Cambridge O Level Economics: Inflation and deflation (2281) – Revision Notes

Condensed notes on section 4.8 (4.8.1 to 4.8.5, inflation and deflation) from the 2026 Cambridge O Level Economics (2281) syllabus, version 2. All numbers here are fictional. The study guide has the full explanations; afterwards try the practice questions. Other links: the Cambridge O Level Economics hub, the printable checklist and the free diagnostics.

4.8.1 Definitions

Term	Meaning
Inflation	A sustained increase in the general price level
Deflation	A sustained decrease in the general price level
Rate of inflation	How fast the price level is changing, as a percentage per year
Purchasing power	What a unit of money can buy; it falls in inflation and rises in deflation
Nominal value	Measured in money at the prices of the time
Real value	Nominal value adjusted for price changes

Must-know distinction: falling inflation is not deflation. If the rate drops from 5% to 2%, prices are still rising. Deflation means the rate is below zero.

4.8.2 Measuring with the Consumer Prices Index (CPI)

The CPI follows the cost of a basket of goods and services that typical households buy. Each category carries a weight for its place in the household budget. The base year is 100.

Formula	Use
Price relative = new price / base price x 100	Index for one item
CPI = sum of (weight x category index) / total of weights	Weighted average
Inflation rate = (new CPI - old CPI) / old CPI x 100	Percentage change
New value = old value x (1 + rate/100)	Applying a rate

Method in steps:

1. Write each category index and its weight.
2. Multiply each pair, then add.
3. Divide by the total of the weights (100 if they are percentages).
4. Compare two years with the inflation formula and keep the sign.

Worked reminder: a household has three categories (illustrative) with weights 40, 35 and 25 and indices 110, 120 and 90. Weighted sum: 44 + 42 + 22.5 = 108.5. A price that was 5.50 and is now 6.60 has an index of 6.60 / 5.50 x 100 = 120.

Worked reminder: the CPI moves from 104 to 110.24. Rate = 6.24 / 104 x 100 = 6.0%.

Worked reminder: the CPI moves from 120 to 115.2. Rate = -4.8 / 120 x 100 = -4.0%, which is deflation.

Limits of the CPI: it is an average; weights go out of date; quality changes and new goods are hard to include; different households have different baskets.

4.8.3 Causes

Type	What changes	Causes
Demand-pull inflation	Total demand rises	More consumer spending, investment, government spending or export demand; faster growth of the money supply; economy near full capacity
Cost-push inflation	Total supply falls (costs rise)	Higher wages without higher productivity; dearer raw materials or energy; weaker exchange rate; higher indirect taxes
Demand-side deflation	Total demand falls	Weak confidence; high interest rates; lower exports; cuts in government spending
Supply-side deflation	Total supply rises (costs fall)	New technology; higher productivity; cheaper inputs or imports

Chains of reasoning to practise:

• Demand-pull: more spending, so excess demand at capacity, so firms raise prices, so the price level rises.
• Cost-push: higher wages or fuel costs, so unit costs rise, so firms pass on the rise, so the price level rises.
• Demand-side deflation: lower confidence, so households save, so demand falls, so firms cut prices and output.
• Supply-side deflation: better technology, so unit costs fall, so firms cut prices and output rises.

Cost share calculation: if wages are 50% of costs and rise by 8%, total costs rise by 50% x 8% = 4%.

Effects on prices and output (explain in words)

The syllabus says aggregate demand and aggregate supply are not required (in its note on fiscal policy), so explain each cause by saying whether total demand or total supply changes.

Event	What changes	Effect
Demand-pull inflation	Total demand rises	Higher price level, higher output (little output rise near capacity)
Cost-push inflation	Total supply falls	Higher price level, lower output
Demand-side deflation	Total demand falls	Lower price level, lower output
Supply-side deflation	Total supply rises	Lower price level, higher output

State the cause, the change in total demand or supply, then the effect on prices and on output.

Must-know distinctions

• Demand-pull comes from a rise in total demand; cost-push comes from a fall in total supply.
• Inflation (prices rising) is not the same as a high price level. A country can have a high price level and low inflation.
• Nominal is in money terms; real allows for price changes.
• Demand-side deflation lowers output and jobs; supply-side deflation raises output.
• Fiscal policy uses taxes and government spending; monetary policy uses interest rates and credit.

4.8.4 Consequences

Group	Inflation	Deflation
Consumers	Purchasing power falls, especially with fixed incomes	Money buys more, but spending may be delayed
Workers	Real wage falls if pay rises more slowly than prices	Wage cuts or job losses possible
Savers	Lose if interest rate is below inflation	Gain in real terms
Lenders	Lose on fixed-rate loans	Gain
Borrowers	Gain: the real debt shrinks	Lose: the real debt grows
Firms	Higher costs, uncertainty, loss of competitiveness	Lower revenue and profit, harder debt repayment, less investment
Economy	Weaker exports, possible wage-price spiral	Falling demand, output and jobs; lower tax revenue

Real calculations:

• Real wage change is approximately the nominal pay rise minus inflation: 6% pay rise, 2.5% inflation, so +3.5%.
• Real interest rate is approximately the nominal interest rate minus inflation: 2% interest, 4.5% inflation, so -2.5%.
• Applying inflation to a price: 80 rising by 12.5% gives 80 x 1.125 = 90.
• Compounding: inflation of 3.5% for two years takes an index of 100 to 100 x 1.035 x 1.035 = 107.1 (to 1 decimal place).

Mild, steady inflation can be consistent with growth. Fast or unpredictable inflation and any deflation tied to falling demand are more damaging.

4.8.5 Policies and effectiveness

Policy	Against inflation	Against deflation	Main limit
Fiscal	Raise taxes, cut government spending	Cut taxes, raise government spending	Slow to organise; unpopular; may raise debt
Monetary	Raise interest rates, restrict credit	Cut interest rates, expand credit	Time lags; weak if confidence is low
Supply-side	Improve education, training, infrastructure, competition	Rarely needed for supply-side deflation	Takes years; costly
Exchange rate	Stronger currency lowers import prices	Weaker currency raises import prices	Hurts exporters or importers
Direct controls	Limits on wages or prices	Not usual	Shortages; hard to enforce

Evaluation checklist: (1) policy matches the cause; (2) time lags; (3) cost to growth and jobs; (4) confidence and expectations; (5) the economy’s size and openness; (6) a final judgement with a reason.

Quick self-test

1. Define deflation.
2. The CPI rises from 250 to 262.5. Calculate the rate of inflation.
3. Explain why a fall in the rate of inflation from 4% to 1% is not deflation.
4. State two possible causes of cost-push inflation.
5. State one cause of supply-side deflation and say what happens to output.
6. A worker’s pay rises 6% while inflation is 2.5%. Approximate the change in the real wage.
7. A saver earns 2% when inflation is 4.5%. Approximate the real interest rate.
8. Explain why a lender with a fixed-rate loan loses in inflation.
9. Give one reason why raising interest rates might fail to control cost-push inflation.
10. Name one fiscal policy to deal with deflation and one drawback.

Answers

1. A continuing decrease in the general price level.
2. (262.5 - 250) / 250 x 100 = 5.0%.
3. Prices are still rising, only more slowly. Deflation needs a negative rate.
4. Any two of: higher wages not matched by productivity, dearer raw materials or energy, a weaker currency, higher indirect taxes.
5. For example new technology lowers costs. Output rises while prices fall.
6. About 6 - 2.5 = +3.5%.
7. About 2 - 4.5 = -2.5%.
8. Repayments are made in money that buys less than when it was lent.
9. Higher rates reduce spending, yet the source of cost-push inflation is on the supply side. Output and employment may fall while prices keep rising.
10. Cut taxes or raise government spending; the drawback is higher government borrowing (or a time lag).

Where marks are usually lost

• Writing “prices rise” without “general” and “sustained” in a definition.
• Treating lower inflation as deflation.
• Forgetting to divide by the old value, not the new one, in a percentage change.
• Dropping the negative sign on a deflation rate or a negative real interest rate.
• Giving a list of effects without saying who gains and who loses.
• Giving “raise interest rates” with no chain of reasoning to prices.
• Using demand-side policies for cost-push inflation without noting the limit.
• Ending an evaluation without a judgement.

Official syllabus

Source: the Cambridge O Level Economics (2281) syllabus for the 2026 examinations (version 2), from Cambridge University Press & Assessment; this page follows section 4.8.