Worked example: from an illustrative CPI series and nominal GDP figures, calculate the inflation rate and real GDP, then recommend and justify an anti-inflation policy.
Paper 3, calculations and policy recommendation · IB HL · Command term: Calculate; Recommend
This IB Economics model essay is by the ETG IB Economics team, led by Mr Eugene Toh, who designs the in-house IB curriculum and writes the IB specific textbooks and workbooks used in class.
Original ETG worked example; figures are illustrative, not from any IB paper.
3.3.73.1.53.3.3SK-CALCSK-RECOMMEND
The model thesis in brief
In this ETG worked example a country's CPI runs 100, 104, 109.2 over three years, so inflation is 4% then 5%. Nominal GDP is $480bn, $520bn, $546bn; deflating by the index gives real GDP of $480bn, $500bn, $500bn.
Real output is flat between years 2 and 3 while inflation accelerates, which points to demand-pull pressure near capacity. The recommendation is contractionary monetary policy (a higher policy rate) as the main tool, with a supportive note on the supply side and on the risks of overshooting.
Examiner's note: what reaches the top band
Each calculation is a labelled step with units. Inflation rates, the real-GDP deflation and the real-growth rate are each written out as a formula, substituted, and finished with a clearly stated value, which is how Paper 3 awards the AO4 marks.
The data drive the diagnosis. The response reads the numbers before prescribing: flat real output with rising prices signals demand-pull near full capacity, so the policy follows the evidence rather than a generic checklist.
The recommendation is conditional and justified. It names a specific tool, explains the transmission mechanism in prose, and weighs lags, the exchange-rate channel and the growth cost before committing, which is what the AO3 Recommend skill rewards.
Reading the scenario
Take an illustrative economy with the data below. These are ETG teaching figures, not from any exam paper. The consumer price index (CPI) uses Year 1 as the base year (index = 100).
CPI: Year 1 = 100.0, Year 2 = 104.0, Year 3 = 109.2
Nominal GDP: Year 1 = $480bn, Year 2 = $520bn, Year 3 = $546bn
Step 1: the inflation rate
The inflation rate between two years is the percentage change in the price index:
Inflation = (CPI in later year - CPI in earlier year) / CPI in earlier year x 100.
Year 1 to Year 2: (104.0 - 100.0) / 100.0 x 100 = 4.0 / 100.0 x 100 = 4.0%.
Year 2 to Year 3: (109.2 - 104.0) / 104.0 x 100 = 5.2 / 104.0 x 100 = 5.0%.
So inflation is positive and rising: prices grew 4.0% in the first interval and 5.0% in the second. Inflation is accelerating.
Step 2: real GDP from nominal GDP
Real GDP strips out price changes by deflating nominal GDP with the price index:
Real GDP = nominal GDP / price index x 100.
Year 1: 480 / 100.0 x 100 = $480bn (the base year, so real equals nominal). Year 2: 520 / 104.0 x 100 = 5.0 x 100 = $500bn. Year 3: 546 / 109.2 x 100 = 5.0 x 100 = $500bn.
Real output rose from $480bn to $500bn between Years 1 and 2, then stayed flat at $500bn into Year 3, even though nominal GDP kept climbing. The gap between the nominal rise and the flat real figure is pure price increase.
Step 3: the real growth rate
The rate of economic growth is the percentage change in real GDP:
Year 1 to Year 2: (500 - 480) / 480 x 100 = 20 / 480 x 100 = 4.2% (to one decimal place). Year 2 to Year 3: (500 - 500) / 500 x 100 = 0.0%.
Step 4: what the numbers say
Put the three results together. By Year 3, real growth has stalled at 0.0% while inflation has risen to 5.0%. Output is no longer expanding but the price level is rising faster. The most consistent reading is demand-pull inflation in an economy operating close to its full-employment level of output: aggregate demand is still pushing against a near-vertical supply, so extra spending shows up almost entirely as higher prices rather than more real output. (A supply shock could give a similar look, so a full answer would check input costs, but the flat real output alongside earlier solid growth fits demand-pull best.)
Recommendation
Given demand-pull pressure near capacity, I recommend contractionary monetary policy as the lead tool: the central bank should raise its policy interest rate. The mechanism runs through borrowing and spending. A higher rate raises the cost of credit and the reward for saving, so households delay big purchases and firms postpone investment, while a stronger currency from higher rates makes imports cheaper and exports dearer. Aggregate demand growth slows, easing the upward pressure on prices and bringing inflation back towards a low and stable target.
The recommendation is conditional. Monetary policy works with long and variable lags, so tightening now bites in future quarters and risks over-shooting into a slowdown, especially as real growth is already 0.0%; the central bank should therefore move in measured steps and watch the data. If part of the price rise is in fact cost-push, higher rates would cut output without curing the cause, so I would pair the demand-side tightening with supply-side measures that lift productive capacity over time, which also guards against the inflation returning. Fiscal restraint can support the central bank, but it is slower to legislate and politically harder than a rate decision. On balance, a moderate, data-led increase in the policy rate is the right first move, reviewed as fresh inflation and growth figures arrive.
What a student should drawIf you sketch this, use a monetarist/new classical AD-AS diagram with a vertical LRAS at potential output. Show aggregate demand shifting right against the near-vertical range, so the price level rises with little change in real output (demand-pull). Contractionary monetary policy shifts AD back left, lowering the price level towards target.
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No. This is an original ETG worked example written to the IB markbands. It is not an IB publication, it reproduces no official mark scheme, and every figure is illustrative and invented for teaching, not taken from any IB paper.
How do you calculate real GDP from nominal GDP and a price index?
Divide nominal GDP by the price index and multiply by 100: real GDP = nominal GDP / price index x 100. In this worked example Year 3 real GDP is 546 / 109.2 x 100 = $500bn, compared with nominal GDP of $546bn, so the difference is the effect of higher prices.
How do you calculate the inflation rate from a CPI series?
Inflation between two years is the percentage change in the CPI: (later CPI minus earlier CPI) divided by the earlier CPI, times 100. Here the CPI moves 100 to 104 (4.0%) and 104 to 109.2 (5.0%), so inflation is positive and accelerating.
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