Inflation is a sustained rise in the general price level, which means the value of money falls over time. Deflation is a sustained fall in the general price level.
Two causes of inflation
- Demand-pull inflation — total demand rises faster than the economy can supply, so “too much money chases too few goods” and prices are pulled up.
- Cost-push inflation — the costs firms face, such as wages or raw materials, rise, so firms push these higher costs onto customers as higher prices.
Effects of inflation and deflation
Moderate inflation is normal, but high inflation reduces the buying power of money, discourages saving and can make a country's exports less competitive. Deflation sounds pleasant, yet falling prices can lead shoppers to delay buying, so firms sell less, cut jobs and the economy slows.
Measuring inflation with a price index
Statisticians choose a “basket” of goods and services that a typical household buys. They track the total cost of this basket and turn it into a Consumer Price Index (CPI). One year is chosen as the base year and given an index of 100.
Price index = (cost of basket now ÷ cost of basket in base year) × 100
The inflation rate is the percentage change in the index from one year to the next.
| Year | CPI |
|---|---|
| 1 (base) | 100 |
| 2 | 104 |
Here the index rose from 100 to 104, a rise of 4, so inflation was 4%.
Put these steps in order to calculate the inflation rate from a price index:
- Find the cost of the basket in the base year and the current year
- Divide the current cost by the base year cost
- Multiply by 100 to get the price index
- Subtract 100 (or the earlier index) to find the inflation rate