Inflation and Deflation

How to calculate inflation?

There are two methods that the government uses to calculate inflation. These are the Retail price index (RPI) and the Consumer price index (CPI).

The RPI inflation was used for a number of years in the UK until 2003, but it is not currently used. The main purpose of using RPI was to calculate the inflation in the retail prices by including mortgage interest repayments.

Currently, the government uses the CPI, which is relatively similar to the RPI but doesn’t include mortgage interest repayments. The key features of CPI are:

• The government records the expenditures of the ‘national shopping basket’. This usually consists of goods that people consume on a daily basis.

• The CPI is calculated based on data collected from various supermarkets. The data includes family shopping basket prices.

• To calculate the index, items that are included in the shopping basket are weighted in regards to their importance. The importance is decided depending on how much the household spends on the item: the more they spend on it, the higher the importance and thus the weight of the item.

• The CPI can be used to calculate the prices of the shopping baskets of various consumer groups and consumers in different geographical regions. It can also identify the periods of inflation and deflation.

• The CPI results can be compared annually to calculate the inflation rate throughout the years in regards to consumers' shopping baskets.

CPI example

The table below represents an example of CPI calculation. The items in the example are the essential items consumed by the household. The importance or weighting of each product or service displayed in the example depends on how much the household spends on it. The weighting of all items should usually add up to 1000. The price index of the previous year (2020) is always displayed as 100 and the increase in price is shown in the ‘Price index in 2021’ column.

Deflation

Deflation is the opposite of inflation. It means that the prices of goods and services in an economy are falling.

Deflation usually occurs due to the following reasons: there may be a fall in aggregate demand, which would cause the general price level to decrease. Alternatively, the short-run aggregate supply could shift to the right due to decreased costs of production, causing the general price levels in the economy to fall.

What causes inflation?

The two main types of inflation (demand-pull and cost-push) are caused by different factors that affect the economy.

Demand-pull inflation

• The main cause of demand-pull inflation is an increase in aggregate demand. The prices of products and services will increase to stimulate firms to produce more output in response to growing demand.

• The positive output gap is another cause of demand-pull inflation. It means that the growth rate of the economy is above the trend growth rate, which leads to higher inflation.

Figure 2. Demand-pull inflation, StudySmarter Originals

Figure 2 depicts demand-pull inflation. The aggregate demand for goods and services increases from AD1 to AD2 (a rightward shift), causing an increase in the price level from P1 to P2.

Cost-push inflation

• This type of inflation is caused by the growing monopoly power of trade unions. As unions become more powerful they demand higher wages, which raises the cost of labour, thereby raising the costs of production for a firm.

• Additionally, cost-push inflation can be caused by the increased commodity or energy prices, which raises the overall cost of production causing the short-run aggregate supply to shift to the left.

Figure 3. Cost-push Inflation, StudySmarter Originals

Figure 3 depicts cost-push inflation. The short-run aggregate supply curve shifts to the left from SRAS1 to SRAS2 due to increased production costs, causing an increase in the price level from P1 to P2. The real output falls from Y1 to Y2.

The situation when the price level increases due to a supply-side shock in the economy with a simultaneous fall in real output, coupled with a rise in structural unemployment is a very specific economic situation: stagflation.

What causes deflation?

Several factors can cause deflation. They are:

• shortages or falling of the money supply
• decrease in the velocity of money circulation
• fall in aggregate demand
• increase in productivity.

Firstly, the monetarist theory describes that it can occur due to the shortages or falling of the money supply in the economy. Additionally, a decrease in the velocity of money circulation could cause a fall in the general price level.

Secondly, deflation could be caused by a fall in aggregate demand. A fall in the aggregate demand causes a fall in consumer confidence and therefore a fall in spending. This causes the general price level to fall. Firms may then react to this by decreasing wages to lower their costs of production. Lower wages will feed into lower households’ income, causing their demand to fall further. This is referred to as a deflation spiral.

Additionally, deflation can occur due to an increase in productivity. This can be influenced by improvements in technology, which reduce the costs of production, causing the aggregate supply to shift to the left and lower the overall price level in the economy.

Consequences of inflation and deflation

Let's explore the consequences that inflation and deflation have on the overall economy, consumers, and businesses.

The consequences of inflation

These are some of the consequences of inflation:

Consumers and employees

• Decrease in consumers' purchasing power due to the increased prices of goods and services.

• Inflation is favourable for consumers that have loans. Despite the increased prices of goods and income levels, the debt repayments stay at the same level, which makes them decrease in value. This makes it easier for consumers to repay their debts.

• Along with inflation of the prices of goods and services, workers' income also increases. However, if it increases at a lower rate, consumers become less wealthy.

• Due to inflation, businesses have to pay higher wages to their employees. To reduce the costs of labour, businesses may make cuts in employees by making them redundant.

• High and unstable inflation affects agents’ expectation formation about future price levels, which in turn affects the economy in an unpredictable way.

To learn more about how expectation formation affects the price level in the economy take a look at our explanation on Monetarist Theory of Inflation

Businesses

Employees may be demanding higher wages due to inflation, which will result in the increase of the business costs of production. This can cause a reduction in exports as they will become relatively more expensive. For example, if there is inflation in the UK, the prices of goods in the UK will increase, therefore exports will become more expensive for foreign countries to import. This will result in lower demand for exports and an overall decrease in business profits from exports.

The consequences of deflation

These are some consequences of deflation:

• In the long run, consumer spending declines. As prices are decreasing, consumers are likely to hold on to their savings, as in the future they believe that the costs of goods will be even lower.

• Along with the decrease in the prices of goods, consumer salaries will decrease simultaneously.

• There is a decline in business productivity due to the lower demand for consumer goods. This results in an increase in unemployment as businesses will not need to supply as many goods.

• As a result of deflation, price mechanisms are disrupted, which makes people confused about the true value of products and services. This also affects their expectation formation about future price levels.

• Deflation causes an overall slowdown in the economy.

Examples of inflation and deflation

Let’s explore some examples of how inflation and deflation affect the UK and the rest of the world.

Changes in other economies affect inflation and deflation in the UK

The global increase in prices of goods that the UK imports, such as oil, raw materials, food, and others causes the price of these products to increase when they are imported into the UK.

For example, the oil prices increased significantly during 2008 and 2011-12, which influenced inflation in the UK. How did that happen? The higher oil prices caused plastic manufacturing costs to increase. Due to this, the plastic production companies passed increased prices of plastic goods onto consumers, and this caused inflation of goods containing plastic.

On the other hand, the global economy can have an influence on inflation to slow it down and even cause deflation. For example, rising productivity and technology lower the prices of goods in major exporter countries such as China. If the UK increases its imports from China, this will reduce the prices of those goods sold in the UK.¹

Changes in world commodity prices affect domestic inflation

Commodity prices usually respond to changes in the exchange rate of the US dollar. If the dollar increases in value the commodities such as oil and gas will increase in prices in the domestic economies.

Shocks in the economy such as natural disasters increase the export cost of commodities. Therefore, once the commodity gets to the consumer, its price is higher, which results in domestic inflation for that particular commodity.

Controlling inflation and deflation

High deflation and inflation rates can be bad for the economy. Deflation slows down economic growth, while inflation causes a decrease in the consumers’ purchasing power. It also disturbs savings because as money loses value, consumers are likely to spend their money instead of saving it. Therefore, the government and central banks implement various techniques and policies to control inflation and deflation rates.

To control inflation, the government uses different macroeconomic policies. This is aimed to deflate the economy. That is, decreasing the economic activity and aggregate demand to regulate the price levels of goods and services. The main government’s aim is to achieve disinflation.

To control deflation, the government and central banks implement monetary and fiscal policies. The central bank uses monetary policy to lower the reserve limits and generate more loans for various investments and consumption. That way, there is increased demand for borrowing, which stimulates aggregate demand and supply.

Additionally, the government can use fiscal policy to increase spending and increase the aggregate demand. To achieve this, the government can provide funds and grants to businesses so that they can employ more people. This would mean that households would have more purchasing power due to more employment, which would result in increased consumer spending. This will increase the demand for goods and services and their prices simultaneously.

High inflation and deflation are bad for the economy, which is why government implements policies to control them. The government’s overall goal is to achieve low and stable inflation, which is very important for a balanced economy.

Sources

1. Tejvan Pettinger, Impact of the global economy on UK inflation, 2013.