagram Analysis

2. Cost Push Inflation

Diagram Analysis

The Costs of Inflation

The Causes and Costs of Deflation

1. Demand-side Deflation (Bad Deflation)

Diagram Analysis

2. Supply-side Deflation

Diagram Analysis

Exam Tip

The Relative Costs of Unemployment Versus Inflation

Exam Tip

Author: Steve

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