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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]
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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?
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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?
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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
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(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
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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?
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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).
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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
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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
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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
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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.
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