Economic Growth, Unemployment and Inflation: Question 10

Worked solution

Part (a): Nordvale’s rate of inflation

Percentage change uses the starting CPI value as the base:

$\text{Inflation rate} = \frac{105-100}{100}\times100 = 5\%$

Nordvale’s rate of inflation over the year is $5\%$.

Part (b): Why this is demand-pull, not cost-push, inflation

Demand-pull inflation is caused by aggregate demand rising faster than aggregate supply, while cost-push inflation is caused by rising costs of production shifting aggregate supply to the left.

Every cause described in the stem raises aggregate demand: a cut in interest rates makes borrowing cheaper, which raised consumer borrowing and, alongside higher confidence, is likely to have raised consumption spending (C); higher government spending (G) ahead of the election adds directly to aggregate demand. AD $=C+I+G+(X-M)$, so a rise in both C and G shifts AD to the right. There is no mention anywhere in the stem of rising wages, rising import prices, or any other increase in firms’ costs of production that would instead point to cost-push inflation. This makes Nordvale’s inflation demand-pull.

Part (c): Consequence for international price competitiveness

Nordvale’s prices rose by $5\%$ over the year, compared with only $1\%$ in its main trading partner, Ravenna. Assuming the exchange rate between the two countries does not move enough to offset this difference, Nordvale’s goods and services are now relatively more expensive than equivalent goods and services from Ravenna.

This is likely to reduce Nordvale’s international price competitiveness: consumers in Ravenna are likely to buy fewer of Nordvale’s now relatively pricier exports, while Nordvale’s own consumers are likely to switch towards Ravenna’s relatively cheaper imports. Both effects would tend to reduce Nordvale’s net exports $(X-M)$, worsening its trade position with Ravenna.

Part (d): A policy to reduce demand-pull inflation

Because the inflation is demand-pull, the appropriate policy response is one that reduces aggregate demand. Nordvale’s central bank could raise interest rates: this increases the cost of borrowing (discouraging consumer credit-financed spending and business investment) and increases the reward for saving (encouraging households to save rather than spend). Both effects reduce consumption and investment, which are components of aggregate demand, so AD growth slows and the upward pressure on prices eases. (A contractionary fiscal policy (for example, raising taxes or reversing some of the increase in government spending) would work through the same channel of reducing aggregate demand and would be equally valid.)

Final answers

• (a) Rate of inflation $=$ $5\%$
• (b) Demand-pull, caused by lower interest rates raising borrowing and consumption, plus higher government spending, with no cost-side cause given
• (c) Nordvale’s exports become less price-competitive and its imports relatively cheaper, likely reducing net exports
• (d) Raise interest rates (or use contractionary fiscal policy) to reduce aggregate demand and ease inflationary pressure