EDEXCEL A LEVEL ECONOMICS INFLATION EXAM SOLVED #3
Define Inflation - correct answer a general increase in prices and fall in the purchasing
value of money.
How is inflation measured? - correct answer Using Index Numbers, beginning with a
base year, updated monthly by ONS. UK uses CPI
Define Disinflation - correct answer A decrease in the rate of inflation; prices are going
up, but not as fast as before
Define deflation - correct answer rise in the value of each unit of currency, but a fall in
general price levels
What can cause inflation - correct answer If the economy grows too quickly without
enough workers to fill all the new jobs, wages will increase. This leads to inflation.
If aggregate demand in an economy grows, but the LRAS doesn't shift
If a government injects too much money in to an economy
If the economy is operating very close to full capacity
Define Purchasing Power Parity (PPP) - correct answer A method of measuring GDP
per capita - how much a person's income is able to buy them in their local economy
What is the Big Mac Index? - correct answer The Big Mac Index is published by The
Economist as an informal way of measuring the purchasing power parity between two
currencies and provides a test of the extent to which market exchange rates result in
goods costing the same in different countries. It "seeks to make exchange-rate theory a
bit more digestible."
Government Target Inflation Rate - correct answer 2%
Trends in UK inflation rates (CPI) - correct answer 1975 - 25%
1987 - approx. 5%
2008 - approx 6% CPI approx -1.5% RPI
2015 - 0%
2019 - approx 1.5%
2020 - 0.2% - 0.5%
Monetarist Inflation Policy (Friedman) - correct answer If Money Supply rises faster than
the rate of growth of national income, then there will be inflation. If money supply
increases in line with real output there will be no inflation
Idea that inflation can be fixed by increasing interest rates to decrease consumer
spending and increase saving, therefore decreasing AD and inflation
Thatcher's economic policies - correct answer Belief in the desirability of free markets
over government intervention. E.g. Pursuing policies of privatisation and deregulation.
,The pursuit of supply-side policies to increase efficiency and productivity.
Reducing the power of trades unions and increased labour market flexibility.
Financial deregulation, e.g. Building societies becoming profit-making banks.
Reducing higher rates of marginal income tax to increase incentives to work.
Ending state subsidies for major manufacturing companies.
Encouraging home ownership and share ownership.
Targeting money supply and monetarist policies to reduce inflation of late 1979.
Monetarism was effectively abandoned by 1984.
Joining EU Single Market in 1988
Thatchers Economic Goals - correct answer Reduce inflation - running at around 14% in
1979 (after periods of 20% plus in the late 1970s)
Reduce budget deficit.
Increase efficiency of the economy
Reduce the power of trades unions
What is the Quantity Theory of Money? - correct answer Fischer Version MV=PT,
M = Money Supply
V= Velocity of circulation
P= Price Level and
T = Transactions.
T is difficult to measure so it is often substituted for Y = National Income
MV = PY where Y = national output
What is the a Monetarist's View on why increased money supply leads to inflation? -
correct answer Monetarists believe that in the short-term velocity (V) is fixed This is
because the rate at which money circulates is determined by institutional factors, e.g.
How often workers are paid does not change very much. Milton Friedman admitted it
might vary a little but not very much so it can be treated as fixed
Monetarists also believe output Y/T is fixed. They state it may vary in the short run but
not in the long run (because LRAS is inelastic and determined by supply-side factors in
the Classical model .)
Therefore an increase in the Money Supply will lead to an increase in inflation.
What are the 2 types of Inflation - correct answer demand pull inflation and cost push
inflation
Cost push inflation diagram explanation - correct answer Initiated by firms costs, so as
costs increase, LRAS decreases.
Demonstrated by a shift left of LRAS
,Demand pull inflation diagram explanation - correct answer Caused by increased
demand in an economy where demand is increasing faster than supply. Demonstrated
by a shift outwards of AD
How to achieve sustainable economic growth - correct answer Keep to the inflation
target, and have both AD and LRAS shift outwards.
How to demonstrate monetarists view of inflation - correct answer 1) Use a classical
diagram
2) Show the SRAS equilibrium shifts out as AD increases due to increased money
supply, firms pay workers more, workers are willing to work more for more money
3) The workers find their extra money doesn't go as far, so shrink back down to their
original hours, at the LRAS equilibrium, meaning there has been a general increase in
prices but no change in LRAS
How to work out the Real Price of a product - correct answer CPI 2 (Final CPI)
Real Price = ———————————— x nominal price
CPI 1 (Year in question's CPI
What is Nominal Price - correct answer The Current Monetary Value
What is Real Price - correct answer The price of goods/services adjusted for inflation
What does the Phillips curve show? - correct answer the inverse relationship between
inflation and unemployment - more employment = higher inflationary pressures
With less slack in the economy workers are able to demand higher wages
Long-Run Phillips Curve (LRPC) - correct answer shows the relationship between
unemployment and inflation after expectations of inflation have had time to adjust to
experience. Shows that unemployment level will stay the same but inflation will be built
in to the economy
How do the Government borrow money from BOE? - correct answer BOE buys govt.
Bonds, giving more money to fund system creating jobs and strengthening economy.
Then BOE creates corporate bonds to lend money to commercial banks, who supply the
public with credit and can generate interest, more interest than they owe the BOE for
their corporate bond.
What is a bond? - correct answer A long-term debt instrument in which a borrower
agrees to make payments of fixed interest, on specific dates, to the holders of the bond.
Every year a bond matures. Most profitable when interest rates are low. Bonds can be
sold to other buyers to quickly raise capital.
What is an Index Number - correct answer Where a value is placed on the price of a
product in a nominal time period - beginning at 100 which is the baseline measurement.
, Allows us to compare prices from different time periods and to see changes in prices in
terms of inflation
Limitations of CPI as a measure of inflation - correct answer - Does not factor in PED
and XED, assumes consumer behaviour is constant, and that consumers do not
substitute their goods
- Changes in quality are not factored which may reflect a price change
- Sampling errors
- Ignores housing costs and all consumers need housing, so may not accurately
represent inflation.
Impacts of Inflation on those borrowing money - correct answer High Inflation for those
borrowing is positive, as a fixed rate loan with a lower interest rate than the inflation rate
will actually get cheaper as the value of each unit of currency decreases - loans become
easier to pay off
Impacts of Inflation on Savings - correct answer Inflation increases the price of goods
and services requireing a greater portion of household income, this will reduce level of
savings. As the future purchasing power of savings may fall, households will be less
inclined to save.
Impacts of inflation on Lenders - correct answer Lenders impact negatively as the loans
they issued will be worth less in real terms if interest is lower than inflation
Positive Effects of Inflation on Firms - correct answer - Industry wide price rises enable
revenue to grow, especially trade agreements have been made prior to inflation, also
can be pushed on to consumer if inflation is demand pull OR cost push for inelastic
products
- Growing revenues and constant gross margin = higher gross profit
- Makes using debt as a source of finance cheaper in real terms
Negative Effects of Inflation on Firms - correct answer - Price sensitive products (with
high elasticity) may fall in sales if there is cost push inflation on to consumers
- Inflation can cause businesses to lose confidence as high inflation can mean an
unstable economy and risk hyperinflation
What is hyperinflation? - correct answer A very rapid rise in the price level; and
extremely high rate of inflation.
Dangers of Hyperinflation - correct answer As demonstrated in Venezuela:
- people get poorer
- govt loses control of economy
- nobody wants to use that country's currency
- complete economic collapse
Define Inflation - correct answer a general increase in prices and fall in the purchasing
value of money.
How is inflation measured? - correct answer Using Index Numbers, beginning with a
base year, updated monthly by ONS. UK uses CPI
Define Disinflation - correct answer A decrease in the rate of inflation; prices are going
up, but not as fast as before
Define deflation - correct answer rise in the value of each unit of currency, but a fall in
general price levels
What can cause inflation - correct answer If the economy grows too quickly without
enough workers to fill all the new jobs, wages will increase. This leads to inflation.
If aggregate demand in an economy grows, but the LRAS doesn't shift
If a government injects too much money in to an economy
If the economy is operating very close to full capacity
Define Purchasing Power Parity (PPP) - correct answer A method of measuring GDP
per capita - how much a person's income is able to buy them in their local economy
What is the Big Mac Index? - correct answer The Big Mac Index is published by The
Economist as an informal way of measuring the purchasing power parity between two
currencies and provides a test of the extent to which market exchange rates result in
goods costing the same in different countries. It "seeks to make exchange-rate theory a
bit more digestible."
Government Target Inflation Rate - correct answer 2%
Trends in UK inflation rates (CPI) - correct answer 1975 - 25%
1987 - approx. 5%
2008 - approx 6% CPI approx -1.5% RPI
2015 - 0%
2019 - approx 1.5%
2020 - 0.2% - 0.5%
Monetarist Inflation Policy (Friedman) - correct answer If Money Supply rises faster than
the rate of growth of national income, then there will be inflation. If money supply
increases in line with real output there will be no inflation
Idea that inflation can be fixed by increasing interest rates to decrease consumer
spending and increase saving, therefore decreasing AD and inflation
Thatcher's economic policies - correct answer Belief in the desirability of free markets
over government intervention. E.g. Pursuing policies of privatisation and deregulation.
,The pursuit of supply-side policies to increase efficiency and productivity.
Reducing the power of trades unions and increased labour market flexibility.
Financial deregulation, e.g. Building societies becoming profit-making banks.
Reducing higher rates of marginal income tax to increase incentives to work.
Ending state subsidies for major manufacturing companies.
Encouraging home ownership and share ownership.
Targeting money supply and monetarist policies to reduce inflation of late 1979.
Monetarism was effectively abandoned by 1984.
Joining EU Single Market in 1988
Thatchers Economic Goals - correct answer Reduce inflation - running at around 14% in
1979 (after periods of 20% plus in the late 1970s)
Reduce budget deficit.
Increase efficiency of the economy
Reduce the power of trades unions
What is the Quantity Theory of Money? - correct answer Fischer Version MV=PT,
M = Money Supply
V= Velocity of circulation
P= Price Level and
T = Transactions.
T is difficult to measure so it is often substituted for Y = National Income
MV = PY where Y = national output
What is the a Monetarist's View on why increased money supply leads to inflation? -
correct answer Monetarists believe that in the short-term velocity (V) is fixed This is
because the rate at which money circulates is determined by institutional factors, e.g.
How often workers are paid does not change very much. Milton Friedman admitted it
might vary a little but not very much so it can be treated as fixed
Monetarists also believe output Y/T is fixed. They state it may vary in the short run but
not in the long run (because LRAS is inelastic and determined by supply-side factors in
the Classical model .)
Therefore an increase in the Money Supply will lead to an increase in inflation.
What are the 2 types of Inflation - correct answer demand pull inflation and cost push
inflation
Cost push inflation diagram explanation - correct answer Initiated by firms costs, so as
costs increase, LRAS decreases.
Demonstrated by a shift left of LRAS
,Demand pull inflation diagram explanation - correct answer Caused by increased
demand in an economy where demand is increasing faster than supply. Demonstrated
by a shift outwards of AD
How to achieve sustainable economic growth - correct answer Keep to the inflation
target, and have both AD and LRAS shift outwards.
How to demonstrate monetarists view of inflation - correct answer 1) Use a classical
diagram
2) Show the SRAS equilibrium shifts out as AD increases due to increased money
supply, firms pay workers more, workers are willing to work more for more money
3) The workers find their extra money doesn't go as far, so shrink back down to their
original hours, at the LRAS equilibrium, meaning there has been a general increase in
prices but no change in LRAS
How to work out the Real Price of a product - correct answer CPI 2 (Final CPI)
Real Price = ———————————— x nominal price
CPI 1 (Year in question's CPI
What is Nominal Price - correct answer The Current Monetary Value
What is Real Price - correct answer The price of goods/services adjusted for inflation
What does the Phillips curve show? - correct answer the inverse relationship between
inflation and unemployment - more employment = higher inflationary pressures
With less slack in the economy workers are able to demand higher wages
Long-Run Phillips Curve (LRPC) - correct answer shows the relationship between
unemployment and inflation after expectations of inflation have had time to adjust to
experience. Shows that unemployment level will stay the same but inflation will be built
in to the economy
How do the Government borrow money from BOE? - correct answer BOE buys govt.
Bonds, giving more money to fund system creating jobs and strengthening economy.
Then BOE creates corporate bonds to lend money to commercial banks, who supply the
public with credit and can generate interest, more interest than they owe the BOE for
their corporate bond.
What is a bond? - correct answer A long-term debt instrument in which a borrower
agrees to make payments of fixed interest, on specific dates, to the holders of the bond.
Every year a bond matures. Most profitable when interest rates are low. Bonds can be
sold to other buyers to quickly raise capital.
What is an Index Number - correct answer Where a value is placed on the price of a
product in a nominal time period - beginning at 100 which is the baseline measurement.
, Allows us to compare prices from different time periods and to see changes in prices in
terms of inflation
Limitations of CPI as a measure of inflation - correct answer - Does not factor in PED
and XED, assumes consumer behaviour is constant, and that consumers do not
substitute their goods
- Changes in quality are not factored which may reflect a price change
- Sampling errors
- Ignores housing costs and all consumers need housing, so may not accurately
represent inflation.
Impacts of Inflation on those borrowing money - correct answer High Inflation for those
borrowing is positive, as a fixed rate loan with a lower interest rate than the inflation rate
will actually get cheaper as the value of each unit of currency decreases - loans become
easier to pay off
Impacts of Inflation on Savings - correct answer Inflation increases the price of goods
and services requireing a greater portion of household income, this will reduce level of
savings. As the future purchasing power of savings may fall, households will be less
inclined to save.
Impacts of inflation on Lenders - correct answer Lenders impact negatively as the loans
they issued will be worth less in real terms if interest is lower than inflation
Positive Effects of Inflation on Firms - correct answer - Industry wide price rises enable
revenue to grow, especially trade agreements have been made prior to inflation, also
can be pushed on to consumer if inflation is demand pull OR cost push for inelastic
products
- Growing revenues and constant gross margin = higher gross profit
- Makes using debt as a source of finance cheaper in real terms
Negative Effects of Inflation on Firms - correct answer - Price sensitive products (with
high elasticity) may fall in sales if there is cost push inflation on to consumers
- Inflation can cause businesses to lose confidence as high inflation can mean an
unstable economy and risk hyperinflation
What is hyperinflation? - correct answer A very rapid rise in the price level; and
extremely high rate of inflation.
Dangers of Hyperinflation - correct answer As demonstrated in Venezuela:
- people get poorer
- govt loses control of economy
- nobody wants to use that country's currency
- complete economic collapse
