TEACHER tt etd —— as AICS : Article # 158 A | Ly | \ Book-2 Imran Latif STUDENTS RECOUR' (OHA)LHR’ CIAL)DHA.LHR, 0 EM 0 672569 ey READS WRITE « PUBLICATIONS 35714038 (]192-326-5314141 @ wowseainvtie og C, Zahoor Ela Road, Gulberg I Lal wp No, 25-28 Lower Ground Floor, Hada Haleema @ 2. @ tase Eh cealanrtepubicatons/Shop readanvite publications @gnaicom Centre, Ghani Stet, Ueda Bazar Lahore \ ‘ | }At Macroeconomics Notes Book-2 2018 Edition Article: 158 Imran Latif MA. Economies, M.A. Mass Communication VISITING TEACHER AT: The City School (TCS) Green Hall Academy (GHA) Lahore Grammar School (LGS) Salamat School System (SICAS) Beaconhouse School System (BSS) Keynesian Institute of Management Sciences (KIMS) Editor: Uzair Shahed Islam eg READ XWRITE Hs PUBLICATIONS @v92-42-35714038 — [) +92-336-5314141 @ worwzeadnwrite.org Kf] readandwritepublications/Shop @ Hend Office: +, Zahoor Elahi Road, Gulberg I, Lahore. © readandwrite.publications@gmail.com Sule Point: Shop No. 25-28 Lower Ground Floor, Haadia Haleema Centre, Ghazni Street, Urdu Bazar, LahoreContents UNIT1 AGGREGATE DEMAND (AD) AND AGGREGATE SUPPLY (AS CONCEPTS OF NATIONAL INCOME. ‘SECTORS AND TYPES OF ECONO MIE AGGREGATE DEMAND (AD): ... Why does the AD curve slope downward? Changes in Aggregate Demand. AGGREGATE SUPPLY (AS). The short-run aggregate supply curve. The shape of the long-run aggregate supply curve .. INTERACTION OF AGGREGATE DEMAND AND AGGREGATE SUPPLY AND NATIONAL INCOME EQUILIBRIUM. CHANGES IN NATIONAL INCOME EQUILIBRIUM BUSINESS (TRADE) CYCLE... UNIT2 MONEY AND INFLATION Mone. History of specialization, trade, and money Concepts Features of money Functions of money: INFLATION MEASUREMENT OF INFLATION / VALUE OF MONEY / Cost OF LIVING ‘THE CAUSES OF INFLATION. Demand-pull inflation. Cost-push Inflation... ‘THE CONSEQUENCES OF INFLATION... Costs: . Benefits. (CAUSES a CONSEQUENCES OF BEFLATION PAST PAPER QUESTIONS. UNIT3 INTERNATIONAL TRADE. DOMESTIC AND INTERNATIONAL TRADE ‘THEORIES OF INTERNATIONAL TRADE: Theory of absolute advantage Theory of Comparative advantage. Mutually beneficial rate of exchange: Trading possibility curve (TPC): LIMITATIONS OF ABSOLUTE AND COMPARATIVE ADVANTAGE THEORY’ PROTECTIONISM.. Methods of protection and their impact. Effectiveness of protectionism:. ‘THE ARGUMENTS IN FAVOR OF FREE TRADE AND AGAINST PROTECTIONS. “THE ARGUMENTS IN FAVOR OF PROTECTIONISM AND AGAINST FREE TRADE ‘TRADE SLOCS OR INTERNATIONAL ECONOMIC INTEGRATION CONSEQUENCES OF FORMATION OF TRADING BLOCS:. 1. Trade creation... 2. Trade diversion PAST PAPERS QUESTION...(ANGE RATE: rAsUREMENT OF EXCHIANG unira EXCH DEFINITIONS AND | Ml ExcHaNat RATE SYSTEMS: ree Floating Exchange Rate fined Exchange causts oF EXC WANGE Causes OF Excnanet RATE Apr Errects oF DU pReciATION/DLVALUATION Turects oF APPRECIATION/ REVALUATION. Ahnvantnst AND DSADVANTAGES OF EXCIANG RATE SYSTEMS: ‘Managed floating system. THE TEAMS OF TRADE» ‘Movements in Terms of Trade. The Impact of changes in the terms of trade. PAST PAPER QUESTIONS wu UNITS BALANCE OF PAYMENTS: COMPONENTS OF THE BALANCE OF PAYMENTS. BALANCE OF PAYMENT DISEQUILIBRIUM ‘Causts OF BALANCE OF PAYMENT DISEQUILIBRIUM CCONSLQUENCES OF A CURRENT ACCOUNT DEFICIT ‘AND A CURRENT ACCOUNT SURPLUS Consequences of current account deficit: Consequences of current account surplus: PAST PAPER QUESTIONS UNIT GOVERNMENT INTERVENTION IN A MACRO-ECONOMY, MacroECoNoMIC POLICES 4. Fiscol policy 2. Monetary policy. 3. Supply-side policy. PoUcits TO CORRECT CURRENT ACCOUNT DEFICIT 41. Expenditure-switching policies 2. Expenditure-dampening policies POLICES TO REDUCE CURRENT ACCOUNT SURPLUS: POUCIES TO CORRECT OEMANO-PULL INFLATION oUcits TO CORRECT COST-PUSH INFLATION, POUICIES TO CORRECT DEFLATION AND THEIR EFFECTIVENESS. ast PAPER QUESTIONS. IC RATESPreface The idea of writing notes for Cambridge A-level Economics came to me in 2003, when, having already taught for a year, | realized that no single economics book available in the local and international markets covered all the topics with the depth and perspective required by the CIE syllabus. Both students and teachers had to consult 3 to 4 different books to find all the material that they needed—private candidates and new teachers had it even worse. Furthermore, it was really difficult for students to keep having to refer through different books when the exams were close and they were starved for time. | took on the challenge and decided to write a comprehensive text that explicitly followed the syllabus and exam pattern of the CIE. A year and a half later, in the middle of 2004, | had finally written and published four entire volumes of A- level economics notes. Part of them had been hand-written, and part of them had been typed. Soon, word of their usefulness spread, and they were bought all over Pakistan. The notes had served their purpose well till the end of 2014. Till that point, there had only been minor changes in the syllabus. But now, there was a dire need to update them, for the new syllabus for the 2016 examination introduced some significant changes in course content. In this new and improved edition, old topics have been revised and new topics have been added. At the end of each topic there is a relevant list of essay questions spanning from 1990 to 2015. These questions provide a clear guideline regarding how the examiners assess students’ knowledge on the topics for Paper 2 and Paper 4, allowing the student to practice effectively. While writing these notes | kept in mind the way in which the examiner tests MCQs as well. The notes have been divided into four volumes to make it easier for those who are following the AS and A2 track separately and for those who are taking the composite exam; the syllabus division in the following pages has been provided for this express purpose. | hope my efforts will help to contribute both to the learning of the student, as well as to the inquisitiveness of any teachers of A-level economics, Your suggestions will help me improve the quality of the content for later editions and will be highly appreciated. Imran Latif Cell: +92 300 441 0900 Email: imranlatifmalik@gmail.comReferences . Econdmics, 6th Edition / Sloman, J. . Principles of Economics, 10th Edition /Karl E. Case, Ray C Fair and Sharon C Oste, Economics, 18th edition / Mcconnell Brue . Economics, 9th Edition / Amold . Principles of Economics / N. Gregory Mankiw Oar one . Cambridge International AS and A Level Economics, 3rd edition / Bamford, Colin and Grant, Susan 7. Cambridge Intemational AS and A Level Economics Revision Guide / Susan Grant 8, Economics A Level Sth edition / Anderton, AG 9. Comprehensive economics guide / Hashim Ali. 40. Stanlake's Introductory Economics/ Susan Grant 11. Economics AS and A Level Through Diagrams / Gillespie, A 42. Penguin Dictionary of Economics / Bannock, Graham et al (eds) 43. Economics: A Student's Guide / Beardshaw, J 44. Essentials of Economic Sth edition / Sloman, John 15, Economics, 9th edition / Begg, David et al 46. Economics, 11th edition / Michael Parkin 17. www.tutor2u.net 18. www.s-co0l.co.uk 19. www.wikipedia.comBook 2 (AS Level Macroeconomics) WANT t =AGGREGATE DEMAND (AD) AND AGGREGATE SuPPLy (As): _ the rape ant omecmmants of AD and AS Curves O=Cri+GeK-W tre dancin between a movement along and a shiftin AD and AS the enecacton of AD and AS and the determination of the level of output, Prices ang eooret UNMET 2: MONEY AND INFLATION: a here; tector a0 Caaceristics in a modem economy wane, cash and bark deposits, checks, near money, liquidity be. wt, tte Chitin of ification - deen f wtation ' tetiahicrs a0 isinfiation indarusesniest of inflation the distinction between money values and real data (shifted to Book 2 Unit 1) the causes of inflation (cost-push and demand-pull inflation) the consequences of inflation UNIT 2; INTERNATIONAL TRADE: 6, Specialization and division of labor b, Principles of absolute and comparative advantage the distinction between absolute and comparative advantage {106 trade area, customs union, monetary union, full economic union {rade creation and trade diversion the benefits of free trade, including the trading possibility curve 6, Protoctionism the ning of protectionism in the context of international trade different methods of protection and their impact, for example, tariffs, import duties and quotas, export subsidies, embargoes, voluntary export restraints (VERs) and excessive administrative burdens (‘red-tape’) ~ the argume: In favor of protectionism INIT 41 EXCHANGE RATE: Exchange rates = definitions and Measurement of exchange ratesrconomies 9708 1" Syflabus nominal, real, trade-weighted exchange rates b. Exchange rate systems — the determination of exchange rates floating, fixed, managed float ¢. Changes and effects the factors underlying changes in exchange rates — the effects of changing exchange rates on the = domestic and external economy using AD, Marshall-Lerner and J curve analysis — depreciation/appreciation devaluation/revaluation d. The terms of trade the measurement of the terms of trade causes of changes in the terms of trade the impact of changes in the terms of trade UNIT 5: BALANCE OF PAYMENTS: a. BOP accounts the components of the balance of payments accounts (using the IMF/OECD definition) — current account — capital account = financial account = balancing item b. BOP equilibrium and disequilibrium = meaning of balance of payments equilibrium and disequilibrium — causes of balance of payments disequilibrium in each component of the accounts = consequences of balance of payments disequilibrium on domestic and external economy UNIT 6: GOVERNMENT MACRO INTERVENTION: a. Types of policy fiscal policy - monetary policy, ~ supply side policy (instruments of each policy) b. Policies to correct balance of payments disequilibrium — assessment of the effectiveness of fiscal, monetary and supply side policies to correct a balance of payments disequilibrium (expenditure-reducing an expenditure-switching) ©. Policies to correct inflation and deflation — assessment of the effectiveness of fiscal, - monetary and supply side policies to correct inflation and deflation Book 3 (A2 Level Microeconomics)4 Glossary of command words This glossary should prove heleful to candidates as a guide, although it is not exhaustive and it has deliberately been kept brief. The number of marks allocated for any part of a question is a guide to the depth required for the answer. Command wo Pe Calculate Work out using the information provided Define Give the exact meaning of Describe Give a description of, explain the main features of Identity Name the key knowledge point Mustrate Give examples, use a diagrem Outline Describe the key points without detall State Give a concise answer with little or no supporting argument required Analyse Explain the main points in detail, examine closely, separate into parts and show how ail the parts connect and link Compare Explain the similarities end differences between Explainyhow Give clear reasons or make clear the meaning of, use examples and explain ‘the theory behind the question. This command word requires ‘Knowledge and Understanding’ as well as Application’ Consider Give your thoughts about, with some justification Assess Show how important something is, give your judgement on ‘Comment upon Give your reasoned opinion on, with explanations Criticise Give an opinion but support it with evidence Discuss Give the important arguments for and against, often requires 2 conclusion. This command word requires Analysis’ anc ‘Evaluation’ Justify Explain why the arguments for an opinion ere stronger than the arguments against Evaluate Discuss the importance of, |udge the overall worth of, make an attempt to weigh up your opinions To what extent Give reasons for and against, come to a conclusion with a justification of which argumants are strangest and which are weakestAggregate b Demand (Ad) & Aggregate Supply (AS) ~* AS Level Macroeconomics Notes Book 2 — Imran Latif Cell: 0300-44-10-900 Imranlatifmalik@gmail.com GREEN HALL Resource Center reatandoanie publications R ad Q 3-6; Zahoor Habu Koad Gulbergi, | ahore Write gscrsr Gooessriwow 0 oessiait emaras 1 eae Syllabus 2016 — 18 the distinction between money values and real data Aggregate demand (AD) & Aggregate supply (AS) — the shape and determinants of AD and AS Curves ~ AD=C+I+G+(X-M) — the distinction between a movement along and a shift in AD and AS National income equilibrium ~~ the interaction of AD and AS and the determination of the level of output, prices and employment=_ ne os 2 ‘Aggregate Demand (AD) and unt ? 28 ABDC Supp. WTS eee enc cto Ca LL Aggregate To Ue) Concepts of National Income = Gross Domestic Product (GDP) = Gross National Product (GNP) = Disposable income (Y) ~ Nominal GOP - Real GDP Gross Domestic Product (GDP): Gross domestic product (GDP) is the monetary value of all final goods and services produced within the geographical boundaries of a country irrespective of whoever is producing it, in one year. Whereas monetary value means the value of a product expressed in terms of money. GDP will not include all those goods which are produced abroad, in previous year and/or goods that are unfinished. Monetary Value = Price x Quantity GDP = P; Qs + P2Qe + Ps Qs. PaQn = SPQ “Ps Qs” is the monetary value of Good "1". “Pz Qi’ is the monetary value of Good "2", “Py Qs’ is the monetary value of Good "3" Gross National Product (GNP): Gross national product (GNP) is the monetary value of all goods and services which are produced by the citizens of a nation, irrespective of wherever they are living in the world, in one year. GNP = GDP + Net Property Income from Abroad Net property income from abroad = Property income from abroad — Property payment to abroad Disposable National Income (Y, Disposable income (2) is the income left after paying income tax (direct tax). Disposable income = National income — Income Tax Nominal GDP: Nominal GOP is the GDP figure measured at the current year prices and is not yet adjusted for inflation. Nominal GDP = Current Year Price index x Current Year Output Example So Current Year Price index = $120 OS Current year output = 3,000 units & 2 Nominal GDP (Current Year) = 120 x 3,000 = $360,000 eS ny Real GDP: By or Real GDP is the GDP figure measured at constant or base pear price level eng een adjusted for inflation, wo Real GDP = Base Year Price Index x Current Ye&i Syfbut Example: % Ra ‘Year 2000: > Base year price index = $100 Og Base year output = 20 units “eeaon 23 ‘Aggregate Demand (AD) and Aggregate Supply (AS) eat Current year output = 30 units Real GDP (Current Year) = 100 x 30 = $3,000 CONVERSION OF NOMINAL GDP TO REAL GDP To convert nominal national income to real national income, the income deflator is used. The income deflator is a value that removes the effect of inflation from nominal national income. The following steps explain the procedure of the deflator. Nominal national income Re: i = al national income Daliston rent year price index Where Deflator = current year ee r an Base year price index Example: Nominal NY=$200 million Current year price index = 110 Base year price index=100 Current year price index _ 110 Deflator = Se Yes pS Ett Base yearpriceindex 100 Nominal national income _ 200 Real national income = Dattator Ty = 182m 5 Sectors and Types of Economies: FST ETT Expenditure on Expenditure on Expenditure on merit and Expenditure on consumer goods capital goods public goods exports and imports Consumption and saving Investment Government spending ané | Exports and imports ation os 1 6T XM ‘Types of Economies Percy Een pene ag With Government Households v v Firms v v Government * v Tntemational Trade * x Type of Economy Closed Closed2 ‘Aggregate Demand (AD) and Aggragay, Une t Ry Aggregate Demand (AD): ‘Agoregate demand (AD) i the total spending on an economy/s goods and services ata given pi, in a given time period. Demand for an economy's products, known as aggregate demand (AD), comes from households, 4, andthe government within te county and from households, fhm, and governments in other cour Aggregate demand (AD) consists of four components: Economy t Sectors aed Coed oy ‘spending by households on ‘consumer goods and| services government spending on public and merit goods The part of the economyinvolved in the international trade, ie. exports and spending by private sector firms on capital goods Consumption Goverment Net Exports I spending I c + I + GS + X-M—-=AD The Aggregate Demand curve The aggregate demand curve shows the different quantities of total demand for the economy's products (real GDP) at different price levels. AD=C+I1+G+X-M General Price Level A Oe ‘Arise in the price level will cause a contraction in aggregate soles a fall in the price level will result above ""#!0n in aggregate demand. The downward sloping natuts of the AD curve is shown in Figure above,seggegee et EO ee baggage oa nag weotershg tetween agyegste demand #3 78 3 nn the Cemand OFVe for an nareaat prod. Tr were 2 product shows te reiatonship between a change m Te Pdine quatty demanded, The price of 78 product s changing Ot tS 2ssu7 on eA Tak Te res St ter rapes nave mek changed. More of Te product S purchased when Te ree las, © pat tacaee eee Sesh away FO rval proaUCS B, contrast te case of the AD ove the prices of most products are geq nite same Grecton “ly ren does aggregate demand fal wren tre pecs vel 1S=s ad vee ve Buca Be las . Exports mace price coment Dece2s® | Srencial assetst—-teal Imports ess price competitive 1) | wean? = C7 ADT vet exports (K- cress | Purchasing power of Exports tess price come Se aera aie ii ES | francial assets|—real Imports—more price competive = aes borrowing + ) wealth |-C, ADL Net exports (X-M), ADL see Changes in Aggregate Demand ogregate demand can change in two ways movement along the same aggregate demand curve. A shift of the aggregate demand curve. ‘Changes in aggregate demand (AD) ‘She of the AD axe due to exogencustacios | [eae extogenustonor | gener gree evel Exension General Price Leeta Aggregate Demand (AD) an tga, unt snus in the Aggregate Demand curve ; movement along the AD curve; but, if any factor othe, A in the pace level causes & . then the entire AD curve will shift. A shift tothe | “Semand (ADs to AD2), whereas a shift to the right (ADs to AD:) ing ceoeose 2am mand, 2s shown inthe figure above on the right. cecrease hn aggregate " than the price level will influence consumption, investment, go A change may far oedng the AD curve. Examples that would cause an increase in xy Conta on ua elative pri business + level of economic a ~ exchange rate expectations _| - social objectives = relative quality of ‘ y of = corporation tax | need formert and public |” domestica genic - subsidies goods products . « foreign 2 domestic = law and order economic gram - ome — iy = protectionisrn - cost of raw materials - foreign relations | poate ha _ Preesin e | for spending consumer goods Determinants of Consumption and Savings: 4. Wealth: A rise in wealth causes consumption to rise and saving to fall. Where as a fall in wealth causes consumption to fall and saving to rise. focome tax: When income tax rises, consumption and saving fall. When income tax fal’, 2 ‘consumption and saving rise. 3. Age: in an older population, consumption falls and saving rises. In a younger population consumption ises and saving falls. 4. Family size or population: If the family is small, then consumption is low and saving is high. If the famnty i large, then consumption is high and saving is low. 5. Range of goods and services: When there is a wide range of goods and services in the market, consumption is high and saving is low. But, when there is a narrow range of goods and He. Consumption is low and saving is high. A 6. Interest rate: When the rate of interest is high, consumption is low and saving is high. age hesa the ‘fate Of interest is low, consumption is high and saving is low. ~ 7. Avoilability of credit: If credit is easily available, consumption is high and saving we credit is ‘tot eaty available, consumption is low and saving is high. ye 2, Expectations regarding an increase in future income: If ase I rs : If people expect aQIfckedse in incorne, sZrnimpton dees and saving fas. people expect a decrease in incorpegcontumption fal and saving ; 9. Price level: If the price levels falls, consumption rises bolt i | , and savingsiphsclf the price level rises. sroaumpion fale and saving ries. However, if the price level is ats rise furthar in the future, consumption rises and saving falls more rapidly. 9s vas Determinants of investment: 4. Technology: Technolog (0.2 decreave in inveet na om 88 Heads to an increase Ferment Technological regress loads &rF watt ar ‘Aggregate Demand (AD) and Aggregate Supply (AS) 2, Gost of capital: I there is a decrease in the cost of capital, investment rises. If there is an increase in the cost of capital, investment falls 4, Corporation tax: I there is @ decrease in corporation tx, investment fises. If there is an increase in corporation tax, investment falls 14. Subsidies: An inctease in subsidies causes investment fo rise. A decrease in subsidies causes investment to fall Profits: An increase i in profits leads to a rise in investment. A decrease in profits leads to a fall in 5 investment. 6, infrastructure: An improvement in infrastructure causes investment to rise, A worsening of infrastructure causes investment to fall 7, Political stability: Poically stability leads to an increase in investment, Poicalinstabilty leads 10 2 fall in investment. 8, Law and order: A lower crime rate and strong legal institutions will lead to an increase in investment. High crime rates and weak legal institutions will ead to a decrease in investment. 9, Business expectations: High business confidence leads to an increase in investment. Low business confidence leads to a decrease in investment. Foreign relations: Good foreign relations lead to an increase in investment. Bad foreign relations lead to a decrease in investment. 44. Interest rate: If the interest rate is low, low. 42, Demand for consumer goods: An increase in demand for consumer goods leads fo greater production, which, in turn, requires more machinery (an increase in investment). Similarly, a decrease in demand for consumer goods will lead to a decrease in investment. 10. investment is high. If the interest rate is high, investment is Determinants of Government Spending: 4. Political objectives: Political seasons also affect government spendin government spending is high but after elections government spending is low. 2, Level of economic activity: Economic conditions are also an important factor. During recession government spending rises whereas during boom government spending falls. 19. Before elections 4. Social objectives: Government may spend more to eradicate poverty and for more equitable distribution of income. 4, Need for merit and public goods: Need for merit goods like street lights, etc. Determinants of Exports and Imports: 4. Foreign income: If foreign income rises, exports will also rise whereas if foreign in will aso fall 2. Domestic income: If domestic income rises, imports will also fall 3. Relative quality: If quality of imports is better than the quality of locally produced goods then ¢mRas will ise but if the quality of local goods is better than the imported goods than imports il. ually of local goods is better than the quality of imported goods than exports rises BHD ity of ey local goods is worse than the imported goods than exports fall. 4. Tariff or duties (protectionism): If tariff applied on imports increases imports prprou if tariff goods such as education, healthcare, and public \come falls, exports imports will also rise and when domestic income falls, applied on imports decrease than imports will rise. If tariff imposed on our ex; er countries increase than exports will fall but if tariff imposed on our exports by other epOnigss decrease than exports will Zo, 5. Exchange rate: If a currency depreciates, imports get expensive and @ ‘Secome cheaper which leads to a rise in exports and a fall in imports. On the other hand i i@ehcy appreciates, exports become expensive and imports become cheaper which leads to aa and a fall in exports. ae"— a ey Unit 28 Aggregate Demand (apy 184 Arey Aggregate supply (AS) te supply (AS) is the total output (real GDP) that producers in an eg oe ata given price level in a given time period, MOY BFE Vili any iy Regarding aggregate supply (AS), economists sometimes distinguish between supply (SRAS) and long-run aggregate supply (LRAS). Short-run angregie | The short-run aggregate supply curve Short-run aggregate supply (SRAS): the total output of an economy that will be supplieg has not been enough time for the prices of factors of production to change. when there The short-run aggregate supply curve slopes up from left to right as shown in Figure below SRAS General Price Level ° Yo Y: Real GDP As the price level rises, producers are willing and able to supply more goods and services. There are three possible reasons for this positive relationship: The profit effect | Seen bo Producers may confuse changes in the price level with changes in relative prices. They may think that a rise in the price they receive for their products indicates that their own product is becoming more popular. As a res| wi ry be encouraged ce re em 8 more — AS} Xs CN Sra As the price level 1 — wages do not change —+ gap between — output and input prices 1 = profit | AST ‘Although the wage rates and raw material costs remain unchanged in the short run, average costs may rise as output increases. This is because, for example, overtime payments may have to be paid and costs will be involved in recruiting more members. To cover any extra costs that may be involved in producing a higher output, producers will require higher prices — AS? Shifts in the Short-run Aggregate Supply curve On While a change in the price level will cause a movement along the short-run aagedep bur cue, there are four main causes of a shift in the SRAS curve. These are: © _ 4. A change in the price of factors or cost of production: A rise in wagers, not matched by 27 increase in labor productivity, and raw material costs will cause a dgebsin ‘SRAS, shifting curve to the left a illustrated in figure below. v 2. A.change In taxes on firms: A reduction in corporation tax or indi 385 wit cause an increase in rete oe pital 3. A change In factor productivity/quality of resources:: labor productivity andlor 2 productivity will cause an increase in aggregate supply bottign ie short run and long ru!n Sipe SAAS IFA hPa Ati uumntihy OA rancratcass I thar AA UL YI AY te OE nye in the souteay; iy tho A arta voi, woh al dratdnts, hey cert: atnty A NAIA Wh Cath: entry acgnotyni chy HAA I te abr rane anid ang 086 eee General Pros Lae’ o Peal OOF ‘The shape of the long-run aggregate supply curve we curve shows the relationship between real GOP ana ranges © 7 The long-tun aggregate supply input prices to adjust to changes in aggregate demand Jovol whan there has been time fo Koynosians aro the followers of the economist John Maynard Keynes who maintain that govererest intorvention is needed to achieve full employment. ve is vertical and that Te | economists are the economists who think that the LRAS cu Now classical ull employment without government intervention. ‘oconorny will move towards flSeomnOsaI Shun eye UeD a indjno tunUIKEW YY BuloNposd SI AWD oY ‘4A SByDeEL INdINO UayAA UoLUdiNbS > aoud fe Seoud jeualew med ‘seGem dn pig pue sindul jo se6eyoys eouavadxe 0} uiBaq sul 4 way Sasu yndino sy Jou op AW) ‘pueUIEp Bje62165e Jo [ana] Mo} UI 0} ANP ‘Ing @BUEYD o} Saolid yndu! 105 a 3 S| RAUL 18A2] Sud oy Suiseasour jnoywm pasie) aq UL INdINO "LA 0} O WOY EY SMOYS BOGE }YBL! 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(sya Aiddns @7e53.58e unu-Suo jo uojeyuesaidai e Osie si} ‘ogsejaur Aqoayad — SaSu [SA9] coud eu Ajuo — eul| eoWeA — exo, ‘Btuno Ayiqissod vogonpoid sil ye — quawio|due | Ing 38 — Ayoedeo ss2oxe ou AjainI0sae j1 “puemdn aq wa uonenys stip ul anno Aiddns eye6a166e ‘eousy eo ety Jonsuay seoud seu) Bulsies Aq yee) suuy — | 109 —sindul J0 saBepoys — sseoxe ‘awOs SI 219t UBUM ‘Ou feWOZLOY 8 eq 0} enino fiddns aje6a662 “eoue}} ‘Siax10m mau DeMe 01 qua!oyjns q Kew gol e jo 4240 aun ‘YBIY s1 UaWAo|dwWeuN uaym ‘ajduiexe 404 “seoud uo aunssaid Aue Buleq azeuy nom andino eseeioul pue seounose iow JRE UED SUL ‘MO} a1e quawifojdwa pue yndyno vey, Ssesremrn| z Bev z z 2 § “omy ou Uaemjeq abuel aje!pauLia}Ul Ue (¢) pue “*yDedeD In (z) ‘Ayoedeo sseoxe (1) :suONEMYS ee1y euIWwexe 0} srey am ‘anuno A\ddns aje62166e uns Buc] UeIseUAey 24) JO aunyeU aN.y ay} PUEISIEPUN 0} J8PI0 Ul Aecedes ny ye ayeisdo wa hucucce og uns B., 019 UL eM sKatIEg Fypedes jin} ye Auesseoau jOU pue jndjno Jo |@Ae| Aue ye eyesedo ued Awouooe ve “uns Buoy ey UI EU) enar9g ‘Ase|ou! ‘Aypeyed Kyjeuy pue yndjno jo e6ues & 19A0 Buldojs puemdn uaYs ‘jndyno jo Sayed mo} ye oNseIe ANO@HEd S111 A jeomen, Sean pre os Lawn, or hate extathy v8 (ay) puewen oie60l6By ofuot! a” ‘Aggregate Demand (AD) andl Aggregate Supoly (AS) shifts In the LRAS curve goth Keynesian and new classical economists agree change in the quantity and/or quality of resour productive potential of an economy, al the causes of a shift in the LRAS curve are a (factor productivity). Both of these will increase the ‘The causes of an Increase in the quantity of resources in the long run are: |4. Chango In the Quantity of Resources | 2: Change in Quality (Productivity) of | Land: Resources: | Land may increase because of: Labour: Discovery of oil, metal or mineral reserves by | ~ Wage rate | active search ~ Education and training | — Eroded, water-logged land may be made - Technology | usable for_—agricultural_~—_ purposes. Work conditions | (Reclamation of land) = Length of working hours Labour: — Fringe benefitsiperks\non-monetary benefitinon-pecuniary benefits = Bonuses and commissions — Promational opportunities Labor may increase by: — Increase in total population, especially in the working population. Change in structure of population from less ~ Health dependent population to more working | 6. vital: population, even without an increase in total | “PUA ay | population. > — Immigration is greater than emigration. 5 et ae — Increased women-participation in jobs. lana , — Lower school-leaving age. ~ Technology — Higher retirement age = skilled labor Capital: atinvesiment - Fertility rates, etc. - urship: = Rate of return on Capital Entre a emuricakon = Interest rate ; Business optimism and pessimism = Government policies about taxation and subsidies — Political stability — Technology = _Infrastructure = Management techniques, etc. Pra Stow Crd cortanee Pen Gaui Price Level LIRAS, LRAS, LRAS, General Price Level” Aggragala Darnand (10) 4025 Keyyeriang ni Faotore that shift both AD and AB: 4 investment net immigration & government spending on aducation Interaction of aggregate demand and aggregate supply and nation Income equilibrium al ‘The equilidtium level of output or national income and the price level are determined where ary domand is equal to aggregate supply. Tho macroeconomic equilibrium is illustrated by the point yj. the AD and AS curves Intersect, as shown In the diagram below. Price level ° Y, Real GDP initially below Po, the excess demand would push the price level back up to the i$ If the price level was goods and services would not be sold any ‘equilibrium level. If the price level was above Po, some would have to cut their prices. OS és | OR Changes in national income equilibrium ony KG Changes in aggregate demand and aggregate supply wil move the economy to RBiegPracoeconamie position. Where that position will be will depend on the »%o, Vs = cause of change, ie., AD or AS XE’ = direction of the change %& size of the change oe = initial level of economic activity os eome | if the aggregate demand curve intersects the | aggregate supply curve prior to output rate ¥, then | any increase in demand will not lead to a rise in the price level. Thus a shift from ADs to AD: leaves the | price level unaltered at Po A shift from ADs to ADa, | however, will cause the price level to increase Ps. ‘After output rate Y2, any increase in demand will simply result in a higher price level since, by Sofnition, at full capacity output no more output is Price level Agareaate Demand (AD) and Agaregate 5 Supply (AS) a, Riso in SRAS (Supply-side policies) | AS, Y, Y: GOP ‘An increase in aggregate supply (AS) will sift AS from ASo to AS1 causing the price level to fall from Po to P: and GDP increases from Yo to Ys physically possible. b. Fall in AD (Deflation) b. Fall in SRAS (Cost-push inflation) ‘A fall in AD will lead to fall in general price level (deflation) if economy is at or close to full- Chloyment. Effect of fallin AD on price level and GDP depends upon initial position of the economy. from Yo to Ys. Priog level ‘A decrease in aggregate supply (AS) will shift AS from ASo to ASt causing price level to rise (cost push inflation) from Po to P1 and GDP decreases @Y, Ye _GOP. shifts in AD and AS. ° FTBGN AD and AS Si tagather then effet on price level and oh depend upon relative size ofM ‘Aggregate Demand (AD) and Aggingate { national output around its ong t the periodic fluctuation o 9 term trong ‘The term trade cyCle dor the ‘rlume of economic activity (GNP) such as employment, p.. is used to dese the tn dene son of booms and slumps (also caled troughs) 28 shown in day, ty proceed in a succes ata Real GOP ‘Actual output Trend growth in potential output Frecer Time of output, foreign trade, investment, share prices, employment and ‘ases of the trade cycle are labeled as a, b, and c. Booms and ‘or even years and then come to an end. No two trade cycles are also called the duration Economic activiy refers to the level consumer spending. The different phi recessions can last for several months quite the same. The interval between the peaks or between the troughs (which is Gta rade cycle) is not constant, and the intensity of the troughs varies, trade cycles show a rough pattern cover time and display unpredictable deviations from the expected pattern. Stages of the trade cycle The trade cycle consists of four phases: boom (point b), recession (point H between b and c), trough (point a or ), and recovery (between a and b). Recovery follows a recession, then reaches @ peak/boom and is succeeded by another recession. The length of a business cycle is measured by the interval between the peaks (or between any other pair of corresponding points). Some economists argue that the ‘cycles are brought about by new inventions, population growth, mineral or oil discoveries, political factors, ‘and war. The cycles tell us about the behavior of the economy as a whole. o o es ES) Lowest ses ighest Highest Falls Lowest Highest Falls Lowest Highest Falls Lowe: eRises ae Highest Falls to af Rises ployment Highest Falls esKe Rises ‘Demand-pull inflation Highest Falls. st Rises Ci urrent account Deficit [Improves RO surplus | _ Worsen i . ie eee i. eid when business activity is expanding, Le, p \Wforeases, prices and wages rise, unemployment deciines and the current account deficit. This phase is characterized by high output, low unemployment, high inflation and a deficit current account.er unit % ‘Aggtogate Domand (AD) and Aggregate Supply (AS) Recossion is a temporary faling off in business activity which may or may not develop into a tough. During a recession, the rate of inflation falls, exports will rise and imports fall; consequently, the balance ‘of payments improves, consumption and investment are low and interest rates charged by banks are also low. In brief, this phase is characterized by low output, high unemployment, low inflation and a surplus current account. ‘Trough is when business activity is at the bottom, In the recovery phase of the trade cycle, an attempt is made by the government to expand the economy either by monetary means (e,g., encouraging banks to increase their lending) or fiscal measures (eg. cutting taxes). This phase is marked by a rapid rate of economic growth due to government policies such as easing of credit restrictions to encourage expansion of production and a reduction in cyclical tinemployment. During this phase ofthe trade cycle, prices wil rise, total transactions wil increase and the national income will rise as well. Recovery may develop into a boom.ad Maney a4 infaton UNIT 2 Syllabus 2016 — 18 a, Money: — functions and characteristics in 2 modern economy ~_ barter, cash and bank deposits, checks, near money, liquidity b. Inflation Money and inflation cee a raat = deflation and disinflation — measurement of inflation = the causes of inflation (cost-push and ‘demand-pull inflation) — the consequences of inflation AS Level Macroeconomics Notes Book 2 —_—_—_———— Imran Latif Cell; 0300-44-10-900 Imranlatifmalik@gmail.com © 3, Zahoor ahi Road Gulberglt, Lahore Read Geesnord oxcsiue ‘cavitation co SirneptcainsSiop § cowrecirteonMoney andy LTT SS ESL CLF ine Money is anything that is generally acceptable as a means of payment, Normail Of cafe and note bt he defiton seo nudes Donk deposits (which ca debit cards and credit cards), However, money can also be in the form of a gold, platinum or oil, ly, this is cash in y n De accessed by cj valuable commodity he fore, hequi SUCh as History of specialization, trade, and money 1. Self-sufficiency: In the very beginning of human civilization history, people used to relay shelter, ete. There were only hunter-gatherer societies and everyone there was no specialization and trade. 2. Barter trade: y on Natural Sources for food ang was self-sufficient and thereiora ‘When human beings invented agriculture, they settled at certai ‘Specialization resulted in production of surplus goods (in quantitie then were to be exchanged or traded and required certain mech: barter trade (the exchange of goods for goods or swapping). ~ Double coincidence of wants: mean: ie services that the other wants. The need to buy and sell the same time and Creates problems. This is very cumbersome and time-consuming process ~ Exchange rate: The exchange rate is arbitrarily determined In terms of units of account. There is no standard value to follow. ~ _Divisibility: Some goods cannot be divided into smaller units 900d, e.g., part of a buffalo or half of a fruit. ~ Perishables: Some goods are easily perishable, spoilt or will deteriorat and eggs. In the cumbersome process of looking for the right buyer and the good to be exchanged may have perished, ~ Fortability: The problem of having to carry those goods to find the right buyer to do transaction wil always rise, e.g., bulky goods such as bags of rice and firewood, in places and learned specialization S greater than one needed). Surpluses ‘anism for that. Initially people relied oe as this would destroy that particular te, like fruit, vegetables, fish seller to exchange the good, Due to the difficulties faced with barter trade, man developed a new medium of exchange: Money. 3. Commodity money A wide variety of commodities have served as mone} ' at one time or another. Commodities used inglude shells, cattle, tea, sheep, tobacco, etc, co 4. Metallic money aS sf nS ‘Among the metals used were iron, tin, copper, silver, and gold, However, most metals wieMob Scarce to Serve the functions of a good medium of exchange. yy. Set 5. Paper money se © False rine in the receipts issued by goldsmiths to customers who depggtbgiteir money and other Valuables to them for safe keeping. The receipts were issued in smaller di ations. This gave rise to bank notes. Today, we use paper money, e.g., dollar. Paper money is tg predominant form of money in less developed economies, oe Oe efvuatz 39 Money and Inflation 6. Bank money it refers to bank deposits, which are transferable using cheques, debit cards, cred cards or electronic tansfers. Bank deposits are considered as money but not cheques, cards oF electronic transfers. They ven merely orders from the owmer to the banker to transfer his or her money to someone else a oped countries are cashless socielies and they have greater proportion of heir money 19 the form of pank deposits. Concepts Intrinsic value: | though serves as medium of exchange, stil it has its oun value. ‘Commodities and metals were demanded for their own sake because of their intrinsic value, unlike paper money, which only serves the function of money. Legal tender: notes and coins issued by the central bank must be accepted as the medium of exchange (@s itis regulated by law). Itis an offense to refuse to accept legal tender. Liquidity is the extent to which there is an adequate supply of assets that can be turned into cash. Near money: it is quite liquid but not totaly liquid, i.e., non-cash assets that can be quickly turned into cash. watt yould include foreign currencies, credit cards, traveler's cheques, fixed dep’ treasury bills, bonds etc. The public is not obliged to accept them. Near money cat into cash because itis fairly liquid. osits, saving deposits, in be converted easily Treasury Bills: they are short-term loans to the government (lasting for usually 90 days). Treasury bills tan be taken to discount houses to be used as money. It is rather liquid because it can be easily converted into cash. Bills of exchange: these are the bills drawn up by the creditor and presented to the debtor. It is quite fiquid because it can be converted into cash easly (on payment Features of money Here, we will consider what attributes, or characteristics, an asset should have to function as money and Hew iheee attributes faciitate trade and resolves the problems of barter trade: 4. Searelty: The scarcity or limited supply of money helps to maintain its value and perform the basic function of money, ie., act as a medium of exchange, 2. Abseptapility: Money is generally acceptable legal tender (acceptability is enforced by faw) and, theretore, resolves the problem of lack of general acceptability in barter rade 9 4. Divisibility: Large and bulky goods may be difficult to divide, making it difficult to trade Gierent values (6. part of a buffalo or half of a frut)—therefore, reducing the volume: level of epecialization. Money has different values in denomination and, therefore, ma buy and sell goods and services of different values SY 4. Durability: In barter trade some goods lke fruits are perishable and hard to eee ‘on the other hard, is durable and can easily be stored. This is a problem which may af jer money and Pee aeaer extent coins. The chief form of money in a modem society, which igpank’deposits, suffers no physical depreciation whatsoever as it exists only as numbers on a p gus in a computer. 5. Portability: Commodily money and even coins suffer from the disadvayttags that may be dificult to transport A modern bank deposit, however, may be transferred gleckphically from one place 10 another. As 6, Uniformity: Every unit of a product is not necessarily the samghtsive and quality, and, therefore, creates a problem in trade when goods are traded in ginga barter economy. Money, being homogeneous, allows the assigning of different prices for ant sizes and qualities of the same product, eliminating the problem that this creates in barter, thereby stimulating trade.ae Money ang 40 va? in its value. In the past te Ni ble that money should retain i Past this szavitty of value: ICS righ ea hing rere was in relatively stable Supply, suchas 7. ‘monetary Val gm money that it may De affected by ination Funct There are four majo * achieved by ind er geous defects of 1 me it ‘example, made its currency worthless, hyperinfiation in zmbebwe ns oe eal Te mey which has only exchange value and nt in. ores °ceetel voit possi for aud and countertet be kept fo a minimum. 3 value, tions of money? functions of money which can be Ss tion of four sure, deferred, and a store summarized in the following rhyme: Money is a func Amedium, ameas Medium of Exchange: Primary function Money spits a single transa in time and place; thus, it coincidence of wants” means the other is offering for sale. Money facil ‘When money acts as a medium of exchange, ‘a good deal of economic independence and also ‘competition and widening the market. sorarmedium of exchange, money acts as intermediary. it helps production incifectly through specialization and division of labor which, in urn, increase efficiency and output. othe last analysis money facilitates trade. When acting as the intermediary, it helps one good ora service to be traded indirectly for others. The essential characteristic for anything to act as @ medium of exchange Is, scarcity. Not anything, which is not scarce, can act as money. ction of barter into separate transactions of sale and purchase, bth ‘minates the need for a double coincidence of wants. “Dou transaction must want to buy whzt that both parties involved in the itates trade by making it easier to exchange it means that it is generally acceptable and gives us perfects the market mechanism by increasing 2. Measure of Value or unit of account: f values for a product. Every time goods are exchanged 3, Standard of deferred payments (credit payments): In barter trade there may be hundreds of with different products, people need to negofiate a new rate of exchange, and this makes trade extremely dificult and slow. The use of money as a standard of value eliminates the necessity of ‘quoting price of apples in terms of oranges, the price of oranges in terms of nuts, and so on Money expresses the value of each good of service in terms of price; therefore, the problem of ‘no exact value of a product” in barter trade is solved. In barter trade there is no single agreed unit of account to record sales, expenses, or to compute profits and losses; therefore, it is hard to determine the relative profitability of different businesses. Money as a unit of value also facilitates accounting. Assets of all kinds, liabilities otal nds, name of al kinds and expenses of all kinds can be stated in terms of copgnon ‘monetary units to be added or subtracted. The unit of Imaneary units fo be e unit of accounts function helps to mn Be ess Money as a unit of account helps in calculation of eco nomic importance Is the eatmaton of th cose, and revenues of fe business fms, the reiatve costs opacity of public enterprises and projects under a planned economy, and the gr039P) ial product, Ald < O° lebls are taken and repaid in money, as, in the absence of innation orey provides greater certainty of value compared to other forms of i assets. “oo simplifies lending and borrowing transactions for firms,kusesemen, banks, and other » & edit foustig et cena ‘On the other hand, it will ekttetnely difficult to make cr beeen ons and see deb! payments as there wil me Cation basis for setting debts - However, ui ic n However, unanticipated inflation and changes in valuorefbney over time may harm or benetit ‘and weaken the function of mony as a standard of deferred payments.unit 2 a Money and Inflation 10 01 i i fo avercorne ini cious some of the countries have fixed debt contracts in terms of a price index whch measures changes in the value of money. Such confet overtime ‘guarantees the fire evinant or ces by compensating the loser by the same amount of the purchasing power 4, Store of valuefwealth: . ~ Weal poe hire ty aig of assets that one possesses at a point in time. One can store the value Goods, ing bonds, shares, furniture, houses, land, or any other kind of valuable - Me is Money i alee 8 si of wealth and has the advantages of liquidity (ease for being ready to use eaonmees oe 'ange) and no storage cost over the other forms of store of wealth, but a appreciation (on! mo gncome generated (e.g., interest dividend or rents) and less chances of inaation ly if there is deflation). Money rather depreciates in its value in the periods of These tuations of money are vital forthe smooth operation of all economies, If ery of the fun on ieee ie in. age of Zimbabwe, where money lost all meaning as a store of value or wealth— jomic collapse is the inevitable outcome. It is therefore essential that a prudent government puts economic policies in place to ensure that this does not happen \ctions Inflation Inflation means a sustained increase in an economy's price level. Inflation does not mean: = price of a particular product is rising — every product's price is rising = all products prices are rising at the same rate Degrees of inflation Creeping inflation: hlowrand stable rate, of for instance 2%, is generally regarded not to be a problem. Indeed, seeing a low and steady rise in prices may encourage firms to produce more, Such a rate of inflation is sometimes known as creeping inflation. Hyperinflatio Hyperinflation is an extreme form of inflation in which price level rises By, 100s, 1000s and milion times in a year. Effects of hyperinflation: ce Money value falls so rapidly that money loses its function of medium of exchange, and Be le start preferring barter as a system of exchange Ok — Other currencies might be used instead of domestic currency xs oe ~ Economy may collapse : ow we Exampl we At the start of the twenty-first century, Zimbabwe experienced an intan Qa? ‘so high that uGa 2008 anywhere economists had difficulty measuring it. It has been estimated that it re between 200 million per cent and 89 sextrilion per cent. ws Zimbabwe's descent into economic catastrophe was a long, dra uiSifair. Following a drop in agricultural production after controversial land seizures, expo Resse foreign investors went elsewhere. The government sought to solve its liquidity proble jorrowing from foreign banks, knowing that it could not meet its loan repayments. The ggGretent made the situation worse by printing more money, much of which was used to pay the affmyolice, and civil servants. Eventually, pr Teached tore. than one milion per cent and local people lost all confidence in theeo Money at uy a tne county decision It 2000 0 com eat ur na US dolar tral ansactin pound. OT Negative f inflation is constant or increases even if rate 0! ras long as rate of ination is falling. {arn pation rate is zer0 price lave! stays unchanged Wren rate of ination is negative, price level falls even if ral se ong as rate of inftation is postive, Pree level is lowest in first y = AS jong as rate of inflation is negative price revel is highest in first +e of inflation is constant or falling ‘ear and highest on last year. year and lowest in last Rate of inflation (7) ie year was the price level at its highest? © Xi a wh year was the rate of inflation at its highest? a ih year was the price level atts lowest? year was the rate of inflat lowes! neh ion at its lowest? (ignori fn wt year did the price level fall for the first an aa ‘year did the rate of inflation fall for the first time? eeunt? a3 Money and inflation Measurement of Inflation / Value of Money / Cost of Living ‘consumer price index (CPI) is an index that shows the average change in the prices of a representative basket of products purchased by households. Cost of living means how much it costs to live in a country. ‘Acountry’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 ‘consumer price indices. There are a number of stages in doing this 4, Selecting a base year and current year: = Current year is the one whose rate of inflation is to be measured. - Base year is the standard year with which rest of years prices are compared. = Anormal economic year in which there are no political or economic balances should be taken as Base Year. Price level in base year is represented by 100. 2, Selection of basket of goods and services: = To show the changes in general price level, itis simply impossible to record and calculate tne ptice changes of all the goods and services (which are even more than millions) produced in country, = Therefore, by using the statistical technique of sampling almost a basket of 300 to 600 goods and services should be selected for indication in changes in general price level. — Goods and services that an average family uses like fuel, clothing, food etc should be included in the selected basket of goods and services, Those goods and services which are used by @ very limited group of people will not be taken in the selected basket of goods and services. 3. Collection of price data: Statistical department of government collects information about the prices in base year as well as current year. This information about prices of selected basket of goods is collected from retail outlets, news papers, price lists and co-operative society's offices etc. Index (or price relatives) is calculated by: Current Year Price ,. Base Year Price 100 Index = 5, Assigning weights: Consumers spend much more oftheir incomes on certain goods and services and these should be given greater Imporanee in the index. For instance, if on average households spend $500 of their total ‘expenditure of $2,000 on food, the category will be given a ‘weight of 'A or 25%, Commodities should be given a weight which reflects their relative importance in the consumer spending expenditure onthe good ‘Total Expenditure Weight = 100 6, Calculating weighted index: Weights are multiplied by indexes to calculate weighted indexes. Weighted Index = Index x Weight 7.CPL CPI is obtained by taking sum of all weighted indexes and dividing it by total weight, we? p< TamtWosed nex Co Total Weights — SS 8. Rate of inflation s Rate of inflation is calculated by taking percentage change in cusfehtJear average prices (ie. RPI of current year) to the base year average prices (i.¢., RPI of base .Money a» __cPhy-chhs Rate of inflation = oh x 100 end = CPI of the base year / wrere cPtz= Coe et aye 100, so we can write rate of inflation as: that As we know Rate of inflation = CPI, -CPlr aces categoriced into 3 broad groups. ie. A, B and C. Their base year piece 520 goes 92001 ra ipenged $6, 311, $7. Average families inthe country speng 5 eek reso an goods B and $3000 on C. Calculate rate of inflation on | ae RC oy a Poet en an re faite ed ae | a | ss | 8 s4oo0 | 4o00/10000% 100=40 | 921.5 | 40 x120= aan. 11/10 x ~ ; 8 $10 si $3000 3000/10000 x 100 = 30 400 = 110 bas *110 = 3300 4/5 x 100 = Cc | $5 4 $3000 3000/10000 x 100 = 30 eet 30 « 80 = 2400 TOTAL = $10000 = 100 = 10500 __] CPI of Current year }0500/100 =105 Rate of inflation = CPlz - CPI: =105 — 100 = 5% (ANS) Problems of constructing Consumer Price Index (limitations of the Price Index) 4. Selection of base year: The questions that arise are: "Normal to what extent?” “No inflation, no deflation, no high unemployment, no political instability?” “What is an ideal year?" It is not easy to decide. Hence, it is not an arbitrary selection. 2. Selection of basket of goods: Again, this depends on what is essential and what is not. Often the goods selected are normally refiective of a certain class, and hence they are not representative of the whole population. The views of upper class and the lower class will be different. Even within the same class, there are still differences in perception. 3. Prices of the selected goods: Prices fluctuate from day to day. The rage may be very wide, for example, $5 to $50. We will then have difficulty in determining the average price. Moreover, for some comments, such as rice, theres a question of which grad to choose. Again, selection is arbivary 4. Weights: The relative importance of the goods, i.e., the proportion of income spent on. (abd. om ses, is Different people have different scales of preference. Moreover, when a person's inc the proportion spent on different goods will change; more may be spent on entertai jan on necessities. Wr’ vax 5. Sampling Errors: The consumer price index is not an exact measurement € Pree changes. It is subject to sampling errors which cause it to deviate somewhat from the resyjtgthatwould be obtained if actual records of all retail purchases could be used to complete the it ese sampling errors are unavoidable. They could be reduced by using much larger sample xo" s Inaccurate Information: People who give information do not always“eSort ist accurately. The statistics bureau makes every effort to keep these errors to a minimum, Sechrest them iienaver they are subsequently discovered, eeComparison overtine: becauine: Now products may have entered the markets {tis difficult to cor brpare (0 compare prices overtime. We SONAUNEL price thd. wi . F he;, biaty v MW the 1980 consumer price index, Le. between long period of times Menery aris inftation cannot prepare the 2016 Necensition may have changed and (mass rapid transit) Fashion and tanton may have changed Spending habits may have changed Quality may have improved Income changos s. Compari c ; & Comparison betwoon countries: It is even more dificult to compare consumer price index of one county with another be Base year differen Differences in basket of goods Prices of selected goods diffor Differences in weightage 0 of Conclusion A price index is a mere approximation. Human error in compiling, recording and analyzing data can never be totally absent. However, despite these limitations, it is still the best yardstick available to measure changes in the general price level and the value of money. The causes of Inflation There are two causes of inflation: = Demand-pull Inflation = Cost-push Inflation Demand-pull Inflation (ere Meaning: | if there is too much demand in the economy relative to | the supply of goods and services, prices will rise and this | type of inflation is known as demand-pull infiation. Cost-push inflation describes a situation where the process of rising prices is initiated and sustained by rising costs which push the prices up. Explanation: Demand-pull inflation can ocour when: Economy is below full employment — Economy is already at full employment When the economy is initially operating below full employment, increase in AD will lead to increased prices as well as real GDP. It can be shown by the following figure: Explanation: If cost of production rises (say trade union demands for higher wages), fall in ie it margin of producers will lead to f from ASo to AS: as shown ine toure below. Price level will rise fro RIO Ps, and note that GDP will alstiyelf om Yo to Ys. @ Ser © dhe producers to cut short their pr resulting into co- existence 9f, loyment with inflation. ‘ This sit se known as stagflation or Higher costs will slumpfl g aeIt the aggregate demand curve intersects the aggregate supply curve prior to output rate Ys, then any increase in demand will not load to a rise in the price level, Thus 2 Shift from ADo to ADs loaves the price level unaltered at Pa, A shift from ADi to ADz, however, will cause the price Jevel to increase Ps, After output rate Yz, any Increuse in demand will simply result in a higher price level since, by definition, at full capacity output no more output is physically possible. ‘Arise in aggregate demand will have a greater impact on the price level, the closer the economy comes to full capacity. Determinants: Excessive demand in the economy may be due to: Too much consumer spending (because of excessive Income, lower Interest, more credit availabilty, more wealth, expected Increase in future incomes and prices etc.) Too much capltal investment (because of lower Ingres! ral, business optim, beter techno. political and social stabllty, government investment friendly policies ete) 3 ‘ment Too much government spending on merit goods, public goods infrastructure ete and reduced taxation (Expansionary fiscal measures or budget defi) 1. Mer Determinants: ‘This may be due to increases in: Raw-materials. may expensive if there is a shortage of raw. materials Wages may rise because of powerty trade unions Government may impose high taxes to cover its budget deficit. An increase in indirect taxation (i., tax on goods and services) is another way of giving the general price level on inflationary ‘push’. Increase in sales tax, VAT etc will raise the cost of production and fall in AS, consequently a rise in general price level. 4 Inflation caused by rising i is sometimes referred Inflation. Prices of NY materials and oil may depreciation in th x% moa ‘economists argue @tCost-push inflation is an sie ‘cost (i.e., wages). Wages Ingle element in total cost. is rise faster than productivity (ol unit of input) labor cost will raw rise due to | oRange rate However that main incredse and so will prices because of fallunit2 a7 [4 Sudden increase in demand for exports and fall n Sudden increas for export demand for imports (e.g., be tol ieee .9., because of fall in vah | sameste cure, charges quai, tse ad fashion and international economic activities etc) . 5, Monetarists argue that the ke} ca aggregate demand is increases inthe mona sone | They suggest that if the money supply grows more rapidly than output, the greater supply of money will drive up the price level, bes os Money anv ilation in AS. | Effects: |Demand-pull inflation is assoc it iated with | unemployment because excess demand in the economy | leads to increased production and employment. There ¢ a tradeoff between demand-pull _ inflati i unemployment. aton and Wage-price spiral Higher wages can cause a wage-price spiral. Workers gain a wage rise, which causes increase, causing workers to seek higher wages to restore their real value, and so on. explained as follows: wages. — If wages may increase more than lal occurs. Other groups will demand higher wages bec: to re-instigate itself and known as wage price spiral. - Everyone becomes at of living ~ Eventually, pensions and so on would rise by 10%. This could tum into hyperinflation (if it gets out ose confidence in their domestic currency. Once infiation is underway, it is difficult to determine expenditure may be increasing the result of demand-pull or cost-push factors. The consequences of Inflation Costs: Inflation affects different people differe the society gain, some lose and some si — The rate at which it is rising — Whether the rate is accelerat — Whether the rate is the one wi — How the rate compares wit! ling or stable ‘ccustomed to living with inflation and become anxious to maint prices and incomes may become indexed; every time pri but it may be hard to tell whict tly. When price rises or the value of mone tand in between. The effects of ihn mn: ich had been expected , © th that in other countries > Effects: 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. prices to It can be When prices rise, people find that their real incomes are falling and thus, they will demand higher i bor productivity and so result in a rise in labor costs, the price of goods and services they produce would increase (cost-push inflation) With higher wages they have more spending power, so demand increases .s and demand-pull inflation ‘ause they see prices rising and this will cause the cycle their standard ices rise by 10%, incomes, rents, of control) and the economy would collapse as people its cause. For instance, wages and consumer h occurred first and so whether inflation is Se Ox e48 Monoy an met tribution of Income and wealth. There are many gio, frects on the distribution of Inco 's major effects is on the redis| eno Il receive the same amount ich suffer due to in Although they wi to ore aie al oi re rece Jess as the value of money has fallon, tn tems, they wil wand other white collar people AlSO IOSe When there Siow to adjust when prices are rising. vi ifation as their salaries are ted by Inflation is fixed income groups Such people , negatively affected by Infaton Sn vcomes elc. Pensioners to ecu, interest and." f nts of pensions ae as Akh miementsofinerest and rent. These persons lose in paring fixed pension and renter ce a receive now will be less in real terms 28 value of money fas ¢ sr infation as the income a other hand, businessmen, Industrials, traders, real estate holders, speculators ang - sai incomes gain during rising prices ; rea debtor gains ee rpense of households who are its principal creditor, others with var - The government as @ tees on the govemment bonds are fixed and are not raised to offset rales OF ert als. Also its easier to pay back debt to general publi as This is because inte expected rise in prices ar has less real value. Tene can be a transfer of income from private sector to the government through fiscal drag and bracket creep. In a fiscal drag, those individuals who were previously in the tax exempted bracket of inflation, In a bracket creep, those individuals would be dragged into tax brackets during times who were prewousi Th lower tax bracket would creep to higher tax brackets due to an increase in rae wernnal incomes inthe period of inflaon, It can be argued, however, that this is @ cost of an inefficient tax system rather than a cost of inflation 2. Effects on production: Inflation has adverse affects on production. =. Firstly, there is misallocation of resources. Pro Ney y arg ducers may divert resources from the production of areal items to non-essential Items to expect higher profits. There may be reduction in production as expectation of rising prices alongside rising costs if inputs bring uncertainty — There will be hoarding and black marketing. Producers will create artificial shortages in the market by hoarding up stocks of commodities and consequently sell their products in the black market, which gives rise to inflationary pressures. Unanticipated inflation can create uncertainty and so make it more difficult for firms to plan ahead ‘This may dissuade firms from investing, which will have an adverse effect on economic growth. Inflation also reduces foreign investment because of rising costs of materials and other inputs. = Menu costs are the costs involved in changing prices. For example, catalogues, price tags, bat ‘codes and advertisements have to be changed. This involves staff time and is unpopular with customers. However, itis viewed as a small cost to the society. o ~ Shoe leather costs are the costs involved in moving money from one financial institution tage Ks) in search of the highest rate of interest. x5 Ono 3, External Effects (on exchange rate and balance of payments): oe = _ Inflation affects adversely on the balance of payments. When prices rise in tht peony than in fs. This tends 10 foreign countries, domestic products become . 2 ’e More costly than fc Wer Hee soe anos rae thus having an Unfavorable balaneg ents. = re rapidly in the h it i rate i telation b foreign carenciegs ey Meat i foreign count lowers the exchange ss cS Pg ifuse price signals. Inflation can in the price of a product may not 4. Inflationary noise or money illusion: This arises when inflation causes const umers and ‘make it difficult to assess what is happening to relatve| io Tian that it has become more expensive relative to other products. Indeed, the product may have gen in price by less than inflation and so may have become relatively cheaper. Infationary noise 22" resull in consumers and firms making the wrong decisions. For example, firms seeing the price their products rising may increase output when the higher price 1s the result of mfiation rather then increased demand for their products, This may result in a misallocation of resources, 5. Inflation causing inflation: Inflation may generate further inflation as consumers, workers and firms will come to expect prices rise. As a result, they may act in a way that will cause inflation. For example, workers may press fo" higher wages, firms may raise prices to cover expected higher costs and consumers "ay seek purchase products now before their prices rise further. If prices start to rise at an abnormal aie creating a hyperinflation situation, then there is fear of an eventual collapse of the monetary syste 6. Effects of inflation on functions of money: Infiation affects the functions of money in a number of ways. — If the inflation rate is slow, that is there is mild or creeping inflation (1 % to 3 %) and * 's aso anticipated (expected), then only the store of wealth function of money will be weakened. \t 7 ‘would not be beneficial for the people to save in terms of money .As the inflation rate is Siow 30¢ anticipated, there would not be a greater instability in value of money and it will continue {© PE used as a standard of deferred of payments. People will continue to record their transactons > the same currency and will keep on using current money as medium of exchange. = If inflation rate of the country is high and unanticipated, the function of money as a store of wealth will be weakened once again. Apart from this, the function of money as a standard of deferred payment will also be weakened. With high and unanticipated, the value of money wou fall and the lenders would suffer. Thus, they would be discouraged to make transactions re\ated to deferred payments. — Ifthe inflation rate of a country is extremely high, that is more than 100% and the country is fSoS hyperinflation, then all the four functions of money will be lost, The intemal value of cumency would fall at a great extent and this would detarionate its function as a measure of value and medium of exchange, There would be no stability in its valuo and it would be stopped using as 2 standard of deferred payments. It would also not ba usad as a store of wealth, Thus the monetary systems would collapse and the economy might revert to barter trade of Use fOreITN CUTENEES. but its dotenoration will depend Oy Thus, the inflation affects the functions of monay in a negative the rate of inflation and its anticlpations, ffocts: 7. Political and socit a Inflation is also socially harmful Rising prices also encourage agitation and protests by politleal partian’ opposed NY the government x Gath increase in disparity betwoon rich and poor dua to rising price, there WG sy discontent ment among tho masses we With rung coute of livin, wotkore rawor 0 stow why aed to owe in patintigOss Corruption spreads in evory walk of Ita, Wy Ya However, A would bo unjustitied to say thal Inflation only haw negative aay} Now ave ene cnestionss which prove thal inflation Is nol always bal yo eo Bonofits oe \) has geAnniial baielts includes 2. a we 4, Aimulating output: / low and wtable (nflation tale Gaia nbstoveetyy cosy anne ane MN food opicristic, about the future. (ny addition, IP piioem tive Move aay cnn, |auatitn AMA GR, mhichs aol prc San for inven| Reduce the burden of debt: During the petiod of inflation, real Intaraat ratow may fall of my, al interest rates do hot tend to Ase In hive with Devoe negattive This ts because nominal interwat rates do Hol len iran resol dedt burdens may fall. For example, those who have borrowed money 10 buy a hoe AM ene a tall in their mortgage payments in real terms, Likewise, @ COUntY'S ng resayments are reduced in mal terms, A reduction in the debt burden may atimulate oo expenditure that, in tum, could lead to higher output and employment um 3. Prevent some unemployment: Firms in difficulties may have (o taduce their costs to ‘survhy many firms, wages form a significant proportion of their total costs. With Zero inflation, fms me, ‘9 cut their labor force. However, inflation would enable them {0 reduce the real costs of ig either Keeping nominal (money) wages constant or by not raising them in ling With inflation (yy inflation, workers with strong bargaining power are mora likaly 10 bo abla to resist cuts in they, (0a) wages than workers who lack bargaining power. For Y have 4. Another group of people which gains from inflation are businessmen of all {yp98, such as prody traders, etc. When prices rise, the value of producers’ stocks wil Increase In the same pronation yy they will profit more when they sell stored commodities. 5. Further, inflation is not as bad as doflation is, |e., opposite to Inflation, Factors affecting the consequences of Inflation: The effects of inflation depend on: ~ its rate whether the rate is accelerating or stable - whether the rate is the one that has been expected — how the rate compares with that of other countries. 1. 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 iy associated with falling output. 2. The rate of inflation: A high rate of inflation is likely to cause more damage than a low rate especially ifthe high rate develops into hyperinflation, Indeed, hyperinflation can lead to households and firms losing faith in the currency and may bring down a government. 3. Stable or accelerating rate of inflation: An accelerating inflation rate, and indeed even a fluctuating inflation rate, will cause uncertainty and may discourage firms from undertaking investment. They eed to devote more time and effort to establishing future inflation will Increase costs. 4, Anticipated or unanticipated inflation: Unanticipated inflation, which occurs when the inflat was different from that expected, can also create uncertainty and 60 can discourage 601 expenditure and investment. In contrast, if households, firms and the government anticipated inflation, they can take measures to adapt to it and so avoid some of its effects. For instance, firms may have adjusted their prices, nominal interest 1 changed to maintain real interest rates and the government may have adju pensions and public sector wages in line with inflation, se 5. Relative inflation rate to trading partners: It is possible for a cou Me. vest high rae Of infation but if tis below that of rival trading partners, its products more international competitive. Anticipated and unanticipated inflation and indexation oe Anticipated—expected rate of inflation ee Unanticipated—unexpected rate of inflationo erony wees ities sage bakes aSsets—whose rwal value dows not change with inflation uch mfapon s unaateipated; households, finms and government are uncertain what the rate of mifistion Wivye n MAee When planning, they therofore have {o estimate as best they can the expected rate of g's umAeY that they Will guess correctly and hence their plans will be to sore enent (usaied Y Ae mand. inflabon may be anticipated. Inflation may be a constant 6% per year and theretore SUsacs. fms and government are able to buildin this figure to their plans. cnsnpeseted ination imposes far greater costs than anticipated inflation. If inflation & anticipated SSSSe egents can take steps to mitigate the effects of inflation. One way of doing this is through SSoxaton. Ths is where economic variables like wages or taxes are increased in line with inflation. For SSENS'T union might negotiate a wage agreement with an employer for staged increases V6" & yea of CSSSS Re thange in the Consumer Price Index. The annual changes in social security benefits the Ux 3 linked to the Consumer Price Index. ccnomisis ate divided about whether indexation provides a solution to the problem of ination One the eine. i reduces many of the costs of inflation although some cosis such as shoe eater costs, TaN] costs remain. On the other hand, it reduces the pressure on government to tackle the problem but is not a cure for it loreover, indexation may hinder government attempts to reduce inflation because indexeton builds in ve tructures, such as wage increases, which reflect past changes in prices. If a government wants to cost estan down to 2% a year, and inflation has just been 10%, it wll not be helped in achieving its arget f workers are all awarded at least 10% wage increases because of indexation ‘agreement. Why it is important to have accurate statistics of inflation? 4, Inflation is @ central economic target. If the statistics are inaccurate the direction and level of action (macroeconomic policy) may be inappropriate and may worsen the position, 2. Intotion figures are a means by which the success of current policy can be judged Inaccurate figures of inflation may understate or overstate the success of government macroeconomic policy. a eek ef ust of the statistics may undermine the acceptance of policies and their effectiveness. sds unions and firs may anticipate more than actual inflation, which my build wage-price spiral 4. 1a used to assess the elfects on the distribution of income of the people in the country. Certain group of people will gan with rising prices atthe expense of others. Among those who will gain with fang pres are the businessmen and the shareholders, Those who do not benefit are pensioners, oent individuals and the bondholders. With such effect, the gap between the rich and the poor will be widened and the government should take positive steps to reduce such income inequality. However inaccurate statistics will make it dificult for government to define appropriate cost of lying allowance. 5, Itis-2 basses for future contracts between creditors and debtors. With rising prices, th will gain (ie, they are losing less purchasing power). Hence, it should be maintained that rs Ste repaid with at least the same purchasing power, in terms of real income. To co tS for the loss ih real income, the debtors are charged an interest, which includes inflatighSpempensation. However, inaccurate inflation statistics will make either of the group losers a 6. With rising cost of living, the consumers’ real income will fll. When the gene! riePlevel increases, real income will decrease. The trade unions must step in to demand for m: Ney income so as tO Get the increase in general price level. Accurate inflation statistics wilke netied for that purpose Gtherwise trade unions may end up with either too high or too low denfalidgffor the wage increase. 7. Errors may be made in planning and real values may not be maintaiféd aS 8. There will be a fall in business confidence resulting into fall in invegsmaht. Oe eegece level. Deflation involves a negative inflation ra eatanes 1 ue of mney, with each cutrency unit having greater purchaci: tad deflation depending upon the cause of deflation Mone Ha for ex, 8 wma tion sequences of defla Causes and con ome ee oe eer be gr axtaticn 3nd Ci Bad deflation takes place when the price levels arn supply. Figure below from, an iezease m aggregate SUPP | pensting ma Yah in the price level and 2 rise in real GOP. | Price Level ° Y, Y, Real GDP Effects: ‘Advances in technology, for instance, may create new methods of production and lower costs of production, As well as output increasing, employment may rise and the international competitiveness of the country's products may increase. down by a fallin aggregate demand as shown in fi, below. ° Price Level YY Real GDP’ Effects: 4.Deflation causes real wage to rise, which tends to raise unemployment and reduce profit, which, in ur, triggers investment fall and thereby a fallin AD and income and increase in unemployment 2.Deflation leads to an increase in real interest rate, | which tends to raise the cost of debt and thereby discourages investment, causing income to fall and unemployment to rise. ‘3.Deflation causes the expected price to fall, which, in turn, causes consumption and investment to fall and aggregate supply to rise. The latter two events reinforce each other to cause price to fall futher developing nto a deflationary spiral ‘A.May result in menu costs. g 5.Deflaion will increase the burden of cope h borrowers and government. e The above factors are obviously very hi ‘economy and therefore all governme their best to ‘overcome the deftationary threat ee) oO we okwt —4y Money and Inftaion pasT PAPER QUESTIONS Laura +0 a ey ily (Nov 2015/P22/Q3/a) Explain what is meant by the term mo, (Jun 2014/P21/Q4/a), (Jun 2 orapasaae ils characteristics in a modern economy (el Explain what is meant by the term ‘mone la) economy, ey’ and outline its characteristics in a modern twenty-first century (June 2012/21/Q2/a) cy) Explain why all types of economic s faune 2040124102") stem benefit from the existence and use of money. @ piscuss how the operation of ab: (Nov 2008/Q2/a) arter economy would be affected by the introduction of money. 121 Explain the characteristics re foune 1996/a) ‘duired by money if its to carry out its functions effectively. (8) iM Explain why economies make use of money, oy ook ay (June 2016/P23/Q3/a) aggregate de id Use aa a fis Seren and aggregate supply analysis to distinguish between cost-push and demand- Pal (Specimen Paper 2016/P2/3/a) Define the components of aggregate demand and, with the help of a diagram, explain how an increase in spending in an economy might result in inflation, 8 (Nov 2015/P21/Q3/a) With the help of diagrams, explain how both cost-push and demand-pull inflation can be caused by @ faling exchange rate. @ (June 2015/P23/Q4/a) Define each component of aggregate demand and, using a diagram, show how a reduction in one of these components might reduce inflationary pressure in an economy. @ (June 2015/P21/Q4/a) Explain what acts as money in a modern economy and what is likely to happen to the price level if the quantity of money increases significantly. 8] (Nov 2014/P23/Q3/a) Explain why an increase in the money supply and rising world energy prices are categorized as gee causes of inflation in an economy. Oo (Nov 2014/P22/Q4/b) ro Discuss whether inflation is more likely to be caused ty a shift in an economy's. wget ora shiftin its aggregate supply. (Jun 2014/P22/Q4/a) 2 sy" Using diagrams, explain the difference between demand-pull and cost-push megs fin 8 (Jun 2014/P22/Q4/b) Distinguish between the domestic and external consequences of erage wich is most damaging to an economy. G6 < (12) (June 2013/P22/Q3/a) Define the components of aggregate demand and, with the help of ghee ‘explain how an increase in spending in an economy might result in inflation. Qe as (8)nit 2 in aggregate Geman, to thay to have an IMpRaCH om ” Wthatven, . f ease is more tty ale supply (AS) diagram, the ‘hen mand (AD) and agi ‘on real output B ind-pull inflation in the existence of mfiztran m TE hee e 2012/P23/04/3) a . ee does pate cemand and aaa" eae supply analysis expla cn a) ts Nov 2010/P23/03'b) 5s be ex whether rapid inflation can De caused only by government actions. a (Sune 2011/P22/04/b) ; 4 fears inet isthe behaviour of Producers consumers or governments that IS Maat Italy to cya infiation y (June 2010/23/03/b) | Siecuss whether inflaton is more iKelY to be caused by domestic OF international influences ‘i (June 2008/03/b) Discuss whether @ widespread shortage of labor might be 2 major cause Of inftation, 13 (Nov 2006/04/a) Explain the difference between cost-push inflation and demand-pul inftation. ” (Nov 2001) (2) ; Explain the different between cost Push inflation and demand-pull inflation. 19) (Nov 2001/2) Explain what causes inflation. 0 (Nov 1999/a) {in recent year, the rate of inflation in many countries has been low. Guggest possible rezones why an inflation rate may be low. (June 1998) anUK. the growth in retail sales in the year ending Jne 1996 was higher than expected. () Would you suppor the implication of tis at Stement than infiation is caused by consumer spending?) (June 1994/0) Eiplein the meaning ofthe phrase fal in infetion’ and discuss what might cause a fallin infiztion. [15] (Nov 1992) may experience a persistent rise in its general price level 6 Explain why 2 country acy Pr cd (Specimen Paper 2046/P2/03/b) IP saa vie tts green sal be eee ome) 1 an economy is expesiencing infatios ‘about the enernal effects of infition than its effects within the dornestic economy. Ss ys (Nov 2015/P21/Q3/b) Distinguish between the doses! amaginn Wo an economy, 2s exes consquences ot tation and cS ave ne mae (June 2016/P23/Q4/b) we Discuss the inpaca of a high rate of inflation on ¢ mrp ny Aptis Zan ecomomy and assess (dune 20421722103) 113) an economny ie experiencing ifiation, discuss exten , the HAST nel ohacts Was ks elec withthe coment 4 nent shoul be more concern