In simple terms
A friendly intro before the formal notes — no formulas yet.
Rising prices economy-wide
Inflation is a sustained increase in the general price level. Moderate inflation is a policy target; hyperinflation destroys money's store of value.
Inflation is like all prices in a supermarket rising together — your shopping basket costs more even if you buy the same items. Deflation is the reverse: the same basket gets cheaper year after year.
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CPI tracks basket of goods — inflation rate = ((CPI₁ − CPI₀)/CPI₀) × 100%.
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Demand-pull: AD shifts right — 'too much money chasing too few goods'.
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Cost-push: SRAS shifts left — oil shock, wage push, import costs.
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Deflation: falling P — may increase real debt burden and delay spending.
Explore the concept
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Inflation: sustained rise in general price level
Inflation: sustained rise in general price level.
Key formulas
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At a glance — side by side
Compare key properties side by side — ideal for exam contrasts.
Comparing Demand-Pull and Cost-Push Inflation
| Feature | Demand-Pull Inflation | Cost-Push Inflation |
|---|---|---|
| Primary Cause | Excess Aggregate Demand (AD) | Increase in costs of production |
| AD/AS Diagram Shift | Rightward shift of the AD curve | Leftward shift of the SRAS curve |
| Effect on Real GDP (Output) | Increases (in the short run) | Decreases |
| Effect on Unemployment | Decreases (in the short run) | Increases |
| Associated Term | Economic Boom / Overheating | Stagflation |
| Example Policy Response | Increase interest rates (Contractionary Monetary Policy) | Supply-side policies to reduce business costs |
Primary Cause
Demand-Pull Inflation
Cost-Push Inflation
AD/AS Diagram Shift
Demand-Pull Inflation
Cost-Push Inflation
Effect on Real GDP (Output)
Demand-Pull Inflation
Cost-Push Inflation
Effect on Unemployment
Demand-Pull Inflation
Cost-Push Inflation
Associated Term
Demand-Pull Inflation
Cost-Push Inflation
Example Policy Response
Demand-Pull Inflation
Cost-Push Inflation
Full topic notes
Formal explanation with the rigour you need for the exam.
Understanding Price Stability and Its Measurement
Price stability does not mean zero inflation. Instead, it refers to a low, stable, and predictable rate of inflation, which most developed economies target at around 2% per annum. This small, positive rate avoids the significant risks of deflation and allows for gradual adjustments in real wages and prices, 'greasing the wheels' of the economy. The primary measure of inflation is the Consumer Prices Index (CPI). This index tracks the price of a representative 'basket' of goods and services consumed by the average household. Each item is weighted according to its importance in household expenditure. The annual inflation rate is the percentage change in the value of this basket from one year to the next.
Price stability is a macroeconomic objective referring to a low and stable rate of positive inflation, typically around 2%.
It avoids the dangers of deflation while allowing for economic flexibility.
The Consumer Prices Index (CPI) is the headline measure of inflation.
The CPI tracks a weighted basket of goods and services to reflect average household spending patterns.
When defining price stability, always state that it refers to a low and stable rate of inflation, not an absence of it. This nuance demonstrates a deeper understanding and is crucial for higher-level marks.
Demand-Pull Inflation: Analysis and Causes
Demand-pull inflation occurs when aggregate demand (AD) persistently outstrips the economy's ability to supply goods and services. It is often described as 'too much money chasing too few goods'. This situation arises from a rightward shift in the AD curve, caused by increases in any of its components: consumption (C), investment (I), government spending (G), or net exports (X-M). For example, a sustained fall in interest rates could boost consumer spending and business investment, shifting AD to the right. On an AD/AS diagram, this leads to a higher equilibrium price level and, in the short run, a higher level of real GDP as firms increase output to meet the higher demand.
Caused by a rightward shift in the Aggregate Demand (AD) curve.
Occurs when AD grows faster than the economy's productive capacity (AS).
Key drivers include increased consumer confidence, lower interest rates, expansionary fiscal policy, or a global economic boom boosting exports.
Results in a higher price level and, in the short run, higher real output.
In AD/AS diagrams for demand-pull inflation, ensure you clearly label the initial and new equilibrium points, showing an increase in both the price level (from P to P1) and real GDP (from Y to Y1) along the SRAS curve.
Cost-Push Inflation: Analysis and Causes
Cost-push inflation is caused by a decrease in short-run aggregate supply (SRAS), represented by a leftward shift of the SRAS curve. This shift is triggered by an increase in the costs of production for firms, which are then passed on to consumers in the form of higher prices. Common causes include rising prices of imported raw materials (e.g., an oil price shock), powerful trade unions negotiating wage increases above productivity growth, or an increase in indirect taxes like VAT. The unwelcome outcome of cost-push inflation is 'stagflation'—a simultaneous rise in the price level (inflation) and a fall in real GDP (stagnation), which also leads to an increase in unemployment.
Caused by a leftward shift in the Short-Run Aggregate Supply (SRAS) curve.
Stems from increased costs of factors of production.
Common triggers are rising commodity prices, wage-price spirals, or a currency depreciation making imports more expensive.
Leads to a higher price level and lower real output, a condition known as stagflation.
When explaining cost-push inflation, always link a specific cause (e.g., rising oil prices) to the leftward shift of the SRAS curve and the resulting 'stagflation' – the combination of higher inflation and lower real GDP.
The Dangers of Deflation
Deflation, a persistent fall in the general price level (negative inflation), is often more damaging than moderate inflation. It is typically caused by a significant fall in aggregate demand. When prices fall, consumers and firms delay purchases, expecting goods to become even cheaper in the future. This reduces current spending, further depressing AD and creating a deflationary spiral of falling prices and falling output. Furthermore, deflation increases the real burden of debt; while asset prices and incomes fall, the nominal value of debt remains fixed, leading to widespread defaults and financial instability. This combination of delayed spending and rising real debt can trigger a deep and prolonged recession, making it a major concern for policymakers.
Deflation is a sustained decrease in the general price level.
It encourages consumers to delay spending, which reduces aggregate demand.
The real value and burden of existing debt increases, raising the risk of bankruptcies.
It can lead to a 'deflationary trap' which is very difficult for policymakers to escape.
Measuring inflation
Inflation rate =
Real value of money falls as P rises
Purchasing power = (inversely related to price level)
Demand-pull vs cost-push
Demand-pull: AD ↑ → P ↑ and Y ↑ — expansionary policy can worsen inflation near Yf.
Cost-push: SRAS ↓ → P ↑ and Y ↓ — contractionary policy may deepen recession.
Policy dilemma: cost-push creates stagflation — no easy trade-off.
Deflation: falling P increases real debt burden; consumers delay purchases.
Worked examples
See the formulas applied — reveal one step at a time, like the exam.
The CPI was 110 in 2023 and 116.6 in 2024.
(a) Calculate the inflation rate. (b) A worker's nominal wage rose from 31,500. Calculate the real wage change. (c) Identify whether this is demand-pull or cost-push if AD also rose sharply while oil prices were stable.
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(a) Inflation rate = ((116.6 − 110) ÷ 110) × 100 = 6.0%
An oil price shock increases production costs. On a separate AD–AS diagram:
(a) Show the effect on P and Y. (b) Explain why contractionary monetary policy may be inappropriate. (c) Suggest one supply-side response.
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(a) Diagram SRAS shifts left from SRAS₁ to SRAS₂. New equilibrium: higher P, lower Y — stagflation.
How it all connects
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Glossary
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Quick check
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Revision flashcards
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Define inflation.
A sustained increase in the general price level — not a one-off rise in a single good.
Key takeaways
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Price stability is a macroeconomic objective referring to a low and stable rate of positive inflation, typically around 2%.
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It avoids the dangers of deflation while allowing for economic flexibility.
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The Consumer Prices Index (CPI) is the headline measure of inflation.
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The CPI tracks a weighted basket of goods and services to reflect average household spending patterns.
Practice — then mark it
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