Inflation: Causes & Effects
Government and the Macroeconomy · 4 question types
Exam Frequency Analysis
Past paper frequency (2018 to 2024)
This topic accounts for approximately 17% of your exam marks.
Inflation causes (demand-pull vs cost-push), effects on different groups, and measurement appear in almost every series; 8 to 15 marks per paper.
The Consumer Price Index (CPI) is a weighted index that tracks the average price of a representative basket of goods and services that a typical household buys. The percentage change in the CPI from one period to the next is the rate.
How the CPI is constructed
Three steps the statistical agency takes.
Step 1: choose the basket. Statisticians survey thousands of households to find out what they actually spend their money on. The basket is then a representative selection: food, rent, transport, energy, clothing, entertainment, services, and many more sub-categories.
Step 2: apply weights. Items are weighted by their share of household spending. Rent and food typically have very large weights; restaurant meals and overseas holidays have smaller weights. So a 10% rise in rent has more impact on the CPI than a 10% rise in cinema tickets.
Step 3: record prices. Statisticians record the price of every item in the basket each month, in many locations. The weighted average is calculated to give the index value.
The basket and weights are updated periodically (usually annually) to reflect changing consumption patterns. New items are added; outdated items are removed.
Calculating the inflation rate
Inflation rate (%) = ((new CPI − old CPI) ÷ old CPI) × 100
Calculating the inflation rate from two CPI values
A country's Consumer Prices Index stood at 120 at the start of the year and rose to 138 by the end of the year.
Solution:
- Change in index = 138 − 120 = 18
- Divide by the starting value: 18 ÷ 120 = 0.15
- Multiply by 100 to express as a percentage: 0.15 × 100 = 15%
- The inflation rate over the year was 15%
Limitations of the CPI
- The "average household" does not exist. The CPI is built from the spending pattern of a typical household, so it misstates the inflation rate faced by any household whose basket differs from that average. When food and energy prices rise faster than average, low-income households (who spend a larger share of their income on them) face a higher inflation rate than the headline CPI shows.
- The basket cannot capture quality improvements. A laptop today is far more powerful than one from a decade ago at a similar price; the CPI does not always reflect that.
- The CPI may not include owner-occupied housing costs correctly, leading to debates about its accuracy.
- It is backward-looking: the basket reflects past spending patterns, not the basket households would buy at today's prices.