Inflation in Lydora

Read the extracts and answer the questions that follow.

Text A — Rising demand

1. Lydora has experienced rapid growth in household consumption and housing investment. Unemployment has fallen to 3.8%, while inflation has risen above the central bank's target. The central bank identifies price stability as an important monetary-policy objective.

2. The central bank increased its policy interest rate from 3% to 5%. Commercial banks subsequently increased mortgage and business-loan rates. Officials expect weaker consumption and investment to reduce aggregate demand, although the effects may take more than a year to appear.

Text B — Costs and consequences

1. Food and energy prices have also increased because of poor harvests and higher world oil prices. Some economists therefore argue that the inflation is partly cost-push and will not be removed directly by higher interest rates.

2. The central bank uses inflation targeting and aims for inflation of 2%, within a range of 1% to 3%. Heavily indebted households report that higher mortgage repayments have reduced their disposable income.

Table 1 — Consumer price index and interest rate

Consumer price index and lending interest rate in Lydora.

Table 2 — Selected macroeconomic indicators

Selected macroeconomic indicators for Lydora

Recession in Norvia

Read the extracts and answer the questions that follow.

Text A — Weak private spending

1. Norvia entered a recession after exports and business confidence declined. Firms postponed investment and unemployment rose. The central bank responded with expansionary monetary policy, reducing its policy rate from $2.5\%$ to $0.5\%$.

2. Commercial banks lowered some lending rates, but many firms remained unwilling to borrow because they expected weak sales. Banks also tightened credit checks. The central bank stated that policy changes influence spending through a transmission mechanism involving borrowing, saving, consumption, investment and the exchange rate.

Text B — Prospects for recovery

1. The lower interest rate reduced the reward for saving and caused Norvia's currency to depreciate. Exporters became more competitive, but imported fuel became more expensive.

2. The economy has substantial spare capacity. However, consumer confidence remains low and the policy rate is already close to zero, limiting the scope for further conventional rate cuts.

Table 1 — Prices and borrowing costs

Prices and borrowing costs in Norvia

Table 2 — Indicators of economic activity

Selected indicators of economic activity in Norvia.

Household debt in Estara

Read the extracts and answer the questions that follow.

Text A — Monetary tightening

1. Estara's inflation has exceeded its target following strong household demand. The central bank adopted contractionary monetary policy, increasing the official interest rate in several small steps.

2. Most mortgages in Estara have variable interest rates. Higher repayments have reduced the disposable income of indebted households, while retired savers have received higher interest income. Retail sales have declined sharply.

Text B — Distribution and stability

1. The central bank argues that small changes make monetary policy incremental and easily reversible. It could lower the rate quickly if unemployment rises more than forecast.

2. Critics argue that the burden of tightening is uneven. Low-income mortgage borrowers spend a large proportion of income on housing, while wealthy households are more likely to own interest-bearing financial assets.

Table 1 — CPI and mortgage rate

CPI and variable mortgage interest rate in Estara

Table 2 — Household indicators

Table 2 — Household indicators in Estara

External balance in Calidia

Read the extracts and answer the questions that follow.

Text A — Imports and domestic demand

1. Calidia has a large current account deficit. Strong consumption has increased imports of vehicles and electronics. The central bank raised interest rates to reduce domestic demand and improve external balance.

2. Higher rates reduced consumer credit and investment. However, they also attracted short-term financial inflows, causing the calid to appreciate.

Text B — Conflicting exchange-rate effects

1. The appreciation made imported goods cheaper but Calidia's tourism and manufactured exports more expensive abroad. Export firms have reduced employment.

2. The central bank's main objective remains a low and stable rate of inflation. Officials argue that cheaper imported fuel will reduce inflation, while exporters argue that the policy may worsen the trade balance.

Table 1 — CPI and consumer-credit rate

Calidia consumer prices and consumer-credit interest rate

Table 2 — External indicators

External indicators for Calidia in 2025.

Very low interest rates in Arandia

Read the extracts and answer the questions that follow.

Text A — Persistent weakness

1. Arandia has experienced weak consumption, falling investment and very low inflation. The central bank cut its policy rate to 0.1%, but aggregate demand remained weak. The economy has a recessionary gap and high cyclical unemployment.

2. Households increased saving because they feared job losses. Firms did not borrow despite cheap credit because they expected poor sales. Commercial banks were cautious about lending to small businesses.

Text B — Limits to policy

1. Economists describe this as the near-zero lower bound constraint: there is little practical scope for reducing nominal interest rates further. The central bank continues to promise low rates, hoping to improve confidence.

2. Critics argue that monetary policy cannot force pessimistic households and firms to spend. Others note that low rates have depreciated Arandia's currency, supporting tourism and exports.

Table 1 — CPI and lending rate in Arandia

Indicators of weak aggregate demand in Arandia.

Delayed recovery in Selucia

Read the extracts and answer the questions that follow.

Text A — Rate cuts and delayed effects

1. Selucia's central bank cut its policy interest rate after unemployment increased. Commercial-bank lending rates fell quickly, but household spending responded only gradually. The delay between a policy decision and its effect on output and inflation is called a time lag.

2. Businesses initially postponed investment because confidence was weak. Six months later, orders and borrowing began to rise. The central bank expects aggregate demand to strengthen further next year.

Text B — Risk of overstimulation

1. Selucia now has less spare capacity and house prices are increasing rapidly. Some policymakers fear that keeping rates low for too long could create an inflationary gap.

2. Others emphasize that monetary policy is easily reversible: the policy rate can be raised if inflationary pressure becomes excessive. However, an early increase could stop the recovery before employment has fully recovered.

Table 1 — CPI and lending rate

Selucia's consumer price index and lending interest rate.

Table 2 — Recovery indicators

Recovery indicators in Selucia

Interest rates and housing in Pelagos

Read the extracts and answer the questions that follow.

Text A — Credit-led expansion

1. Pelagos experienced rapid growth in mortgage borrowing and house prices while interest rates were low. Construction and consumption increased because homeowners felt wealthier. The central bank became concerned that excessive spending would increase inflation.

2. It raised the interest rate, and commercial banks increased mortgage rates. New housing demand declined, construction slowed and households with variable-rate mortgages reduced other spending.

Text B — Wider objectives

1. The central bank seeks low inflation, low unemployment and a stable environment for long-term growth. These objectives may conflict when policy changes aggregate demand.

2. Housing construction employs many lower-skilled workers. A sharp slowdown could create cyclical unemployment, while stable inflation could reduce uncertainty and support sustainable investment over time.

Table 1 — CPI and mortgage rate

CPI and nominal mortgage interest rate in Pelagos

Table 2 — Housing indicators

Housing indicators in Pelagos, 2024–2025

Recession in Lydora

Lydora’s central bank has an inflation target of 2% per year. Following a decline in consumer and business confidence, the economy entered a recession. Commercial banks are willing to lend any excess reserves, but firms remain cautious about borrowing.

Table 1

Selected macroeconomic and banking data for Lydora.

The central bank is considering purchasing government securities from the banking system. It estimates that this would create 600 million lydors of new commercial-bank reserves. Assume initially that all loans are spent, all funds are redeposited in commercial banks, banks hold no excess reserves and the public holds no additional cash.

Demand-pull inflation in Montara

Montara’s economy has experienced rapid growth in household credit and investment. Its central bank believes that aggregate demand is above the economy’s productive capacity and is considering selling government securities to commercial banks.

Table 1: Selected data for Montara

Selected macroeconomic and monetary data for Montara.

Assume that the sale of securities would reduce commercial-bank reserves by 300 million montars. Under the simplified deposit-creation model, banks hold no excess reserves, the public holds no additional cash and all loans are redeposited.

Very low inflation and quantitative easing in Norland

Norland has experienced weak private investment and declining prices. Its policy interest rate is already close to zero. The central bank is considering creating reserves to purchase 40 billion norins of long-term government bonds from financial institutions.

The following data are provided in Table 1.

Selected economic and financial data for Norland.

Surveys indicate that only 38% of firms expect sales to rise during the next year. Commercial banks have also increased voluntary excess reserves because they are concerned about borrowers defaulting.

Credit growth in Bellaria

Bellaria’s central bank operates an inflation-targeting framework. Rapid growth in bank lending has contributed to rising consumption and house prices. The central bank is considering increasing the minimum reserve requirement for commercial banks.

Use the following table for the questions.

Monetary and macroeconomic data for Bellaria.

For the calculations, assume that the banking system has 50 million bellars of new reserves available to support deposits. Assume that all excess reserves are lent, all loan proceeds are redeposited, banks hold no voluntary excess reserves and the public holds no additional cash.

Imported inflation in Vardena

Read the extracts and answer the questions that follow.

Text A — Energy shock

1. Vardena imports most of its energy. A global supply disruption doubled the world price of gas, increasing firms' transport and production costs. Inflation rose well above target even though domestic demand was weak. This is described as cost-push inflation.

2. The central bank raised interest rates to prevent inflation expectations from becoming embedded. Officials accepted that policy could not create more gas but argued that it could limit second-round increases in wages and prices.

Text B — Economic costs

1. Higher borrowing costs have reduced investment and housing demand. Unemployment has increased, and small firms report difficulty refinancing debt.

2. The currency appreciated after the rate increase, making imported energy cheaper in domestic currency. The bank must decide whether the improvement in price stability justifies weaker output and employment.

Table 1 — CPI and business-loan rate

Vardena's consumer price index and nominal business-loan interest rate.

Table 2 — Energy and labour indicators

Energy, labour, investment and currency indicators for Vardena.

Exchange-rate pressure in Kintara

Read the extracts and answer the questions that follow.

Text A — Currency depreciation

1. Kintara's currency depreciated after world interest rates rose and investors moved funds abroad. Imported food and machinery became more expensive, increasing inflation. The central bank raised domestic rates to attract financial inflows and support exchange-rate stability.

2. Higher rates reduced consumption and investment. Manufacturers that borrow to buy machinery have postponed expansion, while the stronger currency has reduced imported input costs.

Text B — Policy dilemmas

1. The central bank also aims to achieve low unemployment, but unemployment is already increasing. Exporters benefit from a weaker currency and fear that appreciation will reduce their competitiveness.

2. Economists disagree about whether monetary policy should prioritize inflation and the exchange rate or domestic output and employment. The outcome may depend on investors' confidence and changes in foreign interest rates.

Table 1 — CPI and lending rate

Kintara's consumer price index and nominal lending rate.

Table 2 — External and domestic indicators

Table 2 — External and domestic indicators in Kintara

Monetary-policy choices in Dorsia

Read the extracts and answer the questions that follow.

Text A — Uneven recovery

1. Dorsia is recovering from a recession. Consumer spending has increased, but business investment remains weak and unemployment is still high. The central bank has kept interest rates low to promote a stable environment for long-term economic growth.

2. Inflation has moved above target following floods that damaged crops and raised food prices. The central bank must decide whether to increase rates despite the weak labour market.

Text B — Interdependence and policy

1. Dorsian households have high variable-rate debt. Environmental damage has reduced food supply, while low business confidence limits investment. These economic, social and environmental factors are interdependent and affect monetary-policy outcomes.

2. Supporters of tightening emphasize inflation expectations and price stability. Opponents argue that higher rates would reduce demand without restoring damaged crops and would impose heavy costs on indebted households.

Table 1 — CPI and lending rate

Dorsia's consumer price index and nominal lending rate.

Table 2 — Recovery and household indicators

Recovery and household indicators for Dorsia

Imported inflation in Estavia

A disruption to global energy supplies has sharply increased Estavia’s production and transport costs. Headline inflation is well above target, but real output is below potential. Estavia’s central bank is considering increasing its policy interest rate.

Table 1

Selected macroeconomic and household data for Estavia

A representative household has a variable-rate mortgage balance of 200 000 estars. Assume, only for the mortgage calculation, that the annual interest charge equals the stated mortgage rate multiplied by the outstanding balance.

Overheating and external imbalance in Carvia

Carvia has experienced strong domestic demand, inflation above target and a current account deficit. Its central bank has raised its policy interest rate and is considering selling government securities to reduce bank reserves.

Table 1: Macroeconomic and exchange-rate data for Carvia

Macroeconomic and exchange-rate data for Carvia.

Table 2: Proposed open-market operation

Proposed open-market sale by Carvia’s central bank.

Assume for the deposit calculation that commercial banks lend all excess reserves, all loans are redeposited, banks hold no voluntary excess reserves and the public holds no additional cash.