The CPI measures the average price of a fixed “basket” of goods and services bought by a typical household.
Formula:
CPIt = \(\displaystyle \frac{\text{Cost of basket in year }t}{\text{Cost of basket in base year}} \times 100\)
Inflation rate between two periods:
Inflation % = \(\displaystyle \frac{\text{CPI}{t} - \text{CPI}{t-1}}{\text{CPI}_{t-1}} \times 100\)
Example (base year = 2015, CPI2015=100):
Cost of basket 2015 = £500;
Cost of basket 2024 = £620;
CPI2024 = (620 ÷ 500) × 100 = 124;
Inflation 2015‑2024 = (124 ‑ 100) ÷ 100 × 100 % = 24 %.
Definition: Inflation that occurs when aggregate demand (AD) grows faster than aggregate supply (AS) at the existing price level, creating upward pressure on prices.
In the short‑run AD‑AS diagram the AD curve shifts right from AD1 to AD2 while SRAS remains unchanged. The new equilibrium is at a higher price level (P2) and a higher real GDP (Y2), representing demand‑pull inflation.
Definition: Inflation caused by a rise in production costs that shifts the short‑run aggregate supply (SRAS) curve leftward, forcing firms to raise prices.
A leftward shift of SRAS from SRAS1 to SRAS2 with AD unchanged raises the price level (P2) while output falls (Y2), producing cost‑push inflation.
| Group | Effect of Inflation | Effect of Deflation (brief) |
|---|---|---|
| Consumers | Reduced purchasing power; higher cost of living. | Prices fall, real income may rise but expectations of further falls can delay spending. |
| Savers | Real value of saved money erodes unless interest rates exceed inflation. | Real value of savings increases, encouraging hoarding. |
| Lenders | Nominal repayments are worth less; real returns fall. | Real returns rise; borrowers may struggle to repay. |
| Borrowers | Real burden of debt falls; easier to repay. | Real burden rises; risk of default increases. |
| Firms | Higher input costs can squeeze margins; may pass costs to customers. | Lower selling prices can reduce revenue; may cut production. |
| Government | Higher tax receipts (bracket creep) but also higher cost of public services. | Reduced tax revenue; higher real debt burden. |
| Policy Tool | Typical Action | Direct Effect on AD / SRAS | Time‑frame | Intended Outcome | Distributional / Environmental Note |
|---|---|---|---|---|---|
| Fiscal Contraction | Increase taxes or cut government spending | Shifts AD leftward | Short‑run | Reduces price‑level pressure | May be regressive (higher taxes on consumption) unless offset by targeted rebates. |
| Monetary Tightening | Raise policy interest rates; sell government securities | Reduces borrowing → lower consumption & investment → AD leftward | Short‑run (fast transmission through banking system) | Slows demand‑pull inflation | Higher rates can discourage investment in green projects unless green‑finance incentives are retained. |
| Supply‑Side Measures | Improve productivity (training, R&D, infrastructure); deregulation; encourage competition | Shifts SRAS rightward (long‑run); may also shift AD rightward if productivity boosts income | Long‑run (effects appear after months/years) | Higher output without price rise; tackles cost‑push inflation | Often environmentally positive (e.g., renewable‑energy infrastructure). |
| Environmental Taxes (e.g., carbon tax) | Tax on carbon‑intensive activities; recycle revenue to households or green R&D | Can raise short‑run production costs (leftward SRAS) but incentivise lower‑carbon output → rightward SRAS in the long‑run | Short‑run cost‑push, long‑run supply‑side benefit | Reduces cost‑push inflation from energy‑price shocks; aligns price signals with sustainability goals | Potentially regressive; revenue recycling essential to protect low‑income groups. |
| Maximum (Price) Controls | Set legal ceiling on prices of essential goods | Artificially caps price level; can create shortages (AD > SRAS) | Very short‑run | Immediate relief for consumers | Often leads to black markets; distributional impact depends on enforcement. |
| Minimum (Price) Controls | Set legal floor on prices (e.g., agricultural products) | Raises price level; can reduce excess supply | Short‑run | Support producer incomes; may curb deflationary pressure | Can increase consumer costs; may be justified for vulnerable producers. |
| Indirect Taxes (e.g., VAT increase) | Raise tax on consumption | Shifts AD leftward (higher prices reduce real consumption) | Short‑run | Helps dampen demand‑pull inflation | Regressive unless essential items are exempt or revenue is recycled. |
| Subsidies | Government payments to producers or consumers (e.g., energy subsidies) | Can shift SRAS rightward (lower production cost) or AD rightward (higher real income) | Medium‑term | Targeted relief; can counteract cost‑push effects | Fiscal cost; may be distortionary if not well‑targeted. |
| Regulation / Standards | Set safety, environmental or labour standards | May increase short‑run costs (leftward SRAS) but improve long‑run productivity and sustainability | Long‑run | Enhances quality and long‑run supply‑side capacity | Distributional impact depends on compliance costs for firms. |
| Privatisation / Nationalisation | Transfer ownership of state‑owned enterprises | Potentially improves efficiency → rightward SRAS; privatisation can raise short‑run prices (leftward SRAS) if monopoly power emerges | Medium‑ to long‑run | Increase productivity and competition | Revenue from privatisation can be used for redistribution; nationalisation may protect jobs. |
| Quotas (Import/Export) | Limit quantity of a good that can be imported or exported | Restricts supply → leftward SRAS (import quota) or protects domestic producers → rightward SRAS (export quota) | Short‑ to medium‑run | Control specific price pressures (e.g., food inflation) | Can be protectionist; may raise prices for consumers. |
| Policy | Effectiveness in Reducing Inflation | Key Trade‑offs / Limitations | Distributional Impact | Environmental / Sustainability Considerations |
|---|---|---|---|---|
| Fiscal Contraction | Highly effective when demand is the dominant driver; quickly lowers AD. | Can increase unemployment and reduce growth; politically unpopular; may deepen recession if over‑used. | Regressive unless tax cuts are targeted at low‑income groups. | Neutral – no direct environmental effect. |
| Monetary Tightening | Effective for moderate demand‑pull inflation; interest‑rate changes transmit quickly through the banking system. | Higher borrowing costs can depress investment, house prices and may trigger a recession if rates are raised too far. | Benefits borrowers (lower real debt) but harms savers; may disadvantage small firms reliant on cheap credit. | Potentially negative for green investment unless central banks adopt “green‑leaning” policies. |
| Supply‑Side Measures | Long‑run solution; shifts SRAS right, reducing price pressure without sacrificing growth. | Time‑lag before gains materialise; requires upfront public spending and effective implementation. | Generally progressive if measures improve productivity of low‑skill sectors. | Positive – many measures (e.g., renewable‑energy infrastructure, energy‑efficiency programmes) enhance sustainability. |
| Environmental Taxes (Carbon Tax) | Can curb cost‑push inflation from energy‑price spikes and steer the economy toward lower‑carbon production. | Short‑run cost‑push effect; may be politically sensitive; needs revenue recycling to avoid regressive outcomes. | Low‑income households may bear a larger share of the tax unless compensated. | Directly supports environmental goals; aligns market incentives with climate policy. |
| Maximum (Price) Controls | Provide immediate consumer relief. | Often create shortages, black markets, and reduce incentives for producers to increase supply. | Beneficial for low‑income consumers if well‑targeted; harms producers. | Neutral – no direct environmental impact. |
| Indirect Taxes (VAT increase) | Effective at curbing demand‑pull inflation by reducing real consumption. | Regressive; can disproportionately affect low‑income households unless essentials are exempt. | Regressive unless mitigated by targeted rebates. | Neutral – can be designed to favour environmentally friendly goods. |
| Subsidies (e.g., energy subsidies) | Can offset cost‑push inflation for specific goods. | Fiscal cost; may distort market signals and lead to over‑consumption. | Often progressive if aimed at vulnerable households. | Positive when directed to clean‑energy technologies; negative if supporting fossil‑fuel use. |
Inflation is a sustained rise in the general price level, measured most commonly by the CPI. It can arise from excess demand (demand‑pull) or from rising production costs (cost‑push, including wage‑push and import‑price shocks). The consequences differ across consumers, savers, lenders, borrowers, firms and the government, and they intersect with the broader macro‑economic aims of growth, low unemployment, price stability, balance‑of‑payments equilibrium, equitable income distribution and environmental sustainability.
Governments have a toolbox that includes fiscal contraction, monetary tightening, supply‑side reforms, environmental taxes, price controls, indirect taxes, subsidies, regulation, privatisation, nationalisation and quotas. Each instrument works through the AD‑AS framework, has a characteristic time‑lag, and carries distributional and environmental trade‑offs. Effective inflation management therefore requires selecting the right mix of policies, timing them appropriately, and balancing short‑run price stability against long‑run growth, employment and sustainability objectives.
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