Inflation - Measures of Economic Performance

Inflation is one of the government's four main measures of economic performance (alongside growth, unemployment and the balance of payments). The three terms below sound similar but mean very different things — mixing them up is a classic exam error.

• Inflation is a sustained rise in the general (average) price level of goods and services in an economy over a period of time. Because prices are higher, each £1 buys less — so inflation means the value (purchasing power) of money falls.
• Deflation is a sustained fall in the general price level — i.e. a negative inflation rate. The value of money rises, but as we will see, deflation is usually a symptom of a weak economy and carries serious costs.
• Disinflation is a fall in the RATE of inflation, while inflation remains positive. Prices are still rising, just more slowly than before (e.g. inflation falling from 6% to 2%).

The key contrast is between the price level and the rate of change of the price level:

Term	What happens to prices	Inflation rate
Inflation	General price level rises	Positive (e.g. +4%)
Deflation	General price level falls	Negative (e.g. −1%)
Disinflation	Prices still rise, but more slowly	Positive but falling (e.g. 6% → 2%)

Two more useful terms:

• Hyperinflation — extremely high and usually accelerating inflation (often defined as over 50% per month), which destroys confidence in a currency (e.g. Zimbabwe, Weimar Germany).
• Creeping inflation — low, steady inflation, close to the typical 2% target many central banks aim for. A little inflation is normal and even desirable.

We cannot follow the price of every good, so inflation is measured with a price index built from a representative basket of goods and services.

Step 1 — the basket. A large survey (in the UK, the Living Costs and Food Survey) records what a typical household buys. This becomes a basket of goods — a fixed list of hundreds of items (bread, petrol, streaming subscriptions, rent, and so on) meant to represent average spending. The basket is updated each year to reflect changing habits (adding, say, electric-car charging; dropping items nobody buys any more).

Step 2 — the weights. Not every item matters equally: households spend far more on housing and transport than on, say, salt. Each item is given a weight proportional to the share of household spending it represents. A 10% rise in the price of a heavily weighted item (housing) affects the index far more than a 10% rise in a lightly weighted one.

Step 3 — the index. Prices are collected regularly and combined with the weights into a single number, the price index, set to 100 in a chosen base year. If the index is 100 in the base year and 105 a year later, prices have risen 5% on average.

Step 4 — the rate of inflation. The rate of inflation is the percentage change in the price index between two periods:

$\text{Inflation rate} = \frac{\text{Index}_{\text{new}} - \text{Index}_{\text{old}}}{\text{Index}_{\text{old}}} \times 100$

CPI vs RPI. Two indices are commonly quoted:

	CPI (Consumer Prices Index)	RPI (Retail Prices Index)
Housing costs	Excludes mortgage interest & most housing costs	Includes mortgage interest and housing costs
Population	Broad, incl. some higher-income households	Excludes highest earners & pensioner households
Maths	Uses a geometric mean	Uses an arithmetic mean
Typical value	Usually lower than RPI	Usually higher than CPI
Status	The headline / target measure	Older measure; still used for some pensions & rail fares

Because the RPI includes mortgage-interest and housing costs and uses a different average, it usually reports a slightly higher inflation figure than the CPI.

Examiners love a short weighted-index or rate-of-inflation calculation (a classic Section B question). The method is always the same.

Method for a weighted price index.

1. For each item, find its price index (price relative), usually 100 in the base year.
2. Multiply each item's index by its weight.
3. Add up the weighted figures.
4. Divide by the total weight to get the overall weighted index.

$\text{Weighted index} = \frac{\sum (\text{item index} \times \text{weight})}{\sum \text{weights}}$

Worked walkthrough. A simple three-item basket. In the base year every index is 100; in Year 1 the indices are as shown.

Item	Weight	Year-1 index	Index × weight
Food	40	110	4 400
Housing	45	108	4 860
Transport	15	102	1 530
Total	100		10 790

Weighted index (Year 1) $= \dfrac{10\,790}{100} = 107.9$.

Now the rate of inflation. Because the base-year index was 100, the inflation rate over the year is simply the % change:

$\text{Inflation rate} = \frac{107.9 - 100}{100} \times 100 = 7.9\%$

Reading between two later years. Inflation between any two periods is the % change in the index. If the index rises from 107.9 to 112.2 the following year:

$\text{Inflation rate} = \frac{112.2 - 107.9}{107.9} \times 100 = 3.98\% \approx 4.0\%$

Note this second year still shows positive inflation (prices rose ~4%) but the rate has FALLEN from 7.9% to 4.0% — that is disinflation, not deflation. Only if the index actually fell (e.g. 107.9 → 106) would we have deflation.

Inflation has two main demand/supply causes plus a monetary explanation.

1. Demand-pull inflation (excess aggregate demand). When aggregate demand (AD = C + I + G + (X − M)) rises faster than the economy can supply, buyers bid up prices: 'too much spending chasing too few goods'. On an AD/AS diagram, AD shifts right (AD → AD₁) along an upward-sloping short-run aggregate supply (SRAS) curve, raising both the price level and real output. Triggers include a consumer boom, cheap credit, tax cuts, higher government spending or rising exports.

Reading the diagram: AD shifts right from AD to AD₁ along the upward SRAS. The economy moves up the SRAS from the first equilibrium to the second, so the price level rises (PL → PL₁) and real output rises (Y → Y₁).

2. Cost-push inflation (rising costs of production). When firms' costs rise — higher wages, dearer raw materials/energy, a weaker exchange rate raising import prices, or higher taxes on production — firms pass the costs on as higher prices. On the diagram, SRAS shifts LEFT (SRAS → SRAS₁) along a given AD, so the price level rises but real output FALLS. Rising prices with falling output is the danger of stagflation.

Reading the diagram: SRAS shifts left from SRAS to SRAS₁ along the fixed AD. The economy moves up the AD curve to a new equilibrium at a higher price level (PL → PL₁) but a lower real output (Y → Y₁) — the tell-tale sign of cost-push inflation.

3. Growth of the money supply. The monetarist view (Milton Friedman) is that "inflation is always and everywhere a monetary phenomenon." If the money supply grows faster than real output, there is too much money chasing too few goods, so the general price level rises. In practice this often works through AD — more money and cheaper credit raise spending — so it can be seen as an underlying driver of demand-pull inflation.

Whether inflation is 'bad' depends on how high, how stable, whether it is anticipated, and whether it is demand-pull or cost-push. Low, stable, anticipated inflation is far less damaging than high, volatile, unexpected inflation.

Costs of (especially high/unexpected) inflation.

Affected group	Effect
Savers	If the interest rate is below the inflation rate, the real value of savings falls — money saved buys less later.
People on fixed incomes	Pensioners and workers on fixed wages see their real income fall as prices rise faster than their income.
Borrowers vs lenders	Borrowers can gain — the real value of debt is eroded — while lenders lose (redistribution from lenders to borrowers).
Firms	Face menu costs (repricing), uncertainty that discourages investment, and difficulty planning; wage demands rise.
Workers	Real wages fall unless pay keeps pace; may push for higher wages → risk of a wage–price spiral.
Government	Higher inflation can raise the cost of index-linked benefits and debt-interest, but can also erode the real value of existing debt.
International competitiveness	If domestic inflation is higher than trading partners', exports become less price-competitive and imports relatively cheaper → worsening current account (unless the exchange rate adjusts).

Two named costs to quote:

• Menu costs — the cost of changing prices (re-labelling, re-printing, updating systems).
• Shoe-leather costs — the time and effort spent searching for the best prices / moving money to protect its value when prices change quickly.

Does it depend? Yes — a key evaluation point:

• Demand-pull inflation comes with rising output and jobs, so mild demand-pull inflation can accompany a healthy, growing economy.
• Cost-push inflation comes with falling output (stagflation) — clearly more harmful.
• Anticipated inflation lets people plan (index wages, adjust interest rates); unanticipated inflation is far more damaging because it redistributes wealth arbitrarily.

The costs of DEFLATION (falling prices) are also serious — often worse.

• Deferred spending — if consumers expect prices to keep falling, they delay purchases, cutting AD and deepening the downturn.
• Rising real value of debt — with falling prices and incomes, the real burden of existing debt rises, squeezing borrowers and risking defaults.
• Falling profits and investment — firms facing falling prices cut output, investment and jobs → a deflationary spiral.
• This is why central banks target low positive inflation (≈2%), not zero — a small cushion keeps the economy away from damaging deflation.

The CPI is the best single figure we have, but it is not perfect. Examiners reward candidates who can evaluate it.

• The basket lags behind spending habits. The basket is fixed for a year and updated only annually, so it can be out of date — new products (or a switch to cheaper substitutes when prices rise) are captured late, which can overstate the inflation people actually experience.
• It ignores changes in quality. If a laptop costs the same but is far more powerful, the CPI records no price change even though buyers get more for their money — so the CPI can overstate inflation by missing quality improvements (and understate it when quality falls).
• It is only an average — not everyone's inflation rate. The basket reflects a typical household. But a low-income household spending most of its money on food and energy will face a different (often higher) personal inflation rate than the headline figure when those prices rise fastest. Non-typical groups (students, pensioners) are poorly represented.
• Sampling and coverage issues. Prices are sampled, not measured everywhere; response errors and the exclusion of some spending (e.g. the CPI excludes owner-occupier housing costs) mean it is an estimate, not an exact figure.
• Voluntary/quality-of-life factors are excluded. The index tracks prices, not living standards, so it says nothing about whether people are actually better or worse off.

Why it still matters. Despite these limits, a consistent, transparent index is essential: it lets the central bank target inflation, and it is used to index wages, pensions, benefits and tax thresholds. The limitations are reasons to interpret the number with care, not to abandon it.