IGCSE Economics 0455: CPI Inflation Rate, Demand-Pull vs Cost-Push

The Consumer Prices Index (CPI) for the country of Fenlow rose from 180 in Year 1 to 189 in Year 2.

(a) Define inflation. Calculate Fenlow's rate of inflation between Year 1 and Year 2. [4]

(b) In Fenlow, total spending in the economy grew rapidly because of a sharp rise in consumer confidence and higher government spending, at a time when factories were already producing at full capacity. In the neighbouring country of Astoria, inflation was instead caused by a sharp rise in the world price of imported oil, which raised firms' fuel and production costs. Identify which country is experiencing demand-pull inflation and which is experiencing cost-push inflation. Explain your answer for each country. [4]

Part (a): Defining inflation and calculating the rate

Inflation is a sustained rise in the general (average) level of prices across the economy over time, commonly measured using the Consumer Prices Index (CPI).

$\text{Rate of inflation} = \frac{\text{new CPI} - \text{old CPI}}{\text{old CPI}} \times 100$

$\frac{189 - 180}{180} \times 100 = \frac{9}{180} \times 100 = 5\%$

Fenlow’s rate of inflation between Year 1 and Year 2 is $\boxed{5\%}$ .

Part (b): Demand-pull vs cost-push inflation

Fenlow (demand-pull inflation. The cause described is a rapid rise in total spending (from higher consumer confidence and government spending) at a time when factories are already producing at full capacity. When total demand grows faster than the economy can supply, the excess demand “pulls” prices upward) this is the definition of demand-pull inflation.
Astoria (cost-push inflation. The cause described is a rise in the world price of imported oil, which raises firms’ costs of production directly (through higher fuel and input costs). Firms pass these higher costs on to consumers through higher prices, even without any change in total spending) this is the definition of cost-push inflation.

Part (c): Consequences of inflation for savers and borrowers

Savers: Inflation reduces the real value of money that has already been saved. If prices rise by 5% but a saver’s money in a bank account earns no interest (or interest below 5%), that money buys fewer goods and services than it did before, savers lose purchasing power.
Borrowers: Inflation tends to benefit borrowers in real terms. A borrower who took out a loan of a fixed money amount will repay that same money amount in the future, but because prices have risen, that repayment is worth less in real terms than when the loan was taken out, effectively reducing the real burden of the debt.

Final answers

(a) Inflation = a sustained rise in the general price level; Fenlow’s inflation rate $= \dfrac{9}{180}\times100 = \mathbf{5\%}$ .
(b) Fenlow: demand-pull inflation (total demand outrunning supply at full capacity). Astoria: cost-push inflation (rising imported oil costs passed on by firms).
(c) Savers lose real purchasing power on money already saved; borrowers gain, as they repay fixed debts with money that is worth less in real terms.