Inflation explained

Inflation is a sustained rise in the general price level over time. Two words in that sentence do a lot of work. Sustained means it keeps going, not one jump in one month. General means prices across the economy, not the price of one good.

How it is measured

Most countries measure it with a consumer price index. Statisticians pick a basket of goods and services that a typical household buys, check the prices every month, and weight each item by how much of the household budget it takes up. Food gets a bigger weight than cinema tickets because families spend more on it.

Two things are worth remembering about the index. It describes a typical household, so your own cost of living can rise faster or slower than the figure in the news. And the basket has to be updated, because what people buy changes.

Two more words. Deflation is on both syllabuses, and it means the price level is actually falling, so the inflation rate has gone below zero. Disinflation is an A Level term, and it means something else: the inflation rate has fallen, say from 9 per cent to 4 per cent, but prices are still rising, just more slowly.

Demand-pull inflation

This is too much spending chasing too few goods. Total demand in the economy grows faster than the economy can produce, so sellers put their prices up.

It tends to come from things like these:

• Consumers spending more, often because incomes are rising or credit is easy to get.
• Firms investing more.
• The government spending more or cutting taxes.
• Lower interest rates, which make borrowing cheaper and saving less attractive.
• Higher exports, which bring demand from abroad into the economy.

Demand-pull inflation is most likely when the economy is already near full capacity. If there are plenty of idle factories and unemployed workers, extra spending mostly raises output rather than prices.

Cost-push inflation

This one comes from the supply side. The cost of producing goods rises, firms pass the cost on, and prices go up even though demand has not changed.

Common causes:

• Wages rising faster than productivity.
• Imported raw materials or fuel getting dearer.
• A fall in the value of the currency, which makes every import cost more in local money.
• Higher indirect taxes.

Cost-push is the more painful type, because it pushes prices up and output down at the same time.

Why it matters

• People on fixed incomes lose out. If your wage or pension does not move and prices rise 10 per cent, you can buy 10 per cent less.
• Savers lose if the interest rate on their savings is below the inflation rate, because the real value of their money falls.
• Borrowers can gain, because the real value of what they owe falls.
• Firms find planning harder. If you cannot guess your costs next year, a new factory is a risk.
• Exports can suffer. If your prices rise faster than other countries' prices, your goods look dear abroad.
• There are smaller costs that add up. Firms keep having to change and reprint their prices, and people waste time moving money around to protect its value.

It is worth saying that low, steady inflation is not a disaster. Many central banks aim for something like 2 per cent rather than zero, because a little inflation makes it easier to adjust wages and keeps the economy away from deflation.

What a government can do

The right policy depends on the cause, and saying so is one of the easiest evaluation marks in the paper.

Against demand-pull inflation, the aim is to slow spending. A central bank can raise interest rates, which makes borrowing dearer and saving more attractive, so consumption and investment fall. The government can also use fiscal policy: cut its own spending, or raise direct taxes so households have less to spend.

Against cost-push inflation, those tools work badly. Raising interest rates to fight a rise in world oil prices reduces demand in an economy that is already struggling. Supply side policy fits better: training to raise productivity, help with energy costs, more competition to hold prices down, or a cut in an indirect tax.

Using this in an answer

Always name the type before you recommend anything. An answer that says raise interest rates without asking what caused the inflation in the first place will not reach the top marks.

Then think about the side effects. Higher interest rates slow inflation, but they also slow growth and can raise unemployment. Supply side policy avoids that, but it works slowly and often costs the government money. Saying which effect matters more, and why, is exactly the judgement the examiner is looking for.