If every price in an economy doubled overnight, and every wage doubled too, would anyone be worse off? The instinct is to say no. The reason inflation matters, and the reason central banks fight it so hard, is that this never happens evenly. Some prices move first, some wages lag, some savings are eroded, and the losses fall on people who did nothing wrong.
Inflation
A sustained increase in the general price level of an economy over a period of time.
Both 'sustained' and 'general' carry marks. A one-off jump in the price of one good is neither. Candidates who write only 'prices going up' typically score one mark out of two.
Inflation has two broad causes. Demand-pull inflation occurs when total demand in the economy grows faster than the economy's ability to supply, so buyers bid prices up. Cost-push inflation occurs when the costs of production rise, through wages, imported raw materials or a weaker exchange rate, and firms pass those costs on. The distinction matters because the appropriate policy response differs: demand-pull responds to tighter demand management, whereas cost-push does not and may worsen under it.
A country's currency depreciates sharply, raising the price of imported oil and components. This is most likely to cause:
Deflation
A sustained fall in the general price level of an economy over a period of time.
Inflation is measured with the Consumer Prices Index (CPI). Statisticians choose a basket of goods and services that a typical household buys, record their prices regularly, and give each item a weight according to how much of household spending goes on it, so that a rise in the price of food counts for more than a rise in the price of matches. The cost of the basket is compared with its cost in a base year, which is given the value 100. An index of 112 means prices are 12% higher than in the base year, and the percentage change in the index from one year to the next is the rate of inflation.
Building a weighted price index
A country's basket has four categories. Their weights and this year's price indices (base year = 100) are: Food: weight 40, price index 110. Housing: weight 30, price index 105. Transport: weight 20, price index 120. Other: weight 10, price index 100. Calculate the weighted price index and state what it shows.
Governments have several ways to control inflation, and each works best against a particular cause. Contractionary monetary policy, raising interest rates, makes borrowing dearer and saving more attractive, so spending falls; it works against demand-pull inflation. Contractionary fiscal policy, raising taxes or cutting government spending, reduces total demand directly. Supply-side policies, such as training and investment in infrastructure, raise productivity so that the economy can produce more without prices rising, and are the main answer to cost-push inflation, though they take years to work. The first two can reduce inflation quickly but at the cost of slower growth and higher unemployment.
The consequences fall unevenly. Savers lose if interest rates sit below the inflation rate, while borrowers gain as the real value of their debt shrinks. Those on fixed incomes lose most, because their income does not adjust. Firms face uncertainty that discourages investment. And if domestic inflation exceeds that of trading partners, exports become less price competitive.
Measurement, and its problems
Inflation is measured using a consumer price index. A representative basket of goods is selected, each item is weighted by its share of typical household spending, and the cost of the basket is tracked over time against a base year. The percentage change in the index is the inflation rate.
Calculating an inflation rate from an index
A country's CPI stands at 128.0 in 2025 and 133.1 in 2026. Calculate the inflation rate for 2026, and state what has happened to the price level.
The method has real weaknesses, and questions frequently ask about them. The basket reflects an average household that may resemble nobody in particular, so pensioners and students experience different effective rates. It updates only periodically, so it lags changes in spending habits. It struggles to separate a price rise from a quality improvement. And it typically excludes housing costs in ways that vary by country, which matters greatly when property prices move.
Three terms are routinely confused and are worth fixing precisely. Inflation is a rising price level. Deflation is a falling price level, meaning a negative inflation rate. Disinflation is a fall in the rate of inflation while the price level is still rising. Prices in a disinflationary period are still going up, just more slowly.
Deflation and disinflation are among the most reliably mixed-up pairs in the whole specification. If a question describes inflation falling from 5% to 2%, that is disinflation, and writing 'prices are falling' is an error that undermines everything after it.
Nominal values are measured in the prices of the day; real values are adjusted for inflation. A 3% pay rise in a year of 5% inflation is a 2% real pay cut. Whenever data appears in a question, check which you have been given, because the entire interpretation can reverse.
How demand-pull inflation develops
- A component of aggregate demand rises, for example consumption following a cut in income tax.
- Aggregate demand shifts right.
- Firms initially respond by raising output to meet the extra demand.
- As the economy approaches full capacity, spare resources become scarce.
- Firms compete for the remaining labour and raw materials, bidding up wages and input prices.
- The AS curve becomes steeper as capacity constraints bite, so a growing share of the demand increase feeds into prices rather than output.
- The price level rises, and if aggregate demand continues growing faster than productive capacity, the rise is sustained rather than one-off.
The steepness of the AS curve is what determines the split between output and prices. Answers that ignore where the economy sits relative to full employment miss the analytical core.
Practise this chain →Draw two AD/AS diagrams. In the first, show demand-pull inflation near full capacity. In the second, show cost-push inflation.
Demand-pull shifts AD right, raising both price level and output. Cost-push shifts SRAS left, raising the price level while output falls, which is the stagflation case. Label the price level and real output on both axes.
Applied context
The global inflation episode that began in 2021 is unusually useful because it combined both causes at once. Pandemic support measures and released savings pushed aggregate demand up sharply, while supply chain disruption and later energy price shocks pushed short-run aggregate supply left. Central banks faced the awkward problem that raising interest rates addresses only the demand-pull component, and does so at the cost of output, while doing nothing about the imported energy costs driving the rest.
This example lets you argue that policy choice depends on diagnosis, which is exactly the judgement a 13-mark question is looking for.