5988 4.1 Government and The Macroeconomy Govt Role & Polices

4 Government and the
Macro-economy
4.1 The role of government,
4.2 The macroeconomic aims of government
4.3 Fiscal policy
4.4 Monetary policy
4.5 Supply-side policy
The role of government in an economy
Government
Producer Employers
International Trade
Trading block
• Local Government FDI • Employs worker
• Natural Monopoly Free trade • Operate public sectors
• Strategic Industries • Reduce unemployment
• Trading block • Control price, control wages
• Partnership of public • Provide training
sector & private sector • Provide pensions
06/02/2024 O level_ Economics, Section 4, zia-academy.com 2

Local role
The central or federal government collects taxes which it uses to
fund local services such as rubbish collection (public refuse
collection), street lighting, libraries, schools, hospitals and public
parks. Central government gives local government funding to
spend on these public and merit goods in the local area.

National Role
The central government makes decisions about how to achieve its macroeconomic aims :
economic growth, stable price levels, low unemployment, a healthy balance of payments and
redistribution of income and wealth. It does this by seeking to use appropriate macroeconomic
policies .For example, the national government may make decisions on the following policy
areas:
• Fiscal policy
• Monetary policy
• Supply-side policies
• Policies to protect the environment

International Role
The role of government also involves an international dimension as modern economies need
to trade with other countries. An economy may be part of a trading bloc, such as the European
Union, which promotes free trade and mobility of factors of production between member
countries. There will be some countries with which the country does not have free trade, so
tariffs and quotas may be imposed on goods traded . For example, the USA places a tariff
(import tax) on tyres and solar panels imported from China

The role of government in an economy
The government plays a key role as a producer of goods and services and as an employer. As a producer, the
government supplies goods and services to the general public. For example, it will provide:
• Public goods - These products are non-excludable and non-rivalrous in consumption. Examples - defense,
street lighting, flood, lighthouses.
• Merit goods - These products are deemed to have social benefits yet are under-consumed without
government Intervention or provision. Examples are education, health care services and public libraries.
• Public services - In many countries, the government also directly provides other essential public services,
such as postal services, public transport systems, the emergency services (fire, police and ambulance) and
immigration services.
• Welfare services - In mixed economic systems, the government provides social and welfare services to
people in need. These include transfer payments such as unemployment benefits and state pension
schemes for the elderly.

Government influence on private producers
Governments influence private producers through the use • Competition law - Government regulation is used
of regulation, subsidies and taxation policies. to prevent anti-competitive practices of private-
Regulation sector monopolists. This helps to protect
Government regulations determine the boundaries within consumers and smaller firms that are less
which private producers can operate. Examples are the use competitive.
of employment legislation. • Intellectual property rights - To encourage
• Employment legislation - These regulations protect the innovation and to safeguard the interest of
interests and safety of employees. For example, private- producers, the government can use copyright,
sector producers should comply with antidiscrimination trademark and patent laws to protect the
laws. intellectual property of firms.
• Consumer protection laws - These regulations require Subsidies
private -sector firms to provide truthful descriptions of A subsidy is financial assistance provided by a
their goods and services, which must also meet minimal government to reduce the costs of production for
quality standards. firms.
• Environmental protection - Laws exist to prevent or Taxes
reduce the damage to the environment caused by private - A tax is a levy or charge imposed by a government
sector firms, such as pollution and the depletion of scarce to raise costs of production and to reduce
resources. consumption of certain goods or services.

25 The macroeconomic aims of government
Topic Guide
the macroeconomic aims Economic growth, full employment/low unemployment,
of government stable prices/low inflation, balance of payments stability,
redistribution of income. Reasons behind the choice of
aims and the criteria that governments set for each aim.
possible conflicts between Possible conflicts between aims: full employment versus
macroeconomic aims stable prices; economic growth versus balance of
payments stability; and full employment versus balance
of payments stability.

Aims of government policies
Government policies tend to be aimed at achieving the five key macroeconomic (economy-wide)
objectives:
• full employment (or reduced unemployment), -Unemployment refers to people who
are out of work, but who are of working age, are physically and men rally able to work, and are
actively looking for work.
• Controlled inflation (price stability) -Inflation refers to a persistent rise in the general
level of prices in the economy. Low and sustainable rates of inflation are viral to achieving economic
stability and social wellbeing.
• sustainable economic growth - Economic growth is the increase in a country's gross
domestic. product (GDP) over time. Achieving economic growth brings greater prosperity to an
economy and therefore tends to raise the standard of living for most people.
• The redistribution of income (lower income inequality) - As an economy grows,
the gap between top and bottom income earners tends to widen. For example, huge bonuses are
often awarded to executives in the finance industry. This causes greater income inequalities in the
economy. The government might therefore intervene by using progressive taxes to redistribute
income to low-income households.
• balance of payments stability - The balance of payments is a record of a country's financial
transactions with other nations. This includes the money flows into and out of a country from the sale
of exports and the purchase of imports

Economic growth
Economic growth refers to an increase in a country’s
real gross domestic product (GDP) over time.
Economists believe that sustained economic growth
is an important macroeconomic aim because it is
the most practical measure of standards of living in
a country. Economic growth represents a long-term
expansion in the productive capacity of the
economy.
Diagrammatically, economic growth can be shown
by an outward shift of the production possibility
curve (PPC ). In Figure , a combination of an
increase in the quantity and quality of factors of
production shifts the PPC outwards from PPC1 to
PPC2, creating more producer and consumer goods,
shown by the movement from A to B. By contrast,
negative economic growth results in a recession in
the business cycle.

Full employment/ low unemployment
Unemployment occurs when people are The unemployment rate calculates the
willing and able to work, and actively percentage of the labour force that is
seeking employment, but are unable to unemployed. It is measured using the
fi nd work. Low unemployment is a key formula:
macroeconomic aim because it
complements economic growth —
higher employment tends to lead to
greater GDP. Hence, low For example, in a country with a
unemployment tends to increase the workforce of 50 million people, of
standards of living in an economy. In which 5 million are of working age and
addition, full employment or low actively seeking employment but
unemployment represents greater cannot find work, the unemployment
efficiency in the use of the economy’s rate equals (5m ÷ 50m) × 100 = 10%.
resources.

Stable prices/low inflation
Inflation is the sustained rise in the general price level in an

economy. This does not mean that the price of every good and
service is increasing, but that on average prices are rising.
Governments set a target inflation rate as a key macroeconomic aim
in order to control economic activity. Inflation is typically measured
by using a Consumer Price Index (CPI). This weighted index measures
the change in prices of a representative basket of goods and services
consumed by the average household in the economy

Balance of payments stability
The balance of payments is a financial record of a country’s transactions with the rest of the
world for a given time period, usually one year. This includes the country’s trade in goods and
services with other countries. The government records credit items (all payments received
from other countries) and debit items (all payments made to other nations) in its balance of
payments. For example, the expenditure by French tourists visiting the UK would be recorded
as a credit item on the UK’s balance of payments. In theory, the balance of payments must
always balance over time because a country, like an individual, can only spend what it earns.
In general, a large and persistent balance of payments deficit suggests that the country is
uncompetitive in international markets. This can have detrimental consequences for the
domestic economy, such as job losses. Thus, a deficit on the balance of payments will have a
negative impact on economic growth and standards of living.

Redistribution of income
Governments aim to achieve greater equality through the redistribution of

income. A report by Oxfam and Forbes in 2017 suggested that the world’s eight
richest people had as much wealth as the poorest 3.6 billion of the world’s
population.
Economies face unequitable distribution of income due to the naturally unequal
ownership of factors of production in a free market economy. For example,
consider the wage differentials between professional footballers, doctors and
pilots, on the one hand, and those earning the national minimum wage, on the
other.
A major role of taxation is to redistribute income to help the relatively less well-off
in society. For example, progressive taxation charges a higher percentage tax as an
individual’s income rises — in other words, those who earn more pay a greater
proportion of their income in tax (see Chapter 26). Other ways to redistribute
income include the use of subsidies and welfare benefits, such as old age pensions
and unemployment benefits.

Conflicts between government aims
As it is not possible simultaneously to achieve all five macroeconomic objectives, there is said to be a
trade-off or conflict between these targets. Examples of possible conflicts between a government's
macroeconomic goals are considered below.
• Economic growth versus low inflation – if an economy grows due to excessive consumer demand,
this will force prices to increase, thus creating inflation in the economy. Similarly, the government
might choose to deflate the economy to control inflation, but this limits the ability to achieve
economic growth. Therefore, it is rather difficult to achieve both macroeconomic objectives at the
same time.
• Low unemployment (or full employment) versus inflation - In theory, there is an inverse
relationship between the level of unemployment and the rate of inflation. For example, an attempt to
reduce unemployment via the use of expansionary fiscal policy, such as lowering taxes or increasing
government spending, can cause demand-pull inflation. Similarly, when the government tries to
control inflation by using deflationary policies such as higher taxes or higher interest rates , the
resulting fall in both consumer spending and investment will result in job losses.

Conflicts between government aims
• Economic growth versus a balance of payments equilibrium – Consumer spending and

business investments tend to be high during an economic boom. However, if this is fuelled by a
significant rise in spending on imports relative to exports, this leads to a worsening trade deficit
on the country's balance of payments.
• Economic growth versus protection of the environment - Economic growth often leads to
environmental problems such as land degradation, climate change , pollution and the depletion of
non-renewable resources.
• Economic growth versus the redistribution of income and wealth - As an economy grows, there
tends to be a widening income and wealth gap between the rich and the poor .

4.3 Fiscal policy ( Ch-26)
4.3.1 definition of the government budget
4.3.2 reasons for government spending
4.3.3 reasons for taxation
4.3.4 classification of taxes
4.3.5 principles of taxation
4.3.6 impact of taxation
4.3.7 definition of fiscal policy
4.3.8 fiscal policy measures
4.3.9 effects of fiscal policy on government macroeconomic aims

Fiscal policy
The government budget refers to the Budget
government’s financial plans in terms of planned

revenues and expenditure. There are other Budget Deficit Budget Surplus
sources of government revenue (such as (Revenue<Govt. Spending) (Revenue>Govt. Spending)
government borrowing or privatisation proceeds

from the selling of state assets) but tax revenues
are by far the most significant source.

Reasons for Govt. Spending & taxation
Govt. Spending Taxation

• To redistribute income from the rich to the
• To influence economic activity poor
• To reduce market failure • To discourage the consumption of demerit
• To promote equity goods
• To pay interest on national debt • To raise the costs of firms that impose
costs on others
• To discourage the consumption of imports
and hence protect domestic industries
• To influence economic activity

Classification of taxes
Tax Direct and indirect taxation Taxes can be
classified into direct and indirect taxation:
Based on » Direct taxation — this type of tax is

source paid from the income, wealth or profit of
individuals and fi rms. Examples are taxes
on salaries, inheritance and company
Direct Tax Indirect Tax
profits.
Based on
» Indirect taxation — these are
structure
expenditure taxes imposed on spending
on goods and services. For example,
Proportional countries such as Australia and Singapore
Tax use a ‘goods and services tax’ (GST),
Regressive
whereas the European Union uses value
Tax
Progressive added tax (VAT). Other examples are taxes
Tax on petrol, alcohol and cigarettes.

The main categories of taxes
Progressive tax
Direct tax – taxes on income & wealth Income ($) Tax Paid ($) Tax Rate (%)
100 10 10
Indirect Taxes – Taxes on Expenditure 500 100 20
1000 400 40
Progressive tax – A larger % of Income or
wealth of the rich.
Proportional tax
Income ($) Tax Paid ($) Tax Rate (%)
Proportional tax –same % for all tax 100 25 25
payers 500 125 25
1000 250 25
Regressive tax – A larger % of the income
or wealth of the poor.
Regressive tax
Income ($) Tax Paid ($) Tax Rate (%)
100 40 40
500 150 30
1000 200 20

Example of Taxes

Progressive taxation
Under this tax system, those
with a higher ability to pay are
charged a higher rate of tax.
This means that as the
income, wealth or profit of
the taxpayer rises, a higher
rate of tax is imposed.
Examples of progressive taxes
are income tax, capital gains
tax and stamp duty (see slide
23).

Regressive taxation
Under this tax system, those with a
higher ability to pay are actually
charged a lower rate of tax — in other
words, the wealthier the individual,
the lower the tax paid as a percentage
of the income level . For example,
although a high income earner pays
the same amount of airport tax or
television licence fee as a less wealthy
person, the amount of tax paid is a
smaller proportion of the wealthier
person’s income.

Proportional taxation
Under this tax system, the
percentage paid stays the
same, irrespective of the
taxpayer’s level of income,
wealth or profits. An
example is a sales tax, such
as VAT or GST. For example,
Denmark has a 25 per cent
GST whereas sales taxes in
India and Japan are as low
as 5 per cent.

Impact of tax
• Total tax revenue
• Consumers pay
• Producers pay
• Tax
• Dead weight loss
• Community welfare loss

canons of taxation
These state that a ‘good’ tax is one that is:
 equitable – those who can afford to should pay more
 economic – the revenue should be greater than the costs of
Collection
 transparent – tax payers should know exactly what they are
paying
 convenient – it should be easy to pay.
 Certainty — the taxpayer should know what, when, where and
how to pay the tax (to limit tax evasion).
 Efficiency — the tax system should attempt to achieve its aims
without any undesirable side-effects.
 Flexibility — taxes need to be flexible enough to adapt to a
change in the economic environment without requiring the
rewriting of tax legislation.
The impact of taxation
Taxation has varying impacts depending on the type of tax in question. The impact of taxation on
economic agents and the economy are considered below.
• Impact on price and quantity - price increase, supply decrease
• Impact on economic growth - Taxation tends to reduce incentives to work and to produce.
• Impact on inflation -to reduce the spending ability of individuals and the profits of firms, it
helps to lessen the impact of inflation
• Impact on business location - The rate of corporation tax and income tax will affect where
multinational businesses choose to locate
• Impact on social behaviour - Taxation can be used to alter social behaviour with the intention
of reducing the consumption of demerit goods
• Impact on incentives to work – lf taxes arc too high, this can create disincentives to work.
• Impact on tax avoidance and tax evasion - Some taxes arc preventable. Tax avoidance is the
legal act of not paying taxes: for example, non-smokers do not pay tobacco tax and non-
overseas travellers do not pay air passenger departure taxes. However, tax evasion is illegal as
it refers to non -payment of taxes due, perhaps by a business under-declaring its level of
profits.
• Impact on the distribution of wealth - The use of taxes can help to redistribute income and
wealth from the relatively rich to the poorer members of society.

Use of fiscal policy
Fiscal policy can be used either to expand or to contract economic activity in order to achieve macroeconomic
objectives and to promote economic stability.
Expansionary fiscal policy is used to stimulate the economy, by increasing government spending and/or
lowering taxes.
By contrast, contractionary fiscal policy is used to reduce the level of economic activity by
decreasing government spending and/or raising taxes.
• Incentives to work - Cuts in income tax can be used to create incentives for people to seek employment and to
work harder. Some economists argue that reducing social welfare assistance such as unemployment benefits
can also create incentives for people to seek employment. Government support for business start-ups can also
create incentives for entrepreneurs and business creation.
• Investment expenditure - Government capital expenditure on infrastructure (such as railroads, motorways,
schools and hospitals) helps to boost investment in the economy.
• Human capital expenditure - This refers to government expenditure on the workforce by investing in
education and training. Such fiscal policies arc designed to boost the productivity of labour (or the human
capital of the workforce). Human capital expenditure is often accompanied by government spending on
health care and transportation networks, as these help to raise labour productivity

Effects of fiscal policy on government
macroeconomic aims
Fiscal policy can be used to achieve a government’s macroeconomic aims. Examples are
provided below.
» Economic growth — government capital expenditure on infrastructure (such as railways,
motorways, schools and hospitals) helps to boost investment in the economy. Lower rates of corporation tax
can help to attract foreign direct investment (FDI) into the country, thereby boosting the economy’s potential
output.
» Low inflation (stable prices) — lower taxes, and hence higher FDI, can boost the productive
capacity of the economy in the long run, which helps to keep the general price level relatively low.
Contractionary fiscal policy measures also help prevent price levels from soaring.
» Employment (low unemployment) — cuts in income tax can be used to create incentives
for people to seek employment and to work harder. Government support for business start-ups, through
subsidies or tax concessions, can also create incentives for entrepreneurs, thus helping to lower
unemployment.
» Healthy balance of payments — relatively low rates of taxation help to keep domestic firms
competitive, thereby benefiting exporters. The government might also choose to subsidise domestic
industries to improve their international competitiveness. These fiscal measures should benefit the country’s
balance of payments.
» Redistribution of income — the use of both progressive taxes and government spending (on
welfare benefits, education and healthcare) helps to redistribute income and wealth in the economy

Limitations of fiscal policy
There are three main limitations of using fiscal policy to control the level of economic activity:
problems with the timing (time lags), conflicting macroeconomic objectives and political
considerations.
There are three problems with the timing of fiscal policy:
• Recognition lags - There is a time lag in recognising that government intervention is needed to
affect the level of economic activity. This is because governments do not necessarily know if the
economy is growing too fast (or declining too quickly).
• Administrative lags - There is a time delay between recognising the need for fiscal policy
intervention and actually implementing's appropriate action, such as approving tax changes or
alterations to the government budget.
• Impact lags - There is a time lag between implementing fiscal policy and seeing the actual
effects on the economy. A cut in income tax, for example, will take time to have a significant
impact on the spending habits of households.

Subsidies
Another form of government intervention in the market
is through the provision of subsidies. These are direct
payments made by governments to the producers of
goods and services.
Governments pay money to producers and may be done

for many reasons including:
■ to keep down the market prices of essential goods
■ to encourage greater consumption of merit goods
■ to contribute to a more equitable distribution of income
■ to provide services that would not be provided by the
free market
■ to raise producers’ income, especially in the case of
farmers
■ to provide an opportunity for exporters to sell more
goods
■ to reduce dependence on imports by paying subsidies to
domestic producers of close substitutes.

4.4 Monetary policy (ch-27)
4.4.1 definition of money supply and monetary policy

4.4.2 monetary policy measures
4.4.3 effects of monetary policy on government macroeconomic aims

Monetary policy (Ch-27)
Monetary policy is the manipulation of Direct control of the money supply is relatively
interest rates, exchange rates and the money difficult, as the definition of money is quite loose
supply to control the amount of spending and and banks can create credit quite easily .
investment in an economy. Interest rates can Manipulation of exchange rates is also rather
refer to the price of borrowing money or the difficult for many countries due to the reliance on
yield from saving money at a financial international trade and compliance with the
institution. The money supply refers to the regulations of the World Trade Organization.
entire quantity of money circulating an
economy, including notes and coins, bank Hence, most governments rely on interest rate
loans and bank deposits policy to achieve economic stability. In most
countries, the central bank or monetary authority
is responsible for overseeing exchange rate
changes.

Monetary policy
Interest rates
Cost of Exchange Loans to Business

borrowing Rates consumers Investment

Use of monetary policy
Like fiscal policy, monetary policy can be used either to expand or to contract economic
activity in the economy.
Expansionary monetary policy, also known as loose monetary policy, aims to boost
economic activity by expanding the money supply. This is done mainly by lowering
interest rates. This makes borrowing more attractive to households and firms because
they are charged lower interest repayments on their loans. Those with existing loans and
mortgages have more disposable income, so they have more money available to spend.
With contractionary monetary policy, also known as tight monetary policy, an increase
in interest rates rends to reduce spending and investment in the economy.
Thus, this slows down economic activity. Tight monetary policy is used to control the
threat of inflation, although it can harm economic growth and therefore cause job losses
in the long run.

Monetary policy measures
There are three main monetary policy measures, as described below.
» Changes in interest rates — the main monetary policy measure is the use of
interest rates to influence the level of economic activity.
» Changes in money supply — the government can control the money supply in order
to influence the level of economic activity.
» Changes in foreign exchange rates — the foreign exchange market has a direct
impact on the domestic money supply.
Expansionary monetary policy, also known as loose monetary policy, aims to boost
economic activity by expanding the money supply.
With contractionary monetary policy, also known as tight monetary policy, an

increase in interest rates tends to reduce overspending and limit investment in the economy.

The effects of monetary policy measures on
macroeconomic aims
Monetary policy measures can enable the government to achieve its macroeconomic aims :
» Economic growth — the monetary policy measure of lower interest rates can be used to
achieve economic growth.
» Full employment/low unemployment — lower interest rates, as described above, will
tend to cause economic growth. More spending and investment in the economy will tend to
create more jobs.
» Stable prices/low inflation — economic growth stimulated by lower interest rates will
result in higher consumption and investment expenditure. This will increase the productive
capacity of the economy, so more can be produced without having to incur higher prices. By
contrast, higher interest rates are used to limit consumption and investment in order to control
the rate of inflation.
» Balance of payments stability — a lower exchange rate, through government
intervention in the foreign exchange market, will tend to improve the international
competitiveness of the country. Hence, this should help to improve the balance of payment.

Changes in Money supply
A central bank can increase money supply by printing more money, buying back government
bonds or encouraging commercial bank to lend more.
- Printing money is a straightforward way of increasing money supply (resorting to the printing
press).
- Buying government bonds gives commercial banks more money to lend their customers.
- Increase borrowing to spend on consumer and capital goods.
- Increase consumer spending and investment
- Increase AD
- Increase output

Changes in the rate of interest
A rise in Interest rate-

- Reduce AD
- Reduce consumer Expenditure
- Reduce investment
- Borrowers (past) will have to pay more interest on their loans
- More expensive finance
- Increase save
- Rise foreign exchange
- Lower net exports by causing a rise in the price of exports and a fall in the price of imports.
** A fall in interest rate effects the factors in opposite way.

Limitations of monetary policy
As with fiscal policy, there are time Jags to the reaction to interest rate changes in the economy.
This can make the effectiveness of monetary policy less certain or even estabilising for the economy.
Furthermore, economic activity is not totally and only dependent on interest rates. Other factors,
such as consumer and business confidence levels, have an impact on gross domestic product. The
global financial crisis of 2008 proved that, de spire interest rates being close to, or equal to, 0 per
cent in countries such as Japan, the USA and Hong Kong, the lack of business and consumer
confidence led to a prolonged economic recession.
Some economists argue that the use of monetary policy can be counter productive because it
restricts economic activity and discourages foreign direct investment in the country. For example,
higher interest rates raise the costs of production for firms, as existing and new loans become
more expensive. This has negative impacts on profits, job creation, research and development
expenditure, and innovation. Hence, higher interest rates (used to combat inflation) can conflict
with other macroeconomic objectives, especially with economic growth and employment.

4.5 Supply-side policy (ch-28)
4.5.1 definition of supply-side policy
4.5.2 supply-side policy measures
4.5.3 effects of supply-side policy measures on government macroeconomic aims

Supply-side policies
Supply-side policies are long-term strategies aimed at increasing the productive capacity of the
economy by using policies to improve the quality and/or quantity of factors of production . This
means that the economy can produce more goods and services at all price levels. This can be shown
as an outward shift of the country's production possibility curve . Examples of supply-side policies
are given below.
• Privatisation
• Deregulation
• Capital investment
• Human capital investment (Education
& Training)
• Tax reforms ( Lowering direct tax and
increasing incentives)
• Enterprise zones
• Labour market reforms
• Subsidy
The main criticism of supply-side policies is the rime that it takes to reap the benefits. For example, it might
take decades for a nation to enjoy the benefits of an improved education system or better infrastructure in the
country.

Supply side policy
Privatisation
Training and
education
Capital investment, programmes for
infrastructure, New
workers
technologies, R & D
Incentives to Deregulation,
work taxes reforms,
Enterprise zones
Incentives to
invest

The merits of supply-side policies
The advantages of using supply-side policies to achieve economic stability include:
• Improved economic growth - Supply-side policies can be used to achieve sustainable economic
growth by increasing the productive capacity of the economy.
• Lower inflation - As supply-side policies increase the productive potential of the economy, they
help to prevent the general price level from rising beyond control.
• Lower unemployment - An increase in the economy's productive capacity will tend to increase
national output, thereby creating jobs in the economy in the long term. Also, supply-side policies
can help to reduce both frictional and structural unemployment .
• Improved balance of payments - Since supply-side policies can improve productivity and national
output without increasing the general price level, the international competitiveness of the country
should improve. For example, firms should become more productive and competitive, which will
help to boost the economy's export earnings. Therefore, supply-side policies tend to improve a
country's balance of payments .

The effects of supply side policy on
government Macroeconomic aims
- All the government’s macro economic aims Price level

AS
AS1
have the potential to benefit from supply side

policy.
- An increasing AS enables an economy to
continue to grow in a non –inflationary way.
(output and employment increase without P
inflation) AD1
- Increase BOP ( increasing productive potential AD
and efficiency)
- Increase export and reduce imports
0 Y Y1 Real GDP
** these all are involved with time lag

4.6 Economic growth (Ch-29)
4.6.1 definition of economic growth

4.6.2 measurement of economic growth
4.6.3 causes and consequences of recession
4.6.4 causes of economic growth
4.6.5 consequences of economic growth
4.6.6 policies to promote economic growth

Economic growth
Economic growth is the increase in the level of
national output - that is, the annual percentage
change in GDP. Hence, in theory, an increase in any of
the components of GDP (consumption, investment,
government spending and net exports) can cause
economic growth.
An increase in the quantity and/or the quality of
factors of production can also create economic
growth, such as an increase in the labour supply or
improvements in the state of technology.
Economic growth increases the Jong-term productive
capacity of the economy, shown by an outward shift
of the production possibility curve .
Causes of economic growth

• Factor endowments
• The labour force
• Labour productivity
• Investment expenditure

Measurement of economic growth
Economic growth can be measured using real gross domestic product (real GDP) and GDP per
head (or GDP per capita). These are arrived at from a calculation of nominal GDP as follows.
Nominal gross domestic product (nominal GDP) measures the monetary value of
goods and services produced within a country during a given period of time, usually one year.
The components of nominal GDP are:
» Consumption expenditure (C) — this refers to the total spending on goods and
services by individuals and households in an economy.
» Investment expenditure (I) — this refers to the capital spending of firms used to
increase production and to expand the economy’s productive capacity.
» Government spending (G) — this is the total consumption and investment
expenditure of the government.
» Export earnings (X) — this measures the monetary value of all exports sold to foreign
buyers.
» Import expenditure (M) — this measures the monetary value of all payments for
imports.
The difference between the values of a country’s exports and imports (X – M) is called net
exports.

GDP and Real GDP
a country’s GDP is calculated using the formula: GDP = C + I + G + (X – M)
From this, two measures can be used to gauge the level of economic growth:
» Real GDP refers to the value of national income (GDP) that is adjusted for inflation. It reflects
the true value of goods and services produced in a given year because inflation artificially raises the
value of a country’s output.
» GDP per head (or GDP per capita) measures the gross domestic product of a country
divided by its population size. This is a key measure of a country’s economic growth and standards
of living, as GDP per head indicates the mean average national income per person. Ceteris paribus,
the larger the population size, the lower the GDP per head for a certain level of GDP.

Causes and consequences of economic growth
An increase in any of the components of GDP (consumption, investment, government spending or net
exports) can cause economic growth. In addition, an increase in the quantity and/or the quality of factors of
production can also create economic growth, such as an increase in the labour supply or improvements in
the state of technology. The factors that account for the differences in the economic growth rates of
different countries include variations in the following:
» Factor endowments — this refers to the quantity and quality of a country’s factors of production.
» The labour force — the size, skills and mobility of the economy’s workforce has an impact on the
country’s economic growth.
» Labour productivity — this refers to the amount of goods and services that workers produce in a
given time period. It is often referred to as output per worker, expressed as a monetary value (GDP divided
by the country’s labour force).
» Investment expenditure — investment is a component of overall demand in the economy, so any
increase in investment should help to boost the country’s GDP.

Positive consequences of economic growth
In general, economic growth is desirable due to its positive consequences for members of society.
These advantages include the following:
» Improved standards of living — economic growth tends to lead to higher standards of

living for the average person.
» Employment — economic growth leads to higher levels of employment in the economy. This
helps to raise consumption and encourages further investment in capital, helping to sustain
economic growth.
» Tax revenues — economic growth is associated with higher levels of spending in the
economy. This generates more tax revenues for the government.

Negative consequences of economic growth
Despite the advantages of economic growth, there are also potential drawbacks:
» Environmental consequences — high rates of economic growth can create negative
externalities such as pollution, congestion, climate change and land erosion.
» Risk of inflation — if the economy grows due to excessive demand, there is the danger of
demand-pull inflation. This can lead to prices of goods and services rising to unstable levels, with
negative consequences for the economy, such as a decline in the country’s international
competitiveness.
» Inequalities in income and wealth — although the country as a whole might
experience economic growth, not everyone will benefit in the same way. Economic growth often
creates greater disparities in the distribution of income and wealth — the rich get richer and the
poor get relatively poorer, creating a widening gap between the rich and poor.
» Resource depletion — economic growth often involves using up the world’s scarce
resources at rates that are not sustainable. For example, deforestation and overfishing have led to
problems in the ecosystem.
Hence, economic growth does not necessarily resolve a country’s socioeconomic problems, such
as resource depletion, market failures (see Chapter 14) and income inequality
Policies to promote economic growth
Economic growth can be promoted by using macroeconomic policies to increase demand in the
economy and/or boost the productive capacity of the economy. These policies include demand-
side policies (namely fiscal and monetary policies) and supply-side policies.
» Fiscal policy involves the use of taxation and/or government spending to control the
level of economic activity in the economy. If demand in the economy is too low, the
government may choose to stimulate economic growth by cutting taxes and/or increasing its
own expenditure in order to boost the level of economic activity.
» Monetary policy involves the central bank changing interest rates in order to control the
level of demand and hence economic activity. To promote economic growth, lower interest
rates can be used to cut the costs of borrowing to consumers and firms.
» While both fiscal and monetary policies target demand in order to achieve economic growth,
supply-side policies are used to increase the economy’s productive capacity. These
policies seek to increase competition, productivity and innovation in order to promote
economic growth.

Causes of recession
There are several interrelated reasons why a recession may come about:
» a higher level of unemployment
» higher interest rates, which discourages investment but raises demand for
savings
» greater uncertainty in the economy
» lower rates of disposable income, causing a fall in consumer spending
» lower levels of government expenditure
» a decline in the demand for exports
» lower levels of consumer and business confidence.

The business cycle
Economic growth occurs when
there is an increase in the level
of economic activity in a
country over time. The term
business cycle (also known as
the trade cycle) describes the
fluctuations in economic
activity in a country over time.
These fluctuations create a
long-term trend of growth in
the economy, as shown in
Figure.

Recession Cause & Consequences
Causes: Consequences:
• Decrease in AD or AS • Rise unemployment
• Fall in consumer or Business • Lower living standard
confidence • Fall in investment
• Reducing govt. spending • Revenue will decline

4.7 Employment and unemployment
(ch-30)
4.7.1 definition of employment, unemployment and full employment

4.7.2 changing patterns and level of employment
4.7.3 measurement of unemployment
4.7.4 causes/types of unemployment
4.7.5 consequences of unemployment
4.7.6 policies to reduce unemployment

Employment
Employment refers to the economic use of labour as a factor of production. For example, people
may work in the primary, secondary or tertiary sectors of the economy. Employment also
includes those who are self-employed. High employment, or low unemployment, is a key
macroeconomic objective of all governments. There are several reasons for this:
» High employment raises standards of living for the average person in the
country.
» It promotes economic growth — another key macroeconomic objective.
» It increases tax revenues (due to higher levels of income and spending in the
economy), which are used to finance government spending.
» It reduces the financial burden and opportunity cost to the government as
spending on welfare benefits falls.
» It prevents ‘brain drain’ from the economy. This can occur during periods of high
unemployment when highly skilled workers leave the country in search of job opportunities
elsewhere.
» It reduces income and wealth inequalities — poorer people are more affected by
unemployment as they lack savings and wealth.

Unemployment
Unemployment occurs when people of working age are both willing and able to work but cannot
find employment. The United Nations International Labour Organization (ILO) states the lower
limit of the working age to be 15 years old. While there is no official upper limit, many countries
use an age limit of between 65 and 70. For example, the official retirement age for females in the
UK is 66 years and 5 months, while the retirement age is 67 years for all workers in Norway,
Poland and the USA. Figure 30.1 shows the unemployment rates in Portugal from 2007 to 2017.
Full employment refers to the ideal situation when everyone in a country who is willing
and able to work has a job. Governments strive to ensure that everyone who is able and
willing to work finds employment. This helps the economy to make the most of its human
resources.

Unemployment
Unemployment occurs when people of working age are both willing and able to work but cannot
find employment. The United Nation's International Labour Organisation (ILO) states the lower age
limit for employment as 15 years old. While there is no official upper limit, many countries use an
age limit of between 65 and 70.
The unemployment rate shows the percentage of the country's workforce (those of working age)
that is unemployed. It is calculated by the formula:
X100
Alternatively, this can be expressed as
X100
The ILO measures a country's unemployment based on the number of people who are:
• willing to work, bur unable to find it
• actively looking for work - that is, they have looked for a job in the last 4 weeks
• able to start work within the next 2 weeks or waiting to start a new job within in the next 2 weeks.

Changing patterns and levels of employment
Employment refers to the use of factors of production, such as labour, in the economy. For
example, people may work in the primary, secondary or tertiary sectors of the economy . It also
includes those who arc self-employed.
Employment patterns change over time with changes in economic trends. For example, there have
been large job losses in manufacturing industries in the USA and the UK as many firms have
shifted their operations to India and China.
Some changing employment patterns in modern economies include:
• Employment sector - As a country develops, the number of people employed in the primary
industry tends to full and the majority of workers are employed in the tertiary sector.
• Delayed entry to workforce - As more people study to tertiary education level, the average age
of employees entering the workforce rises.
• Ageing population - This occurs when the average age of the population rises, partly due to
lower birth rates and longer life spans in developed economies.
• Flexible working patterns - Changes in the world economy have meant that firms need to be far
more flexible in order to compete internationally
• Public sector employment
• Formal sector employment
• Female participation rates

Measuring unemployment
There are two main ways of measuring (or defi ning) unemployment: the claimant count and the
labour force survey.
The claimant count measures the number of people who are out of work and claiming
unemployment benefits. To qualify for benefits, they must prove they are actively seeking
employment.
The labour force survey (LFS) is an alternative measure of unemployment produced by
the ILO. It uses a standardised household-based survey to collect work-related statistics, such as
employment status, education and training opportunities. The LFS is used by all member states
of the European Union and other countries too. Questionnaires are collected face-to-face or
completed over the telephone.
The ILO measures a country’s unemployment based on the number of people who are:
» willing to work, but unable to find it
» actively looking for work — that is, they have looked for a job in the last 4 weeks, and
» able to start work within the next 2 weeks, or » waiting to start a new job within the next 2
weeks

Causes of unemployment
There are many potential causes of unemployment. These causes can be explained by examining the
various types of unemployment.
• Frictional unemployment is transitional unemployment that occurs when people change jobs,
due to the time delay between leaving a job and finding or starting a new one.
• Seasonal unemployment is caused by regular and periodical changes in demand for certain
products.
• Technological unemployment occurs when workers Jose their jobs due to firms opting to use
capital-intensive technologies. This can cause large· scale unemployment in certain industries.
• Youth unemployment affects members of the working population aged 21 and below. They have
relatively fewer skills and less experience, so they are the most likely to be affected during an economic
downturn.
• Regional unemployment occurs when unemployment affects specific geographical areas of a
country. While busy central business districts tend to have higher rates Of employment, remote rural
areas have relatively high rates of unemployment.

Measures and indicators of living standards
Economists believe that sustained An alternative measure of standards of living that looks at factors beyond
economic growth is an important real GDP is called the Human Development Index (H DI ). This is a composite
macroeconomic objective because indicator of living standards in a country, obtained by measuring three
it is the most practical measure of dimensions of human development:
standards of living in a country. • Health care - this indicator measures life expectancy at birth. The better
the health care in a country, the greater social and economic wellbeing
The two main measures or tends to be.
indicators of living standards are • Education - this indicator measures the mean years of schooling and the
GDP per head (or GDP per capita) expected years of schooling in the country.
and the Human Development • Income levels - the higher the national income (or GDP) of a country, the
Index (HDI). greater human development tends to be.
One problem in using GDP figures However, there are limitations in using the HDI to measure standards of living:
to measure standards of living is • Qualitative factors - the HDI ignores qualitative measures affecting standards
that the size of the population is of living, such as gender inequalities and human rights.
ignored. • Income distribution - the HDI does not take account of inequitable income
Another consideration is inflation - distribution, thus being less accurate in measuring Jiving standards for the
a persistent increase in the 'average‘ person.
general level of prices over rime. • Environmental issues - the H DI ignores environmental and resource depletion
Inflation erodes the value of GDP resulting from economic growth.
because the value of money falls if • Cultural differences - although the HDI is a composite indicator, it ignores
there is inflation. cultural differences and interpretations of the meaning of standards of living.

Causes of unemployment…..
• Structural unemployment occurs when the demand for products produced in a
particular industry falls continually, often due to foreign competition. There are structural and
Jong-term changes in demand for the products of certain industries.
• Voluntary unemployment occurs when workers choose not to work. Voluntary
unemployment usually exists in economies with relatively generous welfare benefits for the
unemployed as well as high rates of income tax, thus creating disincentives to work at current
market (equilibrium) wage rates.
• Classical (real-wage) unemployment
occurs when real wage rates are set above the market-
clearing level, such as in the case of a national
minimum wage . This leads to excess supply of labour,
as the number of job-seekers exceeds the demand for
labour. In the Figure , the imposition of a minimum
wage raises the cost of labour from W1 to W2 . At the
higher wage rate, demand
for labour is N, but the supply of labour is N2 ; the
difference represents unemployment, as firms arc
unable and/or unwilling to pay workers more than
their market (equilibrium) value.

Causes of unemployment…..
• Cyclical unemployment, also
known as demand - deficient
unemployment, is
the most severe type of unemployment
because it can affect every industry in the
economy. It is caused by a lack of aggregate
demand, which causes a full in national
income. In Figure, the full in aggregate
demand in the economy from AD1 to AD2
causes national income to full from Y1 to
Y2 , creating mass unemployment.
Demand-deficient unemployment is
experienced during an economic downturn
- that is, in recessions and slumps.

Consequences of unemployment
Unemployment affects a range of stakeholders: the individuals who are unemployed themselves, firms
(employers) and the economy as a whole. The consequences of unemployment include the following:
» The individuals who are unemployed may suffer from stress, depression, other health problems, low
self-esteem, a lack of dignity and homelessness. In extreme cases, unemployment can even lead to
suicides.
» Family and friends may also suffer from lower incomes as a result of unemployment. This often leads to
arguments and even separation or divorce.
» The local community can suffer if there is mass unemployment, as a result of poverty, falling house
prices (and hence asset values) and increased crime rates.
» Firms lose out as there are lower levels of consumer spending, investment and profits. Business failures
and bankruptcies are therefore more likely to occur during periods of high unemployment.
» The government may face higher expenditure on welfare benefits and healthcare for the unemployed.
Hence, prolonged periods of high unemployment can lead to increased government debts.
» Taxpayers stand to lose due to the opportunity costs of unemployment — namely, increased reliance on
taxpayer’s money to finance unemployment and welfare benefits.
» The economy as a whole suffers from being less internationally competitive due to falling levels of
spending and national output.

Policies to deal with unemployment
Governments can try to deal with the problems of unemployment in a number of ways. This party
depends on the causes of unemployment in the economy. As there are many types and causes of
unemployment, the government needs to identify the best policies to deal with the problem. There
are four general policics for reducing unemployment: fiscal policy, monetary policy,
supply-side policy and protectionist measures .
• Fiscal policy - This is the use of

taxation and government spending policies
to influence the level of economic activity. It
can be used to tackle unemployment caused
by demand-side issues, such as cyclical and
structural unemployment. The use of
expansionary fiscal policy (tax cuts and
increased government spending) can boost
aggregate demand and real national income,
as shown in Figure. In turn, this will lead to
more employment opportunities.

Policies to deal with unemployment…..
• Monetary policy - This refers to

the use of interest rates to affect the level
of economic activity. By lowering interest
rates, the cost of borrowing falls, thus
encouraging households and firms to
spend and invest. In Figure , higher
aggregate demand boosts the demand for
labour curve from DL1 to DL2. This results
in higher levels of employment in the
economy, as shown by the move from N1
to N2 • The resulting rise in real wage
rates from W1 to W2also helps to attract
more labour, causing an expansion along
the supply of labour (SL) curve. Like fiscal
policy, monetary policy tackles demand-
side causes of unemployment.

Policies to deal with unemployment…..
• Protectionist measures such as tariffs and quotas can be used to safeguard

domestic jobs from the threat of international competition.
• Supply- side policies - These government strategies arc used to deal with
imperfections in the labour market and to reduce unemployment caused by supply-side
factors. Thus, these policies arc aimed at addressing frictional, voluntary and classical
unemployment, although they can also be used to help reduce structural and cyclical
unemployment. Examples of supply-side policies are as follows:
• Investment in education and t raining
• A reduction in trade union Powers
• Employment incentives
• A review of welfare benefits

Employment as a macroeconomic objective
High employment, or low unemployment, is a key macroeconomic objective of all governments.
There are several reasons for this, as high employment helps to:
• raise standards of living for the average person in the country
• increase economic growth - another key macroeconomic objective
• raise tax revenues (due to higher levels of income and spending in the economy) to finance
government spending
• reduce the financial burden and opportunity cost for the government, as spending on welfare
benefits falls
• prevent 'brain drain' from the economy - this can occur during periods of high unemployment
when highly skilled workers leave the country in search of job opportunities elsewhere
• reduce income and wealth inequalities - poorer people are more affected by unemployment, as
they lack savings and wealth.

4.8 Inflation and deflation
(ch-31)
4.8.1 definition of inflation and deflation

4.8.2 measurement of inflation and deflation
4.8.3 causes of inflation and deflation
4.8.4 consequences of inflation and deflation
4.8.5 policies to control inflation and deflation

Inflation
Inflation is a sustained rise in the general price level in an economy over time. This docs not
mean that the price of every good and service increases, but that on average the prices are
rising.
Governments aim to control

inflation because it reduces the
value of money and the spending
power of households, governments
and firms. For example, the inflation
rare in the western Asian country of
Syria was around 48 per cent in
2013, meaning that the general
price level in Syria increased by an
average of 48 per cent in a year. This
means that a product priced at 100
Syrian pounds would increase to
148 Syrian pounds by the end of the
year.
O level_ Economics, Section 4, zia-
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Measuring inflation and deflation/
The consumer price index (CPI)
The consumer price index (CPI ) is a common The statistical weights in the CPI are based on
method used to calculate the inflation rate. It the proportion of the average household's
measures price changes of a representative income spent on the items in the representative
basket of goods and services (those basket of goods and services. For example, if the
consumed by an average household) in the typical household in a country spent 15 per cent
country. For example, items such as staple of its income on food, then 15 per cent of the
food products, clothing, petrol and weights in the index would be assigned to food.
transportation are likely to be included.
Therefore, items of expenditure that take a
However, different weights are applied to greater proportion of the typical household's
reflect the relative importance of each item in spending are assigned a larger weighting .
the average household's expenditure. For Changing fashions and trends, such as a hike in
example, a household expenditure on smartphones, online
10 per cent increase in the price of petrol will apps and tablet computers, require a review (or
affect people far more than a 50 per cent update) of the weights in the CPI.
increase in the price of light bulbs, batteries
or tomatoes. Changes in the CPI therefore
represent changes in the cost of living for the
average household in the economy.
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The CPI versus the RPI
Both the consumer price index and the retail price index (RPI ) can be used to calculate the rate of inflation. Both
indices follow a similar pattern . However, there are three key differences to these price indices:
• The items included in the calculations - The main difference is that the RPI includes the cost of housing, such
as mortgage interest payments and other housing costs. The RPI also includes overseas expenditure by
domestic. households. The CPI includes costs paid for financial services.
• The population base - Both price indices try to measure changes in the cost of living for the average
household. However, the RPI excludes low-income pensioner households and very high-income households,
as it is argued that these do not represent the 'average' household or the expenditure of the average family.
• The method of calculation - The RPI is calculated using the arithmetic mean whereas the CPI uses the
geometric mean. What this means is that the RPI tends to be lower than the CPI (un less interest rates for
mortgage repayments are extremely low). For example, suppose the price changes for a product in the last
three months were 1 per cent, 2 per cent and 3 per cent. The arithmetic mean (RPI ) would average these
changes to 2 per cent, i.e. . However,the geometric mean (CPI ) would average these changes to just 1.8 per
cent, i.e. .
A key political and economic reason for calculating both price indices is that inflation affects the whole economy
and can have major impacts on certain stakeholders.

Calculating the CPI or RPI
A price index is used to indicate the average percentage change in prices compared with a starring
period called the base year. The CPI and RPI compare the price index of buying a representative
basket of goods and services with the base year, which is assigned a value of 100. Hence, a price
index of 115.2 means that prices
have in general increased by 15.2 per cent since the starring period. If prices were to rise by
another 5 per cent in the subsequent year, the price index number would become 120.96 (that is,
11 5.2 x 1.05), or 20.96 per cent higher since the base year. Price changes in the CPI and RPI are
measured on a monthly basis bur reported for a 12-momh period.
Calculating changes in the CPI or RPI gives the rate of inflation. To do so, two steps are involved:
• collection of the price data on a monthly basis
• assigning the statistical weights, representing different patterns of spending over time.

Calculating the CPI or RPI….
The simplified example in the table , with three To calculate inflation between 2013 and 2014,
products in the representative basket of goods first calculate the price indices for the two
and services, shows how the total basket price is years in question:
calculated. Assume 2012 is the base year, when
the total basket price was $20.
• 2013: 100 = 110 (prices in 2013 were 10
per cent higher on average than in
Product Price in Price in 2012).
2013 ($) 2014 ($) • 2014: X 100=122.5 (prices in 2014 were
Pizza 9 10 22.5 per cent higher on average than in
2012).
Cinema Ticket 10 11
The inflation rate between 2013 and 2014
Petrol 3 3.5 is the percentage change in the price
Total Basket Price 22 24.5 indices during these two periods: =11.36%.

Weighted price index
the products measured in the CPI are of different degrees of importance to the typical household,
so weights are applied to reflect this. Suppose, for example, in a particular country food
consumption accounts for 40 per cent of average household spending whereas entertainment
represents 20 per cent, transport represents 25 per cent and all other items represent the
remaining 15 per cent. To create a weighted price index, economists multiply the price index for
each item (in the representative basket of goods and services) by the statistical weight for each
item of expenditure. Applying these weights gives the results shown in Table
Product Price index Weight Weighted index
Food 110.0 0.40 110 X 0.40 = 44.0
Entertainment 115.0 0.20 115 X 0.20 = 23.0
Transport 116.4 0.25 116.4 X 0.25 = 29.1
Other 123.3 0.15 123.3 X 0.15 = 18.5
Weighted index 114.6
While the price of food has increased the least (only 10 per cent) since the base year, spending on food
accounts for 40 per cent of the typical household's spending. This has a much larger impact on the cost of
living than the 15 per cent increase in the price of entertainment, which accounts for only 20 per cent of the
average household expenditure.

The causes of inflation
There are two main causes of inflation. These
relate to demand-pull inflation and cost-push
inflation.
Cost-push inflation is caused by higher costs
of production, which makes firms raise their
prices in order to maintain their profit
margins. For example, in the Figure, higher
raw material costs, increased wages and
soaring rents shift the aggregate supply (total
supply) curve for the economy to the left from
AS1 to AS2, forcing up the general price level
from P1 to P2 and reducing national income
from Y1 to Y2.

The causes of inflation….
Demand-pull inflation is caused by higher levels
of aggregate demand (total demand in the
economy) driving up the general price level of
goods and services. For example, during an
economic boom, household consumption of
goods and services increases due to higher GDP
per capita and higher levels of employment. In
Figure, this is shown by a rightward shift of the
aggregate demand curve from AD1 to AD2,
raising national income from Y1 to Yi and forcing
up the general price level from P1 to P2 .
In general, inflation can be controlled by
limiting the factors that cause demand-pull
inflation and cost-push inflation. For example,
the government can raise taxes and interest
rates to limit consumption and investment
expenditure in the economy.

Other possible causes of inflation
Monetary causes of Imported inflation occurs

inflation are related to due to higher import
increases in the money prices, forcing up costs of
supply and easier access to production and therefore
credit, e.g. loans and credit causing domestic
cards. inflation.

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The consequences of inflation
Inflation can complicate planning and decision making for households, firms and governments, with many consequences as
outlined below.
Menu costs - Inflation impacts on the prices charged by firms. Catalogues, price lists and menus have to be updated regularly and
this is costly to businesses.
Consumers - The purchasing power of consumers goes down when there is inflation - there is a fall in their real income because
money is worth less than before.
Shoe leather costs - Inflation causes fluctuations in price levels, so customers spend more time searching for the best deals.
Savers - Savers, be they individuals, firms or governments, lose out from inflation, assuming there is no change in interest rates for
savings. This is because the money they have saved is worth less than before.
Lenders - Lenders, be they individuals, firms or governments, also lose from inflation.
Borrowers - By contrast, borrowers tend to gain from inflation as the money they need to repay is worth Jess than when they
initially borrowed it - in other words, the real value of their debt declines due to inflation.
Fixed income earners - During periods of inflation, fixed income earners (such as pensioners and salaried workers whose pay do
not change with their level of output) see a fall in their real income.
Low income earners - Inflation harms the poorest members of society far more than those on high incomes. Low income earners
tend to have a high price elasticity of demand for goods and services.
Exporters - The international competitiveness of a country tends to fall when there is domestic inflation.
Importers - Imports become more expensive for individuals, firms and the government due to the decline in the purchasing power
of money.
Employers - Workers are likely to demand a pay rise during times of inflation in order to maintain their level of real income.
Business confidence levels - Inflation also causes business uncertainty. The combination of uncertainty and the lower expected
real rates of return on investment (due to higher costs of production) rends to lower the amount of planned investment in the
economy.

Deflation
While the prices of goods and services tend to rise, the prices of some products actually fall over
time. This is perhaps due to technological progress or a fall in consumer demand for the product,
both of which can cause prices to fall. Deflation is defined as a persistent fall in the general price
level of goods and services in the economy - in other words, the inflation rate is negative.

The causes of deflation
The causes of deflation can be categorised as either demand or supply
factors. Deflation is a concern if it is caused by falling aggregate demand
for goods and services (often associated with an economic recession
and rising levels of unemployment).
Aggregate supply
Aggregate demand

Aggregate supply
Deflation can be caused by higher levels of aggregate
supply, increasing the productive capacity of the economy.
This drives down the general price level of goods and
services while increasing national income. Such deflation is
called benign deflation (non-threatening deflation). For
example, supply-side policies such as investment in
education and infrastructure, China's high-speed rail higher
productivity, improved Inflation managerial practices,
technological advances and government subsidies for major
industries all help to raise national income in the long run.
In Figure, this is shown diagrammatically by a rightward
shift of the aggregate supply curve from AS1 to AS2,
reducing the general price level from P1 to P2 . This
happened in China during the past three decades with the
Chinese government pouring huge amounts of investment
funds into building new roads and rail networks (the
country spent $104 billion on railway investment in 2013).

Aggregate demand
Deflation can also be caused by lower levels of
aggregate demand in the economy, driving down the
general price level of goods and services due to
excess capacity in the economy. This causes what is
known as malign deflation (deflation that is harmful
to the economy). For example, during an economic
recession, household consumption of goods and
services falls due to lower GDP per capita and higher
levels of unemployment. In Figure, this is shown by a
leftward shift of the aggregate demand curve from
AD1 to AD2, reducing national income from Y1 to Y2 ,
and forcing down the general price level from P1 to P2
. This happened in Japan for much of the past two
decades as the Japanese suffered from severe
economic recession. This cause of deflation is a
concern as it is associated with a decline in national
income and standards of living.

The consequences of deflation
The consequences of deflation depend on whether we Wealth effect -As the profits of firms fall, so does the
are considering benign deflation or malign deflation. value of their shares during times of deflation.
The consequences of benign deflation are positive as Debt effect - The real cost of debts (borrowing)
the economy is able to produce more, thus boosting increases when there is deflation. This is because real
national income and employment, without interest rates rise when the price level falls. For
causing an increase in the general price level. This example, if
therefore boosts the international competitiveness of interest rates average 1.0 per cent but the inflation
the country. However, malign deflation is generally rare is - 1.5 per cent, then the real interest rare is 2.5
harmful to the economy. The consequences of malign per cent.
deflation include the following: Government debt - With more bankruptcies,
Unemployment - As deflation usually occurs due to a unemployment and lower levels of economic activity,
fall in aggregate demand in the economy, this causes a tax revenues fall while the amount of government
fall in the demand for labour - that is, deflation causes spending
job losses in the economy. rises (due to the economic decline associated with
Bankruptcies - During periods of deflation, consumers malign inflation).
spend less so firms tend to have lower sales revenues Consumer confidence - Deflation usually causes a fall
and profits. This makes it more difficult for firms to in consumer confidence levels, as consumers fear
repay their costs and liabilities that things will get worse for the economy.

Policies to control inflation and deflation
Inflation can be controlled by using macroeconomic policies to slow down the growth of
demand in the economy and/or boost the rate of growth of the economy’s overall supply of
goods and services. These policies include the following.
Fiscal policy
Fiscal policy involves the use of taxation and/or government spending to control the level of
economic activity in the economy. If the general level of demand in the economy is too high
(causing demand-pull inflation), the government may choose to ‘tighten fiscal policy’ by
raising taxes and/or reducing its own expenditure in order to reduce the level of economic
activity.
During times of deflation, it can be very difficult to break out of a downward

deflationary spiral. To do so would require a significant boost to demand in the economy. The
government may choose to cut direct taxes, leading to an increase in real incomes and thus
greater levels of demand. This should result in higher levels of economic activity, which has a
positive effect on employment and economic growth.

Policies to control inflation and deflation ….
Monetary policy
Monetary policy involves the central bank changing interest rates in order to control the
level of economic activity. For example, higher interest rates may reduce consumer and
investment expenditure as the cost of borrowing (to fund household spending and business
investments) soars.
Lower interest rates can also be used to control deflation as the cut in interest rates
reduces the exchange rate, ceteris paribus. This is because foreign investors receive a lower
return on their investments. The resulting fall in the exchange rate brings about a fall in
the price of imports and hence an increase in the demand for exports.

Policies to control inflation and deflation ….
Supply-side policies
Whilst both fiscal and monetary policies target the demand side of the economy in order to
tackle the issue of inflation or deflation, supply-side policies are used to increase the
economy’s productive capacity. These policies seek to increase competition,
productivity and innovation in order to maintain lower prices. Some countries, such as Iran
and France, have used subsidies for food and fuel to reduce prices in the economy.
A reduction in corporate tax rates can also encourage risk-taking and greater
investment. Countries that do not charge any corporate tax include Bahrain, the Bahamas,
the Cayman Islands, the Isle of Man and the United Arab Emirates.
In the short run, fiscal and monetary policies are used to control inflation or
deflation. In the long run, supply-side policies boost the productive capacity of
the economy, thereby giving it flexibility to grow without suffering from the costs of inflation.

Source / References
1. Cambridge O level Economics
By Susan Grant
2. Edexcel IGCSE Economic
By Rob Jones
3. Economics IGCSE Revision guide
By Brian Titley with Halen Carrier
4. Economics for IGCSE
By Robert Dransfield, Terry cook, Jane King
5. Economics GCSE(9-1)
By Rob Jones
6. Economics for IGCSE and O level
By Moynihan and Titley
7. Cambridge IGCSE & O level Economics
by Paul Hoang & Margaret Ducie

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4 Government and the

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Inflation is the sustained rise in the general price level in an

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Governments aim to achieve greater equality through the redistribution of

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• Economic growth versus a balance of payments equilibrium – Consumer spending and

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government’s financial plans in terms of planned

government borrowing or privatisation proceeds

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Govt. Spending Taxation

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Based on » Direct taxation — this type of tax is

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Governments pay money to producers and may be done

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4.4.1 definition of money supply and monetary policy

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Cost of Exchange Loans to Business

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With contractionary monetary policy, also known as tight monetary policy, an

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A rise in Interest rate-

** A fall in interest rate effects the factors in opposite way.

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- All the government’s macro economic aims Price level

have the potential to benefit from supply side