Summary
Inflation is the general and sustained rise in the level of prices of goods and services in an economy over a period of time, while deflation is the general fall in the price level.
- Inflation — a rise in the average price level of goods and services. Example: The inflation rate in the UK in 2010 was 4.7%.
- Consumer Price Index (CPI) — a measure that examines the weighted average of prices of a basket of consumer goods and services. Example: CPI changes are used to assess price changes associated with the cost of living.
- Demand-pull inflation — inflation caused by an increase in aggregate demand exceeding aggregate supply. Example: Higher incomes or lower taxes can lead to demand-pull inflation.
- Cost-push inflation — inflation caused by an increase in the cost of production. Example: Higher wage rates or raw material costs can lead to cost-push inflation.
- Deflation — a fall in the average price level of goods and services. Example: CPI index below 100 indicates deflation.
- Contractionary monetary policy — a policy to reduce demand by raising interest rates. Example: Used to control inflation by discouraging spending.
- Expansionary monetary policy — a policy to increase demand by cutting interest rates. Example: Used to control deflation by encouraging spending.
Exam Tips
Key Definitions to Remember
- Inflation
- Deflation
- Consumer Price Index (CPI)
- Demand-pull inflation
- Cost-push inflation
Common Confusions
- Confusing inflation with a temporary price increase
- Misunderstanding the difference between demand-pull and cost-push inflation
Typical Exam Questions
- What is inflation? Inflation is the general and sustained rise in the level of prices of goods and services in an economy over a period of time.
- How is the Consumer Price Index (CPI) calculated? CPI is calculated by taking price changes for each item in a predetermined basket of goods and averaging them.
- What are the consequences of deflation? Deflation can lead to lower production, unemployment, and a potential recession.
What Examiners Usually Test
- Understanding of how inflation and deflation are measured
- Causes and consequences of inflation and deflation
- Policies used to control inflation and deflation