How is inflation measured, what causes it, and why is price stability a policy objective?
The measurement of inflation using price indices, the causes of inflation (demand-pull and cost-push), deflation, and the consequences of changing prices.
A focused CCEA A-Level Economics answer on inflation, covering the Consumer Prices Index and Retail Prices Index, how a price index and the inflation rate are calculated, demand-pull and cost-push causes, deflation and disinflation, and the consequences of inflation, with a worked index calculation.
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What this dot point is asking
CCEA wants you to define inflation, deflation and disinflation, explain how inflation is measured using the Consumer Prices Index and Retail Prices Index, calculate a price index and an inflation rate, explain the demand-pull and cost-push causes using AD/AS, and analyse the consequences of changing prices.
Measuring inflation
The two main UK measures are:
- Consumer Prices Index (CPI) - the official target measure used by the Bank of England; it tracks the price of a basket weighted by household spending patterns but excludes most housing costs such as mortgage interest.
- Retail Prices Index (RPI) - an older measure that includes mortgage interest and council tax, so it usually shows higher inflation; it is still used in some contracts and index-linked products.
The basket and weights are updated annually to reflect changing spending habits. Inflation tends to be understated if quality improvements are ignored and can misrepresent particular households whose spending differs from the average.
Causes of inflation
A wage-price spiral can sustain inflation: workers demand higher wages to keep pace with prices, which raises firms' costs, which raises prices again. Expectations of inflation can therefore become self-fulfilling.
Deflation and disinflation
Deflation sounds attractive but is usually harmful: consumers delay purchases expecting lower prices, demand falls, and the real burden of debt rises, which can deepen a recession. This is why the inflation target is a low positive figure, not zero.
Consequences of inflation
Inflation erodes purchasing power and the real value of savings, hurting those on fixed incomes while benefiting borrowers. If domestic inflation is above competitors', exports lose competitiveness and the current account worsens. High or volatile inflation creates uncertainty, discouraging investment, and imposes menu costs (constant re-pricing) and shoe-leather costs (economising on cash). Moderate, stable inflation, by contrast, is normal in a growing economy.
Try this
Q1. Define inflation. [2 marks]
- Cue. A sustained rise in the general price level, which reduces the purchasing power of money.
Q2. A price index rises from 100 to 105 over a year. State the rate of inflation and what it means. [2 marks]
- Cue. Inflation is 5 percent; the average price of the basket has risen by 5 percent over the year.
Q3. Using an AD/AS diagram, explain how a sharp rise in world oil prices could cause inflation. [6 marks]
- Cue. Higher energy costs raise firms' costs, shifting short-run AS left, so the price level rises while output falls (cost-push, stagflation).
Exam-style practice questions
Practice questions written in the style of CCEA exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.
CCEA AS 26 marksDistinguish between demand-pull and cost-push inflation.Show worked answer →
Worth 6 marks. Markers reward a clear definition of each, the mechanism, and ideally a diagram or example.
Demand-pull inflation: caused by excess aggregate demand. When AD rises faster than the economy can supply, especially near full capacity, prices are pulled up. On an AD/AS diagram, AD shifts right, raising the price level. It is sometimes summarised as too much money chasing too few goods.
Cost-push inflation: caused by rising costs of production, such as higher wages, raw materials or energy, or a fall in the exchange rate raising import prices. Firms pass higher costs on as higher prices. On the diagram, short-run AS shifts left, raising the price level while reducing output.
Key difference: demand-pull comes from the demand side and tends to raise output as well as prices; cost-push comes from the supply side and raises prices while lowering output (stagflation).
CCEA AS 28 marksExamine the consequences of a high and rising rate of inflation for an economy.Show worked answer →
Worth 8 marks. A strong answer covers several distinct effects and reaches a judgement.
Purchasing power and saving: inflation erodes the real value of money and of savings, hurting those on fixed incomes and savers, while benefiting borrowers whose debt shrinks in real terms.
Competitiveness: if domestic inflation is above that of trading partners, exports become less competitive and the current account can worsen.
Uncertainty and investment: high or volatile inflation creates uncertainty, discouraging investment and long-term planning, and can trigger wage-price spirals.
Menu and shoe-leather costs: firms must keep re-pricing and people economise on cash holdings.
Judgement: the costs are serious when inflation is high, volatile or above competitors' rates, which is why central banks target low and stable inflation, typically around 2 percent, rather than zero.
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Sources & how we know this
- CCEA GCE Economics specification — CCEA (2016)