Paper 1 Practice: Elandra’s Price-Stability Dilemma
Original practice material
Elandra and all evidence are fictional. This is one 30-mark case study, not a complete Paper 1. Suggested time: 75 minutes.
Answers: Elandra’s Price-Stability Dilemma — Answers.
Case Study: Inflation with weak activity
Extract 1: Recent indicators
| Indicator | Year 1 | Year 2 |
|---|---|---|
| Consumer price index | 114.0 | 120.6 |
| Real GDP growth (%) | 2.8 | 0.7 |
| Population growth (%) | 1.2 | 1.4 |
| Unemployment rate (%) | 3.9 | 5.6 |
| Export revenue (E billion) | 188 | 181 |
| Import expenditure (E billion) | 176 | 190 |
The figures conceal differences between households. Energy and food occupy a larger budget share for lower-income families, while nominal wages in several service occupations rose by only 2%.
The nominal effective exchange-rate index fell by 7% during Year 2. Inflation expectations in a household survey rose, but most wage agreements remain annual and have not yet been renegotiated. Government debt is denominated mainly in domestic currency, while many firms borrow at variable interest rates.
Extract 2: The origin of the shock
Elandra imports fuel and intermediate components. Shipping disruption and a depreciation of its currency raised firms’ costs. Several producers reduced output or increased prices. At the same time, weaker foreign demand reduced export orders. Vacancies remain high in health technology, but displaced assembly workers often lack the required skills.
Shipping costs have started to decline, although fuel contracts reset with a lag. Export manufacturers face weaker orders and more expensive imported components at the same time. The economy therefore experiences both an adverse supply shock and weaker aggregate demand. Their relative sizes are uncertain, and the unemployment increase cannot be attributed to a single cause.
Extract 3: Three policy proposals
The central bank proposes higher interest rates and measures to support the currency. The finance ministry proposes temporary energy rebates for lower-income households and accelerated public transport maintenance. A longer-term plan would subsidise retraining, diversify energy sources and improve port automation. The government already has a persistent budget deficit, and automation may displace some routine workers.
Energy rebates can be delivered quickly through the tax system, but a universal scheme would also support high-income households. Public-transport maintenance is relatively import-light and ready to begin, whereas port automation and retraining take longer. The central bank cannot directly repair supply chains; its interest-rate decision may nevertheless affect domestic demand, inflation expectations and the exchange rate.
Extract 4: A disputed objective
Business groups want rapid restoration of GDP growth. Community organisations argue that average real GDP is an incomplete measure of living standards. Environmental groups support energy diversification only if it reduces emissions rather than locking in another fossil-fuel source.
Community organisations propose evaluating policy using median real disposable income, employment security, access to essential services and local air quality as well as real GDP per capita. Business groups reply that weak productivity growth would eventually limit wage and tax-revenue gains. The dispute is therefore partly about the determinants and measurement of living standards, not simply about the preferred GDP growth rate.
Questions
(a) With reference to Extract 1:
(i) Calculate Elandra’s inflation rate from Year 1 to Year 2. [2]
(ii) Explain what the growth figures suggest about real GDP per capita. [2]
(b) Explain why the shocks in Extract 2 may cause both inflation and unemployment. [4]
(c) Explain what the trade figures suggest about Elandra’s balance of trade and why this change may have occurred. [4]
(d) Assess whether tighter monetary policy is likely to solve Elandra’s inflation problem. [8]
(e) Discuss the policy mix Elandra should use to improve living standards. [10]
[Total: 30]