Inflation and deflation — practice question

For a period of time, many central banks have aimed for an inflation target of around 2%. A modest, steady increase in the general price level can create several advantages for an economy. For central banks and governments, the earlier challenge was to keep the inflation rate from moving above the target while also maintaining a low unemployment rate. The challenge has now shifted, with the danger being that inflation may drop below this target. By the end of 2014, China’s consumer prices index was 100.5. The inflation rate in the country during 2015 was 2%. In contrast, several European countries experienced deflation. This produced a number of effects, including a wider pay gap between skilled and unskilled workers. A key cause of the downward pressure on inflation was the fall in the world price of oil from US$120 to US$66 per barrel in 2015. This lowered energy and transport costs. Reduced transport costs had a clear effect on food prices. Fig. 1 shows the way the food market was influenced in 2015. Fig. 1 The market for food in 2015. The vertical axis is labelled 'price of food' and the horizontal axis is labelled 'quantity of food'. The origin is labelled O. The price levels are labelled $P_1$ and $P_2$. The quantities are labelled $Q_1$ and $Q_2$. There is a downward sloping demand curve labelled D. There are two upward sloping supply curves labelled $S_1$ and $S_2$. While inflation was falling, unemployment declined in some countries. However, other countries saw inflation fall alongside a rise in unemployment. For instance, unemployment in France increased between 2014 and 2015. This created upward pressure on French Government spending.