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Inflation is defined as the persistent upward movement of the price level.
The average level of prices is called the price level. It is measured by a price index. A price index measures the average level in an earlier period, called the base period.
The inflation rate is the percentage change in the price level. The formula for the annual inflation rate is:
Inflation rate =
Current year's price level - Base year's price level
Base year's price level
1.2 Types Of Inflation
1.2.1 Demand-pull inflation
This type of inflation is caused by an initial increase in aggregate (i.e. total) demand. An increase in aggregate demand can be due to an increase in the money supply, government purchases, investment expenditure or exports. It is usually associated with conditions of full employment.
If the economy is already at full employment, when there is a further increase in aggregate demand, it increases real GDP as well as the price level. When the real income is above full employment, the wage rate will definitely rise and short-run aggregate supply decreases, so real GDP decreases but the price level keeps rising.
If aggregate demand keeps increasing, wage continues to rise and the price level rises in an ongoing inflation process. Figure 1 illustrates a demand-pull inflation spiral.
Figure 1 Repeated increases in demand create a price-wage spiral.
1.2.2 Cost-push inflation
This type of inflation is caused by an increase in costs. The rise in costs may come from a number of different sources, e.g. an increase in money wage rates or the prices of raw materials.
When costs rise, the short-run aggregate supply will decrease, leading to a decrease in real GDP and a rise in the price level. When real GDP falls, the unemployment rate rises above the natural rate. We call such a situation stagflation.
To restore full employment, the government may attempt to increase aggregate demand. Such action may lead to a further increase in the price level and as a result of repeated stimulation, a price spiral may form.
Figure 2 illustrates a cost-push spiral.
Figure 2 Oil price increases lead to cost-price inflation spiral.
1.2.3 Imported inflation
This type of inflation is caused by an increase in the prices of imported goods or raw materials, leading to an increase in the cost of production and hence the prices of the final goods and services.
It is particularly important to a country with a small, open economy which depends heavily on foreign supply of raw materials.
2. MEASUREMENT OF INFLATION
There are two common ways of indicating changes in the price level: a price index and an implicit GNP deflator.
2.1 Consumer Price Index
The consumer price index (CPI) is the most commonly used. The price index takes a value of 100 in the base period. The CPI provides measures of the relative change over time in the total cost of a specified basket of goods and services. It only reflects the price movements as the basket is fixed in terms of quantity and quality of the items it contains.
There are three separate CPI series relating to different levels of income.
The different series of CPI give indications of the cost of living in different expenditure patterns.
CPI (A) gives ideas about daily necessaries while CPI (C) tends to give information on the prices of luxury items.
2.1.1 How is the CPI obtained?
Every month, we have to find the item index for each individual item first, which reflects the change in price of the items since the base period. Then, we find the weighted product of the item and item index.
Item Index (Period 1)
Item Index (Period 2)
The CPI for Period 1 is calculated as follows:
CPI = 40% x 100 + 50% x 100 + 10% x 100
The CPI for Period 2 is calculated as follows:
CPI = 40% x 105 + 50% x 110 + 10% x 125
2.2 Implicit GDP Deflator
This price change is measured as the ratio of money GDP to real GDP. It differs from the price index in that it includes all the goods counted in the GDP.
Let's assume there are only three goods in an economy - books, oranges and cars. In the current period, nominal GDP is $2,096.75. If the current-period quantities are valued at the base-period prices, we obtain a measure of real GDP that is $2,035. The GDP deflator in the current period is 103, which is calculated by dividing nominal GDP by real GDP in that period and multiplying by 100.
3. UNANTICIPATED INFLATION VERSUS
3.1 Unanticipated Inflation
Unanticipated inflation refers to the situation in which people cannot correctly foresee the inflation rate.
Unanticipated inflation can either be at a higher or lower rate than anticipated.
The costs of unanticipated inflation can be substantial:
â€¢ Income distribution
Unanticipated inflation redistributes income and wealth. If the actual inflation rate is higher than the anticipated inflation rate, the real interest rate will fall below the actual interest rate. This results in a redistribution of purchasing power from lenders to borrowers because loans are repaid with a lower real value than they were borrowed.
When inflation is unanticipated or under-anticipated, a fall in the value of money will transfer purchasing power from those living on fixed incomes and redistribute it to those who are able to adjust to a nominal income in pace with or even ahead of inflation, such as those workers with strong bargaining power.
â€¢ Disincentive to save
Negative real interest rates discourage people to borrow, and also an strong inducement against saving.
â€¢ Distortion of economic behaviour
Inflation can distort consumer behaviour by making consumers to increase their spending and hoarding commodity.
Inflation can also distort the behaviour of firms and imposes costs upon them. If the inflation rate rises at a rapid rate, firms will find it difficult to plan for the future because of uncertainties surrounding costing and profitability. Firms then may be tempted to divert their funds out of productive investment into commodity hoarding and speculative activities.
3.2 Anticipated Inflation
Anticipated inflation refers to the situation in which people correctly predict the rate of increase in the general price level.
The costs of anticipated inflation are relatively small. If inflation is fully anticipated, people can adopt measures to reduce the impact of inflation.
In that case, prices, wages, interest rates, etc., will all be adjusted to take into account the expected level of inflation. However, there are still welfare costs incurred by society. To preserve the value of their cash holdings, people engage in active cash management. All these will waste time and effort to minimise their cash holdings and maximise the amount of money kept in other assets.
Unemployment can be defined as the condition in which workers that are willing and able to work do not currently have jobs and are actively looking for work.
The unemployment rate is the ratio of the number of unemployed persons to the labour force. The labour force refers to people belonging to the working age who are economically active.
Underemployment can be defined as the situation in which workers are working but are not being utilised to their full capacity.
For example, some workers may hold a part-time job but prefer to work full time; other workers may be holding jobs that are far below their capabilities and they want to work more hours.
4.2 Cost Of Unemployment To Society
Society pays a price for unemployment:
â€¢ Waste of human resources
Unemployment represents a waste of human resources to the whole society in terms of the loss of potential output if those workers were employed.
People who are unemployed will suffer from different degrees of frustration and
depression. There is also a loss of self-confidence and motivation. Therefore, the
long-term unemployed may find it difficult to gain employment again.
â€¢ Financial burden to the community
The government has to provide social and financial assistance to the unemployed which will increase the financial burden of the whole community.
â€¢ Tax revenue
The salaries tax revenue received by the government falls as the amount of unemployed workers increases.
â€¢ Social problems
When unemployment rises, many social problems such as divorce, suicide and stress-related diseases emerge.
5. TYPES OF UNEMPLOYMENT
Unemployment comes in different forms.
5.1 Frictional Unemployment
Frictional unemployment refers to the time lag involved when people change their jobs, either voluntarily or because they are dismissed or made redundant.
People cannot change from one job to another immediately. This may be due to lack of information, for example if there is mismatching of information between the employers and the employees about the availability of suitable positions.
Searching for the right job and employers takes time.
5.2 Structural Unemployment
The development of the economy is unbalanced in that some industries are expanding while some are declining, which leads to a structural imbalance in the demand for labour.
Structural unemployment happens when labour is occupationally immobile, continuing to seek employment in the declining industries even though chances of finding work are very slim. These workers thus become structurally unemployed.
5.3 Cyclical Unemployment
Cyclical unemployment is due to a decrease in the aggregate demand for goods and services during recessions.
When the economy falls into recession, consumer demand falls. Firms would then be unable to sell their current level of output. They start to reduce output, so layoffs rise and new hires decline in a wide variety of trade and industries. Cyclical unemployment increases during this period.
5.4 Natural Rate Of Unemployment
The natural rate of unemployment refers to the situation in which the labour market is in long-run equilibrium, when all workers and employers have reflected all changes in the economy.
This is only an estimated rate of unemployment that would expect to prevail in the long run.
The natural rate of unemployment should not reflect cyclical unemployment and therefore it consists of only frictional and structural unemployment.
5.5 Full Employment
Since the economy is dynamic and continually changing, new jobs are created and old ones are destroyed, people are moving in and out of the labour market every day.
There is always some unemployment in any economy, taking into account of the normal turnover in the labour market.
The economy is considered to be at "full employment" when the actual unemployment rate is equal to the natural rate of unemployment.
6. ECONOMIC GROWTH
We are interested in long-term growth because it brings rising income to each person.
Preconditions for economic growth are:
â€¢ markets for increased output
â€¢ property rights clearly defined
â€¢ monetary exchange, i.e. trade between economies
Activities that generate economic growth are:
â€¢ Saving and investment in new capital: New capital spending increases the capital per worker and increases real GDP per hour of labour (i.e. labour productivity).
â€¢ Investment in human capital: The accumulated skill and knowledge of human beings is the most fundamental
source of economic growth.
â€¢ Discovery of new technologies: The discovery and application of new technologies and goods will increase labour productivity.
6.1 Growth Accounting
Growth accounting is used to calculate how much real GDP growth results from growth of labour and capital and how much is attributable to technological change.
The quantity of real GDP supplied (Y) depends on three factors:
â€¢ Quantity of labour (N)
â€¢ Quantity of capital (K)
â€¢ State of technology (T)
A key tool of measurement is the aggregate production function: Y = F (N, K, T)
Growth accounting divides growth into two components:
â€¢ Growth in capital per hour of labour
â€¢ Technological change includes everything that contributes to labour productivity growth that is not included in growth in capital per hour
6.1.1 Labour productivity
Labour productivity is real GDP per hour of work which is equal to real GDP divided by aggregate labour hours. It determines how much income an hour of labour generates.
Figure 3 How productivity grows
6.1.2 The productivity function
The shape of the productivity function reflects the law of diminishing returns, which states that as the quantity of one input increases with the quantities of all other inputs remaining the same, output will increase, but by ever smaller increments.
Applying the law of diminishing returns to capital, the law states that if a given number of hours of labour use more capital, the additional output that results from the additional capital gets smaller as the amount of capital increases.
6.1.3 Classical growth theory
This theory suggests that real GDP growth is temporary and that when real GDP per person rises above the subsistence level, a population explosion eventually brings real GDP per person back to the subsistence level.
Thomas Malthus is given most of the credit for this theory, which we call the Malthusian theory.
A growth in real GDP will trigger a greater demand for labour and thus the real wage rate increases. But the classical economists believe that this new situation cannot last because it will induce a population explosion.
6.1.4 Neo-classical growth theory
This theory holds that real GDP per person grows because technological change induces saving and investment that makes capital per person grow.
Technological change can be understood as follows:
â€¢ The rate of technological change influences the rate of economic growth, but economic growth does not influence the pace of technological change. Technological change results from chance.
â€¢ These technological advances bring new profit opportunities. Businesses expand and new businesses are created to exploit the newly profitable technologies. Investment and savings increase. The economy enjoys new levels of prosperity and growth. According to the neo-classical growth theory, the prosperity will persist because there is no classical population growth induced to lower wages.
Figure 4 Neo-classical growth begins.
However, growth will stop if technology stops advancing for two reasons:
â€¢ high profit rates
â€¢ diminishing returns to capital because further investment does not justify a reasonable return.
6.1.5 Target rate and long-run saving
Throughout the process of technological advancement, real GDP grows but the growth rate gradually decreases and eventually ends. Ongoing capital advances are constantly increasing the demand for capital, raising the real interest rate and inducing saving. The process repeats as long as technology advances, creating an on-going process of long-term economic growth.
In reality, this convergence is slow and does not appear imminent for all countries.
â€¢ Unanticipated inflation redistributes income and wealth.
â€¢ The quantity of real GDP supplied (Y) depends on the quantity of labour (L), capital (K) and the state of technology (T).
â€¢ The shape of the productivity function reflects the law of diminishing returns.
What You Need To Know
â€¢ Inflation: The persistent upward movement of the price level.
â€¢ Unanticipated inflation: A situation in which we cannot foresee or foresee correctly the inflation rate.
â€¢ Unemployment: A situation in which workers who are willing and able to work do not have jobs, and are actively looking for work.
â€¢ Underemployment: A situation in which workers are working but are not being utilised to their full capacity.
â€¢ Frictional unemployment: Time-lag involved when people change their jobs, either voluntarily or because they are dismissed or made redundant.
â€¢ Natural rate of unemployment: The situation in which the labour market is in long-run equilibrium, when all workers and employers reflect all changes in the economy.
â€¢ Full employment: Actual unemployment rate is equal to the natural rate of unemployment.
Work Them Out
1. Which group will gain in an unanticipated inflation?
B savings deposit-holders
C fixed-income earners
D insurance companies
2. If the Consumer Price Index A increases at a faster rate than the Consumer Price Index C, we may say that
A they are not good indicators of inflation
B the property market performs much better than the overall economy
C the low-income group suffer more than the high-income group
D the real income is falling
3. When the nominal GNP increases at a faster rate than the real GNP, we may say that
A the standard of living is increasing
B the cost of living is increasing
C the cost of living is decreasing
D the population is decreasing
4. Which of the following is NOT an effect of inflation?
A a change in preferences in favour of physical goods
B a possible increase in government revenue from income taxes
C an increase in speculative activities
D a redistribution of income from the borrowers to the lenders
5. Which one of the following could not be the initiating cause of demand-pull
A an increase in the money supply
B an increase in exports
C an increase in the prices of imported goods and services
D an increase in investment expenditure
6. When the wage rates and the inflation rate increase at the same rate
A workers will be better off
B nominal wage rates will rise faster than the real wage
C there will be no change in real wages
D real wages will be higher than nominal wages
7. An anticipated inflation
A has no effect on wealth-redistribution
B will not decrease the cost of living
C is always caused by fiscal policy
D is always caused by international trade deficit
8. Which of the followings is not a necessary precondition for economic growth?
A restrictions on private ownership of resources
C private property rights
D exchange with money
9. The amount of knowledge that a worker possesses can be classified as
A money capital
B human capital
C physical capital
D intrinsic capital
10. The productivity function shows that technological progress causes
A an increase in the level of real GDP per hour of work at any level of capital input
B no change in the level of real GDP per hour of work at any level of capital input
C a decrease in the level of real GDP per hour of work at any level of capital input
D an increase in the labor input in production
The following table shows the consumer Price Index of a hypothetical country for the period of 2005-08:
Annual Average Index
(Base year 2004 = 100)
Calculate the percentage increase in the price level as measured by the CPI
(i) in 2006 as compared with 2005.
(ii) in 2007 as compared with 2006.
(iii) in 2008 as compared with 2007.
Did the country experience inflation for the above period? Explain.
Explain three possible causes of inflation.
Classify the following situations as frictional unemployment, structural unemployment, or cyclical unemployment, and briefly explain your choice:
(a) Jane is laid off during a recession. Jane is willing to work even at a wage slightly less than current wages but no jobs are available.
(b) An accountant refuses a job offer and decides to look for another job which has a better pay.
(c) A fashion designer is laid off when the firm relocates its production to other countries.
(d) A clerk is made redundant due to the installation of new automatic payment system.
(e) James realises that the salary at his current job does not keep up with inflation. He quits his job to look for a better one elsewhere.
1. Would the following persons gain or lose during an unanticipated inflation? Explain.
(a) a person who holds bond and receives fixed interest every year
(b) a businessman borrows a 2-year fixed-interest loan
(c) a retired civil servant who receives his pension at a fixed monthly rate
(d) a worker who signs a 3-year contract with his employer that his salary will be the same for a 3-year period
2. What are the suitable government policies for each of the following types of unemployment? Explain briefly.