Economics Chapter 6 http://3education.

mu

Inflation

Inflation is defined as a sustained increase in the general level of prices for goods and
services. It is measured as an annual percentage increase. As inflation rises, every dollar you
own buys a smaller percentage of a good or service.

Deflation
A general decline in prices, often caused by a reduction in the supply of money or
credit. Deflation can be caused also by a decrease in government, personal or investment
spending. The opposite of inflation, deflation has the side effect of increased unemployment
since there is a lower level of demand in the economy, which can lead to an economic
depression. Central banks attempt to stop severe deflation, along with severe inflation, in an
attempt to keep the excessive drop in prices to a minimum.

http://3education.mu/forum

How to measure inflation?

The inflation is measured by calculating the percentage price increases in goods and services
over a year.

Percentage price rises are usually shown by a price index. In this case, index numbers or
indices are simply a way of expressing the change in the prices of a number of items as a
movement in just one single number. The average price of all items as a movement in just
one single number .the average price of the items selected in the first year, or base year, is
given the number 100.if on average all the prices of the selected items rise by 25% over the
following year the price index for the second year it will be 125.if in the next year the price
rises average 10%the price index will now stand at 137.5(10%125=12.5)(125+12.5=137.5%).

http://3education.mu/forum

© Open Intelligence 2009 -1- htpp://Atuator3freeeducation.mu

Economics Chapter 6 http://3education.mu

THE RETAIL PRICE INDEX (RPI)

The RPI calculates the average price increase as a percentage for a basket of 600 different
goods and services. Around the middle of each month it collects information on the prices of
these commodities from 12000 different retailing outlets.
http://3education.mu/forum
What causes inflation?

1. Cost push inflation

Cost-push inflation occurs when businesses respond to rising production costs, by raising
prices in order to maintain their profit margins. There are many reasons why costs might rise:

http://3education.mu/forum

Rising imported raw materials costs perhaps caused by inflation in countries that are
heavily dependent on exports of these commodities or alternatively by a fall in the value of
the pound in the foreign exchange markets which increases the UK price of imported inputs.
A good example of cost push inflation was the decision by British Gas and other energy
suppliers to raise substantially the prices for gas and electricity that it charges to domestic and
industrial consumers at various points during 2005 and 2006.

Rising labour costs - caused by wage increases which exceed any improvement in
productivity. This cause is important in those industries which are ‘labour-intensive’. Firms
may decide not to pass these higher costs onto their customers (they may be able to achieve
some cost savings in other areas of the business) but in the long run, wage inflation tends to
move closely with price inflation because there are limits to the extent to which any business
can absorb higher wage expenses.

http://3education.mu/forum

Higher indirect taxes imposed by the government – for example a rise in the rate of excise
duty on alcohol and cigarettes, an increase in fuel duties or perhaps a rise in the standard rate
of Value Added Tax or an extension to the range of products to which VAT is applied. These
taxes are levied on producers (suppliers) who, depending on the price elasticity of demand

© Open Intelligence 2009 -2- htpp://Atuator3freeeducation.mu

Economics Chapter 6 http://3education.mu

and supply for their products, can opt to pass on the burden of the tax onto consumers. For
example, if the government was to choose to levy a new tax on aviation fuel, then this would
contribute to a rise in cost-push inflation.

http://3education.mu/forum

Cost-push inflation can be illustrated by an inward shift of the short run aggregate supply
curve. This is shown in the diagram below. Ceteris paribus, a fall in SRAS causes a
contraction of real national output together with a rise in the general level of prices.

2. Demand Pull Inflation

Demand-pull inflation is likely when there is full employment of resources and when SRAS
is inelastic. In these circumstances an increase in AD will lead to an increase in prices. AD
might rise for a number of reasons – some of which occur together at the same moment of the
economic cycle

• A depreciation of the exchange rate, which has the effect of increasing the price of
imports and reduces the foreign price of UK exports. If consumers buy fewer
imports, while foreigners buy more exports, AD will rise. If the economy is already
at full employment, prices are pulled upwards.
• A reduction in direct or indirect taxation. If direct taxes are reduced consumers
have more real disposable income causing demand to rise. A reduction in indirect
taxes will mean that a given amount of income will now buy a greater real volume of
goods and services. Both factors can take aggregate demand and real GDP higher and
beyond potential GDP.

http://3education.mu/forum

• The rapid growth of the money supply – perhaps as a consequence of increased

bank and building society borrowing if interest rates are low. Monetarist economists
believe that the root causes of inflation are monetary – in particular when the
monetary authorities permit an excessive growth of the supply of money in circulation
beyond that needed to finance the volume of transactions produced in the economy.
• Rising consumer confidence and an increase in the rate of growth of house prices
– both of which would lead to an increase in total household demand for goods and
services

© Open Intelligence 2009 -3- htpp://Atuator3freeeducation.mu

Economics Chapter 6 http://3education.mu

The cost of inflation

The problems of a wage-price spiral – price rises can lead to higher wage demands as
workers try to maintain their real standard of living. Higher wages over and above any gains
in labour productivity causes an increase in unit labour costs. To maintain their profit
margins they increase prices. The process could start all over again and inflation may get out
of control.

http://3education.mu/forum

Higher inflation causes an upward spike in inflationary expectations that are then
incorporated into wage bargaining. It can take some time for these expectations to be
controlled. Higher inflation expectations can cause an outward shift in the Phillips Curve.

Inflation can also cause a reduction in the real value of savings - especially if real interest
rates are negative.

This means the rate of interest does not fully compensate for the increase in the general price
level. In contrast, borrowers see the real value of their debt diminish. Inflation, therefore,
favors borrowers at the expense of savers.

Consumers and businesses on fixed incomes will lose out. Many pensioners are on fixed
pensions so inflation reduces the real value of their income year on year. The state pension is
normally updated each year in line with average inflation so that the real value of the pension
is not reduced.

http://3education.mu/forum

Unemployment

Unemployment refers to the inability for willing workers to find gainful employment. The
degree of unemployment in a nation is one indicator of the economic health of the country.
There are a variety of different causes of unemployment, and disagreement on which causes
are most important.

© Open Intelligence 2009 -4- htpp://Atuator3freeeducation.mu

Economics Chapter 6 http://3education.mu

1. Frictional unemployment

Frictional unemployment occurs when a worker moves from one job to another. While he
searches for a job he is experiencing frictional unemployment. This applies for fresh
graduates looking for employment as well. This is a productive part of the economy,
increasing both the worker's long term welfare and economic efficiency. It is a result of
imperfect information in the Labour market, because if job seekers knew that they would be
employed for a particular job vacancy, almost no time would be lost in getting a new job,
eliminating this form of unemployment.

http://3education.mu/forum

2. Structural unemployment

Structural unemployment is caused by a mismatch between jobs offered by employers and

potential workers. This may pertain to geographical location, skills, and many other factors.
If such a mismatch exists, frictional unemployment is likely to be more significant as well.

3. Cyclical or Keynesian unemployment

Cyclical or Keynesian unemployment, also known as demand deficient unemployment,

occurs when there is not enough aggregate demand in the economy. This is caused by a
business cycle recession, and wages not falling to meet the equilibrium rate.

Measurement
Unemployment rate =unemployed workers
Working people

http://3education.mu/forum

The output

Gross Domestic product

The Gross Domestic Product or GDP is a measure of all of the services and goods produced
in a country over a specific period, normally a year. The GDP considers the market value of
goods and services to arrive at a number which is used to judge the growth rate of the
economy and the overall economic health of the nation concerned.

© Open Intelligence 2009 -5- htpp://Atuator3freeeducation.mu

Economics Chapter 6 http://3education.mu

The solid arrows indicate the components of the GDP, and the direction of the money flows.
The arrow indicating the Trade Deficit would be in the opposite direction in the case of a
Trade Surplus.

http://3education.mu/forum

Methods for calculating GDP

1. expenditure approach -- sum the monetary value of all final goods and services
2. income approach -- sum all factor incomes

Two sides of the same coin

Expenditure approach

Expenditure approach -- sum the monetary value of all final goods and services

http://3education.mu/forum

© Open Intelligence 2009 -6- htpp://Atuator3freeeducation.mu

Economics Chapter 6 http://3education.mu

consumption

C = personal consumption expenditures -- final goods and services, non durable and durable
goods.

Investment

I = gross private domestic investment -- expenditures that add to (or replace) the economy's
capital stock (plants, equipment, structures, and inventories).

Investment is not an intermediate good because it is not completely used up

Two main categories of investment

http://3education.mu/forum

1. Inventory investment - increase or decrease (disinvestment) in the value of the stocks

of inventories that businesses have on hand.
2. fixed investment -- addition of new plants, equipment, commercial buildings, and
residential structures

Government

G = local, state, federal purchases of final goods and services.

• final goods and services by convention

• valued at the cost of supply because they are not sold to final consumer therefore
government expenditures

does not include: transfer payments -- recipients who have not supplied current goods or
services in exchange for these payments (do not represent current output), produce no income
or output

http://3education.mu/forum

Net exports

Exports minus imports

X = exports (produced domestically but sold to foreigners) -- dollars in, goods out

© Open Intelligence 2009 -7- htpp://Atuator3freeeducation.mu

Economics Chapter 6 http://3education.mu

M = imports (produced by foreigners but purchased by domestic consumers) -- dollars out,

goods in

Income approach

Income approach -- sum all factor incomes

http://3education.mu/forum

National income -- sum of all payments made to resource owners

1. compensation of employees ~ 71% of national income

2. rental income, rent -- payment for the use of property, e.g. land, housing, office space
3. corporate profit -- return to owners of incorporated firms

• Dividends
• Retained earnings
• Corporate taxes

4. proprietor's income -- own own business

5. net interest, how capital enters the process

There are four criteria that define living standards:

1. The level of individual disposable income in terms of the government’s currency

2. The purchasing power and stability of the government’s currency
3. The level of individual net worth
4. The cost of consumer goods and services

The economic rating of governments is frequently expressed in terms of the gross domestic
product (GDP) of a government divided by its population count (GDP per capita).
However, GDP per capita is unacceptable as a measure of living standards because GDP
includes the operations of government institutions, which do not contribute to individual net
worth or income, and it omits the negative effect of taxes.
http://3education.mu/forum
For example, government-owned military installations, museums, courthouses, and libraries
are needed to maintain human rights and provide high quality-of-life standards -- but they add
nothing to individual net worth and, to the extent that the operation of these assets is
supported by taxes, they decrease individual disposable income.
While GDP per capita may be a convenient indicator of a nation’s economic activity, it is an
unacceptable measure (i.e., an overstatement) of living standards.

© Open Intelligence 2009 -8- htpp://Atuator3freeeducation.mu

Economics Chapter 6 http://3education.mu

The goal of quality programs for laws is to enable the people as a whole to realize the highest
possible levels of human rights, living standards, and quality of life.

The human Development Index

The Human Development Index (HDI) is an index used to rank countries by level of
"human development”. It combines measures of life expectancy, literacy, educational
attainment, and GDP per capita for countries worldwide. It is claimed as a standard means of
measuring human development
http://3education.mu/forum
Consist of
1. Life expectancy at birth, as an index of population health and longevity
2. Knowledge and education, as measured by the adult literacy rate.
3. Standard of living, as measured by the natural logarithm of gross domestic product
(GDP) per capita at purchasing power parity

http://3education.mu/forum

© Open Intelligence 2009 -9- htpp://Atuator3freeeducation.mu