Effect of inflation on the Macroeconomy (Paper 2/3)

Question 1

AD

KAA points 1

Answer 1

Knowledge:
-inflation=sustained increase in the general price level
-reduction in the purchasing power of consumers

Application:
-UK inflation is at least 3% (2025)
-Necessities like food and fuel are now more expensive for consumers
-Consumption is 60-65% of UK AD

Analysis:
Increase price level-decreased value of money-lower real income-consumers afford less-reduced living standards-reduced MPC

reduced consumption-reduced AD-increased negative output gap-increased cylical unemployment-reduced actual economic growth

Real value of savings decreases-affecting future planning of savings

Diagram:
AD shifting inwards on the Keynesian LRAS curve

Question 2

AD

Eval points 1

Answer 2

Short run Philips curve-an increase in inflation may have a positive effect on the economy due to a decrease in unemployment (one of the UK govt’s macroeconomic objectives)

Inflation leads to increase in price of goods and services-govt receives more indirect tax revenue (VAT=20%)-improved budget deficit-allows for increase in govt spending-increased injections into circular flow-positive multiplier effect-increase AD-actual economic growth

Some inflation can also encourage spending, as consumers may expect prices to rise in the future and therefore choose to purchase now (this can boost economic activity).

Question 3

AS/Impact of firm in international markets

KAA points 2

Answer 3

Knowledge/Analysis:
-Inflation will increase input prices-increased cost of production for firms-reduction in SRAS-cost-push inflation

Firms raise prices to offload higher costs:
-increased export prices
-reduction in price competitiveness in international markets-reduction in exports-reduction in export revenue-worsened current account deficit-worsened balance of payment stability
-Smaller businesses may struggle with the increase in input costs

Application:
-Tesco-rising food prices
-Shell-rising oil prices
-British Gas-rising gas prices

Diagrams:
Inward shift of SRAS

Question 4

AS

Eval 2

Answer 4

-Central bank may cut interest rates-decrease in hot money inflows-decrease in demand for UK currency-depreciation-exports are more price competitive

-Inflation rates of trading partners may be high-currency depreciation in oother countries-exports may not decrease

-Improvement in terms of trade