The measurement, causes (demand-pull and cost-push), costs and control of inflation, and the causes and dangers of deflation.

What this dot point is asking

WJEC wants you to explain how inflation is measured, distinguish demand-pull from cost-push inflation, analyse the costs of inflation, and explain the causes and dangers of deflation and the policies used to control them.

The answer

Measuring inflation

The CPI weights items by how much households spend on them and tracks the price change of the basket over time. The government sets the Bank of England a symmetric 2 per cent CPI target. The CPI has limitations: it may not match any individual's spending pattern, the basket and weights must be updated as habits change, and it can mismeasure quality improvements. Disinflation is a fall in the rate of inflation (prices still rising, but more slowly), which is different from deflation (prices actually falling), a distinction the exam tests.

Causes and costs of inflation

The two causes call for different responses. Demand-pull inflation can be tackled by reducing aggregate demand (tighter fiscal or monetary policy). Cost-push inflation is harder, because reducing AD to curb it worsens output and unemployment (the stagflation problem). The costs of inflation include: erosion of the real value of incomes and savings (especially for those on fixed incomes); menu costs (changing prices) and shoe-leather costs (economising on cash); loss of international competitiveness if domestic inflation exceeds rivals'; redistribution from lenders to borrowers; and damaging uncertainty that deters investment. High and volatile inflation is therefore harmful, which is why price stability is a core objective.

Deflation: benign and malign

Malign deflation is dangerous. Falling prices lead consumers to delay purchases (expecting still-lower prices), cutting demand; the real value of debt rises (debt deflation), squeezing borrowers; real wages and real interest rates rise, raising costs and discouraging borrowing; and a self-reinforcing deflationary spiral can deepen a recession, as happened in Japan's "lost decades". Benign deflation, by contrast, occurs when prices fall because supply has risen through productivity gains and technological progress, which can reflect a healthy, more efficient economy. So deflation is not always harmful: demand-side deflation is dangerous, but supply-side deflation can be benign, a distinction central to the evaluation.

Examples in context

Example 1. The 2022 cost-push inflation surge. The sharp rise in UK inflation in 2022, driven by soaring global energy and food prices and supply-chain disruption, was largely cost-push: aggregate supply costs rose, pushing prices up while squeezing output. It posed the classic dilemma, raising interest rates to curb inflation also slowed an economy already hit by the cost shock, illustrating why cost-push inflation is so much harder to manage than demand-pull.

Example 2. Japan's deflation. Japan's prolonged deflation from the 1990s is the textbook case of malign, demand-side deflation: falling prices led households to delay spending, the real burden of debt rose, and the economy stagnated for years despite very low interest rates. It shows why central banks fear deflation as much as high inflation and why the inflation target is symmetric, with a small positive rate preferred to falling prices.

Try this

Q1. Define cost-push inflation. [2 marks]

• Cue. Inflation caused by rising costs of production (wages, raw materials, energy, import prices or indirect taxes) that shift short-run aggregate supply left and push prices up.

Q2. Explain one reason why deflation can be harmful. [3 marks]

• Cue. For example consumers delay purchases expecting lower prices (cutting demand), the real value of debt rises (debt deflation), or a deflationary spiral deepens a recession.