Inflation & Deflation
📊 The Big Idea: When prices rise overall (inflation) or fall overall (deflation), different people benefit differently — consumers, workers, firms, and governments each gain or lose. Understanding why prices change and how to fix it is crucial to managing a healthy economy.
At a Glance
Inflation
Sustained increase in the general price level of goods and services, measured by the Consumer Price Index (CPI).
Deflation
A fall in the general price level of goods and services. Only occurs when the percentage change in prices falls below 0%.
CPI
Consumer Price Index: measures the prices of a 'basket' of ~700 goods/services an average household buys each month.
Root Causes
Inflation: demand-pull (too much demand) or cost-push (higher costs). Deflation: demand-side (recession) or supply-side (productivity boost).
Winners & Losers
Inflation harms savers and workers on fixed income; helps borrowers. Deflation harms borrowers; can signal recession.
Policy Fixes
Raise interest rates or cut spending to fight inflation; lower rates or spend more to fight deflation (demand-side approach).
1. Definitions & Measurement
What is Inflation?
Inflation is the sustained increase in the general price level of goods and services in an economy. It's not about individual prices going up — it's about the overall trend. A loaf of bread costing 20p more in your local shop isn't inflation. But if nearly everything you buy gradually costs more over the course of a year, that's inflation.
The key word is sustained. A one-off spike in prices isn't inflation. It must be ongoing.
Key Point: The UK inflation target is 2% per annum. Low inflation (~2%) is actually a sign of healthy economic growth. Zero inflation (or deflation) is usually worse.
What is Deflation?
Deflation occurs when there is a fall in the general price level of goods and services. Unlike inflation, deflation is when prices are falling overall.
However, it's crucial to understand: deflation only occurs when the percentage change in prices falls below zero %. If inflation was 3% last year and 1% this year, that's not deflation — that's disinflation (inflation is slowing, but prices are still rising).
Common Mistake: Students often confuse "falling inflation" with "deflation." Remember: inflation at 5% → 3% = disinflation (prices still going up, just slower). Inflation at 2% → –2% = deflation (prices actually going down).
The Consumer Price Index (CPI)
Governments can't check every price in the economy (there are millions!). Instead, they use the Consumer Price Index (CPI) to measure how prices are changing.
How it works:
- A 'household basket' of ~700+ goods and services is compiled each year based on what an average family actually buys (food, transport, clothing, housing, etc.).
- weighted
Why weighting matters:
The CPI Formula
Worked Example