A government is assessing progress towards stable prices and sustainable economic growth. The country’s consumer price index (CPI) rose from 120 in one year...
Question 1 Report
A government is assessing progress towards stable prices and sustainable economic growth. The country’s consumer price index (CPI) rose from 120 in one year to 126 in the next year. Real GDP grew by 1.2%, compared with growth of 3.8% in the previous year. The government is concerned that inflation is above its 2% target, but it does not want to reduce economic growth too sharply or increase unemployment. A rise in the costs of imported energy has increased firms’ production costs. The diagram shows a market in which supply shifts left from S1 to S2 following higher costs. Demand remains unchanged at D. The initial equilibrium is E1. The government is considering a reduction in indirect taxes to lower firms’ costs, but this could reduce tax revenue. It is also considering higher interest rates, which could reduce spending and inflation but may discourage investment.
(a) Which inflation measure is calculated using changes in the CPI? [2]
(b) What is meant by sustainable economic growth? [2]
(c) Draw an arrow to show the movement from E1 after supply shifts from S1 to S2. [3]
(d) Which type of inflation is caused by rising imported energy costs? [2]
(e) Explain one conflict the government may face between reducing inflation and maintaining economic growth. [3]
(f) Which monetary-policy action is most likely to reduce aggregate demand? [2]
(g) Draw a rightward shift of supply that could result from a reduction in indirect taxes. [3]
(h) Which likely effect would a successful reduction in firms’ costs have on real output? [2]
(i) Which economic figure should the government compare with its 2% inflation target? [2]
Answer Details
(a) Changes in the CPI calculate the inflation rate. [2]
(b) Sustainable economic growth is an increase in real output that can continue over time without serious inflation, resource exhaustion or damage to future productive capacity. [2]
(c) Higher costs shift supply left from S1 to S2; equilibrium moves up and left, so the price level rises and real output falls.
[3]
(d) Rising imported energy costs cause cost-push inflation. [2]
(e) Higher interest rates reduce consumer spending and investment, lowering aggregate demand and inflation. However, lower sales can reduce output, slow growth and increase unemployment. This is the policy conflict. [3]
(f) Increasing interest rates is the monetary-policy action most likely to reduce aggregate demand. [2]
(g) Lower indirect taxes reduce firms’ costs, shifting supply right. The new curve lies to the right of both S1 and S2.
[3]
(h) Real output is likely to rise because lower costs increase supply and firms can profitably produce more. [2]
(i) The government should compare its 2% target with the current annual inflation rate:
\[\frac{126-120}{120}\times100=5\%\]
[2]
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