What you'll learn

• How inflation is measured using price indices, weights, and twelve-month percentage changes.
• Why inflation can be caused by demand-pull, cost-push, monetary, and expectations-based pressures.
• How to analyse the costs of inflation and evaluate policy responses.
• Why deflation can be harmless in some cases but very damaging in others.

Inflation as a macroeconomic objective

Price stability is a key macroeconomic objective. In the UK, the Bank of England has an inflation target of 2% CPI inflation, meaning prices should rise slowly and predictably rather than rapidly or erratically.

Inflation does not mean every price rises. Some prices may fall, but the average price level across a representative basket of goods and services increases.

Measuring inflation

Price indices

A price index is a number that shows how prices have changed relative to a base period. The base period is normally set equal to 100.

$$Price\; index=\frac{current\; price}{base-year\; price}\times 100$$

If an index rises from 100 to 125, the price level is 25% higher than in the base period.

Index numbers are useful because they allow economists to compare changes over time even when actual prices are in different units. The same idea can be used for house prices, wages, output, or trade volumes.

Weighted price indices

A weighted price index gives more importance to items households spend more on. This matters because a 10% rise in rent affects living costs more than a 10% rise in the price of pens.

In the Consumer Prices Index, the Office for National Statistics uses a representative “basket” of goods and services. The weights are based on typical household spending patterns.

$$Weighted\; price\; index=\frac{\sum (price\; relative\times weight)}{\sum weight}$$

Inflation is then calculated as the percentage change in the index, usually over twelve months:

$$Inflation\; rate=\frac{index\; this\; year-index\; last\; year}{index\; last\; year}\times 100$$

Main measures of inflation

The UK uses several measures, each with a slightly different purpose:

Causes of inflation

Demand-pull inflation

Demand-pull inflation occurs when aggregate demand rises faster than the economy’s productive capacity. Aggregate demand is total planned spending in the economy: consumption, investment, government spending, and net exports.

It can be caused by rising consumer confidence, tax cuts, low interest rates, higher government spending, export growth, or a credit boom. If the economy is close to full capacity, firms cannot easily increase output, so prices rise instead.

Demand-pull inflation is shown by a rightward shift of AD. Cost-push inflation is shown by a leftward shift of SRAS, raising the price level while reducing real GDP.

Cost-push inflation

Cost-push inflation occurs when firms’ costs of production rise, causing short-run aggregate supply to fall. Firms pass higher costs on to consumers through higher prices.

Examples include:

• higher oil and gas prices, as seen during the global energy shock after Russia’s invasion of Ukraine
• wage increases above productivity growth
• a depreciation of the pound, making imported raw materials more expensive
• supply-chain disruption, such as during the pandemic
• higher indirect taxes, such as VAT or fuel duty

Cost-push inflation is harder for policy makers because reducing AD may lower inflation but also increase unemployment.

Expectations and the wage-price spiral

Inflation expectations are beliefs about future inflation. If workers expect prices to rise, they may demand higher wages. If firms expect higher wage bills, they may raise prices. This can create a wage-price spiral, where wage rises and price rises reinforce each other.

This is why central bank credibility matters. If households and firms believe the Bank of England will return inflation to target, they are less likely to build high inflation into wage demands and contracts.

Quantity theory of money

The quantity theory of money links the money supply to nominal GDP using:

$$M\times V=P\times Y$$

where $M$ is the money supply, $V$ is the velocity of circulation, $P$ is the price level, and $Y$ is real output.

Monetarists, associated with Milton Friedman, argue that if velocity and real output are fairly stable, excessive money supply growth leads to inflation.

The theory is useful for explaining why sustained excessive money creation can be inflationary. However, it is less reliable in the short run because velocity may change, banks may not lend extra reserves, and inflation can be driven by supply shocks rather than demand.

Costs of inflation

The costs of inflation depend on:

• the rate of inflation
• whether it was anticipated or unexpected
• whether it was caused by demand-pull or cost-push factors
• how quickly wages, benefits, pensions and tax thresholds adjust

Redistributive effects

Inflation redistributes income and wealth. Borrowers may gain if the real value of their debt falls. Savers and lenders may lose if interest rates do not keep up with inflation. People on fixed incomes can suffer unless payments are index-linked.

Macroeconomic effects

High inflation can damage growth. It creates uncertainty, which may reduce investment. If UK inflation is higher than in competitor countries, UK exports may become less price competitive, worsening the current account.

Inflation may also lead the Bank of England to raise interest rates. This can reduce consumption and investment but may increase mortgage costs and create a cost-of-living squeeze for indebted households.

Efficiency effects

Inflation can distort price signals. Firms and consumers find it harder to tell whether a price has risen because demand is high, supply is scarce, or the whole price level is rising.

Other efficiency costs include menu costs, which are the costs of changing prices, and shoe-leather costs, which are the time and effort spent managing cash balances when money loses value quickly.

Policies to reduce inflation

Monetary policy

Monetary policy uses interest rates and money-supply tools to influence aggregate demand. The Bank of England can raise Bank Rate to make borrowing more expensive and saving more attractive.

Higher interest rates may reduce consumption and investment. They may also strengthen the pound, reducing import prices. However, monetary policy works with time lags and can be painful if inflation is mainly cost-push.

Fiscal policy

Fiscal policy uses government spending and taxation. The government can reduce spending or raise taxes to lower aggregate demand.

This may reduce demand-pull inflation, but it can be politically unpopular and may reduce public services or economic growth. The effect depends on the size of the multiplier and the state of the economy.

Supply-side policies

Supply-side policies aim to increase productive capacity or reduce production costs. Examples include training, infrastructure investment, planning reform, energy security, competition policy, and measures to improve labour-market flexibility.

These policies can reduce inflationary pressure without simply cutting demand. However, they often take years to work and may be expensive.

Direct controls and expectations management

Governments can use wage and price controls, but these risk shortages, black markets, and reduced incentives. They may work only as a temporary measure.

A more sustainable approach is to reduce inflation expectations through credible targets, clear central bank communication, and consistent policy.

Deflation

Deflation is different from disinflation, which means inflation is falling but remains positive. For example, inflation falling from 8% to 3% is disinflation, not deflation.

Deflation can be caused by falling aggregate demand or by rising aggregate supply. The effects are very different: demand-side deflation usually reduces output and employment, while supply-side deflation may reflect productivity improvements and higher real GDP.

Demand-side deflation

Demand-side deflation happens when AD falls. Firms face weak sales, cut prices, reduce output, and may make workers redundant.

It can create a deflationary spiral:

1. consumers expect prices to fall, so they delay spending
2. firms’ revenues fall
3. wages, profits and employment fall
4. aggregate demand falls further
5. prices continue falling

This can be very difficult to escape, especially if interest rates are already close to zero. Japan’s long period of low inflation and deflation is often used as a real-world example.

Costs of demand-side deflation

For households, deflation may increase unemployment and raise the real burden of debt. For firms, it reduces revenue and can increase bankruptcies. For governments, it lowers tax receipts while increasing welfare spending, worsening public finances.

Supply-side deflation

Supply-side deflation happens when production becomes cheaper or more efficient, shifting SRAS to the right. Prices fall, but real GDP rises.

This can be beneficial if caused by productivity growth, technological progress, cheaper energy, or more efficient global supply chains. Consumers gain from lower prices, and firms may sell more output.

The key exam judgement is therefore: deflation is not automatically bad. Its impact depends on whether it comes from weak demand or stronger supply.