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INFORMATION AND COMMUNICATIONS UNIVERSITY SCHOOL OF HUMANITIES. Course name An assignment submitted in partial fulfilment of the requirements for the BA Degree in Human Resource Management. Name Felistus Mulenga Kanyembo Assignment Student details 1505232945 Lecturer’s Name Mr Fred Mukonda Year 2015 Subject Macroeconomics 1 Email Address [email protected] 1|Page Q.1. In the case of Zambia, would an increase in aggregate demand generate an inflationary boom or deflationary boom? Aggregate demand is the relationship between spending on goods and services and the total level of prices (Dornbusch and Fisher 2002:30). A rapid rise in aggregate demand will create shortages. This will tend to stimulate firms to increase output, thus reducing slack in the economy. Likewise, a reduction in aggregate demand will leave firms with increased stocks of unsold goods. They will therefore tend to reduce output. Aggregate demand and actual output therefore, fluctuate together in the short run. A boom is associated with a rapid rise in aggregate demand: the faster the rise in aggregate demand, the higher the short-run growth rate. A recession, by contrast, is associated with a reduction in aggregate demand (Sloman, 2006, p.410.) Sloman further adds that “a rapid rise in aggregate demand, however, is not enough to ensure a continuing high level of growth over a number of years, without an expansion of potential output too; rises in actual output must eventually come to an end”. Once spare capacity has been used up, once there is full employment of labour and other resources, the rate of growth of actual output will be restricted to the rate of growth of potential output. As long as actual output is below potential output, the actual output curve can slope upwards more steeply than the potential output curve. Expansionary aggregate demand policies tend to produce inflation, unless they occur when the economy is at high levels of unemployment. Protracted periods of low aggregate demand tend to reduce the inflation rate. In addition, in the case of inflation there is no obvious loss of output (Dornbusch and Fisher 2002:30).When the economy is close to full employment, increased aggregate demand will be reflected primarily in higher prices or inflation. Therefore, in the case of Zambia, the economy is not at full employment. This being the case, an increase in aggregate demand would create deflationary boom. Q.2 In an economy, if aggregate demand increases and aggregate supply remains the same what happens to GDP and inflation? 2|Page When aggregate demand increases while aggregate supply remains the same, the Gross Domestic Product is affected in the following manner: Aggregate demand is the relationship between spending on goods and services and the level of prices. When unemployment is high, increased spending or an increase in aggregate demand will raise output and employment with little effect on prices. Aggregate supply curve specifies the relationship between the amount of output firms produce and the price level. The supply side boot only enters the picture in telling us how successful demand expansions will be in raising output and employment, but also has a role in its own. Supply disturbances, or supply shocks, can reduce output and raise prices. All in all, gross domestic product will reduce since there will be few goods in the economy. This means that there will be disequilibrium in the market since demand exceeds supply. On the other hand, the inflation will rise causing shocks in the economy. Goods will be limited and due to low supply. Price P AS level P0 AD Y0 Output Source: Dornbusch and Fisher Expansionary aggregate demand policies tend to produce inflation, unless they occur when the economy is at high level of unemployment protracted periods of low aggregate demand tend to reduce the inflation rate. Q3. As Zambia continues to grow, then demand for raw materials, food, shipping and energy will increase. Will Zambia’s growth generate cost-push or demand-pull inflation in your economy? 3|Page Inflation is a term often applied to a situation in which there is a persistent tendency for the general level of prices to rise (Stuart and Stephen, 2007:374). Demand pull inflation is seen as being caused mainly by an increase in the components of aggregate demand (e.g. consumption, investment, public expenditure, exports). A rise in any of these components will shift aggregate demand upwards. The rise in aggregate demand results in many more consumers buying products, but a rise in aggregate output to Y2 requires a higher price to cover the extra production costs (marginal and average) incurred. With demand-pull inflation we move along the aggregate supply curve to a point where both output and price levels are higher. The increase in AD could be brought about by an increase in consumer spending, a rise in business confidence leading to an increase in investment, an increase in government expenditure or an increase in the demand for Zambian goods and services by foreigners. In outlining demand-pull inflation it has been assumed that the increase in AD has been the result of an increase in aggregate expenditure, such as government expenditure. This is, in fact, a Keynesian explanation of inflation. However, the increase in AD could have been the result of an increase in the money supply, resulting in a monetary rather than a non-monetary explanation of inflation (Stephen and Stuart, 2007:383). The figure below shows what happens during demand pull inflation. Price level AS P2 P1 AD1 AD2 0 Y2 Y1 National output Source: Stephen and Stuart, 2002 Demand-pull inflation can be caused by an increase in aggregate demand (AD). This can be illustrated by a shift in AD from AD1 to AD2 and the resulting increase in the price level from P1 to P2. The increase in AD may be caused by an increase in consumer expenditure 4|Page (not associated with an increase in income), government expenditure, and investment by firms or foreigners’ demand for Zambian goods and services. Cost push inflation occurs when an increase in the costs of production, which occurs independently of the level of aggregate demand. Firms then pass on these higher costs to consumers in the form of higher prices. The rise in costs reduces profit margins and results in some firms becoming insolvent so that they exit the market. As a result the aggregate supply curve shifts to the left from AS1 to AS2, with less output supplied at any given price. This raises the average level of prices from P1 to P2 but reduces national output from Y1 to Y2. With cost-push inflation we move along the aggregate demand curve to a point where output is lower and price levels are higher. The figure below illustrates the cost push inflation. AS2 PRICE AS1 P2 P1 Y2 Y1 National output Cost-push inflation occurs when there is an increase in the cost of production not associated with AD. If a firm’s costs increase they will react by increasing their prices and reducing production. This is represented by a shift to the left in the AS curve and results in an increase in the price level, P1 to P2, and a reduction in the real national income from Y1 to Y2. Q4. During credit crisis and global recession, many bankers lost their jobs. Is this demand deficit, or structural unemployment? Structural unemployment is unemployment that occurs when the pattern of demand and methods of production are continually changing. There could be a change in the comparative costs of an industry, technological change may mean that an industry’s labour requirements are somewhat less or demand for a particular product may simply decline. Any of these 5|Page changes could lead to structural unemployment. Examples in Zambia include unemployment resulting from a decline in the production of textiles, shipbuilding, coal and steel. Those workers who become structurally unemployed are available for work but they have either the wrong skills for the jobs available or they are in the wrong location. There is a mismatch between the skills and the location of labour and the unfilled vacancies (Stephen and Stuart, 2007:367). Demand deficient unemployment is often referred to as Keynesian unemployment or cyclical unemployment. It occurs when aggregate demand is too small in relation to aggregate output so that there is a deficiency of demand for goods and services. Since the demand for labour is a derived demand, the lack of demand for goods and services will also lead to a deficiency of demand for labour (Stephen and Stuart, 2007:367). This is the type of unemployment Keynes was concerned with in his General Theory (1936). The figure below show the demand pull inflation situation. price AS level p1 p2AD1 AD2 0 Y2 Y1National output Source: Stephen and Stuart, 2007. A fall in aggregate demand from D1 to D2 results in a reduction of national income from Y1 to Y2 and an increase in the number unemployed. Q5. Explain the relationship suggested by the Phillips curve. How might governments exploit this relationship? 6|Page The Phillips curve emphasises on excess aggregate demand being the major source of inflationary pressures with the level of unemployment being a proxy (stand-in) variable for the level of aggregate demand. The relationship between unemployment and inflation can be analysed by reference to the Phillips curve. The traditional Phillips curve described the inverse relationship between unemployment and the rate of change of money wages (i.e. wage inflation). The ‘Phillips curve’ appeared to indicate a stable relationship between unemployment and inflation, the view being that when the level of demand in the economy increased, unemployment would fall but at the expense of higher inflation. The reason put forward for this is that if there is excess demand in the labour market it will result in a reduction in unemployment. The excess demand for labour will cause an increase in the money wage rate and, since wages are a cost of production, this is likely to lead to an increase in prices, i.e. price inflation. The figure below illustrates this relationship. Rate of change Of money wages Unemployment rate Source: Stephen and Stuart, 2007 The Phillips curve illustrates the relationship between unemployment and inflation. There is always a trade-off between unemployment and inflation, such that a certain level of unemployment could be traded off for a certain rate of inflation. Thus, if the policymakers are unhappy with a particular level of unemployment, they can stimulate demand in the economy but the reduction in unemployment would be at the expense of higher inflation. Alternatively, lower inflation would imply higher unemployment (Stephen and Stuart, 2007:401). 7|Page Additionally, the Phillips curve describes an empirical relationship between wage and price inflation and unemployment. The higher the rate of unemployment, the lower the rate of inflation. The curve suggests that less unemployment can always be attained by incurring more inflation and that inflation rate can always be attained by incurring the costs of more unemployment. The curve suggests that there is a trade-off between inflation and unemployment (Dornbusch and Fischer). Government might exploit this relationship by introducing certain policies that tend to reduce unemployment and the other variables in the economy. The policies may also reduce the price level but later on disturb the employment levels. Government further sets prices of goods and services in the economy to help maintain the steady flow of goods and services. Q6. The inflation forecast for next year is 3 percent. Workers are asking for a 5 percent pay rise. Should the firm agree to the 5 percent rise? Inflation redistributes income away from those on fixed incomes and those in a weak bargaining position, to those who can use their economic power to gain large pay, rent or profit increases. It redistributes wealth to those with assets (e.g. property) that rise in value particularly rapidly during periods of inflation, and away from those with types of savings that pay rates of interest below the rate of inflation and hence whose value is eroded by inflation. Pensioners may be particularly badly hit by rapid inflation. Extra resources are likely to be used to cope with the effects of inflation. The costs of inflation may be relatively mild if inflation is kept to single figures. They can be very serious, however, if inflation gets out of hand. If inflation develops into ‘hyperinflation’, with prices rising perhaps by several hundred per cent or even thousands per cent per year, the whole basis of the market economy will be undermined. Firms constantly raise prices in an attempt to cover their soaring costs. Workers demand huge pay increases in an attempt to stay ahead of the rocketing cost of living. Thus prices and wages chase each other in an ever-rising inflationary spiral. People will no longer want to save money. Instead they will spend it as quickly as possible before its value falls any further. People may even resort to barter in an attempt to avoid using money altogether. Inflation is likely to worsen the balance of 8|Page payments. If a country suffers from relatively high inflation, its exports will become less competitive in world markets. At the same time, imports will become relatively cheaper than home-produced goods. Thus exports will fall and imports will rise (Sloman J,2006:436). Hence or otherwise, the notion above is strongly supported based on the findings stated above. Q7. Explain how you would assess the size of the government deficit to determine whether the government was using fiscal policy to expand or contract the economy. Whether the economy expands or contracts depends on the balance of total injections and total withdrawals. The government’s fiscal stance refers to whether it is pursuing an expansionary or contractionary fiscal policy. The size of the deficit or surplus is not entirely due to deliberate government policy. It may not give a very good guide, therefore, to government intentions. The size of the deficit or surplus is influenced by the state of the economy. If the economy is booming with people earning high incomes, the amount paid in taxes will be high. In a booming economy the level of unemployment twill be low. Thus the amount paid out in unemployment benefits will also be low. The combined effect of increased tax revenues and reduced benefits is to give a public-sector surplus (or a reduced deficit). By contrast, if the economy were depressed, tax revenues would be low and government expenditure on benefits would be high. The publicsector deficit would thus be high. This analysis can be understood by the use of the following graph. G,T Tax revenue Surplus deficit Government expenditure 0 Y1 Source: Sloman, 2006 9|Page Y The tax revenue function is upward sloping. Its slope depends on tax rates. The government expenditure function (which in this diagram includes benefits) is drawn as downward sloping; showing that at higher levels of income and employment less is paid out in benefits. As can be clearly seen, there is only one level of income (Y1) where there is a public-sector financial balance. Below this level of income, there will be a public-sector deficit. Above this level there will be a surplus. The further income is from Y1, the bigger will be the deficit or surplus. During the boom that was experienced in Europe and North America between 1996 and 2000, deficits fell. Japan, by contrast, was experiencing a prolonged recession. Its deficit rose, partly as a result of falling tax revenues and partly from a deliberately expansionary fiscal policy (Sloman, 2006). The public-sector deficit or surplus that would arise if the economy were producing at the ‘sustainable’ level of national income is termed as the structural deficit or surplus. Remember that the sustainable level of national income is where there is no excess or deficiency of aggregate demand. If sustainable national income were below the intersection point of the two lines, there would be structural deficit. If the economy is producing above or below the sustainable level of national income, there will be a cyclical component of the public-sector deficit or surplus. Thus the government could aim for a structural balance (G = T at the sustainable level of national income), but be prepared to accept a deficit if the economy was in a recession, or a surplus if it was experiencing a boom (Sloman, 2006). Finally, the size of the deficit or surplus is a poor guide to the stance of fiscal policy. A large deficit maybe due to a deliberate policy of increasing aggregate demand but it may be due simply to the fact that the economy is depressed 10 | P a g e REFERENCE Dornbusch, R and Fischer, S (2002) Macro Economics, 6th edition, New York: McGraw hill. Sloman, J (2006) Economics, 6th edition, New York: Prentices Hall Financial Times. Stephen and Stuart (2007) Economics, England: Pearson education Limited. 11 | P a g e