IGCSE Economics

Inflation — Revision Notes

Topic 26 · Government and the Economy

This revision guide covers: what inflation is and how it's measured, the difference between demand-pull
and cost-push inflation, the costs/effects of inflation on prices, wages, exports and unemployment, the link
between inflation and interest rates, and exam-style practice questions with answers.

Dhrruti's Academic Edge Page 1

 1. What Is Inflation?
Inflation is a general and continuing rise in the average price level of goods and services in an
economy over time. The inflation rate tells us the percentage by which prices have risen over a year.

Example: if inflation is 3.2% in a year, then goods that cost 4,000 units of currency the previous year would
cost about 4,128 units this year (4,000 + 3.2% of 4,000).

Deflation is the opposite — a fall in average prices over time. It can also describe a period when
aggregate demand (total demand in the economy) is falling.

Inflation
A general and continuing rise in the average price level of an economy.

Deflation
A fall in the average price level; can also describe a falling level of aggregate demand.

Aggregate demand
Total demand in the economy: consumption + investment + government spending + exports − imports.

Consumer Price Index (CPI)

The main measure of average prices worldwide, based on a representative 'basket' of goods and services
(excludes housing costs).

Retail Price Index (RPI)

A measure of the general price level that also includes house prices and council tax.

How CPI is measured: Each month the prices of roughly 600 representative goods and services
purchased by thousands of households are recorded. An average monthly price is calculated and
converted into an index number, allowing price levels to be compared between different time periods.

2. Types and Causes of Inflation

A. Demand-Pull Inflation
Caused by too much demand relative to supply in the economy. If aggregate demand rises faster than
firms can increase output (especially near full employment/full capacity), the general price level is pulled
upward.

Demand-pull inflation can be caused by:

• Rising consumer spending, encouraged by tax cuts or low interest rates
• Sharp increases in government spending
• Rising demand for resources by firms
• A booming demand for exports
Note: it is most likely to occur when the economy is close to full employment, since businesses operating near full
capacity cannot easily produce extra output to meet demand, so they raise prices instead.

B. Cost-Push Inflation
Caused by rising costs of production. When firms face higher costs, they raise prices to protect their
profit margins.

Common causes include:

• Rising costs of imported goods, e.g. oil (UK oil prices rose ~400% in the early 1970s, pushing inflation
to almost 25%)
• Wage increases — strong trade unions negotiating higher wages, which employers pass on as higher
prices

Dhrruti's Academic Edge Page 2

 • Increases in taxation, e.g. a rise in VAT
Worked example: a retailer buys a good for £10 and adds a 10% mark-up, giving a price of £11. If the
supplier's cost rises to £12, the new price becomes £13.20 (£12 × 1.10). The price has risen from £11 to
£13.20 purely because costs rose.

C. Inflation and the Money Supply (Monetarist view)

Monetarists believe there is a strong link between the growth of the money supply (notes, coins, bank
deposits and other financial assets) and inflation. If households, firms and government borrow more, bank
deposits and the money supply increase, boosting demand and pushing up prices. This type of inflation is
more likely when interest rates are low, since low rates encourage borrowing.

Governments can raise interest rates to reduce inflation: higher rates make borrowing more expensive, so
the money supply grows more slowly, demand falls, and price pressure eases.

Dhrruti's Academic Edge Page 3

 3. The Costs and Effects of Inflation
Menu costs
The costs to firms of repeatedly changing prices — reprinting brochures/menus, updating websites,
informing sales staff.

Shoe leather costs

The costs (mainly time) to consumers and firms of 'shopping around' for the best prices when prices
change frequently.

Hyperinflation
Extremely high inflation (hundreds or thousands of percent a year) where prices spiral out of control and
money may no longer be accepted as payment.

Purchasing power of money

The amount of goods and services that can be bought with a fixed sum of money.

Prices & purchasing power

Rising prices reduce the purchasing power of money — people can buy less with the same income. Living
standards fall unless incomes rise as fast as, or faster than, prices.

Wages
Workers push for higher wages to keep up with rising prices. If firms then raise prices to cover higher wage
costs, a wage–price spiral can develop, sometimes leading to conflict/strikes between unions and
employers.

Uncertainty
Firms can't predict future prices, making planning and investment decisions difficult, and long-term
contracts hard to price.

Business & consumer confidence

Uncertainty reduces confidence. Consumers borrow less and save more (reducing demand); firms may
postpone growth plans, reducing economic growth.

Investment
Because investment needs large upfront spending for returns that may take 5–10+ years, uncertainty
about future prices and weak confidence often cause investment projects to be postponed or cancelled —
harming future growth and employment.

Exports
If domestic inflation is higher than in other countries, exports become relatively more expensive, demand
for exports falls, the balance of payments worsens, and export-related jobs may be lost.

Unemployment
High inflation often reflects rising aggregate demand, prompting firms to raise output and hire more
workers, reducing unemployment. A trade-off has historically been suggested between inflation and
unemployment, though it doesn't always hold — e.g. Venezuela and Iran have had very high inflation and
rising unemployment at the same time.

Dhrruti's Academic Edge Page 4

 4. Quick Summary Table
Concept Key Point

Inflation General, continuing rise in average prices

Deflation General fall in average prices / falling aggregate demand

CPI Main measure of inflation; basket of ~600 goods/services

Demand-pull Too much demand relative to supply

Cost-push Rising costs of production (imports, wages, taxes)

Monetarist view Inflation linked to growth in money supply

Menu costs Cost of changing prices

Shoe leather costs Cost/time of shopping around

Main negative effects Falling purchasing power, uncertainty, lower investment,

weaker exports, wage-price spirals

Dhrruti's Academic Edge Page 5

 5. Practice Questions
Section A — Multiple Choice
1. Which of the following best defines inflation?
A. A fall in average prices over time
B. A general and continuing rise in average prices over time
C. A rise in the exchange rate
D. A rise in unemployment

2. Which index is used worldwide as the main measure of inflation?

A. Retail Price Index (RPI)
B. Consumer Price Index (CPI)
C. Producer Price Index
D. Wage Price Index

3. Demand-pull inflation is most likely to occur when:

A. The economy is in a deep recession
B. The economy is close to full employment
C. Interest rates are very high
D. Exports are falling sharply

4. Which of these is an example of a cost that could cause cost-push inflation?

A. A fall in the price of imported oil
B. A cut in income tax
C. A rise in VAT (a tax on spending)
D. A fall in wages

5. The costs to a firm of repeatedly reprinting menus/price lists when prices change are known
as:
A. Shoe leather costs
B. Opportunity costs
C. Menu costs
D. Sunk costs

6. According to the monetarist view, inflation is closely linked to:

A. Growth in the money supply
B. The level of exports
C. The unemployment rate
D. Government subsidies

7. Which of the following is a likely consequence of high inflation for exporters?

A. Exports become cheaper abroad, boosting demand
B. Exports become relatively more expensive, so demand for them may fall
C. Exports are unaffected by domestic inflation
D. The balance of payments automatically improves

Section B — Short Structured Questions

1. Define the term 'inflation'. (2 marks)
2. Distinguish between demand-pull inflation and cost-push inflation. (4 marks)

3. Explain two causes of demand-pull inflation. (4 marks)

Dhrruti's Academic Edge Page 6

 4. Explain how a rise in interest rates could help reduce inflation. (4 marks)

5. Explain what is meant by 'menu costs' and 'shoe leather costs', using examples. (4 marks)

6. Analyse two ways in which inflation could affect the level of investment in an economy. (6
marks)

7. Discuss whether inflation is always harmful to an economy. (8 marks)

8. A retailer buys a product from a supplier for £15 per unit and adds a 20% mark-up. If the
supplier's cost rises to £18, calculate the retailer's new selling price and explain why this is an
example of cost-push inflation. (4 marks)

Dhrruti's Academic Edge Page 7

 Answer Key & Mark Scheme Guidance
Section A — Multiple Choice Answers
1. B, 2. B, 3. B, 4. C, 5. C, 6. A, 7. B

Section B — Guidance
1. Inflation is a general and continuing rise in the average price level of goods and services in an economy
over a period of time.
2. Demand-pull inflation is caused by too much aggregate demand relative to supply (demand 'pulls' prices
up). Cost-push inflation is caused by rising production costs (e.g. wages, imported materials), which firms
pass on as higher prices to protect profit margins. Award marks for a clear distinction plus an example of
each.
3. Any two of: rising consumer spending (from tax cuts/low interest rates); sharp rises in government
spending; rising demand for resources by firms; a booming demand for exports. Each cause should be
explained, not just listed.
4. Higher interest rates make borrowing more expensive and saving more attractive, so consumer and firm
borrowing falls. This slows growth in the money supply, reduces aggregate demand, and eases the upward
pressure on prices.
5. Menu costs: the costs of physically changing prices (reprinting menus/brochures, updating websites,
informing staff). Shoe leather costs: the time/effort cost to consumers and firms of searching around for the
best prices when inflation is high.
6. Investment requires large upfront spending for returns that may take many years, so it depends on being
able to predict future costs and revenues. High/uncertain inflation makes future prices hard to forecast,
discouraging long-term investment. It can also reduce business confidence, causing firms to postpone or
cancel expansion plans — both points should be developed with a consequence (e.g. lower future
growth/employment).
7. A balanced answer should note that low, stable inflation can be a sign of a healthy, growing economy and
may be linked to falling unemployment (demand-pull), but that high or unpredictable inflation creates
uncertainty, discourages investment, harms export competitiveness, erodes purchasing power (hurting those
on fixed incomes) and, at extreme levels (hyperinflation), can destabilise an economy entirely. A justified
conclusion is needed for full marks.
8. Original price = £15 × 1.20 = £18. New price = £18 × 1.20 = £21.60. This is cost-push inflation because the
price rise is driven entirely by the increase in the supplier's cost, with the firm maintaining the same
percentage mark-up to protect its profit margin.

Dhrruti's Academic Edge — IGCSE Economics Revision Notes

Dhrruti's Academic Edge Page 8