Inflation, Recession and Unemployment
What is Macroeconomics?
Macroeconomics is the study of the economy as a whole, rather than the individual
markets and other elements of which it consists.
Policies used by government to achieve macroeconomic goals
Fiscal policy
Fiscal policy is the use of government spending and taxation to control aggregate
demand in the economy. ‘Aggregate’ is a term used in macroeconomics and means ‘total’.
‘Aggregate demand’ is total demand in the economy.
When the government increases government spending and/or reduces taxes, this increases
aggregate demand in the economy, and is thus termed ‘expansionary’ or ‘reflationary’ fiscal
policy. When the government decreases government spending and/or increases taxes, this
decreases aggregate demand, and so is termed ‘contractionary’ or ‘deflationary’ fiscal policy
Monetary policy
Monetary policy is the use of interest rates and other direct measures to control the money
supply and, consequently, aggregate demand in the economy. (Reflationary monetary policy)
Monetary policy that increases the money supply and aggregate demand is termed
‘expansionary’ or ‘reflationary’ monetary policy. These policies include:
• Reducing interest rates. When interest rates fall, individuals save less and spend more.
They also borrow to make purchases. This increases the money supply in the economy.
• Improving the availability of credit by decreasing the down payment needed and
increasing repayment periods on loans. A lower down payment makes it easier for individuals to
enter into a hire-purchase agreement. Having to make a down payment of only 10 per cent on a
car to obtain a loan from a bank is much easier than having to make a 15 per cent down payment.
Also, longer repayment periods on loans mean that each monthly instalment is smaller. This also
makes borrowing more attractive.
• Open market operations. This is the buying and selling of government securities
(bonds and Treasury bills) on the open market. When the government (through the central bank)
buys back securities from the holders of these securities, the government pays them money,
which increases the money supply, as money enters the financial system.
• Reducing the required reserve ratio. All banks are required by law to keep a certain
percentage of their deposits as reserves. The lower the reserve requirement, the more banks can
lend and the greater the money supply will be.
Monetary policy that decreases the money supply and aggregate demand is termed
‘contractionary’ or ‘deflationary’ monetary policy, and includes: (deflationary monetary
policy)
• Increasing interest rates. When interest rates rise, individuals save more and spend
less. They are less likely to borrow, as the cost of borrowing is higher. This reduces the money
supply in the economy.
• Making credit less accessible by increasing the down payment and decreasing
repayment periods on loans. A higher down payment makes it more difficult for individuals to
enter into a hire-purchase agreement. Having to make a down payment of a larger percentage of
the value of a purchase to obtain a loan from a bank is more difficult than having to make a
smaller percentage down payment. Also, shorter repayment periods on loans mean that each
monthly instalment is larger and might be more difficult for the borrower to meet.
• Open market operations. When the government sells securities to individuals and
firms in the domestic economy, the buyers pay the government money, which decreases the
money supply, as money leaves the financial system.
• Increasing the required reserve ratio. The higher the reserve requirement, the less
the amount that banks can lend, which will lead to a smaller money supply. When there is
pressure in the economy for the money supply to contract, this is called a ‘credit squeeze’.
INFLATION AND ITS CAUSES
Inflation is defined as the steady and continuous rise in the general price level (that is, an
average of all prices in the economy). A one-off increase in prices is not inflation. Prices must
rise steadily and over a prolonged period for it to be considered as inflation. An increase in a
small number of prices does not constitute inflation either.
Inflation is measured by a rise in the retail price index (RPI) from year to year. The
retail price index is computed by measuring the change in prices of a given ‘basket’ of goods that
consumers buy.
The four contributing causes of inflation are:
1. Demand-pull inflation is caused by an increase in demand in the economy. Total
demand in the economy by all groups – households, firms, government and the export
sector – is termed ‘aggregate demand’. When aggregate demand increases and the
supply of goods in the economy cannot be expanded to meet this increase in demand,
the result is rising prices.
2. Cost-push inflation is caused by an increase in the prices of the factors of
production. This causes firms’ costs to rise. The four factors of production are: land,
labour, capital and entrepreneurship. If payments to any of these factors of production
increase, this will cause costs to increase. Firms will, in most instances, increase
prices in order to maintain profit levels.
3. Imported inflation. The Caribbean economies import a large proportion of their food
and other finished goods. Increasing world prices will result in the domestic prices of
these imported goods rising. Caribbean economies also import capital, raw materials
and fuel such as oil. Rising world prices of these factors also contribute to imported
inflation. This element of imported inflation contributes to cost-push inflation.
4. An increase in the money supply causes an increase in aggregate demand. Just as in
demand-pull inflation, this increase in aggregate demand, output remaining constant,
causes an increase in prices. This is why you might have heard the expression
‘inflation is too much money chasing after too few goods’.
CONSEQUENCES OF INFLATION
When there is inflation it affects all the different groups in the economy. The
following are some of the consequences of inflation:
• Fixed income earners suffer a fall in real income. The purchasing power of
money falls during inflationary times, so that a given amount of money can buy fewer
goods and services. The purchasing power of money is what goods and services the
money can buy.
• When prices are increasing in the domestic economy, it means that the
prices of goods that the country is exporting will rise. As prices rise, foreigners
will demand fewer of the country’s goods and services. This means that the given
country will earn less foreign exchange. If the level of exports falls and the level of
imports remains constant, the country will suffer a trade deficit.
• Borrowers gain as the value of the debt to be repaid in real terms falls during an
inflationary period. Inflation tends to encourage borrowing.
• Creditors lose out because the sum to be repaid will now be able to buy less.
Imagine you lent your friend $1000 a year ago. Now, when prices have risen, you
receive that same $1000. Your $1000 is now worth less than when you made the
loan! Inflation tends to discourage lending.
• Looking for better prices in times of continuous inflation means that people
might have to walk from place to place. These are costs in terms of time and effort,
and they are called shoe leather costs.
• Shops, stores and restaurants also have to change price tags and menus. These
are called menu costs.
• Rising costs of production cannot be passed on. Some firms might find it
difficult to survive when their costs of production are rising and they cannot pass
on this increase in costs in the form of higher prices to consumers. This is the case
for goods with substitutes, and such producers might be forced out of the market.
• Employers might be forced to reduce the quantity of labour employed
because of rising labour costs. This could result in some unemployment.
1. What is the main focus of macroeconomics?
- A. Individual markets
- B. National output only
- C. The entire economy
- D. Firm-level demand and supply
2. Fiscal policy primarily involves changes in:
- A. Government spending and taxes
- B. Exchange rates
- C. Interest rates
- D. Employment policies
3. When a government decreases taxes and increases spending, this is called:
- A. Contractionary fiscal policy
- B. Reflationary fiscal policy
- C. Deflationary fiscal policy
- D. Stabilization policy
4. Expansionary monetary policy aims to:
- A. Decrease aggregate demand
- B. Reduce interest rates and increase the money supply
- C. Increase taxes to lower demand
- D. Limit money supply growth
5. Which of the following is an example of an expansionary monetary policy?
- A. Increasing interest rates
- B. Selling government bonds
- C. Reducing the required reserve ratio
- D. Decreasing government spending
6. When the central bank buys back securities, the effect on the money
supply is:
- A. Decrease in money supply
- B. Increase in money supply
- C. Neutral effect on money supply
- D. Decrease in bank reserves
7. A contractionary monetary policy would most likely include:
- A. Lowering interest rates
- B. Increasing the reserve requirement
- C. Increasing government spending
- D. Lowering taxes
8. Inflation is defined as:
- A. A temporary increase in prices
- B. A steady and continuous rise in the general price level
- C. The increase of prices in only a few sectors
- D. A decrease in purchasing power
9. Demand-pull inflation occurs when:
- A. Aggregate demand falls sharply
- B. Aggregate demand rises faster than supply
- C. Costs of production rise
- D. Imports exceed exports
10. Which of the following best describes cost-push inflation?
- A. Caused by an increase in consumer demand
- B. Caused by increases in production costs
- C. Triggered by falling prices of inputs
- D. A temporary change in specific goods' prices
11. Imported inflation is a result of:
- A. Decreased domestic production
- B. Rising prices of imported goods
- C. Falling world prices
- D. Lower costs for local products
12. Which of these is a consequence of inflation?
- A. Fixed income earners experience increased purchasing power
- B. Borrowers benefit as the value of debt decreases
- C. Export demand increases due to higher prices
- D. Lenders benefit as loan repayments hold their value
13. Shoe leather costs refer to:
- A. Costs of finding better prices during inflation
- B. Expenses related to increased production
- C. Taxes on footwear items
- D. New business opening costs
14. Which of the following represents a *menu cost* in an inflationary
period?
- A. Costs to employers when hiring new staff
- B. Increased costs for goods with no substitutes
- C. The effort in changing price tags and menus
- D. Costs associated with higher government taxes
15. The term "credit squeeze" refers to:
- A. Reduction in interest rates
- B. Tightening of money supply by increasing reserve requirements
- C. Decrease in the availability of credit
- D. Both B and C
16. One likely effect of high inflation on exports is:
- A. Increased demand for exported goods
- B. Decreased competitiveness and lower export demand
- C. Decrease in prices of exported goods
- D. No impact on export demand
17. Which factor directly contributes to demand-pull inflation?
- A. Higher interest rates
- B. Increased aggregate demand
- C. A surplus in domestic goods supply
- D. Lower production costs
18. Cost-push inflation can be triggered by an increase in:
- A. Consumer saving rates
- B. The cost of labor or raw materials
- C. The supply of consumer goods
- D. The amount of money available
19. When inflation is present, which group is most likely to be
disadvantaged?
- A. Borrowers
- B. Fixed income earners
- C. Lenders with fixed interest rates
- D. Entrepreneurs
20. The term "aggregate demand" in macroeconomics refers to:
- A. Total supply of goods and services
- B. Total demand in the economy
- C. Demand for imported goods only
- D. Individual firm-level demand