Cambridge IGCSE Economics: Inflation and deflation (0455)

This guide covers section 4.8, Inflation and deflation, of the Cambridge IGCSE Economics syllabus for examination in 2026. The course is not tiered, so all candidates study this content. Paper 1 is 30 multiple-choice questions (45 minutes) and may include calculations. Paper 2 is structured questions (2 hours 15 minutes). The syllabus says calculators may be used in both papers. All countries, firms and figures below are invented for illustration.

Go to the course hub or the printable checklist. When you finish, use the revision notes and the practice questions. To find weak spots first, take a free 10-minute diagnostic.

What you must be able to do

Section	Outcome
4.8.1	Define inflation and deflation
4.8.2	Explain how the Consumer Prices Index (CPI) measures them, and calculate with it
4.8.3	Explain demand-pull and cost-push inflation, and demand-side and supply-side deflation
4.8.4	Explain the consequences for consumers, workers, savers, lenders, firms and the economy as a whole
4.8.5	Explain the range of policies to control inflation and deflation, and judge how effective they might be

4.8.1 Definitions

Inflation means the general price level keeps rising over time. Deflation means the general price level keeps falling over time. Three words matter.

• General. One price rising, such as tomatoes in a drought, is not inflation.
• Sustained. A single month of higher prices is not enough.
• Level versus rate. The price level is how high prices are. The inflation rate is how fast the level is changing.

So if inflation falls from 6% to 3%, prices are still rising, only more slowly. That is disinflation, not deflation. Deflation needs the price level itself to fall, which means a negative rate of inflation.

A low, stable rate of inflation is one of the government’s macroeconomic aims. Read the role of government and macroeconomic aims page for the full list.

4.8.2 Measuring inflation with the CPI

The Consumer Prices Index (CPI) follows the prices of a basket of goods and services that households typically buy. The basket is split into groups. Each group has a weight, which shows its share of typical household spending. Weights matter because a 10% rise in the price of food, which takes a large share of spending, affects the average far more than a 10% rise in the price of a rarely bought item.

A price index compares prices with a base year, which is set at 100. An index of 112 means prices are 12% higher than in the base year.

Key formulas:

• Weighted CPI = total of (weight × group index), divided by the total of the weights
• Inflation rate (%) = change in CPI ÷ old CPI × 100

Worked example 1: building the CPI

Country Zeta uses a base year of 2020 (index = 100). The basket has five groups.

Group	Weight	Index 2025	Weight × index	Index 2026	Weight × index
Food and drink	30	112	3,360	118	3,540
Housing and energy	25	108	2,700	112	2,800
Transport	15	120	1,800	117	1,755
Clothing	10	104	1,040	105	1,050
Other	20	110	2,200	113	2,260
Total	100		11,100		11,405

CPI 2025 = 11,100 ÷ 100 = 111.0. CPI 2026 = 11,405 ÷ 100 = 114.05.

Inflation 2026 = (114.05 − 111.0) ÷ 111.0 × 100 = 3.05 ÷ 111.0 × 100 = 2.7% (1 d.p.).

Transport prices fell, but the CPI still rose because food and housing carry large weights.

Worked example 2: deflation

Country Zeta’s CPI falls from 120.0 to 117.6. Rate = (117.6 − 120.0) ÷ 120.0 × 100 = −2.4 ÷ 120.0 × 100 = −2.0%. A negative answer means deflation. Say so in words in the exam.

Limits of the CPI

• It reflects the average household. A pensioner who spends more on heating and a student who spends more on transport may each face a different rate.
• The basket and weights must be updated as spending habits change.
• It does not fully capture better quality, so a price rise may partly reflect a better product.

4.8.3 Causes

Demand-pull inflation

This is caused by total demand in the economy rising faster than the economy’s ability to produce. Too much spending chases too few goods.

Possible causes of rising demand:

• cheaper borrowing after a cut in interest rates
• lower income tax, leaving households with more to spend
• more government spending
• optimism among households and firms
• stronger overseas demand for exports

Chain of reasoning: spending rises, so firms sell stocks and receive more orders. If they have spare capacity, output rises with little effect on prices. When capacity is full, firms cannot produce more, so they raise prices and bid for scarce workers by offering higher wages. The general price level rises.

A simple check: suppose total spending in an economy grows by 8% in a year, but output can grow by only 3%. Since spending = price level × output, the price level must rise by 1.08 ÷ 1.03 − 1 = 0.0485, or about 4.9%.

Cost-push inflation

This is caused by rising costs of production, which firms pass on in higher prices. It starts on the supply side.

Possible causes: higher wages not matched by higher productivity, dearer raw materials or energy, higher indirect taxes, a fall in the exchange rate that makes imported inputs cost more, and supply disruption.

Worked example 3: cost pass-through

A small furniture workshop in Country Zeta makes 300 tables a month. Monthly costs are timber 3,000, wages 4,500, energy 500 and other costs 1,000, total 9,000. Average cost = 9,000 ÷ 300 = 30 per table.

Timber rises 20%, wages 6% and energy 10%. Other costs are unchanged.

• Timber: 3,000 × 1.20 = 3,600
• Wages: 4,500 × 1.06 = 4,770
• Energy: 500 × 1.10 = 550
• Other: 1,000
• New total = 9,920. Average cost = 9,920 ÷ 300 = 33.07.

Cost rise = (9,920 − 9,000) ÷ 9,000 × 100 = 10.2%. If the workshop adds a 25% mark-up, its price goes from 37.50 to 41.33. If many firms do this, the price level rises.

Causes of deflation

Demand-side deflation comes from weak total demand. Causes include high interest rates, higher taxes, cuts in government spending, falling confidence and falling export demand. Firms with unsold stock cut prices to attract buyers.

Supply-side deflation comes from falling costs or rising productive capacity. Causes include cheaper raw materials or energy, new technology, higher productivity, and cheaper imports (for example after the exchange rate rises). Firms can cut prices and still earn profit.

The two are different in effect. Supply-side deflation usually comes with rising output and is often welcome. Demand-side deflation usually comes with falling output and rising unemployment.

4.8.4 Consequences

The result depends on whether the change is expected, how large it is and how fast it happens. Use “real” to mean adjusted for price changes. A real value shows what money can buy.

Group	Inflation	Deflation
Consumers	Purchasing power falls, especially for fixed incomes	Goods get cheaper, but buyers may delay purchases hoping for lower prices
Workers	Real wages fall if pay rises more slowly than prices; strong pay claims may push costs up further	Firms facing falling revenue may cut pay or jobs
Savers	Hurt if the interest rate is below inflation	Gain, because money buys more over time
Lenders	Hurt if the interest rate on a loan is below inflation	Gain, as repayments are worth more
Borrowers	Gain, as debts shrink in real terms	Lose, as debts become harder to repay
Firms	Uncertainty, costs of changing prices, dearer inputs, less competitive exports	Falling revenue, squeezed profits, delayed investment, possible closures
Economy	Lower competitiveness, less saving and investment, redistribution of income	Weak spending, lower output, higher unemployment, a risk of spiralling decline

Worked example 4: saver and lender

A saver in Country Zeta puts 5,000 in an account paying 2% when inflation is 4%. After a year she has 5,000 × 1.02 = 5,100. In prices of a year earlier this is worth 5,100 ÷ 1.04 = 4,904. The real return is negative, about −2% (approximately nominal rate − inflation = 2 − 4).

A lender gives a 20,000 loan at a fixed 3% for one year when inflation is 5%. Repayment = 20,000 × 1.03 = 20,600. In real terms that is 20,600 ÷ 1.05 = 19,619, a real loss of about 381. The borrower gains by the same amount.

Worked example 5: workers

A worker earns 2,400 a month when the CPI is 111.0. Next year pay rises 2% to 2,448 and the CPI is 114.05. Real pay index = pay ÷ CPI × 100: 2,400 ÷ 111.0 × 100 = 2,162.2 before, and 2,448 ÷ 114.05 × 100 = 2,146.4 after. Real pay changed by −0.7%. Pay rose, but buying power fell.

Worked example 6: why deflation raises debt burdens

A household owes a fixed 10,000. Its monthly wage is 1,500, so the debt is 10,000 ÷ 1,500 = 6.7 months of pay. Deflation lowers wages 4% to 1,440. The debt is now 10,000 ÷ 1,440 = 6.9 months of pay, though the amount owed has not changed.

Effects on the whole economy

High inflation can make exports dearer compared with rivals’ goods, so exports fall and imports rise, harming the balance of payments. It makes planning difficult, because firms and households cannot predict future prices. Deflation is dangerous when expected: households delay buying, firms sell less, cut output and jobs, incomes fall and demand weakens further. Link this to employment and unemployment.

4.8.5 Policies and how effective they are

To control inflation

• Monetary policy: raise interest rates. Borrowing becomes dearer and saving more attractive, so consumption and investment fall. A higher rate may also raise the exchange rate, which lowers import prices. Reducing the money supply works in a similar way.
• Fiscal policy: raise taxes or cut government spending, so spending falls. A budget surplus is the result when revenue exceeds spending.
• Supply-side policy: education, training and investment raise productivity and output, so cost pressures ease and production can match demand.

See fiscal and monetary policy and supply-side policy for detail. The syllabus says AD and AS are not required for fiscal policy, so explain in words.

Evaluation points:

• Cause matters. Higher interest rates suit demand-pull inflation. Against cost-push they cut output and employment too, so this policy does less for the cause.
• Time lags. Policy takes months to work.
• Conflict. Slowing demand can raise unemployment (aim conflict).
• Spending cuts or tax rises are politically unpopular.
• Supply-side policy works slowly but lowers costs permanently.
• Imported inflation may be beyond domestic control.

To control deflation

• Monetary policy: cut interest rates, increase the money supply, or let the exchange rate fall so that exports are cheaper and imports dearer.
• Fiscal policy: cut taxes or raise government spending, accepting a bigger budget deficit.
• Supply-side policy: may help if costs are the cause, but it is a poor tool when demand is the problem.

Evaluation points: rates can only be cut so far. Firms and households may not borrow even when credit is cheap if they lack confidence. Households may save a tax cut. A bigger deficit adds to debt. Supply-side deflation may not need correcting.

Common errors

• Writing that a fall in the inflation rate is deflation.
• Mixing up the CPI level and the inflation rate.
• Forgetting to divide by the old CPI, or by the sum of weights.
• Saying all inflation harms everyone: borrowers can gain.
• Recommending higher interest rates as an automatic cure for every inflation cause.

Official syllabus

Cambridge IGCSE Economics syllabus for examination in 2026, section 4.8, published by Cambridge University Press & Assessment.