Measurement of inflation using the Consumer Prices Index (CPI)

IGCSE Economics (0455) – Revision Notes

How to use these notes

• Read each unit’s Key Concepts first – these are the facts you must recall.
• Use the Diagrams & Formulas sections to practise drawing and writing the required equations.
• Answer the Quick‑Check Questions at the end of each unit to test understanding.
• For the CPI sub‑topic, work through the example and then try a similar problem on your own.

Unit 1 – The Basic Economic Problem

Key Concepts

• Scarcity: limited resources versus unlimited wants.
• Economic vs. free goods

  • Economic goods – scarce, have a price (e.g., a loaf of bread).
  • Free goods – abundant, no price (e.g., air).

• Three fundamental economic questions:

  1. What to produce?
  2. How to produce?
  3. For whom to produce?

• Factors of production and their rewards:

  • Land – rent
  • Labour – wages
  • Capital – interest
  • Entrepreneurship – profit

• Quantity and quality changes in factors:

  • More labour (quantity) → outward shift of the PPC.
  • Better‑educated labour (quality) → outward shift of the PPC.

• Opportunity cost: the value of the next best alternative fore‑gone.

Diagram – Production Possibility Curve (PPC)

Draw a PPC with “Quantity of Good A” on the x‑axis and “Quantity of Good B” on the y‑axis. Label:

• Efficient points (on the curve)
• Inefficient points (inside the curve)
• Unattainable points (outside the curve)
• Outward shift – economic growth (more resources or better quality)
• Inward shift – resource loss (e.g., natural disaster)

Quick‑Check

1. Define scarcity in one sentence.
2. Explain opportunity cost with a simple example (e.g., studying vs part‑time work).
3. What does an outward shift of the PPC represent?
4. How would an improvement in labour skills affect the PPC?

Unit 2 – Allocation of Resources

Key Concepts

• Market mechanism: interaction of demand and supply determines price and quantity.
• Equilibrium price and quantity – where the demand and supply curves intersect.
• Price‑elasticity of demand (PED) and price‑elasticity of supply (PES):

  
  \(PED = \dfrac{\%\Delta Q_d}{\%\Delta P}\)

  
  \(PES = \dfrac{\%\Delta Q_s}{\%\Delta P}\)

• Determinants of PED:

  • Availability of close substitutes
  • Proportion of income spent on the good
  • Necessity vs. luxury
  • Time horizon

• Determinants of PES:

  • Availability of inputs
  • Time horizon
  • Mobility of factors of production
  • Capacity utilisation

• Elasticity classifications:

  • Elastic (|PED| > 1)
  • Unitary (|PED| = 1)
  • Inelastic (|PED| < 1)
  • Perfectly elastic (PED = –∞) and perfectly inelastic (PED = 0)

• Price‑change analysis – how shifts in demand or supply affect equilibrium price and quantity.
• Mixed economy: coexistence of market forces and government intervention.

  • Pros: efficient allocation, innovation, social welfare.
  • Cons: possible market failures, inequality, government failure.

• Government intervention tools (price controls, taxes, subsidies, regulation, privatisation, nationalisation, quotas).
• Market failure – when the market does not allocate resources efficiently.

  • Public goods (e.g., street lighting)
  • Merit goods (e.g., vaccinations)
  • De‑merit goods (e.g., cigarettes)
  • Externalities – positive (e.g., education) and negative (e.g., pollution)

Diagrams & Formulas

• Demand‑supply diagram showing equilibrium, surplus, shortage.
• Elasticity illustration – steep (inelastic) vs flat (elastic) demand curve.
• Price‑change diagram: show a right‑ward shift of demand and resulting higher price & quantity.
• Table of government tools with brief description and example.
• Market‑failure table with real‑world examples.

Government Tools Table

Quick‑Check

1. If demand increases and supply stays constant, what happens to equilibrium price and quantity?
2. Given a PED of –0.4, is demand elastic or inelastic? Explain.
3. Identify one public good and one negative externality.
4. State two determinants of PED and two determinants of PES.
5. Give an example of a government policy that corrects a negative externality.

Unit 3 – Micro‑economic Decision‑Makers

Households

• Income sources: wages, profit, rent, interest.
• Spending decisions – consumption vs saving; marginal propensity to consume (MPC) and save (MPS).
• Labour‑market diagram (wage determination):

  • Supply of labour – upward sloping (higher wages attract more workers).
  • Demand for labour – derived from the marginal product of labour (MPL).

  Diagram: MPL curve intersecting labour supply to show equilibrium wage.

Firms

• Production function: relationship between inputs (labour, capital) and output.
• Cost curves:

  • Total Cost (TC) = Fixed Cost (FC) + Variable Cost (VC)
  • Average Total Cost (ATC) = TC ÷ Q
  • Average Variable Cost (AVC) = VC ÷ Q
  • Average Fixed Cost (AFC) = FC ÷ Q
  • Marginal Cost (MC) – change in TC for one extra unit.

• Market structures:

  Structure	Number of Sellers	Product Type	Price‑setter?
  Perfect competition	Many	Homogeneous	No
  Monopoly	One	Unique	Yes
  Monopolistic competition	Many	Differentiated	Some
  Oligopoly	Few	Either	Limited

Money & Banking

• Functions of money: medium of exchange, store of value, unit of account.
• Types of banks:

  • Commercial banks – accept deposits, grant loans to households & firms.
  • Central bank – issues currency, sets the policy interest rate, controls the money supply.

• Reserve ratio: proportion of deposits that banks must keep as reserves (e.g., 10 %).
• Money creation – the money multiplier:

  
  \( \text{Money multiplier} = \dfrac{1}{\text{Reserve ratio}} \)

• Open‑market operations – buying/selling government securities to change bank reserves.

Quick‑Check

1. Write the formula for ATC and explain what it shows.
2. Why does a monopoly set a higher price than a perfectly competitive firm?
3. Calculate the money multiplier if the reserve ratio is 10 %.
4. Distinguish between a commercial bank and a central bank.
5. State two determinants of a firm’s marginal cost.

Unit 4 – Government and the Macro‑economy

4.1 Macroeconomic Objectives

• Economic growth – increase in real GDP.
• Low unemployment – measured by the unemployment rate.
• Price stability – low and stable inflation.
• Equitable distribution of income.

4.2 Fiscal Policy

Budget balance:

• Budget deficit = G – T (spending exceeds tax revenue)
• Budget surplus = T – G (tax revenue exceeds spending)

4.3 Monetary Policy

• Primary tool: policy interest rate set by the central bank.
• Secondary tools: open‑market operations, reserve requirements, discount rate.
• Transmission mechanism:

  1. Change in interest rate.
  2. Change in borrowing & saving behaviour.
  3. Shift in aggregate demand (AD).

4.4 Supply‑side Policies

• Improving labour productivity – education, training, health.
• Infrastructure investment – roads, ports, ICT.
• Regulatory reform – deregulation, competition policy.
• Tax incentives for investment – capital allowances, reduced corporation tax.

4.5 Unemployment

• Types:

  • Frictional – short‑term job search.
  • Structural – mismatch of skills/locations.
  • Cyclical – caused by downturn in AD.

• Measurement:

  
  \( \text{Unemployment rate} = \dfrac{\text{Number unemployed}}{\text{Labour force}} \times 100\% \)

• Policy responses – active labour‑market programmes, fiscal stimulus, monetary easing.

4.6 Inflation – Causes & Consequences

• Demand‑pull inflation: AD > AS (excess demand).
• Cost‑push inflation: rising production costs (wages, raw materials) shift AS left.
• Built‑in inflation: wage‑price spiral, expectations of future price rises.
• Consequences:

  • Reduced purchasing power.
  • Menu‑costs (price‑changing costs).
  • Shoe‑leather costs (more frequent cash handling).
  • Potential interest‑rate hikes to curb inflation.

4.7 Measuring Inflation – The Consumer Prices Index (CPI)

What is the CPI?

The CPI is a statistical measure that reflects the average change over time in the prices paid by households for a fixed basket of goods and services. The index is expressed with a base year set to 100.

How is the CPI calculated?

For year t:

\( \displaystyle CPI{t}= \frac{\displaystyle\sum{i=1}^{n} P{i,t}\,Q{i,base}}{\displaystyle\sum{i=1}^{n} P{i,base}\,Q_{i,base}} \times 100 \)

• \(P_{i,t}\) = price of item i in year .
• \(P_{i,base}\) = price of item i in the base year.
• \(Q_{i,base}\) = quantity of item i in the base‑year basket (fixed).
• n = number of items in the basket.

Calculating the Inflation Rate

Percentage change between two consecutive periods:

\( \displaystyle \text{Inflation Rate}{t}= \frac{CPI{t}-CPI{t-1}}{CPI{t-1}}\times 100\% \)

Worked Example

Step 1 – Total cost of the basket

• 2020: \(100(0.80)+80(0.50)+20(5.00)=£220\)
• 2021: \(100(0.85)+80(0.55)+20(5.20)=£233\)
• 2022: \(100(0.90)+80(0.60)+20(5.50)=£248\)

Step 2 – CPI (base = 2020, CPI = 100)

• CPI₂₀₂₀ = \(\frac{£220}{£220}\times100 = 100\)
• CPI₂₀₂₁ = \(\frac{£233}{£220}\times100 \approx 106.0\)
• CPI₂₀₂₂ = \(\frac{£248}{£220}\times100 \approx 112.7\)

Step 3 – Annual inflation rates

• 2021: \(\frac{106.0-100}{100}\times100\% = 6.0\%\)
• 2022: \(\frac{112.7-106.0}{106.0}\times100\% \approx 6.3\%\)

Interpretation

1. Rising CPI: General price increase – inflation.
2. Stable CPI (≈ 100): Price stability (zero inflation).
3. Falling CPI: Deflation – overall price decline.
4. Policymakers use the magnitude of the inflation rate to decide whether to tighten or ease fiscal/monetary policy.

Limitations of the CPI

• Fixed‑basket bias: Does not reflect changes in consumer preferences or new products.
• Substitution bias: Consumers may switch to cheaper alternatives; CPI assumes they keep buying the original basket.
• Quality‑change bias: Improvements in quality raise prices without representing pure inflation.
• Coverage bias: Owner‑occupied housing costs are often excluded, yet they form a large part of expenditure.
• Regional differences: A single national CPI can mask variations across regions.

Suggested Diagram

Line graph showing CPI values for 2020‑2022 with the two annual inflation rates annotated.

Unit 5 – Economic Development

Key Indicators

• Real GDP per head – measures average income.
• Human Development Index (HDI) – combines life expectancy, education, and per‑capita income.
• Absolute poverty – people living on less than a set monetary threshold (e.g., $1.90 /day).
• Relative poverty – people earning below a certain % of median income (e.g., 60 %).

Demographic Factors

Factors Influencing Development

• Physical capital – infrastructure, machinery.
• Human capital – education, health, skills.
• Technology & innovation.
• Institutional quality – rule of law, corruption levels.
• External environment – trade openness, foreign aid, remittances.

Policies to Promote Development

Quick‑Check

1. Explain why HDI is a broader measure of development than GDP per head.
2. Give two ways in which improving human capital can raise a country’s real GDP per head.
3. Identify one supply‑side policy that could help a developing country increase productivity.
4. What is the difference between absolute and relative poverty?