MODULE 1: FUNDAMENTAL

ECONOMIC CONCEPTS: AN
OVERVIEW
This introductory module will allow you to understand the very basic
foundation of why we have the discipline of economics. The nature and
scope of economics will be discussed in this module so that you will
understand: (1) how economists contribute in the body of knowledge in
economics, and (2) what are expected to be studied in the two branches of
economics, namely microeconomics and macroeconomics.

At the end of this module, you should have achieved the following topic or
unit learning outcomes.

There are three topics to be tackled in this module. These are:

1. The Foundation of Economics
2. The Nature and Scope of Economics
2.1 Definition of Economics
2.2 Methodology of Economics
2.3 Branches of Economics
2.4 Approaches to Economics
3. The Economizing Problem
3.1 Resources and Factor Payments
3.2 Economic Efficiency
3.3 The Production Possibilities
3.4 Economic Growth
3.5 Basic Economic Questions
3.6 Economic Systems
3.7 Role of Government

TOPIC 1: THE FOUNDATION OF ECONOMICS

Two basic facts of life exist in the society: we live in a world of scarcity and human wants and needs are
unlimited. The word scarce is closely associated with the word limited or economic. Therefore, scarcity means
there is a (perpetual) state of insufficiency of resources. The society has limited resources and therefore cannot
produce all the goods and services people wish to have. On one hand, there is no end to people’s wants. Man is
said to be insatiable – never fully satisfied. When one or two wants is satisfied, more new wants are felt
successively. But the means or resources are limited. People do not get sufficient resources which are needed to
satisfy the unlimited wants. So, the resources are always scarce in relation to the wants of the individuals, state
or the government. Under this situation we have to choose the more urgent wants. The question is: How do we
reconcile these two basic facts of life?

People are confronted with innumerable wants from the cradle to the grave. If one want is satisfied,
other wants emerge in succession. To satisfy these wants people are engaged in different activities in the
society. But the means are limited in relation to unlimited wants. So, people are constantly striving to satisfy
unlimited wants with limited means. The most basic response people do in dealing with scarcity is to make
choices. Scarcity of resources will force individuals to make their choices. The choices individual make are on
the other hand influence by three factors: (1) rewards or the benefits that individuals receive or expect to
received when choices are made; and (2) costs or opportunity costs which are the values foregone by a resource
owner in making a choice (or the next best alternative use of the same resource that is given up by the resource
owner); and (3) value judgement which is placing a relative importance to a choice.
 Figure 1.1: Scarcity and Factors Influencing Individuals to Make Choices

One of the most important concept that economics will teach you is the concept of opportunity cost,
which has a wide range of application when dealing with scarcity problem. And whether the decision is simple
or complex, opportunity cost is always involved. Indeed, the cost of something is what you give up to go get it.
Making decisions requires comparing the costs and benefits of alternative courses of action because people face
trade-offs. In many cases, however, the cost of an action is obvious as it might first appear.

When making any decision, decision makers should be aware of the opportunity costs that accompany
each possible action. In fact, they usually are. College athletes who can earn millions if they drop out of school
and play professional sports are well aware that their opportunity cost of college is very high. It is not surprising
that they often decide that the benefit of a college education is not worth the cost.

Consider this example of opportunity cost: Expressed in terms of time, consider a commuter who
chooses to drive to work, rather than using public transportation. Because of heavy traffic and a lack of parking,
it takes the commuter 90 minutes to get to work. If the same commute on public transportation would have
taken only 40 minutes, the opportunity cost of driving would be 50 minutes. The commuter might naturally
have chosen driving over public transportation because he could not have anticipated traffic delays in driving.
Once the choice has been made to drive, it is not possible to change one's mind, thus the choice itself becomes
irrelevant. Experience can create a basis for future decisions, however: the commuter may be less inclined to
drive next time, knowing the consequences of traffic congestion.
TOPIC 2: THE NATURE AND SCOPE OF ECONOMICS

The science of Economics has emerged as a discipline to discuss how people are engaged in different activities
to earn money and how do they endeavor to satisfy unlimited wants with limited means. The knowledge of
economics is indispensable to know about how best to solve the manifold economic problems by the proper
utilization of resources in the society.

DEFINITION OF ECONOMICS

The English term “Economics” is derived from the Greek word “Oikonomia”. Its meaning is “household
management”. Economics was first read in ancient Greece. Aristotle, the Greek Philosopher termed Economics
as a science of ‘household management’. But with the change of time and progress of civilization, the economic
condition of man changes. As a result, an evolutionary change in the definition of Economics is noticed.
Towards the end of the 18 th century Adam Smith, the celebrated English Economist and the father of
Economics, termed Economics as the ‘Science of Wealth’. According to him, “Economics is a science that
enquires into the nature and causes of the wealth of nations.” In other words, how wealth is produced and how
it is used, are the subject-matter of economics. In the subsequent period Alfred Marshall defined Economics by
saying, ‘Economics is a study mankind in the ordinary business of life’. In other words, Economics studies not
only the wealth but also the activities centering the wealth. In modern times, more realistic definitions have
been given to economics. Economics studies how to use the limited resources to satisfy the unlimited wants of
men. So, Economics as a social science studies how people perform economic activities and how they try to
satisfy unlimited wants by the proper use of limited resources. Economics is the study of how societies use
scarce resources to produce valuable commodities and distribute them among different people.

SCOPE OF ECONOMICS

The term economics merits considerable attention. First, Economics is a social science. Social science
deals with study of man’s behavior. Thus, the subject matter of economics deals with the analysis of economic problems
of people in the society and the satisfaction of their wants. Second, Economics is a science discipline. Science is
defined as a systematized body of knowledge based from facts. Economists try to address their subject with a
scientist’s objectivity. They approach the study of the economy in much the say way as any scientist.
Economists provide bodies of knowledge using the scientific method – the development and testing of theories
about how the world works. Just like a scientist, an economists follow four scientific steps:

1. Observation and description of a phenomenon or group of phenomena;

2. Formulation of hypothesis to explain the phenomena;
3. Use of the hypothesis to predict the existence of other phenomena, or to predict quantitatively the
results of new observations;
4. Performance of (experimental) tests of the predictions of several independent experimenters and
properly performed experiments. If the hypothesis is supported by experiments, it may come to be
regarded as a theory or law of nature.

Figure 1.2: The Methodology of Economics

The economic method in providing bodies of knowledge is summarized by the figure above. In
Descriptive Economics, economists observe real-world behavior and outcomes then formulate possible
explanation of cause and effect (hypothesis). Collection of data follows next and then analyze those data by
testing the explanation of cause and effect by comparing the outcomes of specific events to the outcome
predicted by the hypothesis. Accepting, rejecting, and modifying the hypothesis tested based on the
comparisons. Economists continue to test the hypothesis against the facts. As favorable results accumulate, the
hypothesis evolves into a theory.

Theoretical Economics is concerned with the formulation of economic theories. A very well-tested and
widely accepted theory is referred to as an economic law or an economic principle – a statement about
economic behavior or the economy that enables prediction of the probable effects of certain actions.
Combinations of such laws or principles are incorporated into models, which are simplified representations of
how something works, such as a market or segment of the economy. Economists develop theories of the
behavior of individuals (consumers, workers) and institutions (businesses, governments) engaged in the
production, exchange, and consumption of goods and services.

Theories, principles, and models are “purposeful simplifications.” This means that they are based on
simplifying assumptions because full scope of economic reality itself is too complex economists try to simplify
the complexity of a reality by using assumptions – these are conditions held to be true. Therefore, there are
some other things you should know about economic principles (or theories or laws or models).

1. Generalizations. Economic principles are generalizations relating to economic behavior or to the

economy itself. Economic principles are expressed as the tendencies of typical or average
consumers, workers, or business firms. For example, economists say that consumers buy more of a
 particular product when its price falls. This “price-quantity” principle, however, holds for the typical
consumer and for consumers as a group.
2. Other-Things-Equal Assumption. In constructing their theories, economists use the ceteris paribus
or other-things-equal assumption – the assumption that factors other than those being considered
do not change. They assume that all variables except those under immediate consideration are held
constant for a particular analysis.
3. Graphical Expression. Many economic models are expressed graphically. Be sure to read the
special appendix at the end of this chapter as a review of graphs.

How useful are theories? Economic theories are highly useful in analyzing economic behavior and
understanding how the economy operates. They are the tools for ascertaining cause and effect within the
economic system. God theories do a good job of explaining and predicting. Also, they are useful for policy
making. Policy economics is concerned with application of policy to resolve (or minimize the impact of) an
economic problem. With an understanding of an economic behavior, correct policies are made and
implemented.

BRANCHES OF ECONOMICS

Economic analysis is divided into two main branches: microeconomics and macroeconomics. These two
branches are important for scarcity problem.

● Microeconomics is the part of economics concerned with individual units such as a person, a household, a
firm, or an industry. At this level of analysis, the economist observes the details of an economic unit, or
very small segment of the economy. In microeconomics we look at decision making by individual
customers, workers, households, and business firms. We measure the price of a specific product, the
number of workers employed by a single firm, the revenue or income of a particular firm or household, or
the expenditures of a specific firm, government entity, or family.

● Macroeconomics examines either the economy as a whole or its basic subdivisions or aggregates, such as
the government, household, and business sectors. An aggregate is a collection of specific economic units
treated as if they were one unit. In using aggregates, macroeconomics seeks to obtain an overview, or
general outline, of the structure of the economy and the relationships of its major aggregates.
Macroeconomics speaks of such economic measures as total output, total employment, total income,
aggregate expenditures, and the general level of prices in analyzing various economic problems. No or very
little attention is given to specific units making up the various aggregates.

APPROACHES TO THE STUDY OF ECONOMICS

Both microeconomics and macroeconomics contain elements of positive economics and normative economics.

● Positive Economics focuses on facts and cause-and-effect relationships. It includes description, theory
development, and theory testing (theoretical economics). Positive economics avoids value judgments, tries
to establish scientific statements about economic behavior, and deals with what the economy is actually
like. Such scientific-based analysis is critical to good policy analysis. Positive economic concerns what is,
thus it is a “what is” analysis.

● Normative Economics, incorporates value judgments about what the economy should be like or what
particular policy actions should be recommended to achieve a desirable goal (policy economics).
Normative economics looks at the desirability of certain aspects of the economy. It underlies expressions of
support for particular economic policies. Normative economics embodies subjective feelings about what
ought to be, making it a “what ought to be” analysis.

Example: Positive and Normative Statements

Positive statement: “The unemployment rate in the Philippines is higher than its neighboring
ASEAN countries.”
Normative statement: Philippines ought to undertake policies to make its labor market more
flexible to reduce unemployment rates.

Note: Whenever words such as “ought or “should” appear in a sentence, you are very likely
encountering a normative statement.
TOPIC 3: THE ECONOMIZING PROBLEM

Society must also make choices under conditions of scarcity. It, too, faces an economizing problem. The
economizing problem involves the allocation of resources among competing wants. There is an economizing
problem because there are: unlimited wants and limited resources.

RESOURCES AND FACTOR PAYMENTS

1. Land – includes all natural resources (“gifts of nature”) used in the production process (e.g., arable land,
forests, mineral and oil deposits, and water resources), as well as space (i.e., location). “Rent” is the
payment for the use of land (the idea that most natural resources are not/cannot be privately-owned, land
requires rental payment for its use, the rental payment may come in for example, in the form of taxes).

2. Capital – (or capital goods) includes all manufactured (man-made) aids used in producing consumer goods
and services. Included are all factory, storage, transportation, and distribution facilities, as well as tools and
machinery. Economists refer to the purchase of capital goods as investment. Note that the term “capital” as
used in economics, refers not to money but to tools, machinery, and other productive equipment. Because
money produces nothing, it is not considered as an economic resource. Money (or money capital or
financial capital) is simply a means for purchasing capital goods.

3. Labor – consists of the physical and mental talents of individuals used in producing goods and services. It
refers to skills, abilities, knowledge (called human capital) and the effort exerted by people in production.
“Wages” is the payment for the use of labor, it is a monetary compensation paid by an employer to an
employee in exchange for work done.

4. Entrepreneurial ability – a special human resource, distinct from labor, which refers to the talents or
abilities of economic agent who creates an enterprise (initiates in combining the resources to create an
enterprise; makes strategic business decisions; an innovator; a risk bearer). The entrepreneurial talent is
paid “profits”, the amount remaining after subtracting from the revenues (or sales) of a firm the total
monetary costs of all business activities, as well as the opportunity costs of all resources used in the current
business activity.

ECONOMICS AND EFFICIENCY

Scarce resources are ideally best allocated if societies used them efficiently. Economic efficiency means
that the societies are able to produce the maximum output given limited inputs. Economic efficiency consists of
the following components (or the requirements to become efficient):

1. Full employment – the economy is employing all its available resources (implies quantity of resources)
2. Full production – employed resources must contributed to their greatest to total output (implies quality of
resources)

There are two concepts of economic efficiency:

1. Allocative efficiency – is attained when the goods and services produced are the ones most valued or most
demanded by society. This means that goods and services are produced because consumers are willing to
pay for them and that meets satisfaction.

2. Productive efficiency – is attained when the economy produces at the least cost possible way.

PRODUCTION POSSIBILITIES MODEL

Society uses its scarce resource to produce goods and services. How does a society decide how scarce
resources are used? The alternatives and choices a society faces can best be understood through a
macroeconomic model of production possibilities. To keeps things simple, we initially assume that the
economy:

● Is at its full employment condition;

● Is using resources at that given time period, thus assumed fixed resources supply;

● Is using whatever technology (the methods used to produce output) present at that time period (fixed
technology); and
● Is producing only two goods.

1. Production Possibilities Table (Schedule) – lists the different combination of two products that can be
produced with a specific set of resources

Example: The economy decides to produce only two goods: rice symbolizes consumer goods (goods that
satisfy wants directly) and industrial robots symbolize capital goods (products that satisfy wants indirectly
by making possible more efficient production of consumer goods)

2. Production Possibilities Curve (PPC) – a curve which shows the various combinations of two goods that
a society in a fully employed economy, assuming a fixed availability of supplies of resources and constant
technology.

Characteristics of PPC:

● Downward sloping
If the society wants to move from one point to another point, it requires that one good has to be given
up or sacrificed (increase X, decrease Y). The rationale for this is that there is opportunity cost involved
in deciding to increase one production at the expense of the other good. Because resources are fixed at
a given production time period, an increase in one production requires that the society needs to reduce
the inputs used in the other production to increase the inputs used to produce more of the other good.

● Concave
Concavity (bowed out from the point of origin) means that as X increases, Y decreases at an increasing
rate. This means that as more and more of rice is produced, more and more of industrial robots must be
given up. This is called the law of increasing opportunity cost. The economic rationale for the law of
increasing opportunity costs is that economic resources are not completely adaptable to alternative
uses. Many resources are better at producing one type of good than at producing others. This means
that as resources are pulled away from one good, the resources will not readily adapt to their next use.
This therefore will become costlier for the society to produce one good at the expense of the other
good.

UNEMPLOYMENT AND ECONOMIC GROWTH

A society can still attain a combination of goods and services beyond its PPC. And when this happens,
the society experiences what is called economic growth, which means that more goods and services are
produced than the previous time period.

MODULE 2: THE MARKET MECHANISM

BASIC ECONOMIC QUESTIONS

Scarcity imposes every society to make choices. In allocating scarce resources, these choices of societies
revolve around three basic economic problems:
What to produce? –This question allows decision makers to determine what their scarce resources will be best
used for. Goods and services are produced to meet people’s wants and needs or to satisfy the demands of the
society, that is based on many factors.
How to produce? – This question allows the economy to determine what combination of inputs will be used to
produce goods and services. Ideally, the best combination of inputs is that which produces at the least-cost
possible way.
For whom to produce? – This question allows societies to decide who gets the produced output (e.g.,
willingness to pay, centralized distribution such as the case of communism)
BASIC ECONOMIC SYSTEMS

Every society needs to develop an economic system – a particular set of institutional arrangements and
a coordinating mechanism – to respond to the economizing problem. The economic system has to determine
what goods are produced, how they are produced, who gets them, how to accommodate change, and how to
promote technological progress.

Economic systems differ as to (1) who owns the factors of production and (2) the method used to
motivate, coordinate, and direct economic activity. Economic systems have two polar extremes: the command
system and the market system.

1. Traditional System
A traditional economic system is one in which people’s economic roles are the same as those of their
parents or grandparents. Tradition decides what the people do for a living and how their work is performed.
Whatever is done in the past is still carried on at present. Societies in this system are still self-sufficient and
needs very little interaction from highly populated and urbanized societies.

2. Command System
This system is also known as communism, where the government owns most property resources and
economic decision making occurs through a central economic plan. A central planning board appointed by
the government makes nearly all the major decisions concerning the use of resources, the composition and
distribution of output, and the organization of production. The government owns most of the business
firms, which produce according to government directives. The central planning board determines
production goals for each enterprise and specifies the amount of resources to be allocated to each enterprise
so that it can reach its production goals. The division of output between capital and consumer goods is
centrally decided, and capital goods are allocated among industries on the basis of the central planning
board’s long-term priorities.

3. Market System
Market system or capitalism is the polar alternative to the command system. This system is one in which a
nation’s economic decisions are the result of individual decisions by buyers and sellers in the market. A
market is a mechanism which brings together buyers and sellers. This system is the widely adapted
economic system of most countries in the world. The following are important characteristics of a market
system:

a. Private Ownership of Property Resources

Private individuals and firms, not the government, own most of the property resources (land and
capital). It is for this reason that the market system is called capitalism. This right of private property,
coupled with freedom to negotiate binding legal contracts, enables individuals and businesses to
obtain, use, and dispose of property resources as they see fit. What property rights can do are the
following:
1. encourage investment, innovation, exchange, maintenance of property and economic growth;
2. also extend to intellectual property through patents, copyrights, and trademarks;
3. facilitate exchange;
4. encourage owners to maintain or improve their property so as to preserve or increase its value; and
5. enable people to use their time and resources to produce more goods and services, rather than
using them to protect and retain the property they have already produced or acquired

b. Freedom of Enterprise and Choice

● Freedom of enterprise ensures that entrepreneurs and private businesses are free to obtain and use
economic resources to produce their choice of goods and services and to sell them in their chosen
markets.
● Freedom of choice enables owners to employ or dispose of their property and money as they see fit.
It also allows workers to try to enter any line of work for which they are qualified. Finally, it
 ensures that consumers are free to buy the goods and services that best satisfy their wants and that
their budgets allow.

c. Self-Interest
In the market system, self-interest is the motivating force of the various economic units as they
express their free choices. Self-interest simply means that each economic unit tries to achieve its own
particular goal, which usually requires delivering something of value to others.

d. Competition
Market system allows competition or economic rivalry based on the freedom of choice exercised in the
pursuit of monetary return. Competition requires:
● Many buyers and many sellers acting independently in a particular product or resource market.

● Freedom of sellers and buyers to enter or leave markets, on the basis of their economic self-interest.

What competition can do:

● diffuses economic power – no single buyer or seller can dictate the price of the product or resource
because others can undercut that price; limits the potential abuse of power
● no insurmountable barriers prevent an industry’s expanding or contracting and provides the
economy with the flexibility needed to remain efficient over time and enables the economy to
adjust to changes in consumer tastes, technology, and resource availability.

e. Markets and Prices

Millions of decisions made by households and businesses are highly coordinated with one another by
markets and prices, which are key components of the market system. They give the system its ability to
coordinate millions of daily economic decisions. A market system conveys the decisions made by
buyers and sellers of products and resources. The decisions made on each side of the market determine
a set of product and resource prices that guide resource owners, entrepreneurs, and consumers as they
make and revise their choices and pursue their self-interest.

f. Technology and Capital Goods

The market system therefore encourages extensive use and rapid development of complex capital
goods: tools, machinery, large-scale factories, and facilities for storage, communication, transportation,
and marketing. Advanced technology and capital goods are important because the most direct methods
of production are often the least efficient. The only way to avoid that inefficiency is to rely on capital
goods.

g. Specialization
Specialization is the use of resources of an individual, firm, region, or nation to produce one or a few
goods or services rather than the entire range of goods and services. Those goods and services are then
exchanged for a full range of desired products.

h. Use of Money
A rather obvious characteristic of any economic system is the extensive use of money. Money
performs several functions, but first and foremost it is a medium of exchange. It makes trade easier.

i. Active, but Limited Government: “Laissez Faire” (Leave it Alone) Ideology

Market system relies on the idea that it can be “left alone” without too much government intervention.
Market system is characterized as self-adjusting, self-regulating system. The government’s role is
limited to provision of legal framework. However limited, the role of government is active and
important because market system has inherent shortcomings.

4. Mixed System
Today, modern economies have evolved to encompass several characteristics of several economic systems.
Market economies, although giving their constituents a very wide range of economic choices and freedom,
still enjoy reasonable government intervention, especially in basic goods and services. Most real-world
economies today are considered mixed, many are heavily reliant on market system (free enterprise
economy) with government intervention (command system).

ROLE OF GOVERNMENT
The economic activities of the public sector – national, state, and local government – are extensive. The
economic functions of government:

1. Providing the Legal Structure

Government provides the legal framework and the services needed for a market economy to operate
effectively. The legal framework sets the legal status of business enterprises, ensures the rights of private
ownership, and allows the making and enforcement of contracts. Government also establishes the legal
“rules of the game” that control relationships among businesses, resource suppliers, and consumers.
Discrete units of government referee economic relationships, seek out foul play, and impose penalties.
Government intervention is presumed to improve the allocation of resources.

2. Maintaining Competition
When monopoly exists, an industry is controlled by controlling supply and charging higher price, this is the
essence of monopoly power. Governments can correct this situation by controlling monopoly through
regulation and through antitrust. For example, telecommunications industry in the Philippines used to be a
monopoly. But since the government deregulated the industry, competition was brought back with more
suppliers now than it used to.

3. Redistributing Income
The market system is impersonal and may distribute income more inequitably than society desires. The
system has created statuses and income levels, making a gap between the rich and the poor. The poor have
less access to some goods and services. Thus, society chooses to redistribute a part of total income through
a variety of government policies and programs. They are:
• Transfer payments – Government payments can come in the form of welfare checks and food stamps,
provide relief to the destitute, the dependent, the disabled, and older citizens.
• Market intervention – Government also alters the distribution of income through market intervention,
that is, by acting to modify the prices that are or would be established by market forces. Providing
farmers with above-market prices for their output and requiring that firms pay minimum wages are
illustrations of government interventions designed to raise the income of specific groups.
• Taxation – The government uses the personal income tax to take a larger proportion of the income of
the rich than of the poor, thus narrowing the after-tax income difference between high-income and low-
income earners.

4. Reallocating Resources
Market failure occurs when the competitive market system (1) produces the “wrong” amounts of certain
goods and services or (2) fails to allocate any resources whatsoever to the production of certain goods and
services whose output is economically justified. Market failures are in the form of:

a. Externalities
An externality occurs when some of the costs or the benefits of a good are passed on to or “spill over
to” someone other than the immediate buyer or seller. Such spillovers are called externalities because
they are benefits or costs that accrue to some third party that is external to the market transaction.
Externalities can be negative or positive. When production or consumption costs inflicted on a third
party without compensation, the costs are called negative externalities. Environmental pollution is an
example. Some externalities get resolved via private negotiations between those creating the
externalities and those affected by them. But when the externalities are widespread and negotiation
between parties is unrealistic, government can play an important role. For example, legislation
prohibiting or limiting a negative externality can be applied especially in the case of pollution. Another
is an imposition of specific taxes, a less direct action imposed on a polluting firm that adds to cost of
production.

Sometimes externalities appear as benefits to other producers or consumers. These un-compensated

spillovers accruing to third parties or the community at large are called positive externalities.
Immunization against measles and polio results in direct benefits to the immediate consumer of those
vaccines. But it also results in widespread substantial external benefits to the entire community.
Education is another example of positive externalities. Education benefits individual consumers:
Better-educated people generally achieve higher incomes than less-well- educated people. But
education also provides benefits to society, in the form of a more versatile and more productive labor
force, on the one hand, and smaller outlays for crime prevention, law enforcement, and welfare
programs, on the other. Government can further enhance positive externality especially when the
 benefit is under-allocated through subsidies (for consumers and producers). Government may finance
or, in the extreme, own and operate the industry that is involved.

b. Public Goods and Services

Everyone can simultaneously obtain the benefit from a public good (eg., national defense, street
lighting, and environmental protection). One person’s benefit does not reduce the benefit available to
others. More important, there is no effective way of excluding individuals from the benefit of the good
once it comes into existence. The inability to exclude creates a free-rider problem, in which people
can receive benefits from a public good without having to pay for it. With taxation, government then
spends the tax proceeds to provide public goods and services. Taxation releases resources from the
production of private consumer goods (food, clothing, television sets) and private investment goods
(printing presses, boxcars, warehouses). Government shifts those resources to the production of public
and quasi-public goods (post offices, submarines, parks), changing the composition of the economy’s
total output.

5. Promoting Stability

• Unemployment. When private sector spending is too low, resulting in unemployment, government may
try to increase total spending (private + public) by raising its own spending or by lowering tax rates to
encourage greater private spending. Also, the nation’s central bank may take monetary actions to lower
interest rates, thereby encouraging more private borrowing and spending.

• Inflation. Inflation is a general increase in the level of prices. Prices of goods and services rise when
the amount of spending in the economy expands more rapidly than the supply of goods and services.
This can happen when the nation’s central bank allows interest rates to remain too low for the
economic circumstances. In such situations, the central bank can act to lower inflation by increasing
the interest rate so as to dampen private borrowing and spending. The government may also try to
reduce total spending by cutting its own expenditures or boosting tax rates to reduce private spending.