Measuring Inflation (Cambridge (CIE) IGCSE Economics): Revision Note

Inflation and deflation

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

  • The general price level is measured by checking the prices of a 'basket' of goods/services that an average household will purchase each month

  • This basket of goods is turned into an index and it is called the consumer price index (CPI)

  • Most economies have an inflation target of 2% per annum

    • Low inflation is better than no inflation, as it is a sign of economic growth

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

  • Deflation only occurs when the percentage change in prices falls below zero percent

Using the Consumer Price Index (CPI) to measure inflation

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

• The inflation rate is the change in general price levels in a given time period

  • The inflation rate is calculated using an index with 100 as the base year

  • If the index is 100 in year 1 and 107 in year 2 then the inflation rate is 7%

• The consumer price index (CPI) is used to measure inflation

The consumer price index (CPI)

• A 'household basket' of 700+ goods and services that an average family would purchase is compiled on an annual basis

  •  A household expenditure survey is conducted to determine what goes into the basket

  • Each year, some goods and services are removed from the basket and new ones are added

• Goods and services in the basket are weighted based on the proportion of household spending

  • E.g., more money is spent on food than shoes, so shoes have a lower weighting in the basket than food

• Each month, prices for these goods/services are gathered from hundreds of locations across the country

  • These prices are averaged out

• The price x the weighting determines the final value of the good and services in the basket

  • These final values are added together to determine the price of the 'basket'

$\mathrm{CPI}=\frac{\mathrm{Cost}\mathrm{of}\mathrm{basket}\mathrm{in}\mathrm{year}\mathrm{X}}{\mathrm{Cost}\mathrm{of}\mathrm{basket}\mathrm{in}\mathrm{base}\mathrm{year}}\mathrm{x}100$

• The percentage difference in CPI between the two years is the inflation rate for the period