Low & Stable Rate of Inflation (Edexcel IGCSE Economics)

An Introduction to Inflation

• Inflation is the sustained increase in the average price level of goods and services in an economy

  • A low & stable rate of inflation is important as it

    • Allows firms to confidently plan for future investment

    • Offers price stability to consumers

• Deflation occurs when there is a fall in the average price level of goods and services in an economy

  • Deflation only occurs when the percentage change in prices falls below zero %

• Disinflation occurs when the average price level is still rising, but at a lower rate than before

  • These figures demonstrate disinflation:  Y1 = 5%  Y2 = 4%  Y3 = 2%

    • Inflation is increasing but at a decreasing rate

Graph analysis

• In the UK, a continual deviation from the target of 2% would not be considered stable

  • An inflation rate in April 2022 of 4-5% was considered to be unstable, eroding household purchasing power

• According to the CPI data, the following changes happened to the price level

  • In 2018, prices were rising at around 3% (inflation)

  • In 2019, prices were still rising but only by 1.8% (disinflation)

  • In 2021, they were still rising but by a much lower 0.5% (disinflation)

  • In 2022, prices rose at their fastest level, reaching 4.2% (inflation)

Measuring Inflation Using the Consumer Price Index (CPI)

• The consumer price index (CPI) is used to measure inflation

• The inflation rate is the change in general price levels in a given time period

  • The inflation rate is calculated using an index with 100 as the base year

  • If the index is 100 in year 1 and 107 in year 2, then the inflation rate is 7%

The Consumer Price Index (CPI)

• A 'household basket' of 700+ goods/services that an average family would purchase is compiled on an annual basis

  •  A household expenditure survey is conducted to determine what goes into the basket

  • Each year, some goods and services exit the basket, and new ones are added

• Goods/services in the basket are weighted based on the proportion of household spending

  • E.g. More money is spent on food than shoes, so shoes have a lower weight in the basket

• Each month, prices for these goods and services are gathered from hundreds of locations across the country

  • These prices are averaged out

• The price x the weighting determines the final value of the good/service in the basket

  • These final values are added together to determine the price of the 'basket'

• The prices of the baskets are then used to calculate the CPU using the following formula:

• The percentage difference in CPI between the two years is the inflation rate for the period