Cambridge O Level Economics: Inflation and deflation (2281)

This guide is written for section 4.8 (4.8.1 to 4.8.5, inflation and deflation) of the 2026 Cambridge O Level Economics (2281) syllabus, version 2. All names and numbers below are fictional. Use it with the revision notes and the practice questions. Other links: the Cambridge O Level Economics hub, the printable checklist, the free diagnostics and the money and banking guide, which explains interest rates and saving.

What the syllabus asks for

Section	Skill needed
4.8.1	Give accurate definitions of both terms
4.8.2	Show how the Consumer Prices Index (CPI) is used to measure price changes
4.8.3	Explain the two types of inflation (demand-pull, cost-push) and the two types of deflation (demand-side, supply-side)
4.8.4	Explain who gains and loses: consumers, workers, savers, lenders, firms and the whole economy
4.8.5	Describe policies against inflation and deflation and judge how well they might work

4.8.1 Definitions

Inflation is a sustained increase in the general price level of an economy. Deflation is a sustained decrease in the general price level. Three points matter.

• “General level” means prices overall. One price rising, such as the price of tomatoes after a poor harvest, is not inflation.
• “Sustained” means the movement continues over time, not for one week.
• Inflation is a rate of change. If prices rise by 2% a year, then 1% a year, prices are still rising. The rate of inflation has fallen, but the economy still has inflation. Prices only fall when the rate of inflation is negative, which is deflation.

Another way to say the same thing: when prices rise, each unit of money buys less, so the purchasing power of money falls. In deflation it buys more.

4.8.2 Measurement using the Consumer Prices Index

The Consumer Prices Index (CPI) tracks the cost of a typical household’s spending. Statisticians pick a basket of the goods and services households commonly buy, record their prices regularly, and combine them into one number.

• Spending is not equal across items, so each category has a weight reflecting how much of a typical budget goes on it. A change in the price of food, which takes a large share of the budget, moves the CPI more than the same change in the price of clothing.
• A base year is given the index value 100. Later values are measured against it. An index of 109 means prices are 9% above the base-year level.
• The inflation rate is the percentage change in the CPI between two dates:

inflation rate = (new CPI - old CPI) / old CPI x 100

Worked example 1: building and using a CPI

Country A (illustrative) has five categories. Each has a price index with the base year equal to 100.

Category	Weight	Year 1 index	Year 2 index
Food	30	108	115
Housing	25	104	108
Transport	20	112	120
Clothing	10	98	100
Other	15	105	110

Step 1: multiply each index by its weight and divide by 100 (the weights add to 100).

Year 1: 32.4 + 26.0 + 22.4 + 9.8 + 15.75 = 106.35. Year 2: 34.5 + 27.0 + 24.0 + 10.0 + 16.5 = 112.0.

Step 2: inflation rate = (112.0 - 106.35) / 106.35 x 100 = 5.3% to 1 decimal place.

Step 3: a single item’s index is its price relative. If an item cost 4.00 in the base year and costs 4.60 now, its index is 4.60 / 4.00 x 100 = 115.

Step 4: show a falling index as deflation. If Country B’s (illustrative) CPI falls from 100 to 97.6, the rate is (97.6 - 100) / 100 x 100 = -2.4%. The minus sign is part of the answer.

Limits of the CPI. It is an average, so it may not match your own spending. Weights are fixed from survey evidence and become out of date. Quality improvements and new products are hard to capture. It tells you nothing about which groups are hit hardest unless you compare their spending patterns.

4.8.3 Causes of inflation and deflation

Think of two forces: total demand (total spending in the economy) and total supply (what firms can produce and at what cost). The syllabus says aggregate demand and aggregate supply are not required (in its note on fiscal policy), so explain causes in words: say whether total demand or total supply has changed, then what happens to the price level and to output.

Demand-pull inflation

Demand-pull inflation happens when total demand grows faster than the economy’s ability to supply. Total demand rises, and when the economy is near full capacity the extra spending bids up prices instead of raising output. Possible sources:

• higher consumer spending, for example after tax cuts, easier borrowing or rising confidence
• higher investment by firms
• higher government spending
• higher export demand from abroad
• growth in the money supply, so more money chases the same goods

Chain of reasoning: tax cut, so households keep more income, so consumption rises, so total demand rises, so firms near capacity raise prices as well as output, so the price level rises.

Cost-push inflation

Cost-push inflation starts on the supply side: firms face higher costs and pass them on in higher prices. Total supply falls at each price level. Possible sources:

• higher wages not matched by higher productivity
• dearer raw materials or energy
• a fall in the exchange rate, which makes imported inputs cost more in local currency
• higher indirect taxes or business costs

Worked example 2: how much does a cost rise add to price?

A bakery (illustrative) has wages equal to 40% of its total costs. Wages rise by 10% and nothing else changes. Cost increase = 40% x 10% = 4%. If the bakery passes the whole rise on and keeps the same profit margin, its prices rise by about 4%. If many bakeries and other firms do this across the economy, the price level rises: cost-push inflation.

Exchange rate version: imports are 30% of a firm’s costs and the currency appreciates by 10%. Import costs in local currency change by 1/1.10 - 1 = -9.09%. Total cost falls by 30% x 9.09% = about 2.7%. The reverse (currency depreciation) pushes costs up.

Causes of deflation

• Demand-side deflation comes from falling total demand: weak consumer confidence, high interest rates, lower exports when trading partners slow, or cuts in government spending. Total demand falls. Firms cut prices to sell stock, and often cut output and jobs too.
• Supply-side deflation comes from rising total supply or lower costs: new technology, higher productivity, cheaper raw materials or cheaper imports. Total supply rises, so output rises and prices fall. This can be healthy because output and employment grow at the same time.

The two types differ in what happens to output. Demand-side deflation usually goes with falling output and rising unemployment. Supply-side deflation goes with rising output.

4.8.4 Consequences of inflation and deflation

Compare who gains and who loses, and say why. Nominal values are in money terms; real values allow for price changes.

Consequences of inflation

Group	Likely effect
Consumers	Purchasing power falls unless income rises as fast as prices. Fixed-income households lose most. Uncertainty may lead people to buy early.
Workers	Real wage = nominal wage adjusted for inflation. If the nominal wage rises by less than prices, the real wage falls. Strong trade unions may win pay rises that keep up; weak ones may not.
Savers	If the interest rate is lower than inflation, the real interest rate is negative and savings lose value.
Lenders	Fixed-rate loans are repaid in money that buys less, so lenders lose and borrowers gain.
Firms	Rising costs and the need to change prices; uncertain planning; investment may fall. Firms with strong pricing power cope better. Exporters may lose competitiveness.
Economy	Possible fall in exports and rise in imports, a wage-price spiral, lower saving, and, at high rates, damage to confidence in money.

Worked example 3: real wages and real interest

Worker X (illustrative) gets a 4% nominal pay rise while inflation is 6%. Real wage change is about 4 - 6 = -2%. (Exact: 1.04 / 1.06 - 1 = -1.9%.) She can buy less than before.

A saver puts 8,000 in an account paying 2.5% when inflation is 4%.

• After one year the balance is 8,000 x 1.025 = 8,200.
• Prices are 4% higher, so in last year’s prices the money is worth 8,200 / 1.04 = about 7,885.
• Real interest rate = 2.5 - 4 = -1.5% (approximately). The saver is worse off in purchasing power despite earning interest.

Reverse the story for a lender who charges a fixed 4% when inflation is 7%: the real return is 4 - 7 = -3%, so the lender loses while the borrower gains.

Consequences of deflation

Group	Likely effect
Consumers	Money buys more, but people delay purchases expecting lower prices later. Debts rise in real terms.
Workers	Firms may cut wages or jobs. Even a fixed wage buys more, but unemployment risk rises.
Savers	Real return rises, even at a zero interest rate.
Lenders	Gain, since loans are repaid with money that buys more.
Firms	Falling revenue and profit margins, debts harder to pay, lower investment, possible closures.
Economy	Falling demand, output and employment can reinforce each other in a downward spiral. Governments collect less tax.

Worked example 4: debt under deflation

A firm owes 50,000 on a fixed loan. The price level falls by 2.4%. Its debt is still 50,000 in money, but in base-period prices it is 50,000 / 0.976 = about 51,230. The firm repays more real value than it borrowed, a burden of roughly 1,230, while its own selling prices are falling.

4.8.5 Policies to control inflation and deflation

Policies work mainly by changing total demand or total supply.

Policies against inflation

• Fiscal policy: raise taxes and cut government spending. This reduces disposable income and demand. Effective against demand-pull, but politically unpopular and slow to organise.
• Monetary policy: raise interest rates and restrict credit. Borrowing and spending fall and saving becomes more attractive. The change affects spending with a time lag, and indebted households and firms are hurt.
• Supply-side policy: improve education, training, infrastructure and competition so productivity rises and costs fall. This helps against cost-push inflation and has no demand-side cost, but takes years.
• Exchange rate policy: a stronger currency makes imports cheaper, as example 2 showed. It hurts exporters.
• Direct controls: limits on prices or wages. They act quickly, but can cause shortages and are hard to enforce.

Policies against deflation

• Fiscal policy: cut taxes and raise government spending, so demand rises.
• Monetary policy: cut interest rates and expand credit and the money supply.
• Supply-side measures are not needed where deflation is the healthy, supply-side type.
• A weaker currency raises import prices and boosts exports.

How effective? Evaluation

1. Match the policy to the cause. Higher interest rates reduce demand-pull inflation well, but do little about a global oil price rise and may cut output further.
2. Time lags. Interest rate changes and supply-side measures take months or years.
3. Side effects. Fighting inflation can raise unemployment and slow growth; fighting deflation can raise government debt.
4. Confidence. In severe deflation, households may not borrow and spend even at very low interest rates.
5. Size and scope. A small open economy may find its price level driven by world prices and its exchange rate.

A balanced conclusion names the cause, chooses a policy and states one limit.

Common errors

• Calling any price rise “inflation” without saying “general” and “sustained”.
• Saying falling inflation means falling prices.
• Mixing up weights and index values, or forgetting to divide by 100.
• Leaving out the minus sign for deflation.
• Describing consequences without saying who gains and who loses.

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.