Effects of Inflation and Deflation

Study the effects of inflation and deflation in Pearson Edexcel A Level Economics through real incomes, inequality, confidence, investment, competitiveness and the current account.

[Maximum number: 8]

Sources for use with Section C.
The French economy

Figure 1 Quarterly real GDP growth rate, Q2 2017 to Q1 2020

Figure 2 Consumer Price Index (CPI), weights and annual percentage price changes, June 2020

Figure 3 CPI inflation rate, January to June 2020

Extract A Inflation, trade and demand-side policy
Throughout 2019 the average price level was rising at a faster rate than nominal wages in France. For example, in Q4 2019 nominal wages rose by 0.2% while the inflation rate was 1.5%. This caused a decrease in living standards for many people.

The inflation rate in France fell in the first six months of 2020. In June it was 0.1%, its lowest level in over four years. This was partly caused by the fall in global energy prices. France was the first major global economy to announce that it was in recession in 2020. France’s real GDP fell by 5.3% in Q1 of 2020.

In April 2020, the value of exports from France fell by 32.4% to €23.7 billion. In particular, France exported fewer cars and pharmaceutical products. In the same month, imports into France fell 25% to €28.7 billion.

In response to the fall in its real GDP, the French Government introduced a range of demand-side policies. It spent €135 billion (over 5% of French GDP) to help the economy to recover. The Government also delayed or cancelled many firms’ tax payments and it guaranteed loans worth €342 billion to businesses.

As France is part of the euro area, monetary policy is conducted by the European Central Bank (ECB). The ECB kept its base interest rate very low throughout 2020. In June 2020 the weaker inflation outlook for the euro area caused the ECB to also expand the size of its asset purchase scheme (quantitative easing) by €600 billion to €1.35 trillion. In December 2020 a further increase in quantitative easing of €500 billion was announced by the ECB. The duration of the scheme was also extended to at least March 2022.

With reference to Figure 3 and Extract A, examine two likely effects on the French economy of the trend in the inflation rate in 2020.

Knowledge 2, Application 2, Analysis 2, Evaluation 2

Quantitative Skill Assessed

QS2: Calculate, use and understand percentages, percentage changes and percentage point changes

QS4: Construct and interpret a range of standard graphical forms

QS9: Interpret, apply and analyse information in written, graphical, tabular and numerical forms

Knowledge and Analysis

1 mark for defining the inflation rate or inflation, e.g.:

- The annual percentage change in the average price level OR

- Sustained increase in the price level of an economy

AND/OR

Up to 2 marks for identifying two likely effects of disinflation and up to 2 analysis marks for developing the identified effect(s), e.g.:

- May improve trade balance (1) as the price of French exports may rise more slowly than the price of other countries' goods / and the price of domestically produced goods and services may rise more slowly than the price of imports (1)

- May improve standard of living for those on fixed incomes (1) such a welfare payments/minimum wage/as the real value of their incomes may rise (1)

- The real value of debt may be eroded more slowly (1) so consumers and firms with outstanding loans may find these more difficult to repay (1)

- May increase investment (1) as firms' confidence may rises/as they may be more able to plan/predict future costs and prices (1)

- May reduce income inequality (1) as price of food and utilities may rise more slowly/so households may spend a lower proportion of their income on these essentials (1)

Application

Up to 2 marks for reference to the data, e.g.:

- Between January 2020 and June 2020 there is disinflation (1)

- In June 2020 the inflation rate ˋwas at its lowest level in over four years' (1)

- The CPI inflation rate fell from 1.5% in January 2020 (1) to 0.1\% in June 2020 (1)

- France was running a trade deficit of € 5 billion in April 2020 (1)

Evaluation

Up to 2 marks for evaluative comments ( 1+1 or 2+0 ), e.g.:

- Effect on trade balance depends on other countries' inflation rates (1)

- Effect on real incomes also depends on the change in nominal incomes (1); given that France is in recession, these may have fallen (1)

- Business confidence is likely to be low given that the economy is in recession/inflation is very low and falling (1) so investment is likely to fall rather than rise in France (1)

- ECB may be unlikely to lower the interest rate further (1) as it has been very low in 2020 (1)

- Only a relatively short period of six months is shown in Figure 3 / there is no data provided for July to December 2020 (1)

- Effects may be short-term (1) given, for example, the French Government's expansionary fiscal policy may be temporary as a result of the financial crises (1)

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2.3.1.2g - Effects of inflation and deflation on: (continued) • Consumers • the government • firms question 1