Definitions & Measurement (Cambridge International IGCSE Economics)

Inflation and Deflation

Spec point — definition of inflation and deflation

• Inflation is the sustained increase in the general price level of goods/services in an economy

  • The general price level is measured by checking the prices of a 'basket' of goods/services that an average household will purchase each month

  • This basket of goods is turned into an index and it is called the consumer price index (CPI)

  • The UK has an inflation target of 2% per annum

    • Low inflation is better than no inflation as it is a sign of economic growth

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

  • Deflation only occurs when the percentage change in prices falls below zero %

Exam Hint Remember that a reduction in the inflation rate from e.g. 5% to 3% means that prices are still rising but rising more slowly (inflation at a decreasing rate is called disinflation)

MCQ will check your understanding of decreasing inflation by asking you questions such as:

In which year are prices their highest?

Y1 Inflation = 5%

Y2 inflation = 3%

Y3 inflation = 1%

Y3 is the answer. Prices are 9% higher in Y3 than at the start of Y1 (5% + 3% + 1%)

Using the Consumer Price Index (CPI) to Measure Inflation and Deflation

Spec point — Measurement of inflation and deflation using the Consumer Prices Index (CPI).

• Inflation is the sustained increase in the general price level of goods/services in an economy

• The inflation rate is the change in general price levels in a given time period

  • The inflation rate is calculated using an index with 100 as the base year
  • If the index is 100 in year 1 and 107 in year 2 then the inflation rate is 7%

• The consumer price index (CPI) is used to measure inflation

The consumer price index (CPI)

• A 'household basket' of 700+ goods/services that an average family would purchase is compiled on an annual basis

  • A household expenditure survey is conducted to determine what goes into the basket
  • Each year, some goods/services exit the basket and new ones are added

• Goods/services in the basket are weighted based on the proportion of household spending

  • E.g. More money is spent on food than shoes, so shoes have a lower weighting in the basket

• Each month, prices for these goods/services are gathered from hundreds of locations across the country

  • These prices are averaged out

• The price x the weighting determines the final value of the good/service in the basket

  • These final values are added together to determine the price of the 'basket'

• $\mathrm{CPI}=\frac{\mathrm{Cost} \mathrm{of} \mathrm{basket} \mathrm{in} \mathrm{year}X}{\mathrm{Cost} \mathrm{of} \mathrm{basket} \mathrm{in} \mathrm{base} \mathrm{year}}x100$

• The percentage difference in CPI between the two years is the inflation rate for the period

Worked Example Using the information in the table, calculate the inflation rate for 2021 if the price of the basket in the base year (2019) was $400

Good	Price 2020	Price 2021	Weighting	Basket 2020 (Price x weighting)	Basket 2021 (Price x weighting)
Housing, water, electricity, gas	950	1200	34%	323.00	408.00
Transport	250	325	11%	27.50	35.75
Food	500	620	9%	45.00	55.80
Recreation and culture	300	340	10%	30.00	34.00
Clothing and footwear	190	210	5%	9.50	10.50
				$435.00**	**$544.05

Step 1: Calculate the CPI for 2020

$\mathrm{CPI}=\frac{\mathrm{Cost} \mathrm{of} \mathrm{basket} \mathrm{in}2020}{\mathrm{Cost} \mathrm{of} \mathrm{basket} \mathrm{in} \mathrm{base} \mathrm{year}}x100\,\,=\frac{435}{400}x100\,\,=108.75\,$

Step 2: Calculate the CPI for 2021

$\mathrm{CPI}=\frac{\mathrm{Cost} \mathrm{of} \mathrm{basket} \mathrm{in}2021}{\mathrm{Cost} \mathrm{of} \mathrm{basket} \mathrm{in} \mathrm{base} \mathrm{year}}x100\,\,=\frac{544.05}{400}x100\,\,=136.01$

Step 3: Calculate the percentage difference between the CPI for 2021 and 2020

$\text{Inflation} \text{rate} = \frac{New \text{CPI} - \text{Old} CPI}{Old CPI} \mathrm{x} 100

= \frac{136.01 - 108.75}{108.75} \mathrm{x} 100

= 25.07 %$