September 2021 Paper 1 Q9

[o.menary11]

Hi,

i am confused about the answer to the following question, how the change creates the benefit/how they are benefits. Any help would be greatly appreciated

question:
A life insurance company in Country A sells annuities that are guaranteed to increase each year in line with an official price index that is published by the country’s government. The government of Country A has decided to make changes to the official price index and create a new index.
Suggest reasons for the government’s decision

ans:

• The new price index may be expected to give a lower rate of inflation which may benefit the government - how?
• The price index is likely to be used for increasing many items of government expenditure - how does this arise?
• These may include salaries, pension and benefit payments -
• It will also be used for the increases in coupons and redemption proceeds for index linked gilts- is this due to the inflation premium?

 

[James Nunn]

Hi

To give some context before answering your question, the bullet points you have quoted actually set out some related points. The second bullet point explains the first and the third and fourth bullet points give some examples for the second.

To answer your questions on the first two bullet points, this means that the benefits of lower inflation to the government in the first bullet point could be is due to the decrease of 'many items of government expenditure' if, as is quite possible, these expenditure items are linked to the inflation index in the question. This arises or is possible due to the fact that government often define benefits they pay out - salaries, pensions and benefits as per the third of the bullet points you've quoted - as increasing in line with an inflation indices in some way; and these benefits are government expenditure.

The fourth bullet point you quote is pointing out that some of the government's expenditure will be paying coupons and redemption proceeds for index linked bonds - these payments will also increase in line in some way in line with a price index so costs to the government will be reduced if this inflation index increases more slowly. To your question on the fourth bullet point, it's more to do with the reduction in the level of coupon and redemption payments in respect of these bonds rather than the risk premium (which will be zero for developed / stable countries).

Hopefully this makes sense and gives you the answers you need.

 

[o.menary11]

Hi

To give some context before answering your question, the bullet points you have quoted actually set out some related points. The second bullet point explains the first and the third and fourth bullet points give some examples for the second.

To answer your questions on the first two bullet points, this means that the benefits of lower inflation to the government in the first bullet point could be is due to the decrease of 'many items of government expenditure' if, as is quite possible, these expenditure items are linked to the inflation index in the question. This arises or is possible due to the fact that government often define benefits they pay out - salaries, pensions and benefits as per the third of the bullet points you've quoted - as increasing in line with an inflation indices in some way; and these benefits are government expenditure.

The fourth bullet point you quote is pointing out that some of the government's expenditure will be paying coupons and redemption proceeds for index linked bonds - these payments will also increase in line in some way in line with a price index so costs to the government will be reduced if this inflation index increases more slowly. To your question on the fourth bullet point, it's more to do with the reduction in the level of coupon and redemption payments in respect of these bonds rather than the risk premium (which will be zero for developed / stable countries).

Hopefully this makes sense and gives you the answers you need.

That's great, thank you!