Understanding Price Stability (Cambridge International A-Level Economics)

Inflation, deflation and disinflation

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

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

  • Deflation is a negative rate of inflation, not simply a slowing rate

• Disinflation occurs when the average price level increases but at a decreasing rate than before

  • These figures demonstrate disinflation: Y1 = 5% Y2 = 4% Y3 = 2%

UK inflation, disinflation and deflation

Between 2013 and 2015, the UK experienced disinflation, with inflation falling from 3.5% to just on 0%. From 2021, it experienced sustained inflation, rising to 4.2%

The distinction between nominal and real data

• Nominal values are measured in current prices

  • They make no adjustment for inflation and therefore reflect both changes in the volume of output and changes in the price level

• Real values are adjusted for inflation using a price index

  • They strip out the effect of price changes and reflect only changes in the actual volume of goods and services

• The distinction matters because nominal figures can be misleading - a rise in nominal wages does not mean workers are better off if prices have risen by the same amount or more

  • A worker whose nominal wage rises by 3% when inflation is 5% has experienced a fall in real wages of approximately 2%
  • Real wages measure purchasing power - what the wage can actually buy

• Converting nominal to real values can be done using the following formula:

$\mathrm{Real} \mathrm{value}=\frac{\mathrm{Nominal} \mathrm{value}}{\mathrm{Price} \mathrm{index}}x100$

Worked Example Calculate real GDP if nominal GDP is $550 billion and the price index is 110

Step 1 - Substitute values into the formula

$\text{Real} \text{GDP} = \frac{Nominal GDP}{Price index} \mathrm{x} 100

\text{Real} \text{GDP} = \frac{550}{110} \mathrm{x} 100

\text{Real} \text{GDP} = $ 500 \text{bn}$

Causes of inflation

• An increase in the average prices in an economy can be caused by demand pull inflation or cost push inflation

1. Demand pull inflation

• Demand pull inflation is caused by excess demand in the economy

• Aggregate demand (AD) is the sum of all expenditure in the economy

  • AD = Consumption (C) + Investment (I) + Government spending (G) + Net Exports (X-M)

*An increase in aggregate demand (AD) raises the average price level in an economy *

Diagram analysis

• If any of the four components of AD increase, there will be a shift to the right of the AD curve from AD₁ → AD₂

• At the original price (AP₁), there is now a condition of **excess demand **in the economy (extend the dotted line across until it hits the new demand curve to identify the excess demand)

• Prices for goods/services are bid up from AP₁ → AP₂

• Demand pull inflation has occurred

• If the Central Bank lowers the base rate, there is likely to be increased** borrowing** by firms and consumers

  • Lower interest rates - lower cost of borrowing - higher consumption and investment - AD shifts right - demand-pull inflation

    • This will result in an increase in consumption and investment

2. Cost push inflation

• Cost push inflation is caused by increases in the costs of production in an economy

*An increase in the costs of production raises the average price level in an economy, leading to cost push inflation *

Diagram analysis

• If any of the costs of production increase (labour, raw materials etc.), or if there is a fall in productivity, there will be a shift to the left of the SRAS curve from SRAS₁→SRAS₂
• At the original price (AP1), there is now a condition of excess demand in the economy
• As prices rise, there is a contraction of AD and an extension of SRAS
• Prices for goods/services are bid up from AP₁→AP₂
• Cost push inflation has occurred

Exam Hint For the AD/AS diagram, always identify whether inflation is demand-pull or cost-push before drawing - the diagrams look different.

Demand-pull shows AD shifting right with both output and price level rising; cost-push shows SRAS shifting left with the price level rising but output falling. The output effect is the key distinction - demand-pull raises output while cost-push reduces it.

The consequences of inflation

Spec point — 4.6.5

• The consequences of inflation are different for different stakeholders in the economy
• The consequences are also dependent on the household level of wealth and income

The impact of inflation on different stakeholders