Inflation

What Inflation covers

Inflation is examined in Unit AS 2, Managing the National Economy. It covers inflation, deflation and disinflation: what the words actually mean, measuring the rate: the CPI and the RPI, working with index numbers, building a price index: the basket and the significance of weights, demand-pull and cost-push inflation, the costs and consequences of inflation and deflation and the policy response to inflation.

The 7 subtopics

Each one has its own page.

• Inflation, deflation and disinflation: what the words actually meanInflation precisely, hyperinflation and what distinguishes it from ordinary high inflation and inflation described as a fall in the value of money.Open →
• Measuring the rate: the CPI and the RPIMain steps by which the UK inflation rate is measured, base effect in inflation measurement and CPI basket kept representative of what people actually buy.Open →
• Working with index numbersTurning a price into an index, reading a weighted index, and comparing series that are measured in different units.Open →
• Building a price index: the basket and the significance of weightsWeights in a price index determined.Open →
• Demand-pull and cost-push inflationDemand-pull inflation and state the diagrammatic change that represents it, cost-push inflation and state the diagrammatic change that represents it and main causes of demand-pull inflation.Open →
• The costs and consequences of inflation and deflationInflation redistribute income between borrowers and lenders, unanticipated inflation do more damage than inflation that everyone expects and menu costs and shoe-leather costs.Open →
• The policy response to inflationContractionary fiscal policy be used against inflation, how supply-side policy can reduce inflation and interest rate described as a blunt instrument for controlling inflation.Open →

What you need to know

Answer each one before you reveal it.

Take Inflation further

The same content, four other ways.

Commonly confused

Pairs that lose marks when they are blurred together.

• The weight of a CPI category vs The price index of a category

  The weight of a CPI category: the share of household spending it absorbs, and says nothing about prices. The price index of a category: it records how the category's prices have moved.

Questions from this topic

Each one with the model answer underneath.

1. 1

   Define inflation precisely.

   Model answer

   Inflation is a sustained rise in the general level of prices in an economy over a period of time, which is the same thing as a sustained fall in the purchasing power of money. It is normally expressed as the annual percentage change in a price index. Two elements matter in the definition: the rise must be general rather than confined to particular goods, and it must be sustained rather than a one-off jump.

2. 2

   Why does the definition of inflation insist on a rise in the general price level rather than a rise in prices?

   Model answer

   At any moment some prices are rising and others are falling as relative scarcities change, and that reshuffling of relative prices is how a market economy allocates resources. Inflation is a different phenomenon: it is the whole set of prices drifting upwards together, so that money buys less of everything. A rise in the price of one good, however large, is a relative price change, and it only counts towards inflation to the extent of that good's weight in the overall index.

3. 3

   Define deflation and explain why it is not simply inflation with a minus sign in front of it.

   Model answer

   Deflation is a sustained fall in the general price level, recorded as a negative rate of change in a price index. It is not merely the mirror image of inflation because the economy responds asymmetrically. Falling prices give households a reason to postpone purchases, which reduces demand and pushes prices down further, and they raise the real value of debts because the sum owed is fixed in money terms while incomes fall. Interest rates also cannot be cut far below zero, so the main tool for stimulating demand loses its power precisely when it is needed.

4. 4

   What is disinflation, and how does it differ from deflation?

   Model answer

   Disinflation is a fall in the rate of inflation while that rate remains positive, so prices are still rising but more slowly than before. Deflation is a negative rate, meaning prices are actually falling. A move from 8 per cent to 3 per cent is disinflation and the price level is higher than it was; a move from 3 per cent to minus 1 per cent is deflation and the price level is lower than it was.

5. 5

   A price index stands at 100, then 110, then 115.5, then 113.19 in four successive years. Calculate the annual rate of change in each year and describe what is happening in words.

   Model answer

   From 100 to 110 the change is 10 divided by 100, which is 10.0 per cent inflation. From 110 to 115.5 the change is 5.5 divided by 110, which is 5.0 per cent inflation. From 115.5 to 113.19 the change is minus 2.31 divided by 115.5, which is minus 2.0 per cent, so this is deflation. In words: prices rose sharply, then continued rising but at half the previous pace, which is disinflation, and only in the final year did the price level actually fall. Even after that fall the index at 113.19 is still 13.19 per cent above where it stood in the first year.

6. 6

   The inflation rate falls from 6 per cent to 2 per cent. Has the cost of living fallen? Explain your answer.

   Model answer

   No. A positive inflation rate of 2 per cent means the general price level is still rising, just more slowly than when it was rising at 6 per cent. The cost of living is higher than it was a year earlier, not lower. It would only fall if the rate became negative, and even then it would fall from a level that earlier inflation had already raised.

What is inside Levo

Six ways to work the same material.

Inflation revision questions

What does Inflation cover in CCEA A-Level Economics?

7 subtopics: inflation, deflation and disinflation: what the words actually mean, measuring the rate: the cpi and the rpi, working with index numbers, building a price index: the basket and the significance of weights, demand-pull and cost-push inflation, the costs and consequences of inflation and deflation and the policy response to inflation. Each one has its own page with questions and model answers.

How is Inflation organised?

By the CCEA 4410 specification, subtopic by subtopic, so it matches the order you are taught it in.