Inflation » Inflation, Deflation and the CPI
What you'll learn this session
Study time: 30 minutes
Cambridge spec: 4.7.1, 4.7.2
- What inflation and deflation mean
- How the Consumer Prices Index (CPI) is built from a household survey, a basket and weights
- How to work out index numbers and the inflation rate
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Unlock This CourseInflation and deflation
Prices of individual goods go up and down all the time. A mango may cost more this week because of a poor harvest. That is not inflation. Inflation is about the general level of prices across the whole economy, and about prices that keep moving in one direction.
Key terms:
- Inflation: a sustained rise in the general price level.
- Deflation: a sustained fall in the general price level.
Two words matter here. Sustained means it carries on for a period of time, not a one-off change. General means most prices, not just one product. When inflation is high, the same money buys less than before. This is why governments watch it closely, as the macroeconomic aim of stable prices shows.
Remember from the lesson on economic growth that real GDP removes the effect of price rises. The CPI is the tool that tells us how big those price rises are.
How the CPI is built
You cannot add up every price in an economy, so economists use a sample. The most common measure of inflation is the Consumer Prices Index (CPI). It follows the price of what a typical household buys. There are three steps.
🏠 1. Household survey
A survey asks a sample of households what they spend their money on, and how much. In many countries an official statistics office does this.
🛒 2. Basket
The goods and services households buy most often go into a basket of goods and services, for example food, housing, transport and clothes. Their prices are collected regularly.
📏 3. Weights
Items are not equally important. A weight shows the share of a typical household's spending that goes on each item, so big items count for more.
Key terms:
- Consumer Prices Index (CPI): a measure of the average change in the prices of the goods and services a typical household buys.
- Household survey: a survey of what households spend their money on.
- Basket of goods and services: the list of items bought by a typical household, used to track price changes.
- Weights: numbers showing how much of household spending goes on each item in the basket.
- Base year: the starting year with which other years are compared. Its index number is set at 100.
- Index number: a number that shows a value compared with the base year, which is 100.
Why weights? Imagine salt doubles in price and rent rises by 10%. A household hardly notices the salt, but the rent takes a large part of its money. Rent must therefore have a bigger weight than salt, or the CPI would give a false picture of how prices affect people.
Index numbers
The CPI is shown as an index. In the base year it is set at 100. If the CPI is 110 in a later year, prices are on average 10% higher than in the base year.
Worked example: a simple index
A basket of goods costs $40 in the base year and $46 this year.
Index = (new cost / base year cost) x 100 = (46 / 40) x 100 = 115.
Prices are on average 15% higher than in the base year.
Calculating the inflation rate
The CPI itself is not the inflation rate. To find the inflation rate you compare the CPI in two years.
Formula
Inflation rate (%) = (CPI this year - CPI last year) / CPI last year x 100
Worked example: inflation rate
The CPI of the made-up country Zendara is 105.4 in year 2 and 110.7 in year 3.
Change = 110.7 - 105.4 = 5.3
Inflation rate = 5.3 / 105.4 x 100 = 5.0% (to one decimal place).
A weighted example
Zendara's basket has three groups. The base year is year 1, so every group has an index of 100 in that year. The table shows the weights and each group's index in year 2.
| Group | Weight | Index in year 2 | Weight x index |
|---|---|---|---|
| Food | 50 | 104 | 5,200 |
| Housing | 30 | 110 | 3,300 |
| Transport | 20 | 102 | 2,040 |
| Total | 100 | 10,540 |
Worked example: weighted CPI
Step 1: multiply each index by its weight (done in the last column).
Step 2: add them up to get 10,540.
Step 3: divide by the total of the weights: 10,540 / 100 = 105.4.
The CPI in year 2 is 105.4, so the inflation rate from year 1 is (105.4 - 100) / 100 x 100 = 5.4%.
Look at housing. It rose most (10%) and has a middle weight, so it pulls the CPI up more than transport, which rose only 2% and has a small weight.
Deflation
If the CPI falls, for example from 104 to 102, the general price level is falling, so there is deflation and the inflation rate is negative. Do not confuse this with disinflation, where the inflation rate falls (say from 6% to 3%) but prices are still rising, just more slowly.
Common mistakes
- Saying that a CPI of 108 means 108% inflation. It means prices are 8% above the base year.
- Dividing by 100 instead of by last year's CPI when you work out the inflation rate.
- Forgetting the weights. Items with a large share of spending must count for more.
Exam-style question
The country Tarvos measures inflation using the CPI. The base year is 2025, when the CPI was 100. The CPI was 104.0 in 2026 and 106.6 in 2027.
(a) Define inflation. [2 marks]
(b) Calculate the inflation rate in Tarvos in 2027. Show your working. [2 marks]
(c) Explain why the CPI uses weights. [3 marks]
Model answer
(a) Inflation is a rise in the general price level (1) that is sustained over a period of time (1).
(b) (106.6 - 104.0) / 104.0 x 100 (1) = 2.5% (1).
(c) Weights show how much of a typical household's spending goes on each item. (1) Items that take a large share of spending, such as housing, matter more to households than small items. (1) Without weights, a price rise in a minor item would count as much as one in a major item, so the CPI would not show the true change in the cost of living. (1)
Exam tip
In a "Calculate" question, write the formula or the numbers you use before the answer. If the final answer is slightly wrong you can still earn a method mark.