Business Economics · Business activity, unemployment and inflation

Inflation: Measurement, Causes and Effects Explained

Updated 11 October 2026 · Fact-checked

Inflation is a sustained rise in the general price level, so money buys less over time. You measure it as the percentage change in a price index such as CPI or WPI. Demand-pull inflation comes from excess demand; cost-push comes from rising costs. Inflation hurts savers and fixed-income holders and creates uncertainty.

Understand Inflation: Measurement, Causes and Effects

Inflation is a sustained increase in the general level of prices. One price rising is not inflation. Deflation is a sustained fall in the general price level. Disinflation is a fall in the rate of inflation: prices still rise, but more slowly.

You measure inflation with a price index. Statisticians define a basket of goods and services, record its cost in a base year and in the current year, and compare. The index is the current cost of the basket divided by the base-year cost, multiplied by 100. The inflation rate is the percentage change in the index between two periods.

In India, the CPI (Consumer Price Index) tracks the prices households pay for goods and services. It is the measure used for the inflation target of the central bank. The WPI (Wholesale Price Index) tracks prices at the wholesale, pre-retail stage and covers goods, not services. So CPI reflects what consumers feel, while WPI reflects price pressure earlier in the supply chain. Exact weights and coverage are set by the statistical authorities and can change, so learn the principle, not the numbers.

There are two classic causes. Demand-pull inflation happens when aggregate demand grows faster than the economy can produce, so prices are pulled up. It often arises from strong consumer spending, easy credit, higher government spending or export demand. Cost-push inflation happens when firms' costs rise, such as wages, imported raw materials or energy, and firms pass this on by raising prices, which shifts aggregate supply to the left. Money supply growth well beyond output growth is also a recognised cause in the monetarist view.

Inflation has costs. Savers lose if the interest rate is below inflation, because the real return is negative. Lenders lose and borrowers gain if inflation is higher than expected. Fixed-income earners lose purchasing power. Firms face menu costs (changing prices) and uncertainty that discourages investment. Higher domestic prices can also reduce export competitiveness. Unexpected inflation is usually more damaging than expected inflation, because people cannot plan for it.

Key rules to remember

Price index: Index = (Cost of basket in current year ÷ Cost of basket in base year) × 100; Base year index is 100. Basket contents are fixed (or weighted) over the comparison.
Weighted price index: Index = Σ (wᵢ × pᵢ,current ÷ pᵢ,base) ÷ Σ wᵢ, multiplied by 100 if wᵢ are weights; Use the weights given in the question. Each item's price relative is multiplied by its weight.
Inflation rate: Inflation rate = (Index_t − Index_(t−1)) ÷ Index_(t−1) × 100%; Divide by the earlier index, not the later one.
Approximate real interest rate: Real rate ≈ Nominal rate − Inflation rate; The exact relation is (1 + real) = (1 + nominal) ÷ (1 + inflation).
Real value of money: Real value = Nominal value ÷ (Price index ÷ 100); Use this to compare amounts across years in base-year prices.

How to solve Inflation: Measurement, Causes and Effects questions

Inflation questions are either calculation questions (index, rate, real return) or explanation questions (cause, measure, effect). Use this method for both.

1Identify what is asked: a calculation, a distinction (CPI vs WPI, demand-pull vs cost-push) or an effect.
2For a calculation, write down the base year, the weights and the price relatives before doing any arithmetic.
3Compute the index first, then the percentage change using the earlier index as the denominator.
4For real values or real rates, state whether you use the approximate or the exact formula and keep it consistent.
5For causes, name the type, say what shifts (aggregate demand right, or aggregate supply left) and state the effect on price level and output.
6For effects, name who gains and who loses, and say whether inflation was expected or unexpected.
7Finish with a short conclusion that answers the exact wording of the question, with units and a percentage sign.

Quickest way: Index, rate, then real

When to use it: Use this for MCQs and short calculations where you have a basket and prices or a nominal rate and an inflation rate.

Convert each price to a relative (current ÷ base) and multiply by its weight.
Add the weighted relatives and divide by the total weight to get the index.
Inflation = new index ÷ old index − 1.
For real returns, use (1 + nominal) ÷ (1 + inflation) − 1 when numbers are large; the subtraction shortcut is fine for small rates.
Check the sign: if prices rose, the index must be above 100 relative to the base.

Common mistakes in Inflation: Measurement, Causes and Effects

Dividing the change in index by the new index instead of the old one.
Students divide by the number they see last.
Fix: The base of any percentage change is the earlier value. Write the formula with Index(t−1) in the denominator.
Treating a fall in the inflation rate as deflation.
Both sound like prices going down.
Fix: Deflation means the price level falls (negative inflation). Disinflation means inflation is still positive but lower.
Mixing up demand-pull and cost-push by the symptom instead of the cause.
Both show rising prices.
Fix: Ask what moved first. If aggregate demand rose, it is demand-pull. If costs rose and aggregate supply fell, it is cost-push.
Saying CPI includes only goods and WPI includes services.
The two are reversed from memory.
Fix: CPI covers consumer goods and services at retail prices. WPI covers goods at the wholesale stage and excludes services.
Ignoring inflation when judging a savings return.
Students quote the nominal rate only.
Fix: Always compare with inflation. A 6% return with 7% inflation gives a negative real return.
Saying all inflation harms everyone equally.
The effects section is memorised as a list.
Fix: Distinguish expected from unexpected inflation, and savers and lenders from borrowers and asset holders.

Worked examples

Example 1

A basket has two items. Item A has weight 60, price ₹100 in the base year and ₹120 now. Item B has weight 40, price ₹50 in the base year and ₹55 now. Find the current index (base = 100) and the inflation rate over the period.

Show the solution

Price relative of A = 120 ÷ 100 = 1.20.
Price relative of B = 55 ÷ 50 = 1.10.
Weighted sum = 60 × 1.20 + 40 × 1.10 = 72 + 44 = 116.
Total weight = 100, so index = 116 ÷ 100 × 100 = 116.
Inflation over the period = (116 − 100) ÷ 100 = 16%.

Answer: The index is 116, so prices rose 16% over the period.

Example 2

A fixed deposit pays a nominal 8% a year. Inflation is 5% a year. Find the exact real rate and explain the effect on the saver if inflation instead rises unexpectedly to 10%.

Show the solution

Exact real rate = (1 + 0.08) ÷ (1 + 0.05) − 1.
1.08 ÷ 1.05 = 1.028571, so real rate ≈ 2.86%.
The approximation 8% − 5% = 3% is close but not exact.
If inflation is 10%, real rate = 1.08 ÷ 1.10 − 1 = −0.01818, about −1.82%.
The saver now loses purchasing power, while a borrower at a fixed rate gains because repayments are worth less in real terms.
Because the rise was unexpected, the saver could not adjust the deposit rate or choose other assets.

Answer: The real return is about 2.86% at 5% inflation and about −1.82% at 10% inflation, so unexpected inflation transfers value from savers to borrowers.

Exam tips

Show the formula before the numbers. Marks in written answers go to method as well as the result.
For MCQs on the index, check the denominator of the percentage change first; wrong options often use the new index.
When asked to distinguish two concepts, give a definition, a cause and a consequence for each side.
Use aggregate demand and aggregate supply language: demand-pull shifts AD right, cost-push shifts AS left.
In effects questions, always separate expected from unexpected inflation and name winners and losers.

Practice questions from Business activity, unemployment and inflation

Inflation: Measurement, Causes and Effects in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Inflation: Measurement, Causes and Effects: frequently asked questions

What is the difference between demand-pull and cost-push inflation?

Demand-pull inflation arises when aggregate demand exceeds the economy's productive capacity, pulling prices up. Cost-push inflation arises when production costs such as wages or raw materials rise and firms pass them on. In demand-pull, output usually rises with prices. In cost-push, output tends to fall.

How is CPI inflation calculated?

You price a fixed basket of consumer goods and services in the current period and in the base period, weight each item, and compute the index. CPI inflation is the percentage change in the index over the earlier index. Weights come from household spending patterns.

What is the difference between CPI and WPI in India?

CPI measures price changes faced by consumers at retail level and includes services. WPI measures price changes at the wholesale stage and covers goods only. CPI is closer to the cost of living, while WPI shows earlier price pressure in the supply chain.

How does inflation affect savers?

If the interest rate on savings is below inflation, the real return is negative and purchasing power falls. Savers on fixed returns are hit hardest, especially when inflation is unexpected. Borrowers on fixed rates gain in real terms.