4/18/2020 6.

1 – Price Inflation – IGCSE AID

Price Inflation

What is inflation?

Inflation is the general and sustained rise in the level of prices of goods and services in an
economy. For example, the inflation rate in UK in 2010 was 4.7%. This means that the average price
of goods and services sold in the UK rose by 4.7% during that year.

How is inflation caused?

Demand-pull inflation: Inflation caused by an increase in aggregate demand is called demand-

pull inflation. This is also defined as the increase in price due to aggregate demand exceeding
aggregate supply. Demand could rise due to higher incomes, lower taxes etc. The demand curve
will shift right, causing an extension in supply and a rise in price.

Cost-push inflation: Inflation caused by an increase in cost of production in the economy. The
cost of production could rise due to higher wage rate, higher indirect taxes, higher cost of raw
materials, higher interest on capital etc. The supply curve will shift left causing a contraction in
demand and a rise in price.

A lot of economics agree that a rise in money supply in contrast with output is the key reason for
inflation. If the GDP isn’t accelerating as much as the money supply, then there will be a higher
demand which could exceed supply leading to inflation.

The consequences of inflation:

Lower purchasing power: when the price level rises, the lesser number of goods and services
you can buy with the same amount of money. This is called a fall in the purchasing power.
Thus, inflation causes a fall in the purchasing power of money.
Exports are less internationally competitive: if the price of exports are high, its
competitiveness in international markets will fall as lower priced foreign goods will rival it.
This could lead to a current account deficit is exports lower, especially if they are price elastic.
‘Inflation causing inflation‘: during inflation, the cost of living in the economy rises as you
have to pay more for goods and services. This might cause workers to demand higher wages

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4/18/2020 6.1 – Price Inflation – IGCSE AID

increasing the cost of production. If the price of raw materials also increase, the cost of
production again increases, causing cost-push inflation.
Fixed income groups and lenders lose: a person who has a fixed income will lose as he cannot
press for higher wages during inflation. Lenders who lent money before inflation and receive
the money back during inflation will lose valuable purchasing power. The same amount of
money is now worth less (here, the people who borrowed gain purchasing power).

How is inflation measured?

Inflation is measured using an consumer price index (CPI) (or retail price index (RPI)).
The consumer price index is calculated in this way:
A selection of goods and services normally purchased by a typical family or household is
identified. The prices of these‘basket of goods and services’ will then be monitored at a number of
different retail outlets across the country. The average price of the basket in the first year or ‘base
year’ is given a value of 100.The average changes in price of these goods and services over the year
is calculated. If it rises by an average of 25%, the new index is 125%*100=125. If in the next year
there is a further average increase of 10%, the price index is 110%*125= 137.5. The average inflation
rate in the two years is thus 137.5-100= 37.5%.

Deflation

Deflation is the general fall in the price level.

Causes of deflation:

Aggregate supply exceeding aggregate demand: a shift in the supply curve to the right will
cause an extension in the demand, causing a fall in the price.
Labour productivity has risen: higher output will make for lower average costs, which could
reflect as lower prices.
Technological advance has reduced cost of production, pulling down cost-push inflation.
Demand has fallen in the economy: this could be due to a number of reasons: higher direct
taxes, higher interest rates etc.

Consequences of deflation:

Lower prices could demotivate producer and they may reduce production, resulting in
unemployment.
As demand falls and prices fall, investors will be discouraged to invest, lowering the
output/GDP.
Deflation can cause recession as demand and prices continue to fall and firms are forced to
close down as enough profits are not being made.
Tax revenue for the government will fall as economic activity and incomes falls. They might
be forced to borrow money to finance public expenditure.

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