AQA A-level Economics: Central banks and monetary policy (7136) – Practice Questions

These are original questions written for Marlbridge, for revision and practice on this content. They are not reproduced past-paper questions, and they do not replicate the exam’s exact structure, question count or mark tariffs – examination boards hold copyright in their own papers. Use these alongside the official past papers from your board or school.

These questions cover central banks and monetary policy for AQA A-level Economics (7136), specification version 1.3, section 4.2.4.3 in the PDF (numbered 3.2.4.3 on the AQA website). Every figure is invented, set in “Country A” or similar. Read the study guide and revision notes first. Course pages: AQA A-level Economics hub and the checklist. The free diagnostics help you choose what to revise. The mark splits in the answers are our own guide to a full response.

Questions

1. State three functions of a central bank. [3]

2. In Country A, the CPI index rises from 98.0 to 101.4 over a year. The inflation target is 2%.

(a) Calculate the rate of inflation, to one decimal place. [2] (b) State the gap between inflation and the target, and say which way the MPC is likely to move bank rate, with one reason. [2]

3. A bank pays 6% on savings while inflation is 4.5%. Later the bank pays 2% and inflation is 3.5%.

(a) Calculate the approximate real interest rate in each case. [2] (b) Explain what the second result implies for saving and spending. [1]

4. A household has a variable-rate, interest-only mortgage of £90,000. The rate rises from 2.5% to 4.0%.

(a) Work out how much more the household pays in interest each year, and the monthly equivalent. [3] (b) Explain one reason why a rise in bank rate might reduce total consumption by less than this suggests. [2]

5. Explain how a rise in bank rate can reduce inflation. [6]

6. The exchange rate falls from £1 = €1.25 to £1 = €1.10.

(a) A UK firm sells a machine for £80. Find its euro price before and after, and the percentage change in that price. [3] (b) A UK importer buys goods priced at €55. Calculate the sterling cost before and after. [2]

7. Explain how an appreciation of the pound affects AD and two macroeconomic objectives. [6]

8. The Bank carries out quantitative easing by buying £25bn of gilts from a pension fund.

(a) Explain what happens in this purchase, including the effect on bank reserves. [3] (b) Explain how QE may raise AD. [3]

9. Explain what is meant by (a) Funding for Lending and (b) forward guidance. [4]

10. Country A’s data before an MPC meeting: forecast inflation 3.6% (target 2%); unemployment 3.8%; wage growth 5.5% against productivity growth of 1.0%; output gap +1.5% of potential output; exchange rate index down 8% over the year; consumer confidence weak.

Using the data, explain two reasons why members may vote to raise bank rate, and one reason for caution. [6]

11. Evaluate the view that raising bank rate is the best way for a central bank to reduce inflation. [12]

Answers

1. Any three of: issues banknotes [1]; banker to the government [1]; banker to commercial banks, holding their reserve accounts [1]; lender of last resort; carries out monetary policy (each worth a mark, up to three in all). [3] Examiner insight: Name distinct functions; “controls the economy” is too vague to be a function.

2. (a) (101.4 - 98.0) / 98.0 x 100 [1] = 3.469…, so 3.5% [1] (b) Inflation is 3.5 - 2.0 = 1.5 percentage points above target [1]; a rise in bank rate is likely, to slow AD and bring inflation back toward 2% [1]. [4] Examiner insight: Show the formula before the answer, and give the gap in percentage points, not percent.

3. (a) First case 6 - 4.5 = 1.5% [1]; second case 2 - 3.5 = -1.5% [1] (b) A negative real return discourages saving and encourages spending and borrowing, so AD tends to rise [1]. [3] Examiner insight: A negative sign on the real rate carries the meaning; saying “lower” loses it.

4. (a) Before: 90,000 x 0.025 = £2,250 [1]. After: 90,000 x 0.04 = £3,600 [1]. Increase £1,350 a year, £112.50 a month [1] (b) Savers receive higher interest, for example £20,000 moving from 1% to 2.5% gains £300 a year [1]; households on fixed rates do not feel the rise yet, so total consumption changes by less [1]. [5] Examiner insight: A reason for a smaller effect must be developed. Naming “fixed rates” without saying what they do to spending gains less.

5. Bank rate rises, so banks raise lending and savings rates [1]. Consumption falls because borrowing is dearer, saving pays more and variable-rate borrowers have less disposable income [1]. Investment falls because the cost of finance rises and fewer projects are profitable [1]. Higher interest rates attract foreign financial inflows, so the currency appreciates [1]. Foreign buyers face higher export prices and imports cost less, so net exports fall [1]. AD shifts left, which reduces demand-pull pressure, and cheaper imports reduce cost pressure, so inflation slows [1]. [6] Examiner insight: Completing the chain to inflation matters. Stopping at “AD falls” leaves the question half answered.

6. (a) Before: 80 x 1.25 = €100 [1]. After: 80 x 1.10 = €88 [1]. Change -12% [1] (b) Before: 55 / 1.25 = £44 [1]. After: 55 / 1.10 = £50 [1]. [5] Examiner insight: Check the direction of the division. Multiply when converting pounds to euros, divide when converting euros to pounds.

7. Foreign buyers pay more for UK exports, while UK buyers pay less for imports [1], so net exports and AD fall [1]. Inflation: cheaper imported raw materials and goods lower costs and prices, and lower AD reduces demand pressure [2]. Growth and employment: lower AD slows growth, and export-led firms may cut output and jobs [2]. [6] Examiner insight: Pick two objectives and give each its own reasoning. A list of three or four effects with no development gains less than two explained effects.

8. (a) The Bank creates new electronic reserves and uses them to buy gilts [1]. The pension fund gives up £25bn of gilts and receives a £25bn deposit at its bank [1]; the bank’s reserves at the Bank rise by £25bn [1]. (b) Gilt prices rise and yields fall, lowering longer-term borrowing costs and encouraging spending [1]. Higher asset prices create a wealth effect on consumption [1]. Banks with extra reserves and deposits may lend more, raising credit [1]. [6] Examiner insight: Say that QE creates reserves electronically; “printing money” invites confusion with banknotes.

9. (a) Funding for Lending: cheap funding for banks, linked to their lending to households and firms [1], to lower loan rates and increase the supply of credit [1]. (b) Forward guidance: the central bank signals the likely future path of policy [1], which shapes expectations so that borrowing and spending adjust today [1]. [4] Examiner insight: Define the tool, then give its purpose. A definition alone is one step.

10. Raise: forecast inflation of 3.6% is above the 2% target [1], so tighter policy is needed to slow AD [1]. Wage growth of 5.5% far exceeds productivity growth of 1.0%, a source of cost pressure [1]; with a positive output gap and low unemployment, spare capacity is small and demand-pull pressure is likely to continue [1]. Caution: weak consumer confidence suggests demand may already be slowing, and with policy lags a rise could overshoot and cut output [2]. [6] Examiner insight: Use the figures, and compare them with something, such as the target or productivity growth. Quoting a figure alone adds nothing.

11. Definition and mechanism: bank rate works through borrowing costs, saving, wealth and the exchange rate to reduce AD [1]; effective against demand-pull inflation, because it removes excess demand [1]; the MPC is independent of government and rate changes are credible, which anchors expectations [1]; it is flexible and can be reversed quickly [1]. Limits: time lags of a year or more, so decisions rest on uncertain forecasts [1]; against cost-push inflation from energy or import prices, a rise cuts output and raises unemployment without addressing the cause [1]; effects are uneven, hitting borrowers and exporters more than savers [1]; effects depend on how interest-sensitive spending is and on household debt [1]. Alternatives: fiscal policy and supply-side policy tackle different causes, and QE or forward guidance may help when rates are low [1]; the exchange rate and global factors can reinforce or weaken the effect [1]. Judgement: bank rate is the main tool for demand-pull inflation but not the only tool, and its success depends on the source of inflation, the lags and the state of confidence [2]. [12] Examiner insight: Evaluation is strongest when tied to a condition, such as the type of inflation or the size of the lag, and ends with a judgement that follows from it.

Where marks are usually lost

• Using the wrong base for an index or growth calculation.
• Giving a gap in percent instead of percentage points.
• Dividing and multiplying the wrong way in exchange rate conversions.
• Describing QE as printing banknotes, or forgetting the effect on reserves and deposits.
• Stopping the transmission chain before reaching inflation.
• Treating an appreciation as good or bad without naming which objective.
• Quoting data without comparing it to a target or another figure.
• Writing a one-sided answer to an evaluation question, or ending without a judgement.

Next steps

• Re-read the revision notes and the study guide.
• Tick off the topic on the checklist and see the course hub.
• Take the free 10-minute diagnostics to check other topics.
• Book a free trial class.

Official syllabus

AQA AS and A-level Economics specification (7135 and 7136), version 1.3, for first teaching from September 2015; published by AQA. Section 4.2.4.3 in the PDF, numbered 3.2.4.3 on the AQA website.