Inflation and price stability
Key terms
Define each term.
Multiple choice
Circle the correct answer.
A country's currency depreciates sharply, raising the price of imported oil and components. This is most likely to cause:
Worked problems
Show your working.
Building a weighted price index. A country's basket has four categories. Their weights and this year's price indices (base year = 100) are: Food: weight 40, price index 110. Housing: weight 30, price index 105. Transport: weight 20, price index 120. Other: weight 10, price index 100. Calculate the weighted price index and state what it shows.
Calculating an inflation rate from an index. A country's CPI stands at 128.0 in 2025 and 133.1 in 2026. Calculate the inflation rate for 2026, and state what has happened to the price level.
Chains of reasoning
The steps are in the wrong order. Write the letters in the order that makes a linked chain.
How demand-pull inflation develops
- A Firms initially respond by raising output to meet the extra demand.
- B As the economy approaches full capacity, spare resources become scarce.
- C The price level rises, and if aggregate demand continues growing faster than productive capacity, the rise is sustained rather than one-off.
- D A component of aggregate demand rises, for example consumption following a cut in income tax.
- E The AS curve becomes steeper as capacity constraints bite, so a growing share of the demand increase feeds into prices rather than output.
- F Aggregate demand shifts right.
- G Firms compete for the remaining labour and raw materials, bidding up wages and input prices.
The monetary transmission mechanism
- A Higher domestic rates attract capital inflows, so the exchange rate appreciates.
- B The central bank raises the policy interest rate.
- C Consumption falls, particularly of durables bought on credit, and mortgage holders on variable rates have less disposable income.
- D Commercial banks raise lending and deposit rates, so borrowing becomes more expensive and saving more attractive.
- E Appreciation lowers import prices and makes exports less competitive, reducing net exports and adding downward pressure on prices.
- F Investment falls, since fewer projects clear the higher required rate of return.
- G Aggregate demand falls, the AD curve shifts left, and inflationary pressure eases, though with a lag typically estimated at eighteen months to two years.
Diagrams
Draw two AD/AS diagrams. In the first, show demand-pull inflation near full capacity. In the second, show cost-push inflation.
Draw a short-run Phillips curve and the long-run vertical curve. Show what happens when a government expands demand to reduce unemployment below the natural rate, and trace the adjustment as expectations catch up.
Extended answer
Plan your answer: list the points you would make in each paragraph.
Discuss whether monetary policy is the most effective means of controlling inflation. (13 marks)
Answers
Inflation: A sustained increase in the general price level of an economy over a period of time.
Deflation: A sustained fall in the general price level of an economy over a period of time.
B. Higher import costs raise firms' costs of production, which are passed on as higher prices. That is cost-push inflation.
Step 1. Multiply each price index by its weight. Food 40 x 110 = 4,400. Housing 30 x 105 = 3,150. Transport 20 x 120 = 2,400. Other 10 x 100 = 1,000.
Step 2. Add them and divide by the total weight. Total = 4,400 + 3,150 + 2,400 + 1,000 = 10,950. Total weight = 100. Weighted index = 10,950 / 100 = 109.5.
Step 3. Interpret. Prices on average are 9.5% higher than in the base year. Transport rose most, by 20%, but it has a weight of only 20, so it adds less to the index than food, which rose 10% with a weight of 40.
The weights are the point. A simple average of the four indices would give 108.75, which ignores how much people actually spend on each category.
Set up the calculation Inflation rate = (new index − old index) ÷ old index × 100
Substitute (133.1 − 128.0) ÷ 128.0 × 100
Compute 5.1 ÷ 128.0 × 100 = 3.98%, so approximately 4.0%
Interpret The price level rose by about 4% during 2026. Note the index itself measures the price level; the percentage change measures inflation. Confusing the two is the most common error in index questions.
D, F, A, B, G, E, C
- A component of aggregate demand rises, for example consumption following a cut in income tax.
- Aggregate demand shifts right.
- Firms initially respond by raising output to meet the extra demand.
- As the economy approaches full capacity, spare resources become scarce.
- Firms compete for the remaining labour and raw materials, bidding up wages and input prices.
- The AS curve becomes steeper as capacity constraints bite, so a growing share of the demand increase feeds into prices rather than output.
- The price level rises, and if aggregate demand continues growing faster than productive capacity, the rise is sustained rather than one-off.
The steepness of the AS curve is what determines the split between output and prices. Answers that ignore where the economy sits relative to full employment miss the analytical core.
B, D, C, F, A, E, G
- The central bank raises the policy interest rate.
- Commercial banks raise lending and deposit rates, so borrowing becomes more expensive and saving more attractive.
- Consumption falls, particularly of durables bought on credit, and mortgage holders on variable rates have less disposable income.
- Investment falls, since fewer projects clear the higher required rate of return.
- Higher domestic rates attract capital inflows, so the exchange rate appreciates.
- Appreciation lowers import prices and makes exports less competitive, reducing net exports and adding downward pressure on prices.
- Aggregate demand falls, the AD curve shifts left, and inflationary pressure eases, though with a lag typically estimated at eighteen months to two years.
Six or seven linked steps like these are what a 'analyse how monetary policy reduces inflation' question is asking for. Naming the exchange rate channel separates strong answers from ones that stop at consumption and investment.
Demand-pull shifts AD right, raising both price level and output. Cost-push shifts SRAS left, raising the price level while output falls, which is the stagflation case. Label the price level and real output on both axes.
The economy moves up the short-run curve, then the short-run curve shifts upward as expectations adjust, returning unemployment to the natural rate at a higher inflation rate.
Define and frame: Define inflation and monetary policy. State immediately that effectiveness depends on the cause of the inflation, and that you will judge demand-pull and cost-push cases separately.
Analysis: the case for: Run the full transmission mechanism through consumption, investment and the exchange rate to a leftward AD shift. Support with an AD/AS diagram. Add that independent central banks have credibility, which anchors expectations and does part of the work before rates even move.
Analysis: the alternatives: Take fiscal and supply-side policy seriously. Fiscal policy acts more directly on demand but is politically slow and hard to reverse. Supply-side policy shifts LRAS right, allowing growth without inflation, and is the only tool that addresses cost-push at source.
Evaluation: Weigh rather than list. Time lags of up to two years mean the policy addresses conditions that may have passed. Against cost-push inflation from imported energy, raising rates reduces output without touching the cause, producing stagflation. The Phillips relationship implies an unemployment cost. At very low rates the liquidity trap limits scope. Against all that, monetary policy is flexible, reversible and free of the political constraints on fiscal policy.
Judgement: Conclude conditionally. Monetary policy is most effective against demand-pull inflation in an economy near capacity with a credible central bank. It is least effective against imported cost-push shocks, where supply-side measures and possibly fiscal support are better matched. State the diagnosis your judgement depends on.