2.3 MACROECONOMIC OBJECTIVES:
LOW UNEMPLOYMENT
LOW AND STABLE RATE OF INFLATION
EQUITY IN THE DISTRIBUTION OF INCOME
THE ROLE OF TAXATION IN PROMOTING EQUITY
2.3 Macroeconomic Objectives: Low unemployment
1.Define the term unemployment.
Unemployment (or joblessness) occurs when people are without
work and actively seeking work.
Full employment and Underemployment: A society is almost never
fully employed, but one of the goals is to reach full employment.
Full employment has two conditions: Everyone who wants to work is
working, and the rate of inflation is stable. When the economy is at
full employment, there is no cyclical unemployment but still frictional
and structural unemployment. This is defined as natural
unemployment.
You are only classified as unemployed if you go and register with
the government as available for work.
The labor force is defined as those of 16 years of age or older who
are employed plus all those who are unemployed seeking work.
Unemployment rate : the number of people with no work
expressed as % of the labor force
2. Explain how the unemployment rate is calculated.
The unemployment rate is the number of people
looking for work divided by the total number of people
in the labor force.
Calculating the Unemployment Rate:
(Number of unemployed)/(Labor force) X 100 =
unemployment rate
3.Calculate the unemployment rate from a set
of data.
HOW TO:
The unemployment rate is the proportion of the labor force that is
unemployed. This means they are actively seeking work but unable to
find it.
You may be given a table showing the number of people in different
groups, like college students, retirees, people looking for jobs, people
who have given up looking for jobs, part time workers, full time
workers, etc… You will have to calculate the unemployment rate from
this information.
NOTE: People who are working part time but want to work full time
ARE EMPLOYED.
People who have given up looking for jobs are DISCOURAGED
WORKERS and are no longer considered unemployed, rather, they
have dropped out of the labor force.
Discouraged workers are not accounted for in unemployment data.
3. Calculate the unemployment rate from a
set of data.
The country of Altinima has a population of 150,000.
According to the latest data, there are 20,000 people
under the age of 16, and 30,000 people who are over
the age of 16, but not looking for work.
Currently, there are 5,000 people who are 16 or older
and actively looking for work.
The president of Altimina has asked you what the size of
the labor force is, what the number of unemployed is and
what the unemployment rate for Altimina is.
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The labor force in Altimina is ?
The number of unemployed is ?
The unemployment rate is ?
Not in labor force ?
4. Explain the difficulties in measuring unemployment, including the existence
of hidden unemployment, the existence of underemployment, and the fact that it is
an average and therefore ignores regional, ethnic, age and gender disparities.
Unemployment data may be based on people who
are registered as unemployed.
Alternatively, it may be calculated as the number of
people who are claiming unemployment benefits.
There may be problems measuring the true numbers of
people unemployed.
For example, the incentive to register as unemployed is
likely to depend on the availability of unemployment
benefits.
A person who is not entitled to any benefits is not likely
to register as unemployed.
4. Explain the difficulties in measuring unemployment, including the existence of hidden
unemployment, the existence of underemployment, and the fact that it is an average and
therefore ignores regional, ethnic, age and gender disparities.
hidden unemployment:
The unemployment or underemployment of workers that is not
reflected in official unemployment statistics because of the way they
are compiled.
Only those who have no work but are actively looking for work are
counted as unemployed. Those who have given up looking, those who
are working less than they would like, and those who work at jobs in
which their skills are underutilized are not officially counted among
the unemployed, though in a sense they are. These groups constitute
hidden unemployment.
Note: Because of hidden unemployment, official statistics
underestimate unemployment.
4. Explain the difficulties in measuring unemployment, including the existence of hidden
unemployment, the existence of underemployment, and the fact that it is an average and
therefore ignores regional, ethnic, age and gender disparities.
Underemployment
Labor that falls under the underemployment classification includes those
workers that are highly skilled but working in low paying jobs, workers
that are highly skilled but work in low skill jobs and part-time workers that
would prefer to be full-time. This is different from unemployment in that
the individual is working but isn't working at their full capability.
BREAKING DOWN 'Underemployment'
For example, an individual with an engineering degree working as a
pizza delivery man as his main source of income is considered to be
underemployed and underutilized by the economy as he in theory can
provide a greater benefit to the overall economy if he were working as
an engineer.
Also, an individual that is working part-time at an office job instead of
full-time is considered underemployed because they are willing to
provide more employment, which can increase the overall output.
4. Explain the difficulties in measuring unemployment, including the existence of hidden
unemployment, the existence of underemployment, and the fact that it is an average and
therefore ignores regional, ethnic, age and gender disparities.
There is also discouraged workers. These people are long-term
unemployed who have given up the search for work and are no
longer eligible for benefits. As soon as they give up the search,
they are no longer part of the unemployed.
Distribution of unemployment:
A national unemployment rate establishes an average for a
whole country, and this is very likely to mask inequalities among
different groups within an economy.
Typical disparities:
 Geographical disparities
 Age disparities
 Ethnic differences
 Gender disparities
4. Explain the difficulties in measuring unemployment, including the existence of hidden
unemployment, the existence of underemployment, and the fact that it is an average and
therefore ignores regional, ethnic, age and gender disparities.
http://big.assets.huffingtonpost.com/unemployment.gif
5. Discuss possible economic consequences of unemployment, including a loss
of GDP, loss of tax revenue, increased cost of unemployment benefits, loss of
income for individuals, and greater disparities in the distribution of income.
Economic consequences of unemployment:
 Lower level of Aggregate Demand
 Under-utilization of the nation’s resources
 Brain-drain
 A turn toward protectionism and isolationist policies
 Increased budget deficits
 diminished
tax base
 increased transfer payments
 increased
difficulty for labor market entrants - employers
have more choices, they favor experienced workers
 unemployed workers lose their skills
6. Discuss possible personal and social consequences of
unemployment, including increased crime rates, increased stress
levels, increased indebtedness, homelessness and family breakdown.
Individual consequences of unemployment:
Decreased household income and purchasing power
 Increased levels of psychological and physical illness, including
stress and depression
 lower quality of life
 lower self-esteem
Social consequences of unemployment:
 Downward pressure on wages for the employed
 Increased poverty and crime
 Transformation of traditional societies
Psychological Effects of Unemployment and
Underemployment

7. Describe, using examples, the meaning of frictional, structural,
seasonal and cyclical (demand-deficient) unemployment.
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Classical Unemployment: (Real-Wage ) your wage is too high, the price of
the good goes up and no one buys it so the firm moves to a cheaper country
Structural: Unemployment caused by the demand for your product falling e.g.
coalmining, we use oil now. Some skills are no longer needed e.g. you are a
trained draughtsman but we use computers now
Frictional: This is the desirable process of finding work, employers looking for
the right worker. In order to help accelerate this process, governments assist
people looking for jobs with programs and qualification surveys.
Seasonal: Unemployment caused by changes in season’s. e.g Santa Clause
only works a few weeks a year
Cyclical/Demand-deficient: Unemployment resulting from business recessions
that occur when total demand is insufficient to create full employment.
Regional Unemployment: if there is a coalmining area which closes down
there will be large unemployment in that area
Voluntary Unemployment: you are unemployed by choice, you get money
from the government anyway
8. Distinguish between the causes of frictional, structural, seasonal
and cyclical (demand-deficient) unemployment.
Different Causes of Unemployment
1. Frictional Unemployment:
 This is unemployment caused by the time people take to move
between jobs, e.g. graduates or people changing jobs. There
will always be some frictional unemployment in an economy
because information isn’t perfect and it takes time to find work.
However, if there is imperfect information and people don't
get to hear of jobs available that may suit them then frictional
unemployment will be higher.
 The better the economy is doing, the lower this type of
unemployment is likely to be. This is because people will usually
be able to find jobs that suit them more quickly when the
economy is doing well.
8. Distinguish between the causes of frictional, structural, seasonal
and cyclical (demand-deficient) unemployment.
Frictional unemployment
2. Structural Unemployment
This occurs due to a mismatch of skills in the labor market it can be caused
by:
Occupational immobility's. This refers to the difficulties in learning new
skills applicable to a new industry, and technological change, e.g. an
unemployed farmer may struggle to find work in high tech industries.
Geographical immobility's. This refers to the difficulty in moving regions
to get a job, e.g. there may be jobs in London, but it could be difficult to
find suitable accommodation or schooling for their children.
Technological change. If there is the development of labor saving
technology in some industries, then there will be a fall in demand for
labor.
8. Distinguish between the causes of frictional, structural, seasonal
and cyclical (demand-deficient) unemployment.
Demand-deficient or cyclical unemployment
Demand-deficient unemployment occurs when there is not enough demand to employ
all those who want to work. It is a type that Keynesian economists focus on
particularly, as they believe it happens when there is a disequilibrium in the economy.
It is also often known as cyclical unemployment because it will vary with the business
cycle. When the economy is booming, there will be lots of demand and so firms will be
employing large numbers of workers. Demand-deficient unemployment will at this
stage of the cycle be fairly low.
If the economy slows down, then demand will begin to fall. When this happens firms
will begin to lay workers off as they do not need to produce so much. The behavior of
demand-deficient unemployment will exactly mirror the business cycle.
Classical economists emphasis supply side factors as the main cause of
unemployment. They argue that demand deficient unemployment tends to be only
short term. However other Keynesian economists emphasize the importance of
aggregate demand in determining unemployment.
8. Distinguish between the causes of frictional, structural, seasonal
and cyclical (demand-deficient) unemployment.
Seasonal unemployment
Seasonal unemployment exists because certain industries only
produce or distribute their products at certain times of the year.
Industries where seasonal unemployment is common include,
 Hotel and catering
 Tourism
 Farming
 Holiday
 Construction
The effects of seasonal unemployment are often highly
regionalized.
9. Explain, using a diagram, that cyclical unemployment is
caused by a fall in aggregate demand.
Cyclical/Demand-deficient: Unemployment resulting from business
recessions that occur when total demand is insufficient to create full
employment.
10. Explain, using a diagram, that structural unemployment is caused by changes
in the demand for particular labor skills, changes in the geographical location of
industries, and labor market rigidities.
Structural unemployment is a
more permanent level of
unemployment that's caused by
forces other than the business cycle.
It can be the result of an
underlying shift in the economy
that makes it difficult for certain
segments of the population to find
jobs.
It's typically when there is a mismatch between the jobs available
and the skill levels of the
unemployed.
Equilibrium Unemployment
If the labor market is in
equilibrium and there is
still unemployment, then
there must be a gap
between the actual
supply of labor and the
potential supply of labor
as this diagram shows.
Equilibrium Unemployment
The labor supply curve shows
the number of people who are
willing and able to supply their
labor at each given wage rate.
If there is equilibrium in the
labor market then that implies
that everybody who is willing to
work at the equilibrium wage
rate is working, so any
remaining unemployment must
be people who could work
(potential supply - Spot) but are
not willing to work at the
equilibrium wage.
This is called equilibrium
unemployment.
11. Evaluate government policies to deal
with the different types of unemployment.
Policies to deal with different types of unemployment:
Classical Unemployment: (Real-Wage )
 Reduce Union labor power and/or reduce or eliminate
national minimum wages laws. (Supply Side policies)
Structural:
 Enhance occupational mobility of people, so that they are
more able to take available jobs.
 Re-trains programs, subsidies to firms that train workers,
tax breaks to move to where the jobs are, support more
apprenticeships programs. (Supply Side policies)
11.Evaluate government policies to deal with the
different types of unemployment.
Policies to deal with different types of unemployment:
Frictional:
 The government should lower unemployment benefits to
encourage unemployed workers to take the jobs that are
available rather than allow them to wait for a better one to
come along.
 Also, by improving the flow of information from potential
employers to people looking for jobs. (Supply Side policies)
Seasonal:
 Reduce unemployment benefits and a greater flow of
information of jobs available in the off season. (Supply Side
policies)
11.Evaluate government policies to deal with the
different types of unemployment.
Policies to deal with different types of unemployment:
Cyclical/Demand-deficient:
 Increase in aggregate demand through the use of fiscal
or monetary policies
Regional Unemployment:
 Reduce unemployment benefits and a greater flow of
information of jobs available in the off season.
(Supply Side policies)
Voluntary Unemployment:
 Reduce unemployment benefits and a greater flow of
information of jobs available in the off season.
(Supply Side policies)
11. Evaluate government policies to deal with the
different types of unemployment.
Policies for Reducing Unemployment:
There are two main strategies for reducing
unemployment  Demand side policies to reduce demand-deficient
unemployment (unemployment caused by recession)
 Supply side policies to reduce structural
unemployment / (the natural rate of unemployment)
12. Explain that the natural rate of unemployment is the rate of
unemployment that exists when the economy is producing at the full
employment level of output.
NATURAL UNEMPLOYMENT:
The combination of frictional and structural unemployment that
persists in an efficient, expanding economy when labor and
resource markets are in equilibrium.
Natural unemployment exists when the economy is at full
employment, which for practical purposes is defined as the
condition in which the quantity of resources demanded is equal to
the quantity of resources supplied.
Most important for policy purposes, natural employment exists with
stable prices, that is, no inflation.
NAIRU is an acronym for Non-Accelerating Inflation Rate of
Unemployment, and refers to a level of unemployment below which
inflation rises.
It is widely used in mainstream economics. It was also introduced as
NIRU (Non-Inflationary Rate of Unemployment).
12. Explain that the natural rate of unemployment is the rate of
unemployment that exists when the economy is producing at the full
employment level of output.
Friedman and Phelps concluded that expected inflation is what changed
the short-term relationship between unemployment and inflation into the
long-term natural rate of unemployment.
Expected inflation causes people to demand greater wages so that their
incomes will keep pace with inflation.
By increasing the cost of labor, the short-term increase in employment is
reversed back to the natural rate of unemployment.
This relationship is summarized in the natural rate hypothesis, which states
that unemployment eventually returns to its normal, or natural, rate,
regardless of the inflation rate.
The short-term unemployment rate can be approximated by the following
equation, where p equals a modifying parameter:
Unemployment Rate = Natural Rate of Unemployment - p × (Actual
Inflation - Expected Inflation)
12. Explain that the natural rate of unemployment is the rate of unemployment
that exists when the economy is producing at the full employment level of output.
12. Explain that the natural rate of unemployment is the rate of unemployment
that exists when the economy is producing at the full employment level of output.
2.3 Macroeconomic Objectives:
Low and stable rate of inflation
13. Distinguish between inflation, disinflation and
deflation. (Stagflation& Hyperinflation)
Inflation is defined as a sustained rise in the
average price level and a fall in the value of
money.
Deflation is defined as a sustained fall in the
average price level and a rise in the value of
money.
13. Distinguish between inflation, disinflation and
deflation. (Stagflation& Hyperinflation)
Good Deflation and Bad
Deflation
Good Deflation is very much a
real condition of the economy,
characterized by substantial
growth and development in
some sectors of a country,
despite the fact that the prices
of products in these sectors has
been reducing since a long span
of time. In fact, Good Deflation
results from technological
progresses, which initiates
excess supply of goods.
13. Distinguish between inflation, disinflation and
deflation. (Stagflation& Hyperinflation)
Bad Deflation is born out of
trifling demands. It is an
economic situation characterized
by reduction in the prices not due
to developments in the
productivities, but because of a
lack of demand induced by
crashing down of the stock
market or other market factors.
In fact, Deflation becomes bad
when the consumers save their
money for future uncertainties, or
in the expectation that prices
may lower further.
13. Distinguish between inflation, disinflation and
deflation. (Stagflation& Hyperinflation)
Disinflation is a decrease in the rate of inflation
– a slowdown in the rate of increase of the
general price level of goods and services in a
nation's gross domestic product over time.
For example if the annual inflation rate
one month is 5% and it is 4% the following
month, prices disinflated by 1% but are still
increasing at a 4% annual rate.
13. Distinguish between inflation, disinflation
and deflation. (Stagflation& Hyperinflation)
Stagflation
In economics, the term
stagflation refers to the
situation when both the
inflation rate and the
unemployment rate are high.
It is a difficult economic
condition for a country, as
both inflation and economic
stagnation occur
simultaneously and no
macroeconomic policy can
address both of these
problems at the same time.
13. Distinguish between inflation, disinflation
and deflation. (Stagflation & Hyperinflation)
In economics,
hyperinflation occurs
when a country
experiences very high and
usually accelerating rates
of inflation, rapidly
eroding the real value of
the local currency, and
causing the population to
minimize their holdings of
the local money.
14. Explain that inflation and deflation are typically measured by calculating a
consumer price index (CPI), which measures the change in prices of a basket of
goods and services consumed by the average household.
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The Consumer price index (CPI) / retail price index (RPI) measures changes
in the average prices of goods and services that the average consumer sees.
The GDP deflator is measured as the ratio of the value of total domestic
output at current prices divided by the same quantity of output valued at the
constant prices of a selected base year
The tax and price index (TPI) attempts to measure the changes in income
before tax that the average consumer would need to maintain their purchasing
power
The producer price index (PPI) measures changes in the average prices of
goods sold in primary markets by producers of commodities in all stages of
processing
All price indices suffer from certain inaccuracies. For example, they have a
hard time taking into account quality changes, and the “basket” may not
always be entirely representative of the purchases actually made.
15. Construct a weighted price index, using a set
of data provided.
To establish a weighed price index, we first determine the
weighted price of a basket of goods by adding together
the average price (P) of each category multiplied by the
category weight expressed in hundredths.
Assuming a price index has three categories, A, B and C, the
weighted price of the basket of good is:
(Pa x weighted in hundredths) + (Pb x weighted in
hundredths) + (Pc x weighted in hundredths)
Calculate the inflation rate from a set of data.
16. Calculate the inflation rate from a
set of data.
HOW TO:
The inflation rate = (CPI year 2 – CPI year 1)/CPI year 1x 100
It is the rate of change in the CPI between two years.
You do NOT always simply take the CPI and calculate the
rate of change since it was 100.
This would tell you how much inflation there was since the
base year, but inflation is usually measured between two
years.
IR = CPI2 – CPI1/CPI1 x 100
17. Explain that different income earners may experience a
different rate of inflation when their pattern of consumption is not
accurately reflected by the CPI.
Not all of a nation’s household are typical in that the income
of a nation is not evenly distributed across all households.
Some consumers will typically purchase a very different
basket of goods than is measured to determine the CPI
and inflation.
If a large percentage of a consumer’s income goes towards
a small selection of the goods measured by the CPI, then the
CPI as a whole may over or understate inflation depending
on how the prices of those particular goods have changed
relative to the rest of the goods measured.
18. Explain that inflation figures may not accurately reflect changes
in consumption patterns and the quality of the products
purchased.
The CPI only looks at one characteristic of the consumer
goods it records: the price.
What is not accounted for is the quality or the
technology behind the products.
What is not captured by this measure, however, is the
improvement in consumer happiness resulting from
improved quality and technology of newer and better
products that increase in both price and quantity.
M10/3/ECONO/HP2/ENG/TZ2/XX/M+
Explain how inflation can be measured and explain three problems associated with the
measurement of inflation.
Candidates may include:
 a definition of inflation
 measures of inflation such as a price index, retail price index, deflator, price deflator
 discussion of basket of goods (regimen), weighting, base year, regional issues (country
and city).
Problems associated with the measurement of inflation:
 price index based on purchasing preferences of “typical” household
 errors in the collection of data
 changes in consumption habits over time
 quality and types of goods and services change over time
 changes in producer prices are excluded
 one-off events such as seasonal variations, oil price shocks
 international comparisons.
19. Explain that economists measure a core/underlying rate of
inflation to eliminate the effect of sudden swings in the prices of
food and oil, for example.
In many countries, what is reported most often to households
by the government is what’s known as the core CPI.
This price index does not include changes in the price of
food and fuel, which economists ignore because of the
frequent dramatic swings in price from one period to the
next.
However, for many households food and fuel make up a
significant proportion of their expenditures.
A CPI that does not account for these goods may not
accurately reflect the effect that inflation is having on the
typical household.
Core CPI
20. Explain that a producer price index measuring changes in the
prices of factors of production may be useful in predicting future
inflation.
The Producer Price Index is a family of indexes that
measures the average change over time in the selling
prices received by domestic producers of goods and
services.
Producer Price Index PPIs measure price change from
the perspective of the seller. This contrasts with other
measures, such as the Consumer Price Index (CPI), that
measure price change from the purchaser's perspective.
21. Discuss the possible consequences of a high inflation rate,
including greater uncertainty, redistributive effects, less saving, and
the damage to export competitiveness.
Costs of Inflation Include:
International competitiveness:

A relatively higher inflation rate will make British goods less competitive, leading to a fall in
exports. However this may be offset by a decline in the exchange rate. But, if a country is in
the Euro (e.g. Greece, Ireland and Spain) they can’t devalue. Therefore, high inflation can be
very damaging as it leads to a decline in competitiveness.
Confusion and Uncertainty:

When inflation is high people are uncertain what to spend their money on. Also, when inflation
is high firms may be less willing to invest because they are uncertain about future profits and
costs. This uncertainty and confusion can lead to lower rates of economic growth over the long
term.
Menu Costs.

This is the cost of changing price lists. When inflation is high, prices need changing frequently
which incurs a cost. However, modern technology has helped to reduce this cost.
Shoe leather costs.

To save on losing interest in a bank people will hold less cash and make more trips to the bank.
21. Discuss the possible consequences of a high inflation rate, including
greater uncertainty, redistributive effects, less saving, and the damage to
export competitiveness.
Income redistribution.

Inflation will typically make borrowers better off and lenders worse off. Inflation reduces the
value of savings, especially if the saving is not index linked. However it does depends on the real
rate of interest. e.g. if a saver gets a higher rate of interest than the inflation rate he will not lose
out.
Boom and Bust Economic Cycles.

High inflationary growth is unsustainable and is usually followed by a recession. By keeping
inflation low it enables a long period of economic growth. E.g. in the UK, low inflation helped
economic growth to be more stable in the period 1992-2007. Sustainable, low inflationary,
economic growth is highly desirable.
Cost of Reducing Inflation:

High inflation is deemed unacceptable therefore governments feel it is best to reduce it. This will
involve higher interest rates to reduce spending and investment. This reduction in Aggregate
Demand will lead to a decline in economic growth and unemployment.
Fiscal Drag.

The amount of tax we pay will increase if there is inflation. This is because with rising wages more
people will slip into the top income tax brackets. See: Fiscal Drag

low inflation is often seen as harmless or even beneficial because it allows prices to adjust more
easily
22. Discuss the possible consequences of deflation, including high
levels of cyclical unemployment and bankruptcies.
Deflation is a period when the general price level falls i.e. the cost of a basket of goods and services is
becoming less expensive
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
It is normally associated with falling AD causing a negative output gap (actual GDP < potential GDP)
Deflation can be caused by an increase in productive potential, which leads to an excess of
aggregate supply over demand
Benign Deflation

If falling prices are caused by higher productivity, as happened in the late 19th century, then it can
go hand in hand with robust growth. On the other hand, if deflation reflects a slump in demand and
persistent excess capacity, it can be dangerous, as it was in the 1930s, triggering a downward spiral
of demand and prices. If the falling prices are simply the result of improving technology or better
managerial practices, that is fine.
Malign Deflation

Malign deflation occurs when prices fall because of a structural lack of demand which creates huge
excess capacity in an economic system. If there is a slump in demand, companies go out of business
and sack people, and hence demand falls again – the negative multiplier effect starts to have its
effect.
Problems of Deflation
22. Discuss the possible consequences of deflation, including high
levels of cyclical unemployment and bankruptcies.
Possible Economic Costs of Deflation:
 Holding back on spending: Consumers may opt to postpone demand if they
expect prices to fall further in the future. If they do, they might find prices are
5 or 10% cheaper in 6 months.
 Debts increase: The real value of debt rises when the general price level is
falling and a higher real debt mountain can be a drag on consumer
confidence and people’s willingness to spend.
 The real cost of borrowing increases: Real interest rates will rise if nominal
rates of interest do not fall in line with prices. For example UK policy interest
rates were slashed to 0.5% in 2009 but realistically they cannot go any lower.
If inflation is negative, the real cost of borrowing increases.
 Lower profit margins: Lower prices can mean reduced revenues and profits
for businesses - this can lead to higher unemployment as firms seek to reduce
their costs by shedding labor.
 Confidence and saving: Falling asset prices such as price deflation in the
housing market hit personal sector wealth and confidence – leading to further
declines in aggregate demand.
N05/3/ECONO/SP1/ENG/TZ0/XX/M
Explain the costs of inflation and the costs of deflation.
[10 marks]
• Definitions of both inflation and deflation
Costs of inflation include:
• effects on those who rely on fixed-income or are in a weak bargaining position
• implications of higher export prices
• inflation harms lenders and benefits borrowers
• uncertainty
• inflation may lead to high nominal interest rates
• menu costs
• “shoe-leather” costs
Costs of deflation include:
• falling prices may cause consumers to defer spending leading to greater deflationary
pressure
• investment spending is discouraged
• benefits lenders and harms borrowers.
23. Explain, using a diagram, that demand-pull inflation is caused
by changes in the determinants of AD, resulting in an increase in AD.
Demand-Pull Inflation:
results from an increase in
aggregate demand when
the economy is at or near
full-employment.
Demand-pull inflation is inflation demanding?
23. Explain, using a diagram, that demand-pull inflation is caused by
changes in the determinants of AD, resulting in an increase in AD.
Demand-pull inflation becomes a threat when an economy has experienced a boom with GDP rising
faster than the long-run trend growth of potential GDP
Demand-pull inflation is likely when there is full employment of resources and SRAS is inelastic
Main Causes of Demand-Pull Inflation
1.
A depreciation of the exchange rate increases the price of imports and reduces the foreign price
of a country's exports. If consumers buy fewer imports, while exports grow, AD in will rise – and
there may be a multiplier effect on the level of demand and output
2.
Higher demand from a fiscal stimulus e.g. lower direct or indirect taxes or higher government
spending. If direct taxes are reduced, consumers have more disposable income causing demand to
rise. Higher government spending and increased borrowing creates extra demand in the circular
flow
3.
Monetary stimulus to the economy: A fall in interest rates may stimulate too much demand – for
example in raising demand for loans or in leading to house price inflation. Monetarist economists
believe that inflation is caused by “too much money chasing too few goods" and that governments
can lose control of inflation if they allow the financial system to expand the money supply too
quickly.
4.
Fast growth in other countries – providing a boost to UK exports overseas. Export sales provide
an extra flow of income and spending into the UK circular flow – so what is happening to the
economic cycles of other countries definitely affects the UK
24. Explain, using a diagram, that cost-push inflation is caused by
an increase in the costs of factors of production, resulting in a
decrease in SRAS.
Cost-Push Inflation:
results from an increase
in the cost of production.
(energy or labor mostly)
Seen by an inward shift
of the aggregate
supply.
Cost-push inflation - is
inflation pushy?
24. Explain, using a diagram, that cost-push inflation is caused by an
increase in the costs of factors of production, resulting in a decrease in
SRAS.
Causes of Cost Push Inflation





Higher Price of Commodities. A rise in the price of oil would lead to higher petrol prices
and higher transport costs. All firms would see some rise in costs. As the most important
commodity, higher oil prices often lead to cost push inflation (e.g. 1970s, 2008, 2010-11)
Imported Inflation. A devaluation will increase the domestic price of imports. Therefore,
after a devaluation we often get an increase in inflation due to rising cost of imports.
Higher Wages. Wages are one of the main costs facing firms. Rising wages will push up
prices as firms have to pay higher costs (higher wages may also cause rising demand)
Higher Taxes. Higher VAT and Excise duties will increase the prices of goods. This price
increase will be a temporary increase.
Higher Food Prices. In western economies food is a smaller % of overall spending, but in
developing countries, it plays a bigger role. (food inflation)
Cost push inflation could be caused by a rise in oil prices or other raw materials. Imported
inflation could occur after a depreciation in the exchange rate which increases the price of
imported goods.
excess monetary growth
Inflation due to excess monetary
growth: With more money in the
system there is more demand and
spending which increases
aggregate demand.
Monetary inflation is a sustained
increase in the money supply of a
country. It usually results in price
inflation, which is a rise in the
general level of prices of goods
and services. Originally the term
"inflation" was used to refer only
to monetary inflation, whereas in
present usage it usually refers to
price inflation.
25. Evaluate government policies to deal
with the different types of inflation.
For Demand-pull inflation, the approach would be to
either:
 reduce aggregate demand with either deflationary
fiscal policy and/ or deflationary monetary policy.
 Policies to increase aggregate supply would also be
used to increase real output and lower price levels.
Cost-Push Inflation:

By addressing Input prices, productivity & governmental
involvement in the business sector cost push inflation can be
addressed
Excess Monetary Growth:

By addressing monetary policy that inflates the money supply
above money demand.
2.3 Macroeconomic Objectives:
Equity in the distribution of income
A Richer World – BBC
26. Explain the difference between equity in the distribution of
income and equality in the distribution of income.
Equity is a normative concept and concerns the fairness with
which scarce resources are allocated among competing ends.
Inevitably there are huge disagreements between people as to
what an equitable distribution of resources should be.
Some people argue for much great equality in the post-tax
distribution of income and wealth achieved by making the tax
and benefit system much more progressive.
They believe that a lack of equity leads to market failure
because each one dollar of income equates to an economic vote.
And since resources tend to flow to those markets where
economics votes are highest, a high level of inequality can lead
to what is perceived as being an unfair allocation of goods and
services.
26. Explain the difference between equity in the distribution of
income and equality in the distribution of income.
The opposite of equity is inequality, and this can arise in two
main ways:
Inequality of outcome

Inequality of outcome from economic transactions occurs when some
individuals gain much more than others from an economic
transaction. For example, individuals who sell their labor to a single
buyer, a monopsony's, may receive a much lower wage than those
who sell their labor to a firm in a very competitive market.
Differences in income are an important type of inequality of
outcome.
Inequality of opportunity

Inequality of opportunity occurs when individuals are denied
access to institutions or employment, which limits their ability to
benefit from living in a market economy. For example, children from
poor homes may be denied access to high quality education, which
limits their ability to achieve high levels of income in the future..
27. Explain that due to unequal ownership of factors of production,
the market system may not result in an equitable distribution of
income.
Given the unequal distribution of income that exists in most
capitalist economies, is unlikely to be one in which all have an
equal say _ clearly economic voting power is directly related
to income so that the rich would have many more votes, and
thus a much greater pull on resources, than the poor.
Consequently, the resulting pattern of resource allocation may
overlook the pressing, often life and death needs of the poor,
and reflect instead the more trivial wants of the rich.
In the economics of the market place, human wants are those
that are supported by effective demand i.e. demand backed
by the ability and willingness to pay the market price.
27. Explain that due to unequal ownership of factors of production, the
market system may not result in an equitable distribution of income.
Human needs, however, if unaccompanied by the
wherewithal to pay, are simply ignored.
This is the overriding reason for the existence of malnutrition and starvation in the world today: it is not that
there is an overall shortage of food - there is more than
enough in total terms to feed everyone; the problem, quite
simply, is that those who need the food lack the money to
pay for it.
Hence the 'free' market, given the degree of inequality
which typically exists, is likely to be one in which many
people are severely disadvantaged in terms of their
market power.
28. Analyze data on relative income shares of given percentages of
the population, including deciles and quintiles.
A quintile is a 20% portion of a country’s
population; we can divide a population into
five quintiles, ranging from the lowest quintile
(the poorest 20% of the population) to the
highest quintile (the richest 20%).
If income were completely equally distributed,
everyone would receive exactly the same
income, in which case every quintile would
receive 20% of income. However, in the real
world this is a virtual impossibility.
Income shares can also be shown by deciles,
which are 10% portions of the population
(there are ten deciles) as well as quartiles, or
25% portions of the populations (there are
four quartiles).
29. Draw a Lorenz curve and explain its
significance.
The two main methods for measuring inequality are the
Lorenz curve and the Gini index.
The Lorenz curve:
A
Lorenz curve shows the % of income earned by a given
% of the population. A ‘perfect’ income distribution would
be one where each % received the same % of
income. Perfect equality would be, for example, where
60% of the population gain 60% of national income. In the
above Lorenz curve, 60% of the population gain only 20%
of the income, hence the curve diverges from the line of
perfect equality of income.
 The further the Lorenz curve is from the 45 degree line, the
less equal is the distribution of income. ‘
29. Draw a Lorenz curve and explain
its significance.
30. Explain how the Gini coefficient is
derived and interpreted.
The Gini co-efficient or index
is a mathematical device used
to compare income
distributions over time and
between economies. The Gini
co-efficient can be used in
conjunction with the Lorenz
curve. It is calculated by
comparing the area under the
Lorenz curve and the area
from the 450 line to the right
hand and 'x' axis. In terms of
the Gini index, the closer the
number is to 100 the greater
the degree of inequality.
31. Distinguish between absolute
poverty and relative poverty.


Absolute Poverty
The state of people who live
on less than $1.25 per day (purchasing power
parity), as defined by the World Bank. Generally,
such individual are unable to afford the basic
necessities of life: food, shelter, education, health, etc.
Relative Poverty
The state of earning an income
that puts one in the lowest income level within his or
her own country. Unlike absolute poverty, it exists
everywhere, since within even the richest nations a
proportion of the population earns relatively less
than the top income earners.
31. Distinguish between absolute
poverty and relative poverty.


poverty line
an absolute level of income
set by the federal
government for each family
size below which a family is
deemed to be in poverty
poverty rate
the percentage of the
population whose family
income falls below an
absolute level called the
poverty line
32. Explain possible causes of poverty, including low
incomes, unemployment and lack of human capital.
Poverty has many causes, some of them very basic. Some
experts suggest, for instance, that the world has too many
people, too few jobs, and not enough food. But such basic
causes are quite intractable and not easily eradicated. In
most cases, the causes and effects of poverty interact, so
that what makes people poor also creates conditions that
keep them poor.
Primary factors that may lead to poverty include
overpopulation, the unequal distribution of resources in
the world economy, inability to meet high standards of living
and costs of living, inadequate education and employment
opportunities, environmental degradation, certain
economic and demographic trends, and welfare incentives.
33. Explain possible consequences of poverty, including low living
standards, and lack of access to health care and education.
Direct costs:






Health care for the uninsured and the underinsured
Shelters for the homeless
Public housing and support for private housing
Food for the hungry
Direct costs to victims of higher crime rates
High debt levels
Indirect costs:




Increased costs for police, the judicial system, correction facilities and
security systems
Reduced income taxes and other taxes
“Loss of the multiplier effect of having people employed at living wages”
Contributions to society lost because of an uneducated public
33. Explain possible consequences of poverty, including low
living standards, and lack of access to health care and education.
What Is Kuznets Curve?
The Kuznets curve is a hypothetical
curve that graphs economic inequality
against income per capita over the
course of economic development.
This curve is meant to illustrate the
behavior and relationship of these two
variables as an economy develops from
a primarily rural agricultural society to
an industrialized urban economy.
The graph shows income inequality
following the curve, first increasing
before decreasing after hitting a peak
as per-capita income increases over the
course of economic development.
2.3 Macroeconomic objectives:
The Role of Taxation in Promoting Equity
34. Distinguish between direct and indirect taxes, providing
examples of each, and explain that direct taxes may be used as a
mechanism to redistribute income.
An indirect tax is a tax collected by an intermediary i.e. seller, from
the person who bears the ultimate economic burden of the tax i.e.
consumer.
 It is imposed on expenditure. In simple terms, it is a tax which
is imposed on goods and services sold. It is usually added to
the cost of the good or service and charged from the ultimate
consumer. The seller will then file a return to the government on
all the taxes he has collected from the consumer.
Examples
 GST (Goods and service tax)
 VAT (Value added tax)
 Consumers are charged a percentage of tax while purchasing
a good/service and then the seller pays the tax collected to
the Government.
34. Distinguish between direct and indirect taxes, providing examples of
each, and explain that direct taxes may be used as a mechanism to
redistribute income.
Direct Taxes
It is a tax paid directly to the government by the
persons on whom it is imposed.
Examples
 Tax imposed on peoples’ income-Income tax
 Tax on wealth – wealth Tax
 Tax on firm’s profits.- corporate tax
35. Distinguish between progressive, regressive and
proportional taxation, providing examples of each.
Progressive Tax
A tax in which people with
more income pay a larger percentage in taxes.
Example: Income tax (Direct Tax)
 Regressive Tax
A tax in which people with
more income pay a smaller percentage in taxes.
Example: Sales Tax (Indirect Tax)
 Proportional Tax
A tax in which people pay the
same percentage of income in taxes regardless of
their incomes.
Example: Flat Tax (Direct Tax)

Examples of the Three Tax Systems
regressive
income
tax
% of
income
$50,000 $15,000 30%
proportional
tax
% of
income
progressive
tax
% of
income
$12,500 25%
$10,000 20%
100,000
25,000 25
25,000 25
25,000 25
200,000
40,000 20
50,000 25
60,000 30
36. Calculate the marginal rate of tax and the
average rate of tax from a set of data.
An average tax rate is the ratio of the total amount of
taxes paid to the total tax base (taxable income or
spending), expressed as a percentage.
 Let T be the total tax liability.
 Let B be the total tax base.
Average tax rate = T / B
36. Calculate the marginal rate of tax and the
average rate of tax from a set of data.
A marginal tax rate is sometimes defined as the tax rate that applies to
the last (or next) unit of the tax base (taxable income or spending).
In plain English, the marginal tax rate is the tax percentage on the highest
dollar earned. For example, in the United States, the top marginal tax
rate is 39.6%, but that rate applies only to earnings over $400,000 per
year; earnings under $400,000 have a lower tax rate of 33% or less.
That formal definition only holds true to the equation following when the
denominator equals one unit of the tax base. In practice most decisions
require the denominator to be a larger amount. The marginal tax rate
equals the change in taxes divided by the change in tax base, expressed
as a percentage.
 Let T be the total tax liability.
 Let B be the total tax base.
Marginal tax rate =
T/
B
37. Explain that governments undertake expenditures to provide directly, or to subsidize, a
variety of socially desirable goods and services (including health care services, education,
and infrastructure that includes sanitation and clean water supplies), thereby making them
available to those on low incomes.




Higher government spending on merit goods should yield
a positive social rate of return which leads to an
improvement in total economic welfare.
There is a case for some form of government intervention
to encourage increased consumption of merit goods. This
might take the form of an explicit government subsidy to
reduce the private marginal costs of consumption and
cause an expansion of demand.
The government often provides merit goods "free at the
point of use" and then finances them through general
taxation.
Examples of merit goods that are largely state provided
include primary health care and public schooling.
38. Explain the term transfer payments, and provide examples,
including old age pensions, unemployment benefits and child
allowances.
A transfer payment is a payment from the government to
an individual for which no good or service is exchanged. In
order to be eligible to receive them, an individual has to
fall below a certain income threshold or to be experiencing
economic hardship.
Transfer payments existing in most developed countries
include:
 Unemployment benefits
 Social security benefits
 Nutritional subsidies
 Higher education grants and tuition subsidies
 Welfare benefits
39. Evaluate government policies to promote equity (taxation, government
expenditure and transfer payments) in terms of their potential positive or negative
effects on efficiency in the allocation of resources.
A tax system that punishes innovation, productivity and
hard work is clearly undesirable and should therefore
be avoided. However, a tax system including
progressive marginal income taxes combined with
regressive indirect taxes ensures that both the rich and
the poor share a portion of the nation’s tax burden. Yet
it also ensures that those with the greatest ability to pay
bear the largest burden while those whose ability to
pay the lowest benefit from the public and transfer
payments that the government provides. This reduces
the inequality of income distribution and corrects for the
market failures that results in a free market system.
39. Evaluate government policies to promote equity (taxation, government
expenditure and transfer payments) in terms of their potential positive or negative
effects on efficiency in the allocation of resources.




Progressive Tax
A tax in which people with
more income pay a larger percentage in taxes.
Regressive Tax
A tax in which people with
more income pay a smaller percentage in taxes.
Proportional Tax
A tax in which people pay the
same percentage of income in taxes regardless of
their incomes.
in-kind transfers
transfers to the poor given in
the form of goods and services rather than cash
39. Evaluate government policies to promote equity (taxation, government
expenditure and transfer payments) in terms of their potential positive or negative
effects on efficiency in the allocation of resources.