Inflation is a persistent increase in the price level.
Deflation is a persistent fall in the price level.
Disinflation is a fall in the rate of inflation. For example when the rate of inflation falls from 10% to 9%.
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Consumer Price Index – how we measure inflation
The consumer price index (CPI) measures the level of inflation.
How does the CPI work?
The CPI looks at a “basket of goods”. This is a set of goods and services that form a large part of the typical household budget.
CPI initially assigns each good a “weight”. The more spending on this good by the average household, the greater the weight.
Statisticians measure the change in price of each good compared with 12 months ago. Then, CPI calculates a weighted (geometric) average of percentage price changes for all goods and services in the basket of goods.
A 2% inflation rate means the price level is 2% higher compared to 12 months prior.
What are the advantages and disadvantages of CPI?
The advantages of CPI include:
- Makes inflation comparable across countries.
- Allows governments and central banks a measurement which they can target. For example, the Bank of England can use the CPI measure to judge whether higher interest rates are required to reduce inflation.
- Allows comparison of the price level over time in a particular country. We can tell whether goods have become more expensive, on average, compared to a year or decade ago.
But the disadvantages of CPI are:
- Inflation rates may be different for different groups or regions. For example, rich and poor may have different inflation rates, depending on how different their consumption habits are.
- New products may be slow to enter the basket of goods. Likewise, items that are barely in use by the average consumer may be more likely to remain in the CPI basket for too long.
- CPI does not account for key housing costs, such as mortgages. Particularly for countries where people tend to buy property rather than rent, the CPI seems less well suited to capturing the true inflation rate people face. The Retail Price Index, an alternative to CPI, captures more of these housing costs.
- CPI may not fully capture the substitution effect.
- If the prices of some goods rises, consumers may switch to cheaper goods, rather than continue consuming the same goods.
- But CPI assumes that the weights of these goods do not depend on the price.
- This dampens the impact of inflation on consumers, reducing the actual inflation rate consumers face.
- A “chain weighted index” captures this phenomenon.
- Quality or size changes cannot be captured. Suppose a laptop’s price rises by 10%. But its quality increases by 50%. Then the laptop would now present a better deal than previously. But CPI just sees the higher price.
3 causes of inflation
1) Demand pull inflation
One cause of inflation is rising aggregate demand. This is demand-pull inflation.
For example, a rise in consumer confidence boosts consumption. Consumption is a component of aggregate demand (AD = C + I + G + X – M), so higher consumption boosts AD.
In the diagram, AD shifts right from AD to AD1, leading to an increase in the price level from PL to PL1 which is inflation.
This creates a trade-off between economic growth and low,, stable inflation.
2) Cost-push inflation
Another cause is rising business costs, also known as cost-push inflation.
For example, high energy prices increase costs for firms. This applies especially for firms that rely on energy heavily, such as the energy intensive industries like steel and glass.
Firms will pass on some of the increase in costs to consumers in the form of higher prices, leading to inflation. The diagram shows the SRAS shifting left from SRAS to SRAS1, increasing the price level from PL to PL1. 
3) Money supply | Quantity theory of money
A third potential cause is the money supply.
The quantity theory of money starts with the equation MV = PY.
Here M is money supply, V is velocity of money (how often money changes hands in a given ), P is price level and Y is real GDP.
The theory assumes V and Y are constant. So an increase in M increases P proportionally.
For example, a doubling of the money supply M doubles the price level P.
With real output fixed, more money is chasing the same amount of goods, forcing prices up and hence leading to inflation.
Quantitative easing by the Bank of England led to the Bank of England holding £895 billion of assets at its peak. This may have contributed to higher money supply.
This depends on the assumptions of the quantity theory of money holding.
- Velocity V may not be constant. It is likely to rise in a boom and fall in a downturn. More transactions may mean money changes hands more frequently.
- Real GDP Y may not be constant. There are short-run fluctuations in output. While the classical LRAS assumes a fixed level of output in the long run, a Keynesian LRAS states the economy can exhibit low levels of output (below full employment) for sustained periods of time.
8 consequences of inflation
1) Lower real incomes if inflation exceeds nominal GDP growth. This erodes purchasing power, which may reduce consumption.
- This depends on the cause of inflation. This is more likely to occur if cause is cost-push. But if the cause of inflation is demand-pull, higher inflation may be the consequence of economic growth.
2) Savers and lenders are worse off. Borrowers are better off. Inflation reduces the value of savings relative to what they can purchase. Also inflation reduces the value of debt (and debt payments) relative to the prices of other goods.
- Depends on the response of interest rates to inflation. If the central bank raises interest rates to control higher inflation, this may benefit savers and reduce the extent to which the inflation erodes the value of savings.
- Net effect on consumers depends on the fraction of savers in the economy versus borrowers.
3) Menu costs – the costs of updating pricing information (menus) with new prices following inflation. The greater the inflation rate, the more frequently prices need updating, E.g. restaurant menus need changing. This increases business costs, reducing profits.
- But menu costs are likely a small part of business costs. Also, technology may reduce menu costs. In online e-commerce stores, prices can be updated click of a button.
4) Bring forward consumption due to higher expected future prices. If you think the price is likely to be higher in the future, it’s cheaper to consume the same good today instead. Higher expected future prices increase aggregate demand today.
5) May allow firms to cut workers wages in real terms more easily than in a zero inflation environment.
The expectations augmented Phillips curve assumes workers may suffer from money illusion, at least in the short run. This means they do not take inflation into account when negotiating for wages.
This can mean lower real income for workers but lower real costs for firms.
For example, a firm may give workers a 1% pay rise for next year. But if inflation is 3% per year, workers’ pay would be cut in real terms (by approximately but not exactly 2%). However suppose inflation is 0%.
Then the firm would have to cut workers’ both money and real wages to achieve a real wage cut. Workers are more likely to resist this.
While this can reduce workers’ real wages, this may prevent a larger rise in unemployment, for example in a recession.
6) Wage-price spiral. Workers bid up wages to account for inflation.
Assume workers realise there is inflation. Then in wage negotiations, they are likely to request wages rises go up in line with inflation. This raises wages.
As wages are a key cost for firms, firms may pass on these higher costs to consumers in the form of higher prices.
So greater inflation occurs.
7) Reduced price competitiveness of exports. Higher domestic inflation, relative to inflation abroad, reduces export demand. This can worsen the current account on the balance of payments.
8) Fiscal drag. Higher inflation may mean nominal wages rise to account for inflation. So workers may be forced into higher tax brackets, paying more tax as a result.
For example, inflation in the UK could see more people paying tax. The personal allowance, the minimum annual income that can be earnt tax-free, is being frozen and is not rising in line with inflation.
- This assumes that tax brackets are not adjusted for inflation.
6 consequences of deflation
1) Delayed consumption. If consumers believe prices will be lower in the future, they delay consumption. So they can buy the good at a cheaper price in the future. This lowers consumption and hence AD falls. This can lead to a downwards wage-price spiral (deflationary spiral).
2) Borrowers are worse off, while savers are better off. The real value of money rises – a given amount of money can purchase more goods and services. This raises the real value of debt (making debt burdens larger) and the real value of savings higher. So debt becomes more difficult to repay and savings become more valuable.
3) Demand-driven deflation can reflect a fall in aggregate demand and economic growth. Deflation, in this case, can decrease consumer, business and investor confidence if they expect this fall in growth to continue.
4) Deflation can be beneficial. If income growth occurs at a higher rate than the inflation rate, then goods and services may become more affordable.
5) Moreover, a cause of deflation may be supply-side improvements to the economy. For example, suppose the economy sees an increase in productivity due to higher education spending. This shifts the long run aggregate supply to the right. Then this lowers the price level, resulting in deflation. Yet this comes with higher economic growth. So if anything, confidence is likely to increase.
6) Deflation may improve the price competitiveness of a country’s exports. This would require that the price levels of other countries fall at a slower rate, or are rising.
Other evaluation points for inflation and deflation
The consequences of inflation or deflation depend on these factors:
- Intervention by government or the central bank may prevent the worst consequences of inflation or deflation. For example, in response to high inflation, a central bank may raise interest rates. Alternatively a government may cut government spending. Either option would reduce aggregate demand, leading to lower inflation.
- Time frame of inflation / deflation. A short period of deflation may mean consumers do not expect deflation to last. In that case, consumers are less likely to delay consumption.
- Other factors already mentioned: the cause of inflation and the share of borrowers versus savers in the economy.
- The types of goods driving inflation. For example inflation driven by necessities like energy and housing is likely to hit the leftover incomes of the poor, but not the rich. Hence inflation can raise inequality in some cases.
Related questions for inflation
What does inflation mean?
Inflation is a general increase in the price level.
When there is inflation, prices are, on average, going up.
What is cost-push inflation?
Cost-push inflation is inflation whose cause is higher business costs (reduced aggregate supply).
An example is higher energy prices. This increases business costs. Businesses then pass this cost on to consumers in the form of higher prices, in other words inflation.
What is demand-pull inflation?
Demand-pull inflation is inflation whose cause is higher aggregate demand.
For example, consider an increase in consumption due to higher consumer confidence. This would boost total (aggregate) demand in the economy, likely raising inflation.
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To read more about inflation, you can read the Bank of England’s “Monetary Policy Reports” [external link].
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