Low & Stable Rate of Inflation (Edexcel IGCSE Economics)

An Introduction to Inflation

Spec point — 1.2.6d

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

  • A low & stable rate of inflation is important as it

    • Allows firms to confidently plan for future investment
    • Offers price stability to consumers

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

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

• Disinflation occurs when the average price level is still rising, but at a lower rate than before

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

    • Inflation is increasing but at a decreasing rate

Between 2011 and 2015, the UK economy mainly experiences disinflation

Graph analysis

• In the UK, a continual deviation from the target of 2% would not be considered stable

  • An inflation rate in April 2022 of 4-5% was considered to be unstable, eroding household purchasing power

• According to the CPI data, the following changes happened to the price level

  • In 2018, prices were rising at around 3%(inflation)
  • In 2019, prices were still rising but only by 1.8% (disinflation)
  • In 2021, they were still rising but by a much lower 0.5% (disinflation)
  • In 2022, prices rose at their fastest level, reaching 4.2%(inflation)

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?

A. Y1 Inflation = 5%

B. Y2 inflation = 3%

C. Y3 inflation = 1%

C is the answer, as prices are 9% higher in Y3 than at the start of Y1 (5% + 3% + 1%)

Measuring Inflation Using the Consumer Price Index (CPI)

Spec point — 2.1.1b

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

• 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)

• 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 and 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 weight in the basket

• Each month, prices for these goods and 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'

• The prices of the baskets are then used to calculate the CPI using the following formula:

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

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

Worked Example What was the rate of inflation if the consumer price index (CPI) of a country rose from 110 to 130? Round to the nearest percentage.

A. 18%

B. 15%

C. 30%

D. 25%

Step 1: CPI data is already provided so calculate the inflation rate

$\text{Percentage} \text{change} = \frac{new - old}{old} \mathrm{x} 100

= \frac{130 - 110}{110} \mathrm{x} 100

= 18.18 % $

A is the correct answer