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

This guide covers inflation and deflation for AQA A-level Economics (7136), specification version 1.3, section 4.2.3.3 (numbered 3.2.3.3 on the AQA website). Every country, firm and figure below is invented and illustrative. Course pages: AQA A-level Economics hub, checklist and free diagnostics. Next: the revision notes and the practice questions. Related pages: aggregate demand and supply and measurement of macroeconomic performance.

What the specification asks for

Content point	What you must be able to do
Inflation, deflation, disinflation	Define each and tell them apart from numbers
Demand-pull and cost-push	Explain and show each on an AD/AS diagram
MV = PQ and the Quantity Theory	Use the equation; explain the monetarist model
Expectations	Explain how expected price changes feed into actual ones
Consequences of inflation	Individuals and the economy, with evaluation
Consequences of deflation	Individuals and the economy, with evaluation
World commodity prices	Trace their effect on domestic inflation
Other economies and UK inflation	Explain the channels
Deflationary policy	Know it means reducing AD, not necessarily producing deflation

The three terms

Inflation is a sustained rise in the general price level. Deflation exists when the price level is falling. Disinflation is when the rate of inflation is falling. These are the specification’s own distinctions, and the common slip is to treat disinflation as falling prices. Under disinflation prices still rise, only more slowly.

Worked example. Country A’s price index goes from 112.0 to 117.6.

• Change = 117.6 − 112.0 = 5.6.
• Inflation = 5.6 / 112.0 × 100 = 5.0%.

Now suppose inflation in Country B is 6% in year 1, 4% in year 2 and 2% in year 3, starting from an index of 100.

Year	Inflation	Index
0		100.00
1	6%	106.00
2	4%	110.24
3	2%	112.44

The index rises every year, so this is disinflation. If an index fell from 100 to 98, the change is −2.0%, and that is deflation.

Demand-pull and cost-push

Demand-pull inflation comes from a rise in aggregate demand (AD) when the economy has little spare capacity. Causes include a consumer boom, a fall in interest rates, higher government spending or strong export demand. The chain is: AD shifts right, firms find demand exceeds what they can supply at current prices, they raise prices and bid for scarce labour and inputs, and the price level rises. Real output also rises, but by less and less as capacity is used up.

Cost-push inflation comes from a rise in costs of production that shifts short-run aggregate supply (SRAS) to the left. Causes include higher wage settlements not matched by productivity, dearer imported raw materials, higher indirect taxes and a fall in the exchange rate that raises import prices. The chain is: costs rise, firms pass some or all on, and the price level rises while real output falls or stalls.

	Demand-pull	Cost-push
Curve that shifts	AD right	SRAS left
Real output	Rises	Falls
Typical source	Spending boom	Input costs

Diagram in words: draw the price level on the vertical axis and real GDP on the horizontal. For demand-pull, the AD curve moves right, from AD1 to AD2, and slides up the SRAS curve, so equilibrium moves up and to the right. For cost-push, SRAS moves from SRAS1 to SRAS2 and equilibrium moves up and to the left. In practice the two combine: a wage-price spiral starts with a demand boom, then workers push up wages, which raises costs.

Evaluation points: it is hard to separate the two in real data; the effect of an AD rise depends on spare capacity; and cost-push inflation only continues if the money supply and spending accommodate it.

The equation of exchange and the Quantity Theory

Fisher’s equation of exchange is MV = PQ.

• M is the money supply.
• V is the velocity of circulation, how many times, on average, each unit of money changes hands in the period.
• P is the price level.
• Q is real output. The specification allows T (the volume of transactions) in place of Q, but it notes that using Q means PQ is nominal national income and avoids the problem of counting intermediate transactions.

The equation is an identity: money spent must equal money received. It becomes a theory when assumptions are added. The Quantity Theory of Money assumes V is stable and Q is fixed in the long run at the full-employment level by supply-side factors, so a change in M changes P in proportion. This is the monetarist model: inflation is always and everywhere caused by money supply growing faster than output.

Worked example 1. M = 400, V = 5, Q = 1,000 (units of real output).

• MV = 400 × 5 = 2,000, so PQ = 2,000.
• P = 2,000 / 1,000 = 2.0.
• The money supply rises 10% to 440, with V = 5 and Q = 1,000 unchanged: MV = 2,200, so P = 2.2.
• Price level change = (2.2 − 2.0) / 2.0 = +10%, in proportion to M.

Worked example 2 (growth rates). In a year the money supply grows by 8%, V is unchanged and real output grows by 3%.

• Growth form: %ΔM + %ΔV ≈ %ΔP + %ΔQ, so 8 + 0 ≈ %ΔP + 3, giving about 5%.
• Exactly: 1.08 / 1.03 − 1 = 4.85%.

Evaluation: velocity can change, particularly in a recession when people hoard money or when new payment methods appear. Real output may respond to money in the short run, so Q is not fixed. Defining and measuring “money” is difficult. Causation may run from prices to money, because banks create credit in response to demand. Monetarists answer that these breakdowns are temporary and that control of money growth is the lasting cure.

Expectations

Expectations of inflation can make inflation self-fulfilling. If workers expect prices to rise 4%, they ask for at least 4% more pay. Firms expecting higher wage bills and higher rivals’ prices raise their own prices. Consumers who expect dearer goods may buy earlier, adding to AD. Lenders add expected inflation to the interest rate they charge.

Worked example. A saver is offered a nominal rate of 5% when expected inflation is 3%.

• Real interest rate ≈ 5% − 3% = 2%.
• Exactly: 1.05 / 1.03 − 1 = 1.94%.

Where expectations are formed from recent experience (adaptive), a period of high inflation raises expected inflation for the next period, which makes disinflation costly. A central bank with a credible inflation target can hold expectations down, so wage and price setters plan on its target. Evaluation: the effect depends on how credible policy is, and on workers’ bargaining power.

Consequences of inflation

For individuals

• Savers lose when the interest rate is below inflation. £10,000 held for 5 years with 4% inflation a year buys what £10,000 / 1.04⁵ = £8,219 buys today, a fall in purchasing power of 17.8%.
• People on fixed incomes, such as those on a set pension, lose real income.
• Borrowers with fixed-rate debt gain, since they repay in money worth less.
• Workers whose pay lags prices lose real income, while strong bargainers keep pace.
• Menu costs and shoe-leather costs: the time and cost of updating prices and searching for the best deal.

For the economy

• Uncertainty about future prices discourages investment and long-term contracts.
• Exports become less competitive if domestic inflation exceeds that of trading partners, harming the current account.
• Redistribution between creditors and debtors, and between those with and without bargaining power.
• A wage-price spiral, if expectations become embedded.
• Policy cost: bringing inflation down may require deflationary policy.

Evaluation: the damage depends on the rate (low, stable and anticipated inflation is much less harmful than high, volatile and unanticipated), the cause (demand-pull may come with rising output and jobs) and whether incomes and savings rates adjust. Mild inflation can also grease the labour market because real wages can fall without nominal pay cuts.

Consequences of deflation

For individuals

• Consumers may delay purchases if they expect lower prices later, which cuts AD further.
• Borrowers with fixed debts lose. A household with a fixed debt of 90,000 and an income of 40,000 has a debt-to-income ratio of 2.25. If prices and income both fall 2% a year for 3 years, income is 37,648 and the ratio is 2.39, so the real burden grows.
• Savers with cash gain purchasing power.
• Workers face wage cuts or job losses, since nominal wages are slow to fall.

For the economy

• Falling profit margins reduce investment and can raise unemployment.
• A deflationary spiral: lower prices, lower spending, lower output, then lower prices again.
• Banks face more bad debts as the real value of debt rises.
• Interest rates cannot fall below about zero, so real interest rates rise when prices fall.

Evaluation: benign deflation arises from supply-side improvements, such as productivity growth shifting long-run aggregate supply (LRAS) right, so prices fall while output grows. Malign deflation arises from a collapse in AD. The first is not harmful, and the second is. Another test is the size and duration of the price fall.

World commodity prices

Commodities such as oil, metals and food are traded in world markets and often priced in a major foreign currency. A rise in their price feeds into domestic inflation in two ways: directly through the prices of fuel and food, and indirectly through higher costs for firms (cost-push).

Worked example 1 (direct effect). Fuel and energy have a weight of 6% in Country A’s price index. Fuel prices rise 25%.

• Direct contribution = 6% × 25% = 1.5 percentage points to inflation.

Worked example 2 (exchange rate). A commodity costs 80 dollars and the exchange rate is 2.00 A-units to the dollar, so the domestic price is 160. The dollar price rises 20% to 96 dollars.

• Rate unchanged: 96 × 2.00 = 192, a 20% rise.
• If A-units also depreciate to 2.20 per dollar: 96 × 2.20 = 211.2, a 32% rise.

A weaker currency magnifies the commodity price rise. Evaluation: the effect depends on the weight of commodities in spending, whether the country produces its own, how long prices stay high, how much firms absorb in margins, and whether the central bank looks through a one-off rise.

Other economies and UK inflation

Changes abroad reach UK inflation in four main ways.

• Import prices. If a trading partner’s inflation rises, UK firms and households pay more for imports. If imports have an illustrative weight of 30% and import prices rise 10%, the direct effect is 30% × 10% = 3.0 points.
• Exchange rate. A fall in the pound raises import prices; a rise lowers them.
• Export demand. Growth abroad raises demand for UK exports, so AD rises and demand-pull pressure builds. A slump abroad does the opposite.
• Competition and input costs. Cheap imports or lower world prices hold down domestic firms’ prices.

Deflationary policies

You should appreciate that deflationary policies are policies to reduce aggregate demand, such as higher interest rates, higher taxes or lower government spending. They do not necessarily result in deflation. Their normal aim is to lower the rate of inflation, which is disinflation, so the price level still rises. For example, if inflation falls from 5% to 3%, prices rise more slowly, not fall. Policy mechanisms and the conflicts with other objectives are covered in other units.

Common errors

• Writing “deflation” when inflation has merely fallen.
• Treating MV = PQ as proof of causation without the assumptions about V and Q.
• Describing cost-push as an AD shift.
• Listing consequences without saying who gains or loses, and by how much.
• Ignoring the exchange rate in commodity and import price questions.

Official syllabus

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