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DMS ECO2103 Macroeconomics
Instructions for CA1 Individual Assignment, July 2022 Semester
â–ª
The purpose of this individual assignment is to enable you to use relevant analytical tools and
macroeconomic concepts (not necessarily all of them) that you have learnt in Lectures 1 to 4.
Choosing Articles as References for Analysis
â–ª Search through newspapers, journals, magazines or internet for THREE articles that are relevant
to the concepts discussed in Lecture 1 to Lecture 4.
â–ª
Quote the source of the article in your report or if the article is obtained from the web, quote
the web address. Include a screenshot of the articles in the reference list section.
â–ª
You have the flexibility to choose (a) all 3 articles from one country or (b) 3 articles from various
countries. But only articles selected from 1 May 2022 onwards will be accepted.
â–ª The articles selected should be in English and based on the following topics:
Article 1 – Lecture Topic 1: Introduction to Macroeconomics, GDP and Economic Growth
Article 2 – Lecture Topic 2: Inflation and the Price Level
Article 3 – Lecture Topic 3: Wages and Unemployment
OR
Lecture Topic 4: Saving, Capital Formation, Financial Markets and Financial System
â–ª
Each article should deal with a different macroeconomic aspect of the country (for example,
GDP growth, labour productivity, wages and unemployment, price level and inflation or national
saving and capital formation).
Analyzing your Country
â–ª For each of the 3 articles, summarize the article first and followed by an analysis of the
macroeconomic performance of the country based on the article. The analysis must crossreference to concepts discussed in one particular lecture topic.
â–ª You are required to use the lecture notes and textbook to help you better illustrate your
analysis. If you extract exact phrases or sentences, please put them in quotation marks in your
report.
â–ª Explain your understanding of the article using the economic concept and knowledge discussed
in the lecture. Establish the linkage between the article and the economic concept under the
particular lecture session and topic. Draw diagrams to support your analysis if needed.
Writing your Report
â–ª Write a summary report for each country based on your analysis. Combine and organize all your
work in a single word document.
â–ª Use Times New Roman Font Size 12pt.
â–ª Number your pages.
â–ª Use single line spacing.
â–ª Save as Word document.
▪ Your report should have a word count ranging from 1000 to 1500. Each Analysis (Part 3 – 5 in the
template below) should have at least 250 words.
1
Submission of Report
â–ª Submit the Word version of your report via eGlobal. Reports submitted through other ways
(e.g. through email or hardcopy to the lecturer) will not be accepted.
Template for Report
â–ª Use the following template or outline for your report:
1. Title: DMS Macroeconomics Individual Assignment
Date of Report:
2. Content Page
List the topics and chapters in the report.
3. Chapter 1 – Analysis on Topic 1
a. Source: Put down the title of the article and its source, or if the article is obtained from
the web, quote the web address.
b. Summary: Briefly discuss the main points of the article.
c. Analysis: Using the concepts in the lecture to relate to the article and analyze the
situation.
4. Chapter 2 – Analysis on Topic 2
a. Source:
b. Summary:
c. Analysis:
5. Chapter 3 – Analysis on Topic 3 or Topic 4
7. Conclusion
Summarize the main findings of your analysis
8. References
â–ª Put down the source of articles, title and Internet link if the articles are obtained from
the web.
â–ª
Insert a screenshot of each article after quoting the source and title. Do NOT type in or
“copy and paste” the articles as this will affect the plagiarism index.
â–ª Indicate other sources of reference, data, or materials used in your report.
SAMPLE
â–ª A sample at the end of the document is included to provide guidance on article selection and
report analysis.
â–ª Please note that you should NOT use the sample articles for your report. No part of the sample
may be copied and reproduced for your report.
2
Important Dates for CA1 Report
CA1 Deadline: 22 July 2022, 11.59 am
Submit your report via eGlobal. Only reports submitted via eGlobal will be accepted.
The distribution of marks will be as follows:
1. CA1 30%
Component
Weightage
Selection of relevant articles & content page
5%
Summary and analysis supported by economic
80%
theory/graphs/diagrams
Conclusion
10%
Reference list
5%
Total
100%
2. CA2 (online quiz) 10%
3. Final exam 60%
CA2 opens on 21 July 2022 12 noon and closes on 28 July 2022 11.59 am (Topics 1 – 6)
CA Submission
â–ª CAs must be submitted online via eGlobal portal. Please read through instructions in your
eGlobal portal and CA outline carefully before submitting. If you have further queries, please
read the FAQ. If after you have read the FAQ, you need assistance on eGlobal submission, please
email to itsd_simge@sim.edu.sg or call 6248 9393 Option 4. For non eGlobal issues please email
he10@sim.edu.sg. Please email with your “Live@Edu email account”. Email from other
addresses will not be entertained. If issues raised are covered, you will be directed to read
through instructions in the CA outline, eGlobal and the FAQ. Please take time read through
before raising issues.
3
SAMPLE ONLY
NO COPYING
SAMPLE – TOPIC 1
Article
NO
Japan’s economy sinks deeper into worst postwar contraction, intensifies challenge for new leader
TOKYO (REUTERS) – Japan’s economy sank deeper into its worst postwar contraction in the second
quarter as the coronavirus jolted businesses more than initially thought, underscoring the daunting
task the new prime minister faces in averting a steeper recession.
Other data put that challenge in perspective, with household spending and wages falling in July as
the broadening impact of the pandemic kept consumption frail even after lock-down measures were
lifted in May.
The world’s third-largest economy shrank an annualised 28.1 per cent in April-June, more than a
preliminary reading of a 27.8 per cent contraction, revised gross domestic product (GDP) data
showed on Tuesday (Sept 8), suffering its worst postwar contraction.
The record drop roughly matched a median market forecast of a 28.6 per cent contraction in a
Reuters poll.
The main culprit behind the revision was a 4.7 per cent drop in capital expenditure, much biggest
than a preliminary 1.5 per cent fall, suggesting the COVID-19 pandemic was hitting broader sectors
of the economy.
“We can’t expect capital expenditure to strengthen much ahead. Companies won’t boost spending
when the outlook is so uncertain,” said Hiroshi Miyazaki, senior economist at Mitsubishi UFJ Morgan
Stanley Securities.
The data will put the new prime minister, to be elected in a ruling party leadership race on Sept 14,
under pressure to take bolder economic support measures.
Chief Cabinet Secretary Yashihide Suga, a frontrunner to become next premier, has signalled his
readiness to boost spending if he were to lead the country.
Japan recently saw a renewed rise in infections but has been spared the kind of big casualties seen in
western countries. Total infections stood at 72,321 as of Monday, with 1,380 deaths versus a global
tally of over 27 million cases and more than 888,000 deaths.
Japan’s economy has shown some signs of life after slipping into three straight quarters of
contraction, with factory output rising in July at the fastest pace on record due to a rebound in
demand for automobiles.
In a sign of any recovery will be modest, however, separate data release on Tuesday showed
household spending fell a bigger-than-expected 7.6 per cent in July from a year earlier. Real wages
declined for the fifth straight month in July, pointing to possible deeper strains ahead for consumer
spending.
4
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Continued from previous page
NO
BROAD IMPACT
The health crisis has ravaged a broad array of sectors, with firms such as automaker Honda Motor
forecasting a 68 per cent decrease in annual operating profit and cosmetics firm Shiseido Co
expecting a net loss for the full year as the pandemic hit cosmetics sales.
The fresh batch of data will be among factors the Bank of Japan will scrutinise at its rate review next
week, when it is widely expected to keep monetary settings unchanged.
Analysts polled by Reuters in August said they expect the economy to shrink 5.6 per cent in the
current fiscal year to next March, and grow just 3.3 per cent in the following year, compared with
the BOJ’s forecast released in July for a 4.7 per cent contraction and 3.3 per cent growth in the same
periods.
The central bank eased monetary policy twice this year including by setting up a lending facility to
pump money to cash-strapped small firms, complementing two big government spending packages.
Many analysts expect the BOJ hold off on ramping up stimulus for now as steps to spur demand
could get people moving more freely into shops and risk spreading the virus.
“Even though restrictions to economic activity have been relaxed, some of them will remain under
the new lifestyle forced upon by the pandemic,” said Yoshiki Shinke, chief economist at Dai-ichi Life
Research Institute.
“It will probably take a long time for the economy to normalise and return to levels before the
pandemic.”
SAMPLE – TOPIC 1
REPORT
1.1 Source:
https://www.straitstimes.com/business/economy/japans-economy-shrinks-more-than-firstestimated-in-q2-heightens-woes-for-new
1.2 Summary
Due to the Covid-19 pandemic, movement was restricted globally, and Japan’s gross domestic
product has suffered a contraction from the past two quarters, with their economy falling by 28.1%
in April-June. Analysts forecast that Japan’s economy would decrease by 5.6% in the current fiscal
year, on the account of falling household spending and wages, low capital expenditure and trade
restrictions. As a result, the government has taken economic measures in their attempt to raise
their GDP.
1.3 Analysis
Through applying the expenditure approach, it is possible to calculate GDP using the formula of GDP
= Consumption(C) + Investment(I) + Government Expenditure(G) + Net Export(Exports(X) –
Imports(M)).
5
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From the source article, it can be deduced that the decrease in GDP was contributed by the
decrease in consumption, investment, exports, and imports. The main reason that consumption(C)
decreased was due to the fall in wages and household spending. According to (Hermesauto, 2020),
the fall in household spending was caused by lower income through job losses amid the recession
during the pandemic.
Additionally, capital expenditure had dropped by 4.7%, which decreased investment(I). In general,
the low consumption and demand, along with big companies like Honda Motor and Shiseido facing
decreased profits and net losses has made companies wary about spending.
The restriction in movement would also impact Japan’s trade industry, resulting in a decrease in the
country’s exports(X) and imports(M).
In hopes of combating the recession and increasing GDP, the government had implemented two
stimulus packages that according to (Kyodo, 2020) is aimed towards helping low-income households
and provide interest-free loans to struggling companies. The aim is to provide consumers and
businesses with more disposable income to encourage spending, which increases consumption(C)
and Investment(I). However, despite the government’s efforts, GDP failed to show signs of
improvement. Furthermore, since the stimulus packages are a form of transfer payments,
Government Expenditure(G) stays the same.
By applying the information above to the expenditure approach assuming no additional information
is added, it would result in GDP = C + I + G + NX ( X – M). Hence, the implications caused by the
pandemic led to the continuous decrease in Japan’s GDP.
6
SAMPLE ONLY
NO COPYING
SAMPLE – TOPIC 2
NO
ARTICLE
India’s October CPI likely above 7% again, industrial output falls: Reuters poll
BENGALURU (Reuters) – India’s retail inflation likely stayed above 7% for a second straight month in
October as supply distortions led to a surge in vegetable prices, especially of onions, a Reuters poll
showed, lowering the chances of further interest rate cuts.
Disruption from by the coronavirus pandemic and excessive rainfall in states such as Maharashtra,
Karnataka and Andhra Pradesh have damaged and delayed the harvesting of onions – a key
ingredient in Indian kitchens – alongside other vegetables.
A Reuters poll of 50 economists conducted from Nov. 4-9 predicted consumer prices rose 7.30% last
month from a year earlier, a touch lower than September’s 7.34% rate.
If realised, it would be above the top end of the Reserve Bank of India’s medium-term target range
of 2%-6% for the seventh consecutive month, a streak not seen since August 2014.
“India’s recent inflation trajectory is driven by a confluence of seasonal supply-side drivers lifting the
food segment, magnified by COVID-19-led disruptions, hindering inter-state transfer as well as
provision of general services,” said Radhika Rao, economist at DBS Bank.
“Price and tax rigidity in commodities has also added to the boost.”
Demand remains weak in Asia’s third-largest economy, which contracted at the sharpest pace on
record of 23.9% in the April-June quarter, as the ongoing pandemic left millions unemployed and
resulted in massive pay cuts. India has the second-highest total infections in the world at more than
8.5 million cases.
The poll also predicted industrial output in September dropped 2.0% from a year earlier, the
seventh consecutive month of falls and its longest streak of decline since June 2009, as
infrastructure output, which accounts for about 40% of total industrial production, contracted 0.8%.
Still, the RBI, which has eased its key repo rate by 115 basis points since March, was widely
expected to wait until February before cutting the rate again amid worries over higher inflation.
“We see a space for a rate cut in the February policy meeting as the RBI leans towards stimulating
growth and acts at the first window it gets when inflation drops within its target range,” said Sakshi
Gupta, senior economist at HDFC Bank.
“That said, we think the RBI is towards the end of its rate cutting cycle and there could be a
prolonged pause as inflation concerns linger on.”
7
SAMPLE ONLY
NO COPYING
NO
SAMPLE – TOPIC 2
REPORT
2.1 Source:
https://www.reuters.com/article/india-economy-poll/indias-october-cpi-likely-above-7-againindustrial-output-falls-reuters-poll-idUSKBN27Q0ML
2.2 Summary
Disrupted supply chains due to the COVID-19 pandemic as well as severe weather in many states in
India reduced the amount of production in agriculture and industry. This has caused India’s retail
inflation to rose above 7% in October 2020 compared to the same period last year.
2.3 Analysis
Obviously from the article, the heavy rain has damaged and delayed the harvesting of onions, a key
ingredient of the Indian dish. The shortage of raw materials, as well as the high transportation costs
due to nationwide lockdown, caused the costs of raw materials to rise, which leads to the reduction
of production output by manufacturers. This will create a shortage of output at existing price level,
price level will climb, and inflation occurs.
The same trend is repeated in the industrial sector. Furthermore, many Indian factories depend
heavily on imported raw materials from China. China is one of the countries most affected by
COVID-19, hence the supply of industrial production in India is interrupted or scarce, causing the
cost of raw materials to rise. This leads to an increase in the producer price index (PPI), which will be
passed on to consumers in the higher retail prices.
In both above cases, there is a combination of higher price and lower output, which causes costpush inflation to occur. The economy has a simultaneous appearance of inflation and recession, this
phenomenon is called as stagflation.
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The above graph indicates that there are lesser resources available in the economy to produce
output, then the Supply Curve decreases (shifts leftward, from AS1 to AS2), whereas consumer
demand remains (AD). Cost-push inflation occurs when manufacturers respond to increasing cost of
raw materials by increasing their prices (from P1 to P2) to protect profit margins. As a result, real GDP
also drops (from Q1 to Q2).
9
SIM MODULE BOOK
MACROECONOMICS
1
Module Book
MACROECONOMICS
Module Book Developer :
Tan Khay Boon
Production
SIM Global Education
:
Module Book  SIM Global Education 2016
All rights reserved.
No part of this material may be reproduced in any form or by any means without
permission in writing from SIM Global Education
First Version @ December 2016
2
Table of Content
Introduction
4
Session 1: Introduction to Macroeconomics, GDP and Economic Growth
12
Session 2: Price Level and Inflation
29
Session 3: Workers, Wages and Unemployment
47
Session 4: Saving, Capital Formation and Financial Markets
68
Session 5: Economic Fluctuations and Aggregate Expenditure
87
Session 6: Spending Multiplier and Fiscal Policy
109
Session 7: Money and Banking
126
Session 8: Central Bank and Monetary Policy
143
Session 9: Aggregate Supply and Aggregate Demand
158
Session 10: International Capital Flow and Trade
181
Session 11: Open Economy and Exchange Rate
201
Session 12: IS-LM Analysis
221
Answers to end of session questions
237
3
Module Book
MACROECONOMICS
INTRODUCTION
Content
The module provides participants with a good understanding of the working of a typical
economy. Participants will learn how the overall performance of an economy is assessed
as reflected by such measures as the Gross Domestic Product, unemployment, inflation rate
and the economic growth rate. In addition, the role of the government in the economy
through the implementation of fiscal and monetary policies will be studied. Then the effects
of a fiscal and monetary policy mix on the economy will be examined using the IS-LM
analysis. Finally, to show the importance of international trade and finance to an open
economy like Singapore, references to global, regional and local case studies will be made
to provide practical insights and understanding of the module.
Module Aims
The aims of this module are to:
1. Provide participants with a fundamental understanding of key economic indicators such
as Gross Domestic Product, unemployment rate, inflation rate, and exchange rate.
2. Provide participants with a fundamental understanding of key economic policy tools
such as monetary policy, fiscal policy, and exchange rate policy.
3. Assist participants to appreciate how policy tools such as monetary policy and fiscal
policy affect the national income and the price level of a country.
4. Assist participants to appreciate the role of government in macroeconomic
management of a country.
Learning Outcomes
On completion of this module, a participant will be able to:
1.
Show a detailed knowledge and understanding of:
4
i)
Measurement and interpretation of the Gross Domestic Product (GDP);
ii) Different types of unemployment;
iii) Consumer Price Index (CPI) and inflation rate;
iv) Keynesian cross model and equilibrium short-run output;
v) Expenditure multiplier and tax multiplier;
vi) Functions of money;
vii) Exchange rate determination, trade balance and capital flows;
viii) Comparative advantage and international trade;
ix) AD-AS model; and
x) IS-LM model.
2.
Demonstrate module specific skills with respect to:
i)
Explaining the possible causes and appropriate remedies of the three types of
unemployment;
ii) Explaining how short-run equilibrium output in the Keynesian cross model is
achieved or changed using the algebra and the multiplier concept;
iii) Explaining how commercial banks create money through the fractional reserve
banking system;
iv) Explaining how central bank controls money supply;
v) Explaining the roles of the government in the economy;
vi) Explaining the tools available to the government for macroeconomic management;
and
vii) Discussing the arguments for and against free trade as well as showing the effects of
trade barriers on an economy.
3.
Show cognitive skills pertaining to:
i)
Analyzing how the government can intervene and influence economic variables via
fiscal and monetary policies;
Analyzing the effects of changes in components of aggregate expenditure on the
short-run equilibrium output of an economy using the Keynesian cross model.
Analyzing the effect of fiscal and monetary policies under the various types of
exchange rate regime;
Analyzing the short-run and long-run effects of changes in fiscal/monetary policies
and changes in components of aggregate expenditure on the output and inflation level
of an economy using the AD-AS model; and
Analyzing the effects of the fiscal and monetary policies on the economy using the
IS-LM model.
ii)
iii)
iv)
v)
4.
Demonstrate transferable skills in:
i)
Analytical reasoning;
5
ii)
iii)
iv)
Economic thinking in the context of macroeconomic management;
Problem formulation and decision making; and
Working with others.
6
Delivery of Module and Lesson Plan
Session
Prescribed
Text, Readings
&/or Activities
Topic
Session Learning Outcomes
1.
Introduction to
Macroeconomics,
GDP and
Economic
Growth
1. Define Macroeconomics
2. Explain the main issues of
Macroeconomics
3. Define and calculate GDP and economic
growth and explain the limitation of GDP
4. Distinguish between nominal and real
GDP
5. Explain the determinants of average
labour productivity
2
Price Level and
Inflation
1. Define inflation, consumer price index and Macroeconomics
distinguish between demand pull inflation Module Book
and cost push inflation
Session 2
2. Compute CPI and calculate inflation rate
using CPI
3. Adjust for Inflation using indexing
method
4. Analyze the limitation of CPI in
measuring inflation
5. Distinguish between real and nominal
quantity in the presence of inflation
6. Analyze the cost of inflation
3
Workers, Wages
and
Unemployment
1. Define unemployment and discouraged
workers
2. Calculate labour force, unemployment
rate and participation rate
3. Analyze the demand and supply of
labour in the labour market
4. Explain the types of unemployment,
the costs of unemployment and the
methods to reduce unemployment
Macroeconomics
Module Book
Session 3
4
Saving, Capital
1. Define Saving, Wealth and distinguish
Formation and
between saving and wealth
Financial Markets 2. Analyze the reasons of saving
Macroeconomics
Module Book
Session 4
7
Macroeconomics
Module Book
Session 1
Delivery of Module and Lesson Plan
Session
Topic
Session Learning Outcomes
Prescribed
Text, Readings
&/or Activities
3. Define and calculate national saving
4. Analyze interest rate and investment in
the financial market
5. Analyze the value of stock and bonds
5
Economic
Fluctuations and
Aggregate
Expenditure
1. Distinguish between recession,
expansion, peak and trough in a
business cycle
2. Define potential output, recessionary
gap and expansionary gap
3. Analyze consumption function and the
other components of aggregate
expenditure
4. Use Algebra to solve for equilibrium
output
5. Use Keynesian Cross Model to analyze
effects of changes in components of
aggregate expenditure
Macroeconomics
Module Book
Session 5
6.
Spending
Multiplier and
Fiscal Policy
1. Explain the multiplier effect in the
aggregate expenditure of an economy
2. Explain the tools of fiscal policy
3. Calculate and apply the (government)
spending multiplier and the tax multiplier
4. Analyze the effects of changes in
government spending and taxes on the
economy
5. Explain the limitations of fiscal policy,
the problems of budget deficit and
crowding out effect
6. Analyze the balanced budget multiplier
and role of automatic stabilizers
Macroeconomics
Module Book
Session 6
7.
Money and
Banking
1. Define money and explain the functions of Macroeconomics
money in an economy
Module Book
2. Determine the money supply and explain
Session 7
the money creation process
3. Explain the roles of central bank
8
Delivery of Module and Lesson Plan
Session
Topic
Session Learning Outcomes
Prescribed
Text, Readings
&/or Activities
4. Explain the methods of changing money
supply
5. Analyze the quantity equation and explain
the relationship between money and
inflation
8.
Central Bank and
Monetary
Policy
1. Define money demand and explain the
benefits and costs of holding money
2. Analyze equilibrium in the money market
and establish the equilibrium interest rate
3. Analyze the tools of monetary policy
4. Analyze the effects of monetary policy in
fighting recession and control inflation
5. Explain and analyze the limitations of
monetary policy
9.
Aggregate Supply
and
Aggregate
Demand
1. Define aggregate demand (AD) and
Macroeconomics
explain the shape of the AD curve
Module Book
2. Define aggregate supply (AS) and explain Session 9
the shape of the short run and long run AS
curve
3. Combine AD and AS and analyze the
equilibrium inflation rate and real output
in an economy
4. Explain the relationship between output
gap and inflation and analyze aggregate
supply shock
5. Analyze supply side policy
10.
International
Capital Flow and
Trade
1. Define international capital flows and
distinguish between capital inflow and
capital outflow
2. Explain the relationship between savings,
investment, trade balance and net capital
flows
3. Define comparative advantage
9
Macroeconomics
Module Book
Session 8
Macroeconomics
Module Book
Session 10
Delivery of Module and Lesson Plan
Session
Topic
Session Learning Outcomes
Prescribed
Text, Readings
&/or Activities
4. Distinguish between consumption and
production possibility to explain gains
from trade
11.
Open Economy
and Exchange
Rate
1. Define exchange rate and distinguish
between fixed and flexible exchange rate
system
2. Establish the equilibrium exchange rate
3. Analyze the factors affecting demand and
supply curves in the foreign exchange
market
4. Analyze the effects of overvalue and
undervalue exchange rate in the fixed
exchange rate system
5. Analyze the effects of monetary policy in
different exchange rate systems
6. Explain the law of one price and the
purchasing power parity theory
Macroeconomics
Module Book
Session 11
12.
IS-LM Analysis
1. Explain the equilibrium in the goods
Macroeconomics
market using the IS curve
Module Book
2. Explain the equilibrium in the money
Session 12
market using the IS curve
3. Analyze the factors that shift the IS curve
and the LM curve
4. Combine the IS and LM curves to analyze
the equilibrium interest rate and real
output
5. Solve for equilibrium using Algebra of ISLM framework
Teaching and Learning Methods
Lectures are used to emphasize the key economic principles that explain the logic underlying
the important economic tools. Current local and international examples will also be provided to
highlight the proper use of these tools in analysis.
10
Activities are used to discuss the concepts taught during the lectures. Participants are to work
out the answers to the questions in the activities. Participants are also encouraged to make use
of relevant websites and the Internet when doing their research for the assignments.
Participants are expected to learn independently through additional self-paced reading and
directed study beyond the taught classes.
Indicative Readings
Tan Khay Boon, Macroeconomics Module Book, SIM Global Education, 2016
Textbooks
required
Supplementary Robert H Frank & Ben S Bernanke, Principles of Macroeconomics, 6th Edition
Reading
(2013), McGraw-Hill Irwin, ISBN: 978-0-07-351899-2
Online
Journals
Use of online databases like EconLit and references to: Macroeconomics
Assessment/coursework
All assessments must comply with the SIM Rules and Regulations. To satisfy module
requirements, students must:
1) Satisfactorily complete and present on due dates their completed assignment. A penalty of
20% of the total marks will be imposed for late submission. A submission later than 1
calendar day past deadline will receive a zero mark.
2) Complete all assignments and the final examination in a satisfactory manner.
3) Reference all their work and observe SIM’s policy on plagiarism. Students found guilty of
plagiarism will be dealt with severely.
4) Adopt either the Harvard or APA (American Psychological Association) Referencing Styles.
Specific for this module are the following requirements:
Weighting between components A and B – A: 70% B: 30%
Element Description
% of Assessment
Component A (Controlled Conditions)
Examination (180 minutes)
70%
Component B (CA: Continuous Assessment)
CA 1
CA 2
30%
Total
100%
11
MACROECONOMICS
SESSION 1
INTRODUCTION TO MACROECONOMICS, GDP AND ECONOMIC
GROWTH
At the end of the session, students should be able to:
1.
2.
3.
4.
5.
Define Macroeconomics
Explain the main issues of Macroeconomics
Define and calculate GDP and economic growth and explain the limitation of GDP
Distinguish between nominal and real GDP
Explain the determinants of average labour productivity
_________________________________________________________________
1.
Introduction
In this session, we begin with a definition of Macroeconomics and an explanation on the
main issues of Macroeconomics. Next, we define Gross Domestic Product (GDP), explain
the concept of economic growth and elaborate on the limitations of using GDP in
measuring quality of life. Then we distinguish between nominal and real GDP and
highlights the importance of using real GDP to measure economic growth. Finally, we
analyse the determinants of average labour productivity which affects the long term growth
of an economy.
2.
Macroeconomics and its Main Issues
Macroeconomics concerns the overall performance of the economy. In an economy, there
are many firms and consumers and the government may also perform certain functions that
affect the economy. An economy may also interact with the rest of the world through
international trade and investment. Thus macroeconomics considers the interaction of all
these economic agents together.
2.1
Definition of Macroeconomics
Macroeconomics refers to the study of an economy as a whole. The focus of
macroeconomics is the performance of the economy and we are interested in issues such
as the amount of output produced, the general price of goods and services and the extent
of people who are unemployed in the economy.
12
2.2
Comparison between Microeconomics and Macroeconomics
The keywords that distinguish between Microeconomics and Macroeconomics are
individual in Microeconomics and aggregate in Macroeconomics.
In microeconomics, we study the behaviour of an individual consumer in demanding for
goods and services, an individual firm in selecting optimal output and the equilibrium price
and quantity of a market. But in Macroeconomics, we aggregate all the consumers to study
the aggregate demand, we aggregate all the firms’ productions to study the aggregate
supply and we sum up all the markets to study the aggregate output in an economy. The
emphasis is on the equilibrium output and the equilibrium price level (average of all prices)
in an economy.
In addition, for Microeconomics the focus is on the establishment of individual
equilibrium, such as the optimal consumption choice of an individual consumer or the
profit maximizing output and price of an individual firm. For Macroeconomics, the focus
is on the interactions among the various economic agents in the country, such as between
households, producers, government and also between one economy and the rest of the
world in international trade and finance.
3.
Gross Domestic Product
In macroeconomics, we are interested in measuring the performance of the economy. Just
like the performance of a firm is measured by its profit, we need a yardstick to measure the
performance of an economy. The performance of an economy is usually measured by the
total value of output produced in a country, known as the gross domestic product (GDP).
Over the years, if the current year GDP is higher than the previous year GDP, then there is
an economic growth and the percentage change in the GDP is known as the economic
growth rate. GDP can also be used to compare the performance across countries. A
country that has a higher GDP is deemed to have better performance compared to another
country that has a lower GDP. If we use the GDP of a country divided by the population
of the country, we have GDP per capita or GDP per person, which is a common indicator
of the standard of living of a country.
3.1
Definition of Gross Domestic Product
The gross domestic product of an economy is the market value of the final output produced
in the country within a certain timeframe. There are four important elements when
analyzing the GDP of an economy. They are market value, final output, location of
production and the timeframe of production.
13
(a)
Market value
First, GDP only measures the market value of output. This means only those goods and
services that are transacted through the market will be recorded in the economy’s GDP.
If a firm produces food and sells the food in the market to customers, the value of the food
will be included in the GDP. But if a household produce food and services for its members
to consume, the value of the food will not be included in the GDP since the output did not
go through the market system. In addition, there are many goods and services produced
by individuals and sell directly to their customers without going through the market system.
These are called underground economy and the values of output produced by the
underground economy are not included in the calculation of GDP.
(b)
Final output
In a typical economy, there are many firms producing many different types of output and
it is common that some firms purchase the other firm’s output as inputs in its own
production. If the output of Firm A is used as an input in Firm B and Firm B’s output is
sold to consumers for consumption, then Firm A’s output is known as an intermediate good
while Firm B’s output is known as a final good. The calculation of GDP only includes the
value of Firm B’s output and excludes Firm A’s output to avoid double counting.
For example, a car producer purchases the car parts and accessories from other producers
and its main role is to assemble all the parts and accessories to make it a complete car
before selling to its customers. If all the output produced by all firms are included in the
calculation of GDP, then the GDP will record the value of the completed car, the value of
the car battery, the car tyres and the car seats, among others. It will be counting the same
car twice and this is double-counting.
To avoid double counting, only the final goods are included in the calculation of GDP.
Thus when the tyre manufacturers sell the 4 tyres to the car producer, the tyres are
intermediate goods, not final goods and the value will not be included in the GDP. Only
the car producer’s completed car is the final good and will be included in the GDP.
If we wish to include all outputs in the calculation of GDP, we can only include the value
added of each output to avoid doubt counting. For example, a wheat farmer grows wheat
and sell the wheat for $1 per unit. A flour producer bought the wheat, use it to produce
flour and sell the flour for $2.20 per unit. Finally, a baker bought the flour, baked it into a
bun and the bun for $4. If we only consider the final output which is the bun, the value is
$4.
If we consider the value added of all output, the value added of the farmer is $1. The value
added of the flour producer is $2.20 – $1 = $1.20. The value added of the baker is $4 $2.20 = $1.80. Adding up all the value added, we have GDP = $1 + $1.20 + $1.80 = $4.
This is the same as value of the final product which is the bun at $4.
14
(c)
Produce in the Domestic Economy
The gross domestic product (GDP) measures the market values of all final goods and
services produced during a year by resources located in a country, regardless of who owns
those resources. The purpose of GDP is to keep track of the performance of an economy
and therefore it should only include the value of output produced within the geographical
boundary of the economy. Hence the GDP of Singapore only includes the goods and
services produced within the geographical boundary of Singapore. It does not matter
whether the firms that produce these outputs are owned by Singapore or the foreign
countries. Goods that are produced in Singapore but exported to foreign countries will be
included in Singapore GDP. On the other hand, goods that are imported into Singapore
will not be included in Singapore GDP since they are not produced in Singapore.
In this context, the output produced by foreign factories located in Singapore is included
in Singapore GDP but the output produced by Singapore firms located in foreign countries
will not be included in Singapore GDP. If we exclude the value of output produced by
foreign firms located in Singapore and include the value of output produced by Singapore
firms located in foreign countries, the value becomes Gross National Product (GNP).
However, in this course, we use GDP to denote the income of an economy.
(d)
Timeframe
GDP normally measures in the timeframe of one year and Singapore GDP for 2013
measures the value of final output produced in the beginning of 2013 until the end of 2013.
If a product is produced in 2012, it should be reflected in the year 2012 GDP only.
In this context GDP also ignores the value of second hand goods, such as resale textbooks,
resale houses and resale cars. The reason is that these goods were already counted in the
GDP in the year they were produced. The same product cannot be counted more than once
in the computation of GDP.
3.2
GDP and Standard of Living
The main purpose of GDP is to measure the performance of the economy and compare the
performance of the economy over time and with the other economies.
If we divide the GDP of an economy by its population, the value is called GDP per capita
or GDP per person. This value can be used as an indicator of the amount of goods and
services a person in the country can consume in a year which indicates the well-being of a
people in the country.
A country with a very high GDP per capita in general implies that the people are better off
than the people in a country with a very low GDP per capita. Hence countries with high
GDP per capita, such as Switzerland and USA, tend to have a higher standard of living and
15
a higher welfare level for its people compared to countries with low real GDP per capita,
such as some sub-Saharan African countries.
However, GDP or GDP per person is an imperfect measurement of standard of living or
well-being of people in the country. There are some limitations in using GDP to indicate
the standard of living or the well-being of the people. These limitations are discussed as
follows:
(a)
GDP ignores household production and underground economy
As mentioned in Section 2, GDP only records the value of output that transacts through the
market system. Thus the goods and services produced by family members of a household
will not be included in the GDP, even though they tend to increase the welfare of the
household members. In a similar context, a country may have a very large underground
economy with productions not recorded in its GDP. This means the GDP value may be
low in record but the residents may actually have a large amount of output for consumption.
Hence the residents need not be worse off compared to other countries with higher GDP.
(b)
GDP ignores leisure
The well-being of a person includes not just the amount of goods and services the person
can consume but also the amount of leisure that the person can enjoy. An economy that
requires its people to work for 12 hours per day will tend to have a higher GDP than another
economy that people only work for 8 hours per day. But it is difficult to conclude that the
latter will have a lower well-being than the former based on GDP figure alone since the
latter will have more time for leisure activities.
(c)
GDP ignores impact on environment
A country can have a high GDP if it carries out large number of economic activities such
as building more houses, cultivate more land, extract more minerals from the earth and
create more offices and factories. However, it will tend to create pollution and damages to
the environment. The well-being of the people includes a pleasant environment to live
with sufficient space and little pollution. Thus a high GDP may imply low well-being if it
is associated with polluted environment.
(d)
GDP ignores crime and congestion
A country may have high GDP but if the crime rate is very high and people feel unsecured
for their life and property, the well-being will not be high. Likewise, space is enjoyed by
people but GDP may be achieved by over development in the economy. This will cause
congestions in the economy and will reduce the well-being of the people.
(e)
GDP ignores distribution of income
16
GDP records the total value of output of an economy but did not consider the distribution
of output in the economy. The term GDP per capita simply divide the GDP by the
population and assume everyone gets an equal share of the output. In reality, the
distribution of income can be very unequal such that majority of the output are distributed
to a small minority in the economy, leaving the majority in poverty situation. In this case,
a high GDP need not implies a high welfare for the people in the economy in general.
(f)
GDP measures production and not consumption
GDP records the value of outputs produced in the economy, while standard of living is
measured by the amount of goods and services consumed by the people in the economy.
A country may have high GDP but it is obtained through production of non-consumer
goods, such as machines for investment or exports to other countries where the local people
may not be experience higher standard of living.
4.
Calculation of Gross Domestic Product
There are three methods of calculating GDP. They are the output method, the expenditure
method and the income method. Regardless of which method is used, the value of GDP
should be the same.
4.1
Output Method
The output method of calculating GDP is to measure the market value of all final outputs
produced by the firms in the economy. The market value of final output is obtained by
multiplying the market price by the quantities of the output produced.
Assume that there are four firms produce four goods in an economy. Firm A produces
food, Firm B produces clothing, Firm C produces computers and Firm D produces cars.
The prices and quantities of the three products in the year 2013 is reflected in Table 6.1
Table 4.1: Calculation of GDP
Firm
A
B
C
D
Output
Food
Clothing
Computer
Cars
Price
$1
$2
$300
$10,000
Quantity
1200
800
30
10
Total Value
$1200
$1600
$9000
$100,000
Using the output method, the GDP of the economy in 2013 is $1200 + $1600 + $9000 +
$100,000= $111,800.
17
While the output method is easy to use, it becomes tedious if the economy produces many
goods and services. A more popular method to compute GDP is the expenditure method,
as discussed in Section 4.2.
4.2
Gross Domestic Product by Expenditure Method
In Section 4.1, we discussed the calculation of GDP by adding up the market value of final
output produced by the firms in the economy. Since the firm’s output are purchased by the
consumers in the market, an equivalent way of measuring GDP is by calculating the total
spending on a country’s production. This is because total spending equals total value of
output in an economy. This is known as the expenditure method of calculating GDP.
The expenditure approach involves adding up the total spending, known as the aggregate
expenditure (AE) on all final goods and services produced during the year. The aggregate
expenditure is divided into four components: Consumption, investment, government
purchases and net exports.
(a)
Consumption (C)
Consumption refers to the expenditure incurred by households to satisfy their needs. This
expenditure denoted by C and it consists of purchases of final goods and services by
households during the year.
The examples of consumption include household purchase of food, clothing, cars,
furniture, transportation, medical and education services. However, it does not include
purchase of houses. The purchase of house is included in investment under residential
investment.
For the calculation of GDP, each product can only be counted once. Hence consumption
spending on resale products are not included in the calculation of GDP. For example, a
student purchases a new textbook from the book shop is counted as consumption. But if a
student bought a resale textbook from the senior student then the spending is not included
in the calculation of GDP.
(b)
Investment (I)
Investment refers to the expenditure incurred in order to produce goods and services and
not for satisfaction of wants. It is denoted by I and there are three categories of investment.
(i)
Physical capital investment: This refers to the expenditure incurred by firms to
produce goods and services. Examples include machinery purchased by firms, such as
computers and vehicles. It also includes the shops, offices, factories and buildings used by
the firm in its operation.
18
(ii)
Inventory investment: This refers to the stock of completed or semi-completed
goods which firms stored in the warehouse instead of releasing them for sale in the market.
It is an investment as firms may hold these stocks until a better time to release them to the
market to earn more profits. Inventories help firms to deal with unexpected change in the
demand for their product so that the stocks can be released at a good time and not for
current consumption.
Firms will keep track of the value of their stocks at the warehouse at the end of the year
and compared this value to the beginning of the year. If there is a higher value of stock
over the period, inventory investment increases. Hence inventory investment is measured
by the value of inventory at the end of the year less the value of inventory in the beginning
of the year.
(iii) Residential investment: This refers to the purchase of newly constructed houses by
households. It is considered as an investment as house prices tend to increase over the
years unlike consumer goods which value tends to decrease over time. However, the
purchase of existing houses will not be included in the GDP. This is to avoid double
counting since every house can only be counted once in the GDP.
When calculating GDP using the expenditure method, the investment does not include the
purchases of existing financial assets, such as stocks and bonds. These represents a transfer
of money from one party to another and there is no new goods or services being produced
in the period. These are financial investment which is meant for generating returns for the
investor and did not represent any production of goods and services in the year as required
in the GDP.
(c)
Government Spending (G)
Besides households and firms, the government also incurs expenditures in order to perform
its function. This is called government purchases or government spending, denoted by G.
It includes spending by all levels of government for goods and services.
Examples of government spending includes spending to provide national defence, purchase
weapons, build roads, parks, schools and hire teachers to provide teaching services in
schools or doctors and nurses to provide medical services in government operated
hospitals.
However, sometimes government gives money to the people without any condition. This
type is spending is called transfer payment. The examples include unemployment benefits
and other welfare benefits such as food or cash vouchers for the low income people. These
payments are transfers of money from the government to the recipients. Although it is a
spending incurred by the government, it is not included in the calculation of GDP since
there is no corresponding goods and services being produced.
(d)
Net export (NX or X – M)
19
Net export, denoted by NX, is the value of a country exports (X) minus the value of its
imports (M). When a country produces its products and sells to foreigners, the values of
the output are recorded in export and are included in the GDP. They are included because
the production occurs in the country. The fact that the goods or services are consumed by
foreigners does not matter as it is the location of the production that counts.
When a country purchases goods and services produced by foreign countries, the value of
these outputs will be recorded in the import. The import should be excluded from the GDP
since they are not produced within the country even though they are consumed by the
people in the country. Thus, part of the spending in the consumption, investment or
government spending could be on goods and services produced by foreign countries and
imported into the local country. They are collectively captured in the import component
to be excluded from the calculation of the GDP.
If the value of exports exceeds the value of the imports, net exports is positive and this is
known as a trade surplus. However, if a country imports more than its exports, then the
net export is negative and this is known as a trade deficit. If the country has export equals
to import, then the net export is zero and this is known as a balanced trade.
Adding all the relevant spending items, we will have the GDP using the expenditure
method. Thus we have C + I + G + X – M = C + I + G + NX = Aggregate expenditure =
GDP. It is common to use Y to denote GDP. Thus we have
Y = C + I + G + NX
4.3.
GDP by Income Method
In Section 6.2, we discussed the calculation of GDP by calculating the total spending on a
country’s production. Since the total spending equals to the total revenue of the firms
which will be distributed to the various resource owners in the form of their incomes, we
can compute GDP by adding up the total income in an economy. This is known as the
income method of calculating GDP.
The income approach involves adding up the total income earned by the resource owners
in the economy during the year. In general, there are 4 types of resources in the economy,
land, labour, capital and entrepreneurship. Their incomes are in the form of rent, wages,
interest and profits respectively. Adding all the rents, wages, interests and profits with
adjustment to reflect the market price at gross value will give rise to GDP. The adjustment
to reflect the market price is through adding taxes and less subsidies.
4.4
Nominal GDP and Real GDP
Over the years, the price of goods and services will tend to increase. Thus when an
economy records a higher GDP value, it may be due to the economy produces more output,
20
the prices of the outputs increase or a combination of both. While an economy produces
more output is reflected as economic growth which is desirable, an economy that
encounters higher prices of output is reflected as inflation which is less desirable. It is thus
important to distinguish between a higher GDP due to more output from a higher GDP due
to higher prices. This give rises to two different ways of calculating GDP: Nominal GDP
and Real GDP.
Nominal GDP is obtained by multiplying the current year output by the current year price.
For example, the year 2012 nominal GDP is obtained by multiplying 2012 prices by 2012
quantities of all final output produced. The year 2013 nominal GDP is obtained by
multiplying 2013 prices with 2013 quantities of all final output produced. If there is an
increase in the nominal GDP, it could be due to prices increase, quantities of output
increases or both. It will be misleading to associate a higher nominal GDP as economic
growth because it may be due to inflation.
Real GDP is obtained by multiplying the current year output by the price of a representative
year, known as the base year. For example, if 2012 is the base year, then the real GDP of
2013 is obtained by multiplying the 2012 prices by 2013 quantities of all final output
produced in 2013. If there is an increase in real GDP, the economy must have produced
more output since the prices are kept constant at the base year. To measure economic
growth over the years, it is more meaningful to comparing real GDP instead of nominal
GDP. This is because real GDP reflects on real changes in production and eliminates
changes due to changes in the prices of output.
Table 4.2: Nominal GDP and Real GDP
2012
2013
Output
Price
Quantity
Price
Quantity
Food
$1
1200
$1.20
1250
Clothing
$2
800
$2.20
830
Computer
$300
30
$330
35
A numerical illustration of nominal GDP and real GDP is shown in Table 4.2. It involves
2 years of production, 2012 and 2013. Assume that 2012 is the base year.
The nominal GDP for 2012 is ($1 x 1200) + ($2 x 800) + ($300 x 30) = $11800.
Since 2012 is the base year, the real GDP for 2012 is also $11800.
The nominal GDP for 2013 is ($1.20 x 1250) + ($2.20 x 830) + ($330 x 35) = $14876.
The real GDP for 2013 is ($1 x 1250) + ($2 x 830) + ($300 x 35) = $13410.
Note that the nominal GDP is higher than the real GDP since both prices and quantities
have increased over the period.
21
We are also interested in the growth rate of the economy. This is expressed as the
percentage change in the real GDP across the period.
Between 2012 and 2013, the nominal GDP growth rate is:
$14876-$11800 X 100% = 26.07%
$11800
The real GDP growth rate is:
$13410-$11800 X 100% = 13.64%
$11800
Note that with prices increase over the period, the real GDP growth rate will be lower than
the nominal GDP growth rate. In contrast, if the prices decrease over time, the real GDP
growth rate. will be higher than the nominal GDP growth rate
5.
Average Labour Productivity and Long Term Economic Growth
To achieve economic growth, in the short run an economy can increase the quantity of its
resources and more resources will translate into more outputs. However, in the long run,
economic growth arises out of higher average labour productivity. It is important to
understand the determinants of average labour productivity and design suitable economic
policies to promote average labour productivity.
5.1
Average Labour productivity
In Section 3, we mentioned that GDP divided by population or GDP per capita can be
used to indicate the standard of living in an economy. GDP per capital is in turn affected
by the average labour productivity and the proportion of population that is working in an
economy.
Specifically, let Y denote GDP, POP denote population, L denote number of workers, we
have:
Y = Y X L.
POP
L
POP
The term (Y/POP) is GDP per person which is a measurement of the standard of living in
an economy. The term (Y/L) is the output per labour in the economy, which is the amount
of output produced by each worker or the average labour productivity. The term (L/POP)
is the proportion of workers in the entire population or the share of the total population that
is working.
22
The equation illustrates that to achieve a higher standard of living, an economy needs to
increase the amount of output produced by each worker (Y/L) and/or increase the share
of the workers in the population (L/POP).
There is a limit that an economy can increase its share of people working. In any economy,
there is always a group of people that is below or above the working age and a group of
people who choose not to work (for example, full time students and home-makers). Once
the limit is reached, an economy can improve its standard of living only through increasing
its labour productivity.
In the long run, an economy can achieve continuous and sustainable improvement in its
output per person mainly from increasing the productivity of its workers. It is important
to understand the factors that can affect the labour productivity in order to prepare the
economy for long term sustainable growth.
5.2
Determinants of Average Labour Productivity
There are 6 factors that can affect the average labour productivity of an economy. The 6
factors are as follows:
(a)
Human capital
Human capital refers to the skills, knowledge and talents of the people in an economy. A
more skilful worker can produce more output than a worker that is less skilful. Talents,
knowledge and skills can be nurtured and cultivated through education and training. Hence
it is important that an economy provides sufficient education and training opportunities for
its workers.
More importantly, there is no limit for human capital to enhance output. The more
knowledgeable and skilful a worker becomes, the more productive is the worker. This is
unlike physical capital where there is always a diminishing returns.
(b)
Physical Capital
Physical capital refers to tools, machines, building and other man-made products used to
produce goods and services. Workers effort can be greatly enhanced by suitable machines
to produce output efficiently. A worker who are equipped with suitable and sufficient
machines will be able to produce more output than workers without sufficient or suitable
tools. Hence it is important for an economy to invest in sufficient physical capital to
achieve higher level of labour productivity.
Recall the concepts of diminishing returns in Microeconomics. The law of diminishing
returns states that given fixed inputs (machines) and increasing variable inputs (workers),
the marginal product of the variable inputs (productivity) of workers will eventually
decline. Thus if there are insufficient machines for the workers to use, the labour
23
productivity will be severely affected. Workers in low income economies tend to be
unproductive due to lack of tools and machines in the production process.
However, there is a limit in increasing labour productivity through capital accumulation.
This is because there is also diminishing returns to capital. When the workers have too
many machines in the production process, the additional machines will contribute
increasing less to the output.
(c)
Land and Natural Resources
Production in goods and services suitable proportion of all relevant inputs. Besides
workers and machines, land and natural resources are also needed in the production
process. The productivity of a worker may be hindered by insufficient land and natural
resources. For agricultural based economies, insufficient land will restrict the output of the
workers. Manufacturing-based economies also require constant access to raw materials
and energy to produce output. An economy that has very little land and natural resources
may constrain its workers’ ability to produce output.
Big countries that are well-endowed in land and natural resources will encounter less
constraints in this aspect. However, even for economies that are not land and natural
resources abundant, such as Singapore, Japan and Hong Kong, labour productivity can still
be enhanced if the economies can acquire resources through international trade.
(d)
Technology
Technology is often considered as the most important source of productivity improvement.
Similar to human capital, there is no diminishing returns to technology. Improvement in
technology results in more advance equipment and better production process. This will
imply lesser needs for land, natural resources and labour to produce goods and services.
Historically, the technology change creates industrial revolution which brings about a large
increase in output per person. The mode of transport has changed from using animals such
as horse to cars, rail and planes which allows more goods to be sent across a longer distance
in a shorter time. Improvement in medical technology has led to curing and prevention of
many diseases, resulting in healthier and more productive workers. The more recent
information and communication technology (ICT) has also created cheaper and more
efficient pathways of information transmission such as email and internet which boost
labour productivity in communications and information sourcing.
However, it is not easy to achieve technological breakthrough. Technology discovery
requires substantial investment in research and development. This type of investment is
costly and may not always be able to bear fruits and hence is considered as a high risk
investment. To enhance technological development, the government can take up
24
fundamental science research and provide financial incentives to companies that invest in
technology research.
(e)
Entrepreneurship
With the availability of land, natural resources, workers and machines in an economy,
entrepreneurs are still needed to combine all the resources together and channel them to
productive uses. A vibrant and dynamic economy requires constant improvement in the
production process and a continuous flow of new and better goods and services. This
requires people who are willing to become entrepreneurs to set up new companies and
produce new high value added outputs.
Entrepreneurship can be enhanced through suitable government policies such as tax
concessions, subsidy and also changes in regulatory framework. It also requires an
innovative culture and risk-taking spirit in the economy.
(f)
Political and Legal Environment
A worker will have the incentive to improve labour productivity if the fruits of higher
productivity can be enjoyed by the worker. Similarly, a firm will have more incentive to
innovate if the firm can protect its innovation and prevent others from copying. This
requires well-defined property rights to clearly define the owner and the rights of the
owner. There must also be reliable legal process to enforce the rights.
Political stability which ensures consistency in the government policy is important to
attract investments, especially foreign investment which may bring in more advanced
technology and management processes. Stability in the society which protects life and
property precedes improvement in labour productivity.
6
Illustration Questions
Nail Addiction is a shop that provides manicure services. Nail Addiction did 4,000 sets of
nails in 2010 and 4,500 sets of nails in 2011. The price of a set of nails was $20 in 2010
and $22 in 2011. 2010 is the base year.
(a)
What was Nail Addiction’s contribution to nominal GDP in 2010?
(b)
What was Nail Addiction’s contribution to nominal GDP in 2011?
(c)
What was Nail Addiction’s contribution to real GDP in 2010?
(d)
What was Nail Addiction’s contribution to real GDP in 2011?
25
Suggested Answers
(a)
Nominal GDP in 2010 is the price in 2010 multiply by the quantity in 2010. Thus
we have 4000 x $20 = $80,000
(b)
Nominal GDP in 2010 is the price in 2010 multiply by the quantity in 2010. Thus
we have 4500 x $22 = $99,000
(c)
If 2010 is the base year, then the nominal GDP in 2010 is the same as the real GDP
in 2010. Thus we have real GDP in 2010 = 4000 x $20 = $80,000
(d)
Since 2010 is the base year, the real GDP in 2011 is the quantity of 2011 multiply
by the price in 2010. Thus we have 4500 x $20 = $90,000
7.
Discussion Questions
Question 1
How are intermediate goods included in the calculation of GDP?
(A)
(B)
(C)
(D)
They are always included in GDP calculation.
They are included in GDP only if they are produced in the current year.
They are included in GDP only if they are produced within the country.
Their value is included as part of the value of the final good of which they are an
input.
Question 2
Summing the value added of all firms yields the value of final goods and services produced
because both measures ____________.
(A)
(B)
(C)
(D)
exclude the value of capital goods
exclude the value of intermediate goods and services
use constant prices
are adjusted for population growth
Question 3
One shortcoming of GDP as an indicator of society’s social well-being is that it fails to
take into account the __________.
(A)
(B)
(C)
(D)
growth in productivity.
increase in the quantity of goods.
non-market production.
change in the price level.
26
Question 4
In symbolic terms where Y equals real GDP, POP equals total population, and N equals
the number of employed workers, Y/POP must equal:
(A)
(B)
(C)
(D)
Y/N × N/POP.
N/Y × POP/N.
Y/POP × N/POP.
N/Y × N/POP.
Question 5
(a)
The table below shows expenditures of an economy in 2013. Calculate the nominal
GDP in 2013.
Item
Expenditure ($m)
Consumption
Investment
Government expenditure
Exports
Imports
CPI = 1.08
(b)
6,988
1,532
1,945
250
600
Refer to the table below:
Year
1960
2009
Average
labour
productivity
45,438
99,763
Share of
population
employed
37.8%
46.0%
Calculate real GDP per capita for the year 2009.
(c)
Explain whether the following items of expenditure are included in the calculation
of the GDP of an economy:
(i)
A resident buys a resale condominium.
(ii)
The government issues vouchers to help families cope with the higher cost of living
in the country.
27
Question 6
The following table provides data for an economy in 2010:
Consumption expenditure
Imports
Government purchases of goods and services
Construction of new homes and apartments
Sales of existing homes and apartments
Exports
Government payment of unemployment benefits
Beginning of year inventory
End of year inventory
Business fixed investment
(a)
(b)
(c)
(d)
$m
1,000
600
700
500
600
500
200
500
600
300
Calculate the nominal GDP for the year 2010.
Explain why you have excluded certain items from your calculation.
What is the real GDP for 2010 if the CPI = 1.25?
Which is a better measure of change in the production of goods and services? –
nominal GDP or real GDP? Explain.
Question 7
The table below shows the information on the GDP of an economy.
GDP Data
Consumption expenditures
Exports
Government purchases of goods and services
Construction of new homes and apartments
Sales of existing homes and apartments
Imports
Beginning-of-year inventory stocks
End-of-year inventory stocks
Business fixed investment
Government payments to retirees
$600
$75
$200
$100
$200
$50
$100
$125
$100
$100
(a)
Calculate nominal GDP for the economy using data from the table above.
(b)
What items are excluded and why?
28
MACROECONOMICS
SESSION 2
PRICE LEVEL AND INFLATION
At the end of the session, students should be able to:
1.
2.
3.
4.
5.
6.
Define inflation, consumer price index and distinguish between demand pull
inflation and cost push inflation
Compute CPI and calculate inflation rate using CPI
Adjust for Inflation using indexing method
Analyze the limitation of CPI in measuring inflation
Distinguish between real and nominal quantity in the presence of inflation
Analyze the cost of inflation
_________________________________________________________________
1.
Introduction
In this session, we begin with a definition of inflation and distinguish between cost push
inflation and demand pull inflation. Next we discuss the method to compute consumer
price index (CPI), how to measure inflation rate using CPI and the limitations of CPI in
measuring inflation rate. Then we distinguish between real and nominal quantity in the
presence of inflation and discuss the adjustment of inflation using indexing method.
Finally, we analyse the cost of inflation in an economy.
2.
Inflation and Types of Inflation
Inflation is a sustained increase in the average level of prices. Since there are many goods
and services in the economy, we often group the goods and services in suitable clusters and
consider the average of all these prices, known as price level, when analyzing inflation.
When price level increases, inflation occurs and the inflation rate is measured by the
percentage change in the price level. A very high inflation is called hyperinflation, which
is defined as price on the average increases by about 50% or more per month. A sustained
decrease in the average level of prices is called deflation.
Inflation is often measured on a monthly or an annual basis. The annual inflation rate
equals the percentage increase in the price level over the period of one year. When inflation
occurs, the same amount of nominal income will be able to buy lesser goods and services.
Thus the household standard of living will decrease if the nominal income did not increase
by at least the same magnitude as the inflation rate.
29
2.1
Price Index
The average prices of products or price level is often indicated by a price index. There are
many price indices in an economy. The common price indices are as follows:
(a)
Consumer Price Index
The consumer price index (CPI) is the average price of goods and services purchased by
households for consumption. The inflation rate measured from the percentage change in
the CPI is often being used as a measure of changes in the cost of living and act as a basis
for workers to bargain with the employers for wage adjustments.
(b)
Producer Price Index
The producer price index (PPI) is the average price of resources purchased by producers in
the production process. This will include prices of raw materials, energy, machines, as
well as rental and wages of workers. A higher PPI means higher cost of production which
will be passed on to consumers in the higher retail prices.
(c)
Export-Import Price Index
Export-Import price index measures the average prices of imported and exported goods
and services. This index is relevant to trades who need to import goods from and export
goods to other countries.
(c)
GDP deflator
GDP deflator measures the average prices of goods and services included in the
computation of GDP in an economy. A higher GDP deflator means the average price of
the outputs produced by the country is higher.
Although the various indices tend to move in the same direction, the different price index
measures the prices of different items and hence the inflation rate measured will be
different. For example, households may consume food imports from other countries and
the price of imported food will be included in CPI. But since the food is not produced by
the local producers, the price of imported food is not included in the computation of GDP
deflator.
It is important to use the relevant price index in order to get an accurate measurement of
the inflation rate. To measure the cost of living for households, CPI is the more suitable
index. To measure the competitiveness of an economy, the GDP deflator is the more
suitable index. Producers will be more likely refers to the PPI to measure the inflation rate
while international traders should refer to the export-import index which is more relevant.
30
2.2
Types of Inflation
Inflation can be depicted as a continuing increase in the economy’s price level resulting
from an increase in the total demand for output or a decrease in the total supply of output.
Thus there are two types of inflation: demand pull inflation and cost push inflation.
(a)
Demand-pull inflation
Demand pull inflation refers to inflation due to higher demand for output. When the
households, the firms, the government and the foreigners want to demand for more goods
and services, they will tend to bid up the price of goods and services, hence inflation occurs.
Recall in Session 7 that the total spending in an economy can be divided into consumption,
investment, government spending and net exports, we can also analyze the demand for
output in these four categories that may create demand pull inflation.
For example, when consumer income increases or when consumers are more optimistic
about the future, then there will be a higher level of consumption and hence higher demand
for output. This will result in demand pull inflation.
When interest rate decreases or when firms become more optimistic, the firms will carry
out more investment and there will be greater demand for output. This will create demand
pull inflation.
When the government implement policies to increase spending in the countries or reduce
taxes in the country, the action may also result in demand pull inflation. Increase in
government spending add on to output demanded in the country, while a tax cut increases
the take home income of the people which increases their ability to demand for more
output. One more method is for the government to make interest rate lower so that people
will borrow more to consume more and firms will borrow ore to investment more. All
these actions may trigger demand pull inflation.
Demand pull inflation may also occur due to higher net export. If the foreign countries
encounter an expansion, the foreigners will have higher income and will buy more products
from the local economy. Thus the local economy encounters a higher demand for its
product and the demand pull inflation may occur.
(b)
Cost-push inflation
Cost push inflation arises firms cut down production, resulting in shortage of output in the
economy and thereby drive up the prices of goods and services in general. This occurs
when resources become more expensive which increases the production costs. When it is
more expensive to acquire resources, firms will hire less resources and produce less output.
This will create a shortage of output at existing price level, price level will increase and
inflation occurs.
31
When cost push inflation occurs, it means not only prices are higher but the economy also
produces less output. Thus there is a combination of inflation and recession in the country
and this phenomenon is known as stagflation stagflation.
Cost push inflation occurs whenever there is a higher resource price. Thus when price of
oil or other important raw materials increase, cost push inflation occurs. It may also occur
when workers demand for higher wages through the labour union demand, when landlord
charges a higher rental or when capital goods producers increase their prices. Cost push
inflation also occurs when there are natural disasters in an economy. When there is a
natural disaster such as earthquake or hurricane, it often results in land and production
facilities being destroyed and people killed. There will be lesser resources available in the
economy to produce output and hence cost of production increases creating inflation.
Note that demand pull inflation results in a higher price level and real GDP. Thus the
higher real GDP partly offset the negative effect of higher price level. In this sense a
demand pull inflation is better than a cost push inflation. A cost push inflation results in a
higher price level and a lower real GDP which means the people in the country are poorer
and goods and services are also becoming more expensive and people are affected
negatively in both situations.
3
Consumer Price Index
The consumer price index (CPI) is the most common price index in measuring inflation. It
keeps track of the price of a representative basket of goods and services consumed by
households in an economy over time and expressed in an index. The percentage change in
the CPI is often being used to represent the inflation rate of the economy.
3.1
Computing Consumer Price Index
To compute the consumer price index, the government will need to conduct surveys on the
households to determine the common goods and services consumed by households in
general and construct a consumption basket for households. The government then set a
year to be the representative year, known as the base year, and measure the price of this
basket of goods and services time. The ratio of the price of basket in the current year
relative to the price of the same basket in the base year is the CPI.
One important issue is that once the goods and services are established in the basket, the
types of goods and services and their quantities cannot change. Only the prices of the items
can change. This is for consistency but it also results in limitations on the accuracy of
using CPI to measure cost of living changes. However, to reflect changes in consumption
pattern due to new products or services, the base year may change in every 5 years
32
Assume that the base year is 2014 and the following items and their respective quantities
are selected in the consumption basket. The unit prices of the goods and services in 2014,
2015 and 2016 are given in Table 3.1.
Table 3.1: A Representative Consumption Basket
Item
Fish
Rice
Bread
Bus fare
Medical care
Quantity
20
30
15
20
5
Price in 2014
$3
$2.50
$1.20
$2
$20
Price in 2015
$3.10
$2.30
$1.50
$2.20
$22
Price in 2016
$3.30
$2.40
$1.60
$2.40
$25
The cost of the consumption basket in 2014 is (20 X $3) + (30 X $2.50) + (15 X $1.20) +
(20 X $2) + (5 X $20) = $60 + $75 + $18 + $40 + $100 = $293.
The cost of the consumption basket in 2014 is (20 X $3.10) + (30 X $2.30) + (15 X $1.50)
+ (20 X $2.20) + (5 X $22) = $62 + $69 + $22.50 + $44 + $110 = $307.50.
The cost of the consumption basket in 2014 is (20 X $3.30) + (30 X $2.40) + (15 X $1.60)
+ (20 X $2.40) + (5 X $25) = $66 + $72 + $24 + $48 + $125 = $335.
CPI is computed by the ratio of the cost of the consumption basket in the current year
relative to the base year. Hence for 2014 which is the base year, the CPI is $293/$293 = 1.
The base year CPI is always equal to 1. In some countries, the CPI is multiplied by 100
and the base year CPI is 100. In this course, we will use 1 to indicate the base year CPI.
For 2015, the CPI is $307.50/$293 = 1.0495
For 2016, the CPI is $335/$293 = 1.1433
When computing the CPI, it is important to follow the base year quantities for consistency.
Only the price of the item changes from 2014 to 2015 and 2016 but the quantities remain
unchanged as the base year. The CPI should measure the price change of the same
consumption basket overtime.
3.2
Calculation of Inflation Rate
Using CPI as the price index, if CPI increases there is inflation and if CPI decreases there
is deflation. Inflation does not require every items in the consumption basket to be more
expensive. It is possible that some items become more expensive while other items are
cheaper over time. Inflation occurs when the prices on the average increases.
We can determine the inflation rate between the two periods by computing the percentage
change in the CPI over the period.
33
Refer to the numerical example in Table 3.2
Table 3.2: CPI and Inflation Rate
Year
2009 (Base Year)
2010
2011
2012
2013
2014
CPI
1.00
1.03
1.08
1.12
1.10
1.15
From Table 3.2, we can compute that the inflation rate by computing the percentage change
of two successive CPI. Thus the formula to compute inflation rate at time period t It is:
It = CPIt – CPIt-1
CPIt-1
In 2012, the inflation rate is the percentage change in CPI between 2011 and 2012:
1.12-1.08 X 100% = 3.7%.
1.08
In 2013, the inflation rate is the percentage change in CPI between 2012 and 2013:
1.10 – 1.12 X 100% = -1.79%
1.12
A positive inflation means prices have in general increase over the period. A negative
inflation, known as deflation, means prices have actually decrease over the period. If
inflation is increasing by a smaller magnitude over time, this is known as dis-inflation.
Inflation rate tends to fluctuates over time. When an economy achieves progress and
income increases, prices of goods and services will tend to increase and hence demand pull
inflation occurs. During the oil shock period in 1970s, the oil importing countries
encounter high imported price for oil and cost push inflation occurs. When there is a
recession and income decreases, consumers buying power will reduce. The prices of goods
and services in general decreases and there will be deflation. Historically, 1930s is the
Great Depression and deflation occurs in many economies. In general, it is more common
for an economy to encounter inflation rather than deflation.
3.3
Limitation of CPI in Measuring Inflation Rate
CPI is widely used to indicate cost of living changes in an economy. Due to higher cost of
living, workers will also need to have higher wages to maintain the standard of living. Thus
34
the inflation rate measured by the percentage change in CPI acts as a basis for workers to
negotiate for wage adjustments. If inflation rate is 5%, it is reasonable for the workers to
demand for 5% increase in the wage to compensate for the higher cost of living. In the
same context, for retirees who draw a pension from the government, the amount of pension
should also be adjusted over time to cover the higher cost of living for retirees. The
government is usually supportive in this type of wage or pension adjustments to
compensate for inflation.
The issue is whether the percentage change in CPI is an accurate measurement of the cost
of living. Statistical evidence shows that CPI tends to overstates inflation by about 1% to
2%. This means if the actual cost of living increases by 3%, CPI will show a 4% to 5%
increase.
There are two reasons why CPI overstates inflation. They are known as the substitution
bias and the quality adjustment bias. They are discussed as follow:
(a)
Substitution Bias
In the computation of CPI, the requirement is that the price of the same basket is measured
overtime. Regardless of the changes in prices, consumers are assumed to buy the same
product and the same quantity. This give rise to the substitution bias because in reality,
consumers are always responsive to price change. Consumers will tend to buy less of a
product when the price increase and buy more of its substitutes when the price increase.
For example, consider four items in a consumption basket as rice, noodle, bus fare and train
fare. To some extent, rice and noodle can be substitutes and bus and train can replace each
other for transportation needs. Refer to Table 3.3 which shows the actual price and quantity
of the 4 items consumed in 2014 and 2015.
Table 3.3: Substitution Bias in CPI
Item
Rice
Noodle
Bus Fare
Train Fare
2014 Price
$2
$3
$1.00
$1.20
2014 Quantity
50
30
30
20
2015 Price
$2.10
$3.50
$1.10
$1.60
2015 Quantity
60
20
40
10
Assume that 2014 is the base year. The price of the consumption basket in 2014 is (50 X
$2) + (30 X $3) + (30 X $1) + (20 X $1.20) = $100 + $90 + $30 + $24 = $244
In 2015, the prices of the 4 items increases but noodle price increases by a larger magnitude
compared to rice price and train fare increases by more than bus fare. It is likely that
households will respond by buying more noodles and less rice and travel by bus more and
travel less by train. The cost of living based on the actual consumption quantity in 2015 is
(60 X $2.10) + (20 X $3.50) + (40 X $1.10) + (10 X $1.60) = $126 + $70 + $44 + $16 =
$256.
35
However, using the methods to compute CPI, the consumption basket must be the same as
the base year. Hence the cost of the same consumption basket in 2015 is (50 X $2.10) +
(30 X $3.50) + (30 X $1.10) + (20 X $1.60) = $105 + $105 + $33 + $32 = $275
Based on the computation method for CPI, the CPI in 2015 is $275/$244 = 1.127. Thus
compared to the base year, inflation rate is 12.7%. However, the actual cost of living in
2015 is $256. Using the actual cost of consumption, the CPI is $256/$244 = 1.049. The
cost of living only increase by about 4.92%. Hence CPI overstates the actual cost of living
and the actual inflation rate.
(b)
Quality Adjustment Bias
CPI assumes that the same product is of the same quality overtime, only its price has
changed. In reality, overtime the quality of a product will tend to improve. CPI did not
consider the possibility of quality improvement and assume that the same product is of the
same quality when price increases.
For example, in the past the bus fate was $0.30 but the bus has no air-con and the seat was
not comfortable. Now the bus fare is $0.70 but the bus has air-con and the seats are more
comfortable. So part of the higher bus fare we paid is for better quality of bus travel.
However, CPI assumes that it is the same quality of bus travel that charges a higher fare
and this is not true. Another example is the change in technology results in better quality
of product. Consider the price of a computer is about $1000 in the past and now we pay
$1500 for a computer that can process much faster and has more functions.
It is difficult to adjust for quality because of large numbers of goods and services and also
the same quality is perceived differently by different consumers due to subjective
preferences.
Besides the substitution bias and quality adjustment bias, there is also the bias due to new
product introduced which is consumed by households but not included in the base year. If
the new product is cheaper and can replace the product in the basket, CPI will also overstate
the actual inflation in the economy.
There are several problems when CPI overstates the actual inflation rate. If employers
compensate the workers based on the inflation rate computed from CPI, the workers will
have a higher standard of living than the level reflected by their wage earned. However,
the employers will have a larger than necessary increase in the cost of production. The
employers may need to increase the price of the output produced to is will result in the
employers need decrease in competitiveness of the product. Similarly, the government will
also overpay the pension to the retirees and this will create a stress in the budget of the
government. The budget stress may lead to the government cutting spending or increase
taxes, creating undesirable outcome to the economy.
36
4
Nominal Quantity, Real Quantity and Deflating
Due to inflation, there will be difficulty when comparing values overtime and this give rise
to the difference between nominal quantity and real quantity. For comparison of quantity
overtime, it is necessary to convert the nominal quantity into real quantity before
comparison. The process of converting nominal quantity into real quantity is called
deflating.
4.1
Nominal and Real Quantity
Nominal quantity refers to value expressed in monetary terms such as current dollars. Real
quantity refers to value measured in physical terms such as quantity of goods and services.
For example, if an individual earns $1000 and a laptop price is $500 per unit, his nominal
income is $1000 and his real income expressed in laptop is 2 units of laptop.
Over time inflation erodes the purchasing power of money, resulting in a lower value of
money when expressed in terms of goods and services. Thus $1000 in 1980 is different
from $1000 in 2016 in terms of purchasing power although they are the same in terms of
nominal value. When comparing value over time, it is more accurate to compare using real
quantities.
4.2
Deflating
To convert a nominal quantity into the real quantity, we require a suitable price index such
as CPI. The deflating process involves divide the nominal value by the price index to
obtain the real value.
For example, consider a family which earn $30,000 in 2010 and $40,000 in 2015. The
nominal income of the family has increased. However, the well-being of the family
depends on how much goods and services the family can afford. The family is better off
only if it can afford to buy more goods and services, that is, only when the real income
increases.
Assume that 2010 is the base year and the CPI is 1. If the CPI in 2015 is 1.5, then the real
income of the family in 2015 is $40,000/1.5 = $26,666.67. The family is actually worse
off as in terms of purchasing power, $40,000 in 2015 is equivalent to only $26,666.67 in
2010. Thus the real income of the family decreases from 2010 to 2015 because the nominal
income increases is insufficient to cover the eroding in purchasing power due to inflation.
4.3
Nominal and Real Wage
The nominal wage is the amount of dollars that a worker receives from its working effort.
The real wage is the amount of goods and services the worker can purchase with the
37
nominal wage. Due to inflation, the nominal wage of a worker increases over time but
the worker may or may not be better off.
For example, consider the wage of the worker is $1000 per month. If there is an inflation
rate of 10% and the worker has a nominal wage increase by 10% to $1100, then there is no
change in real wage and the worker will have the same standard of living as before. If the
worker only receives a 5% increase in nominal wage, then the worker is actually worse off
since his real wage decreases.
Hence when comparing wages over time, it is important to compare in terms of real wage,
not nominal wage. For example, in Singapore, the average salary of a worker is about
$1000 per month in 1980s. In 2016, the average salary of a worker is about $3000 per
month. However, prices of goods and services are much higher in 2016 compared to 1980s.
For meaningful comparison it is necessary to convert the nominal wages to real wages so
that we can compare them in terms of the same purchasing power of money.
4.4
Indexing
Due to inflation, the nominal wage of workers tends to increase over time. However, the
real wage will increase only if the magnitude of nominal wage increase is higher than the
inflation rate. To prevent the decline in the standard of living due to inflation which erodes
the purchasing power of money, a process known as indexing can be adopted,
Indexing refers to the process of increasing a nominal quantity in each period by the same
percentage increase in a price index. With indexing in place, the nominal quantity will be
automatically adjusted by the same amount as inflation, leaving the real quantity
unaffected. The well-being of the individuals will be protected if the payment structure
incorporates indexing. For example, if CPI is used and the inflation rate is determined at
5%, the pension paid to retirees will increase by 5% under indexing so that the retirees can
maintain the same standard of living.
Indexing can be built into wage contracts to protect the real income of workers. For
example, assume that a worker is entering into a 3-year contract with the employer. The
worker demands for $1000 per month in Year 1 and 5% increase in real wage for the next
2 years. This means if there is no inflation, the wage will be $1050 in Year 2 and $1102.50
in Year 3.
With indexing, the employer will have to adjust the nominal wage by the amount of
inflation. Taking Year 1 as the base year, the CPI is 1. If the CPI for Year 2 is 1.04, the
employer will need to pay the worker 4% more, which is $1050 X 1.04 = $1092 in Year 2.
In the same context, if the CPI in Year 3 is 1.08, the employer will need to pay the worker
$1102.50 X 1.08 = $1190.70in Year 3.
38
4.5
Nominal and Real Interest Rate
Inflation creates additional uncertainty for borrowing and lending, Specifically,
unanticipated inflation tends to favours borrowers and hurt lenders due to the difference
between nominal interest rate and the real interest rate.
When borrowers agree to borrow and lenders agree to lend, the money will be transferred
from the lenders to the borrowers at the current period. The borrowers agree to pay back
the lenders in the future period and compensate the lender with the nominal interest rate.
The nominal interest rate is the annual percentage increase in the dollar value of a financial
asset.
With inflation, the amount of money received by the lender in the future period will have
lower purchasing power eroded by inflation. Thus the real interest rate received by the
lender decreases due to inflation. The real interest rate is the annual percentage increase in
the purchasing power of financial assets.
The real interest rate is computed as the nominal interest rate less inflation rate. Using r to
denote real interest rate, i to denote nominal interest rate and π to denote inflation rate, we
have the equation:
r=i-Ï€
At the given nominal interest rate, the higher the inflation rate implies a lower real interest
rate. While the nominal interest rate tends to be positive, the real interest rate can be
negative during high inflation period.
Consider an individual who wish to earn a real interest rate of 3% when lending for one
year. If he believes that the inflation rate next year is 5%, he will demand for a nominal
interest rate of 8%. But if the actual inflation rate next year is 10%, his real interest rate is
8% – 10% which is -2%. Hence he suffers a loss when lending due to unanticipated
inflation. This will discourage the individual to lend unless he can adjust the nominal
interest rate according to the inflation rate when lending. With indexing, lenders will be
protected by having the nominal interest rate increases by the inflation rate to derive the
desired real interest rate.
Hence during period of high inflation, lenders will demand for high nominal interest rate.
During period of low inflation. lenders will be willing to accept low nominal interest rate.
The tendency of nominal interest to follow the inflation rate is known as the Fisher
Effect.
5
Costs of Inflation
If inflation rate is low and stable, then the cost to an economy is very low, mainly in the
form of menu cost and the shoe leather cost. But if inflation is high and volatile, it will
39
impose severe costs to the economy and it may even destroy the functions of money. The
costs of inflation are discussed as follow:
(a)
Menu Cost
Menu cost refers to the cost incurred by the sellers who have to change their price list due
to inflation. Time and effort are needed to remove the old price list and replace it by the
new price list and this is a cost to the producers.
For example, the price of petrol is affected by oil price and petrol station operators will
need to change the price of petrol when oil price changes. Similarly, periodically
restaurants will need to reprint the menu to reflect higher cost of food and drinks. The
time, money and effort spent to change the list prices of the items is the menu cost.
(b)
Shoe Leather Cost
People hold cash to facilitates transactions but with inflation the cash will loses value over
time. Shoe leather cost refers to the time and effort needed by the consumers who need to
constantly replace their money which run out faster during inflation. The time needed and
the inconvenience incurred when consumers need to go to the banks or ATM machines
frequently is a cost created by inflation.
For example, an individual often keeps $1000 which can last him 1 month. So every month
he just need to go to the bank once to withdraw $1000. But with inflation, goods and
services becomes more expensive and $1000 can now only last him 1 week. He will need
to go to the bank 4 times per month. The bank will also have to process more transactions.
The time and money spent in travelling and queuing in the bank and the higher operation
cost of the banks are considered as the shoe leather cost.
(c)
Distorting Price in Resource Allocation
In Microeconomics, we know that price is a resource allocator and the market outcome is
efficient. Consumers indicate their preference based on price and producers responds to
the price in sourcing for resources and produce the output that maximizes profit. The
demand curve represents the marginal benefits of consumption while the supply curve
represents the marginal cost of production.
The intersection of the demand and supply curves give rise to the equilibrium price which
is efficient as it represents marginal benefits equal marginal cost in the society. With
inflation, price increases but there may not be a corresponding adjustment in the benefits
perceived by consumers or cost incurred by producers and hence inefficient outcome may
occur.
40
Inflation refers to the general increase in prices of goods and services or an increase in the
price level measured by a price index. This is different from a change in relative price
where one product becomes more expensive relative to another. It is not easy to distinguish
between an increase in relative price or a general increase in all prices.
When there is a change in relative price, consumers will buy less of the relatively more
expensive product and producers will produce more of the relatively more expensive
product and the market will adjust to the next equilibrium level. If the price rise reflects
only inflation, there is not much change in the relative price and hence there is not much
adjustment in the behaviour of consumers and producers.
Hence when inflation occurs, prices are affected not just by demand and supply of the
product but also by the prices of other products. It takes time to distinguish between a
change in relative price and inflation. Inflation will create a distorted change in the price,
reducing the efficiency in the market system in allocating resources.
(d)
Distorting Tax System
Individuals that earn income needs to pay income taxes and in most economies, income
tax rate is progressive, implying that higher income earners need to pay higher tax rate.
The tax is based on nominal income and inflation will cause a distortion in the tax system.
When inflation occurs, workers will tend to demand for higher wages and hence the
nominal income increases. However, the real income may remain unchanged if the amount
of wage increases just equal to the inflation rate. If the nominal income increases by a
smaller magnitude than the inflation rate, the real income of the workers decreases.
However, income taxes are based on nominal income and it is possible that workers may
need to pay a higher tax in spite of a decline in real income. This is known as the bracket
creep and it will create a disincentive to work.
Another way which inflation distorts tax system is the capital depreciation allowance.
Firms require physical capital (machines) to produce goods and services but machines have
limited life span. When the current machines wore out the firm will need to buy new
machines to replace them. To assist the firms in buying new machines, the government
provides capital depreciation allowance as a form of tax benefits. The government allows
the firms to deduct a share of the purchase price of the machines as a business expenses so
that the firm can save the tax payment for machines purchase.
For example, assume the price of a machine is $1000 and the machine has a life span of 10
years. The government can provide a capital depreciation allowance of $100 per year for
10 years. The idea is that the firm can save $100 of tax per year and after 10 years, the
firm should be able to save $1000 to replace the machine. However, with inflation, the
price of the machine is likely to be more than $1000 10 years later. Thus the capital
depreciation allowance is insufficient to cover the price of new machines. This will result
in firms reducing investment in plant and equipment due to inflation.
41
(e)
Unexpected Redistributions of Income
Inflation benefits variable income earners and penalizes fixed income earners. When
inflation occurs, firms can easily increase the prices of their output and their profits may
increase. But the wages of workers are fixed in the wage contract and hence the workers
will suffer a decrease in real wage if there is no adjustment or insufficient adjustment in
the nominal wage.
Inflation also benefits borrowers and penalized lenders or savers. Borrowers get the money
at the current year, agree to pay a fixed amount of nominal interest rate, and return the
money in the future years. With inflation, borrowers obtained the money at high value and
return the money at low value. If the decrease in purchasing power is not offset by the
nominal interest rate, lenders or savers will suffe…
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