Explain why there is a possible trade-off between the unemployment rate and the inflation rate in the short run.

Discuss the view that the redistribution of income is the most important impact that inflation has on an economy.

Marks should be allocated according to the paper 1 markbands for May 2013 forward, part A.

Answers may include:

• definitions of unemployment (rate), inflation (rate)
• diagram of the short-run Phillips curve to illustrate the trade-off between inflation and unemployment and AD/AS diagram to support the explanation
• explanation that, in the short-run, if aggregate demand in the economy increases, this would lead to increase in national output, forcing firms to hire more workers and decreasing the unemployment rate, while simultaneously increasing the inflationary pressures in the economy, and/or vice versa
• examples of countries that have possibly experienced a trade-off between inflation and unemployment.

Marks should be allocated according to the paper 1 markbands for May 2013 forward, part B.

Answers may include:

• definition of inflation
• AD/AS diagram to show the increase in the price level or a Lorenz curve to show changed distribution of income
• explanation that (unexpectedly) high inflation affects positively the real income/wealth of borrowers and the groups in society with variable income while affecting negatively the real income/wealth of lenders and the groups in society with fixed income
• examples of countries that have experienced inflation with attempt to identify consequences of inflation
• synthesis or evaluation (discuss).

Discussion may include: consideration of alternative impacts of inflation (such as a loss of export competitiveness, increases in short-run economic growth, decreases in savings and increases in uncertainty resulting in lower investment and hence lower long-run economic growth, “menu costs”) with the candidate making judgment with regard to what might be the most important impact and whether or not the candidate feels the potential redistributive effect is the most significant impact of inflation, the importance of how high the inflation rate is, the difference between expected and unexpected inflation.

Examiners should be aware that candidates may take a different approach which, if appropriate, should be rewarded.

NB It should be noted that definitions, diagrams, theory and examples that have already been given in part (a), and then referred to in part (b), should be rewarded.

Candidates were expected to focus their answers on the negative short run relationship between inflation and unemployment and explain it with the help of the AD/AS model. The best answers used both the short-run Phillips curve diagram (to show the alleged negative relationship, and therefore trade-off, between the inflation rate and the unemployment (rate) in the short run) and AD/AS diagram (to explain why there may be a negative relationship between inflation and unemployment in the short run). Both diagrams were usually done well but many candidates found it difficult to use both diagrams to support a coherent and complete explanation. A common mistake for candidates when trying to link the two diagrams was to incorrectly connect points on the two vertical axes with a dashed line as if both axes measure inflation.

Candidates were expected to focus on the impacts of inflation in their answers, but many candidates choose to elaborate on the types and causes of inflation instead. A common mistake was to confuse the impacts of inflation with the impacts of increasing aggregate demand (without explaining why inflation may lead to increasing aggregate demand in the short run in order to make their answer relevant to the specific demands of the question).