3.4 Price stability — OCR GCSE Economics revision notes

Inflation, and real versus nominal

Inflation: A sustained rise in the general price level — prices across the economy rising over time.
Price stability: Prices rising only slowly and predictably. The UK target is 2% inflation, not zero.
Deflation: A fall in the general price level — inflation below zero.
Nominal value: A value measured in the prices of the day, with no adjustment for inflation.
Real value: A value adjusted for inflation, so that changes in purchasing power can be seen.

The target is 2%, not 0%, and knowing why is worth a mark. A small, steady rise in prices gives firms confidence that they can raise prices and wages a little each year, and keeps the economy safely away from deflation — which sounds attractive but is damaging, because consumers delay purchases while they wait for prices to fall further, and firms cut output and jobs in response.

Real and nominal is the distinction that runs through this whole sub-topic. If wages rise by 3% while prices rise by 5%, the nominal wage has risen but the real wage has fallen: the money is greater but it buys less. The rough rule is

real change ≈ nominal change − inflation rate

So that worker is about 2% worse off despite being paid more. Any question asking whether people are actually better off is asking about real values.

Measuring inflation with the CPI

Inflation is measured in the UK using the Consumer Price Index. The method has three steps and is regularly examined:

1. A survey of household spending finds what people typically buy, and a representative basket of around 700 goods and services is chosen from it. 2. Each item in the basket is weighted according to how much of household spending it accounts for, so a change in the price of petrol or rent counts for far more than a change in the price of stamps. 3. The prices are collected each month, and the weighted total is compared with the same basket in a base year to give an index number. The percentage change over twelve months is the inflation rate.

The basket is updated each year, because what people buy changes — streaming subscriptions are in it, video recorders are not.

The limitations are the evaluation points. The basket is an average, so it does not match any individual household: someone who drives a great deal experiences higher inflation than the figure when fuel prices rise. It measures price rises but cannot capture improvements in quality, so a phone that costs the same as last year but does far more is recorded as no change. And it excludes some costs, notably mortgage interest payments.

Worked example

A basket of goods cost £400 in the base year and costs £432 now, and the base year index is 100. Calculate the current index number and the inflation rate. Then find what an item priced at £25 in the base year would cost now.

Index = (current cost ÷ base year cost) × 100.
That is (432 ÷ 400) × 100 = 108.
The inflation rate since the base year is the change in the index: 108 − 100 = 8%.
To update a price, multiply by the ratio of the index numbers.
£25 × (108 ÷ 100) = £25 × 1.08.
That gives £27.

Answer: The index is 108, so prices have risen 8% since the base year. An item costing £25 in the base year would cost £27 now, assuming its price rose in line with the average.

Causes and consequences

Figure: The two causes of inflation

Type	Cause	Examples
Demand-pull	Total demand in the economy rises faster than the economy can produce, so buyers bid prices up	A boom; tax cuts; low interest rates; rising consumer confidence and borrowing
Cost-push	The costs of production rise, so firms raise prices to protect their margins	Higher wages; more expensive raw materials or energy; a fall in the exchange rate making imports dearer

Demand-pull is too much money chasing too few goods; cost-push is the same goods costing more to make. Which one it is decides which policy will work.

Figure: Who inflation affects, and how

Group	Consequences
Consumers	The real value of income falls unless wages keep pace, so living standards drop; those on fixed incomes, such as pensioners, are hit hardest
Producers	Costs and prices become unpredictable, making planning and investment harder; UK goods become less competitive abroad if UK inflation is above other countries'; some firms gain if they can raise prices faster than their costs rise
Savers	Lose out, because the real value of savings falls if the interest rate is below the inflation rate — the money grows but buys less
Borrowers	Gain, because the real value of the debt falls — a fixed £100,000 mortgage becomes easier to repay as wages and prices rise around it
The government	Tax revenue rises with prices, but so does the cost of benefits and public sector wages; high inflation may force interest rates up, slowing growth

Savers lose and borrowers gain — that pairing comes up repeatedly, and follows directly from real versus nominal values.

Common mistake

A fall in the inflation rate does not mean prices are falling. If inflation drops from 6% to 2%, prices are still rising, just more slowly. Prices only fall when inflation is negative, which is deflation.

Before you practise

Inflation is a sustained rise in the general price level; the UK target is 2%.
Deflation is a fall in the price level, and is damaging because it delays spending.
Nominal values ignore inflation; real values adjust for it.
real change ≈ nominal change − inflation rate.
The CPI uses a weighted basket of around 700 goods, priced monthly against a base year.
The basket is an average, so it fits no individual household exactly, and it misses quality improvements.
Demand-pull inflation comes from demand rising faster than output.
Cost-push inflation comes from rising production costs.
Savers and those on fixed incomes lose from inflation; borrowers gain.
A falling inflation rate still means prices are rising.

Inflation, and real versus nominal

Measuring inflation with the CPI

Causes and consequences

Before you practise

Now practise it