CHAPTER
6
MACROECONOMIC PROBLEMS
LEARNING OUTCOMES
At the end of this chapter, you should be able to:
 Define and measure inflation.
 Differentiate the three types of inflation.
 Explain the effects of and measures available to control
inflation.
 Define and measure unemployment.
 Differentiate the types of unemployment and measures
available to control unemployment.
 Discuss the effects of unemployment.
 Interpret
the relationship between inflation and
unemployment.
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INFLATION





Defined as a persistent and sustained increase in the general
price level.
Implies that there is an increase in the cost of living that causes
lower purchasing power.
There is an inverse relationship between inflation and the value
of money. A rise in the general price means a drop in the value of
money.
Measures of inflation:
– Inflation is measured by using the Consumer Price Index
(CPI).
Calculation
INFLATION RATE = CPI 2016 – CPI 2015
CPI 2015
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INFLATION (cont.)
– A weighted CPI measures changes in the average
prices of a ‘market basket’ of goods and services
purchased by a typical urban household, taking into
account the importance of certain goods and services
relative to others.
– Basket of goods and services includes foods, shelter,
clothing, medical, furniture and transportation.
– An increase in the CPI reflects inflation in the
economy.
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INFLATION (cont.)
Types and Causes of Inflation
(i) Demand-pull inflation (shift in demand side)
 This type of inflation is caused by excess demand in
fully employed economy.

Demand-pull inflation occurs when aggregate demand
(AD) exceeds the aggregate supply (AS).

As AD = C + I + G + (X - M), any increase of these
variables will cause aggregate demand to rise.
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INFLATION (cont.)

When the
economy is
at full
employment
level, an
increase in
aggregate
demand will
cause an
increase in
general price
level.
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INFLATION (cont.)

In Figure 14.2, 0YF is the full employment aggregate
output which is determined at the point of intersection of
the aggregate demand curve, AD1 and aggregate supply
curve, AS.

An increase in the aggregate demand from AD0 to AD1
shows an increase in the price level from P0 to P1.

As AD1 shift to AD2 (in full employment stage), price
increases to P2. Real output has reached the maximum
limit, but prices rise rapidly.
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INFLATION (cont.)
(ii) Cost Push Inflation (shift in supply side)
 Caused by a decrease in aggregate supply due to an increase in
cost of production for each unit of output produced.
 For instance, when price of raw materials or wages increase, the
cost of production will also increase causing aggregate supply to
decrease and the price of goods and services to increase.
 The shift in the aggregate supply curve may result from various
factors:
Cost Push Inflation
Wage Push
Inflation
Import Push
Inflation
Exhaustion
of natural
resources
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Fall in
exchange
rate
Tax-push
inflation
Profit Push
Inflation
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INFLATION (cont.)
Wage-push
inflation
• Due to wage increases which will lead to increase in
the cost of production and the output price.
Import-push
inflation
• Due to increase in he prices of imported raw materials
or finished goods.
Profit-push
inflation
• Occurs when firms gain more power and are able to
push up prices to make larger profits.
• Happened when markets move toward monopoly or
oligopoly power.
• Occurs when firms stock up on goods and create an
artificial shortage to increase the price of goods in
order to obtain higher profits.
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INFLATION (cont.)
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INFLATION (cont.)

In Figure 4.3, 0YF is the full employment aggregate output. It
is determined at the point of intersection of the aggregate
demand curve, AD and aggregate supply curve, AS0.

When AS0 shift to AS1,the equilibrium aggregate output falls
from 0YF to OY1, the general price level rises from P0 to P1.

A further upward shift in the aggregate supply curve from AS1
to AS2 creates a further increases in price to P2. The increase
in the general price level is called the cost push inflation.
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INFLATION (cont.)
(iii) Monetary Inflation
 Monetary inflation is a sustained increase in the money supply
of a country, resulting in price inflation.
 Money supply increases through an expansionary fiscal policy
or expansionary monetary policy.
 Quantity Theory of Money shows a direct relationship between
the growth of the money supply and inflation, MV = PT, where:
– M is Money supply
– V is Velocity of circulation
– P is Price level
– T is Transactions or output
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INFLATION (cont.)
Effects of Inflation
(i) Unequal income distribution and wealth
(ii) Reduce investment and production
(iii) The amount of saving will decrease
(iv) Deficit in the balance of trade
(v) Breakdown in functions of money
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INFLATION (cont.)
Measures to Control Inflation
(1) Contractionary Fiscal Policy (Budget Surplus: T > G)
(i) Increase in Taxes
 An increase in tax will reduce the disposable income of
individuals income and their consumption on goods and
services. This is turn will lead to a fall in prices.
(ii) Decrease in Taxes
 A reduction in government spending will directly affect
aggregate demand. The government will cut the salary of
its civil servant and postpone development projects to
reduce the purchasing power of the public.
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INFLATION (cont.)
Measures to Control Inflation
(2) Contractionary Monetary Policy
(i) Open Market Operations
 The central bank may sell government securities, shortterm bonds or treasury bills in the open market to the
public to reduce bank deposits and credit creation of
commercial banks.
 Money supply will reduce, hence reducing aggregate
demand and price level.
(ii) Raising Required Reserve Ratio
 In the event of inflation, the central bank will increase the
required reserve ratio of all commercial banks.
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INFLATION (cont.)
(iii) Raising the base lending rate/bank rate (Interest on loan)
 A rise in the bank rate will cause an increase in the cost
of borrowing. Loans become costly to borrow and firms
will reduce borrowing and spending. Aggregate will
reduce and inflation rate will drop.
(iv) Raising the interest rate (Interest on saving)
 Central bank would direct the commercial banks to raise
their interest rate for deposits from public. The high
interest rates will encourage more public to save and
increase the saving level to decrease the aggregate
demand and price level.
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INFLATION (cont.)
(i)
(ii)
(iii)
(iv)
(v)
Income policy: to ensure wages do not rise faster than
productivity.
Price control and rationing: control directly on prices of
certain goods. Price pegging either by fixing a floor price or
ceiling price is implemented.
Supply side policies: to increase the production of essential
consumer goods give tax incentives, grant and encourage
research and development
Exchange rate policies: reduce quantities or the price of
imports.
Increase in savings: introduce compulsory provident fund or
provident fund-cum-pension schemes to increase savings in
controlling inflation.
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UNEMPLOYMENT


Unemployment occurs when people who are in the
working age group, are able and willing to work, but
are unable to find a suitable job.
Defined as a situation in the economy, where there are
people between the age 16 and 65 who are not
working, but are actively seeking jobs.
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UNEMPLOYMENT (cont.)

We can categorize the population into three different
age groups:
(i) Less than 16 years old
(ii) 16–65 years old
(iii) More than 65 years old

The age between 16–65 years is considered as the
total labour force.
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UNEMPLOYMENT (cont.)
Population
Below 16
years
16–65 years
Labour
force
Employed
66 years and
above
Outside labour
force
Unemployed
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UNEMPLOYMENT (cont.)
Labour Force
 All persons above the age of 16 and older who are
employed or are actively seeking employment.
 The labour force consists of employed and
unemployed persons.
 Is everyone above 16 years of age included in the
labour force?
– No, because students, housewives, pensioners and
discouraged workers are consider as outside of labour
force.
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UNEMPLOYMENT (cont.)
Discouraged Worker
 A discouraged worker is an individual who wants to
work, but who has been unsuccessful for a long period
of time in finding a job and who has consequently given
up on seeking jobs.
 A discouraged worker would like to work if the job
prospects are good.
 Since the labour force is defined as people who are
above 16 years of age and who are actively seeking
employment, discouraged workers are excluded from
the labour force.
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UNEMPLOYMENT (cont.)
Types of Unemployment
(1) Frictional Unemployment
 This is short term or temporary unemployment.
 Occurs when people enter the labour market to look for jobs
or people leave their jobs, either voluntarily or from being
sacked, and are unemployed for a period of time while they
are looking for a new job.
 Includes new entrants such as school-leavers, fresh
graduates and re-entrants, such as people who quit their
jobs for a better position or higher wages, or former
homemakers. Hence, there is a time lag during which a
worker is unemployed when moving from one job to another.
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UNEMPLOYMENT (cont.)
(2) Seasonal Unemployment
 Seasonal unemployment occurs when certain products
cannot be produced during a certain season.
 Hence, many workers are temporarily laid off on a shortterm basis during certain times of the year.
 Example: construction workers who will be unemployed
during rainy season, a fisherman who is unable to fish
during the monsoon season or in winter, and tourist
workers who are unemployed during off-peak periods in
tourist spots.
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UNEMPLOYMENT (cont.)
(3) Structural Unemployment
 This unemployment results from structural decline of
industries, unable to compete or adapt to changing
demand and new products, or changing method of
production.
 A change in the pattern of demand results when tastes
change, demographic profile change or introduction of
new products or technology made the existing product
obsolete, hence the skills of workers are no longer
suitable with the jobs available.
 As major industries tend to be heavily concentrated in
certain region, structural unemployment often leads to
regional unemployment and the impact can be quite
serious.
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UNEMPLOYMENT (cont.)
(4) Cyclical Unemployment
 This unemployment is caused by a decrease in
aggregate demand, due to a downswing of the business
cycle.
 When an economy is under recession, aggregate
demand falls and via the multiplier effect, national income
falls further. Hence, consumption falls, production
reduces, companies may close down and workers are
laid off, resulting in cyclical unemployment.
 Cyclical unemployment is a serious form of
unemployment because it usually creates more
unemployment.
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UNEMPLOYMENT (cont.)
(Increase Money Supply, Decrease
Interest Rate)
(a) Open market operation
The central bank buys government securities, short term
bonds or treasury bills in the open market from the
public to increase money supply. Consumption and
investment will increase, increasing aggregate demand
and production and reducing unemployment.
(b) Lowering the required reserve requirement
When the reserve ratio is decreased, the credit creation
and money supply will increase to stimulate aggregate
spending and reduce unemployment.
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UNEMPLOYMENT (cont.)
(c) Lowering the bank rate (interest on borrowing)
The bank rate is also known as discount rate. A decline in
the bank rate makes loans less costly to borrow and firms
will increase investment by employing more workers.
(d) Lowering interest rate (interest on saving)
The central bank would direct the commercial banks to
lower their interest rate for deposits as to encourage the
public to spend. This would increase aggregate demand
and production and hence, decrease cyclical
unemployment.
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UNEMPLOYMENT (cont.)
(2) Fiscal Policies
(a) Increase government expenditure (G)
Increase government expenditure (G) through creating
more development projects will increase aggregate
demand (AD) via the multiplier effect. Production will
increase, hence reducing the cyclical unemployment.
(b) Decrease in taxes (T)
Decrease in taxes (T), such as a reduction in excise tax,
service tax, sales tax, income tax or corporate tax, will
increase the consumption on goods and services and
also induce investment. Hence, aggregate demand will
increase and production will increase. Thus, cyclical
unemployment will reduce.
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UNEMPLOYMENT (cont.)
(3) Direct Control Policies
 This refers to all direct measures other than monetary
and fiscal policy taken by the government.
(a) Providing training and technical education
Set up training centres to retrain workers in new
skills to improve occupational mobility.
(b) Diversification and integration of economy in
agricultural, manufacturing, construction,
transportation, finance, insurance, services sectors
To match seasonal industries which can share the
labour force.
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UNEMPLOYMENT (cont.)
(c) Better job information
Set up job centres, better flow of job information
through newspapers, radio or Internet.
(d) Migration of labour
Encourage workers to move to regions and
industries where job are available.
(e) Job creation in various sectors
Encourage firms to move into areas where there are
high levels of unemployment by giving tax
incentives.
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UNEMPLOYMENT (cont.)
Effects of Unemployment
(i) Loss of job skills
 If unemployment persists for a long period,
individuals will lose their job skills, causing a loss in
human capital. It will also lead them to radical social
and political activities by increasing crime rates.
(ii) Permanent loss of output of goods and services
 An economy with high unemployment is not using
all of their resources, especially labour available to
it.
 The economy is operating below its production
possibility frontier, reducing the economy’s
efficiency and production.
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UNEMPLOYMENT (cont.)
(iii) Loss in government revenue
 High unemployment means that the government
will receive less taxation revenue but will have to
pay more on unemployment benefits.
(iv) Social problems
 Unemployment results in lower morale and human
suffering. The family unit will be affected if the sole
bread-winner were to lose his job.
 Social problems arise if the unemployed turn to
drugs or crime.
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UNEMPLOYMENT (cont.)
Short-run and Long-run
Phillips Curve Trade Off
 Short run Phillips curve
shows an inverse
relationship between
inflation and
unemployment in the
short run.
 Figure 14.9 shows if the
government objective is
to achieve full
employment, they must
be prepared to accept a
certain high level of
inflation.
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UNEMPLOYMENT (cont.)

In the long run, the rate of inflation does not affect the natural
rate of unemployment. The long-run Phillips curve is vertical
at the natural rate of unemployment at 0U1.
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UNEMPLOYMENT (cont.)

Natural rate of unemployment is the rate of unemployment
that occurs when the economy is at full employment. It is
composed of frictional and structural unemployment.

It is affected by the changing demographic structure of the
labour force, government social policies and rising structural
unemployment.
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