Inflation and deflation
Inflation is a sustained rise in the general price level of goods and services in an economy over time. It means that, on average, prices are rising.
Deflation is a sustained fall in the general price level. It means that, on average, prices are falling.
Simple idea: inflation reduces the buying power of money; deflation increases the buying power of money, but it can be harmful if caused by weak demand.
Inflation
Prices are rising. A basket that cost $100 last year may cost $108 this year.
Deflation
Prices are falling. A basket that cost $100 last year may cost $97 this year.
CPI
The Consumer Price Index measures changes in the price of a typical basket of goods and services.
1. Benign and malign deflation
Deflation is not always bad. The effect depends on why prices are falling.
| Type of deflation | Meaning | Example |
|---|---|---|
| Benign deflation | Prices fall because firms become more productive and production costs fall. This can benefit consumers because goods become cheaper. | New technology makes it cheaper to produce computers, so computer prices fall while output increases. |
| Malign deflation | Prices fall because demand in the economy is weak. Firms may cut prices because people are not buying enough. | During a recession, households spend less, firms reduce prices, output falls and unemployment rises. |
2. Measuring inflation and deflation using CPI
The Consumer Price Index (CPI) measures the average price of a basket of goods and services bought by households. The basket may include food, transport, clothing, housing costs and other common spending items.
- A base year is chosen and usually given an index value of 100.
- If the CPI rises from 100 to 108, average prices have risen by 8%.
- If the CPI falls from 100 to 97, average prices have fallen by 3%, so there is deflation.
Example: calculating CPI
| Item | Quantity in basket | Base-year price | Current-year price | Base-year cost | Current-year cost |
|---|---|---|---|---|---|
| Bread | 10 | $1.00 | $1.20 | $10 | $12 |
| Milk | 5 | $2.00 | $2.10 | $10 | $10.50 |
| Bus fares | 4 | $2.50 | $3.00 | $10 | $12 |
| Total | $30 | $34.50 |
Step-by-step:
CPI = ($34.50 ÷ $30) × 100 = 115
This means the average price of the basket has risen by 15% compared with the base year.
How to read the diagram: when the general price level rises over time, the economy experiences inflation. When the general price level falls over time, the economy experiences deflation. The important point is that inflation and deflation refer to the overall price level, not just the price of one product.
3. Causes of inflation and deflation
Demand-pull inflation occurs when total demand in the economy rises faster than total supply. Consumers, firms, government or foreign buyers want to buy more, so prices rise.
Example: if incomes rise and people buy more cars, phones and holidays, firms may raise prices because demand is strong.
Cost-push inflation occurs when production costs rise and firms pass these higher costs on to consumers through higher prices.
Example: higher oil prices increase transport and production costs, so firms increase prices.
Deflation may be caused by weak demand, lower production costs, improved technology or tight fiscal and monetary policies.
Example: if consumers reduce spending during a recession, firms may cut prices to attract buyers.
4. Consequences of inflation
| Consequence | Student-friendly explanation |
|---|---|
| Menu costs | Firms must keep changing price lists, menus, catalogues and websites. This takes time and money. |
| Lower consumer purchasing power | If prices rise faster than incomes, people can buy fewer goods and services with the same amount of money. |
| Shoe leather costs | People spend extra time and effort searching for the best prices or moving money around to protect its value. |
| Effect on savers | Savers may lose if inflation is higher than the interest rate, because the real value of their savings falls. |
| Effect on lenders | Lenders may lose because the money repaid to them may have less purchasing power than when it was lent. |
| Effect on borrowers | Borrowers may gain if inflation reduces the real value of their debt, especially when interest rates are fixed. |
5. Consequences of deflation
- Unemployment: if prices and demand fall, firms may produce less and need fewer workers.
- Bankruptcies: lower sales and falling prices can reduce business revenue, causing some firms to close.
- Negative wealth effect: if asset prices such as houses fall, people may feel poorer and spend less.
- Debt effect: deflation increases the real value of debt, making loans harder to repay.
Why malign deflation is dangerous: people may delay spending because they expect prices to fall further. Firms then sell less, reduce production, cut wages or jobs, and the economy may slow down even more.
6. Policies to control inflation and deflation
Governments and central banks can use fiscal policy, monetary policy and supply-side policies to control inflation and deflation.
| Policy | To reduce inflation | To reduce deflation |
|---|---|---|
| Fiscal policy | The government may reduce spending or increase taxes to reduce demand. | The government may increase spending or cut taxes to increase demand. |
| Monetary policy | The central bank may raise interest rates or reduce money supply to reduce borrowing and spending. | The central bank may lower interest rates or increase money supply to encourage borrowing and spending. |
| Supply-side policies | Policies such as training, investment and competition can increase output and reduce cost-push inflation. | Supply-side policies can improve productivity and confidence, helping long-term growth. |
7. Easy exam method
- Define inflation or deflation clearly.
- Explain the cause such as demand-pull, cost-push or weak demand.
- Give one example.
- Explain the effect on consumers, firms, workers, savers, borrowers or the economy.
- Suggest a policy such as fiscal, monetary or supply-side policy.
Quick revision check
- Inflation means the general price level is rising.
- Deflation means the general price level is falling.
- CPI measures changes in the price of a typical basket of goods and services.
- Demand-pull inflation comes from too much demand.
- Cost-push inflation comes from rising production costs.
- Malign deflation can be harmful because it may cause lower output, unemployment and bankruptcies.