AQA A-level Economics: Inflation and deflation (7136) – Revision Notes

These notes condense inflation and deflation for AQA A-level Economics (7136), specification version 1.3, section 4.2.3.3 (3.2.3.3 on the AQA website). Full explanations and longer worked examples are in the study guide. Test yourself with the practice questions, then use the AQA A-level Economics hub, the checklist and the free diagnostics. All figures are invented and illustrative.

Key definitions

Term	Meaning
Inflation	Sustained rise in the general price level
Deflation	The price level is falling
Disinflation	The rate of inflation is falling (prices still rise)
Demand-pull	Inflation from a rise in AD
Cost-push	Inflation from a rise in costs, shifting SRAS left
Velocity (V)	How many times, on average, each unit of money changes hands in a period
Nominal national income	PQ, when Q is real output
Real interest rate	Nominal rate adjusted for inflation
Benign deflation	Falling prices from rising supply capacity
Malign deflation	Falling prices from collapsing AD

Method: inflation rate from an index

1. Subtract the old index from the new one.
2. Divide by the old index.
3. Multiply by 100.

Example (Country C, illustrative): 104.0 to 106.6. Change 2.6; 2.6 / 104.0 = 0.025; inflation 2.5%. If the next year’s index is 1% lower, 106.6 × 0.99 = 105.5, so prices fell 1.0%: deflation.

Disinflation check: inflation of 3.0%, then 2.1%, then 1.2% from an index of 100 gives 103.00, 105.16, 106.42. The index rises each year, so prices rise more slowly.

Demand-pull and cost-push at a glance

	Demand-pull	Cost-push
Shift	AD right	SRAS left
Equilibrium moves	Up and right	Up and left
Real output	Rises	Falls
Examples	Lower interest rates, consumer boom, export surge	Dearer imported inputs, wage rises beyond productivity, higher indirect taxes

Chain for demand-pull: more spending, firms near capacity, prices and wages bid up, general price level rises. Chain for cost-push: costs rise, firms pass on, SRAS shifts left, price level rises and output falls.

Evaluation prompts: spare capacity decides how much of an AD rise becomes prices rather than output; both types often combine; continued cost-push needs accommodating spending.

MV = PQ in steps

• M money supply; V velocity; P price level; Q real output (T is allowed in place of Q, but Q makes PQ nominal national income and avoids intermediate transactions).
• It is an identity. The Quantity Theory adds assumptions: V stable, Q fixed at full employment in the long run.
• Result: changes in M lead to proportional changes in P. This is the monetarist model.

Method:

1. Write MV on one side and PQ on the other.
2. Solve for the missing term.
3. For changes, recalculate and compare, or use %ΔM + %ΔV ≈ %ΔP + %ΔQ.

Worked reminder: M = 250, V = 4, Q = 500. MV = 1,000, so P = 1,000 / 500 = 2.0. M rises 10% to 275: MV = 1,100, P = 1,100 / 500 = 2.2, which is +10%.

Growth form: M +6%, V −2%, Q +2%. Approximately %ΔP = 6 − 2 − 2 = 2%. Exactly: 1.06 × 0.98 / 1.02 − 1 = 1.84%.

Criticisms: V unstable (recession, hoarding, new payment methods); Q can rise in the short run when money rises; money is hard to define; causation may run from prices or demand to credit and money.

Expectations

• Expected inflation feeds into wage claims, firms’ price decisions, interest rates and the timing of purchases.
• Past inflation shapes expectations (adaptive), so high inflation in one year raises the next year’s expected rate.
• A credible target helps anchor expectations; this lowers the cost of getting inflation down.
• Real interest rate ≈ nominal − inflation. Nominal 6% and inflation 2%: exactly 1.06 / 1.02 − 1 = 3.92%. Nominal 4% and inflation 5%: −0.95%, so savers lose.
• Real wage: pay up 2.5% with inflation of 4% gives 1.025 / 1.04 − 1 = −1.44%.

Consequences: who and how much

	Inflation	Deflation
Savers	Lose if rate below inflation	Gain purchasing power
Borrowers (fixed debt)	Gain	Lose: real debt rises
Fixed incomes	Lose	Gain
Workers	Real pay falls if pay lags	Wage cuts or job losses
Firms	Menu costs, uncertainty, lost competitiveness	Falling margins, delayed demand
Economy	Weaker investment, current account pressure, spiral	Falling AD, bad debts, real interest rates rise

Judgement points: rate, stability, whether anticipated, and cause. Inflation that is low and expected is much less harmful. Deflation is benign when supply-side gains cause it and malign when AD falls.

External influences

• World commodity prices: direct effect = weight in index × % price change; indirect through costs of production (cost-push). A weaker currency raises the domestic price of dollar-priced goods.
• Fuel weight 4% and a price rise of 30%: direct effect 1.2 percentage points.
• Other economies: import prices, exchange rate, export demand, and competition. Growth abroad raises UK AD; a slump abroad lowers it; cheaper imports hold down prices.

Deflationary policies

Policies to reduce AD, such as higher interest rates, higher taxes and lower government spending. They do not necessarily result in deflation. Usually they reduce the rate of inflation, which is disinflation.

Diagrams to be able to describe

Use the price level on the vertical axis and real GDP on the horizontal axis. Name every curve and every equilibrium.

Case	Starting point	Shift	New equilibrium
Demand-pull	AD1 meets SRAS at P1, Y1	AD1 to AD2 (right)	P2 above P1, Y2 above Y1
Cost-push	AD meets SRAS1 at P1, Y1	SRAS1 to SRAS2 (left)	P2 above P1, Y2 below Y1
Benign deflation	AD meets LRAS1 at P1, Y1	LRAS1 to LRAS2 (right)	P2 below P1, Y2 above Y1
Malign deflation	AD1 meets SRAS at P1, Y1	AD1 to AD2 (left)	P2 below P1, Y2 below Y1

A one-line sketch of the sequence for an AD rise near full capacity: AD up, shortages, prices and wages bid up, price level up, with little extra output.

Reminders with numbers

Commodity and exchange rate. A raw material costs 50 dollars and the rate is 1.60 home-currency units per dollar, so the domestic price is 50 × 1.60 = 80. The dollar price rises 10% to 55, giving 55 × 1.60 = 88, also +10%. If the home currency also weakens to 1.76 units per dollar, the price is 55 × 1.76 = 96.8, a rise of 21.0% on the original 80. A falling currency magnifies a world price rise.

Real debt under deflation. A household owes 60,000 on an income of 30,000, a ratio of 2.0. Prices and income fall 1% a year for 2 years, so income is 30,000 × 0.99² = 29,403 and the ratio is 60,000 / 29,403 = 2.04. The debt has not changed in money terms, but it is harder to repay.

Evaluation phrases that earn credit

• “It depends on the rate and whether it was expected.”
• “In the short run … but in the long run …”
• “This assumes V is stable, which is questionable when …”
• “The size of the effect depends on the weight of the good in spending.”
• “The cause matters: falling prices from higher productivity differ from falling prices from weak AD.”

Finish each evaluation with a judgement that follows from the points made, not a repeat of them.

Quick self-test

1. An index moves from 125.0 to 128.75. Calculate inflation.
2. Inflation falls from 4.5% to 3.0%. Is this deflation or disinflation?
3. M = 300, V = 6, Q = 900. Find P.
4. Using question 3, M rises to 330 with V and Q unchanged. Find the new P.
5. M +7%, V 0, Q +2%. Estimate %ΔP.
6. Name the curve that shifts under cost-push inflation, and the direction.
7. A saver gets a nominal 3% when inflation is 4%. Is the real rate positive or negative?
8. Fuel has a weight of 5% in the index and fuel prices rise 20%. Find the direct effect.
9. Give one reason deflation can reduce spending.
10. Give one reason a central bank might raise interest rates when inflation is rising.

Answers

1. 3.75 / 125.0 = 0.03, so 3.0%.
2. Disinflation; prices still rise.
3. MV = 1,800; P = 1,800 / 900 = 2.0.
4. MV = 330 × 6 = 1,980; P = 1,980 / 900 = 2.2 (up 10%).
5. About 7 + 0 − 2 = 5% (exactly 1.07 / 1.02 − 1 = 4.90%).
6. SRAS shifts left.
7. Negative (about −1%; exactly 1.03 / 1.04 − 1 = −0.96%).
8. 5% × 20% = 1.0 percentage point.
9. Households delay purchases expecting lower prices, or real debt burdens rise so they spend less.
10. It reduces AD (borrowing and spending), easing demand-pull pressure.

Where marks are usually lost

• Calling a fall in the rate of inflation “deflation”.
• Forgetting that a cost-push shift is in SRAS, not AD.
• Using MV = PQ without stating the assumptions about V and Q.
• Using M in a percentage calculation without checking whether V or Q also changed.
• Giving consequences of inflation with no gainers and losers identified.
• Treating all deflation as harmful; benign and malign cases need separating.
• Ignoring the exchange rate when a commodity is priced in dollars.
• Stating a conclusion with no judgement about size, duration or cause.

Official syllabus

Source: the A-level Economics specification published by AQA (version 1.3, 29 June 2022), content section 4.2.3.3.