The measurement of inflation, demand-pull and cost-push causes, the consequences of inflation and deflation, and the role of expectations.

What this dot point is asking

AQA wants you to explain how inflation is measured, distinguish demand-pull from cost-push inflation, assess the consequences of inflation and deflation, and explain the role of expectations. The demand-pull versus cost-push diagrams and the index calculation are recurring exam tasks.

Measuring inflation

The basket is updated annually to reflect changing spending habits. Deflation is a sustained fall in the price level (negative inflation); disinflation is a fall in the rate of inflation (prices still rising, but more slowly). The CPI has limitations: it can overstate inflation if it ignores quality improvements, the fixed basket lags real spending, and it is an average that may not match any one household's experience.

Demand-pull and cost-push inflation

A rapid increase in the money supply can also cause inflation, as in the monetarist view captured by the quantity theory of money, $MV = PQ$: if the money supply M grows faster than real output Q (with velocity V stable), the price level P rises. The 2021 to 2023 surge in many economies combined cost-push pressure (energy and supply-chain disruption) with demand-pull pressure (stimulus and reopening), a useful applied example.

Consequences

• Inflation. Erodes the real value of money and savings, redistributes from lenders to borrowers (the real value of debt falls), creates uncertainty that can deter investment, worsens international competitiveness if it is higher than rivals', and causes "menu" costs (changing prices) and "shoe-leather" costs (managing cash). Moderate, stable inflation is generally seen as far less harmful than high or volatile inflation.
• Deflation. Can cause consumers to delay spending (expecting lower prices), raise the real burden of debt, squeeze profits and lead to falling output and employment, a deflationary spiral. This is why central banks target a low positive rate (2 percent in the UK) rather than zero.

The role of expectations

This is why central banks try to keep expectations "anchored" near the target through credible policy and clear communication. Anchored expectations make inflation easier to control, because they prevent temporary cost shocks from becoming entrenched.