NATIONAL

INCOME
STATISTICS
CHAPTER 15
 National income is a country’s total output. Resulting in total output equal to total income and
total expenditure.
 National income statistics is a general term for measures of a country’s economic activity
regarding output, income and expenditure.
 An economy is usually considered to be doing good if its output is growing at a sustained and
sustainable rate. It can also used to compare with different countries.
 Higher output has the potential to increase people’s living standards.
 Gross domestic product (GDP) measures the total value of output produced by a country's
production factors in a year.
 Gross national income (GNI) is the total domestic and foreign financial output claimed by the
residents of a country, consisting of gross domestic product, plus factor incomes earned by
foreign residents, minus income earned in the domestic economy by nonresidents.
 Gross national disposable income, includes income sent home to relatives by people working
abroad minus income sent by foreigners working in the country to their relatives abroad.
 The difference in GDP and GNI occurs based on the difference in foreign investment in the
country and done by the country. If it is done in the country GDP will be higher than GNI as most
of the profits will go abroad, though if it is done by the country GNI will be higher than the GDP as
funds from abroad will come in their country.
 Methods of measuring GDP – each method should give the same total because they all measure
the circular flow of income produced in an economy.
 The output method
 It measures the value of output produced by industries such as manufacturing,
construction, distributive, hotel catering and agriculture industries or sectors.
 To avoid double counting, output is measured either by totalling the value of the
final goods and services produced or by adding the value added at each
production stage.
 Value added is the difference between the price a firm pays for the goods and
services it buys from other firms and the price it sells its product for.
 The income method
 Payments received in return for providing goods and services to the factors of
production.
  It includes net income from abroad but excludes transfer payments (welfare
payments or subsidies).
 The expenditure method
 Addition of consumer expenditure (spending by households), government
spending on goods and services, total investment, changes in stocks and the
difference between exports and imports.
 Government spending on welfare payments does not represent spending on
goods and services. It is spending that transfers income to the country’s
households and firms.
 In using this method it is necessary to add expenditure on exports and deduct
expenditure on imports.
 This is because the sale of exports represents the country’s output and creates
income in the country, whereas expenditure on imports is spending on goods and
services made in foreign countries and creates income for people in those
countries.
 Market prices are the prices charged to consumers, they include taxes on products and deduct
any subsidies given to producers.
 Basic prices are the prices which would be charged without government intervention and which
equal the income paid to the factor of production for making the equipment.
 To get from market prices to basic prices, taxes on products are deducted and subsidies on
products are added.
 GDP and GNI are both measured in market and basic prices.
 GDP and GNI include gross investment, that is total investment. Gross investment includes the
output of capital goods used to replace existing capital goods that have worn out or become out
of date due to advances in technology and capital goods required to expand capacity.
 Net domestic product (NDP) and net national income (NNI) only include net investment. They
deduct the value of the replacement capital goods. This value is referred to as depreciation or
capital consumption.
 Net investment indicates whether the country’s ability to produce goods and services in the
future will increase, stay the same or even decrease.
 CHAPTER 16
INTRODUCTION
TO THE
CIRCULAR FLOW
OF INCOME
 Output generates income which is then spent on the output. This also explains why GDP can be
measured by calculating the country’s output, income and expenditure.

 A closed economy does not export or import goods and services. In the circular flow of a closed
economy, the inner circle shows the real flow of products and the factor of services and the outer
circle shows the money flow of spending and incomes.
 Closed economy circular flow of income Open economy circular flow of income
 Injections add to spending in the economy whereas leakages reduce spending, in an open
economy. An injection will cause GDP to increase until, after a time, leakages rise to match the
higher total injections.
 For income to be unchanged, injections of extra spending into the circular flow of income must
equal leakages from the circular flow.
 If injections are greater than leakages, there will be extra spending in the economy, causing
income to rise. In contrast, if leakages exceed injections, more spending will leave the circular
flow, and income will fall. The graph below shows equilibrium income in a closed economy
without a government. Such an economy has only two sectors: households and firms.

Equilibrium income in a two-sector economy A rise in GDP in a two-sector economy

 A rise in investment will cause a rise in GDP. The higher investment results in an increase in
production, increase and spending. A fall in savings will have a similar effect. However, in contrast,
an increase in savings will mean that some products will be unsold and so the production will fall.
 Investment (I) plus government spending (G) plus exports (X) equals saving (S) plus taxation (T)
plus imports (M). This is in a four-sector economy. The four sectors are households, firms, the
government and the international economy.
 Income will move to a higher equilibrium level if any injection rises or any withdrawal falls. If tax
rates rise without any change in government spending. More tax revenue collected from
households and firms will reduce their available spending amounts.

CHAPTER 17
AGGREGATE
DEMAND AND
AGGREGATE
SUPPLY
ANALYSIS
 Aggregate demand (AD) in economics is used to describe the total spending of consumers
(households), firms and the government plus foreigners’ spending on the country’s exports minus
spending by the country’s consumers, firms and government on imports.
 Consumer expenditure (spending by households on goods and services to satisfy current wants,
for example, spending on food, clothing, travel and entertainment) is influenced by
 The level of disposable income – when income rises total spending also usually rises, with
rich people spending more than poor people.
 Dissaving – due to being poor most of the income has to be spent and savings are also
used up there might also be some borrowing. When income rises then some savings
might happen.
 Distribution of income – if the income becomes more equally distributed by an increase
in direct tax and state benefits, consumer expenditure is more likely to increase.
 Rate of interest – when the interest rates are low there will be more consumer
expenditure as the return on savings will be more and the interest on borrowed money
will be less
 Availability of credit – if it rises spending is also more likely to rise
 Expectations of the future – if the public is pessimistic about the future they are more
likely to save than spend even if there is a rise in income. When people become
optimistic about a secure job and an increase in wages in future they are more likely to
increase their spending.
 Wealth – an increase in it by a rise in the value of gold or real estate will also increase
consumer expenditure.
 Investment (includes private sector spending by firms on capital goods, such as factories, offices,
machinery and delivery vehicles.)
 Changes in consumer demand -- if demand rises demand is more likely to rise, and firms
are more likely to want to buy more capital equipment to expand their capacity
 Rate of interest --- a fall in it will increase investment as their cost will reduce and raise
consumer demand
 Advances in technology – will raise the productivity of capital goods and will probably
stimulate investment
 Cost of capital goods -- a fall in the price of capital equipment may also increase
investment
 Consumer expectations – when firms are optimistic that economic conditions are
improving and demand for their products will rise, they will be encouraged to increase
investment.
 Government policy – it may increase private sector investment by cutting corporate tax
and by providing subsidies
 Government spending (includes expenditure on providing merit goods, such as education and
healthcare, and public goods, such as defence)
 To raise economic activity – it may increase its spending and lower the tax
 The amount of government spending in any period is influenced by government policy,
tax revenue and demographic changes.
 Net exports (exports - imports)
 A country’s GDP – when it rises demand for imports usually increase; some products may
also be directed from exports to the domestic market
 Other country’s GDP – if it rises demand for the country’s exports is most likely to
increase
 Quality competitiveness of the country’s products -- if it improves demand for exports
will rise due to a rise in productivity or improved marketing
 Exchange rate – if it falls the value of the country’s exports will become cheaper and
imports will become more expensive. If demand for exports and imports is elastic, export
revenue will rise while import expenditure will fall, causing net exports to rise.
 Relative price – if the price of a good is less than that of the domestic country’s export
our country will increase

 The aggregate demand (AD) curve shows the different quantities of total demand for the
economy’s products at different prices. A rise in the price level will cause a contraction in
aggregate demand and a fall in the price level will result in an extension in aggregate demand.

 The demand curve focuses on a particular product and shows the changes that happen due to a
rise in the price of other products but, the AD curve shows the change in price of most products.
 The reasons for AD and price level are inversely proportional
 The wealth effect -- A rise in the price level will reduce the amount of goods and services
that people’s wealth can buy. The purchasing power of savings held in the form of bank
accounts and other financial assets will fall.
 The international effect – a rise in price will make the export expensive reducing the price
competitiveness and lowering the net exports
 The interest rate effect – a rise in price level will increase the demand for loans which will
lead to higher interest tax and a reduction in demand and investment
 While a change in the price level causes a movement along the AD curve, if any non-price level
influence causes aggregate demand to change, then the whole AD curve will shift. A shift to the
left indicates a decrease in aggregate demand while a shift to the right shows an increase in
aggregate demand.
 Non-price thing that will cause the AD curve to shift towards the right
  consumer expenditure – a rise in consumer confidence, a cut in income tax, an increase in
wealth, a rise in the money supply, an increase in population
 investment – a rise in business confidence, a cut in corporate tax, advances in technology
 government spending – a desire to stimulate economic activity, a desire to win political
support
 net exports – a fall in the exchange rate, a rise in the quality of domestically produced
products, an increase in incomes abroad.
 Aggregate supply (AS) is the total planned supply of all the producers in the country.
 Short-run aggregate supply is the output that will be supplied in a period when the prices of
factors of production have not had time to adjust to changes in aggregate demand and the price
level.
 Long-run aggregate supply is the output that will be supplied in the period when the prices of
factors of production have fully adjusted to changes in aggregate demand and the price level.
 The reasons SRAS and price are directly proportional
 The profit effect – as the price level increases, the gap between output and input prices
widens and the amount of profit increases.
 The cost effect – to cover any extra costs like overtime payments and part-time workers,
producers will raise the prices of the product
 The misinterpretation effect – producers might confuse changes in price level with
changes in relative prices
 Shifts in the SRAS curve
 A change in price of factors of production -- A rise in wage rates, not matched by an
increase in labour productivity and raw material costs will cause a decrease in SRAS,
shifting the curve to the left
 Change in taxes of firms – a reduction in corporate tax and indirect taxes will cause an
increase in SRAS
 A change in factor productivity/quality of resources -- A rise in labour productivity and/or
capital productivity will cause an increase in aggregate supply both in the short and long
run.
 A change in the quantity of resources – supply-side shocks or natural disasters can
influence them, but these do not stay in the long run
 The factors that will cause an increase in the quantity of resources in the long run will
also increase SRAS.
 Keynesians often represent the LRAS curve as perfectly elastic at low rates of output, then
upward sloping over a range of output and finally perfectly inelastic. This is to emphasise their
view that, in the long run, an economy can operate at any level of output and not necessarily at
full capacity. 0 to Y, the output can be raised without increasing the price level. As output rises
from Y to Y1, firms begin to experience shortages of inputs and bid up wages, raw material prices
and the price of capital equipment. When the output reaches Y1, the economy is producing the
maximum output it can make with existing resources.
 New classical economists, illustrate the LRAS curve as a vertical line. This is because they think
that in the long run, the economy will operate at full capacity. In the long run, however, this more
intensive use of resources will raise the costs of production.
 As the AD increases the economy will move onto a new lower SRAS curve and the point again will
be on the LRAS curve. Output will return to the initial level but at a higher price level.

 Both Keynesian and new classical economists agree that the causes of a shift in the LRAS curve
are a change in the quantity and/or quality of resources (factor productivity). Both of these will
increase the productive potential of an economy.
 The causes of an increase in the quantity of resources in the long run are
 Net immigration – it will increase the size of the labour force if the immigrants are of
working age.
 An increase in retirement age – it will increase the size of the labour force
 More women in the labour force – will increase the size of the labour force as
the proportion of women who work in various countries increases
 Net investment – gross investment >> depreciation leading to addition in capital stock
 Discovery of new resources – it can increase a country’s productive potential
 Land reclamation – it will increase land as a factor of production
 Main causes of an increase in the quality of resources
 Improved education and training – this will increase the skills of workers and so raise
labour productivity
 Advances in technology – these both reduce costs of production and increase productive
capacity
 The equilibrium level of output and the price level are determined where aggregate demand is
equal to aggregate supply. The macroeconomic equilibrium is illustrated by the point where the
AD and AS curves intersect.
 Changes in aggregate demand and aggregate supply will move the economy to a new
macroeconomic position. Where that position will be depends on the direction of the change, the
size of the change and the initial level of economic activity.

ECONOMIC
GROWTH
CHAPTER 18
 Economic growth is an increase in an economy’s output.
 The economic growth rate is the annual percentage change in output.
 For people to enjoy more goods and services, output has to increase by more than any
population growth. In such a case, GDP per head (per capita) would increase.
 Economic growth does not result in a rise in the living standards and quality of life of everyone in
an economy. It is also possible for a high proportion of people to achieve an improvement in their
living standards and quality of life even if economic growth does not occur, for example, if there is
a more equal distribution of income or a pollution reduction.
 Economic development is the process of improving people’s economic well-being and quality of
life.
 Economic growth is perhaps the key measure of progress in an economy. This can be assessed by
examining economic data. To assess whether an economy is developing is a more normative
judgement.
 Economic growth is measured in terms of changes in real GDP, that is the country’s output.
 The economic growth rate is the percentage change in real GDP from one time period to another.
 Nominal GDP is measured in terms of the prices operating in the year in which output is
produced; it is not adjusted to the changes in price level. It may give a misleading impression of a
country's performance due to price changes.
 Real GDP is an inflation-adjusted measure of the value of all goods and services produced in an
economy.

 A rise in economic growth can be caused by an increase in aggregate demand. This will increase
consumer expenditure, leading to an increase in government spending and a cut in tax rates,
resulting in more factors of production being employed and output rising.
The economy is initially producing at point X. Then the production point increases to point Y and
more goods and services are produced.
The increase in aggregate demand brings into use previously unemployed resources and output
(measured by real GDP) increases from Y to Y1.

 For sustainable economic growth it is necessary for productive capacity and aggregate supply to
increase; it can be increased by – either more resources or better quality resources.
 Increase in the quantity of resources
 Land – by discoveries of new mines and oil fields or making new land on the sea
 Capital – by net investment
 Labour and entrepreneurs – after a period as a result of natural increase in population;
immediate net immigration of people of working age; also depends on government
policies like retirement age and privatisation
 Increase in quality of resources (will increase the productivity of resources)
 Labour entrepreneurs – improved education and better healthcare
 Capital – technology advancement
 Land – use of fertilisers, irrigation and drainage schemes
 Both diagrams illustrate an increase in the maximum output the economy is capable of
producing. The first diagram shows that the production possibility curve has shifted to the right.
The ability of the economy to make both consumer goods and capital goods has increased. It is
now possible to produce a higher maximum combination of the two types of goods. The second
diagram also shows an increase in the economy’s productive capacity. This time it is illustrated by
a shift of the LRAS curve to the right.


 Both diagrams illustrate an increase in the maximum output the economy can produce. The first
diagram shows that the
production possibility curve has
shifted to the right. The ability of
the economy to make both
consumer goods and capital
goods has increased. It is now
possible to produce a higher
maximum combination of the
two types of goods. The
second diagram also shows an
increase in the economy’s
productive capacity. This time
it is illustrated by a shift of the
LRAS curve to the right. The
second diagram also shows
both productive capacity and
output have increased. The
shift to the right in the AD and
LRAS curves raises the
country’s output from Y to Y1.
Again, however, the economy
is not operating at maximum
capacity either when making Y
or Y1. The maximum output
would be achieved if the AD
curve cuts the LRAS curve on the
vertical part of the LRAS curve.
 Recession is when a country's economic growth declines as GDP decreases over two consecutive
quarters. It may be due to a decrease in aggregate demand or aggregate supply.
 The main obstacle to increases in the quantity and quality of resources in some low-income
countries is the opportunity cost of allocating resources away from their current use. This
opportunity cause arises because of scarcity.
 The cost of economic growth
 If an economy is operating at full capacity, there will be an opportunity cost involved in
achieving economic growth, resulting in the consumption of goods and services being
reduced and a decrease in living standards. However, this will only be a short-run cost
since, in the long run, increased investment will increase the output of both capital goods
and consumer goods and services.
 Due to the dynamic nature of the economy, it will undergo structural changes, thus
workers will need to be geographically and occupationally mobile which would be very
difficult.
 Economic growth accompanied by depletion of natural resources and damage to
the environment
 The benefits of economic growth
 Increase in goods and services for citizens of the country to enjoy, leading to higher living
standards.
 Reduces poverty as higher income equals higher spending leading to increased tax
revenue that could be used for higher benefits such as better housing, better education
and better health
 A rise in employment to fulfil the increased aggregate demand. Even an increase in
aggregate supply will make the country’s product more internationally competitive and
may generate more jobs.
 A stable rate of economic growth tends to increase firms and customer confidence, which
encourages investment
 Economic growth may increase a country’s international prestige and power
 Some economists in high-income countries debate whether the benefits of economic growth
outweigh the costs. For those in low-income countries, however, economic growth is seen as
essential to bring people out of poverty.
UNEMPLOYMENT
CHAPTER 19
 Unemployment occurs when people who are willing and able to work cannot find a job.
 People in the labour force are called economically active, even if they are unemployed
 Economically inactive people are not part of the labour force even if they are in working age as
they may be students or homemakers or early retired
 The labour force in an economy is defined as the total number of available workers.
 Labour force = employed + unemployed + people seeking employment
 The size of a country’s labour force depends upon
 The school leaving age
 The number of people who remain in full-time education above the school leaving age
 The retirement age
 The proportion of women who join the labour force
 The labour force participation rate is the economically active divided by the total
population of working age
 Proportion of working women

 Level of unemployment is the total number of unemployed people

 A stock is measured at a particular time whereas flow is measured over time. The level of
unemployment and unemployment rate show unemployment at a particular time. Though
different people might become employed and unemployed in a period.
 Government uses two main methods of measuring unemployment
 The claimant count measure -- counts as unemployed those who register as unemployed
to claim unemployment benefits.
 The international labour force survey – involves conducting a survey asking people if they
are employed, unemployed or economically inactive.
 Claimant count measure
 It is cheap and quick to calculate as it is based on information that the government
collects if it pays out benefits
 It is inaccurate as it may understate or overstate the real figure
 International labour force survey
 It is more accurate than the previous measure
 It is internationally agreed so it makes international comparison easier
 The data are more expensive and time-consuming to collect
 There may be sampling errors or other physical obstacle

 Frictional unemployment
 Arises when workers are in between jobs
 Voluntary unemployment
 Workers are not willing to accept jobs at the current wage rate and working
conditions
 Depends on the level of unemployment benefits compared to low wages
 Search unemployment
 Workers do not accept the first job but spend some time looking for a better-
paid job
 The provision of more and better quality information may reduce search
unemployment
 Casual unemployment – workers who are out of work between periods of employment
like actors, construction workers
 Seasonal unemployment – worker demand fluctuates according to the time of year, like
tourism and farming.
 Structural unemployment
 Arises due to changes in the structure of the economy because the demand changes
over time, method of production changes(advancement in technology); this will result in
unqualified skills, qualifications, experience and geographical location
 If workers cannot move from one industry to another due to a lack of geographical or
occupational immobility, they may stay structurally unemployed for a long time.
 Regional unemployment – declining industries may be concentrated in a particular area
or areas of the country
  Technological unemployment – introduction of labour-saving industries
 International unemployment – workers lose their jobs because demand switches from
domestic industries to more competitive foreign industries
 Cyclical unemployment
 Arises due to lack of aggregate demand
 Job losses occurring across a range of industries
 The labour market is initially in equilibrium at a wage rate of W. Then as a result of a fall
in aggregate demand, firms reduce output and aggregate demand for labour shifts to
ADL1. If workers resist wage cuts, demand-deficient unemployment XQ will exist.


 A cut in wages would reduce demand for goods and services as people would have less money to
spend, which would cause firms to reduce both their output further and make more workers
redundant.
 Unemployment has consequences for the unemployed themselves, firms and the economy as a
whole.
 Workers unemployed
 A fall in income
 It is more difficult to get another job the longer they have been out of work due to
missing out on training in advanced technology
 May lose confidence
 A decline in their physical and mental well-being
 A frictional or structural; unemployment may allow them to search for a job they enjoy
more
 Firms
 They may have a greater choice of potential workers to expand
 structural unemployment allows the economy to respond quicker to changes in demand
and supply conditions, with workers moving from one industry to another
 workers will not request a wage rise in fear of losing their jobs
 suffer from lower demand for their goods and services
 The economy
 Output will be below its potential level
 The tax revenue received by the government will be reduced
 There will be an increase in the proportion of payment of taxes resulting in opportunity
cost
 A high rate of unemployment means that the economy is producing well inside its production
possibility curve, forgoing a large quantity of output.
 Unemployment is also more significant the longer the workers are employed. The income of the
long-term unemployed will be low. They may suffer poor mental health because of the stress of
being out of work.
 Chances of workers gaining employment tend to fall the longer they are out of work because
 The skills of the unemployed may become outdated
 The unemployed may lose confidence
 Some may become discouraged workers
 Employers may also be reluctant to employ those who have been out of work for a
relatively long time
 Frictional unemployment is considered the least serious type of unemployment; whereas, cyclic
unemployment can cause serious problems as it may be of high rate and last for a long time.
 Governments want to achieve is to avoid structural and cyclical unemployment and to keep
frictional unemployment as low as possible.
 Low unemployment may not always be a sign of strong economy
 Workers may be in low-paid and insecure jobs
 Heavy underemployment
 Workers might be in part-time jobs when they want full-time jobs
 Their jobs may not fully match their talents
 Reasons for a fall in a country’s unemployment rate falling
 The result of previous unemployed gaining good quality jobs is likely to be beneficial
 The result of the unemployed becoming inactive is destructive

PRICE STABILITY
CHAPTER 20
 Price stability occurs when prices by only a small percentage and there is an advance of
fluctuation in the price level. A low and stable inflation rate can bring many advantages.
 Price stability can encourage firms to expand. Higher national output can create employment, as
well as increase the goods and services available for governments to spend on education and
healthcare.
 Inflation means on average prices are rising at a particular rate. As the price level increases the
value of money falls and its power declines meaning each unit of currency will buy less
 Creeping inflation is low and steady that even encouraging firms to produce more
 Hyperinflation occurs when inflation gets out of control and sometimes results in people
resorting to barter, exchanging goods and services for other goods and services rather than using
money to buy and sell products. In such cases, the currency usually has to be replaced by a new
currency unit.
 Deflation generally refers to a sustained fall in the price level. It results in a rise in the value of
money, with each currency unit having greater purchasing power. Deflation involves a negative
inflation rate, for example, –3%.
 Disinflation occurs when the inflation rate falls but is still positive. For instance, the inflation rate
may decline from 8% to 6%. In this case, the price level is still rising but at a slower rate.
 Calculating inflation
 The annual average method compares the average level of prices during twelve months,
for example, 2021 with the average level in the previous twelve months, 2020.
 The year-on-year method is calculated as the percentage change in the price level for a
given month with that of the same month of the previous year. For instance, if the price
level rose from 120 in June 2021 to 126 in June 2022, the inflation rate would be 5%
 A country’s price level indicates how much it costs to live in that country. A rise in the price level
means that the cost of living has increased. To assess changes in the cost of living, governments
construct a consumer price index (CPI). Consumer Price Index measures change over time in the
prices paid by consumers for a representative basket of goods and services.

 The difficulties of measuring changes in the price level

 The base year -- selecting it is hard as it heavily influences the inflation rate significantly
 The survey
 Are the people selected to keep details of their expenditure represent the whole
population
 How accurately the survey is completed
 Basket of goods and services
 The goods and services being measured may become out of date to ensure they
represent the current household expenditure patterns
 CPI does not fully reflect how consumers react to changes in prices as they
consider all coffee brands in one category which tea and coffee are different
 Though prices may remain the same and the quality and size of the commodity
might decrease
 The accuracy of a country’s CPI is influenced by whether there are sampling errors, how often the
basket of goods and services is updated and the extent to which its government statisticians can
avoid substitution and quality bias.
 Money values are the values of the operation of the price at that time. Real data has been
adjusted for inflation. To convert money values into real data, the figures are multiplied by the
price index in the base year and divided by the price index in the current year. Changes in real
data can be estimated by deducting the change in the inflation rate from the change in the money
value.
 Cost-push inflation occurs when prices are pushed up by an increase in the cost of production. A
decrease in aggregate supply caused by higher costs of production pushes up the price level,
causes a contraction in aggregate demand and reduces real GDP. Costs might be pushed up
because
  Labour might demand higher wages and cause a wage-price spiral
 Increase in cost of raw material
 A fall in the exchange rate if the value of the Indian rupee falls, the price of oil imported
into the country will rise. This, in turn, will result in higher transport and production costs,
which will lead to higher prices.
 An increase in firms’ profit margins will also increase the costs of production.
 Costs may be pushed up by damage to or depletion of resources.

 Demand-pull inflation occurs when prices are ‘pulled up’ by increases in aggregate demand that
are not matched by equivalent increases in aggregate supply. Any of the components of aggregate
demand may increase. So demand-pull inflation may result from a rise in consumer expenditure,
government spending, investment or a rise in net exports.
 A rise in aggregate demand will have a greater impact on the price level the closer the economy
comes to full capacity.
 Monetarists argue that the key cause of higher aggregate demand is increases in the money
supply. They suggest that if the money supply grows more rapidly than output, the greater supply
of money will drive up the price level. Whereas, Keynesians argue that it is inflation that causes
an increase in the money supply and not the other way around. If costs rise, firms may borrow
more from banks. This will cause an increase in the quantity of money.
 Some changes will both increase aggregate demand and increase costs of production. For
example, a fall in a country’s foreign exchange rate may both raise the price of imported raw
materials (cost-push inflation) and increase export revenue (demand-pull inflation). Also, once
inflation occurs, there is a risk that an inflationary spiral may occur.
 Costs of inflation
 A reduction in net exports – as the country’s products become less financially
competitive, thus It, ay increase import expenditure and reduce export revenue resulting
in a disbalance of payments
 Unplanned distribution of income – if the rate of interest does not rise with inflation
borrowers might gain and lenders and severs might lose as the value of money has
decreased
 Menu costs – costs involved in changing prices(catalogues, price tags) It involves a lot of
time and is usually unpopular with the customer
 Shoe-leather cost – moving money from one financial institution to another in search of
high interest rates
 Fiscal drag – income tax for different tax brackets is not adjusted in line with inflation
 Discouragement of investment – because uncertainty makes it difficult to plan ahead
  Inflationary noise – makes it difficult to assess what is happening to relative prices, it can
lead to consumers and firms making the wrong decisions which would lead to
the misallocation of resources
 More inflation – as workers may demand higher wages, firms may raise prices to cover
the costs and consumers buy products now before the price rises more as all of them
expect more rise in prices and it will be difficult for the government to handle them
 Benefits of Inflation
 Leads to economic growth – if the inflation is low and stable caused by an increase in
demand firms will generate more profit and may even invest, Due to the low rate of
interest and higher wages consumers will feel confident and spend more
 Reduction of the debt burden – as interest rates decrease with inflation the real debt
value will become less and the consumer may even spend more due to less interest on
loans
 Factors affecting the consequences of inflation
 The cause of inflation -- Demand-pull inflation is likely to be less harmful than cost-push
inflation. This is because demand-pull inflation is associated with rising output whereas
cost-push inflation is associated with falling output.
 The rate of inflation. A high rate of inflation is likely to cause more damage than a low
rate especially if the high rate develops into hyperinflation.
 Whether the rate of inflation is accelerating or stable. An accelerating inflation rate, and
even a fluctuating (constantly changing) inflation rate, will cause uncertainty and may
discourage firms from investing. The need to devote more time and effort to estimating
future inflation rates will increase costs.
 Whether the inflation rate is the one that has been expected. Unanticipated inflation can
also create uncertainty and so can discourage some consumer expenditure and
investment. In contrast, if households, firms and the government have correctly
anticipated inflation, they can take measures to adapt to it and so avoid some of its
potentially harmful effects.
 How does the inflation rate compare with the rate of other countries? A country can have
a relatively high rate of inflation, but if it is below that of competing countries its products
may become more internationally competitive
 Reasons for a reduction in inflation
 Advances in technology – keep costs down and enable higher aggregate demand to be
met by higher aggregate supply
 Increased international competition
 Reduction in trade union memberships and growth of more casual employment, resulting
in reduced ability of workers to call for wage rises
 Deflation will increase the burden of debt, may increase the real rate of interest and may result in
menu costs.
 Good deflation occurs as a result of an increase in aggregate supply. As advancements in
technology may create new methods of production also an increase in output, employment may
rise and the international competitiveness of the country’s products may increase.
 Bad deflation takes place when the price level is driven down by a fall in aggregate demand. Bad
deflation runs the risk of developing into a deflationary spiral. Consumers may delay their
purchases, expecting prices to fall further in the future. Firms, seeing lower demand, may not
invest and may reduce the number of workers they employ. Some debtors may get into difficulty
and this may cause banks, in turn, to get into difficulty with the risk of some going out of
business, and losing their customers’ money. These effects will reduce demand further and
economic activity will decline again.
 Most governments aim for a low and stable rate of inflation rather than a fall in the price level
because of
 a low rate of demand-pull inflation may promote economic growth
 measures of inflation tend to overstate the inflation rate because they tend to take full
account of quality improvements and the effect of consumers switching to lower-priced
products