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IB DP Economics — Unit 3: Macroeconomics | SL | 3.3 Macroeconomic Objectives
📋 What You Will Learn
- Define inflation, deflation, and disinflation, and distinguish between them precisely
- Explain how the Consumer Price Index (CPI) is calculated and identify its limitations as a measure of inflation
- Analyse the demand-pull and cost-push causes of inflation using AD/AS diagrams
- Evaluate the costs of inflation for different economic groups and the economy as a whole
- Explain the causes and costs of deflation, and distinguish deflation from disinflation
- Apply inflation concepts to real-world policy contexts and Paper 1/2 exam questions
🔍 Guiding Question Is inflation always harmful — and under what circumstances might deflation be even more damaging to an economy than rising prices?
🌍 Why This Matters In 2022–23, inflation in the United Kingdom reached 11.1% — the highest in 41 years — driven by surging energy prices following Russia's invasion of Ukraine and post-pandemic supply disruptions. Meanwhile, Japan spent much of the 1990s and 2000s trapped in deflation, where falling prices caused consumers to delay spending and firms to cut investment, producing a "lost decade" of near-zero growth. Both extremes — too much inflation and too little — impose serious costs on real economies and real people.
Measuring Inflation: The Consumer Price Index (CPI)
Before analysing causes and costs, we need a precise way to measure inflation. The most widely used tool is the Consumer Price Index (CPI), which tracks changes in the price of a representative basket of goods and services purchased by a typical household.
📖 Definition — Inflation Inflation is a sustained increase in the general price level of goods and services in an economy over a period of time, resulting in a fall in the purchasing power of money.
How the CPI Is Constructed
- A representative basket of goods and services is selected, reflecting the spending patterns of a typical household (food, housing, transport, clothing, healthcare, etc.)
- Each item is assigned a weight reflecting its share of total household expenditure — items on which households spend more are weighted more heavily
- Prices of all items are collected monthly from a sample of retailers and service providers
- The weighted average price change is calculated to produce the CPI index number
- The inflation rate is the percentage change in the CPI between two periods
CPI Inflation Rate
\[ \text{Inflation Rate} = \frac{\text{CPI}_{\text{current year}} - \text{CPI}_{\text{base year}}}{\text{CPI}_{\text{base year}}} \times 100 \]
For example, if the CPI was 105 in 2023 and 100 in the base year 2022, the inflation rate = \(\frac{105 - 100}{100} \times 100 = 5\%\).
Limitations of the CPI
- Basket may not reflect all households: the basket represents an "average" household — it may not reflect the spending patterns of the elderly, low-income households, or rural communities
- Quality changes: if a product improves in quality but rises in price, the CPI may overstate inflation (e.g. smartphones becoming more powerful)
- New goods problem: new products (e.g. streaming services) may not be included in the basket immediately, causing the CPI to miss price changes in growing sectors
- Substitution bias: when prices rise, consumers switch to cheaper substitutes — but the fixed basket does not account for this, potentially overstating inflation
- Housing costs: different countries treat housing differently in the CPI — owner-occupied housing costs are often excluded or underweighted
💡 Note — Inflation Rate vs Price Level A falling inflation rate does NOT mean prices are falling — it means prices are rising more slowly. This is disinflation , not deflation. Prices are still rising; the rate of increase has slowed. This distinction is critical in exams.
Defining the Key Terms
📖 Definition — Deflation Deflation is a sustained decrease in the general price level — a negative rate of inflation.