Lilongwe University of Agriculture and Natural Resources

Faculty of Development Studies

Department of Agricultural and Applied Economics

Agricultural Economics II (AAE221)

Year 2

By
Sensei: MAONGA B.B. (PhD)

1
 Topic 3
UNEMPLOYMENT AND INFLATION

3. Introduction
• Unemployment and inflation are referred to as the
twin evils (problems) arising from economic
instability.
• Unemployment leads to resource (labour)
underutilization and makes the economy fail to
produce its potential GDP.
• Inflation on the other hand, brings confusion and
anxiety in consumers and causes economic
instability because people change their spending
habits and generally act differently when they
expect prices to rise.
2
Topic Objectives

• By the end of this topic you will be able to

• 1. Explain how unemployment is determined.
• 2. Describe kinds of unemployment.
• 3. Use Okun’s law to determine real GDP gap.
• 4. Explain how inflation is measured.
• 5. Discuss causes of inflation.
• 6. Analyze the destabilizing consequences of inflation.

3
3.2 Unemployment

• Nearly 80% of Malawi’s population belongs to the civilian

labour force, and at any given time, millions of these people
are without jobs.
• Being without a job is a problem that has affected almost
everyone, and it affects some people more than others.
• The issue is so important that achieving full employment is
probably one of the most important economic goals of
world economies.

4
3.2.1 Measuring Unemployment

• To understand the severity of joblessness, we need to

know how it is measured, as well as what the measure
overlooks.
• The measure of joblessness is the unemployment rate,
and it constitutes one of the most closely watched
statistics in most global economies.
• To measure unemployment rate, we must first
determine who is eligible and available to work.
• Figure 3.2 provides a helpful starting point. It divides the
total population into three groups.

5
Employment and Unemployment in the
Population
• Group 1: Under 16 and/or institutionalized for example, in
mental hospitals or correctional institutions e.g. Mpemba
Juvenile Centre. Such people are not considered potential
members of the labour force.
• Group 2: Not in labour force - composed of adults who are
potential workers but are not employed and are not seeking
work. Example, homemakers, full-time students, or retirees.
• Group 3: Labour force – consists of people who are able and
willing to work. This group has persons 16 years of age or
older who are not in institutions and they are either
employed or unemployed but seeking employment.

6
Labour Force, Employment and Unemployment

Under 16 and/or
institutionalized

Total Not in labour force

population Employed
Labour force

Unemployed

Figure 3.2: The labour force, employment and unemployment

7
The Unemployment Rate

• The unemployed – are people available for work who made a

specific effort to find a job during the past month and who, during
the most recent survey week, worked less than 1 hour for pay or
profit.
• People are also classified as unemployed if they worked in a
family business without pay for less than 15 hours a week.
• Unemployment rate – the number of unemployed individuals
divided by the total number of persons in the labour force. It is
expressed as the percentage of the labour force unemployed.
• Unemployment rate = (unemployed ÷ labour force) ×100
• Unemployment rate tends to rise dramatically during
recessions.

8
Limitations of the Unemployment Rate

• Unemployment rate understates employment conditions

for two reasons:
• (1) Part-time employment – Someone who has lost a high
paying job, but is working just one hour a week at a
minimum wage job, would still be considered employed. By
counting partially employed and partially unemployed
workers as employed the data understates the
unemployment rate.
• (2) Discouraged workers – the unemployment rate does not
count those who have stopped seeking employment because
they have been frustrated or discouraged by the
unavailability of jobs. These labour-force dropouts may be
millions in number during recessionary periods.
9
3.2.2 Kinds/Types of Unemployment

• There are three major types of unemployment, as follows:

• (1) Frictional unemployment – unemployment caused by
workers who are “between jobs” for one reason or another.
• The economy always has some workers who have left one job to
look for another. As long as workers change jobs, some frictional
unemployment will be present.
• In this category there are seasonal workers and many young
workers searching for their first jobs.
• Frictional unemployment therefore consists of search
unemployment and wait unemployment.
• The word “frictional” implies that the labour market does not
operate perfectly without friction in matching workers and jobs.
•
10
Kinds/Types of Unemployment: Frictional
unemployment (cont’d)

• Frictional unemployment is inevitable and, at least in part,

desirable.
• Many workers who are voluntarily between jobs are moving
from low-paying to higher-paying jobs, low-productivity to
higher-productivity positions.
• That means greater income for the workers, a better
allocation of labour resources and a larger real GDP for the
economy.

11
Kinds/Types of Unemployment: (2) Structural
Unemployment

• (2) Structural Unemployment – This occurs when a fundamental

change in the operations of the economy reduces the demand for
workers and their skills.
• Changes over time in consumer demand and in technology alter
the structure of the total demand for labour, both occupationally
and geographically.
• Occupationally, demand for certain skills may decline or even
vanish . The demand for other skills will intensify.
• Unemployment results because the composition of the
labour force does not respond immediately or completely to
the new structure of job opportunities.

12
Structural unemployment (cont’d)

• Workers who find that their skills and experience have

become obsolete or unneeded thus find that they have no
marketable talents. They are structurally unemployed until
they adapt or develop skills that employers want.
• Such workers can adapt or acquire the needed skills through
retraining, or gaining additional education.
• Geographically, the demand for labour change over time
through migration of industry or the movement of jobs from
inner-city factories to suburban industrial parks.
• As job opportunities move from one place to another, some
workers (who cannot relocate) become structurally
unemployed.

13
Difference Between Frictional and Structural
unemployment

• The key difference between frictional and structural

unemployment is that
• Frictionally unemployed workers have marketable skills and
either live in areas where jobs exist or are able to move to areas
where jobs do exist.
• Structurally unemployed workers find it hard to obtain new jobs
without retraining, gaining additional education, or relocating.
• Frictional unemployment is short-term; structural
unemployment is more likely to be long-term and consequently
more serious.

14
Kinds/Types of Unemployment: (3) Cyclical
Unemployment
• (3) Cyclical Unemployment – Caused by a decline in total
spending and is likely to occur in the recession phase of the
business cycle.
• As the demand for goods and services decreases,
employment falls and unemployment rises.
• For this reason, cyclical unemployment is sometimes called
deficient-demand unemployment.
• For example, during recession, many people put off buying
certain durable goods such as automobiles (cars),
refrigerators, washers, dryers, and new homes. As a result
some industries lay off workers until the economy
recovers.

15
Cyclical Unemployment (cont’d)

• Even though cyclical unemployment is serious, affected

workers generally get their jobs back when the
economy improves.
• Accordingly, many laid off workers try to wait out the
recession by living on savings or taking temporary jobs.

16
3.2.3 Definition of full employment

• Because frictional and structural unemployment are unavoidable

in a dynamic economy, full employment is sometimes less than
100% employment of the labour force.
• Therefore, full employment occurs when there is no cyclical
unemployment
• The unemployment rate that is consistent with full employment is
described as the full employment rate of unemployment or the
natural rate of unemployment (NRU).
• At NRU the economy produces its potential output that is, the
real GDP that occurs when the economy is fully employed.
• NRU occurs when the number of job seekers equals the number
of job vacancies.

17
3.2.4 Economic Costs of Unemployment

• Unemployment that is above the NRU involves great economic and social
costs.
• The basic economic cost of unemployment is forgone output., - potential
production of goods and services is irreversibly lost.
• GDP gap and Okun’s law
• The sacrificed output is measured as the GDP gap – the amount by
which actual GDP falls short of potential GDP.
• GDP gap can be estimated using Okun’s law.
• Okun’s law indicates that for every 1 percentage point by which the
actual unemployment rate exceeds the natural rate (NRU), a GDP gap of
about 2% occurs.
• Example: In 2011 unemployment rate in country X was 8.5% while NRU
was 5.2% and real GDP was MK300 billion. (a) What was real GDP gap in
percentage point terms? What was the economy’s full employment
GDP?
18
 Unequal burdens of unemployment
• Part of the burden of unemployment is that its cost is unequally
distributed.
• Generally, cost of unemployment vary in the following categories:
• Occupation – lower-skilled occupations (labourers) exhibit high unemployment
rates than workers in higher-skilled occupations.
• Age – Teanagers have higher unemployment rates than adults.
• Race and ethnicity – Minority groups suffer more (have higher) unemployment
rates than majority groups.
• Gender – I n some societies, unemployment rates for men tend to be lower than
women’s. But this is industry specific.
• Education – Less educated workers, on average, have higher unemployment
rates than workers with more education.
• Duration – During recession, number of persons unemployed for long periods
tends to increase.

19
3.2.5 Noneconomic Costs of Unemployment

• Severe cyclical unemployment is more than an economic

malady; it is a social catastrophe.
• Depression means idleness – which translates to loss of skills,
loss of self-respect, plummeting morale, family disintegration,
and sociopolitical unrest. The July 20 saga in Malawi?
• Widespread joblessness increases poverty, heightens racial
and ethnic tensions, and reduces hope for material
advancement
• At individual level joblessness leads to increases in suicide,
homicide (murder, shooting, killing, stabbing), fatal heart
attacks, and strokes, and mental illness.

20
3.3 Inflation

• Inflation is a rise in the general level of prices.

• Inflation does not mean that all prices are rising. Even during period of
rapid inflation, some prices may be relatively constant while others are
falling.
3.3.1 Measuring inflation
• Price index numbers are used to measure inflation. You will recall that a
price index measures the general level of prices in any year relative to
prices in a base period.
• If in 2010 consumer price index (CPI) was 185, it means that the price level
was 85% higher in 2010 than in the base period when the CPI was 100.
• The rate of inflation for any given year is found by subtracting the
preceding year’s price index from that (current) year’s index, dividing by
the preceding year’s index, and multiplying by 100 to express the result as a
percentage. Example: Inflation rate = (185 – 170)÷ 170) ×100

21
3.3.2 Degrees of Inflation

• Several terms describe the severity of inflation.

• (1) Creeping (or mild) inflation – inflation in the range of 1% to
3% per year.
• (2) Galloping inflation – a more intense form of inflation that
can go as high as 100% to 300% per year.
• (3) Hyperinflation – When inflation gets totally out of control –
in the range of 500% a year and above – it turns into
hyperinflation.
• Hyperinflation, however, does not happen very often and
generally is the last stage before total monetary collapse.

22
3.3.3 Type of Inflation

• Economists distinguish between two types of inflation: demand-

pull inflation and cost-push inflation. However, there is also one
other type known as stagflation.
• Demand-pull inflation – caused by an excess of total spending
beyond the economy’s capacity to produce.
• The essence of this type of inflation is “too much spending
chasing too few goods.”
• The relationship between total spending, on the one hand, and
output, employment, and price level, on the other, is not so
simple.
• Figure 3.3 is a graph of the price level and real GDP, with the full
employment level of output (potential output designated Qf.
• The three ranges marked on the curve are ranges in price level and real
output.
23
Demand-pull inflation
• AS
Price level R3

R1 R2
Full employment output

Increase in total spending

0 Qf Q
Figure 3.3, The price level and the level of real GDP (and thus
employment)

24
Demand-pull inflation: too much spending chasing
too few goods
• Range 1
• Toward the left in range 1 output is very low relative to the
economy’s full employment output.
• This implies very low level of total spending and a substantial
GDP gap. Unemployment rates are high, and businesses have
much idle production capacity.
• Now, as total spending increases, real GDP will increase, and
unemployment rate will fall. But there is little or no increase in
price level within range 1.
• Since firms have excess production capacity, their costs and
thus their prices do not rise as they increase their output.
• Large amounts of idle human and property resources will be
put back to work at their existing prices. An unemployed
worker does not ask for a wage increase when called back to
work. 25
Demand-pull inflation: too much spending chasing
too few goods
• Range 2
• As output continues to expand in response to further increases in
total spending, the economy enters range 2. The economy enters
and eventually surpasses its full employment output.
• Even before full employment is achieved, the price level may
begin to rise. Workplaces become increasingly congested as more
workers are employed, and each added worker contributes less
to output.
• Labour costs therefore begin to rise, forcing up product prices.
Also as production expands, suppliers of idle resources disappear
at different rates in various sectors and industries.

26
 Range 2 (cont’d)
• Some input-supplying industries are able to reach their full-production
capacity before others and thus cannot respond to further increases in total
spending for their products.
• These shortages of inputs cause resource prices to rise, boosting the
production costs and product prices of industries that still have excess
capacity.
• As total spending in range 2 increases beyond output Qf, still higher prices
induce some businesses to demand, and some households to supply,
resources beyond the full-employment level of output.
• Firms may employ additional work shifts and use overtime to achieve greater
output. Households may supply additional workers such as teenagers and
spouses, who previously had chosen not to enter the labour force.
• Within range 2, after Qf, the rate of unemployment falls below the natural
rate and the actual GDP exceeds potential GDP. Here the pace of inflation
usually quickens.
27
 Demand-pull inflation: too much spending
chasing too few goods
• Range 3
• As total spending increases into range 3, the economy siply cannot
supply more resources.
• Firms cannot respond to increases in demand by increasing
output.
• Real domestic output is at an absolute maximum. So, in affect,
further increases in demand raise the price level.
• The rate of inflation may be high and still rising because total
demand greatly exceeds society’s absolute capacity to produce.
• There is no increase in real output to absorb some of the
increased spending.

28
A simple depiction of demand-pull inflation

Price level
AS

P3
P2 AD3
P1 AD2

AD1
0 q1 q2 q3 Quantity (Q)
Figure 3.4 A Simplified graph of demand-pull inflation
29
 Cost-push inflation

• Inflation may also arise on the supply, or cost, side of the economy.
• The theory of cost-push inflation explains rising prices in terms of
factors that raise per-unit production cost at each level of spending.
• A per-unit production cost is the average cost of particular level of
output.
• Per unit production cost = total input cost ÷ units of output
• Rising per unit production costs squeeze profits and reduce the
amount of output firms are willing to supply to the existing price level.
• As a result, the economy’s supply of goods and services declines and
the price level rises. In this scenario, costs are pushing the price level
upward, whereas in demand-pull inflation demand is pushing the price
levels upward.

30
A simple graph of cost-push inflation

Price level
AS2
AS1
P2

P1
AD
0 q2 q1 Q
Figure 2.5, An illustration of cost-push inflation

31
Complexities of inflation
• The real world is more complex than the distinction between
demand-pull and cost-push inflation suggests
• It is difficult to distinguish between demand-pull and cost-push
inflation unless the original source of inflation is known.
• Demand-pull inflation may be mistakenly judged as cost-push
inflation:

Demand-pull inflation Increase in cost of living

? Which?

Further increase in Demand for increase in wages

price level (Cost-push by workers (labour cost)
inflation) 32
Complexities of inflation (cont’d)
• Another complexity is that cost-push inflation and demand-pull
inflation differ in their sustainability.
• Demand-pull inflation will continue as long as there is excess
total spending.
• Cost-push inflation is automatically self-limiting; it will die out by
itself.
• Increased per unit costs will reduce supply, and this means
lower real output and employment. Those decreases will
constrain (hinder/limit) further per-unit cost increases.
• In other words, cost-push inflation generates a recession. And
in a recession, households and businesses concentrate on
keeping their resources employed, not on pushing up the prices
of those resources.

33
Redistributive effects of inflation
• Inflation hurts some people, leaves others unaffected and
actually helps still others.
• That is, inflation redistributes real income from some people to
others.
• Who gets hurt? Who benefits?
• Before answering the questions above, lets revisit some
terminology.
• Nominal and Real Income
• Nominal income is the number of money (Kwachas, Dollars)
received as wages, rent, interest, or profits.
• Real income is a measure of the amount of goods and services
that nominal income can buy, it is the purchasing power of
nominal income, or income adjusted for inflation

34
Nominal Income and Real Income

• Real income = [Nominal income ÷ Price index (in hundredths)]

• Inflation need not alter an economy’s overall real income – its
purchasing power.
• From the above equation, it is evident that real income will
remain the same when nominal income rises at the same
percentage rate as does the price level.
• For example, when inflation rises by 5%, nominal income should
also be increased by 5% in order to retain its purchasing power.
• However, when inflation occurs, not everyone’s nominal income
rises at the same pace as the price level.
• If the change in price level differs from the change in a person’s
nominal income, his or her real income will be affected
35
Rule of approximate change in real income
• The following rules tells us approximately by how much real
income will change:

• Percentage change in real income is approximately equal

to (Percentage change in nominal income – percentage
change in price index).
• For example
• Suppose that the price level rises by 8% in some period. If
Thom’s nominal income rises by 8% his real income will
remain unchanged. But if his nominal income instead rises
by 15% , his real income will increase by 7%. And if Thom’s
nominal income rises by only 5%, his real income will
decline by about 3%.
36
Application of the approximation rule
 Application
 Suppose that Thom’s nominal income rises by 15%
from K100,000 to K115,000 and the price level (index)
rises by 8% from 100 to 108, then real income has
increased as follows:
 K115,000 ÷ 1.08 = K106,481.48
 Percentage increase in real income
= [(106,481.48 – 100,000 ÷100,000) × 100]
= 6.5% (approximately 7%)

37
Anticipations

• The redistributive effects of inflation depend on whether or not

it is expected.
• With fully expected or anticipated inflation, an income receiver
may be able to avoid or lessen the adverse effects of inflation
on real income.
• The generalizations that follow about who is hurt by inflation
or who benefits from inflation assume unanticipated inflation
– that is, inflation whose full extent was not expected.

38
Who is Hurt by Inflation?
• Unanticipated inflation hurts fixed income recipients, savers, and
creditors (lenders). It redistributes real income away from them
and toward others.
• (1) Fixed income Receivers – People whose incomes are fixed see
their real incomes fall when inflation occurs.
• Examples
• Retired workers receiving fixed pension or annuity,;
• Landlords who receive lease payments of fixed amounts - they
receive money of declining value, over time;
• Public workers whose incomes are dictated by fixed pay
schedules. The fixed “steps” (the upward yearly increases) in
their pay schedules may not keep up with inflation;
• Minimum-wage workers and families living on fixed welfare
incomes will also be hurt by inflation.

39
Who is Hurt by Inflation? (cont’d)

• (2) Savers – Unanticipated inflation hurts savers.

• As prices rise, the real value, or purchasing power, of an
accumulation of savings deteriorates.
• Of course, most forms of savings earn interest. But the value of
savings will still decline if the rate of inflation exceeds the rate of
interest.
• Example:
• A household may save K150,000 in NBS Bank which pays an
interest rate of 4.5% per annum. If inflation is 12% as it stands
now (May 2012), the real value of that K150,000 will be cut to
about K139,955.40 by the end of the year
• Thus, [(K150,000 × 1.045 = K156,750) ÷ 1.12]= K139,955.40

40
Who is Hurt by Inflation? (cont’d)

• (3) Creditors – Unanticipated inflation harms creditors (lenders).

• Suppose, FDH Bank lends Ambewa K200,000 to be repaid in 2
years. If in that time the price level doubles, the K200,000 that
Ambewa repays will have only half the purchasing power of the
K200,000 that was borrowed.
• Indeed, if we ignore interest charges, the same amount of money
will be repaid as was borrowed.
• But because of inflation, each of those Kwachas will buy only half
as much as it did when the loan was negotiated.
• As prices go up, the value of the Kwacha goes down. Thus, the
borrower is lent “dear or expensive” money but, because of
inflation, pays back “cheap” money. The owners of FDH Bank
suffer a loss of real income.
41
 Who is Unaffected or Helped by Inflation?
• Some people are unaffected by inflation and others are actually
helped by it. In this category, inflation redistributes income toward
them and away from others.
• (1) Flexible-Income Receivers– For example, individuals who derive
their incomes solely from social security that is indexed to the CPI are
not harmed by inflation.
• In an economy that finds it difficult to increase workers’ wages, labour unions
may push for automatic cost-of-living adjustments (COLAs) in their pay when
the CPI rises, although such increases may rarely equal the full percentage
rise in inflation.
• Property owners may be able to boost flexible rents more rapidly than the
rate of inflation.
• If product prices rise faster than resource prices, business revenues will
increase more rapidly than costs – and the growth rate of profit incomes will
outpace the rate of inflation.
42
Who is Unaffected or Helped by Inflation?

• (2) Debtors – Unanticipated inflation benefits debtors

(borrowers).
• In our earlier example, FDH Bank’s loss of real income from
inflation is Ambewa’s gain of real income.
• Debtors borrow “dear” money but, because of inflation, pay
back the principal and interest with “cheap” money whose
purchasing power has been eroded by inflation.
• Real income is redistributed away from the owners of FDH Bank
toward borrowers such as Ambewa.

43
 Anticipated Inflation
• The redistributive effects of inflation are less severe or are
eliminated altogether if people anticipate inflation and can adjust
their nominal incomes to reflect the expected price-level rises.
• Similarly, if inflation is anticipated, the redistribution of income
from lenders to borrowers may be altered.
• Suppose FDH Bank and Ambewa both agree that 13% is a fair rate
of interest on a 1-year loan provided the price level is stable. But
assume that inflation has been occurring and is expected to be
15% over the next year.
• If the 15% inflation occurs during that year, the lender can avoid
paying a subsidy to the borrower by charging an inflation
premium – by raising the interest rate by 15% which is the
amount of the anticipated inflation.
44
Anticipated Inflation (cont’d)

• The bank will charge 28% (=13% lending rate + 15% inflation rate),
and thereby manage to recover the loan as if the interest of 13%
prevailed without inflation.
• Thus, in this example, the real rate of interest (13%) differs from
the nominal rate of interest (28%).
• The real rate of interest is the percentage increase in purchasing
power that the borrower pays the lender.
• The nominal rate of interest is the percentage increase in money
that the borrower pays the lender, including that resulting from
the built-in expectation of inflation , if any.
• Nominal interest rate = real interest rate + inflation
premium (the expected rate of inflation)

45
Addenda

• Deflation – the decline in the general price level.

• The effects of unanticipated deflation are the reverse of those of
inflation.
• Mixed effects of inflation – A person who is an income earner, a holder
of financial assets, and owner of real assets simultaneously will probably
find that the redistribution impact of inflation is cushioned.
• If the person owns fixed-value monetary assets (savings accounts,
bonds, and insurance policies), inflation will lessen their real value.
• But that same inflation may increase the real value of any property
assets (a house, land).
• Stagflation – An inflation that occurs when the economy is experiencing
prolonged recession or depression. The economy is stagnant at low
output levels and at the same time the price level is rising. Remember
the 2009 to 2012 fuel crisis in Malawi.
46
Effects of Inflation on Output

• Apart from the redistributive effects of income, inflation

may also affect an economy’s level of output (and thus its
level of real income).
• The direction and significance of this effect on output
depends on the type of inflation and its severity.

47
Effects of Cost-push Inflation on Real Output
• Recall that abrupt and unexpected rises in key resource prices such
as oil can sufficiently drive up overall production costs to cause cost-
push inflation.
• As prices rise, the quantity of goods and services demanded falls. So
firms respond by producing less output, and unemployment goes up.
• Historically, in late 1973 the Organization of Petroleum Exporting
Countries (OPEC), by exerting its market power, managed to
quadruple the price of oil. The cost-push inflationary effects
generated rapid price-level increases in the 1973 – 1975 period.
Similar outcomes occurred in 1979 – 1980 in response to second
OPEC oil supply shock.
• In short, cost-push inflation reduces real output. It redistributes a
decreased level of real income.

48
Effects of Demand-pull Inflation on Real
Output
• Economists do not fully agree on the effects of mild inflation (less
than 3%) on real output.
• One perspective is that even low levels of inflation reduce real
output, because inflation diverts time and effort toward activities
designed to hedge against inflation.
• Examples:
• The cost of changing thousands of prices on shelves and in the
computers by businesses to reflect inflation
• Households and businesses spend considerable time and effort obtaining
the information needed to distinguish between real and nominal values
such as prices, wages, and interest rates.
• To limit loss of purchasing power from inflation, people try to limit the
amount of money they hold and instead put more money in interest-
bearing accounts and stocks and bonds
49
Effects of Demand-pull Inflation on Real
Output (cont’d)
• Without inflation, these uses of resources, time, and effort would
not be needed, and they could be diverted toward producing more
valuable goods and services.
• Proponents of “zero inflation” bolster (support) their case by
pointing to cross-country studies that indicate that lower rates of
inflation are associated with higher rates of economic growth.
• They say that even mild inflation is detrimental to economic
growth.
• In contrast, other economists point out that full employment and
economic growth depend on strong levels of total spending.
• Such spending creates high profits, strong demand for labour,
and a powerful incentive for firms to expand their plants and
equipment.

50
Effects of Demand-pull Inflation on Real
Output (cont’d)
• A little inflation may have positive effects because it makes it
easier for firms to adjust real wages downward when the demand
for their products falls.
• With mild inflation, firms can reduce real wages by holding
nominal wages steady (stable/fixed). With zero inflation firms
would need to cut nominal wages to reduce real wages. Such cuts
in nominal wages are highly visible and may cause considerable
worker resistance and labour strife.
• Finally, defenders of mild inflation say that it is much better for an
economy to err on the side of strong spending, full employment,
economic growth, and mild inflation than on the side of weak
spending, high unemployment, recession, and deflation.

51
Hyperinflation and Breakdown
• All economists agree that the nation’s policymakers must carefully
monitor mild inflation so that it does not snowball into higher rates
of inflation or even into hyperinflation.
• Hyperinflation is an extremely rapid inflation whose impact on real
output and employment usually is devastating.
• When inflation begins to escalate, consumers, workers, and businesses
assume that it will rise even further.
• So, rather than let their idle savings and current incomes depreciate,
consumers “spend now” to beat the anticipated price rises. Businesses
do the same by buying capital goods.
• Workers demand and receive higher nominal wages to recoup lost
purchasing power and to maintain future purchasing power in the face of
expected higher inflation.
• Actions based on these inflationary expectations then intensify the
pressure on prices, and inflation feeds on itself.
52
 Hyperinflation and Breakdown (cont’d)
• Hyperinflation may also cause economic collapse.
• Severe inflation encourages speculative activity. Businesses anticipating
further price increases, may find it profitable to hoard (store/stockpile) both
materials and finished products.
• But restricting the availability of materials and products intensifies the
inflationary pressure.
• Also rather than invest in capital equipment, businesses and individual savers
may decide to purchase nonproductive wealth – jewels, gold and other
precious metals, real estate, and so forth – as a hedge against inflation.
• In the extreme, economic relationships are disrupted – price setting becomes
difficult. Money eventually becomes almost worthless, - and the economy
may be thrown into the state of barter. The net result is economic, social and
possibly political chaos.
• Hyperinflation has precipitated monetary collapse, depression and
sociopolitical disorder. The Case of Zimbabwe 2004 – 2010.

53
 Assignment 3 – Individual Exercise. May 4, 2016
• Instructions:
• Write your name and study program on the answer sheet that you use.
Q1. In 2015 unemployment rate in the Malawi economy was 25% while the natural rate of unemployment
was 11.5% and full employment real GDP was K904.11 billion. Using Okun’s law estimate
(a) Size of real GDP gap. (Correct to 2 decimal points). [5 marks]
Answer: K[(25 -11.5)×2) = 27% === (27/100)×904.11] = K244.11 billion
(b) Malawi’s current real GDP. [5 marks]
Answer: K[(100% – 27%) = 0.73 == 0.73×904.11] = K660.0003 billion
Q2. At the end of Fiscal Year 2015/2016 the Malawi economy reported an increase in annual inflation
rate from 17.5% to 25%. During the same period Tanaka received an annual salary increment of
12% from K749,650.
(a) By what percentage did his real income increase? (Correct to 2 decimal points). [8 marks]
Answers: Tanaka’s Initial Real Salary (Y1) =( K749,650.00 )÷1.175 )= K638,000.00;
Tanaka’s Real Salary after increment (Y2) = [(K749,650.00×1.12)÷1.25] = K671,686.40
% Increase in Tanaka’s Salary = [(K671,686.40 - K638,000.00) ÷K638,000.00]×100% = 5.28%
(b) It is argued that mild inflation is better than zero inflation. With tangible facts, discuss briefly, the
economic truth about this school of thought. [2 marks]
Answers: Mild inflation leads to increases in producer profits without upward wage adjustments. This
is so because increase in price level tends to be insignificant to consumers who also form part of
the workforce. With high total revenues and profits producers expand levels of output and
investment, leading to economic growth and a decline in unemployment.
54