Inflation is a sustained increase in the general price level or cost of living in an economy. The UK government targets an inflation rate of 2% as measured by the Consumer Price Index (CPI). The Bank of England sets interest rates to control inflationary pressures and meet this target. High inflation can cause problems like inequality, falling real incomes, and higher borrowing costs. Some key causes of inflation include rising costs of production, excess demand in the economy, and external factors like increases in commodity prices or a weaker currency.

1. Inflation
EdExcel AS Economics 2.1.2

2. Introduction to Inflation
Inflation is a sustained increase in the cost of living or the general
price level leading to a fall in the purchasing power of money
• The rate of inflation is measured by the annual
percentage change in consumer prices
• The UK government has set an inflation target of 2%
using the consumer prices index (CPI)
• It is the job of the Bank of England (BoE) to set
monetary policy interest rates so that inflationary
pressures are controlled and the inflation target is
reached
• A fall in inflation is not the same as a fall in prices! Only
when there is deflation will the general price level fall

3. Inflation – Some Key Terms
Consumer Price Index (CPI)
A measure of the price level in the economy based on
the prices of a collection of products designed to reflect
the consumption basket of the average consumer
Deflation
A decline in the general price level in an economy,
signified by an annual inflation rate below 0% (negative).
Disinflation
Disinflation is a fall in the rate of inflation e.g. from 5%
to 2%. Prices are still rising but at a slower rate.
Hyper-inflation
A period of very high rates of inflation, usually leading to
a loss of confidence in an economy’s currency.
Inflation rate
The annual rate of change of the average price of goods
and services.
Unit labour costs
Reflect total labour costs, including social security and
employers’ pension contributions, and including the
costs of self-employed labour, incurred in the
production of a unit of economic output.

4. CPI: How is the Rate of Inflation Calculated?
• Inflation in the UK is measured by the consumer prices index (CPI)
• A base year is selected and a family expenditure survey is carried
out – the survey covers over 40,000 households
• A representative basket of goods and services used and weights
are attached to each item - based on these items’ importance in
people’s expenditure as measured the family spending survey
• Each month government officials collect 120,000 separate price
quotations in 141 locations of around 600 products
• Weights are multiplied by price changes - the weighted price
changes are then totalled to calculate the inflation rate
At the start of each year the weights used to compile both the CPI
are updated using the latest information on household spending

5. Weights in the Consumer Prices Index (2013)
Brought into CPI in 2013
• White rum
• Continental meats
• E-readers
• Daily disposable contact
lenses
• Hot chocolate
Taken out of CPI in 2013
• Champagne
• Gas barbeques
• Pairs of soft contact lenses
• Round lettuces
The “shopping baskets‟ of items used in the
Consumer Prices Index (CPI) are reviewed
each year. Some items are taken out and
some are brought in to make sure the CPI is
up to date and representative of consumer
spending patterns

6. Category in the CPI Weights
CPI in June
2014
CPI in June 2015
Food and non-alcoholic beverages 110 143.2 140.1
Alcoholic beverages and tobacco 43 156.5 160.1
Clothing and footwear 70 83.4 82.8
Housing, water, electricity, gas and other fuels 128 154.7 155.4
Furniture, household equipment and maintenance 59 120.9 120.5
Health 25 130.0 132.0
Transport 149 137.6 135.0
Communication 31 112.5 113.7
Recreation and culture 147 102.9 101.9
Education 26 222.2 244.3
Restaurants and hotels 121 132.6 135.1
Miscellaneous goods and services 91 120.3 120.5
Overall consumer price index 1000 128.3 128.2
Weighting the Consumer Price Index in the UK

7. Limitations of the CPI as a measure of inflation
Few households are average – the published figure for inflation is
rarely the actual rate of inflation experienced by different people
1. The CPI is not fully representative - it will be inaccurate for the
‘non-typical’ household, e.g. 14% of the CPI index is devoted to
motoring costs - inapplicable for non-car owners.
2. Spending patterns: e.g. Single people have different spending
patterns from households that have one or more children
3. Changing quality of goods and services: Although the price of a
good or service may rise, this may also be accompanied by
improvements in quality / performance of the product
4. New products: The CPI is slow to respond to new products and
services – the CPI basket is changed each year but only a few
items fall out / come in

8. The UK Consumer Price Index (CPI) from 2000-2015
93.1 94.2 95.4 96.7 98
100
102.3
104.7
108.5
110.8
114.5
119.6
123
126.1
128 128
80
90
100
110
120
130
140
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
ConsumerPriceIndex(2005=100)
Text goes hereInflation is a sustained rise in the general price level e.g. as shown by the
annual change in the consumer price index.
Source: Office for National Statistics

9. 0.8%
1.2% 1.3% 1.4% 1.3%
2.1%
2.3% 2.3%
3.6%
2.2%
3.3%
4.5%
2.8%
2.6%
1.5%
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
4.5%
5.0%
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Inflationrate
CPI inflation target = 2%
Inflation Rate in the UK Economy in Recent Years
A lower inflation rate means
prices rise more slowly – this is
known as disinflation
Source: Office for National Statistics

10. CPI Inflation in the UK over the last 20 Years
The inflation rate for goods such as clothing and computing equipment has been,
on average, lower than for service such as insurance and education
-3
-2
-1
0
1
2
3
4
5
6
7
1995
JAN
1996
JAN
1997
JAN
1998
JAN
1999
JAN
2000
JAN
2001
JAN
2002
JAN
2003
JAN
2004
JAN
2005
JAN
2006
JAN
2007
JAN
2008
JAN
2009
JAN
2010
JAN
2011
JAN
2012
JAN
2013
JAN
2014
JAN
CPI all items
CPI goods
CPI services
Annual rate of change of consumer prices (%) Source: Office for National Statistics

11. UK Inflation Rates in Recent Years
Year
UK Consumer
Price Inflation
UK Whole
Economy
Average
Earnings
Halifax House
Price Inflation
Inflation in the
European
Union
Per cent Per cent Per cent Per cent
2011 4.5 2.5 -2.5 3.1
2012 2.8 1.4 -0.6 2.6
2013 2.6 1.2 4.6 1.5
2014 1.5 1.1 8.8 0.6
2015 (April) 0.1 2.7 8.6 0.3
Source: HM-Treasury Databank
The Bank of England’s target is for inflation to be 2%. The Governor of the Bank of England
must write an open letter to the Chancellor if inflation is more than one percentage point
higher or lower than this target (i.e. more than 3% or less 1%). CPI Inflation has been either
above 3% or less than 1% in 25 of 57 months since May 2010.

12. What are the Main Causes of Inflation?
Demand Pull inflation
• Caused by excess aggregate demand
• Often linked to a money and credit boom
• Economy close to full capacity (inelastic AS)
• Positive output gap (AD > potential GDP)
Cost Push Inflation
• Rising wage costs in labour market
• Increasing raw material and component
costs from domestic and overseas suppliers
• Rising import prices due to a falling
exchange rate – this increases import costs
Administered Prices
• Changes in regulated prices e.g. water bills
• Changes in indirect taxes and subsidies
• Changes in environmental taxes
Inflation Expectations
Once inflation becomes
established in an economy it
can be difficult to remove.
Most agents in the economy
(e.g. workers, businesses and
lenders) will raise their
inflation expectations and
build it into their calculations
and decisions
A rise in inflation can lead to
an increase in inflation
expectations. This can then
feed through to higher wage
claims and rising costs

13. Some factors affecting inflationary pressures
Rising property
prices
Increased
consumer wealth
Demand pull
inflation risk
Increasing
world oil prices
Higher costs
for businesses
Cost-push
inflation risk
Depreciating
exchange rate
Increased import
prices + rising
exports
Cost-push and
Demand pull
inflation risk
Rapid expansion
of money and
credit from banks
Rising consumer
spending financed
by loans
Demand pull
inflation risk

14. Cost-Push Inflation using AD-AS Diagram
GPL
Real GDP
GPL1
AS1
Y1
AD
AS2
Y2
GPL2
Cost-push inflation occurs
when firms respond to rising
costs by increasing their prices
to protect profit margins
Can be caused by:
1. Rising unit labour costs
2. Higher prices for
important
components/raw materials
3. A depreciation in the
exchange rate causing a
rise in import costs
4. An increase in business
taxes e.g. VAT or
environmental taxes such
as a carbon tax

15. Demand Pull Inflation using AD-AS Diagram
GPL
Real GDP
GPL2
AS
Y2
AD2AD1
Y1
GPL1
1. Demand-pull inflation
occurs when AD grows at
an unsustainable rate
leading a positive output
gap (i.e. Actual GDP >
Potential GDP)
2. When there is excess
demand, producers can
raise their prices and
thereby achieve bigger
profit margins
3. Demand-pull inflation is
most likely when there is
full employment of
resources, when aggregate
supply is inelastic

16. Analysis: Internal and External Causes of Inflation
A large surge in
property prices
Higher wages /
labour costs
Boom in credit /
money supply
Rise in business
taxes e.g. VAT
Increase in world
oil / gas prices
Inflation in global
commodity prices
Depreciation of
the exchange rate
High inflation in
other countries
Internal causes of inflation External causes of inflation

17. Countries with Highest Inflation in 2015
96.8%
33.48%
28.98%
22.08%
19.03%
18.65%
17.94%
17.31%
16.5%
13.07%
12.85%
12.26%
12.2%
10.75%
10.26%
0.0% 20.0% 40.0% 60.0% 80.0% 100.0% 120.0%
Venezuela
Ukraine
South Sudan
Belarus
Sudan
Argentina
Russia
Malawi
Islamic Republic of Iran
Sierra Leone
Tajikistan
Eritrea
Ghana
Kyrgyz Republic
Egypt
Inflation rate (per cent) compared to previous year (March 2015)
Source: IMF

18. Why is High Inflation an Economic Problem?
Many governments target a low but positive rate of inflation. They
believe persistently high inflation can have damaging consequences
• Inequality: Inflation has a regressive effect on lower-income families in
developed & developing countries – most of their wealth is held in cash
• Falling real incomes – if wage rises lag behind price increases each year
• Negative real interest rates: If the interest on savings is lower than inflation
• Cost of borrowing: High inflation may also lead to higher interest rates for
businesses and consumers with debts (e.g. Rising mortgage rates)
• Risks of wage inflation: This leads to rising labour costs and lower profits
• Business competitiveness: A high relative rate of inflation can reduce
competitiveness which will lower demand for the country’s exports
• Business uncertainty: High and volatile inflation is not good for confidence
partly because businesses cannot be sure of what their costs and prices are
likely to be. This uncertainty might lead to a fall in capital investment

19. Possible Winners and Losers from High Inflation
One of the effects of inflation is that it can lead to arbitrary changes
in the distribution of real incomes and wealth in a country
Winners
• Workers with strong wage
bargaining power
• Debtors if real interest
rates are negative
• Producers if prices rise
faster than costs
Losers
• Retired on fixed incomes
• Lenders if real interest
rates are negative
• Savers if real returns are
negative
• Workers in low paid jobs

20. Why is inflation difficult to forecast accurately?
Forecast inflation for UK (source: BoE)
The chart shows the UK CPI inflation
forecast published by the Bank of
England. The probability fan chart for
inflation indicates the range of
probabilities for inflation in the
forecast period.
Volatile
global
energy
prices
Changes in
value of
the
currency
Uncertain
growth of
aggregate
demand
Volatile
food prices
Government
indirect
taxes can
change

21. Macroeconomic Policies to Control Inflation
Inflation can be reduced by policies that (i) slow down the growth
of AD or (ii) boost the rate of growth of aggregate supply (AS)
• Fiscal policy: A tightening fiscal policy would include less spending on
public and merit goods or welfare payments or raising direct taxes
• Monetary policy:
• A ‘tightening of monetary policy’ via higher interest rates or a
reversal of quantitative easing or tougher controls on bank lending
• Higher interest rates may cause the exchange rate to appreciate
bringing cheaper imported goods and services
• Supply side policies to increase productivity, competition and
innovation
• Direct controls
• Public sector pay controls e.g. Limiting pay rises for NHS workers
• Capping or other regulation of prices of utilities such as water bills

22. Inflation
EdExcel AS Economics 2.1.2