Inflation, Deflation and Price Stability

Statement

• Inflation is the sustained increase in the general price level of an economy over time.
• Deflation is the sustained decrease in the general price level of an economy over time.
• Price stability occurs when the general price level of an economy increases at a low, stable and expected rate — that is, with no high inflation and no deflation.

Notes

The defining word is sustained: a one-off price rise is not inflation, and inflation is a rise in the general price level (the average across the economy), not in any single good’s price. Inflation is measured from the consumer price index (CPI), the cost of a fixed basket of goods and services bought by the average household, tracked over time:

$CPI = \frac{\text{value of basket in current year}}{\text{value of basket in prior year}} \times 100, \qquad \text{inflation rate} = \frac{CPI_2 - CPI_1}{CPI_1} \times 100\%$

A distinction is drawn between headline inflation, computed from a CPI that includes all goods and services, and core inflation, which excludes goods with volatile prices such as food and fuel. Neither high inflation nor deflation is desirable, so price stability is one of the government’s macroeconomic aims. The mechanisms that generate inflation are set out in demand-pull inflation and cost-push inflation; the effects on each agent, including the wage–price spiral and the shoe-leather and menu costs, are catalogued in the consequences of inflation.