Explain inflation and its measurement using the Consumer Prices Index, the causes of inflation, and its effects on consumers, savers, borrowers, firms and the wider economy.

What this dot point is asking

Inflation is one of the four macroeconomic objectives and a favourite exam topic. CCEA expects you to define inflation, explain how it is measured by the Consumer Prices Index (CPI) and how a price index works, set out the two main causes (demand-pull and cost-push), and explain the effects of inflation on different groups: consumers, savers, borrowers, firms and the economy as a whole. You also need to calculate a rate of inflation from index numbers. This is core Section 4 content with a quantitative element.

What inflation is

Inflation is a sustained rise in the general (average) level of prices over time. It does not mean every price rises, but that prices on average are going up. The key consequence is that the purchasing power of money falls: each pound buys fewer goods than before. Deflation is the opposite, a sustained fall in the general price level, and disinflation is a fall in the rate of inflation (prices still rising, but more slowly).

Measuring inflation: the Consumer Prices Index

Inflation is measured using a price index, in the UK mainly the Consumer Prices Index (CPI). The idea is to track the cost of a fixed "basket" of goods and services that a typical household buys. The basket is weighted, so goods people spend more on (such as housing or food) count for more than minor items. The cost of the basket is given an index number, set at 100 in a chosen base year, and the index in later years shows how the cost has changed.

The rate of inflation is the percentage change in the index from one year to the next.

The causes of inflation

CCEA expects you to know the two main causes.

Demand-pull inflation happens when total demand in the economy rises faster than the economy can supply. With "too much money chasing too few goods", firms respond to strong demand by raising prices. It is common in a boom, when spending, confidence and employment are high.

Cost-push inflation happens when firms' costs of production rise, for example higher wages, dearer raw materials, or a jump in energy prices. To protect their profit margins, firms pass the higher costs on as higher prices, pushing the price level up even if demand has not risen. A rise in import prices, perhaps from a weaker exchange rate, can also cause cost-push inflation.

The effects of inflation

Inflation affects different groups in different ways, and good answers consider winners and losers.

• Savers tend to lose: if prices rise faster than the interest on their savings, the real value of their money falls.
• People on fixed incomes lose, because their money buys less while prices rise.
• Borrowers can gain, because the real value of the money they repay is lower than the value they borrowed (especially if wages and prices rise but the debt is fixed).
• Firms face uncertainty: it is harder to plan, set prices and decide on investment when prices are rising fast.
• The economy can become less competitive: if UK prices rise faster than other countries', UK exports become dearer and imports cheaper, worsening the balance of payments.

Low and stable inflation is the goal because it keeps the value of money predictable; high or volatile inflation damages confidence, savings and competitiveness.

Why this matters

Inflation is one of the four objectives, a frequent calculation topic, and the main target of monetary policy, where the central bank raises interest rates to bring inflation down. It links to unemployment (the two can move in opposite directions), to personal finance (it erodes savings), and to international trade (it affects competitiveness). Examiners reward candidates who can calculate an inflation rate from an index, distinguish the two causes, and explain effects on specific groups rather than in general terms.