Inflation is a sustained rise in the general price level of goods and services in an economy over a period of time. It is expressed as the percentage change in a price index (usually the Consumer Price Index, CPI). Deflation is not required for the 2027‑29 syllabus.
If the price of the CPI basket was 120 in month 1 and rises to 126 in month 2, the inflation rate is:
$$\pi = \frac{126-120}{120}\times100\% = \frac{6}{120}\times100\% = 5\%$$Additional (extended) causes – useful for evaluation (AO3):
| Group Affected | Typical Consequence |
|---|---|
| Savers | Real value of money falls – purchasing power erodes. |
| Borrowers | Benefit if interest rates are fixed – real debt burden falls. |
| Lenders (banks) | Real returns fall unless interest rates rise. |
| Consumers | Higher living costs; may cut discretionary spending. |
| Workers | Demand higher wages (built‑in inflation) to keep up with price rises. |
| Producers/Firms | Uncertainty about input costs; may delay investment. |
| Economy as a whole | Increased uncertainty, possible overheating, and reduced international competitiveness. |
Implemented by the central bank; the quickest tool for tackling demand‑pull inflation.
Directly affects aggregate demand through the government’s budget.
Target long‑run determinants of the price level by improving productivity and competition.
Relevant for small open economies. An appreciation of the domestic currency makes imports cheaper, putting downward pressure on import‑priced inflation.
Legal limits on the rate at which prices or wages can increase. Usually employed only in extreme situations.
| Policy Tool | Typical Time‑lag to Impact | Primary Mechanism | Short‑run Effectiveness | Long‑run Effectiveness | Main Limitation |
|---|---|---|---|---|---|
| Interest‑rate increase (Monetary) | 6–12 months | Higher cost of borrowing → lower consumption & investment | High – quickly cools demand‑pull inflation | Moderate – may slow growth if kept too high | Risk of recession; less effective against cost‑push inflation |
| Open market sales (OMO) (Monetary) | 3–6 months | Liquidity withdrawn from banks → higher market rates | High – immediate effect on money supply | Moderate – depends on banks’ willingness to lend | Requires credible, independent central bank; can affect exchange rates |
| Higher reserve‑requirement ratio (Monetary) | 6–12 months | Reduces banks’ capacity to create loans | Medium – slower transmission than interest rates | Low – banks can circumvent with other funding sources | Can constrain credit for productive investment |
| Contractionary fiscal policy (Fiscal) | 12–24 months | Lower government spending or higher taxes → reduced disposable income | Medium – political decision‑making adds delay | Low – fiscal stance may be reversed; impact on debt | Political opposition; crowding‑out of private investment |
| Supply‑side reforms (Structural) | 2–5 years | Increase productive capacity & competition → lower cost‑push pressures | Low – long implementation lag | High – sustainable price stability and higher growth potential | Requires structural change; benefits are not immediate |
| Exchange‑rate appreciation (Exchange‑rate) | Immediate to 6 months | Cheaper imports reduce imported inflation | Medium – depends on openness of the economy | Low – may hurt export competitiveness and current‑account balance | Limited by capital flows; can lead to “Dutch disease” |
| Price / wage controls (Direct) | Immediate | Directly cap the rate of price or wage increase | High – short‑run impact on headline inflation | Low – often cause shortages, black markets and loss of credibility | Distorts market signals; hard to enforce over time |
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