UNIT- 3:Macro Economic concern

Inflation-

Inflation is a quantitative measure of the rate at which the average price level of a basket of selected goods and services in an economy increases over a period of time. It is the constant rise in the general level of prices where a unit of currency buys less than it did in prior periods. Often expressed as a percentage, inflation indicates a decrease in the purchasing power of a nation’s currency

Inflation is measured in a variety of ways depending upon the types of goods and services considered and is the opposite of deflation which indicates a general decline occurring in prices for goods and services when the inflation rate falls below 0 percent. 

KEY TAKEAWAYS

  • Inflation is the rate at which the general level of prices for goods and services is rising and, consequently, the purchasing power of currency is falling.
  • Inflation is classified into three types: Demand-Pull inflation, Cost-Push inflation, and Built-In inflation.
  • Most commonly used inflation indexes are the Consumer Price Index (CPI) and the Wholesale Price Index (WPI).
  • Inflation can be viewed positively or negatively depending on the individual viewpoint.
  • Those with tangible assets, like property or stocked commodities, may like to see some inflation as that raises the value of their assets.
  • People holding cash may not like inflation, as it erodes the value of their cash holdings.
  • Ideally, an optimum level of inflation is required to promote spending to a certain extent instead of saving, thereby nurturing economic growth.

Pros and Cons of Inflation

Inflation is both good and bad, depending upon which side one takes.

For example, individuals with tangible assets, like property or stocked commodities, may like to see some inflation as that raises the value of their assets which they can sell at a higher rate. However, the buyers of such assets may not be happy with inflation, as they will be required to shell out more money.

People holding cash may also not like inflation, as it erodes the value of their cash holdings. Inflation promotes investments, both by businesses in projects and by individuals in stocks of companies, as they expect better returns than inflation.

However, an optimum level of inflation is required to promote spending to a certain extent instead of saving. If the purchasing power of money remains the same over the years, there may be no difference in saving and spending. It may limit spending, which may negatively impact the overall economy as decreased money circulation will slow overall economic activities in a country. A balanced approach is required to keep the inflation value in an optimum and desirable range.

Example of Inflation

Imagine your grandma stuffed a $10 bill in her old wallet in the year 1975 and then forgot about it. The cost of gasoline during that year was around $0.50 per gallon, which means she could have then bought 20 gallons of gasoline with that $10 note. Twenty-five years later in the year 2000, the cost of gasoline was around $1.60 per gallon. If she finds the forgotten note in the year 2000 and then goes on to purchase gasoline, she would have bought only 6.25 gallons. Although the $10 note remained the same for its value, it lost its purchasing power by around 69 percent over the 25-year period. This simple example explains how money loses its value over time when prices rise. This phenomenon is called inflation.

Types of inflection-

US ECONOMY INFLATION

Types of Inflation: The Four Most Critical Plus Nine More

Including Asset, Wage, and Core Inflation

Inflation is when the prices of goods and services increase. There are four main types of inflation, categorized by their speed. They are creeping, walking, galloping and hyperinflation. There are specific types of asset inflation and also wage inflation. Some experts say demand-pull and cost-push inflation are two more types, but they are causes of inflation. So is expansion of the money supply.

01 Creeping Inflation

Creeping or mild inflation is when prices rise 3 percent a year or less. According to the Federal Reserve, when prices increase 2 percent or less it benefits economic growth. This kind of mild inflation makes consumers expect that prices will keep going up. That boosts demand. Consumers buy now to beat higher future prices. That’s how mild inflation drives economic expansion. For that reason, the Fed sets 2 percent as its target inflation rate.

02 Walking Inflation

Health care costs rise faster than 3% a year.

This type of strong, or pernicious, inflation is between 3-10 percent a year. It is harmful to the economy because it heats up economic growth too fast. People start to buy more than they need, just to avoid tomorrow’s much higher prices. This drives demand even further so that suppliers can’t keep up. More important, neither can wages. As a result, common goods and services are priced out of the reach of most people.

03 Galloping Inflation

Galloping inflation occurred during WWII.
U.S. National Archives and Records Administration

When inflation rises to 10 percent or more, it wreaks absolute havoc on the economy. Money loses value so fast that business and employee income can’t keep up with costs and prices. Foreign investors avoid the country, depriving it of needed capital. The economy becomes unstable, and government leaders lose credibility. Galloping inflation must be prevented at all costs.

04 Hyperinflation

Hyperinflation is when prices skyrocket more than 50 percent a month. It is very rare. In fact, most examples of hyperinflation have occurred only when governments printed money to pay for wars. Examples of hyperinflation include Germany in the 1920s, Zimbabwe in the 2000s, and Venezuela in the 2010s. The last time America experienced hyperinflation was during its civil war.

05 Stagflation

Stagflation is when economic growth is stagnant but there still is price inflation. This seems contradictory, if not impossible. Why would prices go up when there isn’t enough demand to stoke economic growth?

It happened in the 1970s when the United States abandoned the gold standard. Once the dollar’s value was no longer tied to gold, it plummeted. At the same time, the price of gold skyrocketed.

Stagflation didn’t end until Federal Reserve Chairman Paul Volcker raised the fed funds rate to the double-digits. He kept it there long enough to dispel expectations of further inflation. Because it was such an unusual situation, stagflation probably won’t happen again.

06 Core Inflation

The core inflation rate measures rising prices in everything except food and energy. That’s because gas prices tend to escalate every summer. Families use more gas to go on vacation. Higher gas costs increase the price of food and anything else that has large transportation costs.

The Federal Reserve uses the core inflation rate to guide it in setting monetary policy. The Fed doesn’t want to adjust interest rates every time gas prices go up.

Continue to 7 of 13 below.

07 Deflation

Deflation is the opposite of inflation. It’s when prices fall. It’s caused when an asset bubble bursts.

That’s what happened in housing in 2006. Deflation in housing prices trapped those who bought their homes in 2005. In fact, the Fed was worried about overall deflation during the recession. That’s because deflation can turn a recession into a depression. During the Great Depression of 1929, prices dropped 10 percent a year. Once deflation starts, it is harder to stop than inflation.

08 Wage Inflation

Wage inflation is when workers’ pay rises faster than the cost of living. This occurs in three situations. First, is when there is a shortage of workers. Second, is when labor unions negotiate ever-higher wages. Third is when workers effectively control their own pay.

A worker shortage occurs whenever unemployment is below 4 percent. Labor unions negotiated higher pay for auto workers in the 1990s. CEOs effectively control their own pay by sitting on many corporate boards, especially their own. All of these situations created wage inflation.

Of course, everyone thinks their wage increases are justified. But higher wages are one element of cost-push inflation. That can drive up ​the prices of a company’s goods and services.

09 Asset Inflation

An asset bubble, or asset inflation, occurs in one asset class. Good examples are housing, oil and gold. It is often overlooked by the Federal Reserve and other inflation-watchers when the overall rate of inflation is low. But the subprime mortgage crisis and subsequent global financial crisis demonstrated how damaging unchecked asset inflation can be.

10 Asset Inflation — Gas

Gas price inflation

Gas prices rise each spring in anticipation of the summertime vacation driving season. In fact, you can expect gas prices to rise ten cents per gallon each spring. But political uncertainty in the oil-exporting countries drove gas prices higher in 2011 and 2012. Prices hit an all-time peak of $4.11 in July 2008, thanks to economic uncertainty. 

What do oil prices have to do with gas prices? A lot. In fact, oil prices are responsible for 72 percent of gas prices. The rest is distribution and taxes. They aren’t as volatile as oil prices. 

11 Asset Inflation — Oil

oil price inflation
 David McNew/Getty Images

Crude oil prices hit an all-time high of $143.68 a barrel in July 2008. This was in spite of a decrease in global demand and an increase in supply. Oil prices are determined by commodities traders. That includes both speculators and corporate traders hedging their risks. Traders bid up crude oil prices in two situations. First, is if they think there are threats to supply, such as unrest in the Middle East. Second, is if they see an uptick in demand, such as growth in China.

12 Asset Inflation — Food

Food prices soared 6.8 percent in 2008, causing food riots in India and other emerging markets. They spiked again in 2011, rising 4.8 percent. High food costs led to the Arab Spring, according to many economists. Food riots caused by inflation in this important asset class could reoccur.

13 Asset Inflation — Gold

Gold price inflation

An asset bubble occurred when gold prices hit the all-time high of $1,895 an ounce on September 5, 2011. Although many investors might not call this inflation, it sure was. That’s because prices rose without a corresponding shift in gold’s supply or demand. Instead, investors ran to gold as a safe haven. They were concerned about the declining dollar. They felt gold protected them from hyperinflation in U.S. goods and services. They were uncertain about global stability.

What spooked investors? In August, the jobs report showed absolutely zero new job gains. During the summer, the eurozone debt crisis looked like it might not get resolved. There was also stress about whether the United States would default on its debt. Gold prices rise in response to uncertainty. Sometimes it’s to hedge against inflation. Other times it’s the exact opposite, the resurgence of recession. 

What is Unemployment?

Unemployment occurs when a person who is actively searching for employment is unable to find work. Unemployment is often used as a measure of the health of the economy. The most frequent measure of unemployment is the unemployment rate, which is the number of unemployed people divided by the number of people in the labor force.

KEY TAKEAWAYS

  • Unemployment occurs when workers who want to work are unable to find jobs, which means lower economic output, while still requiring subsistence.
  • High rates of unemployment are a signal of economic distress, but extremely low rates of unemployment may signal an overheated economy.
  • Unemployment can be classified as frictional, cyclical, structural, or institutional.
  • Unemployment data are collected and published by government agencies in a variety of ways.

Understanding Unemployment

Unemployment is a key economic indicator because it signals the (in)ability of workers to readily obtain gainful work to contribute to the productive output of the economy. More unemployed workers mean less total economic production will take place than might have otherwise. And unlike idle capital, unemployed workers will still need to maintain at least subsistence consumption during their period of unemployment. This means the economy with high unemployment has lower output without a proportional decline in the need for basic consumption. High, persistent unemployment can signal serious distress in an economy and even lead to social and political upheaval.

On the other hand, a low unemployment rate means that the economy is more likely to be producing near its full capacity, maximizing output, and driving wage growth and rising living standards over time. However, extremely low unemployment can also be a cautionary sign of an overheating economy, inflationary pressures, and tight conditions for businesses in need of additional workers.

While the definition of unemployment is clear, economists divide unemployment into many different categories. The two broadest categories of unemployment are voluntary and involuntary unemployment. When unemployment is voluntary, it means that a person has left his job willingly in search of other employment. When it is involuntary, it means that a person has been fired or laid off and must now look for another job. Digging deeper, unemployment — both voluntary and involuntary — can be broken down into four types.

Frictional Unemployment

Frictional unemployment arises when a person is in between jobs. After a person leaves a company, it naturally takes time to find another job, making this type of unemployment short-lived. It is also the least problematic from an economic standpoint. Frictional unemployment is a natural result of the fact that market processes take time and information can be costly. Searching for a new job, recruiting new workers, and matching the right workers to the right jobs all take time and effort to do, resulting in frictional unemployment.

Cyclical Unemployment

Cyclical unemployment is the variation in the number of unemployed workers over the course of economic upturns and downturns, such as changes to oil prices. Unemployment rises during recessionary periods and declines during periods of economic growth. Preventing and alleviating cyclical unemployment during recessions is a major concern behind the study of economics and the purpose of the various policy tools that governments employ on the downside of business cycles to stimulate the economy.

Structural Unemployment

Structural unemployment comes about through technological change in the structure of the economy in which labor markets operate. Technological change such as automation of manufacturing or the replacement of horse-drawn transport by automobiles, lead to unemployment among workers displaced from jobs that are no longer needed. Retraining these workers can be difficult, costly, and time consuming, and displaced workers often end up either unemployed for extended periods or leaving the labor force entirely.

Institutional Unemployment

Institutional unemployment is unemployment that results from long term or permanent institutional factors and incentives in the economy. Government polices such as high minimum wage floors, generous social benefits programs, and restricive occupational licensing laws; labor market phenomena such as efficiency wages and discriminatory hiring; and labor market institutions such as high rates of unionization can all contribute to institutional unemployment.

Measuring Unemployment

In the United States, the government uses surveys, census counts, and the number of unemployment insurance claims to track unemployment.

The US Census conducts a monthly survey on behalf of the Bureau of Labor Statistics called the current population survey in order to produce the primary estimate of nation’s unemployment rate. This survey has been done every month since 1940. The sample consists of about 60,000 eligible households, translating to about 110,000 people each month. The survey changes one-fourth of the households in the sample so that no household is represented for more than four consecutive months in order to strengthen the reliability of the estimates.

Meaning of Trade Cycle:

A trade cycle refers to fluctuations in economic activities specially in employment, output and income, prices, profits etc. It has been defined differently by different economists. According to Mitchell, “Business cycles are of fluctuations in the economic activities of organized communities. The adjective ‘business’ restricts the concept of fluctuations in activities which are systematically conducted on commercial basis.

The noun ‘cycle’ bars out fluctuations which do not occur with a measure of regularity”. According to Keynes, “A trade cycle is composed of periods of good trade characterised by rising prices and low unemployment percentages altering with periods of bad trade characterised by falling prices and high unemployment percentages”.

Features of a Trade Cycle:

1. A business cycle is synchronic. When cyclical fluctuations start in one sector it spreads to other sectors.

2. In a trade cycle, a period of prosperity is followed by a period of depression. Hence trade cycle is a wave like movement.

3. Business cycle is recurrent and rhythmic; prosperity is followed by depression and vice versa.

4. A trade cycle is cumulative and self-reinforcing. Each phase feeds on itself and creates further movement in the same direction.

5. A trade cycle is asymmetrical. The prosperity phase is slow and gradual and the phase of depression is rapid.

6. The business cycle is not periodical. Some trade cycles last for three or four years, while others last for six or eight or even more years.

7. The impact of a trade cycle is differential. It affects different industries in different ways.

8. A trade cycle is international in character. Through international trade, booms and depressions in one country are passed to other countries.

Circular flow upto four sector economy-

International trade includes exports and imports. The four sectors are as follows: household, firm, government, and foreign. The arrows denote the flow of income through the units in the economy. This circular flow of income model also shows injections and leakages

Circular flow of income in a four-sector economy consists of households, firms, government and foreign sector.

Household Sector:

Households provide factor services to firms, government and foreign sector.

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In return, it receives factor payments. Households also receive transfer payments from the government and the foreign sector.

Households spend their income on:

(i) Payment for goods and services purchased from firms;

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(ii) Tax payments to government;

(iii) Payments for imports.

Firms:

Firms receive revenue from households, government and the foreign sector for sale of their goods and services. Firms also receive subsidies from the government.

Firm makes payments for:

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(i) Factor services to households;

(ii) Taxes to the government;

(iii) Imports to the foreign sector.

Government:

Government receives revenue from firms, households and the foreign sector for sale of goods and services, taxes, fees, etc. Government makes factor payments to households and also spends money on transfer payments and subsidies.

Foreign Sector:

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Foreign sector receives revenue from firms, households and government for export of goods and services. It makes payments for import of goods and services from firms and the government. It also makes payment for the factor services to the households.

Circular Flow of Income in a Four Sector Economy

The savings of households, firms and the government sector get accumulated in the financial market. Financial market invests money by lending out money to households, firms and the government. The inflows of money in the financial market are equal to outflows of money. It makes the circular flow of income complete and continuous. The circular flow of income in a four-sector economy is shown in Fig. 1.7.

Government in the macro economy

Three main types of government macroeconomic policies are as follows: 1. Fiscal Policy 2. Monetary Policy 3. Supply-side Policies!

The three main types of government macroeconomic policies are fiscal policy, monetary policy and supply-side policies. Other government policies including industrial, competition and environmental policies. Price controls, exercised by government, also affect private sector producers.

1. Fiscal Policy:

Fiscal policy refers to changes in government expenditure and taxation. Government expenditure, also called public expenditure, and taxation occur at two main levels – national and local. Governments spend money on a variety of items including benefits (for the retired, unemployed and disabled), education, health care, transport, defense and interest on national debt.

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A government sets out the amount it plans to spend and raise in tax revenue in a budget statement. A budget deficit is when the government’s expenditure is higher than its revenue. In this case, the government will have to borrow to finance some of its expenditure.

In contrast, a budget surplus occurs when government revenue is greater than government expenditure. A balanced budget, which occurs less frequently, is when government expenditure and revenue are equal. A government may deliberately alter its expenditure or tax revenue to influence economic activity.

If a government wants to raise aggregate demand in order to increase economic growth and employment, it will increase its expenditure and/or cut taxation by lowering tax rates, reducing the items taxed or raising tax thresholds. For example, a government may cut income tax rates.

This will raise people’s disposable income, which will enable them to spend more. Higher consumption is also likely to raise investment. Fig. 1 shows the effect of a reflationary fiscal policy (also called an expansionary fiscal policy).

The Effect of a Reflationary Fiscal Policy

A government may implement a deflationary fiscal policy (also called a contractionary fiscal policy) to reduce inflationary pressure. A cut in government expenditure on, for instance, education would reduce aggregate demand. Such a reduction may lower the rise in the general price level.

2. Monetary Policy:

Monetary policy includes changes in the money supply, the rate of interest and the exchange rate, although some economists treat changes in the exchange rate as a separate policy. The main monetary policy measure, currently used in most countries, is changes in the rate of interest.

A rise in the rate of interest helps implement a deflationary monetary policy. It will be likely to reduce aggregate demand by lowering consumption and investment. Households will spend less due to availability of less discretionary income, expensive borrowing and greater incentive to save.

Firms will invest less as they will expect consumption to be lower. Also the opportunity cost of investment will have risen and borrowing will have become expensive. A higher interest rate may also reduce aggregate demand by lowering net exports.

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Changes in the money supply, as with changes in interest rates, are implemented by Central Banks on behalf of governments. If the money supply is increased by the Bank printing more money, buying back government bonds or encouraging commercial banks to lend more, the aggregate demand increases. On the other hand, a decrease in the money supply reduces aggregate demand.

3. Supply-side Policies:

Supply-side policies are policies designed to increase aggregate supply and hence increase productive potential. Such policies seek to increase the quantity and quality of resources and raise the efficiency of markets. These include improving education and training, cutting direct taxes and benefits, reforming trade unions and privatization. Improving education and training is designed to raise labour productivity.

The intention behind cutting direct taxes and benefits is to make work more attractive, relative to living on benefits. If successful, this will make the unemployed search for work more actively and will raise the labour force by encouraging more people (including for instance married women and the disabled) to seek employment. Reforming trade unions may make labour more productive and privatization may increase productive capacity, if private sector firms invest more and work more efficiently than state owned enterprises.

Measuring national income and output

A variety of measures of national income and output are used in economics to estimate total economic activity in a country or region, including gross domestic product (GDP), grass national product(GNP), net national income (NNI), and adjusted national income (NNI adjusted for natural resources depletion – also called as NNI at factor cost). All are specially concerned with counting the total amount of goods and services produced within the economy and by different sectors. The boundary is usually defined by geography or citizenship, and it is also defined as the total income of the nation and also restrict the goods and services that are counted. For instance, some measures count only goods & services that are exchanged for money, excluding bartered goods, while other measures may attempt to include bartered goods by imputing monetary values to them.