ECON NOTES for midterm Price Indexes and Inflation

Aloha Joy Samporna Price index is a measure of the average level of prices.
Inflation denotes a rise in the general level of price.
Among price indexes, the most well-known is the Consumer Price Index. It is an index made
What is National Income Accounting?
to a basket of consumer goods. The movement in this price index shows the general movement
➢ It is the economy’s overall performance or the Gross Domestic Product (GDP). of price of consumer items.
➢ It can also be the market value of all final goods and services produced within a country
CPI can be computed as:
in a given time period.
Expenditure Approach
Formula: GDP = C + G + I + NX
C – Personal Consumption goods G – Government Expenditure
The Wholesale Price Index is another indicator. It is an index of a set of prices for a basket of
I – Gross Domestic Investment NX – Net Exports (X – M)
products sold at their wholesale prices. It is also called “Producer Price Index.
GDP deflator reflects the current level of prices in the base year. It is a measure of the price
Industrial Value-Added Approach level calculated as the ratio of nominal GDP and real GDP times 100, or

➢ The “Gross Domestic Product” or GDP is the total value of all output produced within
the country.
➢ GDP is the sum of the entire individual “Gross Value Added” or GVA of the different
productive sectors or
DP = sum of all sector GVAs.
Nominal GDP is the production of goods and services valued at current prices on actual
Exclusions from the GDP: market prices.
1. Purely financial transactions consists of the ff: “Real GDP” is the production of goods and services valued at constant prices.
A. Public transfer payments The rate of inflation is the rate of change of the general price level and is measured as follows:
B. Private transfer payments
C. Buying and selling of securities
Public transfer payments are those given by the government to individuals or households, but
which do not contribute to current production in return for them.
Production is an economic activity that is undertaken to serve the needs of consumers.
Private transfer payments involve the transfer of funds from one private individual to another
Consumption is the total expenditure in an economy on goods and services by individuals
and which does not entail production.
or a nation during a given period.
2. Secondhand sales 3. Underground market
Consumption may be categorized into the following: Disposable Consumption
Income Expenditure ∆Y ∆C MPC
1. Durable goods – such as motor vehicles, household equipment and others. 1,000 1,500 - - -
2. Nondurable goods – are perishable goods, such as food, clothing and the likes. 1,500 1,800 500 300 0.60
2,000 2,200 500 400 0.80
3. Services – are intangible utilities such as medical care, recreation, education etc. 2,500 2,500 500 300 0.60
3,000 2,800 500 300 0.60
Consumption Function – shows the relationship between the total consumption 3,500 3,100 500 300 0.60
expenditure in the economy and the total consumer’s income. 4,000 3,300 500 200 0.40
Table 1: Disposable Income & Consumption
(In billions of pesos) MPC = ∆C / ∆Y

Disposable Income (Y) Consumption (C) Saving (S) or Dissaving = 1,800 – 1,500
1,000 1,500 - 500 1,500 – 1,000
1,500 1,800 300
2,000 2,200 - 200 = 300
2,500 2,500 0
3,000 2,800 200 500
3,500 3,100 400 = 0.60
4,000 3,300 700

Average Propensity to Consume (APC) – refers to the proportion of income devoted to Savings – consumers does not always spend entirely on consumption after an income was
consumption. received, as sometimes, only a part of the income is spent. When consumers decide not to
spend all their income, they are exercising their option of saving. The amount that they
FORMULA: APC = C / Y decided to keep or not to spend is regarded as savings.
Disposable Income Consumption Expenditure APC Components of total saving:
1,000 1,500 1.5
1,500 1,800 1.2 1. Personal savings 2. Business savings
2,000 2,200 1.1 3. Government savings 4. Foreign savings
2,500 2,500 1.0
3,000 2,800 0.93 The savings function, on the other hand, shows the relationship between savings and income.
3,500 3,100 0.885
4,000 3,300 0.825

Marginal Propensity to Consume (MPC) – refers to the proportion of a small increase

in income which will be devoted to increased consumption expenditure.

FORMULA: MPC = ∆C / ∆Y
Average Propensity to Save (APS) – is the proportion of income (of an individual or the • Depression – a recession that is major in both scale and duration.
whole economy) which is not spent on consumption of goods and services.
2. Expansion are the mirror images of recession, with each other of the above factors
FORMULA: APS = S / Y operating in the opposite directions. (Recovery and Growth).

Disposable Income Income and APS savings APS Mark turning points of the cycle is Peak and Through.
1,000 - 500 - 0.5 Peak – the high point of business cycles.
1,500 - 300 - 0.2
2,000 - 200 - 0.1 Through – it is the low point of business cycles.
2,500 0 0
3,000 200 0.066 Contraction – where the economy is shrinking.
3,500 400 0.11 Expansion – where the economy is growing.
4,000 700 0.175

Marginal Propensity to Save (MPS) – is the proportion of an increase in income that is INVESTMENT is one of the components of aggregate expenditure. Investment funds come
saved. Those who receive additional incomes have 3 options depending on certain factors: (1) from the public and the private sector which are the result of either saving or borrowing. A
to spend the entire amount on consumption; (2) to save the entire amount; or (3) to spend a major portion of the aggregate demand for the products and services is attributed to
part for consumption and to save the remaining amount. investment. A change in investment levels affects the demand for the various factors of
production. Investment also causes increases in the nations output and promote long run
FORMULA: MPS = ∆S / ∆Y economic growth.
The INVESTMENT FUNCTION is when households save. However, there is a “leak” in the
flow and the total outputs of firms are at risk of partial disposal. When this happens, there is
Disposable Change in Change in
an imbalance in the relationship between households and firms. There is a balancing factor,
Income Savings Income Saving MPS
1,000 - 500 – – – and it is called investment.
1,500 - 300 500 200 0.40 Sources and uses of Investment funds
2,000 - 200 500 100 0.20
2,500 0 500 200 0.40 1. Public sector 2. Private sector
3,000 200 500 200 0.40
Investment fund is a result of any or both of the following:
3,500 400 500 200 0.40
4,000 700 500 300 0.60 1. Savings 2. Borrowings
Borrowing may be made through banks or from abroad. The funds made available by banks
Business Fluctuations – are the increase and decrease in economic activity, as measured comes from pooled savings or depositors. Foreign countries are also sources of borrowed fund.
by increase and decrease in real GDP. It is a short-term variation in economic activity also
known as the ‘Business Cycles’. It features an economy wide fluctuation in total national Investments are undertaken by the following:
output, income and employment, usually lasting for a period of 2 to 10 years, mark by
1. Government 2. Business firms 3. Private Individuals
widespread contractions in most sectors in the economy. It has 2 main phases:
Government investments are mainly for public works, business firms are for machinery and
1. Recession is a recuring period of decline in total output, income and employment, usually
equipment; and private persons for construction.
lasting from 6 months to a year and marked by widespread contractions in many sectors.
Investment and the multiplier effect – is an increase in investment generally gives rise
to an increase in income, a number of times larger than the original investments. The ratio of
a change in income to a change in investment is called the multiplier.
FORMULA:
Where K = Multiplier; Y = Income; and I = Investment.
An example (in billions of pesos) is provided as follows:
Old income = 3,000 New income = 3,500
Old investment = 250 Old investment = 450
To solve for the multiplier:
The result of the computation implies that an increase in investment will result into 2.5 times
increase in income. So, a 20 billion pesos in investment will result to a 50 billion pesos
increase in income.
Types of Investment
1. Tangible capital such as those classified as structures, equipment and inventories.
2. Intangible investments such as those for education or “human capital” research and
development, and health.
Gross investment – is investment without allowance for depreciation.
Net investment – is the gross expenditure on capital formation minus the amount required
to replace worn out and absolute plant and equipment.
Investment do not happen by chance. There are times when the investment level is high and
there are times when it is low. These are because of the following determinants of investment:
1. Investment rate 2. Innovation 3. Profit 4. Expectation
FOUNDATION OF AGGREGATE DEMAND
Aggregate demand (AD) is the total or aggregate quantity of output that is willingly bought at
a given level of prices, other things held constant. It is the desired spending in all product
sectors, consumption, private domestic investment, government purchases of goods and
services and net exports. And it has 4 components, namely:
1. Consumption – is primarily determined by disposable income, which is personal income
less taxes.
2. Investment – spending that includes purchases of buildings, software and equipment, and
accumulation of inventories.
3. Government purchases – are purchases of goods like tanks or road building equipment, as
well as the services of judges and public school teachers.
4. Net Exports – A final component of AD, which equals the value of exports minus the value
of imports.
C + I + G + NX = AD
Economic Policy and Institutions
Unemployment refers to a situation whereby a person who belongs to the labor force and is
willing to work is unable to find any job owing to some reasons.
“unemployed workers” are those who currently not working but are willing and able to
work for pay currently available to work, and have actively searched for work.
FORMULA:
Types of unemployment
1. Cyclical unemployment – is due to macroeconomic fluctuations and occurs when there
is not enough aggregate demand in the economy.
2. Frictional unemployment – occurs when an individual is out of his current job and
looking for another job.
3. Structural unemployment – arises in an economy when a mismatch occurs between
the kinds of jobs being offered by employers and the skills, experiences, education and
geographical location of potential employees.
4. Classical unemployment – also known as the real wage unemployment or
disequilibrium unemployment.
IMPACTS OF UNEMPLOYMENT
1. Social impact – unemployment that increases susceptibility to malnutrition, illness, mental
stress and loss of self-esteem leading to depression.
2. Economic Impact – for the economy as a whole, unemployment reduces the output of goods
and services that otherwise have been produced by unemployed labor force.
VOLUNTARY UNEMPLOYMENT – is when a worker chooses not to accept a job at the
going wage rate.
INVOLUNTARY UNEMPLOYMENT – occurs when a worker would be willing to accept
a job at the going wage but cannot get an offer.
ENSURING PRICE STABILITY
A. Nature and Impacts of Inflation
Inflation is a rise in the general level of prices and goods and services in an economy over a
period of time.
LEVELS OF INFLATION SEVERITY
1. Low inflation – characterized by prices that rise slowly and predictably.
2. Galloping inflation – occurs in the double or triple-digit race of 50,100 or 200% per year.
3. Hyperinflation – occurs when prices are rising a million or even trillion % per year.
B. Modern Theories of Inflation
1. Inertial Inflation – is the rate of inflation that is expected and built into contracts and
informal arrangements.
2. Demand-Pull Inflation – caused by increases in aggregate demand due to increased
private and government spending, etc.
3. Cost-Push Inflation – caused by a drop in aggregate supply.
Numbers of possible sources of rising costs:
A. Wage – if trade unions gain more power, they may be able to push wages up independently
of consumer demand.
B. Profits – if firms gain more power and are able to push up prices independently of demand
to make more profit, then this is considered to be cost-push inflation.
C. Exhaustion of national resources – as resources runs out, their price will gradually rise.
D. Taxes – changes in indirect taxes (taxes on expenditure) increase the cost of living and push
up the prices of products in the shops.
E. Imported inflation – we work in a very global economy and many firms import a significant
proportion of their raw materials or semi-finished products.
E.1. Exchange rate changes – if there is depreciation in the exchange rate, then our exports
will become cheaper abroad, but our imports will appear to be more expensive.
E.2. Commodity price exchanges – if there are price increases on world commodity markets,
firms will be faced with higher costs if they use these as raw materials.
E.3. External shocks – this could be either for natural reasons or because a particular group
or country has gained more economic power.
General effects – is an increase in the general level of prices that implies in a decrease in the
purchasing power of the currency.
Negative effects
1. Redistribution of real income – inflations impact on income distribution making a random
redistribution of real income.
2. Lower output and employment – high or unpredictable inflation rates are regarded as
harmful to an overall economy.
3. Hoarding – high inflation may lead to shortages of goods if consumers begin hoarding out
of concern that prices will increase in the future.
4. Loss of allocative efficiency – a change in the supply or demand or a goods will normally
cause its price to change, signaling to buyers and sellers that they should reallocate resources
to respond to the new market conditions.
5. Cost-push inflation – rising inflation can prompt employees to demand higher wages, to
keep up with consumer prices.
6. Higher “shoe leather cost” – high inflation increases the opportunity cost of holding cash
balances, inducing people to hold a greater portion of their assets in interest paying accounts.
7. Hidden tax increase imposed as inflated earnings push tax payers to higher income tax rate.
Positive effects
1. Labor-market adjustment: Keynesians believe that nominal wages are slowly to adjust
downwards.
2. Debt relief: Debtors who have debts with a fixed nominal rate of interest will see a reduction
in the “real” interest rate as the inflation rate rises.
3. Room to maneuver: The primary tools for controlling the money supply are the ability to
set the discount rate, the rate at which banks can borrow from the central bank.
The MONETARY BOARD is the policy making body of central bank composed of a
Chairman, the Secretary of Finance, the Director General of the National Economic and
Development Authority, the Chairman of the Board of Investment and 3 members from the
private sector.
FUNCTION OF THE MONETARY BOARD
1. Issues rules and regulations for the effective discharge of the responsibilities and exercise
of the powers vested in it.
2. Direct the management operations and administration of Bangko Sentral as it organize and
issues such rules and regulations that may deem necessary or desirable for this purpose.
3. Establish a human resource management system which governs the selection, hiring,
appointment, transfer, promotion, dismissal of all personnel. AND MANY MORE!
Philippine Monetary Policy – is the control of the amount in the economy. The BSP has a
number of monetary policy instrument at its disposal to promote price stability: open market
operations, acceptance of fixed-term deposits, standing facilities and reverse requirements.
Types of Monetary Policy
MONETARY POLICY INTERMEDIATE POLICY ULTIMATE TARGET
Monetary-base targeting Growth in money supply Inflation rate
Inflation targeting Interest rate Inflation rate
Nominal GDP targeting Growth in money supply Inflation rate
Responsibilities of the Bangko Sentral ng Pilipinas
- Primary objective is to maintain price stability conductive to a balance and sustainable
growth. It performs the functions of property management, policy issue, management
of foreign currency services, determination of exchange rate policy and etc.
Commercial Bank – is a financial institution that provide services such as loans, certificate
of deposits (CDs), savings bank accounts, bank overdrafts, etc. to its customers. These
institutions make money by lending loans to individuals and earning interests on loans.
Retail bank – offers banking services to consumers and small businesses. However, unlike
the Commercial Banks, they are one opposed to the dealing with large corporations and
financial institutions.
Credit Union – is a type of financial institution similar to a Commercial Bank except for that
it is a member-owned nonprofit financial cooperative. Credit unions generally provide
services to members similar to retail banks, including deposit accounts, provision of credit
and other financial services.
Central Bank – also known as reserve bank or monetary authority is an institution that
manages the currency and oversees their commercial banking system, and monetary policy of
a country or monetary union. In contrast to commercial banking, a central bank possesses a
monopoly on increasing the monetary base.
How banks developed from Goldsmith establishment?
Commercial banking began in England with the Goldsmiths, who took in their customers gold
and silver for safekeeping. The Goldsmiths used a fractional-reserve system, lending some out
and retaining the rest for the portion of the customers who came calling for their deposits. As
a record, depositors were given a receipt that were transferrable to other people (an early
checking system), who could collect the corresponding amount of gold or silver. The profit -
maximizing Goldsmith-banker did not keep 100% percent of deposits as sterile reserves;
reserve earn no interest when they are sitting in vault. So early banks use the money entrusted
to them to make investments, by using most of the money with them in earning profits.