Understanding Price Stability (Cambridge (CIE) A Level Economics): Revision Note

Inflation, deflation and disinflation

• Inflation is the sustained increase in the average price level of goods and services in an economy  

• Deflation occurs when there is a fall in the average price level of goods and services in an economy

  • Deflation is a negative rate of inflation, not simply a slowing rate

• Disinflation occurs when the average price level increases but at a decreasing rate than before

  • These figures demonstrate disinflation:  Y1 = 5%  Y2 = 4%  Y3 = 2%

UK inflation, disinflation and deflation

The distinction between nominal and real data

• Nominal values are measured in current prices

  • They make no adjustment for inflation and therefore reflect both changes in the volume of output and changes in the price level

• Real values are adjusted for inflation using a price index

  • They strip out the effect of price changes and reflect only changes in the actual volume of goods and services

• The distinction matters because nominal figures can be misleading - a rise in nominal wages does not mean workers are better off if prices have risen by the same amount or more

  • A worker whose nominal wage rises by 3% when inflation is 5% has experienced a fall in real wages of approximately 2%

  • Real wages measure purchasing power - what the wage can actually buy

• Converting nominal to real values can be done using the following formula:

Causes of inflation

• An increase in the average prices in an economy can be caused by demand pull inflation or cost push inflation

1. Demand pull inflation

• Demand pull inflation is caused by excess demand in the economy

• Aggregate demand (AD) is the sum of all expenditure in the economy

  • AD = Consumption (C) + Investment (I) + Government spending (G) + Net Exports (X-M)

Diagram analysis

• If any of the four components of AD increase, there will be a shift to the right of the AD curve from AD₁ → AD₂

• At the original price (AP₁), there is now a condition of excess demand in the economy (extend the dotted line across until it hits the new demand curve to identify the excess demand)

• Prices for goods/services are bid up from AP₁ → AP₂

• Demand pull inflation has occurred

• If the Central Bank lowers the base rate, there is likely to be increased borrowing by firms and consumers

  • Lower interest rates - lower cost of borrowing - higher consumption and investment - AD shifts right - demand-pull inflation

    • This will result in an increase in consumption and investment

2. Cost push inflation

• Cost push inflation is caused by increases in the costs of production in an economy

Diagram analysis

• If any of the costs of production increase (labour, raw materials etc.), or if there is a fall in productivity, there will be a shift to the left of the SRAS curve from SRAS₁→SRAS₂

• At the original price (AP1), there is now a condition of excess demand in the economy

• As prices rise, there is a contraction of AD and an extension of SRAS

• Prices for goods/services are bid up from AP₁→AP₂

• Cost push inflation has occurred

The consequences of inflation

• The consequences of inflation are different for different stakeholders in the economy

• The consequences are also dependent on the household level of wealth and income

The impact of inflation on different stakeholders