Explain two possible causes of deflation.

Using real-world examples, evaluate the effectiveness of monetary policy to achieve low inflation.

Answers may include:

• Definition: deflation.
• Explanation: any determinant of AD that could shift it to the left, eg falling consumer or business confidence, falling consumption, falling investment, falling government spending, or any determinant that shifts AS to the right, eg falling costs of raw materials or labour, increased productivity, rising exchange rate.
• Diagram: AD/AS diagram to show falling AD or increasing AS in such a way that the average price level falls.

Answers may include:

• Definition: inflation, monetary policy.
• Explanation: that it is incremental, easily changed, flexible, fast to implement, does not burden the government’s budget. That there are limitations: it is less effective when business/consumer confidence is low; effectiveness may depend on the type of inflation.
• Diagram: AD/AS diagram to illustrate contractionary monetary policy.
• Synthesis (evaluate): strengths and limitations of monetary policy in achieving low inflation. Fiscal policy might be considered as an alternative, but the emphasis of the response should be on monetary policy.
• Examples: real-world examples of where governments have attempted to lower inflation using monetary policy.

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