Pearson Edexcel IAL Economics: Inflation, employment and unemployment (YEC11) – Revision Notes

Condensed recall for the final weeks. These notes follow the Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics specification, Issue 2, June 2018, sub-topic 2.3.1 (Measures of economic performance), items 2 (Inflation) and 3 (Employment and unemployment). The specification places this in Unit 2, an IAS compulsory unit that is also part of the full International Advanced Level. Item 1 of the same sub-topic, economic growth, is in the measuring economic growth revision notes. All data below is invented, for Country K.

Links: Edexcel A Level Economics hub, printable checklist, macroeconomic objectives revision notes and 10-minute diagnostics.

1. Inflation, deflation and disinflation (item 2a)

Term	Meaning	Example
Inflation	A sustained rise in the general price level	CPI up 3% a year
Deflation	A sustained fall in the general price level	CPI down 1% a year
Disinflation	A fall in the rate of inflation; prices are still rising	Inflation falls from 6% to 3%

Trap. Inflation falling from 6% to 3% is disinflation, not deflation: the price level is still rising, only more slowly.

2. Measuring inflation: the CPI (items 2b to 2d)

How a consumer price index is built

1. A household expenditure survey shows what households spend their income on.
2. A representative basket of goods and services is chosen.
3. Each category is given a weight equal to its share of household spending: the bigger the share, the bigger the weight.
4. Prices of the items are collected regularly from many places.
5. Each category’s price index is multiplied by its weight, the results are added, and the total is divided by the sum of the weights.
6. The index is set to 100 in the base year; the inflation rate is the percentage change in the index.

Inflation rate = (new index - old index) / old index x 100

Worked reminder: Country K

Category    Weight   Price index (base year = 100)
Food          30       104
Housing       25       106
Transport     20        98
Other         25       102

Weighted: 30x104 + 25x106 + 20x98 + 25x102 = 3,120 + 2,650 + 1,960 + 2,550
        = 10,280; divide by total weight 100 -> CPI = 102.8
Inflation = (102.8 - 100) / 100 x 100 = 2.8%

Transport prices fell, but because food and housing carry more weight and rose, the index still rose.

Limitations of the CPI (item 2c)

• The basket reflects an average household, so it may not match the spending of particular groups (for example pensioners or low-income households).
• Weights and the basket are updated only periodically, so new products and changes in spending patterns are picked up late.
• Quality changes are hard to measure: a higher price may buy a better product.
• Consumers switch to cheaper substitutes when prices rise, which a fixed basket does not fully capture.
• Some costs, such as certain housing costs, may be left out.
• Prices come from a sample of items and outlets, so there is some sampling error.

Producer (wholesale) price index (item 2d). Measures the prices firms pay for inputs and the prices they charge for output leaving the factory. Rising producer prices are usually passed on to consumers later, so the index is an early indicator of future CPI inflation.

3. Causes of inflation and deflation (items 2e and 2f)

Cause	Mechanism	AD/AS effect
Demand-pull	Aggregate demand grows faster than the economy’s ability to supply, especially near full capacity	AD shifts right: price level and real output rise
Cost-push	Higher costs of production, such as wages, raw materials, imported inputs (for example after a currency depreciation) or indirect taxes	SRAS shifts left: price level rises, real output falls
Excessive growth of the money supply	Money grows faster than output, so more money is spent on the same quantity of goods	Spending and AD rise; the price level rises

Cause of deflation	Mechanism	AD/AS effect
Falling AD	Weaker consumption, investment or exports	Price level and real output fall: often harmful
Increase in AS	Lower costs or higher productivity, for example from new technology	Price level falls while real output rises: often benign
Fall in the money supply	Less spending power in the economy	AD falls

Trap. “Prices rise because demand rises” is not enough: say AD rises faster than capacity, and link it to the price level on an AD/AS diagram.

4. Effects of inflation and deflation (item 2g)

Group or area	Inflation	Deflation
Consumers	Real incomes fall if prices rise faster than incomes; savers lose if interest rates are below inflation	Purchasing power rises, but people may delay purchases expecting lower prices
Government	Tax revenue rises as incomes and prices rise (fiscal drag); index-linked spending rises; the real value of debt falls	Tax revenue may fall; the real burden of government debt rises
Firms	Menu costs and shoe-leather costs; uncertainty makes planning harder	Falling prices squeeze revenue and profits, while debts stay fixed
Workers	Real wages fall unless pay rises keep up; wage bargaining becomes harder	Real wages may rise, but firms may cut jobs or resist pay rises
Income distribution	Hurts people on fixed incomes and savers; borrowers gain	Borrowers lose as the real value of debt rises; savers gain
Investment	High and unstable inflation makes returns uncertain, reducing investment	Expected falling demand and prices discourage investment
Competitiveness	Inflation higher than in trading partners makes exports dearer	Lower prices than partners can improve price competitiveness
Current account	Exports fall and imports rise, worsening the current account	May improve it, though weak domestic demand also cuts imports

Worked reminder. Wages in Country K rise 4% while inflation is 6%. Real wages change by 1.04 / 1.06 - 1 = -1.9%: workers can buy less, even though their pay rose.

5. Measuring unemployment (items 3a and 3e)

ILO definition. People are unemployed if they are without a job, have actively looked for work in the past four weeks and are available to start work in the next two weeks (or have found a job and are waiting to start it). The figure is collected by a labour force survey of households.

The claimant count, used in some countries (such as the UK), counts only people claiming unemployment-related benefits. The specification names the ILO measure; the claimant count is a useful contrast, because people who are not eligible for benefits, or who choose not to claim, are left out of it.

Labour force (economically active) = employed + unemployed (ILO)
Unemployment rate = unemployed / labour force x 100
Employment rate   = employed / working-age population x 100
Inactivity rate   = economically inactive / working-age population x 100

Economically inactive: working-age people who are neither employed nor unemployed, for example full-time students, carers, the long-term sick and early retirees.

Worked reminder: Country K

Working-age population 30.0m; employed 22.8m; ILO unemployed 1.2m
Labour force   = 22.8 + 1.2 = 24.0m
Unemployment   = 1.2 / 24.0  = 5.0%
Employment     = 22.8 / 30.0 = 76.0%
Inactive       = 30.0 - 24.0 = 6.0m, so 6.0 / 30.0 = 20.0%

Significance of the three rates (item 3e). Unemployment can fall because people find jobs (employment rises) or because they give up looking and become inactive. Always check the employment and inactivity rates before saying the labour market has improved.

6. Causes of unemployment (item 3b)

Type	Cause	Example
Frictional	Time spent moving between jobs while searching	A graduate looking for a first job
Seasonal	Demand for labour changes with the seasons	Tourism workers out of season
Structural	Long-term decline of an industry; workers’ skills or location do not match the jobs available	Coal miners after mines close
Demand deficiency (cyclical)	Too little aggregate demand, usually in a downturn or recession	Job losses across many industries in a recession
Real wage inflexibility	The real wage is held above the market-clearing level (for example by a minimum wage or union bargaining), so labour supplied exceeds labour demanded	Excess supply of labour at the set wage

7. Effects of unemployment (items 3c, 3d and 3f)

On	Effects
Consumers	Lower incomes and spending; less confidence even among those still employed
Firms	Lower demand for products; but a larger pool of workers and less pressure on wages
Workers	Lost income; skills decline the longer they are out of work (making it harder to return); stress
Public finances	Less income tax and spending tax revenue; more spending on benefits; the budget deficit widens
Resource use and the PPF	Labour is an unused resource, so the economy produces at a point inside its production possibility frontier
Society	Higher risk of poverty, inequality and social problems, often concentrated in particular regions

Unemployment versus underemployment (item 3d). Unemployed people have no job. Underemployed people have a job but want more hours than they are given, or work in a job below their skills and qualifications. Underemployment does not appear in the unemployment rate.

Net migration (item 3f). Net inward migration of working-age people raises the size of the labour force. It can fill skill shortages and add to demand through migrants’ spending, which creates jobs; it may also increase competition for some jobs. The overall effect on unemployment depends on the skills of migrants and the state of the economy.

8. Must-know distinctions

Pair	Difference
Disinflation vs deflation	Inflation rate falling but positive vs price level falling
Price level vs inflation rate	The index vs its percentage change
Demand-pull vs cost-push	AD shifts right vs SRAS shifts left
CPI vs producer price index	Consumer prices now vs firms’ prices, an early indicator
Unemployed vs inactive	Looking and available vs not looking for work
Unemployment vs underemployment	No job vs not enough work or a job below one’s skills
Structural vs demand deficiency	Mismatch of skills or location vs too little AD
Nominal vs real wage	Money paid vs what it can buy

9. Quick self-test

1. Inflation falls from 4% to 1%. Is this deflation? Explain.
2. A CPI rises from 240.0 to 247.2. Calculate the inflation rate.
3. A price index falls from 150.0 to 147.0. Calculate the rate and name it.
4. Weights 50, 30 and 20; category indices 110, 100 and 90. Calculate the weighted index.
5. Give two limitations of the CPI.
6. Why can the producer price index help forecast inflation?
7. Name the type of inflation caused by a rise in imported oil prices, and the curve that shifts.
8. Give one reason deflation caused by rising AS may be less harmful than deflation caused by falling AD.
9. There are 0.9m ILO unemployed and 17.1m employed. Calculate the unemployment rate.
10. State the three conditions in the ILO definition of unemployment.
11. Which type of unemployment is caused by a minimum wage set above the market-clearing wage?
12. Unemployment falls, but the inactivity rate rises sharply. Why should you be careful before calling this an improvement?

Answers

1. No. It is disinflation: prices are still rising, by 1% a year.
2. 7.2 / 240.0 x 100 = 3.0%.
3. -3.0 / 150.0 x 100 = -2.0%: deflation.
4. (50 x 110 + 30 x 100 + 20 x 90) / 100 = (5,500 + 3,000 + 1,800) / 100 = 103.0.
5. Any two: the basket fits an average household only; slow to include new products; quality changes; substitution between goods; some housing costs left out; sampling error.
6. Producer price rises are usually passed on to consumer prices later.
7. Cost-push inflation; the SRAS curve shifts left.
8. Real output rises while prices fall, so jobs and incomes are not lost; falling-AD deflation comes with falling output and rising unemployment.
9. Labour force 18.0m; 0.9 / 18.0 = 5.0%.
10. Without a job; actively sought work in the past four weeks; available to start within two weeks.
11. Real wage inflexibility (classical unemployment).
12. People may have stopped looking for work rather than found jobs, so employment may not have risen.

Where marks are usually lost

• Calling a lower but positive inflation rate “deflation”.
• Dividing the unemployed by the whole population instead of the labour force.
• Treating “falling prices” and “a falling inflation rate” as the same thing.
• Naming demand-pull or cost-push with no link to AD or SRAS.
• Listing CPI limitations with no explanation of why each distorts the figure.
• Assuming lower unemployment always means more people in work.
• Describing structural unemployment as “not enough demand”, which is demand deficiency.
• Ignoring that the effects of inflation depend on whether it was expected, and on how high and how stable it is.

Frequently asked questions

Can unemployment fall without more people finding jobs? Yes. Unemployment can also fall if people stop looking for work and become economically inactive, so lower unemployment does not always mean more people in work. Check the employment and inactivity rates too.

What is the difference between unemployment and underemployment? Unemployed people have no job. Underemployed people have a job but want more work, or are in a job below their skills.

Who gains and who loses from inflation? People on fixed incomes and savers whose interest rate is below inflation tend to lose, while borrowers gain because the real value of their debt falls. The effects also depend on whether inflation was expected and how high and stable it is.

What is fiscal drag? Fiscal drag is the rise in tax revenue as incomes and prices rise with inflation, which pulls more income into tax.

How do you calculate the unemployment rate in Edexcel International A Level Economics? Divide the number of ILO unemployed by the labour force, which is the employed plus the unemployed, and multiply by 100. Dividing by the whole population is a common error.

Official syllabus

Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics specification, Issue 2, June 2018 (first teaching September 2018), Pearson Education Limited; sub-topic 2.3.1, items 2 and 3. Item 4 of the same sub-topic (the balance of payments) is not covered on this page.