Cambridge International as and a level Economics Ebook

SELF-ASSESSMENT TASK 
5.7
Between June 2013 and December 2013 the UK’s 
infl ation rate, as measured by changes in the 
consumer price index, fell from 2.9% to 2%. Prices 
were, nevertheless, rising at more than twice pay 
increases.
Th
e central bank, the Bank of England, had kept 
its interest rate unchanged at an all-time low of 0.5% 
since March 2009. Th
is was despite rising economic 
growth and falling unemployment.
1
What was happening to UK workers’ purchasing 
power between June and December 2013?
2
Explain why a central bank may keep its interest 
rate unchanged despite ‘rising economic growth 
and falling unemployment’.
124
Cambridge International AS Level Economics

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Policies to correct deflation and their 
eff ectiveness
A government will not seek to stop good defl ation but it 
will be anxious to correct bad defl ation. To reverse a fall in 
aggregate demand and the price level, governments employ 
refl ationary fi scal and monetary policy measures. For 
example, a government may increase its spending, cut tax 
rates, reduce interest rates and/or increase the money supply.
A rise in government spending may be more eff ective 
than the latter three policy measures. Th
is is because 
fi rms and households may be pessimistic during periods 
of defl ation and so may not spend more even if their 
disposable incomes rise and it becomes cheaper to 
borrow.
When interest rates are low it may not be possible to 
reduce them much further and any cuts may have little 
eff ect. For instance, a 2% interest rate is already low so if 
fi rms and households are not borrowing, it suggests they 
are concerned about future economic prospects. So if the 
interest rate is reduced to 1.5%, it is unlikely to stimulate 
increased borrowing and spending.
Central banks may increase the money supply, increasing 
the funds commercial banks have available to lend. Th
e 
banks, however, may be reluctant to lend because they may 
think there is an absence of creditworthy borrowers.
TOP TIP
In assessing the eff ectiveness of one type of policy, it is 
oft en useful to compare it with the other two types of 
policy.
Keep up-to-date with changes in government policy 
measures.