Definitions of inflation and deflation

Government and the Macroeconomy – Inflation

Objective

To define inflation and deflation, explain how inflation is measured using the Consumer Price Index (CPI), and identify the main causes and consequences of inflation as required by Cambridge IGCSE Economics (0455) Section 4.7.

4.7.1 Definitions of Inflation & Deflation

Inflation

Inflation is a sustained increase in the general price level of goods and services in an economy over a period of time. It is expressed as an annual percentage change.

Deflation

Deflation is a sustained decrease in the general price level of goods and services in an economy over a period of time. It is also expressed as an annual percentage change, but the result is negative (the opposite of inflation).

4.7.2 Measurement of Inflation – Consumer Price Index (CPI)

What the CPI measures

• A weighted basket of goods and services that a typical household purchases.
• Each item in the basket is given a weight that reflects the proportion of total household expenditure it represents.
• The base year is assigned an index value of 100 (or another convenient number); all other years are expressed relative to this base.

Formula for the inflation (or deflation) rate

\[ \text{Inflation Rate} = \frac{\text{CPI}_{t} - \text{CPI}_{t-1}}{\text{CPI}_{t-1}} \times 100\% \]

A negative result indicates deflation.

Worked example (using the table below)

1. Identify the CPI for the current year (2023) and the previous year (2022).
   \(\text{CPI}_{2023}=105\), \(\text{CPI}_{2022}=100\)
2. Insert the values into the formula:

\[
\frac{105-100}{100}\times100\% = \frac{5}{100}\times100\% = 5\%
\]

3. Interpretation: The economy experienced a 5 % inflation rate in 2023.

Illustrative CPI table

Limitations of the CPI (useful for AO2 analysis)

• Coverage bias: The CPI does not include all goods and services (e.g., owner‑occupied housing in some countries).
• Substitution bias: The basket is fixed, so it does not reflect consumers switching to cheaper alternatives when relative prices change.
• Quality changes: Improvements in product quality can raise prices even when the real cost to the consumer is unchanged.
• New products: Emerging goods may be omitted for several years, under‑representing actual price movements.

4.7.3 Causes of Inflation

Demand‑pull inflation

• Occurs when aggregate demand (AD) exceeds aggregate supply (AS) at the existing price level.
• Result: upward pressure on the general price level.
• Example: After the COVID‑19 pandemic, pent‑up consumer demand combined with strong fiscal stimulus led to a surge in spending, pushing prices up.

Cost‑push inflation

• Arises from rising production costs (wages, raw materials, energy) that firms pass on to consumers.
• Result: upward pressure on the price level even if demand is unchanged.
• Example: The 2022‑2023 oil‑price shock increased transport and manufacturing costs, leading to higher consumer prices.

Other contributors (briefly)

• Imported inflation: Higher prices for imported goods—often due to exchange‑rate depreciation—raise the CPI.
• Expectations‑driven inflation: If households and firms expect prices to rise, they may demand higher wages or pre‑emptively raise prices, creating a self‑fulfilling cycle.

4.7.4 Consequences of Inflation

• Reduced purchasing power: Money buys fewer goods and services, hurting consumers on fixed incomes.
• Uncertainty for businesses: Planning and budgeting become more difficult, potentially reducing investment.
• Menu‑costs: Firms incur costs when they must change price lists, re‑tag items, or renegotiate contracts.
• Distortion of relative prices: Some prices may rise faster than others, leading to an inefficient allocation of resources.
• Impact on savers and borrowers: Inflation erodes the real value of savings but reduces the real burden of existing debt.

4.7.5 Why Precise Definitions Matter

• They help students distinguish short‑term price fluctuations from the sustained trends required by the syllabus.
• Exact wording mirrors the Cambridge specification, maximising the chance of full marks in exams.
• Understanding the measurement process enables learners to calculate inflation or deflation rates from any CPI data set.
• Clear definitions provide a solid foundation for later topics such as policy responses, inflation targeting, and the inflation‑unemployment trade‑off.