What is inflation, how is it measured, and why does it matter?
The meaning and measurement of inflation using a price index, the causes of inflation (demand-pull and cost-push), and its effects on the economy.
An OCR J205 answer on inflation: how it is measured with a price index, the difference between demand-pull and cost-push inflation, and the effects of inflation on the economy.
Reviewed by: AI editorial process; not yet individually human-reviewed
Have a quick question? Jump to the Q&A page
Jump to a section
What this dot point is asking
OCR wants you to define inflation, explain how it is measured using a price index, distinguish demand-pull from cost-push inflation, and describe its effects. Price stability (low, stable inflation) is one of the four macroeconomic objectives.
What inflation is
A small, stable rate of inflation (the UK target is 2%) is normal and even helpful, but high or unpredictable inflation is a problem.
Measuring inflation with a price index
For example, if the index rises from 120 to 126, inflation is .
An index number sets a base year to 100, so a value of 110 means prices are 10% higher than in the base year. This makes comparisons over time easy.
The causes of inflation
There are two main causes:
- Demand-pull inflation. Total demand in the economy grows faster than supply can keep up, so "too much money chases too few goods" and prices are pulled up. It often happens in a boom.
- Cost-push inflation. Firms' costs rise (wages, raw materials, energy, import prices), and they raise prices to protect their profit margins, pushing the price level up. A spike in oil prices is a classic cause.
The effects of inflation
Moderate, stable inflation is manageable, but high or unstable inflation causes problems:
- Falling real incomes. If prices rise faster than wages, people can afford less; their real income falls.
- Savers lose. The real value of savings falls if interest rates are below inflation.
- Uncertainty. Firms and households find it hard to plan and invest when prices are unpredictable.
- Less competitive exports. If a country's inflation is higher than its trading partners', its exports become relatively dearer, worsening the trade balance.
Some groups can gain: borrowers benefit if the real value of their debt falls, and firms can gain if their prices rise faster than their costs.
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 103. Calculate the rate of inflation. [2 marks]
- Cue. .
Exam-style practice questions
Practice questions written in the style of OCR exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.
OCR J205/02 20204 marksA price index rises from 100 to 105 over one year. Calculate the rate of inflation and explain what the figure means.Show worked answer →
A Calculate question using an index. The rate of inflation is the percentage change in the price index: .
This means average prices rose by 5% over the year, so the purchasing power of money fell: the same money now buys about 5% fewer goods. Markers reward the correct percentage change and a clear statement that prices rose by 5%, reducing what money can buy.
OCR J205/02 20226 marksExplain the difference between demand-pull and cost-push inflation, using an example of each.Show worked answer →
A 6 mark question on the two causes of inflation.
Demand-pull inflation happens when total demand grows faster than supply, so "too much money chases too few goods" and prices are pulled up. An example is a consumer boom funded by low interest rates and rising confidence.
Cost-push inflation happens when firms' costs rise (wages, raw materials, energy) and they pass these on as higher prices. An example is a sharp rise in oil or gas prices raising costs across the economy. Markers reward a clear definition of each, the contrast between demand and costs, and a valid example of each.
Related dot points
- The government's main economic objectives (growth, low unemployment, price stability and a fair distribution of income), and why they can conflict.
An OCR J205 answer on the government's main macroeconomic objectives (economic growth, low unemployment, price stability and a fair distribution of income) and the trade-offs between them.
- The meaning of economic growth, how it is measured using GDP and GDP per capita, the determinants of growth, and the economic cycle.
An OCR J205 answer on economic growth: its meaning, how it is measured with GDP and GDP per capita, the determinants of growth, and the stages of the economic cycle.
- What monetary policy is, how the central bank uses interest rates to affect saving, borrowing, spending and investment, and the effects on growth and inflation.
An OCR J205 answer on monetary policy: how the Bank of England uses interest rates to affect saving, borrowing, spending and investment, and the effects on growth and inflation, with interest calculations.
- The difference between income and wealth, the meaning of a fair distribution, the causes of inequality and poverty, and how government can redistribute.
An OCR J205 answer on the distribution of income and wealth: the difference between the two, the causes of inequality and poverty, and how governments redistribute through tax and benefits.
- What an exchange rate is, how to convert between currencies, and how a rise or fall in the exchange rate affects exporters, importers and consumers.
An OCR J205 answer on exchange rates: what an exchange rate is, how to convert between currencies, and how an appreciation or depreciation affects exporters, importers and consumers (the SPICED and WPIDEC effects).
Sources & how we know this
- OCR GCSE (9-1) Economics J205 specification — OCR (2017)