Pearson Edexcel International GCSE Economics: Inflation, deflation and the CPI (4EC1)

This guide covers the “low and stable inflation” statement, section 2.1.1 b), of the Pearson Edexcel International GCSE Economics (4EC1) specification, Issue 3, February 2026. It sits in Paper 2, Macroeconomics and the Global Economy, and the course is a single tier of entry. Every country, firm and figure below is invented and illustrative. Check your progress with the revision notes and the practice questions, see the course hub and checklist, or test yourself with the free diagnostics.

What the specification lists

Specification point	What you must be able to do
Definition of inflation and deflation	Give a two-part definition of each
Measurement using the consumer price index (CPI)	Explain how a weighted index works and calculate it
Demand-pull and cost-push inflation	Explain causes, with a chain of reasoning
Inflation and interest rates	Explain how each affects the other
Impact on prices, wages, exports, unemployment	Analyse who gains and who loses
Menu costs, shoe leather costs	Define and give examples
Uncertainty, confidence, investment	Explain the knock-on effects on firms and households

Inflation and deflation

Inflation means the general level of prices in an economy keeps rising over time. A full definition has two parts: the rise is general (not one product) and it is sustained (not a single month). The rate of inflation is the percentage change in the price level over a period, usually a year.

Deflation is a sustained fall in the general level of prices. Prices of some goods fall in every economy; deflation means the average falls.

One effect to note: when prices rise, each unit of money buys fewer goods. Its purchasing power falls.

Measuring inflation with the CPI

The consumer price index (CPI) measures the average change in the prices of a basket of goods and services bought by typical households. It is a weighted index. Households spend more on food and housing than on cinema trips, so a price change in food must count for more.

Steps:

1. Choose a base year and set its index at 100 for each group of items.
2. Record each group’s index in the current year.
3. Give each group a weight showing its share of household spending. The weights add up to 100 here.
4. Multiply each index by its weight, add the results, and divide by the total of the weights.

Worked example 1: calculating a weighted CPI

Country K has a basket with five groups. The base year is 2025, so every group is 100 in 2025.

Group	Weight	Index in 2026	Weight × index
Food	30	106	3,180
Housing	35	103	3,605
Transport	15	110	1,650
Clothing	10	98	980
Leisure	10	104	1,040
Total	100		10,455

CPI in 2026 = 10,455 ÷ 100 = 104.55. Average prices are 4.55% above the base year. Transport rose most, but housing mattered more because its weight is bigger. Clothing fell and pulled the CPI down slightly.

A group index comes from prices. A loaf cost KD 1.60 in 2025 and KD 1.76 in 2026, so its index is 1.76 ÷ 1.60 × 100 = 110.

Worked example 2: inflation and deflation rates

Rate of change = (new CPI − old CPI) ÷ old CPI × 100.

• 2026 to 2027: the CPI rises from 104.55 to 107.0. (107.0 − 104.55) ÷ 104.55 × 100 = 2.3% (to 1 d.p.). Inflation is positive but lower than in 2026. Prices are still rising, only more slowly.
• 2027 to 2028: the CPI falls from 107.0 to 105.5. (105.5 − 107.0) ÷ 107.0 × 100 = −1.4%. A negative rate means deflation.

Do not confuse a CPI of 107 with 107% inflation. It means prices are 7% above the base year.

Limits to keep in mind

The CPI is an average. A household that spends heavily on transport has a different experience from the typical household. Weights are updated only periodically, so they can drift from real spending patterns.

Types of inflation

Use a price-level and real-output diagram. The vertical axis is the general price level, the horizontal axis is real output, and the curves are aggregate demand (AD) and aggregate supply (AS).

	Demand-pull	Cost-push
Curve that shifts	AD shifts right	AS shifts left
Price level	Rises	Rises
Real output	Rises, if there is spare capacity	Falls

Demand-pull inflation

Demand-pull inflation happens when total spending in the economy grows faster than the economy’s ability to produce. Possible causes:

• lower interest rates, which make borrowing cheaper and saving less attractive
• cuts in income tax, which raise disposable income
• more government spending
• higher consumer or business confidence
• rising export demand from abroad

Chain of reasoning: rising demand means firms sell more, and stocks fall. Firms with little spare capacity cannot easily raise output, so they raise prices and compete for workers, which pushes wages up. The nearer the economy is to full capacity, the more of the extra demand becomes higher prices rather than higher output.

Cost-push inflation

Cost-push inflation happens when firms’ costs of production rise and they pass the increase on in higher prices. Causes include higher wages, higher raw material or energy prices, higher indirect taxes, and higher prices for imported inputs.

Worked example 3: cost pass-through

A small bakery has weekly costs of KD 400 for ingredients, KD 500 for wages and KD 100 for rent and energy, a total of KD 1,000. It bakes 2,000 loaves, so average cost is KD 0.50 per loaf.

Ingredients rise 12% and wages rise 8%.

• Ingredients: 400 × 1.12 = 448
• Wages: 500 × 1.08 = 540
• Rent and energy: 100
• New total cost: 448 + 540 + 100 = 1,088, up 8.8%

Average cost is now 1,088 ÷ 2,000 = KD 0.544 per loaf, also up 8.8%. To keep its profit per loaf, the bakery must raise its price by about the same percentage. If many firms do this, the general price level rises. Notice that output may fall: if loaf prices rise, quantity demanded drops.

Inflation and interest rates

The two move together in both directions.

• High or rising inflation leads to higher interest rates. A central bank raises interest rates to reduce spending. Borrowing becomes dearer and saving more rewarding, so consumer spending and investment fall. AD grows more slowly and demand-pull pressure eases.
• Low inflation or deflation leads to lower interest rates. The aim is to encourage spending and borrowing so prices do not keep falling.

Real interest is the nominal rate minus inflation, roughly. If a savings account pays 2% and inflation is 4.55%, the real return is about −2.5 percentage points. Check: KD 1,000 becomes KD 1,020, but the basket that cost KD 1,000 now costs KD 1,045.50, so the saver can buy 2.4% less.

Interest rates also affect firms. A firm borrows KD 200,000 to buy a machine it expects to return 5% a year (KD 10,000). At 4% interest, its interest cost is KD 8,000, so it gains KD 2,000. At 7%, the cost is KD 14,000, so the machine loses KD 4,000 a year and the firm will probably not buy it.

The effects of inflation

Prices and wages

Prices rise, so purchasing power falls. People on fixed incomes, such as pensioners, lose most. Wages may rise too, but what matters is the real wage.

Worked example 4: a worker earns KD 2,000 in 2025, and the pay rises 3% to KD 2,060 in 2026. Real pay = 2,060 ÷ 104.55 × 100 = KD 1,970 in 2025 prices. That is a fall of 1.5%, although the pay packet rose. If workers demand big rises to catch up, firms’ costs rise and may feed more cost-push inflation.

Exports

If Country K’s inflation is higher than its trading partners’, and the exchange rate does not change, its goods become dearer abroad. A good costing KD 50 rises by 4.55% to KD 52.28, whereas a rival’s equivalent rises 1% to KD 50.50. Foreign buyers switch to the cheaper rival, so export sales fall. Imports also look cheaper at home, so the effect can be larger.

Unemployment

The effect depends on the cause. Falling export sales and falling demand under cost-push inflation can lead firms to cut jobs. If the central bank raises interest rates to control inflation, lower spending can also raise unemployment. Demand-pull inflation, by contrast, often goes with rising output and falling unemployment in the short run.

Menu costs and shoe leather costs

• Menu costs are the costs to firms of changing prices. A café reprints 30 menus at KD 1.50 each (KD 45) and uses 3 staff hours at KD 6 (KD 18). That is KD 63 per price change, or KD 252 if prices change four times a year. Larger firms also relabel goods and reprogramme tills.
• Shoe leather costs are the time and effort households and firms spend protecting the value of their money, such as visiting several shops to find lower prices or moving money between accounts to earn more interest.

Uncertainty, confidence and investment

Rapid or unpredictable inflation makes the future harder to plan. Firms cannot be sure what costs and prices will be, so they find it harder to agree long contracts. Consumers who expect prices to keep rising may cut back on spending that is not essential. Falling confidence reduces spending and investment. Higher interest rates and uncertain returns also make firms delay investment, which reduces the economy’s productive capacity over time.

Evaluating inflation

Inflation is a problem when it is high, unstable or unexpected. Low and stable inflation is a macroeconomic objective because it lets people plan. Judge any effect by asking: how high is inflation, what is causing it, who is affected, and how quickly can people adjust? Mild inflation may cause few problems, and some groups gain, such as borrowers whose debts fall in real terms.

Common errors

• Writing “prices rise” without “general” or “sustained” in a definition.
• Dividing by 100 twice, or forgetting to divide by the total weight.
• Using the new CPI as the denominator when finding the rate of change.
• Saying inflation means prices are falling more slowly. That is slower inflation, not deflation.
• Listing effects with no chain of reasoning to say why they follow.

Official syllabus

Pearson Edexcel International GCSE in Economics (4EC1), Specification Issue 3, February 2026, for first teaching September 2017, published by Pearson Education Limited. Section 2.1.1 b), Low and stable inflation.