render/stair/hanna chapter 2 · 2019-12-26 · © 2008 prentice-hall, inc. 2 –3 outline cont’d...

© 2008 Prentice-Hall, Inc.

Chapter 3

ECONOMIC INDICATORSuNEMPLOYMENT

&iNFLATION

© 2008 Prentice-Hall, Inc. 2 – 2

Outline

PART I: Unemployment

Business Cycles

Meaning of Unemployment

Measuring Unemployment

Major Types of Unemployment

The Problem with Unemployment Estimates

Policy Measures to Deal with Unemployment

The Cost of Unemployment

Major Schools of Thought on Unemployment


Outline Cont’d

PART II: Inflation

Definition of Inflation

Measuring Inflation

Descriptions of Inflation

Types and Causes of Inflation

Effects of Inflation

Sources of Inflation

Reactions of Individuals During Periods of Inflation


Introduction

Life is static and stable; it is full of ups and downs. The same applies to doing business.

Sometimes, the overall business climate is buoyant, businesses are expanding and few are going bust – few people are unemployed.

Other times, the business climate is not so good, business are not expanding and many are going bust – many people can’t find work

These situations will destabilize the economy and the result could be mass unemployment.

Conditions could develop in the economy to cause general prices to go up in stead of down – i.e. inflation


Major Schools of Thought on Unemployment

There are three major schools of thought on unemployment;

The Neo-classical Economists (Also called Pre-Keynesians)

The Keynesians

The Monetarists (Also called New Classical Macro-economists)


Neo-Classical Economists View of Unemployment

Believe that employment is a determined by the real forces of DD and SS

Agree that some frictional and structural unemployment is necessary but believe that provided real wages were flexible, a competitive economy market forces would always tend to bring about a long-term equilibrium in the economy at a minimal level of unemployment. (i.e. natural unemployment).

Conclude that unemployment is essentially VOLUNTARYand blame the workforce as a whole for it.

They also argue that the PRICE LEVEL is completely separate from the determination of employment rate.

They also conclude that the price level is determined by monetary forces (via the Quantity Theory of Money)


Keynesian View of Unemployment

Keynes rejects the view that ‘real’ and ‘monetary’ forces are separate.

He argues that money provides a vital link between the different markets of the economy and when this linkage breaks down, unemployment can result.

He accuses the neo-classical economists of committing a fallacy of Composition (i.e. what is true for a single firm is necessarily true for the economy taken as a whole). He believes that is a wrong assumption.

Keynes argues that unemployment is the result of Deficient-Demand. Because “Demand creates its own Supply” and so if people demand goods, suppliers will definitely find the resources to produce for them.

Unemployment for him is INVOLUNTARY and workers cannot be blamed for it. He rejects the Quantity Theory of Money.


Monetarists View of Unemployment

These economists accept the classical dichotomy that the real and monetary forces of the economy are separate

They accept that real forces of DD and SS determine real things; output, employment, and relative prices whilst money determine money things (the overall price level).

They explain unemployment as the growing unwillingness of workers to accept real wages determined by the forces of DD and SS.

Thus according to them, Unemployment is VOLUNTARY and they blame workers for pricing themselves out of jobs.

© 2008 Prentice-Hall, Inc.

PART II

INFLATION


Definition of Inflation

Technically, inflation is defined as a situation in which there is a sustainedrise in the weighted average of all prices.

Alternatively, inflation can be defined as a relatively persistent increase in general prices


Measuring Inflation

Official measurements of inflation use a technique which involves buying the same ‘basket’ of goods and services each month. This method assess the purchasing power of money to judge inflation.

Another measure used is that: A Price Index is computed from this basket making use of a year in which prices were generally stable as a base year.

Price Index = Cost of ‘basket’ today × 100

Cost of ‘basket’ in base year


Measuring Inflation Cont’d

Statistical Weights

These are weights assigned to the goods in the ‘basket’ to reflect their relative importance to an average family.

They are determined by using the average income spent on each of the goods.

They make inflation figures more relevant because goods that consume a big part of an average family’s income gets a higher weight. Food for example will get a higher weight than “Cigarette” because an increase in the price of food affects everybody but an increase in the price of cigarette affects only smokers

This way, the true effect of the inflation figure on the average family can be determined.



Another way to measure Inflation is to use Real World Price Indexes.

There are two common indicators of the price level. These are;

1. The Consumer Price Index (CPI)

2. The Implicit Price Deflator of GNP (IPD)

The CPI estimates the cost of a given bundle of goods and services as a percentage of the cost of the same bundle in a base year.

The IPD on the other hand estimates the average change in prices of all final goods and services between a base year and a given year



Others ways to measure Inflation are to use the:

The Retail Price Index (RPI)

The Producer Price Index (PPI)

Tax and Price Index (TPI)

The RPI measures price movements of a lot more goods than in ordinary Price Index and makes use of the prices in retail shops across a country.

The prices obtained are averaged and the relative importance of the goods is then accounted for using weights.

The average price changes for each group of goods is multiplied by the statistical weights.

The index is published in percentage form to displaying the monthly change.



The TPI measure the persistent and sustained price increases (inflation) resulting from taxation.

The PPI measures price changes from the perspective of the sellers. i.e. price changes from the producer’s increases.

NB: these methods are mostly used in countries where record keeping is extensive


The Accuracy of Price Indexes

How accurate price indexes are is a subject of continued debate. There are a few issues that raises questions about the accuracy of price indexes.1. There is the problem of quantities. RPI and PPI allow for

comparisons between years. PPI for instance uses base-year quantities evaluated at today’s prices. However, the change in the quantities purchased by the average consumer is not taken into account.

2. Quality is not accounted for and that creates bias in the estimates

3. It is difficult and time consuming to include new products into the basket. These are usually adjusted once a year in some countries


Descriptions of Inflation

Inflation can be described based on the rate. These include:

Modest Inflation – Low rates between 3 to 5% (this is not agreed upon but generally accepted)

Hyper Inflation – High rates, 50% or more per month.

Stagflation – occurs when an economy is suffering from economic decline characterized by serious unemployment, inflation, and declining income.

Suppressed Inflation – tough price controls which prevent the price level from rising without at the same time dealing with the underlying inflationary tendencies. The net effect is quantity shortages, queues, waiting lists, black market etc.


Types of Inflation

Inflation can also be described based on the major cause. These include:

Type of Inflation Major Cause

1. Demand-Pull Excess Demand

2. Cost-Push Rising cost of factors of production

3. Imported Imports from countries experiencing

inflation

4. Bottleneck Problems inhibiting production (e.g.

corruption, poor transportation

network, etc resulting in increased

cost of production

5. Marked-Up Entrepreneurs deliberately raising

prices to increase their profits


Demand-Pull Inflation

Occurs when increase in aggregate demand pulls up prices.

Here, Agg. DD > Agg. Supply

It is associated with increased money supply in the economy without corresponding increase in productivity

Often described in simple terms as ‘more money chasing fewer goods’


Causes of Demand-Pull Inflation

1. Increase in money supply by the government to finance deficit.

2. High population growth in a country without a corresponding increase in productivity.

3. Embezzlement and Corruption due to poor control and management of public spending.

4. Low productivity of goods and services resulting from lack of inputs.

5. Government investing in unproductive ventures.

6. Smuggling and hoarding of goods leading to shortages


Causes of Demand-Pull Inflation

7. Too much government expenditure on infrastructure like roads, schools etc. to promote economic activity without a corresponding increase in productivity.

8. Increase in government spending not matched by a corresponding increase in taxation.

9. Autonomous investment without a corresponding increase in savings.

10. Surplus on balance of payment resulting from exports.

11. Diversion of resources to the production of military equipments

12. Post war periods


Cost-Push Inflation

Occurs when the prices of goods and services are rising because of rising cost of factors of production. E.g. increased wages, raw materials costs, land, interest on capital etc.

Rising cost of production decreases aggregate supply and therefore prices increases


Causes of Cost-Push Inflation

Rising prices of raw materials used in the production of goods and services.

Increases in wages and salary

Increase in indirect taxation

Devaluation of the currency

Increase transportation costs


Anticipated and Unanticipated Inflation

Inflation is anticipated when the rate that majority of individuals expect occurs. E.g. If majority of individuals expect inflation to be 10% and it is, then we have ‘anticipated inflation’.

Inflation is unanticipated if the inflation rate comes as a surprise.

The question is what happens when inflation is anticipated or unanticipated?1. When inflation rate is greater than anticipated, creditors lose

and debtors gain

2. When the rate is less than anticipated, creditors gain and debtors loose.


Sources of Inflation

1. Deficit financing by government

2. Credit or loan expansion by commercial banks

3. Fiscal policy i.e. taxing policy and spending policy

4. Economic decline

5. Counterfeiting


Negative Effects of Inflation

Inflation generally affects:

Standard of living

Savings

Balance of payments and foreign trade

Political atmosphere of a country

Lending

Local currency

Income distribution and earnings of labour

Investment

External value of the currency


Positive Effects of Inflation

Inflation is not only a curse. It can be a blessing especially if the rate is modest. i.e. between 3 and 5%. Such Inflation can positively affect:

1. Economic growth

2. Income distribution and earnings of labour. (favour non-fixed income earners like sellers)

3. Employment

4. Government revenue

5. Borrowing


People’s Reactions During Periods of Inflation

Hedge against inflation

Preference for buying and selling

Efforts by firms to reduce future costs – keep more inventory of inputs or enter into long-term contracts to have inputs delivered at constant prices

Efforts for maintaining stable values of expected incomes i.e. indexation

Emergence of two sets of currencies

Resort to forms of barter

Capital flight – both human and non-human


Dealing or Checking Demand –Pull Inflation

Tight monetary policies like Open market Operations, Bank Rate, Cash Ratio etc should be put in place to reduce the money in circulation so as to reduce aggregate demand.

Tight fiscal policy like direct tax to reduce disposable income.

Government should remove bottlenecks in production.

Government should check embezzlement.

Reduction in government expenditure especially on long-tern infrastructure.

Checking against increasing population.

Government should reduce money supply or control its expenditure.

Government should desist from spending on unproductive ventures


Dealing with or Checking Cost-Push Inflation

Control trade union activity

Employ pricing policy

Reduction in indirect taxes

Subsidies to producers to increase productivity

Import equipments from cheaper sources to help reduce the cost of production.

render/stair/hanna chapter 2 · 2019-12-26 · © 2008 prentice-hall, inc. 2 –3 outline cont’d...

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