Giovannie Alvarez

Form 5
Economics

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The Role of Government

Government Macroeconomic Objectives/Problems includes managing economic growth,

unemployment, price stability (inflation/recession), balance of payments and exchange rate
stability.
Governments attempt to manage the circular flow of income to achieve their macroeconomic
goals or to manage the macro-economic problems faced by their economies.
The instruments used includes monetary policy, fiscal policy, Interventionist or direct
policies (minimum wages and price controls), trade policies (tariffs on imports, quotas which
limits the amount of a good that can be imported, embargoes which ban any imports from a
country to name a few) and exchange rate policy.

Circular Flow of Income involves Firms, Households and Government. The economic activity
which takes place between all three makes up the circular flow of income which involves:

The productive services from households provided to firms to engage in production.

From production in the firms, goods and services are produced for the households
(National Output/Product).
The firms pay the households for their services in the form of rent, interest, profits and
wages (National Income/Rewards for the FOP).
The households in turn pay firms for the goods and services they purchase (National
Expenditure).
With the introduction of government and foreign economies into the flow of money, this resulted
in injections and leakages occurring within the economy. (Draw Diagram to Illustrate).

Injections:

On the firm side this involves Investments/Capital Accumulation, Government

Spending and Exports. While on the household side this involves Government
Spending on Services.
Leakages:

On the firms and households’ sides this involves Savings, Taxes and Imports.

This total flow of money in the economy is termed as National Product, i.e., the total
production of goods and services. The flow of payments in the other direction is known as
Total Expenditure.

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If there is an increase in the circular flow of income there would be an expansionary effect on the
level of economic activity as Injections Increase and Withdrawal Decrease. Whereas if there is a
decrease in the circular flow of income there would be a contractionary effect on the circular
flow of income as Injections Reduce and Withdrawals Increase.

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Economic Growth refers to the increase in Real per Capita GDP per head of population.
Real GDP is the total value of all final goods and services produced in an economy within a
year using a base year price to value goods and services to eliminate the effect of inflation.

In other words, Economic Growth can be defined as an increase in the output of final goods and
services with a year, a valued using a base year price to eliminate the effect of inflation.
Economic growth may be positive which is indicated by the outward movement of the PPF,
constant where there is no change from period to period, or negative where the PPF shifts
inwards

Economic growth may result due the following factors:

 The availability of land (land, water and other natural resources) allowing for increased
production ceteris paribus. Finding new resources of natural resources will lead to an
outward shift in the PPF, as more production can take place leading to positive economic
growth.

 A skilled and professional labor force leads to higher productivity which can contribute
to economic growth, ceteris paribus. This may result due to availability of affordable
education and training as well as the migration of skilled and professional individuals
into a country in search of better jobs and a higher SOL. Such actions may increase the
available skilled and professional labor which can lead to positive economic growth.

 Increased availability of capital to be used in production allowing for greater

productivity and an increase in or positive economic growth as indicated by an outward
shift in the PPF.

 Technical advancement allowing for better machinery and equipment as well as

improved communication to enhance productivity and increasing economic growth.

 An increase in Entrepreneurship and innovation which would lead to the

establishment of new businesses to increase GDP allowing for positive economic growth
to occur.

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Economic development refers to great improvements in the quality of life of citizens which
may result from continuous economic growth, improved education and health care, as well as
conservation of the environment. It results in the creation of economic wealth for all citizens
so everyone has improved quality of wealth.
Economic development may be indicated by:
 Increase in Real Per Capita GDP
 Movement towards more Secondary and Tertiary Production
 Increased access to healthcare services
 Increased access to education
 Infrastructure development allowing for implementation of a modern transportation
and communication network
 Low levels of negative externalities
Two Measures of Economic Development:
 Human Development Index focuses on life expectancy, literacy rates and adjusted real
income to determine the quality of life of citizens.

 Human Poverty Index looks at how many people die before 40, the percentage of
illiterate adults, the percentage of individuals without access to good water and proper
health services, and the percentage of children under 5 who may be suffering from
malnutrition.

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Reasons why countries remain poor and underdeveloped:
 Insufficient natural resources
 Lack of human capital
 Attitudes and culture of the people
 Behavior in the elite groups in society
 High birth rates and population growth rates
 Breakdown of law

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Difference Between Developed and Developing Economies:

 Developing countries have high per capita GDP as compared to developing countries
 Developed countries have higher literacy rates
 Developed countries have better healthcare, education services and infrastructure
 Developed countries are fully industrialized having primary, secondary and tertiary
sectors as compared to developing countries which rely heavily on the primary and
tourism sectors. However, today the developed countries have moved their production
facilities to lesser developed countries due to lower wage rates.
 Standard of Living tends to be higher in developed countries
 Resources are more effectively and efficiently used in developed countries
 Birth and death rates tend to be lower in developed countries

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Solutions to Problems faced by Developing Countries:

 Develop Secondary and Tertiary Sectors to encourage full industrialization

 Make education more accessible to all allowing for more productive labour force
 Encourage more savings and investments to encourage more economic development
 Manage population growth to reduce the burden on government who can focus more on
economic growth and development rather than providing for the unemployed and poor

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Economic growth can lead to positive effects such as improved SOL, economic development,
technological improvements, increased employment and poverty reduction. However it may
lead to negative effects such as pollution due to increased production, and depletion of resources
as businesses main focus would be on profit generation and not conservation.

Governments can use Fiscal and Monetary Policies to encourage an expansionary or

contractionary effect of the circular flow of income to achieve their Macro-Economic Objectives
or to Manage the Macro-Economic Problems faced by the economy.

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FISCAL POLICY

This is concerned mainly with influencing the demand for goods and services by
manipulating Government Spending and/or Taxation. They finance their activities by tax
revenue, fees for services provided such as license fee and so on, borrowing locally from banks
or internationally from World Bank, International Monetary Fund (IMF), and so on.

Government can run a Surplus or Deficit Budget. When they are running a Surplus budget, it
suggests that government is earning more money that it intends to spend in the next financial
year. If, however they are running a Deficit budget it suggests that they are spending more than
they are earning.

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If the economy is in a situation where they may be experiencing high levels of unemployment
due to a lack of demand the government may attempt to stimulate economic activity by
increasing its Government Spending. In so doing they would encourage more projects to be
initiated in the economy and thereby causing businesses to increase their production and hence
increasing employment in the economy. Individuals will thus have more disposable income and
further increase the demand for goods/services or economic activity in the economy.

The increased in government spending (expansionary fiscal policy) would be easily financed if
the government is running a surplus budget. If this has been the case over a number of years it is
anticipated that government would have increased their foreign exchange reserves which would
have been used to finance their increased spending. If, however, the government was running a
deficit budget the increased government expenditure would have to be financed by borrowing via
Monetary Policy Open Market Operations to be more effective. Therefore, an expansionary
fiscal policy may be made more effective by also pursuing an expansionary monetary policy
simultaneously.

If the economy was experiencing demand pull inflation where the economy was experiencing a
boom the government may attempt to pursue a contractionary fiscal policy by reducing
Government Spending. This would thus cause a reduction in production domestically as well as
an increase in unemployment reducing demand and relieving the demand-pull inflation.

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TAXATION

This increase or decreases the disposable income of businesses and/or individuals which may
influence the demand or supply of goods/services. To pursue an expansionary fiscal policy
government may reduce taxes such as PAYE/Corporate Taxes or even tariffs/VAT to increase
disposable income and thus increase demand/supply of goods/services. To pursue a
contractionary fiscal policy government may have to increase taxes to reduce demand/supply.

The effectiveness of such policies however depends on the price elasticity of demand for
goods/services. For instance, if the demand for imports is inelastic an increase in taxes may not
necessarily reduce the demand for imports but allow government to increase their revenue
generated.

Tax is defined as a financial obligation where a fee is levied by government on income, goods
and production of goods and services. It is governments main source of revenue and are
classified as Direct or Indirect Taxes.

A Direct Tax is one where the taxpayer bears the burden of payment required. Examples of
direct taxes includes:

 Income Tax/Pay As You Earn (PAYE) paid on wages/salaries earned

 Corporate Tax paid on profits earned by businesses
 Capital Gains Tax based on the proceeds resulting from sale of assets such as house and
land
 Stamp Duty levied on documents such as a tax that you must pay when carrying out
certain transactions that require legal documents. Deeds of Conveyance, Deeds of Gift,
Deeds of Mortgage, Release of Mortgage Loan, Release of Life Insurance Policies,
Transfer of Shares, Deeds of Lease, Deed Polls, Bonds, and any other deeds, require
“stamping”, which means you must pay duty.

Whereas an Indirect Tax is one where the burden of the tax is shared and only faced when
individuals engage in certain activities. Examples include Value Added Tax (VAT), Excise
Duties levied on manufactured goods as soon as they are manufactured and Customs
Duties/Tariff is a tax levied on goods imported.

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Taxes may also be classified as follows:

 Proportional tax is one where the rate of taxation is fixed no matter how much you earn,
i.e., everyone pays the same percentage of tax no matter how much they earn.
Advantages of Proportional Tax Regime:
o Considered to be fair as everyone pays the same percentage/rate
o Tax administration and collection becomes simple
Disadvantages of Proportional Tax Regime:
o Does not result in equality as the burden falls more on the poor
o It is less productive as it will contribute little to the government as the majority of
taxpayers would fall in the poor category

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 Progressive Tax Regime suggests the more you earn the more taxes you pay. This
would generate more revenue for government from the higher income groups as persons
with lower income pay a smaller percentage of their income in taxes.
Advantages of Progressive Tax Regime:
o Fairness of this system is based on the fact that those who earn more income
should contribute more to society in the form of taxes
o Those who earn less income are able to pay and so should pay less

Disadvantages of Progressive Tax Regime:

o It penalizes those who work harder and earn more money

o Reduces the incentive to work hard and excel

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 Regressive Tax Regime suggest that as you earn more the tax rate/percent decreases.
The higher income group pays a lower tax rate than the lower income earners who would
bear the burden of the tax system.

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MONETARY POLICY

There are three macroeconomic tools used by governments under the monetary policy which
attempts to manipulate the money supply of the economy by using:

 Open Market Operations where government may sell bonds (contractionay monetary
policy) to the financial sector or private sector. If government sells to the financial
sector, they would have raised money that was not in the circular flow of income and thus
would lead to a significant increase in NI/GDP. If, however they sold bonds to the
private sector they would have had to increase interest rates and give an incentive to the
private sector. This means that money from the circular flow of income would have been
used by private sector to make this investment and thus reduce the effectiveness of the
increase in government expenditure and thus limit the increase in NI/GDP.

The increase in interest rates by government means that commercial banks would have to
increase their interest rates also to compete for scarce finances. However, this increase in
interest rates would lead to a CROWDING OUT of private investment as it becomes too
costly to borrow for consumer expenditure and business investment. This thus reduces
the effectiveness of Monetary policy as they lose control over interest rates in the market.

An expansionary monetary policy would involve government buying back bonds

previously sold to increase the money supply and as a result increase consumption.

 Interest Rates may be adjusted by the Central Bank adjusting the Discount Rate that
commercial banks borrows from them. If this discount rate is raised then the commercial
banks cost to borrow would be higher and they would thus borrow less money. With less
money to lend they would then raise interest rates which would lead to a contractionary
effect of the circular flow of income as it becomes too costly for individuals and private
businesses to borrow to invest.

If the discount rates were lowered then it becomes cheaper for commercial banks to
borrow from the Central Bank. As a result they would have more money to lend and thus
lower the interest rates on loans to individuals and private businesses to encourage more
economic activity and economic growth.

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 Special reserve requirements/cash reserve ratio which are controlled by the Central
Bank which determines the size of the deposit required by all commercial banks to make
with the central bank. To pursue and expansionary monetary policy the Central Bank
should reduce the Special reserve Requirement thus increasing the money supply at the
banks which would in turn reduce their interest rates to make loans more affordable and
special reserve requirement should be increased reducing the money supply in the banks
which would then increase interest and thereby reduce the levels of loans as they become
too expensive and reduced economic activity results.

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 Exchange Rates which affect international trade. The exchange rate regime that
government can influence is known as the Fixed Exchange Rate where they devalue or
revalue the exchange rate. However, with this exchange rate regime when there is too
much exports of the domestic economy there is an increase in demand for the local
currency and thus may have led to an appreciation of the exchange rate. However, under
the fixed exchange rate regime the government would attempt to prevent this from
happening by buying up excess foreign exchange with their domestic currency on the
Foreign Exchange Market simultaneously reducing the supply of the domestic
currency in the domestic circular flow of income and thus resulting indirectly in an
increase in the domestic interest rates. Thus the government loses some control over
the interest rates and thereby reduces its effectiveness. The reverse happens if the
economy is importing too much and government may attempt to buy up domestic
currency increasing the money supply which may lead to a reduction in the domestic
interest rates. Fiscal Policy is thus more effective under the fixed exchange rate
regime.

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Under the floating exchange rate regime, the effectiveness of fiscal policy may be
reduced. As government follows an expansionary monetary policy by increasing the
money supply would indirectly lead to lower rates of interest. And if government was
also pursuing expansionary fiscal policy where they financed increased government
spending via OMO, interest rates may have increased causing a CROWDING OUT of
private investment. The increased interest rates may also attract HOT MONEY where
foreigners may now be attracted to save money in the economy with higher interest rates
leading to appreciation of exchange rate making their exports more expensive and
imports more attractive. AN EXPANSIONARY FISCAL POLICY WILL BE MADE
MORE EFFECTIVE WITH AN EXPANSIONARY MONETARY POLICY.

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Reasons why Government Borrow:

 To Stabilize the Economy- In an economic downturn/recession, government revenue

will be lower as there is less production and employment where they may also have to
make more unemployment benefits available to the unemployed. So prevent the
worsening of the economic downturn governments may borrow to continue supporting
the unemployed which may in turn increase the level of economic activity or at least keep
it constant.

 Investment – In an attempt to promote economic growth the government may borrow to

engage in infrastructural development such as building of roads, buildings, hospitals and
schools.
 When tax revenues are less than expected – If a budget deficit where government
expenditure for the next year is greater than the income to be earned they may engage in
borrowing to meet their fiscal objectives.

 Political pressures especially around elections encourages governments to promise

lower taxes, increase pensions, increased wages and so forth would result in government
having to borrow to keep their promises to win an election.

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Effects of Government Debt on Economic Growth;

 Crowding Out and Higher Interest Rates – government may borrow by selling bonds
to the private sector offering higher interest rates as an incentive to raise funds to
encourage more government spending encouraging economic growth. However, as
individuals take their money out of the financial institutions to earn higher interest on
their savings, this may result in these institutions having less money available for loans
and indirectly force the lending interest rates to increase thus crowding out individual
and private business investment as they become too expensive.

 Higher Taxes and Lower Spending – As government debt increases they will have to
increase taxes to help with shortfall of revenue and cut back on their government
spending. As a result there would be a slowing down of economic growth where it can
become negative. As a result expansionary fiscal policy (Lower Taxes and Increased
Government Spending to increase demand/economic activity) should be used together
with an expansionary monetary policy (increase the supply of money using Open Market
Operations, Interest Rates, Cash Reserve Ratio and so forth) to be fully effective.

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Expansionary Fiscal and Monetary Policies are used to stimulate the level of economic
activity within a country.
An Expansionary Fiscal Policy would involve a reduction in taxes and an increase in
government spending to encourage an increase in demand for goods and services, resulting in
more production and increased employment as a result. The opposite involves a Contractionary
Fiscal Policy where the taxes would be increased and government spending would be reduced to
contract/reduce the level of economic activity in the economy.
An Expansionary Monetary Policy involves the buying of bonds back from individuals and
businesses, lowering of interest rates and lowering the statutory reserve requirement/cash reserve
ratio. In doing so the supply of money available to encourage economic activity would be
increased to promote economic growth. A Contractionary Policy would involve the selling of
bonds, raising interest rates and raising the statutory reserve requirement/cash reserve ratio to
reduce the money supply and lower the level of economic activity taking place within the
economy.

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Measures of National Income (Total Value of Country’s Final Output of goods/services
Produced in a Year):
 Gross Domestic Product (GDP) the market value of all final goods/services produced
within a country in a given period of time, usually one year using local and/or foreign
resources.

 Gross National Product (GNP) is the market value of all final goods/services produced
by permanent residence of a country, whether they are residing locally or abroad,
within a period of a year. To move from GDP to GNP:
GNP = GDP + Net Property Income from Abroad (Income Earned from Abroad –
Income Paid Abroad).
 Net National Product or Net National Income (NI) is the total market value of all final
goods/services produced by citizens of an economy during a year.

NNP/NI = GNP – Depreciation

Per Capita GDP is total GDP divided by the total population or Per Capital Income is the total
NI divided by the total population.

Gross Domestic Product (GDP) is the total output occurring within an economy using domestic
and foreign factors of production. This equals to Consumption plus Investment plus Government
Spending plus Exports minus Imports. According to the UK National Accounts GDP is defined
as “the sum of all economic activity taking place in the UK territory”.

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GDP at Market/Current Prices is referred to as Nominal GDP.

Potential GDP refers to the total amount of output that can be produced if all the factors of
production in an economy are fully employed.

GDP can be calculated at Market Prices/ Current Prices where there is no account of taxes or
subsidies paid. On the other hand we could deduct all direct and indirect taxes paid while adding
back subsidies paid to producers. This would give us GDP at Factor Cost or National Output
Less of Indirect taxes and Plus Subsidies which gives the actual cost of production. (Students
to need to explain why taxes are deducted and subsidies are added back to get actual cost of
production).

Real GDP refers to calculating GDP at Constant Prices where one specific ‘base year prices’ are
used to value the actual output over each successive year. It reduces the influence of Inflation
over different years.

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GDP is calculated via three different methods:

1. National Product/Output Method is the sum of all the values of all the final goods and
services produced by an economy within a calendar year. Care must be taken to ensure
only the value added or cost of production of final goods and services are taken into
consideration and not the revenue obtained from selling the final product, as the value of
semi-finished products would have already been taken into consideration and if included
will lead to double counting.

2. National Expenditure/Expenditure Method includes household consumption plus

business investment plus government spending plus net export. Capital
investment/formation takes into consideration both government and business investment
which is separate from government spending. Also note that imports may have to be
subtracted from exports to get gross domestic product via expenditure method. Thus you
end up with the equation:

GDP/Total Expenditure = C @ market prices+ I@ market prices + G + (X-M) +

subsidies – indirect taxes = GNP – depreciation = National Income

Or Y = C + I + G + (X – M)
‘C’ refers to private consumption of g/s but not New Housing which is considered an
investment.

‘I’ refers to business investment in capital and individuals purchase of a new house of
non-financial product purchases.

‘G’ refers to government expenditure on final goods and services. It does not include any
transfer payments such as social security and unemployment benefits. Pensions,
unemployment benefits and any other state welfare payments are incomes that don’t
contribute to the GDP and are referred to as Transfer Payments/Income which must be
excluded from the calculation of GDP.

‘X – M’ is referred to as Net Exports or the total of Exports minus the total of Imports
occurred within an economy in a year.

If you add subsidies and subtract indirect taxes you would get GDP at Factor Cost
or if you add back taxes and subtract subsidies you will end up with GDP at Market
Prices.

Gross National Product (GNP) is the total output produced using only domestic factors
of production whether they are produced locally or foreign. This could be shown as GDP

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 plus Net Property Income from Abroad (which is Net property income earned
abroad where locals may invest money or even their expertise minus Net property
income paid abroad where foreigners may invest money or even their expertise
locally). These factors influence the standard of living and levels on employment in an
economy. If you subtract Capital Formation /Depreciation from GNP you will end up
with Net National Product.

Also, when we take away Capital Consumption or Depreciation from GDP we end up
with Net Domestic Product.

3. Gross National Income/Income Method is calculated as follows:

Income from Employment + Profits & Rents + Net Income from Foreign Assets = GNP –
depreciation = National Income

In calculating NI data is gathered from Taxes collected by government. However, some

individuals may earn income that is below the taxable amount and also some may
deliberately avoid paying taxes. To accommodate for this estimates may be made for
some income earners. Thus, national income is never strictly accurate.

When calculating NI we need to make adjustments for transfer incomes such as pensions,
students’ grants, unemployment benefits, gifts of money which must not be included as
they are not adding to our productivity of GDP. Also, incomes from government
activities such as property the government owns, profits from public corporations and
surpluses from public corporations must not be included.

Measure of the increase or decrease in the standard of living;

Standard of living focuses on the quality of life individuals may be experiencing based on
economic performance in the country. This focuses on the basket of goods an individual can
purchase along with non-quantifiable factors such as crime, level of traffic congestion, and the
poverty level.
Developing economies are those countries which are dependent on one or a few industries for its
revenue generation and there is a low standard of living. Developed economies are
significantly industrialized and the citizens’ experience a high standard of living.
Factors that individuals may look at to determine the Standard of Living in a country
includes:
 Level of skilled workers in the country if high suggests a high SOL as more production
and higher productivity should occur allowing for greater innovation and creativity to
increase the GDP in the economy. Thus individuals would have greater disposable

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 incomes to provide higher levels of SOL as well as higher Quality of Life. The opposite
would exist if the workforce is not as skilled.

 Level of access to technology and use of capital in production where the less access to
technology and capital to be used in production is available will lead to lower levels of
productivity in businesses. This therefore would result in less competitive goods and
services lowering the demand and less production taking place in the economy. As a
result there would be greater unemployment, less disposable income/purchasing power
for citizens, resulting in lower SOL.

 Size of the food import bill and other goods and services if large, suggests that the
citizens demand more foreign goods. This therefore will lead to an outflow of foreign
currency (Deficit in the Balance of Payments) which results in less demand for locally
produced goods and services. As a result there would be less production and less jobs
available especially in the Developing Countries which relies heavily on the Primary and
Secondary sectors of the economy, leading to lower levels of SOL.

 If there is a large part of the population living in poverty suggesting the majority of
the population is poor and cannot afford to meet their basic needs according to Maslow’s
Need Hierarchy, then the SOL will be low.

 ‘Brain drain’ where skilled professionals of an economy is leaving in search of better

jobs and SOL, results in lower levels of productivity in an economy. As a result goods
and services produced will be less and the quality may be lower, resulting in decreased
demand for goods and services of local businesses. Unemployment would thus rise and
citizens would not be able to afford as much leading to a lower SOL.

One use of NI statistics is to indicate the overall SOL of a country. However it is not a very
good indicator of SOL due to:
NI focuses on all goods and services produced in a country whereas SOL deals only with
consumer goods and services. There is no way to distinguish the types of goods
identified in calculating the NI. For instance, when capital goods are produced they may
contribute later on to provide consumer goods but not while being produced and thus
would not contribute to increased SOL immediately.

NI cannot tell the “Quality of Life” that people enjoy. NI may have rise due to longer
working hours and not because of an increased variety of consumer goods being
produced. People may have to carry out their work under poor working conditions or
face traffic pile up on their way to work and thus experiencing lower quality of life.
Another example is where mothers are leaving children at baby sitters to make more
money however family life is sacrificed.

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 NI could have increased due to greater exports than imports which may have suggested
that the local businesses are not producing for the local market but for the export markets
and we would not be importing sufficient consumer goods to improve our quality of life.

Government expenditure is included in calculation of NI however it is difficult to

distinguish between expenditure on consumer goods and services as compared to
expenditure on defense. If more money is spent on defense rather than improving social
services then it reduces the countries quality of life.

NI figures could increase due to inflation. If this occurs then individuals may be
experiencing a lower SOL as their purchasing power is reduced.
Per Capita Income
This is average income per head and is a better indicator of SOL as it gives an idea how income
is shared in the economy. It is calculated by dividing NI by Total Population. However, all the
factors we consider against NI being used as a good indicator of Sol can also be applied for Per
capita Income. The per capita income is also affected by the unequal distribution of wealth.
Alternative Measures of SOL:
Human Development Index which focuses on literacy rates, per capita income and the
effects of inflation
The Physical Quality of Life Index measures infant mortality rates, literacy levels and
life expectancy rates
Other Indicators of SOL:
The number of doctors and nurses per thousand
The number of hospitals and health centres available
The number of schools and learning institutions
Infant mortality rates
Access to good communication systems
Rates of crime

INFLATION refers to a consistent increase in the price of goods and services over consecutive
periods which usually occurs during the upturn and boom of the economy’s business cycle. It is

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measured by the Consumer Price Index which is an average of the price of a basket of consumer
goods and services purchased by households.
Types of Inflation:
1. Demand Pull Inflation where the level of unemployment may be so low that demand
exceeds an economy’s ability to produce. It may be caused by expansionary monetary
and fiscal policies.

2. Cost Push Inflation where the cost of the factors of production may have increased. For
instance increases in wages, increases in taxes on the production of goods and services,
increases in rent due to increases in property taxes, increase in interest rates on
borrowing, as well as increased taxes on income/profits.

3. Imported Inflation where Caribbean countries which has a high level of imports results
in higher prices overall.

4. Monetary Inflation which results from increased money supply due to expansionary
fiscal policies especially.

Effects of inflation includes reduction of the purchasing power of individuals real income,
i.e. what can be bought with money. This may result in business owners generating more
income but employed individuals may have lower SOL resulting in a redistribution of real
income. Exports may fall as the prices of our goods and services becomes more expensive,
while Imports becomes more expensive leading to a Balance of Payments Deficit. Also with
demand pull inflation more individuals seems to be employed indicating that as Demand Pull
Inflation increases there is less unemployment.
Measures to reduce inflation includes:
 Contractionary fiscal policy by increasing Individual Taxes for Demand Pull Inflation
to reduce the demand for goods and service. Reduce Government Spending to reduce
aggregate demand for goods and services.

 Contractionary Monetary Policies reducing money supply and increasing interest rates
by increasing the reserve requirement ration and/or sell bonds to the public via open
market operations.

 Price controls and subsidies. Price controls using ceiling prices where prices cannot go
above a predetermined level by government legislation, as well as subsidizing the
production of certain goods to lower their prices.

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RECESSION OR DEFLATION refers to a fall in general price levels as the economy moves
into the downturn or slump in the business cycle.
Causes of recession includes moving from a boom in the business cycle where the economy
may be operating on the PPF at full capacity, Eventually demand for local businesses goods
and services will fall as the economy slips into a downturn where businesses would produce
less and unemployment will start to rise. This would then result in a reduction in investment
by entrepreneurs as overall demand falls worsening the unemployment rate.
Consequences of Recession:
 Falling output as GDP and SOL is falling
 Less disposable incomes as businesses will be producing less and unemployment rises
 Inflationary pressures may occur as lees is being produced and necessities becomes
scarce
 Government’s revenue from taxes will fall as more unemployment occurs and
businesses will be earning less or even closing down.
 More unemployment benefits to be given by government whose revenues are declining
and may lead to more debt financing by government to provide for the needy

Government Policies to Manage Recession:

 Expansionary Fiscal policies by increasing government spending to promote
economic activity and reducing taxes to increase individuals and businesses disposable
income, ceteris paribus, thereby increasing demand.

 Expansionary Monetary policies to increase monetary supply by reducing special

reserve requirement ratios, lowering interest rates and buying back bonds from public.
More money in individuals hands will, ceteris paribus, increase economic activity.
Unemployment refers to those who are of age and able to work, actively seeking employment
but are unable to get a job.

Types of Unemployment and Solutions To Each:

1. Frictional Unemployment – occurs when there is a difficulty of matching shortage of a
given type of labour. Persons are between jobs, shopping around – voluntary
unemployment. Solutions involves making information for jobs easily accessible such
as using job matching services online, use of job recruitment agencies, and networking
through professional bodies such as LinkedIn.

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 2. Structural unemployment arises from the mismatch of skills and job opportunities as
the pattern of supply and demand changes. It reflects the time taken to acquire human
capital which may be a challenge due to:
Geographical immobility where there may be challenges for labour to move from one part of
the country to another possibly due to high transportation costs or lack of transportation.
- Occupational immobility where individuals skills cannot be transferred from one
industry to another.
Solutions may include education and training programs for the modified industry or for
other industries where skilled labour is needed.

3. Seasonal Unemployment occurs when a particular season requires specific labour

but does not last year round. For example, Carnival in Trinidad and Tobago may
create jobs for costume designers and makers only from August to February/March and
not for the other months. Solutions may involve additional training to make such
individuals more qualified to find year long jobs or to promote the industry outside of the
country of origin and export the necessary labour at different times of the year creating
sustainable employment year round.

4. Technological Unemployment is a form of structural unemployment which occurs when

new technologies are introduced:
- Old skills are no longer required
- There is likely to be a labour saving aspect, with machines doing the job that
people use to do.

5. Cyclical Unemployment refers to times when domestic and foreign trade go through
cycles of boom, decline, recession, recovery then boom again. During recovery and
boom, the demand for output and jobs is high and unemployment low. During decline
and recession, the demand for output and jobs falls, and unemployment rises to a
high level. Solutions during economic slump where there is low levels of economic
activity includes expansionary fiscal and monetary policies.

6. Classical or Real Wage Unemployment arises when wages for labour are too high,
resulting in businesses not being able to employ sufficient numbers of the entire
workforce. Wages may be high due to trade unions negotiating for increased salaries, or
due to scarce labour with the necessary skills for a particular field would also force wages
up, and government increasing the minimum wage rates in their annual budget.

Trade Unions refers to an elected body of individuals to represent the entire body of employees
in a particular industry when engaging in collective bargaining with the employers. They tend
to negotiate for better wages and working conditions, influence government to adjust the

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minimum wage, as well representing employees who are members when they are unfairly treated
or even provide training and financial planning services for those who may be retiring or faced
with the business downsizing.
Role of Trade Unions:
 Collective Bargaining by representing workers when negotiating with employers as they
would have greater bargaining power as a group instead of workers negotiating
individually.

 Employee welfare is negotiated for based on improved terms and conditions of

employment. They fight for improved wages, work-life balance by reasonable working
schedules, job security and so forth.

 Protection against unfair labour practices such as paying lower wages, providing
unsafe working conditions threatening employees health and physical being and long
working hours without proper compensation.

 Influencing labour laws and regulations to ensure worker protection by lobbying

government to pass such laws and legislation and inform employees about them.

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