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UNIVERSITY OF MAIDUGURI MAIDUGURI, NIGERIA CENTRE FOR DISTANCE LEARNING MANAGEMENT SCIENCES ECON 304: Unit: 2 ECON MACROECONOMICS 304: MACROECONOMICS UNIT: 2 CDL, University of Maiduguri, Maiduguri ii ECON 304: Unit: 2 MACROECONOMICS Published 2010© All rights reserved. No part of this work may be reproduced in any form, by mimeograph or any other means without prior permission in writing from the University of Maiduguri. This text forms part of the learning package for the academic programme of the Centre for Distance Learning, University of Maiduguri. Further enquiries should be directed to the: Coordinator Centre for Distance Learning University of Maiduguri P. M. B. 1069 Maiduguri, Nigeria. This text is being published by the authority of the Senate, University of Maiduguri, Maiduguri – Nigeria. ISBN: 978-8133- CDL, University of Maiduguri, Maiduguri iii ECON 304: Unit: 2 MACROECONOMICS P R E FA C E This study unit has been prepared for learners so that they can do most of the study on their own. The structure of the study unit is different from that of conventional textbook. The course writers have made efforts to make the study material rich enough but learners need to do some extra reading for further enrichment of the knowledge required. The learners are expected to make best use of library facilities and where feasible, use the Internet. References are provided to guide the selection of reading materials required. The University expresses its profound gratitude to our course writers and editors for making this possible. Their efforts CDL, University of Maiduguri, Maiduguri iv ECON 304: Unit: 2 MACROECONOMICS will no doubt help in improving access to University education. Professor M. M. Daura Vice-Chancellor CDL, University of Maiduguri, Maiduguri v ECON 304: Unit: 2 MACROECONOMICS HOW TO STUDY THE UNIT You are welcome to this study Unit. The unit is arranged to simplify your study. In each topic of the unit, we have introduction, objectives, in-text, summary and selfassessment exercise. The study unit should be 6-8 hours to complete. Tutors will be available at designated contact centers for tutorial. The center expects you to plan your work well. Should you wish to read further you could supplement the study with more information from the list of references and suggested readings available in the study unit. PRACTICE EXERCISES/TESTS 1. Self-Assessment Exercises (SAES) This is provided at the end of each topic. The exercise can help you to assess whether or not you have actually studied and understood the topic. Solutions to the exercises are provided at the end of the study unit for you to assess yourself. CDL, University of Maiduguri, Maiduguri vi ECON 304: Unit: 2 MACROECONOMICS 2. Tutor-Marked Assignment (TMA) This is provided at the end of the study Unit. It is a form of examination type questions for you to answer and send to the center. You are expected to work on your own in responding to the assignments. The TMA forms part of your continuous assessment (C.A.) scores, which will be marked and returned to you. In addition, you will also write an end of Semester Examination, which will be added to your TMA scores. Finally, the center wishes you success as you go through the different units of your study. CDL, University of Maiduguri, Maiduguri vii ECON 304: Unit: 2 MACROECONOMICS INTRODUCTION TO THE COURSE This study unit is a continuation of learning in the field of macro-economics from earlier units based on the semester system. The topics that shall be covered are captured under two broad headings namely; - unemployment and inflation and - analysis of the IS-LM apparatus CDL, University of Maiduguri, Maiduguri 1 ECON 304: Unit: 2 MACROECONOMICS ECON 304: MACROECONOMICS UNIT: 2 TA B LE O F C O N TE N T S PAGES PREFACE - - - - - - - - - - - - - - - - - - - - - - iii HOW TO STUDY THE UNIT iv INTRODUCTION TO THE COURSE - 1 TOPIC: 1: UNEMPLOYMENT - - 3 CDL, University of Maiduguri, Maiduguri 2 ECON 304: Unit: 2 2: MACROECONOMICS INFLATION - - - - - - THE I / S CURVE - - - - - - 4: THE L / M CURVE - - - - - - 26 5: EQUILIBRIUM OF PRODUCT AND MONEY 9 3: 21 MARKETS 31 SOLUTIONS TO EXERCISES CDL, University of Maiduguri, Maiduguri 3 ECON 304: Unit: 2 MACROECONOMICS TOPIC 1: TABLE OF CONTENTS 1.0 TOPIC: UNEMPLOYMENT 1.1 INTRODUCTION 1.2 OBJECTIVES 1.3 IN-TEXT 1.3.1 Meaning of Unemployment 1.3.2 Types/Causes of Unemployment 1.3.3 Meaning of Full Employment 1.3.4 How to achieve Full Employment 1.3.4 Relationship between unemployment and output 1.4 SUMMARY 1.5 SELF- ASSESSMENT EXERCISES CDL, University of Maiduguri, Maiduguri 4 ECON 304: Unit: 2 MACROECONOMICS 1.6 REFERENCE 1.7 SUGGESTED READINGS CDL, University of Maiduguri, Maiduguri 5 ECON 304: Unit: 2 MACROECONOMICS 1.0 TOPIC: UNEMPLOYMENT 1.1 INTRODUCTION Unemployment has been one of the most persistent problems facing most economies of the world. One of the goals of macroeconomic policy is to fight the scourge of unemployment and achieve full employment. This topic will attempt to expose the students to the meaning of unemployment, its type/causes and eventually describe what full employment is all about and how it can be achieved and maintained in an economy. 1.2 OBJECTIVES: At the end of this topic students should be able to: i. Explain what unemployment is. ii. Differentiate between scholars perception of unemployment. iii. Differentiate between unemployment and full employment. iv. Have knowledge on how to achieve and maintain full employment in an economy. v. Understand the relationship between GDP and unemployment. 1.3 IN-TEXT 1.3.1 Meaning of Unemployment According to Everymans Dictionary of Economics unemployment refers to “involuntary idleness of a person who is willing to work at the prevailing rate of pay but unable to find job. In other words, it refers to a situation where individuals who are willing and able to work cannot find jobs due to one reason or the other. 1.3.2 Types/Causes of Unemployment Generally, unemployment has been classified and named according to the sources that gave rise to them. The following have been identified: Frictional Unemployment: This type of unemployment exists whenever there is lack of adjustment between demand for and supply of labor. This may be due to lack of knowledge of existing labor or vacancies on the part of employers and workers respectively. Frictional unemployment may also be as a result of lack of necessary expertise for a particular job, labor immobility, breakdown in production due to different reasons, waiting period when changing from one job to another or as a CDL, University of Maiduguri, Maiduguri 6 ECON 304: Unit: 2 MACROECONOMICS result of unforeseen circumstances that may disrupt production following which workers have to stay idle. Seasonal Unemployment: This type is directly attributable to seasonal fluctuation in demand. For instance, the demand for raincoat and umbrella declines soon after the rainy season. Also, the demand for ice block generally tends to be lower in the winter. Workers in all such line of business have less engagement when demand for their product declines. They are all said to be victims of seasonal unemployment. Cyclical Unemployment: This is attributed to the ups and downs associated with business cycles. In other words, cyclical unemployment is said to exist whenever there is reduced employment activity following a downsizing of the business cycle. Structural Unemployment: This results from a variety of sources. It may be due to lack of cooperate factors of production, or changes in the economic structure of the society. It is in other words associated with massive or extensive restructuring in the consumption pattern of the society. For example workers in the factories producing the old fashioned high heel Shoes or Black and White or the Take-and-wash Camera would have to re-train or remain unemployed as their wares are no longer in the taste and fashion of the community. Technological Unemployment: Modern production process is essentially dynamic where innovations lead to the adoption of new machineries and inventions thereby displacing existing workers. Technological unemployment is observed whenever there is automation leading to less involvement of human labor in production process. 1.3.3 Meaning of Full Employment The compound wards “full employment is a slippery concept. So describe by Professor Ackley due to the divergent scholastic views on it. Hence it is not definable nor should it be defined. Perhaps the controversy on the concept of full employment full employment is best captured in the wards of Professor W.W. Hart. “Attempting to define full employment raises many peoples blood pressure. Rightly so because there is hardly any economist who does not define it in his own way” Despite the definitional inconsistencies however, full employment has been accepted by all scholars as one of the most important goal of macroeconomic policy. We shall accordingly view some of the major definitions as follows: The Classical View This school of thought sees full-employment as normal. According to Pigou, one of the greatest proponents of this school of thought, every economy has a tendency to automatically provide full employment in the labor CDL, University of Maiduguri, Maiduguri 7 ECON 304: Unit: 2 MACROECONOMICS market. Unemployment, according to this school of thought resulted from interventionist activities such as rigidity in the wage structure and interference generally in the working of the free market system through trade union legislation and or minimum wage legislation. Those who are not prepared to work at the existing wage rate are not unemployed in the pigouvian sense because they are voluntarily unemployed. The climax of this contention is that with a perfectly free and competitive environment, there will always be a strong tendency for wage rates to be so related to the level of demand that everybody is employed. The Keynesian View According to Keynes full employment means absence of involuntary unemployment. In other wards full employment is a situation in which all willing and capable hands in an economy have a fairly gainful employment. Keynes assumes that “with a given organization, equipment and techniques, real wages and the volume of output (and hence employment) are uniquely corelated, so that in general, an increase in employment can only occur in the accompaniment of a decline in the rate of wages. In his famous book the general theory of Employment, Keynes gives additional definition of full employment thus “ a situation in which aggregate employment is inelastic in response to an increase in the effective demand for its output” This implied that the test of full employment is when any further increase in effective demand is not accompanied by any increase in output. Hence the supply of output becomes inelastic at the full employment level, and any further increase in effective demand will lead to inflation in the economy. Thus the Keynesian view of the concept of full employment is under laid by the prevalence of three conditions. i) reduction in the real wage rate ii) increase in effective demand; and iii) inelastic supply of output at the level of full employment Other Views Lord Beveridge in his book “full employment in a free society” defined full employment as a situation where there were more vacant jobs than there are unemployed men so that normal lag between losing a job and finding another will be very short. Full employment according to him is not synonymous to zero unemployment which means that” full employment is not always full” There is always a certain amount of frictional unemployment in the economy even when there is full employment. But the notion of more vacant jobs than the unemployed raises series of questions and hence cannot be accepted as condition for full employment. CDL, University of Maiduguri, Maiduguri 8 ECON 304: Unit: 2 MACROECONOMICS The American Economic Association Committee sees full employment to refer to “a situation where qualified individual who seek jobs at the prevailing wage rate can find them in productive activities without considerable delays. In other wards it means full time jobs for all people who want to work full time. It does not mean unemployment is ever zero. Here again, like Beveridge, the Committee considered full employment to be consistent with some amount of unemployment. Individual economists may, however continue to differ in their understanding of what full employment is, but the majority has centered round the view of the U N experts on National and International Measure for full Employment that “ that full employment may be considered as a situation in which employment cannot be increased by an increase in effective demand and ……. Does not exceed the minimum allowances that must be made for the effects of frictional and seasonal factors” This definition is in line with Keynesian and Beveridgean views. It has now been agreed that full employment stands for 96 to 97 per cent employment, with 3 to 4 per cent unemployment existing in the economy due to frictional factors. 1.3.4 Measures to Achieve and Maintain Full Employment Since unemployment is caused by deficiency in effective demand, full employment, according to the Keynesians can be ensured by accelerating effective demand either by stimulating investment or consumption, or both. Contemporary trends show that countries of the world use the traditional policy-mix in ensuring that the economy is fine-tuned towards sustainable growth consistent with full employment in both the short and long run. 1.3.5 Relationship between Unemployment and Output hange in Une mplo yme nt In explaining the relationship between output and unemployment Sir, Arthur Okun, an economist based in Britain, collected and used a data of over one century on the performance of certain European countries. He concluded by pointing out that the level of an economy’s aggregate output as implied by the GDP has inverse relationship with the level of unemployment. In other words, Okuns law states that “for every 2% that GDP falls relative to potential GDP, unemployment rate rises by 1% point”. This means that if GDP begins at 100% of its potential and fall to 90%, the rate of unemployment rises by 5%, say from 5% to 10%. This relationship is depicted in the diagram below. CDL, University 10 of Maiduguri, Maiduguri 5 Okun Law 9 ECON 304: Unit: 2 MACROECONOMICS Implications of the Ukun’s law - It identifies and explains the vital link between the output market and labour market. - It describes the association between short-run movement in real GDP and changes in unemployment. - It stresses the fact that actual/real GDP must grow as rapidly as the potential GDP to keep the rate of unemployment from rising. - In essence, to maintain the current rate of unemployment, actual GDP has to keep running in the same face as the potential GDP. In other words, to bring the rate of unemployment down, actual GDP must be growing faster than the potential GDP 1.4 SUMMARY Unemployment has been one of the most persistent problems facing most economies of the world. One of the goals of macroeconomic policy is to fight the scourge of unemployment and achieve full employment. According to Everymans Dictionary of Economics unemployment refers to “involuntary idleness of a person who is willing to work at the prevailing rate of pay but unable to find job. In other words, it refers to a situation where individuals who are willing and able to work cannot find jobs due to one reason or the other. Generally unemployment has been classified by type and causes to include frictional, seasonal cyclical, structural and technological. The concept of full employment it is shown, differs between different schools of thought. We have also presented the measures for the achievement and maintenance of full employment in an economy along side the relationship between unemployment and output as contained in the work of Sir Arthur Okun. 1.5 SELF ASSESSMENT EXERCISES 1 2. 3 (a) (b) State the “OKUN’S LAW” Mention and briefly explain the relevance of this law to the Nigerian Economy. (a) What is full employment? (b) Differentiate between classists and Keynesians contention of full employment. Differentiate between Voluntary and Involuntary Unemployment CDL, University of Maiduguri, Maiduguri 10 ECON 304: Unit: 2 MACROECONOMICS 1.6 REFERENCES M. L. JHINGAN (1997)– MACRO ECONOMIC THEORY, 11TH Revised Edition, published 2007, Punjabi Publication, India. HENDERSON & POOLE (1991)– PRINCIPLES OF ECONOMICS, Revised Edition, Published 1991. Virinda Publications (P) Ltd. 1.7 SUGGESTED READINGS M. L. JHINGAN (1997)– MACRO ECONOMIC THEORY, 11TH Revised Edition, published 2007, Punjabi Publication, India. TOPIC 2: TABLE OF CONTENTS 2.1 INTRODUCTION 2.2 OBJECTIVES 2.3 IN-TEXT 2.3.1 STRAINS OF INFLATION 2.3.2 TYPES/CAUSES OF INFLATION 2.3.3 STAGFLATION 2.3.4 CAUSES OF STAGFLATION 2.4 SUMMARY 2.5 SELF ASSESSMENT EXERCISES (SAE) 2.6 REFERENCES 2.7 SUGGESTED READINGS CDL, University of Maiduguri, Maiduguri 11 ECON 304: Unit: 2 MACROECONOMICS CDL, University of Maiduguri, Maiduguri 12 ECON 304: Unit: 2 MACROECONOMICS 2.0 TOPIC: INFLATION 2.1 INTRODUCTION The word inflation has been variously defined by scholars depending on what each perceive to be its causative agents. Thus, economists of different backgrounds, from the neo-classical to Keynesians and Neo-Keynesians see inflation differently and hence adopted different approaches and strategies in remedying its consequential effects. Generally however, two major schools of thought have been recognized. The neo-classicals and their followers see inflation as fundamentally a monetary phenomenon. In the wards of Friedman, “inflation is always and everywhere a monetary phenomenon…and can be produced only by a more rapid increased in the quantity of money than in output” But economists of other background do not agree that money supply alone is the cause of inflation. As pointed out by Hicks “the problems of inflation are not entirely of a monetary phenomenon” Thus, Economist like Johnson, Brooman and Shapiro defined inflation differently as “a persistent and appreciable rise in the general level of prices” Dernberg and McDougall are more explicit when they write that “the term usually refers to a continuing rise in prices as measured by an index such as the CPI, PPI or by the implicit price deflator for Gross National Product. 2.2 OBJECTIVES At the end of this topic students should be able to: i. Explain what inflation is all about. ii. Differentiate between different strains of inflation iii. Account for the various causes and types of inflation iv. Understand the theoretical approaches to the study of inflation 2.3 IN-TEXT 2.3.1 Strains of Inflation The sustained rise in price with which inflation is identified with may be of various magnitudes. Hence, inflation has been categorized according to such magnitude/degree as follows:Creeping Inflation: This is when the rise is very slow like 1-3% per annum. Scholars generally have agreed that this type of inflation is safe for the economy and necessary for economic growth. CDL, University of Maiduguri, Maiduguri 13 ECON 304: Unit: 2 MACROECONOMICS Walking/Trotting Inflation: - This is where prices rise moderately at an annual rate of 3-7% or less than 10%. Inflation at this stage is a warning signal for policy makers to apply control measures before the situation deteriorates to the next stage. Running Inflation: - As the name implies, price rises rapidly at an annual rate of 1020%. Such inflation affects the poor and middle income classes adversely. Controlling it requires stringent monetary and fiscal measures otherwise it graduate into galloping inflation. Galloping Inflation:This is the name give to the type of inflation in which prices rise at a very fast and double or triple digit rates above 20% (i.e. 20100% or more per annum) Inflation at this stage has a devastating effects on virtually all spheres of human life Hyperinflation: - This is the worst form of inflation. It is characterized by a rapid and immeasurable price rise which is so frequent that public confidence in money as a means of exchange is completely eroded. Consequently the monetary system collapses with people resorting to barter goods. The productive base of the society cease to function as exchange process is rendered ineffective. On the overall, societal welfare is adversely affected and unless drastic measures are taken, the entire economy collapse. Generally, it is not easy to identify a particular country as having experience any form of inflation. This is because countries are found to withhold or provide biased information on the status of their inflationary strain. By and large however, inflation is real and is more predominant in developing economies with its attendant consequences ravaging the life of the poor and less privilege in society. 2.3.2 Causes/Types of Inflation a) Demand Pull Inflation Otherwise known as excess demand inflation is the traditional and most common type of inflation. It is called this name because it takes place when aggregate demand is rising faster than the rise in the level of output. The failure to expand output in the same proportion as the increase in demand may be either because resources are fully utilized or production cannot be increased as rapidly as the increase in aggregate demand. As a result prices begin to rise in response to a situation often described as “too much money chasing too few goods” CDL, University of Maiduguri, Maiduguri 14 ECON 304: Unit: 2 MACROECONOMICS Theories of Demand Pull Inflation The Monetarist View: - This school of thought emphasis money supply as the principal cause of demand pull inflation. They buttressed their points using the simple quantity theory of money as contained in Fisher’s equation of exchange. MV=PQ Where M = Money Supply V = Velocity of Money P = Price Level Q = Level of Real Output Assuming V and Q as constant, the price level (P) varies in the same proportion with the supply of money (M).With flexible wages the economy is believed to be operating at full employment level. The labor force, the capital stock and technology also changed but only slowly overtime. Consequently, the amount of money spent did not directly affect the level of real output so that a doubling of quantity of money simply results in doubling the price level. Until prices have risen by this proportion, individuals and firms would have excess cash which they would spend leading to rise in prices. So inflation proceeds at the same rate at which the money supply expands. Friedman’s view: - Modern quantity theorists led by Friedman hold that “inflation is always and everywhere a monetary phenomenon that arises from a more rapid expansion in the quantity of money than in total output.” They argued that changes in the quantity of money will work through to cause changes in nominal income which eventually empowers people to spend more resulting to excess demand. Friedman also discussed whether increased in money supply first goes into output or prices. The answer to this question is contained in the following flow chart: - Increase in Money Supply - Increase in Nominal Income - Increased Demand for Goods and Services - Increased Demand for Labor - Higher Wages for Workers - Higher Input cost - Higher Prices - Lower Profit Margins - Higher prices, again. At the beginning people will expect the price rise to be temporary, and so they increase their savings and the price rise therefore will be less than the actual increase in nominal money supply. Gradually people will readjust their savings. CDL, University of Maiduguri, Maiduguri 15 ECON 304: Unit: 2 MACROECONOMICS Prices at this point rise more than the rise in money supply. Thus according to Friedman, the monetary expansion mechanism works through output before inflation starts. The quantity theory version of demand pull inflation is illustrated diagrammatically in the figure below: LM Interest Rate (A) E1 LM 1 R E1 R1 IS YF 0 Figure 1.1 Y1 (B) Price Level S E1 E P1 P YF 0 E1 D D1 Y1 Inc om e Suppose the money supply is increased at a given price level as determined by D and S curves in panel (B) of the above figure. The initial full employment situation at this price level is shown by the intersection of IS and LM curves at point E in panel A of the figure. At this point R is the interest rate and YF is the full employment level of income. With the increase in the quantity of money the LM curve shift to the right to LM1 and intersects the IS curve at E1 such that the equilibrium level of income rises to Y1 and the rate of interest is lowered to R1. As the aggregate supply is assumed to be fixed there is no change in the position of the IS curve. Consequently the aggregate demand rises to the right to D1 and thus excess demand is created of the area EE1 = YFY1 in panel B. This raises the price level as shown by the vertical portion of the supply curve S. The rise in the price level reduces the real value of the money supply so that LM 1 curve shift to the left to LM. Excess demand will not be eliminated until aggregate demand curve D1 cuts the aggregate supply curve S at E. this means a higher price level P1 and a return to the original equilibrium position E in the CDL, University of Maiduguri, Maiduguri 16 ECON 304: Unit: 2 MACROECONOMICS upper panel of the figure where IS cuts LM curve. The result then is that the price level rises in exact proportion to the real value of the money supply to its original value. CDL, University of Maiduguri, Maiduguri 17 ECON 304: Unit: 2 MACROECONOMICS Keyne’s Theory of Demand Pull Inflation This school of thought emphasize that demand pull inflation, as the name implies, is wholly caused by increase in aggregate demand. Aggregate demand denotes various forms of demand for goods and services by various agents in the economy. Thus it comprises all consumption activities by individuals, businesses and governments at various levels. When the value of all such activities exceeds the value of aggregate supply at full employment level of output, inflationary gap arises. The larger the gap between aggregate demand and aggregate supply, the more rapid the inflation. Given a constant average propensity to save, rising money income at the full employment level will lead to an excess of aggregate demand over aggregate supply and to a consequent inflationary gap. The concept of inflationary gap is further elaborated in the diagram below. Figure 1.2 AS LM E A Expenditure { 0 (C+I+G) = AD B 450 YF Y1 Income As shown on the diagram, YF is the full employment level of income. The 45 degrees line represents aggregate supply AS, and C+I+G line the desired level of consumption, investment and government expenditure (or aggregate demand curve). The economy’s aggregate demand curve (C+I+G) = AD intersects the 45 degrees line (AS) at point E at the income level 0Y1 which is greater than the full employment income level 0Y F. The amount by which aggregate demand (YFA) exceeds the aggregate supply (YFB) at the full employment income level is the inflationary gap. This is AB in the figure. The excess volume of total spending when resources are fully employed creates inflationary pressures in the economy which are the result of excess aggregate demand. CDL, University of Maiduguri, Maiduguri 18 ECON 304: Unit: 2 MACROECONOMICS The Keynesian theory of demand pull is based on a short run analysis in which prices are assumed to be determined by non monetary forces. On the other hand output is assumed to be more variable and is determined largely by changes in investment spending. To the Keynesians the relationship between changes in nominal money income and prices is an indirect one through the rate of interest. This is simplified in the flaw chart below: - - Increase in Quantity of Money Decrease in the rate of interest Increase in Investment Increase Aggregate Demand A rise in aggregate demand will first mean an expansion of output and therefore will not affect prices – if resources are not fully employed. Where the rise is large enough and too sudden, then it constitutes a bottleneck as output cannot be immediately expanded even though resources are not fully utilized. Given this situation, the supply of some factors might be inelastic and others simply might be in short supply and non-substitutable. This will lead to increase in marginal cost Increase in Prices, which is above average cost This will result to higher profits Higher wages owing to trade union activity Diminishing Returns might set-in in some industries As full employment is reached, elasticity of supply of output falls to zero Prices continue to rise. Thus, from the point of view of the Keynesians, so long as there is unemployment in the economy all the changes in income is in output, and once there is full employment, all is in prices. This theory is further explained in the diagram below: CDL, University of Maiduguri, Maiduguri 19 ECON 304: Unit: 2 MACROECONOMICS Figure 1.3 LM1 (A) Interest Rate LM E2 R2 R1 E 1 R IS1 IS 0 YF Y1 (B) Price Level s P1 P 0 E2 E YF E 1 D Y1 D 1 In co m e Suppose the economy is in equilibrium at E where the IS-LM curves intersect with full employment income level YF and interest rate R, as shown in panel (A) of the above figure. Corresponding to this situation, the price level is P in the lower panel (B).an increase in government expenditure will shift the IS curve rightward to IS1 and intersect the LM curve at E1 when the level of income and the rate of interest rise to Y1 and R1 respectively. The increase in government expenditure implies an increase in aggregate demand which is CDL, University of Maiduguri, Maiduguri 20 ECON 304: Unit: 2 MACROECONOMICS shown by the upward shift of the demand curve to D1 in the lower panel. This will create excess demand of the area EE1= YFY1 at the initial price level P. The excess demand will raise the price level, as aggregate supply of output cannot be increased after the full employment level. As the price level rises, the real value of money supply falls. This will shift the LM curve to the left to LM1, such that it cuts the IS1 curve at E2 where equilibrium is established at the full employment level of income YF, but at a higher interest rate R2 (in panel A) and a higher price level P1 (in panel B). Consequently the excess demand caused by the rise in government expenditure eliminates itself by changes in the real value of money. b) Costs Push Inflation Cost push is caused by wage increases following intense union pressure and profit increases by employers. This type of inflation was known to exist since the medieval period was revived in the 1950s as one of the principal causes of inflation. Otherwise referred to as “New Inflation” it is caused fundamentally by wage escalation and profit maximization derives of entrepreneur. The basic cause of this type of inflation is the rise in money wages more rapid than the rise in productivity of labour. Union activities at times press employers to grant wage increases in excess of increases in the productivity of labour, thereby raising the cost of production. As a result employers, employers review the prices of their products upward. The higher wages paid to workers enable them to buy as much as before, in spite of higher prices. On the other hand, the increase in prices induces unions to demand still higher wage. In this way, the wage-cost spiral continues, thereby leading to cost-push or wage-push inflation. Cost-push inflation may be further aggravated by upward adjustment of wages to compensate for rise in the cost of living index. This may be through the use of “escalator clause” as provided in contracts with employers which ensures that workers are compensated each time the cost of living index increases by specified number of percentage points. Another cause of cost-push inflation is profit push inflation. Oligopolist and monopolist firms may raise the price of their products to offset the rise in labour and production cost so as to earn higher profits. There being imperfect competition in the case of such firms, they are able to “administer price” of their products. The phenomenon of cost push inflation is illustrated in the figure below. CDL, University of Maiduguri, Maiduguri 21 ECON 304: Unit: 2 MACROECONOMICS Figure 1.4 LM1 Interest Rate (A) LM IS1 E1 R1 E R IS 0 Y1 YF (B) Price Level S E1 P 1 S1 P E D S0 0 Y1 Inc om e YF First consider panel B of the figure where supply curves S0Sand S1S are shown as increasing function of the price level up to full employment level of income YF. Given the demand conditions along D, the supply curve S0 is shown to shift to S1 in response to cost increasing pressures of oligopolies, unions etc. as a result of rise in money wages. Consequently the equilibrium position shifts from E to E1 reflecting rise in the price level from P to P1 and fall in output, employment and income from YF to Y1 level. Now consider the upper panel of the figure. As the price level rises, the LM curve shifts to the left to LM1 because with the increase in the price level to P1 the real value of money supply falls. Similarly the IS curve shifts to the left to IS1 because with the increase in the price level the demand for consumer goods falls due to the Pigou effect. Accordingly, the equilibrium position shifts from E to E 1 CDL, University of Maiduguri, Maiduguri 22 ECON 304: Unit: 2 MACROECONOMICS where the interest rate increases from R to R1, and the output, employment and income levels fall from the full employment level of YF to Y1. 2.3.3 Stagflation This new term is added to economic literature in the 1970s. It is a compound ward made up of “stag” and “flation” derived respectively from stagnation and inflation. It is used to describe a paradoxical situation in which the economy experiences unemployment along side of a high rate of inflation. Also known as inflationary recession, it is measured through the use of the “discomfort index” which is a combination of the rate of unemployment and the rate of inflation. The discomfort index is computed using the consumer price index, producer price index and/or the GDP deflator for GNP. 2.3.4 Causes of stagflation One of the principal causes of stagflation has been a restriction in the aggregate supply. A decline in aggregate supply means a reduction in output and employment and a rise in the price level. This restriction may be due to a restriction in labour supply which might have been caused by a rise in money wages or by increased tax rates which reduces work incentive on the part of workers. When wages rise firms are forced to reduce production and employment. Consequently, there is fall in real income which finally, reduced purchasing power and expenditure. Since the decline in consumption will be less than the fall in real income, there will be excess demand in the market which will push up the price level. The rise in price level reduces output and employment in the following three ways:- it reduces the real quantity of money, raises interest rates and brings a fall in investment expenditure. - It reduces the real value of money balances with the government and the private sector via the pigou effects which reduces their consumption expenditure. - The rise in the price of domestic goods makes exports dearer to foreigners and makes foreign goods relatively cheaper and hence more attractive to domestic consumers, thereby adversely affecting domestic output and employment. Stagflation may also be caused by increase in indirect taxes. Increased indirect taxes invariably lead to higher cost of production, higher prices and as a result output and employment are reduced. Restriction in aggregate supply may also be caused by external factors such as rise in the world price of food stuff and crude oil. 2.4 SUMMARY The word inflation has been variously defined by scholars depending on what each perceive to be its causative agents. Thus, economists of different CDL, University of Maiduguri, Maiduguri 23 ECON 304: Unit: 2 MACROECONOMICS backgrounds, from the neo-classical to Keynesians and Neo-Keynesians see inflation differently and hence adopted different approaches and strategies in remedying its consequential effects. Generally however, two major schools of thought have been recognized. The neo-classicalist and their followers see inflation as fundamentally a monetary phenomenon. But economists of other background do not agree that money supply alone is the cause of inflation. As pointed out by Hicks “the problems of inflation are not entirely of a monetary phenomenon” Thus, Economist like Johnson, Brooman and Shapiro defined inflation differently as “a persistent and appreciable rise in the general level of prices” Dernberg and McDougall are more explicit when they write that “the term usually refers to a continuing rise in prices as measured by an index such as the CPI, PPI or by the implicit price deflator for Gross National Product. Strains of inflation describe the magnitude of rise in the price level. Hence inflation has been classified on these bases to include Creeping, Walking, Galloping and Hyperinflation. Also described in this text are theories of demand pull inflation from different schools of thought. We have also seen that stagflation refers to a paradoxical situation in which the economy experiences unemployment along side of a high rate of inflation. Also known as inflationary recession, it is measured through the use of the “discomfort index” which is a combination of the rate of unemployment and the rate of inflation. 2.5 SELF ASSESSMENT EXERCISES 1 2. 3 Expansive demand policy aimed at a low rate of unemployment might cause a wage – price spiral and an accelerating rate of inflation. Explain the trade off associated with this policy objective. Differentiate briefly between each of the following:(a) Stagflation and Hyperinflation (b) Short Run Philips Curve and Long Run Philips Curve (c) Classical definition and Keynesian definition of Inflation a What is Stagflation? b How is Stagflation different from Inflation? 2.6 REFERENCES M. L. JHINGAN (1997)– MACRO ECONOMIC THEORY, 11TH Revised Edition, published 2007, Punjabi Publication, India. HENDERSON & POOLE (1991)– PRINCIPLES OF ECONOMICS, Revised Edition, Published 1991. Virinda Publications (P) Ltd. 2.7 SUGGESTED READINGS M. L. JHINGAN (1997)– MACRO ECONOMIC THEORY, 11TH Revised Edition, published 2007, Punjabi Publication, India. CDL, University of Maiduguri, Maiduguri 24 ECON 304: Unit: 2 MACROECONOMICS TOPIC 3: TABLE OF CONTENTS 3.0 TOPIC: THE IS CURVE 3.1 INTRODUCTION 3.2 OBJECTIVES 3.3 IN-TEXT 3.3.1 THE IS CURVE 3.3.2 GRAPHICAL DERIVATION OF THE IS CURVE 3.3.3 ALGEBRAIC DERIVATION OF THE IS CURVE 3.3.4 SHIFT OF THE IS CURVE 3.4 SUMMARY 3.5 SELF ASSESSMENT EXERCISE (SAE) 3.6 REFERENCES 3.7 SUGGESTED READINGS CDL, University of Maiduguri, Maiduguri 25 ECON 304: Unit: 2 MACROECONOMICS 3.0 TOPIC: THE IS CURVE 3.1 OBJECTIVES At the end of this topic students are expected to: i. Know the meaning of the IS Curve ii. Derive the IS Curve Graphically iii. Derive the IS Curve Algebraically iv. Explain the shift of the IS Curve 3.3 IN-TEXT 3.3.1 The IS Curve The IS curve is the locus of all pairs of income and interest rate for which the expenditure sector is at equilibrium. That is the expenditure or goods market equilibrium curve shows combination of interest rates and levels of output such that planned spending equals income. It is a depiction of the relationship that links the level of income and interest rate which ensures that aggregate demand (consumption demand plus investment demand plus government demand) is equal to the level of income: Y=C+I+G 3.3.2. Graphical Derivation of the IS curve The IS curve which is negatively sloped can be derived as follows: Figure 1.5 s s (C) (b) Saving Function (s= y-c[y]) (Savings= investment) 0 y (d) CDL, University of Maiduguri, Maiduguri r Expenditure Market Equilibrium 0 I 26 r (a) Investm ent Func tion: ECON 304: Unit: 2 MACROECONOMICS Quadrant (a): This part shows the inverse relationship between investment and interest rate, hence yielding the marginal efficiency of investment (MEI). The higher the interest rate the less inclined firms would be to invest and vice versa. Quadrant (b): This part shows the savings – investment equality thereby clearly explaining their relationship. Thus the capability of individuals to save determines the availability of investment fund which eventually determines the level of interest rate. Quadrant (c): Here, the savings schedule – where savings is positively related to income is shown. The higher the level of ones income, the better up he becomes in terms of reserving a part of that income as savings. Quadrant (d): This part is the goods/expenditure market equilibrium yielding the IS curve as explained above. 3.3.3 Algebraic Derivation of the IS curve Algebraically the IS curve can be derived using either of two alternative procedures. We first assume that income is made up of only consumption and investment, where investment is dependent on income and interest rate as follows: Y=C+I C = a + By I = I0 + I1Y – I2r We solve for the endogenous variable, Y, in terms of the exogenous variable, r: Y = a + By + I0 + I1Y – I2r Hence CDL, University of Maiduguri, Maiduguri 27 ECON 304: Unit: 2 Or MACROECONOMICS Y = (a + I0 – I2r)/(1 – b – I1) 1/(1 – b – I1).(a + I0 – I2r) This expresses the equilibrium level of income as a function of the rate of interest and it is referred to as the IS curve when shown diagrammatically (part b of the quadrant). We can use the equilibrium condition where there is equality between desired savings and desired investment to arrive at the same algebraic expression S=I S = a + (1 – b)Y I = I0 + I1Y – I2r Hence a + (1 – b)Y = I0 + I1Y – I2r Leading again to: Y = 1/(1 – b – I1).(a + I0 – I2r) This again is the IS curve. 3.2.4 Shift of the IS Curve A shift of the IS curve from its original location either to the left or right implies a different level of income and interest rate for the economy. As shown in the figure below, a shift from IS1 to IS2 implies a higher interest rate and higher level of income; while a shift inward, from IS2 to IS1 would imply a lower interest rate and thus lower level of income. Figure 1.6 CDL, University of Maiduguri, Maiduguri 28 ECON 304: Unit: 2 MACROECONOMICS 3.4 SUMMARY The IS curve is the locus of all pairs of income and interest rate for which the expenditure sector is at equilibrium. That is the expenditure or goods market equilibrium curve shows combination of interest rates and levels of output such that planned spending equals income. We have noted also that the IS curve can be drawn both graphically and diagrammatically and that the shift of the curve either to the left or right implies a new level of income for the economy as a whole. 3.5 SELF ASSESSMENT EXERCISES 1. 2 3. With the use of an appropriate diagram show how a shift of the IS curve outward can affect the level of interest rate in an economy a. Define the IS curve. b. Show how it can be derived graphically and algebraically. What is the likely implication of additional government spending in an economy? 3.6 REFERENCES M. L. JHINGAN (1997)– MACRO ECONOMIC THEORY, 11TH Revised Edition, published 2007, Punjabi Publication, India. HENDERSON & POOLE (1991)– PRINCIPLES OF ECONOMICS, Revised Edition, Published 1991. Virinda Publications (P) Ltd. 3.7 SUGGESTED READINGS M. L. JHINGAN (1997)– MACRO ECONOMIC THEORY, 11TH Revised Edition, published 2007, Punjabi Publication, India. CDL, University of Maiduguri, Maiduguri 29 ECON 304: Unit: 2 MACROECONOMICS TOPIC 4: TABLE OF CONTENTS 4.0 TOPIC: THE LM CURVE 4.1 INTRODUCTION 4.2 OBJECTIVES 4.3 IN-TEXT 4.3.1 MEANING OF THE LM CURVE 4.3.2 GRAPHICAL DERIVATION OF THE LM CURVE 4.3.3 ALGEBRAIC DERIVATION OF THE LM CURVE 4.3.4 SHIFT OF THE LM CURVE 4.4 SUMMARY 4.5 SELF ASSESSMENT EXERCISES (SAE) 4.6 REFERENCES 4.7 SUGGESTED READINGS CDL, University of Maiduguri, Maiduguri 30 ECON 304: Unit: 2 MACROECONOMICS 4.0 TOPIC: THE LM CURVE 4.2 OBJECTIVES At the end of this topic students are expected to: i. ii. iii. iv. Know the meaning of the LM Curve Derive the LM Curve Graphically Derive the LM Curve Algebraically Explain the shift of the LM Curve 4.3 IN-TEXT 4.3.1 Meaning of the LM Curve This is the locus of all pairs of income and interest rates for which the monetary sector is at equilibrium or for which the demand for money is equal to its supply. That is the relationship between the rate of interest and the level of income that makes the demand for money equals to the supply of money. Thus, along the LM schedule, the money market is in equilibrium. The LM curve is positively sloped such that an increase in interest rate reduces the demand for real balances. To maintain the demand for real balances equal to the fixed money supply, the level of income has to rise. In the same vein, money market equilibrium implies that an increase in the interest rate is accompanied by an increase in the level of income. 4.3.2. Graphical Derivation of the LM curve Graphically the LM curve can be drawn as shown in the figure below: CDL, University of Maiduguri, Maiduguri 31 ECON 304: Unit: 2 MACROECONOMICS Figure 1.7 M1 M1 S (a ) (b ) Tra nsa ctions Mo ney Dem a nd : MI= L[Y] Mo ney Sup p ly: Ms= MI+ M2. y 0 r LM r (D) Mo ney Ma rke t Equ ilibrium : Ms= L[Y]+ L[r]= Md 0 y M2 0 (a ) Liq uidity Pre fe re nc e: M2= L[r] or Sp e culative Mo ney Dem a nd M2 0 M2 Quadrant (a): Here, speculative demand for money is shown as a function of the level of interest, revealing individuals liquidity preference. Quadrant (b): In this quadrant the total money supply is shown as negatively sloping, made up of M1 and M2, respectively for transaction and speculative demand. Quadrant (c): This quadrant shows the relationship between transaction demand and income. The positive slope indicates that individuals transaction demand increases with the level of income and vice versa. Quadrant (d): The money market equilibrium is demonstrated as the equality between money demand and money supply and hence yielding the LM curve. CDL, University of Maiduguri, Maiduguri 32 ECON 304: Unit: 2 MACROECONOMICS CDL, University of Maiduguri, Maiduguri 33 ECON 304: Unit: 2 MACROECONOMICS 4.3.3 Algebraic Derivation of the LM curve Algebraically for the money market to be in equilibrium, we require that money demand equals money supply: MS = Md or MS0 =L0 + L1Y – L2r Such that solving for (r) in terms of Y gives r = (MS0 + L0 + L1Y)/L2 This equation expresses the equilibrium rate of interest as a function of the level of income and its graph is called the LM Curve as shown by the quadrant (d) in the figure above. 4.3.4 Shift of the LM Curve A shift of the LM curve from its original location either to the left or right implies a different level of income and interest rate for the economy. As shown in the figure below, a shift from LM1 to LM2 implies a lower interest rate and higher level of income; while a shift inward, from LM2 to LM1 would imply a higher interest rate and thus lower level of income. Figure 1.8 LM1 r LM 2 r1 r2 IS 0 CDL, University of Maiduguri, Maiduguri Y1 Y2 Y 34 ECON 304: Unit: 2 MACROECONOMICS CDL, University of Maiduguri, Maiduguri 35 ECON 304: Unit: 2 MACROECONOMICS 4.4 SUMMARY The LM curve is positively sloped such that an increase in interest rate reduces the demand for real balances. To maintain the demand for real balances equal to the fixed money supply, the level of income has to rise. In the same vein, money market equilibrium implies that an increase in the interest rate is accompanied by an increase in the level of income. The LM curve is positively sloped such that an increase in interest rate reduces the demand for real balances. To maintain the demand for real balances equal to the fixed money supply, the level of income has to rise. In the same vein, money market equilibrium implies that an increase in the interest rate is accompanied by an increase in the level of income. The movements of the LM curve either to the right or left indicate a new level of income for the economy as a whole. 4.5 SELF ASSESSMENT EXERCISES 1. 2 3. With the use of an appropriate diagram show how a shift of the LM curve outward can affect the level of interest rate in an economy a. Define the LM curve. b. Show how it can be derived graphically and algebraically. What is the likely implication of a higher interest rate on the level of output in an economy? 4.6 REFERENCES M. L. JHINGAN (1997)– MACRO ECONOMIC THEORY, 11TH Revised Edition, published 2007, Punjabi Publication, India. HENDERSON & POOLE (1991)– PRINCIPLES OF ECONOMICS, Revised Edition, Published 1991. Virinda Publications (P) Ltd. 4.7 SUGGESTED READINGS M. L. JHINGAN (1997)– MACRO ECONOMIC THEORY, 11TH Revised Edition, published 2007, Punjabi Publication, India. CDL, University of Maiduguri, Maiduguri 36 ECON 304: Unit: 2 MACROECONOMICS TOPIC 5: TABLE OF CONTENTS 5.0 TOPIC: EQUILLIBRIUM OF PRODUCT AND MONEY MARKET 5.1 INTRODUCTION 5.2 OBJECTIVES 5.3 IN-TEXT 5.3.1 IS- LM CURVE INTERSECTION 5.3.2 EFFECTS OF CHANGES IN FISCAL POLICY 5.3.3 EFFECTS OF CHANGES IN MONETARY POLICY 5.4 SUMMARY 5.5 SELF ASSESSMENT EXERCISE (SAE) 5.6 REFERENCES 5.7 SUGGESTED READINGS CDL, University of Maiduguri, Maiduguri 37 ECON 304: Unit: 2 MACROECONOMICS 5.0 TOPIC: THE MONEY AND PRODUCT MARKET EQUILIBRIUM 5.1 INTRODUCTION The IS-LM framework or the “Hicks-Hansen” framework was an apparatus developed by John R. Hicks in 1937 and popularized later in 1949 by Alvin Hansen. It is an attempt to put the classical – Keynesian argument on the efficacy of fiscal and monetary policy in proper perspective. The apparatus has developed to be the core of modern macroeconomics and is a key analytical tool of the mainstream neo-Keynesian school. The IS-LM framework has also become the bases of understanding the adjustment process and the interaction of the money and expenditure markets. 5.2 OBJECTIVES At the end of this task students are expected to i. know how to apply the IS-LM curve studied in the previous section to practical situation. 5.3 IN-TEXT 5.3.1 IS-LM Curve Intersection Sir John R. Hicks combined the neoclassical and Keynesian formulations to develop the IS-LM framework. In simple terms, the IS-LM framework refers to the locus of all pairs of income and interest rates for which both the expenditure and monetary sectors are simultaneously in equilibrium. The IS-LM framework lays emphasis on the interaction between the expenditure and money markets. Here, spending, interest rates, and income are determined jointly by equilibrium in the expenditure and money markets. CDL, University of Maiduguri, Maiduguri 38 ECON 304: Unit: 2 MACROECONOMICS The IS and LM curves earlier derived are brought together and shown in one diagram below: CDL, University of Maiduguri, Maiduguri 39 ECON 304: Unit: 2 MACROECONOMICS Figure 1.9 LM r E re IS 0 Ye Y Since the IS curve slopes downwards and the LM curve slopes upwards, the two curves intersect in just one point, at r 0 and Y0, depicted by “e” in the figure above. At this point, two conditions for equilibrium are simultaneously satisfied. First, planned savings equals planned investment. Second, the stock of money in existence equals to the stock of money demanded in the economy. The interest rate r0 and income level Y0 represent the only point at which those two equilibria are simultaneously satisfied. This position is the equilibrium level of income and interest rate in the Hicks-Hansen framework or neoclassical synthesis. 5.3.2 Effects of Changes in Fiscal Policy An increase in government spending generally, or a tax cut will shift the IS curve from IS1 to IS2, implying a higher level of income (Y1 to Y2) and a higher interest rate (r1 to r2). See figure below: CDL, University of Maiduguri, Maiduguri 40 ECON 304: Unit: 2 MACROECONOMICS Figure 1.10 Note that the flatter the LM curve, the more pronounced will be the effects of a fiscal policy change on income and the smaller on the level of interest. On the extreme, a horizontal LM curve will give rise to the highest possible expansion in income and a zero change in the level of interest. Think of how the situation will look like if the LM curve were to be vertical. On the other hand, the flatter the IS curve, the smaller will be the effect of fiscal policy on both interest rate and income. 5.3.3 Effects of Changes in Monetary Policy A rise in the money stock shifts the LM curve to the right, lowering the rate of interest and raising the level of income. See figure below: CDL, University of Maiduguri, Maiduguri 41 ECON 304: Unit: 2 MACROECONOMICS Figure 1.11 Also, the flatter the IS curve, the more pronounced will be the effects of a change in money stock on the level of income, and the smaller on the rate of interest. A horizontal IS curve therefore will give rise to the highest possible expansion in income and leave the interest rate unchanged. Can you think of the effects of a change in money stock on interest rate and income where the IS curve is vertical? To conclude this analysis, the steeper the LM curve, the bigger will be the effects of a change in the money supply on both the level of income and the rate of interest. 5.4 SUMMARY The IS-LM framework or the “Hicks-Hansen” framework was an apparatus developed by John R. Hicks in 1937 and popularized later in 1949 by Alvin Hansen. It is an attempt to put the classical – Keynesian argument on the efficacy of fiscal and monetary policy in proper perspective. The apparatus has developed to be the core of modern macroeconomics and is a key analytical tool of the mainstream neo-Keynesian school. Since the IS curve slopes downwards and the LM curve slopes upwards, the two curves intersect in just one point At this point, two conditions for equilibrium are simultaneously satisfied. First, planned savings equals planned investment. Second, the stock of money in existence equals to the stock of money demanded in the economy. CDL, University of Maiduguri, Maiduguri 42 ECON 304: Unit: 2 MACROECONOMICS This position is the equilibrium level of income and interest rate in the Hicks-Hansen framework or neoclassical synthesis. 5.5 SELF ASSESSMENT EXERCISES 1 (a) (b) What is the IS-LM frame work? Algebraically and graphically derive the IS and LM curves. 5.6 REFERENCES M. L. JHINGAN (1997)– MACRO ECONOMIC THEORY, 11TH Revised Edition, published 2007, Punjabi Publication, India. HENDERSON & POOLE (1991)– PRINCIPLES OF ECONOMICS, Revised Edition, Published 1991. Virinda Publications (P) Ltd. 5.7 SUGGESTED READINGS M. L. JHINGAN (1997)– MACRO ECONOMIC THEORY, 11TH Revised Edition, published 2007, Punjabi Publication, India. CDL, University of Maiduguri, Maiduguri 43 ECON 304: Unit: 2 MACROECONOMICS SOLUTIONS TO EXERCISE TOPIC 1 TOPIC 2 TOPIC 3 TOPIC 4 TOPIC 5 CDL, University of Maiduguri, Maiduguri 44 ECON 304: Unit: 2 MACROECONOMICS TUTOR-MARKET ASSIGNMENT (TMA) CDL, University of Maiduguri, Maiduguri 45