Inflation Explained: How It Is Measured, Deflation vs Disinflation, and Who Gains

Inflation is a sustained rise in the general price level of an economy, which means the same amount of money buys fewer goods and services over time. Economists measure it as the percentage change in a price index, such as the consumer price index (CPI), from one period to the next. One price going up is not inflation. The average price of the whole market basket has to keep rising.

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The AD-AS model in long-run equilibrium at full-employment output. Tap it to drag the curves, open the full version, or put it on your own site free, or turn it into a five-minute class activity.

What counts as inflation

Two words in the definition do the work.

Sustained. A one-month jump that quickly reverses is not inflation.

General. Inflation is about the average price across the whole basket. If the price of gasoline jumps while clothing and electronics get cheaper, the price level may barely move. That is a relative price change, not inflation.

Inflation also changes what a dollar is worth. If the price level rises 25 percent, $100 buys what $80 bought before, because 100 / 1.25 = 80.

How inflation is measured

For the most common index, the consumer price index, statisticians price a fixed basket of goods, turn its cost into an index with the base period set at 100, and track the index over time. (The GDP deflator works differently: it prices everything the economy produces, so its basket changes every year.) The inflation rate is the percentage change in the index:

• Inflation rate = ((price index this year - price index last year) / price index last year) x 100

Hypothetical example: a price index rises from 150 to 156. Inflation is (156 - 150) / 150 x 100 = 6 / 150 x 100 = 4 percent. Divide by last year's value, not by 100.

The CPI guide builds the index step by step. The CPI worked example adds real wages, the GDP deflator vs CPI guide explains why the two main indexes can disagree, and the inflation rate calculator checks any rate.

Inflation vs deflation vs disinflation

• Inflation: the price level rises, so the inflation rate is positive.
• Deflation: the price level falls, so the inflation rate is negative.
• Disinflation: inflation slows down but stays positive. Prices still rise, just more slowly.

Here is a hypothetical price index over four years.

Year 3 trips students up. Prices still rose, from 106.00 to 109.18; only the rate of increase fell. Prices fall only in Year 4, when the rate turns negative.

See the deflation guide for why falling prices can feed on themselves, plus the inflation vs deflation and inflation vs disinflation comparisons.

What causes inflation: demand-pull and cost-push

Demand-pull inflation happens when total spending grows faster than the economy can produce, so aggregate demand shifts right and sellers raise prices.

Cost-push inflation happens when production costs such as nominal wages or energy rise, so short-run aggregate supply shifts left and prices rise while output falls. That mix of rising prices and falling output is stagflation.

Inflation that lasts for years needs the money supply to keep growing faster than real output, the idea in AP Macro topic 5.3, Money Growth and Inflation. Its extreme form is hyperinflation. Both causes are graphed in demand-pull vs cost-push inflation, and what causes inflation adds the quantity theory of money.

Inflation on the AD-AS graph

Put the price level on the vertical axis and real GDP on the horizontal axis. Draw downward-sloping AD, upward-sloping SRAS and a vertical LRAS at full-employment output, and start where all three cross.

Demand-pull. AD shifts right. The new short-run equilibrium has a higher price level and real GDP above full employment, an inflationary gap. If no policy acts, nominal wages and other input prices rise over time, SRAS shifts left, and the economy returns to full-employment output at an even higher price level.

Cost-push. SRAS shifts left. The new equilibrium has a higher price level and lower real GDP, so inflation and unemployment rise together.

The tell on any question is real GDP: up with demand-pull, down with cost-push. You can drag both curves in the AD-AS sandbox, and the AD-AS model guide covers every shifter.

Who gains and who loses from unexpected inflation

The big cost of inflation that nobody expected is a transfer of purchasing power between groups.

A lender makes a hypothetical one-year loan of $10,000 at a 5 percent nominal interest rate. Both sides expect 2 percent inflation, so they expect a real return of about 5 - 2 = 3 percent. Actual inflation turns out to be 6 percent.

1. The borrower repays 10,000 x 1.05 = $10,500.

2. Expected purchasing power of that repayment, in start-of-year dollars: 10,500 / 1.02 = $10,294.12.

3. Actual purchasing power: 10,500 / 1.06 = $9,905.66.

4. The lender's real return was (9,905.66 - 10,000) / 10,000 x 100 = about -0.9 percent, close to the shortcut 5 - 6 = -1 percent.

5. The surprise moved 10,294.12 - 9,905.66 = $388.46 of purchasing power from the lender to the borrower.

Had everyone expected 6 percent inflation, the lender would have asked for about 3 + 6 = 9 percent, and nobody would have been fooled. That is the anticipated vs unanticipated distinction in AP Macro topic 2.5, Costs of Inflation. Even expected inflation has menu costs and shoe-leather costs.

Real vs nominal interest rates

The nominal interest rate is the rate written on the loan or account. The real interest rate adjusts it for inflation and measures the actual gain in purchasing power. The Fisher equation links them:

• Real interest rate = nominal interest rate - inflation rate

Hypothetical example: a savings account pays 4 percent and inflation is 7 percent. The real rate is 4 - 7 = -3 percent, so the balance grows on paper but buys less. When people expect higher inflation, lenders demand higher nominal rates.

This is AP Macro topic 4.2, Nominal v. Real Interest Rates. The Fisher equation guide covers expected vs actual inflation, and the real interest rate calculator checks the math.

How the central bank responds to inflation

When inflation runs too high, the central bank uses contractionary monetary policy and raises its policy interest rate target. With ample reserves, the main tool is a higher interest rate on reserve balances; in a limited-reserves model, the central bank sells government bonds through open market operations.

1. Interest rates rise.

2. Borrowing for investment and big purchases such as cars and houses falls.

3. Aggregate demand shifts left.

4. The price level grows more slowly, so inflation falls. That slowdown is disinflation.

5. In the short run, real GDP falls and unemployment rises.

Step 5 is the trade-off on the short-run Phillips curve: lower inflation in exchange for higher unemployment for a while. Cost-push inflation is harder, because shrinking AD to cut prices pushes output down even further.

Raise the policy rate in the monetary policy sandbox, and see the monetary policy guide for each tool.

How inflation shows up on the AP exam

Inflation questions draw on AP Macro topics 2.4 Price Indices and Inflation, 2.5 Costs of Inflation, 4.2 Nominal v. Real Interest Rates, 4.6 Monetary Policy and 5.3 Money Growth and Inflation, plus the AD-AS topics in Unit 3. The topic 2.5 page summarizes the costs. Expect to:

• Calculate an inflation rate and label a series as inflation, deflation or disinflation.
• Identify who gains and who loses from unexpected inflation.
• Compute a real interest rate.
• Show demand-pull or cost-push inflation on an AD-AS graph and name the policy that reduces it.

Common mistakes:

• Calling disinflation deflation. A drop from 6 percent to 3 percent inflation means prices still rose.
• Reversing the winners. Unexpected inflation helps fixed-rate borrowers and hurts fixed-rate lenders.
• Shifting AD to show cost-push inflation. Cost-push is a leftward SRAS shift.
• Forgetting expectations. Expected inflation is built into nominal rates and wages, so it moves far less purchasing power between groups.

Practice questions are in the unemployment and inflation module.