2.1 Inflation: the CPI and RPI, how the index is constructed, demand-pull and cost-push causes, the role of the money supply, and the costs of inflation, deflation and disinflation.

What this dot point is asking

OCR wants you to explain how inflation is measured through the CPI (and the RPI), how the index is constructed, the causes of inflation (demand-pull, cost-push and the money supply), and the costs of inflation, deflation and disinflation.

Measuring inflation

The UK's main measure is the Consumer Prices Index (CPI). The Office for National Statistics surveys household spending to build a representative basket of goods and services, attaches weights reflecting how much households spend on each item, tracks prices monthly, and expresses the result as an index relative to a base year of 100. The inflation rate is the percentage change in the index over twelve months. The Retail Prices Index (RPI) is an older measure that includes mortgage interest and some housing costs and uses a different formula, so it usually reads higher than CPI.

Causes of inflation

• Demand-pull inflation. Excess aggregate demand, when AD rises faster than the economy's capacity to supply, bids up prices. Near full capacity, a rightward shift of AD along an upward-sloping AS curve raises both output and the price level. Causes include consumer and investment booms, fiscal stimulus and rapid credit growth.
• Cost-push inflation. Rising costs of production shift short-run aggregate supply left, raising the price level and cutting output. Causes include higher energy and commodity prices, higher wages (a wage-price spiral), higher import prices from a weaker currency, and higher indirect taxes.
• The money supply. The quantity theory of money ($MV = PQ$) holds that, in the long run, an excessive increase in the money supply relative to output raises the price level. Sustained high inflation is usually associated with rapid monetary growth.

Inflation expectations matter too: if people expect high inflation, they demand higher wages and set higher prices, which can make inflation self-fulfilling.

The costs of inflation, deflation and disinflation

Costs of inflation. It erodes the real value of savings and fixed incomes; creates menu costs (changing prices) and shoe-leather costs (managing cash); causes fiscal drag and arbitrary redistribution from lenders to borrowers; reduces international competitiveness if it exceeds rivals' inflation; and, if high and volatile, damages business confidence and investment.

Costs of deflation. Falling prices can be damaging: consumers delay purchases expecting lower prices (cutting AD), the real value of debt rises, and falling prices and wages can deepen a downturn (a deflationary spiral), as Japan experienced.

Disinflation (a falling inflation rate) is usually desirable when inflation is too high, but bringing it down can require tighter policy that slows growth and raises unemployment in the short run.

Examples in context

• The 2021 to 2023 inflation surge. UK CPI inflation peaked above 11 per cent, driven by cost-push energy and food prices plus post-pandemic demand, prompting sharp interest-rate rises.
• Japan's deflation. Years of falling or near-zero prices showed how deflation can entrench weak demand and rising real debt.
• Annual basket updates. The ONS regularly adds and removes items (recently reflecting streaming and electric-vehicle charging) to keep the CPI representative.

Try this

Q1. Distinguish between deflation and disinflation. [3 marks]

• Cue. Deflation: the price level falls (negative rate); disinflation: the inflation rate falls but prices still rise.

Q2. Explain one cost of high inflation to savers. [3 marks]

• Cue. Inflation erodes the real value of savings, so purchasing power falls unless interest exceeds inflation.