0455 · 4.7Inflation

Inflation, deflation and purchasing power

0:00Imagine your weekly shopping costs more, even though you buy the same things. If your income stays unchanged, you must cut back somewhere else. Rising prices can change living standards, business decisions and the value of savings. By the end of this video, you will understand how inflation is measured, what causes it, who it affects and how governments can control it. Purchasing power is the quantity of goods and services that money can buy.

0:23When prices rise, each dollar buys less. We also need to distinguish one product’s price from the general price level, which represents prices across the economy. A shortage of strawberries can raise their price, while changes affecting many products can alter the general price level. Inflation is a sustained rise in the general price level over time. The word sustained tells us that the increase continues over a period. General refers to goods and services across the economy, although their individual prices can change differently.

0:51Some products can become cheaper while the overall price level rises. Deflation is a sustained fall in the general price level. During this process, money gains purchasing power because it buys more goods and services. Falling prices can encourage consumers to delay purchases if they expect further reductions. Weaker spending can then reduce firms’ sales, output and employment. The rate of inflation tells us how quickly the general price level rises.

1:15Suppose it falls from eight per cent to five per cent. Prices are still increasing, but their rate of increase has slowed. This is called disinflation, and the distinction matters because households still face a rising cost of living.

Measuring inflation with CPI

1:28The Consumer Prices Index, or C P I, measures changes in the prices of a representative basket of goods and services bought by consumers. A sample of households is surveyed to find out what people buy. This information helps select the basket, which includes items such as food, transport and housing services. Each item receives a weight based on its share of household spending. Food matters more to the overall index when households spend a larger proportion of their budgets on it.

1:52Prices of every item are then recorded in each period so that changes can be compared over time. A base year is chosen and its index is set at one hundred. The weighted index compares later prices with this starting point, so that bigger purchases have greater influence. For a simplified worked example, our basket contains a food purchase and a transport journey. Food accounts for sixty per cent of spending, while transport accounts for forty per cent.

2:16The food price rises from ten dollars to eleven dollars. Over the same period, a transport journey goes up from twenty dollars to twenty-four dollars, and the base-year C P I is one hundred. An item’s price index equals its current price divided by its base-year price, multiplied by one hundred. For food, eleven dollars divided by ten dollars gives one point one. Multiplying one point one by one hundred gives an index of one hundred and ten.

2:39This expresses the food price relative to its base-year value on a common scale. The transport journey uses the same formula, so both prices sit on one common scale. Its current fare of twenty-four dollars, divided by its base-year price of twenty dollars, is one point two. Once we multiply by one hundred, the transport index comes to one hundred and twenty. Transport has therefore risen proportionately more than food in this example.

3:02The weighted C P I equals the sum of each item’s index multiplied by its spending weight. For food, one hundred and ten multiplied by zero point six gives sixty-six index points. The transport figure of one hundred and twenty, weighted by zero point four, adds forty-eight index points. Together, sixty-six and forty-eight make an overall C P I of one hundred and fourteen. The inflation rate equals the change in the C P I divided by its previous value, multiplied by one hundred.

3:29The index has risen from one hundred to one hundred and fourteen. That is a change of fourteen index points. Fourteen divided by the previous value of one hundred is zero point one four. Multiplied by one hundred, that gives an inflation rate of fourteen per cent over the period. Dividing by the previous index expresses the increase relative to where prices started. Weights ensure that the calculation reflects how households allocate their spending.

3:51However, an individual family’s experience can differ from the national average because its purchases have different proportions. A household spending heavily on rapidly rising essentials can face greater pressure than the headline rate suggests.

Demand-pull and cost-push inflation

4:04Demand-pull inflation occurs when total demand grows faster than the economy’s ability to produce. Total demand is spending on goods and services across the economy. Imagine households receive higher incomes and increase their purchases, while firms are already working near full capacity. Businesses face more orders than they can readily fulfil, so prices rise. Spending can also increase because borrowing becomes cheaper, firms invest more, or the government purchases additional goods and services.

4:32The pressure depends on available production capacity. If unemployed workers and unused machinery can produce more, extra demand may mainly increase output. Price pressure becomes stronger when production cannot keep pace with spending. Cost-push inflation starts on the supply side, when rising costs of production lead firms to raise prices. More expensive oil increases fuel bills for transport firms and energy costs for manufacturers. Businesses may pass these increases on to customers to protect their profits.

4:58Because energy supports many activities, its rising cost can affect prices throughout the economy. Higher wages can also raise production costs when pay increases faster than output per worker. More expensive imported raw materials create similar pressure for firms that buy inputs from abroad. Cost-push inflation can occur alongside falling output because higher costs make production less profitable. Both causes can operate together, so identifying the main pressure helps governments choose an appropriate response.

Effects of inflation

5:26Consumers lose purchasing power when their incomes rise more slowly than prices. People on fixed incomes are especially exposed because their money receipts remain unchanged. Households with low incomes can face severe pressure when essentials become more expensive. They have less room to reduce spending without sacrificing necessities such as food or heating. Workers often demand higher wages to maintain their living standards. Real income is the quantity of goods and services that money earnings can buy.

5:52For example, a four per cent wage rise during seven per cent inflation increases money earnings while reducing real income. If higher wages raise production costs and trigger further price increases, pressure for another pay rise can follow. Savers lose purchasing power when inflation exceeds the interest rate paid on their savings. Interest is the payment for borrowing money and the reward for lending it. Suppose savings earn three per cent interest while inflation is six per cent.

6:18The balance grows in dollars, yet its buying power shrinks. Savers are better protected when the return on their money keeps pace with rising prices. For borrowers, inflation reduces the real value of an existing debt. The sum repaid buys fewer goods and services than it did when the loan was made. Borrowers therefore gain, while lenders lose purchasing power on the sum they lent. This effect is especially important when inflation is unexpected and the interest rate is fixed.

6:43A borrower with a variable-rate loan can lose if interest rates rise along with inflation. Firms face menu costs, which are the expenses of changing displayed prices. These include replacing printed menus, updating catalogues and adjusting pricing systems. High or unpredictable inflation also makes future costs and revenues harder to estimate. Greater uncertainty can discourage investment because firms become less confident about whether new projects will be profitable. Business profits depend on how selling prices change compared with costs.

7:13A firm gains when its revenue rises faster than its costs, while a business whose costs outpace its revenue sees its profit shrink. If domestic prices rise faster than those of competitors abroad, exports can become less price competitive. Lower export sales can then reduce production and employment, although currency movements also affect competitiveness. Across the economy, high inflation can redistribute purchasing power and weaken confidence. Reduced investment slows the expansion of productive capacity, while weaker export demand can limit growth.

7:43Low, stable inflation makes planning easier because future prices are more predictable. The consequences therefore depend on the rate, its predictability and whether incomes adjust alongside prices.

Policies to control inflation

7:53Contractionary fiscal policy uses lower government spending or higher taxes to reduce total demand. Reducing public purchases directly lowers spending in the economy. Higher income tax leaves households with less to spend on consumption. These changes ease demand-pull pressure, but lower spending can also reduce output and increase unemployment. The effectiveness of fiscal policy depends partly on the cause of inflation. Lower spending directly tackles demand-pull inflation, but it leaves the higher oil prices behind cost-push pressure unchanged.

8:23Decisions can take time to introduce, and reduced public expenditure may weaken important services. Governments must therefore weigh lower inflation against possible losses in employment, growth and public provision. Another route is contractionary monetary policy, which raises interest rates or restricts the money supply and credit. Higher rates make borrowing more expensive, so households may reduce purchases financed by loans. Firms can postpone investment because finance costs increase. Saving also becomes more attractive, which encourages some people to delay consumption and reduces demand-pull inflation.

8:56This approach takes time because existing spending commitments and fixed-rate loans may continue unchanged. Households and firms that rely little on borrowing may respond weakly. Higher interest payments also increase financial pressure on borrowers and can discourage business expansion. Monetary policy can reduce overall demand during cost-push inflation, but it does not directly remove the original production-cost increase. Supply-side policy aims to increase the economy’s productive capacity and improve efficiency.

9:23Training can help workers produce more, while improved transport infrastructure can lower delivery costs. Targeted subsidies can reduce firms’ production expenses, although they require government funding. Expanding reliable renewable energy can reduce exposure to imported fuel costs and support environmental sustainability. Greater productive capacity allows more demand to be met without strong price increases. Lower costs can also ease cost-push inflation, which makes supply-side measures useful for both causes. However, training, infrastructure and energy projects can take years to deliver benefits.

9:56These policies are often stronger as long-term solutions than as immediate responses to rapidly rising prices.

Exam technique and recap

10:02A common examination error concerns a falling inflation rate. A smaller positive rate still means prices are rising, only more slowly. In calculations, divide the change in the index by the previous period’s value. When judging who gains or loses, compare the inflation rate with each person’s income growth, interest return or loan terms. Cambridge command words guide the depth of your answer. A define answer gives a precise meaning, and for state you express a point in clear terms.

10:29Explain means setting out reasons, showing why or how an outcome occurs. To analyse, you examine in detail to show the relationships. Discuss calls for writing about the issue in depth, in a structured way that covers both sides. Consider this exam-style question: discuss whether higher interest rates are the best policy to control inflation. Higher interest rates raise borrowing costs. Households may reduce spending financed by credit, and firms tend to postpone investment.

10:56Lower total demand eases pressure on limited productive capacity, so demand-pull inflation can slow. However, higher interest rates do not directly reduce rising oil prices or imported raw-material costs. Weaker spending can reduce firms’ sales and increase unemployment. On balance, higher interest rates are usually the best policy when excessive demand is the main cause, because they act directly on borrowing and spending. For inflation driven by production costs, measures that improve supply are more directly targeted, although their benefits often take longer.

11:26Inflation is a sustained rise in the general price level, while deflation is a sustained fall. The C P I tracks a weighted basket, and its percentage change gives the inflation rate. Demand-pull inflation comes from spending growing faster than output, whereas cost-push pressure starts with rising production expenses. Both reduce money’s purchasing power as the general price level rises. The effects depend on whether incomes, savings returns and borrowing conditions adjust.

11:52Policies that reduce spending can control demand-pull inflation, but they can also weaken output and employment. Supply-side improvements address capacity and costs, usually over a longer period. Linking each cause to its effects, its best policy and that policy’s trade-offs gives you the reasoning examiners reward.