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How is inflation measured?
• The rate of inflation is measured by the annual
percentage change in consumer prices.
• The British government has set an inflation target
of 2% using the consumer price index (CPI)
• It is the job of the Bank of England to set interest
rates so that aggregate demand is
controlled, inflationary pressures are subdued
and the inflation target is reached
• The Bank is independent of the government with
control of interest rates and it is free from
political intervention.

http://www.youtube.com/watch?v=S
mOMp8gycMA&safe=active
• Inflation is a general and sustained increase
in prices.
• It is measured by a change in a weighted index
of prices such as the CPI

The CPI
• The consumer price index measures price
levels
• Index numbers are easy to make comparisons
with.
• You can calculate inflation from this by
calculating the percentage change in the index

The RPI
• The retail price index
• The RPI is a more reliable measure for
negotiating wage increases because it is more
inclusive than the CPI as it takes into account
housing costs e.g. mortgage interest
repayments
• However it is not as reliable for international
comparisons as it is unique to the UK

Other problems with CPI
• Measure the cost of living for an average
household. Pensioners not included
• Sampling problems – only 57% of households
respond to the survey
• The 650 items in the ‘basket’ are changed only
once a year, where as peoples tastes and fashions
change more frequently

• For people with atypical spending patterns
e.g. vegetarians and non-drivers, the CPI will
be unrepresentative.
• When the quality of goods changes, the CPI
breaks down because it is not comparing like
with like.

Costs and benefits of inflation
Sort the cards to
identify costs
and benefits of
inflation
Shoe leather costs –
consumers must shop
around to find the best
value goods. The time
and effort taken to find
the best value involves
an opportunity cost

Causes of inflation
Demand pull inflation
• Inflation caused by excess
demand in the economy
Cost push inflation
• Inflation caused by
increases in the costs of
production in the economy

Causes of Demand pull inflation
Where excessive growth in AD results in the economy moving to
higher price levels.
• This can result from an increase in any component of AD=
C+I+G+(X-M)
• E.g. an income tax cut will increase consumption resulting in
demand pull inflation

Solutions to demand pull inflation
• The bank of England has been given
responsibility to target 2.0% CPI inflation. To
reduce inflation it will increase interest rates
thus reducing AD

Solutions to demand pull inflation
Alternatively, the government could use
contractionary fiscal policy to reduce the level of
AD, such as:
- An increase in tax
- A cut in government spending

Causes of Cost push inflation
• Rising input costs e.g. rising price of oil, raw materials or components.
• Rising labour costs e.g. shortage of skilled IT workers enabling them to ask for high
pay rises
• Higher import prices e.g. high inflation in other countries means the goods you
import become more expensive (you ‘import inflation’)
• Increases in indirect tax e.g. increases in National insurance or an energy tax will
increase the costs of producers

Solutions to cost push inflation
• The bank of England is responsible for
controlling inflation
• The government also pursue policies to shift
the AS curve to the right, which will bring the
price level down.
• However these supply side policies take a very
long time to work

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