Topic 6

Inflation

Introduction

Unemployment: a situation where factors of production

that are willing and capable of being
employed at the ruling market price
remain either unutilized or underutilized.

Demand-pull Type of inflation caused by aggregate

inflation: demand.

Cost-push Type of inflation caused by increase in

inflation: costs of production.

Inflation
Inflation is defined as the general rise in the price level of goods or services in an
economy. The converse to inflation is the general decrease in the price level of
goods and services in the economy is known as deflation.

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 Inflation is a macroeconomic concept. There are mainly two types of inflation:

 Demand pull inflation

 Cost push inflation

Demand pull inflation

Demand-pull inflation is caused by an increase in aggregate demand. Aggregate
demand is the total demand for final goods and services in an economy in a given
time period usually a year.

In an open economy, aggregate demand is composed of the following;

 Consumption (C)
 Investment (I)
 Government Expenditure (G)
 Imports (M)
 Exports (X)

An increase in any of these components leads to a rise in inflation

Aggregated demand ( AD)=C+ I +G+ X – M

Taking consumption for example,

d
C=c 0 +c 1 Y

Where c0 – autonomous consumption

C 1 – Marginal propensity to consume

Yd – disposable income = Gross income minus Taxes

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 Fig. 6.1: Demand-pull inflation

The concept of demand pull and cost push inflation is best illustrated using AS/AD
framework. In the figure above, increase in aggregate demand results in a
rightward/outward shift of the AD curve from AD 0 to AD1. As a result of this shift, the
equilibrium price level increase from Po to P1. Concurrently, the equilibrium
aggregate output increase from Yo to Y1. Thus, form an economic point of view,
demand-pull inflation has a beneficial effect of increased economic growth,
compared to cost-push inflation.

If the economy is operating on the steep portion of the aggregated supply curve at
the time of increase in aggregate demand, most of the inflationary effect will be an
increase in price level rather than an increase in output.

Conversely if the economy is operating on the less steep portion of the AS curve,
most of the inflationary effect will be felt as an increase in output rather than an
increase in price.

Cost-push inflation
Cost – Push inflation occurs mainly as a result of increases in the firms cost of
produce which in turn occur due to increase in the cost of factor inputs (capital and

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 labour). When these costs are passed on to end users of goods and services in the
form of increase in the price of goods or services cost – push inflation is said to
result.

Fig. 6.2:Cost-push inflation

Inflation is also caused by an increase in input costs. An increase in costs results in

a leftward shift of the aggregate supply curve from ASo to AS 1. As a result, and in
addition to the shift of equilibrium point time, the aggregate output falls from Yo to
Y1. A situation in which a fall in aggregate output is experienced at the same time
as can increase price level is known as stagflation.

In the long run, the curve increase in price level will cause the aggregate supply
curve to shift to the left. This is as a result of input prices responding to increase in
output. In the long run, the aggregate supply curve is vertical implying that increase
in price results in zero increase in output.

Effect of Unanticipated Inflation

1. Redistribution of income and wealth within the economy

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 When a bank gives a loan it charges an interest rate based on projection of
future inflation. If inflation rises above the anticipated level, then profits are
eroded or even eliminated.

2. Distortion of Price Mechanism

Changes in relative prices may be offset by the substitution of lower price input
used in production. If almost all prices are rising rapidly there’s little incentive to
search for cheaper substitute that would help keep production costs low.

3. Inflation Creates Uncertainty

If businessmen are unsure about the future level of prices and thus of interest
rates, they’ll be less willing to take risks and invest especially in long term
projects. As investments are reduced so is the long run growth potential of the
economy also reduces.

4. There may be a redistribution of resource and production into areas less

affected by high inflation rates. E.g. in the case of white farmers in Zimbabwe
who relocated to other countries e.g. South Africa.
5. Inflationary uncertainty pushes up real interest rates as lenders demand a
bigger risk premium on their money.

Unemployment
Def: Refers to a situation where factors of production that are willing and capable of
being employed at the ruling market price remain either unutilized or underutilized.

Normally the generic understanding of the term is with respect to one factor of
production: labour. However, unemployment as defined in Economics takes into
consideration other factors of production as capital and land. Fallow land, or land
not directly used for productive activities is considered as Unemployed land.
Savings that are not mobilized for investment, both public and private may on the
other hand be considered unemployed capital. For this unit, we will consider labour
unemployment.

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 Labour unemployment is defined as a situation extant in an economy whereby a
person of a working age (between 15 -65 years), who is willing and is qualified for
full time employment at the going market wage, is not able to find work.

Labour unemployment is measured by a tool known as the Unemployment

Rate(UR), where,

No. ofunemployed
UR= X 100
TotalWorkforce

Types of Unemployment
Open Involuntary Unemployment: Occurs whena person is willing and is qualified
for full time employment at the going market wage, and is not able to find work.
Occurs due to a mismatch of expectations between the kinds of jobs available and
peoples interests, i.e. peoples may wish to be employed in white collar occupations
in an economy that only has vacant blue collar jobs.

Disguised(Hidden Unemployment) Occurs when labour is underutilized, such that

the work available is insufficient to keep it fully occupied. E.g Most civil services
especially in Less Developed Countries(LDCs) where, the number of people
employed exceed the demamd for their services, leading to a Marginal Product of
labour of zero or negative.

Structural Unemployment: Structural unemployment affects certain regions of an

economy or certain categories of labour. Results from an imbalalnce between the
demand of a certain cadre of labour and the supply of the same. For example when
technological changes e.g the advent of ICT, occur within an economy, there
is ,ceteris paribus, less demand for jobs such as Secretaries, typists, etc. The
diminishing demands results in structural employment, to the extent that workers
hitherto holding such jobs are made redundant as a result of such technological
progress.

General unemployment: As opposed to structural unemployment, this is one which

is widespread throughout the economy, and is not confined to specific areas.

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 Seasonal unemployment: Caused by annual variations of seasons which affect
economic activities e.g in agricultural sectors.

Frictional unemployment: Results form an immobility of labour rather than the

demand for the same. There notmally is a time lag between matching prospective
employees with job opportunities for which they are qualified for. The time it takes
results in frictional unemployment. Is essentially short term in nature/

Cyclical (Demand-deficient unemployment) Associated with changes in an

economy’s business cycle. During the recovery and boom phases of the cycle,
unemployment is low due to a high demand for output and labour. The reverse is
true during recession and depression phases. Can be relatively long term in nature.

Causes of unemployment in Less Developed Countries (LDCs)

Lack of co-operating factors of production: Despite LDCs having abundant supplies
of labour, they more often than not lack other factors such as capital and land that
go hand in hand with labour in the production process.

Rapid population growth: Growth in population in LDC in most cases outstrips their
respective economic rate of growth, implying the economies are not able to absorb
all prospective workers entering the job market year on year.

Distortion of relative factor prices: Caused by government policies aimed at fixing

wages above the going market prive, in addition to providing incentives aimed at
making capital cheaper, e.g tax breaks, subsidized interest rates, low tariffs, e.t.c.

Education systems: Education systems in LDCs, adopted from developed

economies put an emphasis on development of white collar jobs at the expense of
other categories of jobs( e.g. blue collar jobs). At the same time, the rate of growth
of the formal sector, where most white collar jobs are found, is low.

Seasonality in production: In Kenya for example, the sectors having the greatest
contribution to GDP are agriculture and tourism. The natures of these industries
lead to seasonal unemployment. In the case of tourism, tourist may prefer to visit

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 the country at certain times of the year, leading to increased demands for labour. At
other times there is less demand due to a drop in tourist arrivals.

Limited product markets: Caused by low income inelasticity of demand for primary
goods produced in LDCs. LDCs produce mainly primary goods, which are
characterized by low prices and limited usability. This has the unfortunate
implication that the possibility of expanding these industries, and corollarily creating
more job opportunities is limited.

Rural-urban migration: Results in urban unemployment, as more people migrate to

urban areas in search of jobs, to the extent that they cannot be absorb by the
same.

Consequences of unemployment
Waste of potentially productive human resources: When labour is unemployed, it
implies that the economy is not producing as much as it should, resulting in lower
national income and welfare.

Higher dependency ratio: A high rate of unemployment means that the few who
are employed have to support a larger number of dependants.

Increase in social problems: e.g crime, mental disorders.

Overcrowding in urban areas:Resulting from urban unemployment. This is

especially so in slum areas.

Loss of human capital: When one is unemployed for an extended period of time,
they gradually lose skills acquired through formal and informal education. This is
because skills can only be maintained through constant work and practice.

Increase in government social welfare programs: This constitutes a drain on

resources that would otherwise have been used for other, more productive
development projects.

Policies to combat unemployment in LDCs

These policies mainly involve two strategies

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  Reduction in the number of unemployed citizens
 Increase in the level of job creation.

Increase in job opportunities in the private sector: Mainly achieved through creating
an enabling environment for private sector development. Reductions of budget
deficits have an effect of lowering interest rates, thereby facilitating private sector
investments. Provision of incentives s for Microfinance institutions(MFIs) that
provide cheap loans to Small and Medium Enterprises will provide them
opportunities for growth and expansion and by so doing, aid in employment
creation.

Pricing policies that encourage the use of appropriate technologies: In LDCs,

abundant supplies of labour implies that labour intensive technologies are more
appropriate compared to capital intensive technologies. Therefore, government
policies should aim at lowering the relative factor price for labour so as to create
greater incentive for employment.

Relevant education systems: Education systems aimed at preparing students for

relevant skills in the job market should be encouraged. Education expansion should
for example balance the need for provision of general education and the need for
specific skills needed for the market.

Minimization of seasonal unemployment: Achieved through diversification of

economic activities in various geographical regions in the economy. For example,
regions heavily reliant on tourism may consider introducing alternative such as
labour intensive manufacturing industries.

Product/market diversification: Unemployment resulting from limited product market

may be mitigated through an economy diversifying from primary products into other
lines of production where demand is more price and income elastic. This may
include value addition to primary products. However it is important that such
diversification employ labour intensive technologies for it to result in reduction of
unemployment. Also, firms should seek new markets in cases where current
markets are not expanding substantially.

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 Intensive rural development: An effective way to combat rural urban migration.
Governments should provide incentives for industries to relocate to rural areas,
thereby increasing employment opportunities and standards of living in the same.

Encouraging foreign direct investment: By making political and economic

environment conducive for the same.

Encouraging the use of domestic resources: Should be encouraged as it tends to

create employment domestically.

Topic 7

National Income Accounting

National income accounting is the data collected and published by the government
describing the various components of national income output in the economy.

There are 3 methods of measuring national income:

 Income method
 Expenditure method
 Output or value added method (Product method)

Final Goods – refer to goods and services produced for final use by consumers.

Intermediate Goods – are goods produced by one firm for use in further processing
by another firm.

Gross Domestic Product (GDP)

This is the total market value of all final goods and service produced within a given
period by factor of production located within a given country.

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 Gross domestic product can be thought of as a geographical concept in the sense
that it considers the market value of goods and services produced within a country
or an economy regardless of whether the producers are citizens of the country or
not.

Statisticians measure gross domestic product by adding up all income generated in

producing goods and services or by adding up the expenditure incurred in
purchasing output.

Gross National Product (GNP)

This is the total market value of all final goods and services produced within a given
period by citizens living within and outside the country. It excludes output by non-
citizens working within the country.

GNP = GDP + Net Income from Abroad (Export – imports)

National Income

This is the total aggregate earnings by the factor of productions and which are
earned from the current production of goods and services within a given time period
(usually one year).

OR – it is the total value of goods and services which are produced within a country
or year.

NB: Net National Product (NNP) = GNP – depreciation

Approaches to National Income Account

Income method

This involves up the incomes of all factors of production in he production process.

All factors of production have rewards.

For labour, the reward is Wages or Salaries. For land the reward is rent accrued
from the land or buildings. For capital the reward is Interest while for
entrepreneurship, the reward is Profit. When using this method, the aggregate of
the returns to accord of production is added up.

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 GDP = National Income + depreciation + (indirect taxes – subsidies) + Net factor
payment

Note: The income approach excludes income in which no goods or services are
supplied in exchange. It also excludes the income of persons who sell durable
goods, not produced in the time period.

It excludes government transfer payments e.g. paying pension to retired workers

and unemployment compensation.

Expenditure method

This approach measures the gross domestic products by summing up all the
expenditure accrued in the process of producing the national output types of
expenditure include:

 Consumption expenditure
 Investment expenditure
 Export expenditure
 Import expenditure
a) Consumption expenditure: These are purchases by households of goods and
services produced in the current time period. Second hand items e.g. Mitumba are
excluded in the calculation because they represent the transfer of existing assets.
b) Investment expenditure: These are expenditure for goods and services produced
for future consumption.
c) Government expenditure: These are all the government payment for factor of
production or services rendered to the government. Any government activity is
counted as producing output of goods and services.
d) Export expenditure: This is the expenditure occurring from the export of economic
gods or services.
e) Import expenditure: This represents expenditure by domestic producers on foreign
goods and services. It is normally deducted from total final expenditure in order to
arrive at the GDP (gross domestic product).

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 GDP=C+ I +G+( X – M )

Weaknesses/limitations in measuring National Income

1. Double counting: The double account problem is experienced especially when
adding up the intermediate goods or services. It may also be experienced when
calculating transfer income or payment e.g. old age pension, unemployment
compensation.
2. It doesn’t take into account the production of illicit products, despite the fact that
these goods give some level of satisfaction in addition to using up factor of
production e.g. chang’aa.
3. Import services are sometimes left out in the calculation of National income. This
includes the contribution by housewives in child rearing or their services around the
home.
4. It is a problem to determine the rate of depreciation when calculating national
income
5. Foreign payments from cross-border transactions often do not pass through the
right legal channels. This has an effect on the final figures in GDP calculation.
6. The GDP does not measure economic well being. This has resulted in alternative
indices such as the gross national happiness, used to measure the satisfaction of
the population in regard to the respective country’s economic performance.
7. National income does not account for negative externalities like pollution.

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