What is inflation?
Inflation is a general and continuing rise in the price level of an economy. One price going up (say, onions after bad rain) is not inflation by itself. Inflation means most prices go up over time.
When prices rise, each unit of money buys less. This is a fall in the purchasing power (value) of money.
- Disinflation: inflation is still positive but slowing (8% → 4%).
- Deflation: the price level falls (inflation below 0%).
- Hyperinflation: extremely fast rises, such as more than 50% a month.
How inflation is measured: price indices
Statisticians track a basket of goods and services that a typical household buys (food, housing, fuel, transport, education). Each item gets a weight by how much households spend on it.
The Consumer Price Index (CPI) sets the basket cost in a base year = 100.
Index = cost of basket now ÷ cost in base year × 100
Inflation rate = (index this year − index last year) ÷ index last year × 100
Limits: the basket may not match your family, quality changes are hard to measure, and new products appear. Countries also use other indices (for example a wholesale or producer price index).
Causes: demand-pull, cost-push and expectations
Demand-pull
Total (aggregate) demand rises faster than the economy can produce. Causes: higher consumer spending, low interest rates and easy loans, fast growth of the money supply, big government spending, rising exports. "Too much money chasing too few goods."
Cost-push
Costs of production rise: wages, oil and energy, imported raw materials (made dearer by a weaker currency), indirect taxes. Firms raise prices to protect profits.
Expectations and the wage-price spiral
If people expect prices to rise, workers ask for higher pay and firms raise prices early, so inflation keeps itself going.
Causes of deflation
Weak demand (recession, falling confidence) or falling costs and better technology ("good" deflation from cheaper production).
Effects of inflation and deflation
- Savers lose if interest is below inflation (negative real interest rate). Borrowers gain because debts are repaid in money worth less.
- Fixed incomes (pensions, some wages) lose real value.
- Competitiveness: if prices rise faster than abroad, exports become dearer and imports cheaper.
- Menu and shoe-leather costs: changing price lists, extra time managing money.
- Uncertainty: firms invest less when future prices are hard to guess.
- Mild inflation can help: it encourages spending now and lets real wages adjust.
Deflation can be dangerous: people delay buying, firms cut output and jobs, and the real burden of debt grows.
Inflation, unemployment and policy
Low, stable inflation is one of the main government objectives, together with growth, low unemployment and a healthy balance of payments. Many central banks target about 2%; India's Reserve Bank targets 4% (within 2–6%).
The Phillips curve idea: in the short run, lower unemployment often comes with higher inflation, because strong demand pushes up both jobs and prices. In the long run this trade-off may disappear when people adjust their expectations. Stagflation (high inflation + high unemployment, as in the 1970s oil shocks) shows the trade-off is not always there.
Controlling inflation
- Monetary policy: raise interest rates → borrowing and spending fall.
- Fiscal policy: higher taxes or lower government spending.
- Supply-side policy: improve productivity so output can grow without prices rising.
Try it at home
Find an old bill, receipt or newspaper ad (5–10 years old) and note the price of 3 items. Find today's prices. Work out the percentage rise for each. Then use the slider in step 6 to see which yearly rate gives a similar rise.
Key formulas and definitions
- Price index = cost of basket now ÷ cost in base year × 100
- Inflation rate (%) = (P₂ − P₁) ÷ P₁ × 100
- Real value = nominal value ÷ (price index ÷ 100)
- Real interest rate ≈ nominal interest rate − inflation rate
- Price after n years = P × (1 + r)ⁿ
- Rule of 70: years for prices to double ≈ 70 ÷ inflation rate
Worked examples
1. A basket cost 2000 last year and 2100 this year. Find the inflation rate.
(2100 − 2000) ÷ 2000 × 100 = 5%.
2. The CPI went from 120 to 126. Find the inflation rate.
(126 − 120) ÷ 120 × 100 = 5%.
3. A bank pays 6% interest and inflation is 8%. What is the real interest rate?
6 − 8 = −2%. The saver's money buys about 2% less after a year.
4. Your pay rises from 30,000 to 31,500 while the CPI rises from 100 to 107. Did your real pay rise?
Pay rose 5%; prices rose 7%. Real pay = 31,500 ÷ 1.07 ≈ 29,439 in base-year money, so real pay fell by about 2%.
5. Inflation is a steady 7% a year. About how long until prices double?
Rule of 70: 70 ÷ 7 = 10 years. Check: 1.07¹⁰ ≈ 1.97.
6. Oil prices double worldwide and unemployment also rises. Which type of inflation is this and why is policy hard?
Cost-push. Output falls and prices rise together (stagflation). Raising interest rates fights inflation but makes unemployment worse; cutting them helps jobs but adds to inflation.
Common mistakes
- Calling one price rise (e.g. tomatoes) 'inflation'. It must be a general rise in the price level.
- Thinking a fall in the inflation rate means prices fall. From 6% to 3% prices still rise, only more slowly.
- Dividing by the new price instead of the old one when finding the percentage change.
- Assuming all inflation is bad. Low, stable inflation is the usual target; deflation can be harmful.