Macroeconomics guide, Unit 2, step 3 of 23Previous step Next step

Step 3: Inflation and Price Indices

By the EconTutorials team. 11-minute read with 6 practice questions.

SyllabusAP Macro 2.4–2.5 · Cambridge 4.6 · IB 3.3

In 30 seconds

Inflation is a sustained rise in the general price level. Disinflation means prices are rising more slowly; deflation means prices are actually falling.
Inflation is measured with a weighted price index such as the CPI: $ \text{Inflation rate} = \dfrac{\text{CPI}_2 – \text{CPI}_1}{\text{CPI}_1} \times 100 $.
Demand-pull inflation raises prices and output. Cost-push inflation raises prices while output falls, which is called stagflation.
Unexpected inflation helps borrowers and hurts lenders and savers. Deflation is more dangerous than moderate inflation, which is why central banks aim for 2%, not 0%.

Video lesson coming soonA short animated lesson for this step will appear here.

What inflation means

Last year a coffee at your favourite café cost £3.00; this year it costs £3.15. One price rising is not inflation. But if your bus fare, phone contract and lunch are all creeping up month after month, your money buys less than before. That loss of purchasing power is inflation.

Key termInflation: a sustained increase in the general price level, which reduces the purchasing power of money.

Two words in that definition matter. Sustained: a one-off jump in the price of oil is not inflation unless it feeds into a continuing rise. General: inflation is about the average of all prices. If computers get cheaper while housing gets dearer, whether there is inflation depends on the weighted average.

Make sure you can tell these terms apart:

Disinflation is a fall in the rate of inflation. Prices are still rising, but more slowly. Inflation falling from 9% to 4% is disinflation.
Deflation is a sustained fall in the general price level. The inflation rate is negative.
Hyperinflation is extremely rapid inflation, conventionally above 50% per month. Money stops working as a store of value.

Common mistakeSaying “prices are falling” when inflation drops from, say, 9% to 3%. Prices are still rising, just 3% a year instead of 9%. That is disinflation. Deflation needs the inflation rate to go below zero.

Building a price index

To measure the average price level, statisticians build a price index: one number that sums up the cost of a typical basket of goods, compared with a base year in which the index is set to 100. There are three steps:

Survey households to find out what a typical household buys and in what proportions. These proportions are the weights.
Record the price of every item in the basket each month.
Work out the weighted average cost of the basket and express it relative to the base year.

Key termConsumer Price Index (CPI): a weighted price index measuring the cost of a fixed basket of goods and services bought by a typical household, set to 100 in the base year.

Weights matter: a 10% rise in rents moves the index far more than a 10% rise in newspaper prices.

\[ \text{Inflation rate} = \frac{\text{CPI}_2 – \text{CPI}_1}{\text{CPI}_1} \times 100 \qquad \text{Real value} = \frac{\text{Nominal value}}{\text{CPI} \div 100} \]

With weights, the inflation rate is the sum of (weight × price change) for every category, where the weights add up to 1.

Worked example

A household spends 30% on housing, 25% on food, 15% on transport, 10% on energy and 20% on other items. Over a year, housing prices rise 10%, food 4%, transport falls 2%, energy rises 20% and other items rise 1%. The CPI started the year at 150. Find the inflation rate and the new CPI.

Step 1$ (0.30 \times 10) + (0.25 \times 4) + (0.15 \times -2) + (0.10 \times 20) + (0.20 \times 1) $

Step 2$ = 3.0 + 1.0 – 0.3 + 2.0 + 0.2 = 5.9\% $

Step 3$ \text{New CPI} = 150 \times 1.059 = 158.85 $

Inflation is 5.9%. Housing contributes the most (3.0 points) because of its big weight, while energy contributes 2.0 points from only a 10% weight because its price jumped so much. The fall in transport prices must be subtracted.

Real wages: did your pay rise make you richer?

A pay rise only makes you better off if it beats inflation. To compare, turn money (nominal) figures into real figures using the CPI.

Worked example

A worker earned £30,000 when the CPI was 120. Three years later she earns £33,600 and the CPI is 140. Is she better or worse off?

Step 1$ \text{Pay rise} = \dfrac{33{,}600 – 30{,}000}{30{,}000} \times 100 = 12\%; \quad \text{Inflation} = \dfrac{140 – 120}{120} \times 100 = 16.67\% $

Step 2$ \text{Real pay before} = \dfrac{30{,}000}{1.20} = £25{,}000; \quad \text{Real pay after} = \dfrac{33{,}600}{1.40} = £24{,}000 $

Step 3$ \text{Change} = \dfrac{24{,}000 – 25{,}000}{25{,}000} \times 100 = -4\% $

Her pay rose 12% but prices rose 16.67%, so her real pay fell by 4%. She got a pay rise and became poorer.

Why the CPI overstates inflation

The CPI prices a fixed basket. Real shoppers do not buy a fixed basket. They react to prices, products get better, new goods appear and people change where they shop. This creates four biases, and all four push the CPI above the true rise in the cost of living:

Substitution bias. When beef gets expensive, families buy chicken. The index keeps “buying” beef, so it overstates the rise in the cost of living.
Quality bias. A 2024 car has airbags and satellite navigation that a 1994 car lacked. Part of its higher price buys a better product, not pure inflation.
New goods bias. New products, like the smartphone, enter the basket only after their steepest price falls have already happened.
Outlet bias. Shoppers move to discount stores and online sellers, paying less for the same item, but price collection has been slow to follow.

The US Boskin Commission estimated the bias at about 1.1 percentage points a year; reforms have since cut it to perhaps 0.5. Unlike the GDP deflator (Step 1), the CPI includes imports, so a jump in imported oil prices raises the CPI but not the deflator.

What causes inflation?

Inflation comes from one of two directions: too much spending, or higher costs of production. You will meet the AD–AS diagram properly in Steps 5 and 6. For now, AD is aggregate demand (total spending) and SRAS is short-run aggregate supply (total output firms are willing to produce).

Key termDemand-pull inflation: inflation caused by aggregate demand rising faster than the economy’s ability to produce, so AD shifts right and both prices and output rise.

Milton Friedman called it “too much money chasing too few goods”. Causes include fast money supply growth, government stimulus near full capacity, a credit boom and surging exports.

Key termCost-push inflation: inflation caused by rising production costs, so SRAS shifts left, prices rise and output falls.

Prices rising while output falls, together with rising unemployment, is called stagflation. Causes include oil and commodity price shocks (1973, 1979, 2022), wage rises bigger than productivity growth, a weaker currency making imports dearer, supply chain disruption and higher taxes on producers.

Exam tipThe key idea is the policy difference. Demand-pull inflation has a clear fix: raise interest rates, cool demand, and prices and output both settle. Cost-push inflation has no clean fix. Raising rates lowers inflation but deepens the recession; cutting rates supports output but keeps inflation high. Say this clearly to earn the evaluation marks.

The two can feed each other in a wage-price spiral. Workers see prices rising and demand higher wages. Firms pay more and raise prices again. Once people expect inflation to continue, their behaviour makes it continue. That is why central banks watch inflation expectations so closely.

Who gains and who loses from inflation?

If every price and income doubled overnight, nothing real would change. The costs come from prices rising unevenly and unexpectedly.

Costs of anticipated (expected) inflation are fairly small at low rates:

Shoe-leather costs: the time and effort of holding less cash and moving money around more often.
Menu costs: the cost of changing prices, such as reprinting menus and relabelling shelves.
Fiscal drag: if tax bands are fixed in money terms, inflation pushes people into higher tax bands without any real rise in income.

Costs of unanticipated (unexpected) inflation are much bigger, because it reshuffles wealth:

Borrowers gain and lenders lose. A loan at a fixed 3% while inflation runs at 8% is repaid in money worth far less. The real interest rate is roughly $ 3\% – 8\% = -5\% $.
Savers holding cash lose, and so do pensioners on fixed money incomes.
Workers on fixed pay deals lose if prices rise faster than their wages.
Price signals get blurred. Firms cannot tell whether a dearer input is genuinely scarce or just part of general inflation, so investment becomes guesswork. This is the deepest cost of high inflation.

Why deflation is worse, and why the target is 2%

Falling prices sound like good news, but central banks fear deflation more than moderate inflation, for three reasons:

Delayed spending. If a laptop will be cheaper next month, you wait. When everyone waits, demand falls, prices fall further, and the economy can spiral down.
Debt deflation. Debts are fixed in money terms. When prices and incomes fall, the real burden of debt rises, so borrowers cut spending, which pushes prices down further. Irving Fisher identified this in 1933 as the engine of the Great Depression.
The zero lower bound. Central banks fight weak demand by cutting interest rates, but rates cannot go far below zero. With 2% deflation, a 0% interest rate is a 2% real rate, which is too tight just when stimulus is needed.

Japan shows the danger: after 1990 it had on-and-off deflation for over two decades.

So most central banks target 2%, not zero. The CPI overstates inflation anyway; 2% gives a buffer, so a three-point shock leaves inflation at −1% rather than −3%; and mild inflation lets real wages fall without open pay cuts.

Practise: 6 questions

Try each one on paper first, then check the worked answer.

EasyQ1. The CPI rises from 200 to 210 over a year. Calculate the inflation rate. Show worked answer

$ \dfrac{210 – 200}{200} \times 100 = \dfrac{10}{200} \times 100 = 5\% $

EasyQ2. Name each situation: (a) inflation falls from 6% to 2%; (b) inflation falls from 2% to −1%; (c) inflation rises from 2% to 4%. Show worked answer

(a) Disinflation: prices still rise, but more slowly.
(b) Deflation: the inflation rate is negative, so the price level is falling.
(c) Rising inflation: prices are rising faster than before.

MediumQ3. Weights: food 0.4, housing 0.5, clothing 0.1. Price changes: food +5%, housing +2%, clothing −10%. The CPI was 125. Calculate the weighted inflation rate and the new CPI. Show worked answer

$ (0.4 \times 5) + (0.5 \times 2) + (0.1 \times -10) = 2.0 + 1.0 – 1.0 = 2.0\% $
New CPI $ = 125 \times 1.02 = 127.5 $

MediumQ4. A salary is $20,000 this year and the CPI is 125 (base year = 100). What is the salary worth in base-year prices? Show worked answer

$ \text{Real value} = \dfrac{20{,}000}{125 \div 100} = \dfrac{20{,}000}{1.25} = \$16{,}000 $
In base-year purchasing power, the salary is worth $16,000.

MediumQ5. A student takes a loan at a fixed 4% interest rate. Inflation unexpectedly runs at 9%. Who gains, and what is the approximate real interest rate? Show worked answer

Real interest rate $ \approx 4\% – 9\% = -5\% $.
The borrower gains: the loan is repaid in money worth much less than the money borrowed. The lender loses, because the repayments buy less than expected.

ExamQ6. A country’s CPI is: Year 1 = 100, Year 2 = 105, Year 3 = 107.1, Year 4 = 106.0. (a) Calculate the inflation rate for Years 2, 3 and 4. (b) Identify the year of disinflation and the year of deflation. (c) A saver holds $5,000 in cash from the start of Year 1 to the end of Year 4. Calculate its real value in Year 1 prices. [6 marks] Show worked answer

(a) Year 2: $ \dfrac{105 – 100}{100} \times 100 = 5\% $. Year 3: $ \dfrac{107.1 – 105}{105} \times 100 = \dfrac{2.1}{105} \times 100 = 2\% $. Year 4: $ \dfrac{106.0 – 107.1}{107.1} \times 100 = \dfrac{-1.1}{107.1} \times 100 \approx -1.03\% $. [3 marks]
(b) Year 3 is disinflation: inflation fell from 5% to 2% but stayed positive. Year 4 is deflation: the rate is negative, so the price level fell. [1 mark]
(c) The price level rose from 100 to 106.0, i.e. 6%. Real value $ = \dfrac{5{,}000}{1.06} \approx \$4{,}717 $, a loss of about $283 (about 5.7%), even though prices fell in the final year. [2 marks]

Check yourself

1. Inflation falls from 8% to 3%. This is:

Prices are still rising, just more slowly; deflation needs a negative inflation rate.

2. A sharp rise in world oil prices hits an economy. What happens to the price level and real output?

This is cost-push inflation: SRAS shifts left, causing stagflation.

3. Who gains from unexpectedly high inflation?

Borrowers repay a fixed money sum that is now worth less in real terms.

Your score: 0 out of 3

The short version

Inflation is a sustained rise in the general price level. Disinflation is slower inflation; deflation is falling prices.
The CPI is a weighted index of a fixed basket. Inflation rate = (CPI₂ − CPI₁) ÷ CPI₁ × 100, and real value = nominal ÷ (CPI ÷ 100).
The CPI overstates inflation because of substitution, quality, new goods and outlet biases.
Demand-pull inflation: AD shifts right, so prices and output rise. Cost-push inflation: SRAS shifts left, so prices rise and output falls (stagflation).
Unexpected inflation helps borrowers and hurts lenders and savers. Deflation is more dangerous, so central banks target 2%.

This guide covers the core of Chapter 21 of Economics Made Simple. For the full chapter, including the AD–AS diagrams, the Zimbabwe hyperinflation case study and 15 exam-style questions with a complete answer key, get the book.