These are original Marlbridge practice questions, not past exam questions. All questions use Valdoria, a fictional country whose currency is the valda (VD); all people, prices and index numbers are fictional. The rubrics are a suggested Marlbridge rubric to help you check your work; they are not an official scoring guideline. Assumptions: loans have a fixed nominal interest rate; “in start-of-year valdas” means multiplied by (CPI at start ÷ CPI at end); round money to VD 0.01 and percentages to 2 decimal places.
Question 1 (multiple choice · foundation)
Valdoria’s inflation rate turns out much higher than anyone expected. Which of the following is most likely to gain?
- (A) A household repaying a fixed-rate home loan
- (B) A bank that made many fixed-rate loans last year
- (C) A retired teacher living on a pension fixed in valdas
- (D) A family keeping its savings in cash at home
Answer and explanation
Answer: (A). The household’s repayments are fixed in valdas. After unexpected inflation each valda buys less, so the real burden of the loan falls. The borrower gains.
- (B) The bank is the lender. It is repaid in valdas that buy less than it expected, so it loses.
- (C) A fixed nominal pension buys less when prices rise, so the pensioner loses.
- (D) Cash keeps its face value but loses purchasing power, so the family loses.
Question 2 (multiple choice · core)
Valdoria experiences unexpected deflation. Which of the following is most likely to be harmed?
- (A) A lender who made a fixed-rate loan
- (B) A pensioner whose pension is fixed in valdas
- (C) A farmer repaying a fixed-rate loan on a tractor
- (D) A person holding savings in cash
Answer and explanation
Answer: (C). The farmer’s repayments are fixed in valdas, but falling prices make each valda worth more. The real burden of the debt rises, especially as the farmer’s own crop prices are likely to fall too.
- (A) The lender is repaid in valdas that buy more than expected, so the lender gains.
- (B) A fixed nominal pension buys more when prices fall, so the pensioner gains.
- (D) Cash buys more when prices fall, so its holder gains.
Question 3 (multiple choice · core)
Lina lends VD 2,000 for one year and is repaid VD 2,120. Over the year the CPI rises from 140 to 154. What is the repayment worth in start-of-year valdas?
- (A) VD 1,908.00
- (B) VD 1,927.27
- (C) VD 2,120.00
- (D) VD 2,332.00
Answer and explanation
Answer: (B). 2,120 × (140 ÷ 154) = VD 1,927.27. Inflation was (154 − 140) ÷ 140 × 100 = 10%, so Lina gets back less purchasing power than she lent.
- (A) subtracts 10% from the repayment (2,120 × 0.90). Dividing by 1.10 is not the same as multiplying by 0.90.
- (C) ignores inflation and gives the nominal repayment.
- (D) multiplies by 1.10 instead of dividing. That gives the amount needed at the end of the year to match VD 2,120 of start-of-year purchasing power.
Question 4 (multiple choice · core)
A Valdorian lender and borrower both expect 4% inflation and agree a one-year loan at a nominal interest rate of 7%. Inflation over the year turns out to be exactly 4%. Which statement is correct?
- (A) Neither side gains at the other’s expense; the lender earns about the 3% real return both sides planned.
- (B) The lender loses, because prices rose during the loan.
- (C) The borrower gains, because the loan is repaid in valdas that buy less.
- (D) The lender gains 7% in purchasing power.
Answer and explanation
Answer: (A). The 4% inflation was expected and built into the 7% nominal rate, so the lender’s purchasing power rises by about 7% − 4% = 3% (exactly 2.88%), as both sides planned. There is no arbitrary redistribution.
- (B) and (C) treat any inflation as a cost to lenders. Only unexpected inflation shifts wealth from lender to borrower.
- (D) ignores inflation. The 7% is a nominal return; part of it only makes up for higher prices.
Question 5 (calculation · core)
Dev signs a two-year contract to work for a Valdorian bakery at a fixed wage of VD 2,400 a month. When he signs, the CPI is 100, and both sides expect inflation of about 2% a year. In fact the CPI is 106 after one year and 113 after two years.
(a) Calculate Dev’s real wage in each year of the contract, in valdas of the signing year. (b) By what percentage has his purchasing power fallen by the second year? (c) What monthly wage would he need in the second year to keep the purchasing power he had when he signed? (d) Who gains from this unexpected inflation? Explain.
Worked solution
(a) Year 1: 2,400 × 100 ÷ 106 = VD 2,264.15. Year 2: 2,400 × 100 ÷ 113 = VD 2,123.89.
(b) (2,123.89 − 2,400) ÷ 2,400 × 100 = −11.50%: his purchasing power has fallen by 11.50%.
(c) 2,400 × 113 ÷ 100 = VD 2,712 a month.
(d) The bakery (the employer) gains. It pays the same fixed wage, which is worth less in real terms, while the prices it charges for bread have probably risen with the price level. Dev loses what the bakery gains.
Suggested mark points (4): 1 for both real wages; 1 for the 11.50% fall; 1 for VD 2,712; 1 for identifying the employer as the gainer with a reason.
Question 6 (constructed response · core)
A Valdorian farmer borrows VD 50,000 from a bank for one year at a nominal interest rate of 9%. Both sides expect the CPI to rise from 200 to 210 (5% inflation).
(a) Calculate the amount the farmer must repay. (b) The CPI actually rises to 220. Calculate the repayment in start-of-year valdas and the percentage change in the bank’s purchasing power. State who gains. (c) Instead, the CPI actually falls to 196. Calculate the repayment in start-of-year valdas and state who gains. (d) Explain why economists describe the redistribution in (b) and (c) as “arbitrary”.
Worked solution and suggested Marlbridge rubric
(a) 50,000 × 1.09 = VD 54,500.
(b) 54,500 × 200 ÷ 220 = VD 49,545.45. Change = (49,545.45 − 50,000) ÷ 50,000 × 100 = −0.91%. Inflation of 10% was higher than the 5% expected, so the bank gets back less purchasing power than it lent. The farmer (borrower) gains; the bank (lender) loses.
(c) 54,500 × 200 ÷ 196 = VD 55,612.24 (an 11.22% rise in the bank’s purchasing power). Prices fell unexpectedly, so each valda repaid buys more. The bank (lender) gains; the farmer (borrower) loses.
For comparison, if the CPI had reached 210 as expected, the repayment would be worth 54,500 × 200 ÷ 210 = VD 51,904.76, a 3.81% gain for the bank, as planned.
(d) Neither side chose or controlled the inflation surprise. Purchasing power moved between them because of luck and the terms of a contract fixed in valdas, not because either side was more productive or made a better decision with the information available.
| Point | What earns it |
|---|---|
| 1 | VD 54,500 |
| 1 | VD 49,545.45 and a fall of 0.91% in the bank’s purchasing power |
| 1 | Farmer gains in (b), linked to inflation being higher than expected |
| 1 | VD 55,612.24 and the bank gains in (c) |
| 1 | “Arbitrary” explained as caused by an unforeseen price change, not by effort or productivity |
Accept answers carried forward from an error in (a).
Question 7 (constructed response · stretch)
Hana lives on a Valdorian pension of VD 900 a month, fixed in valdas. Over the year the CPI rises unexpectedly from 160 to 176.
(a) Calculate the purchasing power of her pension at the end of the year in start-of-year valdas, and the percentage change. (b) The government proposes to index pensions to the CPI. Calculate her indexed pension and explain how indexing protects her. (c) After several years of unpredictable inflation, Valdorian banks stop offering 20-year fixed-rate home loans. Explain why, and identify one cost this imposes on the economy.
Model answer and suggested Marlbridge rubric
(a) Inflation = (176 − 160) ÷ 160 × 100 = 10%. Purchasing power = 900 × 160 ÷ 176 = VD 818.18, a fall of 9.09%.
(b) Indexed pension = 900 × 176 ÷ 160 = VD 990. Her pension rises automatically by the same percentage as the price index, so it buys the same basket as before, whatever inflation turns out to be. Unexpected inflation can no longer reduce her purchasing power.
(c) A bank making a 20-year fixed-rate loan risks inflation turning out higher than expected over a long period, which would cut the real value of every repayment. When inflation is hard to predict, this risk is large, so banks refuse such loans or charge much higher rates to cover it. One cost: households and firms find long-term borrowing harder or more expensive, so fewer homes are bought and fewer long-term investments (factories, machinery) are made. Resources are also spent on protecting against inflation instead of producing goods and services.
| Point | What earns it |
|---|---|
| 1 | VD 818.18 and a 9.09% fall |
| 1 | VD 990 with an explanation that indexing keeps purchasing power constant |
| 1 | Links unpredictable inflation to the risk that fixed repayments lose real value for the lender |
| 1 | Identifies a valid cost to the economy, such as less long-term lending and investment |
In (c), “inflation is bad for banks” without the link to unexpected changes in the real value of fixed repayments earns no point.
How did you do?
- Q1, Q2 or Q6(b)–(c) wrong: re-read “Lenders and borrowers” and “Other winners and losers” in the study guide.
- Q3, Q5 or Q7(a) wrong: check the CPI ratio; see Worked example 1 and Worked example 2.
- Q4 or Q6(d) wrong: revisit “Expected and unexpected inflation” and “What if the inflation had been expected?”.
- Q7(b)–(c) wrong: revisit Worked example 2(d) and “Costs to the economy as a whole”.
Then tick off the topic checklist.