Inflation

Definition and Measurement

Inflation is a sustained general increase in the price level in the economy. It is not simply the rise in price of an individual good (if tomatoes become more expensive due to a poor harvest, that is not inflation), but an increase in the average price level of all goods and services. Government policy aims to keep inflation both low and stable—typically central banks set a target rate of around 2%.

Why 2%, and not 0%? Because a small positive inflation is considered “lubrication” for the economy: it enables real wages to decrease (while nominal wages remain unchanged), which helps the labor market adjust to shocks. Deflation (falling prices) is seen as even more dangerous than moderate inflation because consumers delay purchases in expectation of even lower prices, and the economy gets caught in a spiral of contracting demand.

How Inflation Is Measured

Countries publish Consumer Price Indices (CPI) monthly. The CPI tracks the cost of a “basket” of goods and services typical for the average household. This basket includes food, clothing, housing (rent or mortgage payments), transportation, healthcare, education, entertainment, and other categories.

Inflation rate = the percentage increase in CPI over the previous 12 months.

For example, if the CPI in December 2023 = 110, and in December 2022 = 100, then annual inflation = (110 − 100) / 100 × 100% = 10%.

Each item in the basket has its own weight, reflecting its share in the average household’s expenses. Housing usually has the largest weight (25−30%), food—10−15%, transportation—10−15%. The weights are periodically reviewed to reflect changes in consumer habits.

Issues in Measuring Inflation

The CPI is not a perfect indicator. It can overstate inflation because it does not fully account for: (1) the substitution effect—when a good becomes more expensive, consumers switch to cheaper equivalents; (2) improvement in quality—if a computer becomes twice as powerful but its price rises by 10%, the real cost per unit of computing power has fallen; (3) the emergence of new goods and services (smartphones, streaming services), which are included in the basket with a delay.

Actual Inflation Data

Inflation varies significantly between countries and over time. In developed countries, from the 1990s to the late 2010s, inflation remained low and stable: about 2% annually in the USA, UK, and the eurozone. However, in 2021−2023, inflation accelerated sharply: in the USA it reached 9.1% in June 2022 (a 40-year high), in the UK—11.1% in October 2022, in the eurozone—10.6%. In Turkey inflation reached 85% in 2022, in Argentina—over 100% in 2023. Hyperinflation in Zimbabwe (2008) reached billions of percent—prices were doubling every few hours.

The Costs of Inflation

Inflation is not simply an increase in numbers on price tags. It creates real economic problems that reduce economic efficiency and people’s well-being.

1. Menu Costs

When prices change, firms have to spend resources updating price tags, catalogs, menus, price lists, and accounting software. In the era of paper catalogs this was particularly expensive: a company like IKEA, publishing millions of catalogs annually, bore significant costs with every price change. Today, thanks to e-commerce and digital price tags, menu costs have fallen but not disappeared entirely—reprogramming accounting systems, updating contracts with suppliers and clients still require time and money.

2. Redistribution of Income and Wealth

Inflation acts as an “invisible tax”, redistributing income and wealth between different groups. Who wins and who loses?

Losers:

• People with fixed incomes—pensioners, benefit recipients, workers with long-term contracts without indexation. If a pension is 20,000 rubles per month, and inflation is 10%, after a year the real purchasing power falls to the equivalent of 18,182 rubles.
• Savers and creditors—if the interest rate on a deposit (5%) is lower than inflation (10%), the real return is negative: money loses value faster than interest accrues.

Winners:

• Borrowers—if you have a mortgage with a fixed rate, inflation reduces the real value of your debt. If you take a loan of 1 million rubles at 5% per annum and inflation is 10%, the real value of your debt drops by about 5% per year. The government as the largest borrower also benefits from inflation.
• Owners of real assets—real estate, stocks, gold. These assets usually appreciate along with inflation (or faster), preserving and increasing the real wealth of their owners.

3. Uncertainty and Decreased Investment

The higher and more volatile inflation is, the greater the uncertainty regarding future prices. Firms have trouble planning: how much will raw materials cost in a year? What wages will have to be paid? At what price will products sell? Under uncertainty, firms postpone investments, preferring to “wait and see”. This slows down economic growth and job creation.

Research shows that countries with high and unstable inflation grow more slowly than those with low and stable inflation. Latin American countries in the 1980s (Brazil, Argentina, Peru) experienced hyperinflation and economic stagnation simultaneously.

4. Balance of Payments

If inflation in a country is higher than among its trading partners, domestic goods become less competitive on the world market. Exports become more expensive for foreign buyers, while imports become relatively cheaper for domestic consumers. This worsens the trade balance and can lead to a weakening of the national currency. For example, persistently high inflation in Turkey (40–85% in 2022–2023) led to a sharp decline in the lira: if in 2020 you needed 7 lira for $1, by the end of 2023—you needed 29 lira.

Types of Inflation

1. Demand-Pull Inflation

Demand-pull inflation occurs when aggregate demand grows faster than aggregate supply can keep up. Figuratively speaking, “too much money is chasing too few goods.”

Graphically, this looks like a shift of the AD curve to the right (AD₁ → AD₂) with AS unchanged. In the new equilibrium, both the price level and real GDP are higher. However, GDP growth is limited by the economy’s production capabilities—when the economy is near full employment, additional demand almost entirely “goes” into price increases, not output growth.

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Historical example: Postwar boom of the 1960s in the USA. President Lyndon Johnson simultaneously financed the Vietnam War and massive “Great Society” social programs without raising taxes. Government spending rose sharply, aggregate demand increased, and inflation began to accelerate—from 1% in the early 1960s to 5–6% by the end of the decade.

Example: 2021−2022. After the COVID-19 pandemic, governments injected trillions of dollars into the economy through direct citizen payments, business subsidies, and quantitative easing programs. At the same time, supply chains were disrupted and the supply of goods was limited. The result—a sharp rise in demand-pull inflation worldwide.

2. Cost-Push Inflation

Cost-push inflation is caused by rising production costs (regardless of changes in demand). When raw materials, energy, labor, or other resources become more expensive, firms pass the increased costs on to consumers by raising prices.

Graphically: the AS curve shifts left/up (AS₁ → AS₂) with AD unchanged. In the new equilibrium the price level is higher, and real GDP is lower—the economy simultaneously experiences rising prices and declining output.

Classic example: 1973 oil crisis. OPEC (Organization of the Petroleum Exporting Countries) imposed an embargo on oil supplies to countries that supported Israel in the Yom Kippur War. Oil prices quadrupled—from $3 to $12 per barrel. Since oil is a key resource for industry, transport, and energy, production costs soared in all economic sectors. The result: inflation in developed countries jumped to 10–15%, and economic growth slowed or turned negative.

Second oil shock (1979) made the situation even worse: the Iranian Revolution and Iran-Iraq War led to another sharp increase in oil prices. Developed countries experienced stagflation.

Example: 2021–2023. The recovery of the global economy after the pandemic was accompanied by disruptions in global supply chains (shortages of semiconductors, containers, warehouse, and port labor), and the outbreak of war in Ukraine in February 2022 led to a sharp spike in energy and food prices. Gas prices in Europe increased tenfold, wheat prices doubled. This was cost-push inflation layered on top of demand-pull inflation.

3. Stagflation

The combination of inflation and economic downturn (stagnation) is called stagflation. This is an especially dangerous situation, because traditional methods of fighting inflation (raising interest rates, cutting government spending) worsen the downturn, while methods for stimulating the economy (lowering rates, increasing spending) exacerbate inflation. Stagflation is a “headache” for economic policy.

The classic period of stagflation was the 1970s in developed countries, caused by oil shocks. The UK in 1975 experienced inflation of 24% and a rise in unemployment at the same time. Traditional Keynesian policy could not cope with this problem, leading to the rise of monetarism and supply-side policy.

4. Inflation Expectations and the Wage-Price Spiral

One of the most insidious features of inflation is its ability to become self-sustaining through the expectations mechanism.

When people expect inflation, they start acting in ways that make those expectations come true. Workers, anticipating price rises, demand wage increases “in advance.” Firms, foreseeing rising costs, raise prices early. This creates a wage-price spiral: wage growth → increased costs → price increases → workers demand even higher wages → and so on.

This is why central banks attach such importance to “anchoring” inflation expectations. If people believe the central bank will hold inflation at 2%, they will not demand excessive wage increases, and inflation will indeed remain low. But if trust in the central bank is undermined (as happened in Turkey, Argentina, Zimbabwe), inflation expectations become “unanchored” and inflation slips out of control.

Aggregate Demand and Aggregate Supply: Determining the Price Level

The AD-AS model allows us to visualize and analyze both types of inflation. Demand-pull inflation is a shift of AD to the right; cost-push inflation is a shift of AS to the left. Stagflation is a case where AS shifts left: prices rise, output falls.

The AD curve slopes downward for three macroeconomic reasons:

1. International substitution effect—switching to imports as domestic prices rise
2. Intertemporal substitution effect—delaying purchases
3. Real balances effect—decline in the real value of savings

There is also an income effect: rising prices reduce consumers’ real income, forcing them to cut back spending.

The AS curve slopes upward due to:

• Resource prices being fixed in the short run
• Diminishing returns as production expands
• Increasing scarcity of variable factors as capacity utilization nears full

Macroeconomic equilibrium is determined by the intersection of AD and AS, setting the equilibrium price level (Pe) and equilibrium real GDP (Ye). Any event shifting one of the curves changes both indicators. The task of economic policy is to manage these shifts to ensure stable growth with low inflation—a task which, as history shows, is far from simple.

Practical Problems

Problem 1: Calculating Inflation

Question: The basket of goods CPI:

(a) Calculate the inflation rate for 2022 and 2023. (b) Calculate the total increase in prices over two years. (c) If a worker's nominal salary increased from £30,000 to £33,000 in 2021–2023, did their real income rise or fall?

Solution: (a) Inflation in 2022 = ((108 - 100) / 100) x 100% = 8%. Inflation in 2023 = ((119 - 108) / 108) x 100% ≈ 10.2%.

(b) Total price growth = ((119 - 100) / 100) x 100% = 19% over two years.

(c) Growth in nominal salary = ((33,000 - 30,000) / 30,000) x 100% = 10%. Price growth = 19%. Real salary = 33,000 / 1.19 ≈ £27,731 (in 2021 prices). Real income fell by 7.6%: despite a 10% nominal raise, prices went up 19%, which means a decline in purchasing power. The worker can buy 7.6% fewer goods than two years ago.

Problem 2: Demand-Pull vs. Cost-Push Inflation

Question: Identify the type of inflation (demand-pull or cost-push) for each scenario and explain the mechanism:

A. The government significantly increases military spending during full employment B. World wheat prices have doubled due to drought C. The central bank lowers the interest rate from 5% to 1% D. Trade unions achieve a 15% wage increase with productivity rising by 3%

Solution: A. Demand-pull inflation. Increase in G (government spending) raises AD. With full employment, the economy cannot produce more goods → excess demand pushes prices up. AD shifts to the right along the steep part of AS.

B. Cost-push inflation. Wheat is a raw material for many food products (bread, flour, animal feed → meat, milk). Rising wheat prices raise production costs for food → AS shifts left → prices rise. This is the classic example of a supply shock.

C. Demand-pull inflation. Lower rates make credit cheaper → I (investment) and C (credit-based consumption) rise → AD shifts right → with limited productive capacity, prices rise.

D. Cost-push inflation. Wages up 15%, but productivity only 3%. Therefore, unit labour costs have increased by around 12%. Firms pass higher costs onto consumers → AS shifts left → prices rise. This is an example of a wage-price spiral.