June 2009 Context 1 ECON2 AQA
United Kingdom Inflation and Monetary Policy Data Response
Define the term ‘negative output gap’ (Extract C, line 11).
a) A negative output gap is when the economy is not functioning at full capacity, and
when the actual GDP of an economy is less than the potential GDP.
Using Extract A, identify two points of comparison between the changes in
Bank Rate and the changes in the CPI inflation rate between 2004 and 2007.
b) One significant comparison in Extract A between the changes in the Bank Rate
and the changes in the CPI inflation rate is that between September 2004 and July
2006 the Bank Rate did not change at all, staying at 4.5%. In comparison, in the
same period, CPI inflation fluctuated between 1.1% and 2.6%.
Another significant comparison between the changes in the Bank Rate and the
changes in the CPI inflation rate is that the Bank Rate fluctuates far less than the CPI
inflation rate. Over the whole 2004-2007 period the Bank Rate only fluctuated
between 4.5% and 5.8% whereas the CPI inflation rate fluctuated from 1.1% to 3.1%.
Using an AD/AS diagram to help you, explain the likely effect of an increase in
interest rates upon inflation.
c) Inflation, defined as the persistent rise in the general level of prices, is meant to be
kept under control by the government, and one way in which they do this is through
using interest rates, which determine the cost of borrowing.
As can be seen in Fig 1, an increase in interest rates is likely to shift aggregate
demand (AD) left, from AD1 to AD2. This is because interest rates determine the cost
of borrowing, and thus an increase in the rate will deter investment and consumption,
as it is now more costly to borrow money. Moreover, higher interest rates encourage
saving as savers will now get a higher rate of return on their savings, meaning
people save more and spend less. This resultant fall in consumption and investment
will cause a fall in AD as these are both important components of AD, with
consumption making up 66% of GDP in the UK economy. As can be seen in Fig 1,
the fall in AD causes a fall in the price level, from P1 to P2, and thus the inflation rate
is likely to fall.
Extract B (lines 11-12) states: ‘When total spending grows more quickly than
the volume of output produced, inflation is the result.’ Assess the view that
inflation is always caused by an increase in aggregate demand.
d) Extract B asserts the view that ‘when total spending grows more quickly than the
volume of output produced, inflation is the result.’ Inflation is a sustained increase in
the general level of prices leading to a fall in the purchasing power of money. Inflation
can come from both the demand and the supply-side of an economy, and thus the
view that inflation is always caused by an increase in aggregate demand is
inaccurate. Not only can the supply-side of an economy cause inflation, termed cost-
push inflation, but also external sources such as fluctuations in the exchange rate
can lead to inflation.
United Kingdom Inflation and Monetary Policy Data Response
Define the term ‘negative output gap’ (Extract C, line 11).
a) A negative output gap is when the economy is not functioning at full capacity, and
when the actual GDP of an economy is less than the potential GDP.
Using Extract A, identify two points of comparison between the changes in
Bank Rate and the changes in the CPI inflation rate between 2004 and 2007.
b) One significant comparison in Extract A between the changes in the Bank Rate
and the changes in the CPI inflation rate is that between September 2004 and July
2006 the Bank Rate did not change at all, staying at 4.5%. In comparison, in the
same period, CPI inflation fluctuated between 1.1% and 2.6%.
Another significant comparison between the changes in the Bank Rate and the
changes in the CPI inflation rate is that the Bank Rate fluctuates far less than the CPI
inflation rate. Over the whole 2004-2007 period the Bank Rate only fluctuated
between 4.5% and 5.8% whereas the CPI inflation rate fluctuated from 1.1% to 3.1%.
Using an AD/AS diagram to help you, explain the likely effect of an increase in
interest rates upon inflation.
c) Inflation, defined as the persistent rise in the general level of prices, is meant to be
kept under control by the government, and one way in which they do this is through
using interest rates, which determine the cost of borrowing.
As can be seen in Fig 1, an increase in interest rates is likely to shift aggregate
demand (AD) left, from AD1 to AD2. This is because interest rates determine the cost
of borrowing, and thus an increase in the rate will deter investment and consumption,
as it is now more costly to borrow money. Moreover, higher interest rates encourage
saving as savers will now get a higher rate of return on their savings, meaning
people save more and spend less. This resultant fall in consumption and investment
will cause a fall in AD as these are both important components of AD, with
consumption making up 66% of GDP in the UK economy. As can be seen in Fig 1,
the fall in AD causes a fall in the price level, from P1 to P2, and thus the inflation rate
is likely to fall.
Extract B (lines 11-12) states: ‘When total spending grows more quickly than
the volume of output produced, inflation is the result.’ Assess the view that
inflation is always caused by an increase in aggregate demand.
d) Extract B asserts the view that ‘when total spending grows more quickly than the
volume of output produced, inflation is the result.’ Inflation is a sustained increase in
the general level of prices leading to a fall in the purchasing power of money. Inflation
can come from both the demand and the supply-side of an economy, and thus the
view that inflation is always caused by an increase in aggregate demand is
inaccurate. Not only can the supply-side of an economy cause inflation, termed cost-
push inflation, but also external sources such as fluctuations in the exchange rate
can lead to inflation.
