Price Stability: five questions to try now
Real past-paper questions, the answer key from the mark scheme, and the explanation that goes with it. No account needed to answer them.
Question 1
John sells cakes for $10. Aisha offers online tutoring for $20 per hour. One hour of Aisha’s tutoring is worth two of John’s cakes. Which function of money is being illustrated?
Answer: D.
Nothing is actually changing hands in this example. Money is simply being used as a common measuring stick, letting two completely different things, an hour of tutoring and a cake, be priced and then compared, which is how we know one hour is worth two cakes. Measuring and comparing value is the unit of account function, so the answer is D. A would need money to be handed over in payment, which is not what the question describes. B involves paying for something now and settling the debt later, and there is no credit here. C is about holding wealth so that it keeps its value over time, which again is not what the $10 and $20 price tags are doing; they are labelling worth, not storing it.
Question 2
Sweden had a change in its Consumer Prices Index (CPI) of –0.6%.
Which combination of policies might its government use to restore price stability?
Answer: D.
The correct answer is D: reduce interest rates and increase government spending.
A CPI change of –0.6% is negative, which means prices are falling: Sweden is in deflation, not inflation. Restoring price stability therefore requires expansionary policy to raise aggregate demand and push the price level back up. Cutting interest rates lowers the cost of borrowing and the reward for saving, raising consumption and investment. Increasing government spending injects demand directly. Both instruments push AD to the right.
Why the other options are wrong:
A CPI change of –0.6% is negative, which means prices are falling: Sweden is in deflation, not inflation. Restoring price stability therefore requires expansionary policy to raise aggregate demand and push the price level back up. Cutting interest rates lowers the cost of borrowing and the reward for saving, raising consumption and investment. Increasing government spending injects demand directly. Both instruments push AD to the right.
Why the other options are wrong:
- A pairs higher interest rates with higher indirect taxes, both contractionary. This would deepen the deflation.
- B pairs higher interest rates with lower government spending, again both contractionary.
- C pairs lower government spending with higher income tax, both reduce aggregate demand.
Question 3
A country experienced an annual deflation rate of 2% for four successive years.
Which statement is correct for the four-year period?
Answer: B.
The correct answer is B: the price level fell by less than 8%.
Deflation compounds, so the falls cannot simply be added. Starting from an index of 100, each year's price level is 98% of the previous year's: 100 → 98 → 96.04 → 94.12 → 92.24. The total fall is about 7.76%, which is less than 8%.
The reason is that each 2% reduction is taken from a progressively smaller base. The first year's fall is 2 points, the second year's only 1.96 points, and so on. Compounding therefore works against the simple total when the changes are negative.
Why the other options are wrong:
Deflation compounds, so the falls cannot simply be added. Starting from an index of 100, each year's price level is 98% of the previous year's: 100 → 98 → 96.04 → 94.12 → 92.24. The total fall is about 7.76%, which is less than 8%.
The reason is that each 2% reduction is taken from a progressively smaller base. The first year's fall is 2 points, the second year's only 1.96 points, and so on. Compounding therefore works against the simple total when the changes are negative.
Why the other options are wrong:
- A, exactly 8%, treats the annual rates as additive. That is the standard error, and it slightly overstates the fall.
- C and D concern the real value of money, which moves in the opposite direction to prices. When prices fall, a given sum buys more, so the purchasing power of money rises: by a little over 8%, since 1/0.9224 ≈ 1.084. Both options have the direction wrong.
Question 4
A government has a target to reduce the rate of inflation.
Why might it not want to raise interest rates to achieve this target?
Answer: B.
The correct answer is B: aggregate supply may fall.
The question asks for a drawback of using interest rates against inflation, and the supply-side cost is the one that undermines the policy's own objective. Higher interest rates raise the cost of borrowing for firms, so investment projects that were marginally profitable are shelved. Less investment means the capital stock grows more slowly, productivity gains are delayed and long-run aggregate supply is lower than it would have been. A smaller productive capacity makes future inflation harder to control, since any given level of demand then presses against a tighter constraint. Higher borrowing costs also feed directly into firms' costs, adding cost-push pressure.
Why the other options are wrong:
The question asks for a drawback of using interest rates against inflation, and the supply-side cost is the one that undermines the policy's own objective. Higher interest rates raise the cost of borrowing for firms, so investment projects that were marginally profitable are shelved. Less investment means the capital stock grows more slowly, productivity gains are delayed and long-run aggregate supply is lower than it would have been. A smaller productive capacity makes future inflation harder to control, since any given level of demand then presses against a tighter constraint. Higher borrowing costs also feed directly into firms' costs, adding cost-push pressure.
Why the other options are wrong:
- A, aggregate demand falling, is not an objection; it is the intended mechanism. Reducing demand is precisely how higher interest rates lower inflation. There are real costs attached (lower output and higher unemployment), but the fall in AD itself is the policy working as designed.
- C, saving falling, reverses the effect. Higher interest rates raise the reward for saving, so saving rises.
- D, the exchange rate falling, is also the wrong direction. Higher rates attract capital inflows, so the currency tends to appreciate: which incidentally helps against inflation by making imports cheaper.
Question 5
A government statistical office measured changes in income from employment, pensions and benefits, then subtracted income tax and welfare contributions and adjusted for inflation. What did the final figure represent?
Answer: C.
Follow the office's steps in order and label the figure after each one. It began with income from employment, pensions and benefits, which is gross income from all sources. It then subtracted income tax and welfare contributions, and income after compulsory deductions is DISPOSABLE income rather than gross, which rules out D. It finally adjusted for inflation, and a figure adjusted for price changes is REAL rather than nominal, which rules out A and B. Both operations together give changes in real disposable income, so C is right. A ignores both steps entirely. B credits the deduction of tax but not the inflation adjustment, so it stops one step early. D credits the inflation adjustment but calls the figure gross, which contradicts the subtraction of tax and contributions that the office actually carried out.
What this practice covers
These questions are drawn from past CIE 9708 papers and filtered to price stability. You answer, you find out immediately whether you were right, and you get the reasoning for the correct option and for each distractor. Wrong answers go to a mistakes locker so you can come back to exactly those.
Practice is free. You need an account only so your progress and your mistakes are still there next time.
What examiners see students get wrong here
These are the errors that cost marks on price stability, taken from our own topic notes. Read them before you practise and you will recognise the traps in the questions.
- defining inflation as a rise in the price of one product;
- saying disinflation means prices fall;
- calculating inflation using the base year of 100 rather than the previous-period CPI;
- confusing the CPI index level with the inflation rate;
- using the total population as a CPI weight;
- claiming a nominal income increase automatically means a real-income increase;
- shifting SRAS to explain demand-pull inflation;
- shifting AD to explain a pure cost-push shock;
Revise it first
If any of the above is unfamiliar, work through the notes before practising: Price Stability revision notes.