📏 Measuring Inflation
Definitions: Inflation. Deflation.
Consumer Price Index (CPI)
The CPI is the main inflation measure. The inflation rate = percentage change in CPI over a year.
Limitations of CPI
- The basket may not reflect individual households' spending patterns.
- Quality improvements are hard to capture (a phone today vs 10 years ago).
- New products enter the market between basket updates.
- Substitution bias — consumers switch to cheaper alternatives, but the basket is fixed.
🔥 Causes of Inflation
Demand-pull inflation
AD shifts right faster than AS can keep up → excess demand pulls prices up. Common during booms, credit expansions, or loose fiscal/monetary policy.
Cost-push inflation
SRAS shifts left due to rising production costs → firms pass higher costs on to consumers. Triggered by oil price spikes, wage increases, supply chain disruptions, or currency depreciation.
Monetary inflation
Excessive growth in the money supply. The monetarist view (Milton Friedman): "Inflation is always and everywhere a monetary phenomenon." Too much money chasing the same goods → prices rise.
In an IB essay, identify the type of inflation first, then discuss appropriate policy responses. Demand-pull → contractionary demand policy. Cost-push → supply-side policies (demand-side policies make it worse!).
Memorize terms 3x faster
Smart flashcards show you cards right before you forget them. Perfect for definitions and key concepts.
Try Flashcards Free7-day free trial • No card required
💰 Costs of Inflation and Deflation
Costs of high/unpredictable inflation
- Reduced purchasing power — wages may not keep up with prices, especially for fixed-income earners.
- Uncertainty — businesses delay investment because future costs/revenues are unpredictable.
- Menu costs — firms must frequently update prices (catalogues, systems).
- Shoe-leather costs — people spend time and effort minimising cash holdings.
- Redistribution — debtors benefit (repay in cheaper money), creditors lose. Savers are penalised.
- International competitiveness — higher domestic inflation → exports more expensive → (X − M) falls.
Why deflation is dangerous
- Consumers delay purchases expecting lower prices → AD falls further (deflationary spiral).
- Real value of debt increases → borrowers struggle, banks face defaults.
- Firms cut wages and jobs as revenues fall → unemployment rises.
- Central banks struggle — interest rates can't go much below zero (the zero lower bound).
Most central banks target low, stable inflation (around 2%) — not zero. A little inflation lubricates the economy (allows real wages to adjust, reduces the risk of deflation).