EXAM QUESTIONS 1

Exam Questions

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Exam Questions

1. Inflation and deflation can both be damaging. Explain how and what monetary

policies can be used to counter both.

An economy is a multifactorial state that is often affected by numerous factors, including

consumer prices. Generally, a decrease in consumer prices often results in deflation, which is

also characterized by the increase in the purchasing power of a currency. On the other hand, an

increase in consumer prices often results in inflation, which is characterized by a decrease in the

purchasing power of a currency. While, to some degree, deflation may seem like a good thing

since consumers have a greater purchasing power, its effects are equally damaging to an

economy as those of inflation. To measure the two aspects, the consumer price index is

calculated by determining the weighted average prices of a particular basket of goods and

comparing it in different periods or between different countries. Deflation may be caused by an

increase in productivity, a decrease in the total aggregate demand, or a decrease in the supply of

money and credit. On the other hand, inflation may be caused by the reverse of the above

conditions.

Some of the damaging effects of inflation include that it reduces the purchasing power of

consumers since, with the increase in consumer prices, goods and services become unaffordable

to consumers. In addition to this, inflation also increases the cost of production within companies

since resources to be used in production become more expensive. Another damaging impact of

inflation is falling real incomes since increases in the cost of production trigger wage reduction

and pay freeze, thus lowering the real income of workers. On the other hand, some of the

damaging effects of deflation include that it increases unemployment since the falling of prices

pushes the profits of various businesses lower, requiring the termination of some employees.
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Another damaging impact of deflation is that it leads to a reduction in economic activities within

a country. As a result of the low consumer prices, most businesses prefer to scale down their

activities as profits are limited while others close, thus reducing economic activities. Besides

this, deflation also reduces the rate of investment as investment returns are usually low, which

means that few people prefer to invest. Instead, it increases savings.

With regard to inflation, one of the monetary policies that can counter it is the increase in

interest rates. An increase in interest rates counters inflation by making loans more expensive to

consumers, thus reducing the borrowing of credit; as a result, it reduces spending. In addition to

this, an increase in interest rates also attracts more people to save money as they will have better

returns, thus reducing their spending and halting economic growth and inflation in turn. The

other monetary policy that can be used to counter inflation is decreasing bond prices. A decrease

in bond prices often makes individuals purchase them more while the government gets the

money. As a result, the supply of money in the economy is reduced, thus lowering inflation. On

the other hand, one of the monetary policies that can counter deflation is reducing the interest

rate. By decreasing the interest rate, the government makes the cost of borrowing cheaper and

thus, more people tend to borrow credit more to invest and spend, therefore lowering deflation.

The other monetary policy is raising security and bond prices. An increase in security and bond

prices motivates the public to sell them to the government. As a result, more money is released

into the economy, thus facilitating more spending and, in turn, a reduction in deflation.

2. I) Explain the difference between cyclical, seasonal, frictional and structural

unemployment. II) Explain how and why different policies are appropriate to tackle

structural as opposed to cyclical unemployment. III) Explain the concept of a

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natural rate of unemployment and how it assumes the truth of a conservative 'free

market' theory of how capitalism works, which Keynesian might challenge.

Typically, unemployment refers to a situation where persons of working age are jobless

due to various reasons. In economics, there exist four major types of unemployment and they are,

namely cyclical, seasonal, frictional and structural unemployment. The four types of

unemployment differ in that cyclical unemployment refers to a situation where individuals are

jobless as a result of a decline in the demand, making businesses terminate some workers. On the

other hand, seasonal unemployment refers to a type of unemployment situation where

individuals are jobless since some industries only produce or distribute their goods and services

at given times of the year, meaning that at other times employees are jobless. On the contrary,

frictional unemployment refers to an unemployment situation that occurs when one has lost their

current job and they are in the process of finding another job. Lastly, structural unemployment

differs in that it occurs when there is a mismatch between the demographics of the workers

available and the type o jobs available.

One of the strategies that appropriately tackles structural unemployment as opposed to

cyclical unemployment is providing training programs. It does so by equipping structurally

unemployed persons with the required skills to fit the current jobs, which is what structural

unemployment is about. The latter strategy is appropriate to tackle structural unemployment as

opposed to cyclical unemployment since it improves the skills of unemployed individuals and

not the improve demand, which causes cyclical unemployment. The other strategy of paying

subsidies to firms that provide training to displaced workers also appropriately tackles structural

unemployment as opposed to cyclical unemployment by promoting the training of more persons

and the acquisition of skills to unemployed persons. It thus appropriately tackles the former as
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opposed to the latter since it allows the training of more unemployed persons and the acquisition

of skills to match jobs and doesn't improve the demand for goods and services, which is what

cyclical unemployment is about. Further, supporting prospective workers to further their

education also appropriately tackles structural unemployment as opposed to cyclical

unemployment by helping them to acquire more skills and qualifications, which makes them

match available jobs, thus reducing unemployment. The latter strategy appropriately tackles

structural unemployment as opposed to cyclical unemployment since it helps prospective

employees acquire more skills and knowledge that matches current jobs, thus reducing structural

unemployment and doesn't impact the demand, which is what causes cyclical demand.

The natural rate of unemployment concept refers to the lowest unemployment rate, where

the inflation rate is stable. Thus, when a country has achieved the natural rate of unemployment

is expected to have non-accelerating inflation rates. The latter concept assumes the truth of a

conservative 'free market' theory of how capitalism works, which Keynesian might challenge by

proposing that it is possible for inflation to be stable and yet the unemployment rate to be

decreasing. According to the conservative ‘free market’ theory of how capitalism works,

inflation surplus wage labor is beneficial and doesn't necessarily bring negative impacts in the

market. This is what is assumed in the natural rate of unemployment as it is possible to have the

lowest possible unemployment rate when inflation is stable.