📈 Inflation
Prices in general are rising. Each pound buys less than it did last year. An inflation rate of 3% means prices are 3% higher on average than a year ago.
Inflation » Inflation, Deflation and the CPI
What you'll learn this session
Study time: 30 minutes
Edexcel spec: 2.1.1 (b)
- What inflation and deflation mean
- How the consumer price index (CPI) measures price changes
- What a basket of goods, weights and a base year are
- How to calculate and use index numbers and the inflation rate
This topic is examined on Paper 2 (Macroeconomics and the Global Economy). Low and stable inflation is one of the government's main macroeconomic objectives. Before a government can control inflation, it has to measure it. That is what this lesson is about. The causes and effects of inflation come in the next two lessons.
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Unlock This CourseInflation and deflation
Inflation means the same weekly shop costs more than it did a year ago
Last lesson you met inflation as prices going up. Here is the exact version you should write in the exam.
Key terms:
- Inflation rate: the percentage change in the general level of prices over a period, usually one year.
- Deflation: a general fall in prices over time.
Inflation is a general rise in prices across the whole economy. If only the price of one product goes up, that is not inflation. Prices of most goods and services must be rising.
📉 Deflation
Prices in general are falling. Each pound buys more than it did last year. The inflation rate is below zero, for example -2%.
Take care with the wording. If the inflation rate falls from 5% to 2%, prices are still rising, only more slowly. That is not deflation. Deflation only happens when the inflation rate drops below zero.
Measuring inflation: the consumer price index
There are millions of prices in an economy, so how do we find out whether they are rising or falling on average? Governments use the consumer price index (CPI). It follows the prices of the goods and services that households typically buy. In the UK the CPI is produced by the Office for National Statistics.
Key terms:
- Consumer price index (CPI): a measure of the average change in the prices of the goods and services bought by households.
- Basket of goods: a representative selection of the goods and services that a typical household buys.
- Weights: numbers showing how important each item in the basket is, based on the share of household spending it takes.
- Base year: the year the index starts from. The CPI is set at 100 in this year.
- Price index: a number that shows a price compared with the base year, which is set at 100.
How the CPI is built
The CPI tracks the prices of a basket of goods and services that typical households buy
🛒 1. The basket
Officials choose the items a typical household buys, such as food, housing, transport, clothing and leisure. The basket is updated regularly as spending habits change.
💰 2. The weights
Households spend more on some things than others. A big rise in the price of something people spend a lot on matters more than a rise in a small item. So big spending items get big weights.
📅 3. The base year
Prices in the base year are set at 100. A CPI of 110 means prices are 10% higher than in the base year. A CPI of 95 means they are 5% lower.
Each year, the prices of the items in the basket are collected, compared with the base year and combined using the weights. The result is one number: the CPI.
Worked examples
Worked example 1: a price index for one item
In the base year a loaf of bread cost £1.20. This year it costs £1.38. Find the price index for bread.
Price index = (new price ÷ base year price) × 100
= (1.38 ÷ 1.20) × 100 = 1.15 × 100 = 115
The price of bread is 15% higher than in the base year.
Worked example 2: building a weighted CPI
Country Kelvara has a simple basket. The base year is Year 1, so every index is 100 in Year 1. The table shows the weights and the price index for each group in Year 2.
| Group | Weight | Price index, Year 2 | Weight × index |
|---|---|---|---|
| Food | 30 | 110 | 3,300 |
| Housing | 25 | 104 | 2,600 |
| Transport | 20 | 120 | 2,400 |
| Clothing | 10 | 100 | 1,000 |
| Leisure | 15 | 105 | 1,575 |
| Total | 100 | 10,875 |
CPI = total of (weight × index) ÷ total of weights = 10,875 ÷ 100 = 108.75
Prices in Kelvara are on average 8.75% higher than in the base year. Notice that transport rose the most (20%), but its weight is only 20, so it did not pull the CPI up as much as it would with a bigger weight.
Calculating the inflation rate
The CPI itself tells you how prices compare with the base year. To find the inflation rate between two years, work out the percentage change in the CPI.
Formula
Inflation rate (%) = (new CPI − old CPI) ÷ old CPI × 100
Worked example 3: inflation
Country Merlow's CPI was 125 last year and 130 this year.
Change = 130 − 125 = 5
Inflation rate = 5 ÷ 125 × 100 = 4%
Prices are on average 4% higher than a year ago.
Worked example 4: deflation
Country Tolvane's CPI was 120 last year and 117 this year.
Change = 117 − 120 = −3
Inflation rate = −3 ÷ 120 × 100 = −2.5%
The rate is negative, so there is deflation. Prices are on average 2.5% lower than a year ago.
Common mistakes
- Dividing by the new CPI. Always divide by the old CPI, the one you started from.
- Thinking the CPI itself is the inflation rate. A CPI of 130 does not mean 130% inflation. It means prices are 30% above the base year.
- Saying a falling inflation rate is deflation. Deflation needs a negative inflation rate.
- Leaving out the negative sign when the answer is deflation.
- Forgetting that weights matter. A price rise on a heavily weighted item moves the CPI more.
Exam-style question
The table shows the consumer price index for Country Lumora. The base year is 2021.
| Year | 2021 | 2022 | 2023 |
|---|---|---|---|
| CPI | 100 | 104 | 109.2 |
(a) Define deflation. [2 marks]
(b) Calculate the inflation rate in Country Lumora between 2022 and 2023. Show your working. [2 marks]
(c) Explain why the government uses weights when it calculates the CPI. [3 marks]
(d) Which one of the following is the CPI in the base year? [1 mark]
A 0 B 1 C 10 D 100
Model answer
(a) Deflation is a fall (1) in the general level of prices over time (1).
(b) Inflation rate = (109.2 − 104) ÷ 104 × 100 (1) = 5% (1).
(c) Households spend more of their income on some goods and services than others. (1) A price change in an item that takes a large share of spending affects households more. (1) Weights give bigger items a bigger effect on the CPI, so the index shows the true average change in prices that households face. (1)
(d) D (1)
Exam tip
In a calculation part, write the formula and the numbers before the answer. If you divide by the wrong CPI you may still earn a method mark for a clear working line.
Recap
- Inflation is a general rise in prices over time. The inflation rate is the percentage change in the price level, usually per year.
- Deflation is a general fall in prices over time. The inflation rate is below zero.
- The CPI measures the average change in prices of a basket of goods and services bought by households.
- Weights give each item importance based on how much households spend on it.
- The base year is set at 100. Inflation rate = (new CPI − old CPI) ÷ old CPI × 100.