INFLATION AND DEFLATION

4.8 Inflation and Deflation

Topic Guidance

4.8.1 definition of inflation and deflation

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

4.8.2 measurement of inflation and deflation Causes of inflation: demand-pull and cost-push.
Causes of deflation: demand-side and supply-side.

4.8.3 causes of inflation and deflation The consequences of inflation and deflation for
consumers, workers, savers, lenders, firms and the

4.8.4 consequences of inflation and deflation economy as a whole.

The range of policies available to control inflation
and

4.8.5 policies tocontrol inflation and deflation deflation and how effective they might be.

Compiled by Department of Economics 108

INFLATION
Inflation is a persistent and sustained rise in the general price level of goods and services in an
economy over a period of time, usually one year.

Deflation is a persistent and sustained fall in the general price level of an economy over a period
of time, usually one year. It leads to a rise in the value of money and in the purchasing power of
money.
Deflation is fall in the price level while disinflation is a fall in the rate of increase in the price
level (when prices are increasing at a decreasing rate)

Measurement of Inflation

The rate of inflation is measured through a Consumer Price Index (CPI) or Retail Prices
Index (RP1).

The steps used in the construction of the index:

• Basket of goods and services is selected on the basis of what a typical household consumes,
This is identified by conducting a household survey from a representative sample of the
population.
• A base year is selected and prices in that year are assigned an index number of 100. This year
has to be a normal year with neither exceptionally high nor low inflation due to any unforeseen
event.

The goods and services in the basket are assigned weights based on the proportion of
expenditure devoted to them, indicating their relative importance to consumers.

Compiled by Department of Economics 109

• Prices are recorded at the beginning and at the end of the period using retail survey, percentage
changes in prices of products in the basket are taken out.

• An average weighted price index is then calculated. A ‘weighted price index’ is a measure of
changes in the price level/measure of inflation which takes into account the different
proportions spent on items in a basket of goods and services.

WORKED EXAMPLE:
Year 1 (Base year)
Commodity Weight Price Index Weighted index
A 1 10p 100 100

B 2 $1.5 100 200

C 3 $5.00 100 300

6 600

600/6 Base year Index =100

Year 2
Commodity Weight Price Index Weighted index
A 1 15 p 150 150

B 2 $1.50 100 200

C 3 $ 4.5 90 270

6 620
620/6 Year 2 Index=103.3

Compiled by Department of Economics 110

RPI = Sum of weighted indices
Sum of weights

Inflation rate = RPI in year 2 – RPI in year 1 (if previous year is the base year)
= 103.3 – 100 = 3.3%

Some examples of price indices

CPI- Consumer Price Index is a measure of price changes in a vast array of consumer goods and
services, leaving the costs of one’s home out of the basket e.g. mortgage payments and rents etc.
are not included.

RPI- Retail Price Index measures a change in the basket of goods and services including
mortgage payments, rent and property tax etc.

WPI/PPI- Wholesale Price Index/Producer Price Index measures the average changes in prices
received by domestic producers for their output.

ACTIVITY
Students should research price/indices/rate of inflation in Pakistan over a 10-15 year period and
plot the figures. (Sample is provided below)

Causes of inflation and deflation

Demand-pull inflation:
Inflation caused by an increase in total demand is called demand pull inflation. Aggregate
demand in an economy will rise if spending by governments, households and/or firms increases.
An increase in AD will cause the general price level to increase and inflation to rise if firms are
unable to increase the supply of goods and services at the same rate as demand.

AD=C+I+G+(X-M) X:exports & M:imports

Compiled by Department of Economics 111

AD rises due to the following reasons:
 Balance of Payments surplus-exports are greater than imports net exports are positive).
 Budget deficit: When government spending is greater than government revenue.
 Tax reductions: Will increase disposable income hence consumer spending.
 Easy credit conditions: availability of credit (less stringent hire purchase facilities), hence
increased consumer expenditure.

As the AD curve shifts to the right from (AD1 to AD2 to AD3 to AD4), there is an increase in
the general price level(from P1–P4), accompanied by a rise output (Y1-Y3)-unless all resources
are fully employed in the economy, in that case output will not rise, only prices will

Monetary inflation:
Some economists believe that inflation is caused by excessive growth of money supply at a rate
faster than the output of goods and services in the economy. If money supply increases, people
will spend more in the economy which will lead to an increase in the general price level.

Compiled by Department of Economics 112

Cost-push inflation:
Cost-push inflation is caused by increases in the costs of production, example:
 Higher wages-wages rising faster than productivity (wage push)
 Higher raw material costs. Firms pass on higher costs in the form of higher prices to
maintain profit levels/margins (profit push).
 Higher import costs (imported inflation)
 Higher indirect taxes (tax push inflation).
 Higher interest rates increase cost of production.

As aggregate supply shifts to the left from AS-AS1, the general price level rises from P-P1 and
output/GDP falls from Y-Y1.

Compiled by Department of Economics 113

Causes of deflation

A fall in the price level could be caused by a fall in total (aggregate) demand. This may be due
to:
 A fall in consumer expenditure / rise in saving
 A fall in borrowing.
 A fall in investment due to e.g. a lack of confidence
 Spending may be delayed due to the expectation that prices may be lower in the future.
 Deflationary demand-side policy measures e.g. a rise in the rate of interest rise in direct
taxation.
 Exports may fall due to e.g. fall in incomes abroad.
 A rise in exchange rate.
 A rise in total (aggregate) supply due to advances in technology/ increased investment/
reduced costs of production/ increase in productivity/improvements in education and
training-Supply-side policies.

Compiled by Department of Economics 114

 Consequences of deflation
Policie Policies to reduce demand-pull inflation

Governments can adopt contractionary demand side policies:

 Contractionary/Deflationary Fiscal Policy: Increasing direct taxes (e.g. income tax) and
reducing government spending leading to reduced AD hence reducing inflationary pressure.
 Contractionary/Deflationary Monetary Policy: Restrictions on bank lending (increase
MRR) and raising the rate of interest, discourages borrowing and spend and encourages
savings.

Government can adopt supply-side policies:

Expanding the productive capacity and total output of an economy by:
1. Training and re-training workers to boost productivity and mobility.
2. Cutting taxes on profits, hence encouraging enterprise.
3. Financial support or tax incentives to encourage firms to invest in R & D of products
and production processes.
4. Encourage competition.

Policies to deal with Cost-push inflation:

Direct Controls: Some governments may also introduce direct controls on some prices and
wages;
 Capping the rate at which public sector wages can increase each year below the rate of
inflation or freezing them all together so they remain constant. This will reduce the real
disposable incomes and spending power of public sector workers.
 Capping the prices firms can charge in markets regulated by the government.

Contractionary Fiscal Policy: The government can reduce indirect taxes to reduce the pressure
on the prices of goods and services. It could also reduce corporation tax allowing firms to pass
this benefit on to the consumer in the shape of reduced prices.

Compiled by Department of Economics 115

 Contractionary/Deflationary Monetary Policy: Restricting the money supply, curtailing the
printing of new notes and raising the rate of interest will help in controlling monetary inflation.
Policies to control deflation

Government can adopt expansionary Monetary and Fiscal Policy in order to increase aggregate
demand.
This will cause an upward pressure on prices, hence tackling deflation in the economy

Compiled by Department of Economics 116

Question Bank
Nov 19 v23
2 (c) Analyse how lower unemployment may cause inflation. [6]
2(d) Discuss whether or not a country with high wage rates will have a high unemployment rate.
[8]
June 19 v21
1(h) Discuss whether or not a government paying higher state benefits to the unemployed will
reduce unemployment. [6]

3(b) Explain how a rise in the price of food would affect a country’s consumer prices index
(CPI). [4]

4(b) Explain two reasons why the unemployment rate may be higher in one country than another.
[4]
4(c) Analyse how supply-side policy measures may reduce unemployment. [6]

June 19 v22
3(c) Analyse how improvements in education can affect the pattern of employment. [6]
5(d) Discuss whether or not firms will benefit from a fall in unemployment. [8]
6(c) Analyse how a high rate of inflation may harm the poor. [6]

NOV 18 v22
1(g) Discuss whether or not a high rate of unemployment would always cause emigration. [6]

2(c) Analyse how a high rate of inflation affects the functions of money. [6]

3(b) Explain two benefits to a government from a fall in unemployment. [4]

3(c) Analyse, using a production possibility curve (PPC) diagram, the effects of high
unemployment in a country. [6]

Compiled by Department of Economics 117

Nov18 v23
2(c) Analyse how the introduction of an indirect tax may cause unemployment. [6]
2(d) Discuss whether or not MNCs are likely to set up in countries with low unemployment. [8]

7(b) Explain how inflation may affect borrowers and savers. [4]
7(c) Analyse why it is important to a government that inflation is measured accurately. [6]

June 18 v21
3(c) Analyse how fiscal policy measures could reduce inflation. [6]

5(c) Analyse why a government may want to reduce its country’s inflation rate. [6]

June 18 v22
6(d) Discuss whether or not government policy measures to reduce unemployment will cause
inflation. [8]

Nov 17 v22
2(d) Discuss whether low unemployment in a country will encourage multinational companies
(MNCs) to set up there.

5(c) Analyse the effects of an increase in unemployment on inflation. [6]

6(c) Analyse how an increase in the rate of interest could increase unemployment. [6]

7(a) Identify two causes of inflation. [2]

June17 v22
5(a) Define Inflation [2]
5(d) Discuss whether a low inflation rate always benefits an economy. [8]
7(c) Analyse how a reduction in government spending on education could cause unemployment.
[6]

Compiled by Department of Economics 118