Inflation and price stability
Key terms
Define each term.
Multiple choice
Circle the correct answer.
A country's currency depreciates sharply, raising the price of imported oil and components. This is most likely to cause:
Worked problems
Show your working.
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.
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.
Chains of reasoning
The steps are in the wrong order. Write the letters in the order that makes a linked chain.
How demand-pull inflation develops
- A Firms initially respond by raising output to meet the extra demand.
- B As the economy approaches full capacity, spare resources become scarce.
- C The price level rises, and if aggregate demand continues growing faster than productive capacity, the rise is sustained rather than one-off.
- D A component of aggregate demand rises, for example consumption following a cut in income tax.
- E The AS curve becomes steeper as capacity constraints bite, so a growing share of the demand increase feeds into prices rather than output.
- F Aggregate demand shifts right.
- G Firms compete for the remaining labour and raw materials, bidding up wages and input prices.
Diagrams
Draw two AD/AS diagrams. In the first, show demand-pull inflation near full capacity. In the second, show cost-push inflation.
Answers
Inflation: A sustained increase in the general price level of an economy over a period of time.
Deflation: A sustained fall in the general price level of an economy over a period of time.
B. Higher import costs raise firms' costs of production, which are passed on as higher prices. That is cost-push inflation.
Step 1. Multiply each price index by its weight. Food 40 x 110 = 4,400. Housing 30 x 105 = 3,150. Transport 20 x 120 = 2,400. Other 10 x 100 = 1,000.
Step 2. Add them and divide by the total weight. Total = 4,400 + 3,150 + 2,400 + 1,000 = 10,950. Total weight = 100. Weighted index = 10,950 / 100 = 109.5.
Step 3. Interpret. Prices on average are 9.5% higher than in the base year. Transport rose most, by 20%, but it has a weight of only 20, so it adds less to the index than food, which rose 10% with a weight of 40.
The weights are the point. A simple average of the four indices would give 108.75, which ignores how much people actually spend on each category.
Set up the calculation Inflation rate = (new index − old index) ÷ old index × 100
Substitute (133.1 − 128.0) ÷ 128.0 × 100
Compute 5.1 ÷ 128.0 × 100 = 3.98%, so approximately 4.0%
Interpret The price level rose by about 4% during 2026. Note the index itself measures the price level; the percentage change measures inflation. Confusing the two is the most common error in index questions.
D, F, A, B, G, E, C
- 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.
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.