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Inflation is the macroeconomic variable that touches every household most directly and most frequently: it is the reason the same shopping basket costs more this year than last, the reason savers worry about the real value of their money, and the single number that the Bank of England's Monetary Policy Committee is charged above all else with controlling. A sustained rise in the general price level sounds simple, but measuring it is a substantial statistical undertaking, and explaining why it happens requires the full apparatus of aggregate demand and supply, monetary theory and expectations. This lesson builds the topic in three stages. First, measurement: how the Consumer Prices Index is constructed from a basket and a set of weights, how it differs from RPI and CPIH, and how an inflation rate is calculated from an index. Second, causes: demand-pull inflation, cost-push inflation, the quantity theory of money, and the role of expectations and the wage–price spiral. Third, the evaluation of these competing explanations against the UK's recent experience. The headline skill — and the route to the top band — is the ability to diagnose which cause is operating from the data and to represent it correctly on an AD/AS diagram.
This lesson sits within Section 4.2.3 — Economic performance (and the measurement strand of 4.2.1) of the AQA A-Level Economics (7136) specification, the macroeconomics half of the course (4.2 The national and international economy), and is the foundation for monetary-policy analysis later in the course.
Exam Tip: A question that asks you to "analyse the causes of a rise in inflation" is really asking you to (a) identify whether the cause is demand-pull or cost-push (or monetary) from the data, (b) draw the correct AD/AS shift, and (c) build the chain of reasoning to a higher price level. Naming the cause and drawing the right diagram early banks AO1/AO3 marks fast.
| Term | Definition | Example |
|---|---|---|
| Inflation | A sustained increase in the general price level over time | UK CPI inflation of 11.1% in October 2022 |
| Deflation | A sustained decrease in the general price level | Japan experienced deflation for much of the 1990s and 2000s |
| Disinflation | A fall in the rate of inflation (prices still rising, but more slowly) | UK inflation falling from 11.1% in October 2022 to 4.6% in October 2023 |
| Hyperinflation | Extremely rapid and out-of-control inflation, typically exceeding 50% per month | Zimbabwe 2008 (approximately 79.6 billion % per month); Weimar Germany 1923 |
Exam Tip: Students often confuse deflation with disinflation. Deflation means prices are falling; disinflation means they are rising more slowly. A question that says "inflation fell from 5% to 2%" describes disinflation, not deflation.
Key Definition: The Consumer Prices Index (CPI) measures the average change in prices of a representative basket of approximately 730 goods and services purchased by households, weighted by their share of total consumer spending.
The two ideas that do the heavy lifting are the basket and the weights. The basket is a fixed list of representative goods and services chosen so that the index tracks the spending of a typical household rather than any one individual; it is refreshed each year so that new products enter and obsolete ones leave (recent UK additions have included items like air fryers and e-bikes, while coal has dropped out). The weights ensure that a price rise in something households spend a lot on — housing, energy, food — counts for more than the same percentage rise in something trivial. Without weighting, a doubling of the price of a rarely-bought item would distort the index as much as a doubling of energy bills, which would clearly be misleading. The weights are derived from large expenditure surveys and updated annually, so the CPI is technically a Laspeyres-type index that uses base-period quantities updated each year.
How CPI is constructed (ONS methodology):
The numbers below are hypothetical, chosen to illustrate the mechanics. Suppose a simplified basket has three categories with the following weights (shares of household spending) and price changes over a year:
| Category | Weight | Price change |
|---|---|---|
| Housing & energy | 0.40 | +10% |
| Food | 0.20 | +5% |
| Everything else | 0.40 | +1% |
The overall (weighted) inflation rate is the weighted average of the category price changes:
Inflation=(0.40×10%)+(0.20×5%)+(0.40×1%)=4.0%+1.0%+0.4%=5.4%
Notice how the weights drive the result: housing and energy contribute 4.0 of the 5.4 percentage points despite being only 40% of the basket, because their price rose fastest. This is exactly why the 2022 energy shock fed so powerfully into headline CPI — energy is a heavily weighted item. Once the weighted price level is expressed as an index, the annual inflation rate is simply the percentage change in that index:
Inflation rate=CPIlast yearCPIthis year−CPIlast year×100
For instance, if the CPI rose from 120.0 to 126.5 over twelve months:
120.0126.5−120.0×100=5.42%
| Feature | CPI | RPI | CPIH |
|---|---|---|---|
| Includes mortgage interest payments? | No | Yes | No |
| Includes owner-occupier housing costs? | No | No (but includes mortgage interest) | Yes (via rental equivalence) |
| Formula | Geometric mean (Jevons) | Arithmetic mean (Carli) | Geometric mean (Jevons) |
| Population coverage | All private households | Excludes top 4% by income and pensioner households mainly dependent on state benefits | All private households including owner-occupiers |
| Used for | Bank of England inflation target (2%); international comparisons | Some index-linked gilts; student loan interest; some pension uprating | ONS preferred measure since March 2017 |
| Typical relationship | Usually lower than RPI | Usually 0.5–1.0 percentage points above CPI | Usually close to CPI; sometimes slightly higher |
Key Definition: CPIH is the ONS's preferred measure of inflation. It extends CPI by including owner-occupiers' housing costs (OOH), estimated using rental equivalence — the rent a homeowner would pay for an equivalent rented property.
The RPI was stripped of its "National Statistic" status in 2013 by the UK Statistics Authority because the Carli formula has a known upward bias. The reason is technical but examinable: the Carli (arithmetic mean) formula used in RPI tends to overstate price rises relative to the Jevons (geometric mean) formula used in CPI, because the arithmetic mean of price relatives exceeds the geometric mean whenever prices change at different rates. This formula effect alone typically adds several tenths of a percentage point to RPI relative to CPI, before the additional effect of RPI including mortgage interest payments. Despite losing its official status, RPI remains influential — and contentious — because many index-linked gilts, some pension and benefit upratings, student-loan interest and rail-fare increases are still tied to it. The result is that the choice of index has real distributional consequences: pegging payments out (like some pensions) to RPI is generous, while pegging payments in (like fares or some tax thresholds) to RPI is costly to the payer, which is one reason successive governments have been accused of cherry-picking whichever index suits the public finances in each case.
Exam Tip: If asked to evaluate measures of inflation, always mention the formula effect (Carli vs Jevons) and the treatment of housing costs as key differences between CPI and RPI.
| Limitation | Explanation |
|---|---|
| Basket may not reflect individual experience | A non-driver gains no benefit from falling petrol prices; a vegetarian is unaffected by meat prices |
| Quality improvements are hard to capture | A smartphone costing the same as last year's model but with better features represents a fall in the "quality-adjusted" price. The ONS uses hedonic adjustment, but this is imprecise |
| New products | There is a lag before new goods are included in the basket |
| Substitution bias | When prices rise, consumers switch to cheaper alternatives; CPI may overstate the cost-of-living increase (though the Jevons formula partially addresses this) |
| Housing costs | CPI excludes owner-occupier housing costs; CPIH is preferred but still uses rental equivalence, which may not capture actual mortgage-cost pressures |
These limitations matter most for distributional questions. Because the index tracks an average household, it can understate the cost-of-living pressure on particular groups: pensioners, who spend a larger share of their income on energy and food, often experience a higher effective inflation rate than the headline figure during an energy shock, while higher-income households with diverse spending may experience a lower one. This is why commentators sometimes speak of an inflation inequality — the same headline CPI can conceal very different lived experiences. It is also why the existence of a single official number, however carefully constructed, never removes the need for judgement about whose cost of living is being measured.
Key Definition: Demand-pull inflation occurs when aggregate demand grows faster than aggregate supply, pulling up the general price level. It is associated with a positive output gap.
Because aggregate demand is C+I+G+(X−M), anything that raises one of these components can pull up the price level once the economy approaches full capacity. Possible causes of rising AD:
The crucial point is that the inflationary consequence depends on where the economy sits relative to its productive capacity. When there is ample spare capacity (a negative output gap), a rise in AD increases output with little effect on prices, because firms can expand using idle resources. As the economy approaches full capacity, the SRAS curve steepens, and further increases in AD spill increasingly into prices rather than output — which is why demand-pull inflation is most associated with a positive output gap and a booming economy.
On an AD/AS diagram, demand-pull inflation is shown by a rightward shift of the AD curve along an upward-sloping SRAS curve, causing a higher price level and higher real output — the key signature that distinguishes it from cost-push inflation.
Key Definition: Cost-push inflation occurs when rising costs of production (raw materials, wages, energy) are passed on to consumers through higher prices, shifting the SRAS curve to the left.
The defining feature of cost-push inflation is that it originates on the supply side — costs of production rise for reasons unconnected to the strength of demand. Possible causes:
Cost-push inflation poses an especially awkward dilemma for policymakers. Because it raises prices and reduces output simultaneously, the central bank faces a genuine trade-off: raising interest rates to curb the inflation will deepen the output and employment loss, while cutting rates to support output will add to the inflation. There is no painless response — which is precisely why supply-side shocks such as the 1973 oil embargo produced the stagflation that so confounded the simple Phillips-curve thinking of the era.
On an AD/AS diagram, cost-push inflation is shown by a leftward shift of the SRAS curve, leading to a higher price level and lower real output — a situation known as stagflation (stagnation plus inflation). This contrasting output signature is how an examiner expects you to tell the two causes apart: demand-pull raises prices and output; cost-push raises prices while reducing output.
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