Module 20 - Inflation and Unemployment

Question 1

It can be inferred that

I. average output per worker decreased between Year t and Year t +1.

II. prices rose on average by about 2 per cent between Year t and Year t +1.

III. the capital stock decreased between Year t and Year t +1.

Which of the following is correct?

A. II only.
B. II and III only.
C. I and III only.
D. I, II and III.

Answer 1

The correct answer is B. Since real GNP increased by 4 per cent between Year t and Year t +1 and since the labour force only increased by 3 per cent, average output per worker must have increased. Since money GNP rose by 6 per cent and real output by only 4 per cent, prices must have risen by about 2 per cent. Since the labour force grew by 3 per cent but potential output remained constant, the capital stock must have decreased.

Question 2

Which of the following explains why considerable unemployment can exist in a market economy?

A. At full employment, national income is not always sufficient to purchase all output produced.

B. Many product and factor prices respond very slowly when supply exceeds demand.

C. The rate of productivity growth is not always great enough to permit sufficient growth of actual output.

D. The growth of productive capacity always outstrips the growth of consumers’ wants.

Answer 2

The correct answer is B. Other things being equal, the lower the price of a good or resource, the larger will be the quantity demanded. Thus, if prices were completely flexible and responded quickly to situations of excess demand and excess supply, all markets – including the labour market – would clear. Therefore full employment would always exist. In the real world, many markets are ‘sticky’, i.e. respond slowly to excess demand/supply. By definition, national income equals national output; the rate of productivity increase determines potential, not actual, output; to date no nation has sufficient resources to satisfy all of its citizens’ wants.

Question 3

The Chancellor of the Exchequer wishes to use fiscal policy to control aggregate demand and also wishes to reduce the public sector as a proportion of GNP. In the event of a recession, which of the following would be an appropriate policy to adopt?

A. Reduce the level of taxation.

B. Increase transfer payments.

C. Increase government spending on goods and services.

D. Leave both the tax structure and government spending unchanged.

Answer 3

The correct answer is A. Increasing transfer payments and increasing government expenditure on goods and services, while both stimulatory, would increase the relative size of the public sector. Leaving the tax structure and government expendi- ture at their existing levels would not help cure a recession. Only a reduction in the level of taxation would meet both goals, i.e. increasing GNP but reducing the fractions G/GNP and T/GNP.

Question 4

The following policies would be appropriate to help reduce inflationary pressures in an economy:

I. lengthening the repayment period on consumer loans. II. increasing the down-payment requirement on the purchase of consumer durables.
III. selling securities by the central bank. Which of the following is correct?

A. I and II only.
B. II only.
C. II and III only.
D. III only.

Answer 4

The correct answer is C. Longer repayment periods would increase the demand for consumer durables and consequently increase inflationary pressures. Thus option I is incorrect. Increasing down-payment requirements would reduce the demand for consumer durables. Selling securities by the central bank would reduce the cash reserves of the commercial banks and would therefore result in a contraction of the money supply. Thus both options II and III would reduce inflationary pressures.

Question 5

Faced with an inflationary gap, the government decides to increase the money supply.
They argue that this would lower interest rates, which in turn would stimulate investment, increase potential GNP, and consequently decrease the inflationary gap. The likely outcome of such a policy would be

I. as predicted by the government in the long run.

II. to worsen the inflationary gap in the short run. Which of the following is correct?

A. I only.
B. II only.
C. Both I and II.
D. Neither I nor II.

Answer 5

The correct answer is C. An increase in potential GNP requires an increase in the labour force, the capital stock, or technological progress. The lowering of interest rates could achieve an increase in investment expenditure and an increase in potential GNP, but this is a long-run strategy because, in the short run, an increase in investment expenditure adds only negligibly to the existing capital stock. An increase in investment expenditure leads to an increase in aggregate demand; given the economy is at over-full employment already, this will lead to even greater inflationary pressures.

Question 6

An inflationary gap exists; which of the following would tend to decrease that gap?

A. An increase in investment expenditures caused by optimistic forecasts regarding the world economy.

B. An increase in savings.

C. Increased orders for our trucks and buses abroad.

D. An increase in our defence commitments to NATO.

Answer 6

The correct answer is B. Inflationary pressures would be increased by any factor that increases aggregate demand. An increase in investment expenditure, an increase in exports, or an increase in government expenditure, would each increase aggregate demand and consequently the inflationary gap. However, an increase in savings results in a decrease in consumption expenditures, which would reduce aggregate demand and the inflationary gap.

Question 7

Optimistic forecasts concerning world trade have boosted business confidence, with the result that private investment is expected to increase next year. Without any policy changes, the outcome of the increase in investment must be

I. a decrease in consumption expenditures.

II. an increase in imports.

Which of the following is correct?

A. I only.
B. II only.
C. Both I and II.
D. Neither I nor II.

Answer 7

The correct answer is D. Holding the money supply constant, an increase in investment expenditure will increase the demand for money and, given no offsetting decrease in the demand for money by households or government, increase interest rates. The increase in investment expenditure will stimulate the economy, and the increase in interest rates will reduce aggregate demand. Since opposing forces will exist, it is not possible to predict whether consumption expenditure will increase, remain constant, or decrease. Likewise it is not possible to predict what will happen to imports.

Question 8

If an economy were at full employment prior to, during, and after a period of unanticipated inflation, the impact of that inflation would have been to do which of the
following:

A. increase unemployment.

B. redistribute income.

C. decrease the average price level.

D. increase potential GNP.

Answer 8

The correct answer is B. Loans are normally made at some negotiated interest rate. When borrowed money is returned, its value will be inversely related to the inflation rate during the loan period; thus unanticipated inflation will benefit borrowers at the expense of lenders, since the negotiated interest rate will not take the unanticipated inflation into account. Thus income will be redistributed. Since the economy is at full employment, there will be no increase in unemployment but the average price level will have risen. No information is given regarding potential output.

Question 9

An economy that was recently operating at full employment with a high rate of inflation has been severely deflated by substantial increases in tax rates and cuts in government expenditure. However, although unemployment is now much higher than before, inflation has not decreased. The factors that could account for this are

I. some goods and factor markets do not respond immediately to changes in demand and supply.
II. the policies have generated demand–pull inflation.

Which of the following is correct?

A. I only.
B. II only.
C. Both I and II.
D. Neither I nor II.

Answer 9

The correct answer is A. As increasing tax rates and reducing government expenditure must lower aggregate demand, option II is incorrect. Option I could account for the failure of prices to respond immediately to the deflationary policies adopted, as it may take time to modify expectations and behaviour.

Question 10

If the goal of a government is to reduce the inflationary gap, the appropriate policy is

A. increase the money supply to stimulate investment.
B. increase the money supply to stimulate private saving.
C. decrease the money supply to increase interest rates.
D. decrease the money supply to decrease interest rates.

Answer 10

The correct answer is C. To reduce an inflationary gap requires a deflationary policy. An increase in the money supply is expansionary. A decrease in the money supply would cause interest rates to rise, investment and consumption expenditures to fall, and thus reduce aggregate demand and inflationary pressures.

Question 11

Faced with a deflationary gap, the British government adopts a policy of lower tax rates and an increase in the money supply. The following unanticipated changes then occur:

I. an increase in tariffs in the US and Japan.
II. an increase in the marginal propensity to consume.

Those unanticipated changes helped the government solve the deflationary gap problem. Which of the following is correct?

A. I only.
B. II only.
C. Both I and II.
D. Neither I nor II.

Answer 11

The correct answer is B. To assist the government in decreasing the gap between actual and potential output, unanticipated changes would have to exert some positive influence on aggregate demand. An increase in foreign tariffs would reduce the demand for exports, hence reducing aggregate demand. An increase in the marginal propensity to consume would increase consumption expenditures, hence increasing aggregate demand.

Question 12

For an economy operating at full employment, the imposition of domestic tariffs and quotas is expected to reduce imports by 50 per cent next year. Which of the following is the appropriate policy for the government to adopt in order to maintain equality between potential and actual output in light of the decrease in imports?

A. Increase in government expenditure.
B. Decrease in taxes.
C. Decrease in the money supply.
D. Subsidy to exporters.

Answer 12

The correct answer is C. Since expenditure on imports is a leakage from the circular flow of income, the effect of the tariffs and quotas will be to increase aggregate demand and hence cause Y to exceed Q. An increase in government expenditure would add further to aggregate demand, as would a decrease in taxes and a subsidy to exporters, thus increasing the inflationary gap. A decrease in the money supply, given the increase in the transactions demand for money resulting from the higher level of aggregate demand caused by the reduction in imports, would lead to higher interest rates and, consequently, lower investment expenditure by firms and lower consumption expenditure by households.

Question 13

Which of the following explains why the Phillips Curve was hailed by Keynesian economists as the ‘missing link’ in their model?

It purported to show the

A. unemployment rate for a given level of national income
B. inflation rate for a given unemployment rate
C. inflation rate for a given money supply
D. unemployment rate associated with the equilibrium interest rate

Answer 13

The correct answer is B. While Monetarists argue that the price level is a function of the money supply Keynesians, prior to Phillips, could not explain what caused the price level to change. They had identified that the unemployment rate over and above frictional and structural elements was a function of the gap between potential and actual output. The Phillips Curve purported to show a fixed relationship between the unemployment rate and the inflation rate.

Question 14

Monetarists argue that

I. if market forces are allowed to operate, an equilibrium level of national income will emerge but it will not be the full employment level.

II. money determines the price level but not the employment or national income levels.

Which of the following is correct?

A. I only
B. II only
C. Both I and II
D. Neither I nor II

Answer 14

The correct answer is B. Monetarists believed that strong equilibriating forces exist in market economies and only the interference of government prevented market clearing price and quantities being achieved. They would argue, for instance, that full employment national income would result through market forces. Thus I is wrong. The Quantity Theory, MV = PT, with V constant and T proportional to national income meant P was a function of M; M had no direct influence on T. Thus II is true.

Question 15

Policy makers believe zero/low inflation should be a policy goal for economic efficiency reasons. Inflation they argue

I. impairs the efficiency of the price mechanism
II. ‘penalises’ people on fixed incomes, specifically the old and the poor

Which of the following is correct?
A. I only
B. II only
C. Both I and II
D. Neither I nor II

Answer 15

The correct answer is A. Inflation raises the costs of buying and selling because money becomes less reliable as a standard value and as a consequence affects the efficiency of the price mechanism. Thus I is true. Many people on fixed incomes e.g. social security recipients and others with little/no bargaining power and/or not involved in the labour market will experience a loss in real income if nominal income is constant and prices of goods and services are increasing. This however is an issue of economic equity and not economic efficiency. Thus II is wrong.

Question 16

In the demand–pull model of price inflation

I. organised labour pulls up wages/salaries
II. large companies increase prices of goods and services in response to increased wages/salaries

Which of the following is correct?
A. I only
B. II only
C. Both I and II
D. Neither I nor II

Answer 16

The correct answer is D. When aggregate demand exceeds potential output the excess demand causes prices of goods and services to rise. Simultaneously excess demand in factor markets ‘pulls up’ wages and salaries. Thus demand pull inflation as the name suggests is caused by excess demand pulling up prices. Thus both I and II are wrong.

Question 17

Which of the following contains Keynes’s cure for demand pull inflation?

A. Decrease the money supply
B. Raise interest rates
C. Increase banks reserve requirements
D. Decrease government expenditure/raise income taxes

Answer 17

The correct answer is D. The cause of demand pull inflation according to Keynes was excess demand pulling up prices, i.e. aggregate demand in excess of potential output. The cure was to reduce aggregate demand by either raising taxes or reducing government expenditure. Monetary tools played no part in either the cause or cure of demand pull inflation. Thus A, B and C are wrong.

Question 18

In the cost push explanation of inflation, price rises

I. originate in collective bargaining in labour markets
II. in factor markets are passed on in administered higher prices of goods and services

Which of the following is correct?
A. I only
B. II only
C. Both I and II
D. Neither I nor II

Answer 18

The correct answer is C. In the cost push model bargaining determines money wages and salaries; business firms find that labour costs have risen and pass on these higher costs by marking up the prices of goods and services. Thus both I and II are true.

Question 19

Comparing the demand pull model with the cost push model only in the latter will

i. wage rates rise in industries where unemployment rates also are rising
II. wage rate increases lead to increases in the prices of goods and services

Which of the following is correct?
A. I only
B. II only
C. Both I and II
D. Neither I nor II

Answer 19

The correct answer is C. In the cost push model linkage effects are prominent. Equity and justice are often cited in wage demands and the desire to keep existing wage structure and salary differentials can lead to wage increases, granted in strongly unionised sectors, being imitated in sectors where employment opportunities may be decreasing. Thus I is true. In the demand pull model excess demand in goods markets leads to price increases and excess demand in factor markets leads to wage increases. In the cost push model however firms will attempt to pass on cost increases in the form of higher prices. Thus II is true.

Question 20

Given a high employment rate a government decided to increase the money supply by 20%. The inflation rate increased from 4% to 10% within a year as predicted by leading economists and the business community.
Two newspapers had predicted what would happen to the inflation rate according to their expectations, static and rational. Which of the following contains the predictions of the newspapers.

A. Static = 0, Rational = 10
B. Static = 4, Rational = 0
C. Static = 20, Rational = 0
D. Static = 4, Rational = 10

Answer 20

The correct answer is D. Static expectations means tomorrow will be like today thus the static would be today’s inflation rate of 4%. Rational expectations assumes everyone has the same information and if all economists and the business community using such information expect 10% then so will the ‘rational expectations’ newspaper.

Question 21

Cost push inflation would be higher than it otherwise would have been if the prices of imported goods increase and

I. the demand for imported goods became price inelastic
II. the demand for imported goods became income inelastic
III. inflationary expectation which had been adaptive became static

Which of the following is correct?
A. I only
B. I and II only
C. II and III only
D. I, II and III

Answer 21

The correct answer is B. If the demand for imported goods were inelastic with respect to price and/or income then a rise in the prices of imported goods and/or a fall in income will be reflected in higher inflation rates, i.e. the imported goods now more expensive will continue to be bought. Thus I and II are true. If inflationary expectations are static people will assume next year’s inflation rate will equal this year’s, i.e. it will not increase. Thus III is wrong.

Question 22

The Efficient Market Hypothesis which argues that markets utilise all information to produce prices which reflect equilibrium incorporates which of the following assumptions?

A. Expectations are adaptive
B. Expectations are infinite
C. Expectations are rational
D. Expectations are static

Answer 22

The correct answer is C. This is a definitional question.

Question 23

Which of the following explains why the ‘discovery’ of the Phillips Curve posed a painful problem for policy makers?

It forced policy makers to choose between
A. monetary and fiscal policy
B. deflation and inflation
C. inflation and unemployment
D. price stability and economic growth

Answer 23

The correct answer is C. The Phillips Curve purported to show a fixed relationship between the unemployment and the inflation rate posing a trade off. If policy makers enacted policies to lower the rate of unemployment the cost to be borne was a higher inflation rate.

Question 24

Keynesians argued that

I. market forces would clear labour markets in both the short and long run
II. the only cure for severe recessions was sufficient increases in the money supply to reduce interest rates to encourage consumption/investment expenditure

Which of the following is correct?
A. I only
B. II only
C. Both I and II
D. Neither I nor II

Answer 24

The correct answer is D. Keynes believed that in the presence of unemployment employers would not reduce wages to clear labour markets; wages were ‘sticky’ downwards. Thus I is wrong. Keynes used the concept of the liquidity trap to explain the inefficiency of monetary policy in a recession; i.e. at low interest rates with high rates of unemployment and unused capital equipment increases in the money supply would be held in idle cash balances and would not stimulate expenditure. Thus II is wrong.

Question 25

Many politician promise zero/low inflation for equity rather than efficiency reasons. They argue that the people who suffer because of high unanticipated inflation rates are

I. borrowers who agree to fixed interest loans
II. importers of foreign goods and services

Which of the following is correct?
A. I only
B. II only
C. Both I and II
D. Neither I nor II

Answer 25

The correct answer is D. If interest rates are fixed in expectation of stable prices and prices then rise significantly borrowers will return ‘cheap’ dollars having borrowed ‘expensive’ dollars. Indeed if the inflation rate exceeds the nominal interest rate the cost of borrowing will be negative. Thus borrowers benefit from unanticipated inflation; lenders suffer. Thus I is wrong. In the absence of any offsetting factors an increase in the relative inflation rate, i.e. relative to the inflation rate of a nation with which the nation in question trades, will make imported goods more attractive and exporting goods less attractive. Thus exporters will suffer and importers will gain. Thus II is wrong.

Question 26

According to the demand pull model which of the following includes the condition which would cause inflation?

A. Potential output (Q) is growing at 3% actual output (Y) at 4%
B. Actual output exceeds potential output
C. The money supply is growing faster than aggregate demand
D. Interest rates are rising faster than the money supply

Answer 26

The correct answer is B. When aggregate demand exceeds potential output the excess demand pulls prices up. If the economy were at full employment and Q were growing at 3% and Y at 4%, A would be true but there is no information given about how close Y is to Q. Real output cannot exceed Q by much but when it does demand pull inflation results; thus B is true. The demand pull inflation model does not involve the monetary elements of the money supply and interest rate. Thus C and D are wrong.

Question 27

In the demand pull model of price inflation the role of organised labour was

I. to react to price changes by bargaining higher money wages to maintain the value of real wages
II. to seek real wage increases to match the growth rate of potential output
III. to match nominal wage increases to increases in the money supply

Which of the following is correct?
A. I only
B. I and III only
C. II only
D. II and III only

Answer 27

The correct answer is A. In the demand pull model organised labour was seen as passive by reacting to price increases in an attempt to maintain real wages. The adjustment in money wages lagged and therefore never caused inflation. Thus I is true. Potential output growth was not considered and neither were monetary phenomena. Thus II and III are wrong.

Question 28

Cost push inflation is likely to occur in nations where

I. money wages are sticking downwards
II. a significant portion of the labour force is organised
III. potential output is growing rapidly

Which of the following is correct?
A. I only
B. II only
C. I and II only
D. I, II and III

Answer 28

The correct answer is C. In many nations today trade unions and worker associations resist cuts in money wages and many employers believe that good worker relationships essentially prohibit money wage decreases no matter the national unemployment rate. In such economies however wage increases are expected and occur in labour markets where excess demand exists. This asymmetry produces wage inflation. Thus I is true. The greater the proportion of the labour force not subject to constrained market forces the higher the probability that wage inflation and ultimately cost inflation will exist at the cost of employment. Thus II is true. The more rapidly potential output is growing especially if caused by technological change the higher will be unemployment in the absence of offsetting factors and therefore the more moderate the demands of organised labour will be. Thus III is wrong.

Question 29

In the cost push model of inflation if cost push factors were present and if the money supply were held constant

I. there would be a dramatic increase in the velocity of circulation of money
II. the rate of inflation would increase

Which of the following is correct?
A. I only
B. II only
C. Both I and II
D. Neither I nor II

Answer 29

The correct answer is D. If the price level rose because of cost push factors the monetary value of output (PT) would increase. For the equation MV = PT to hold given the rise in PT, MV will increase also. But if M is held constant V would have to increase but V is heavily influenced by existing habits and institutions and can be assumed to be relatively stable. Thus I is wrong. Thus if MV is constant and P increases T would have to decrease; i.e. output would have to decrease and unemployment increase, the latter eventually having an impact on wage demands and expectations. As a result the tight monetary policy would lead to a decrease in the inflation rate. Thus II is wrong.

Question 30

The Phillips Curve flattening out at high rates of unemployment is consistent with

I. the hypothesis that unions and employees strongly resist cuts in money wages even when the unemploy-ment rate is high
II. Keynes’s belief that money wages are ‘sticky downwards’

Which of the following is correct?
A. I only
B. II only
C. Both I and II
D. Neither I nor II

Answer 30

The correct answer is C. The flat part of the Phillips Curve from an unemployment rate of 5% to 11% shows money wages hardly changing (i.e. ½% to −½%) as the unemployment rate more than doubles. This is consistent with well organised labour groups bargaining for no decrease in money wage rates no matter the unemployment rate. To the extent that such agreements have echo effects throughout the economy even into the non unionised area the Phillips Curve represented is realistic. Thus I is true. Keynes added to the above argument the hypothesis that many employers felt their not reducing wage rates when unemployment rose could have a positive impact in the longer run in terms of employee loyalty and commitment when labour markets become tight. Thus II is true.

Question 31

The two decades following the introduction of the Phillips Curve witnessed rising money wage rates, rising inflation rates and simultaneously rising unemployment rates. Advocates of the Phillips Curve explained away this apparent inconsistency by alleging

I. demand pull factors had replaced cost push elements of inflation
II. expectations had helped shift the curve to the right
III. frictional and structural unemployment had decreased

Which of the following is correct?
A. I and III only
B. II only
C. III only
D. I, II and III

Answer 31

The correct answer is B. The empirical data on inflation and unemployment rates in the two decades following Phillips when plotted were consistent with a shifting Phillips Curve. Phillips followers argued that the demand pull element of the 1960s had been replaced by cost push and expectations elements in the 70’s and 80’s. Thus I is wrong and II is true. Only if frictional/structural unemployment had increased would one expect a given inflation rate to be associated with a higher rate of unemployment. Thus III is wrong.

Question 32

At what rate of unemployment do real wages decrease?

A. At an unemployment rate of 3%
B. At an unemployment rate of 6.5%
C. At an unemployment rate of 9%
D. At no rate of unemployment do real wages become negative

Answer 32

The correct answer is D. As long as the rate of change of money wages is greater than the rate of change of prices, i.e. the inflation rate, real wages will never fall. For example, if money wages decrease one year by 2% but prices decrease by 5% workers will experience an increase in real wages of 3%.

Question 33

If Q = Y, the unem- ployment rate will be the ___ ___ rate, where unemployment will be confined to frictional, structural and seasonal unemployment.

Answer 33

If Q = Y, the unem- ployment rate will be the full-employment unemployment rate, where unemployment will be confined to frictional, structural and seasonal unemployment.

Question 34

Economists who adhere to the Keynesian school believe that ___ factors are critical in determining equilibrium ___/___ and equilibrium ___, but they do not ascribe a central role to monetary factors in determining the ___.

Answer 34

Economists who adhere to the Keynesian school believe that monetary factors are critical in determining equilibrium income/output and equilibrium interest rates, but they do not ascribe a central role to monetary factors in determining the price level.

Question 35

The Phillips Curve was the missing link in the ___ since it purported to show a fixed relationship between the ___ rate and the ___ rate, albeit with a lag.

Answer 35

The Phillips Curve was the missing link in the Keynesian structure since it purported to show a fixed relationship between the unemployment rate and the inflation rate, albeit with a lag.

Question 36

Those who argued that there are strong equilibrating forces in market economies, which, if left unhampered by governments and other disruptive forces, would lead to full-employment national income, maintain that money is of prime importance, not in determining ___ such as the level of ___ and ___ (the province of market forces) but in determining the ___. Not surprisingly, these economists are known as ___.

Answer 36

Those who argued that there are strong equilibrating forces in market economies, which, if left unhampered by governments and other disruptive forces, would lead to full-employment national income, maintain that money is of prime importance, not in determining real variables such as the level of employment and national income (the province of market forces) but in determin- ing the price level. Not surprisingly, these economists are known as monetarists.

Question 37

In most capitalist economies, the reduction of ___had become of greater priority than the maintenance of a ___ ___ ___ ___

Answer 37

In most capitalist economies, the reduction of inflation had become of greater priority than the maintenance of a low rate of unemployment.

Question 38

Discuss why price inflation is undesirable?

Answer 38

1. Inflation impairs the efficiency of the price mechanism and raises the cost of buying and selling because money becomes less reliable as a standard of value.
2. Inflation penalizes people on ‘fixed’ incomes and favors those whose money incomes adjust quickly to price changes. The former group includes pensioners, University students, and many salary earners, while most wage and profit earners fall into the latter category.
3. Inflation favors borrowers and penalizes lenders as long as it is unanticipated. Thus, if interest rates are fixed, in money terms in the anticipation that the level of prices will remain constant (or the rate of inflation will remain constant), an increase in the prices will reduce the real cost of borrowing.
4. Given a system of un-indexed taxes, namely one where taxes are fixed in money terms rather than real terms, inflation will redistribute income from the private to the public sector.
5. A continuing higher rate of domestic inflation than experienced in other economies can lead to increased imports and reduced exports and can lead to create potential problems for stable exchange rates.

Question 39

Define demand-pull inflation.

Answer 39

Demand-pull inflation sees prices rise as a result of excess demand for goods and services, namely that exceeds the capacity output at current price levels. This then also causes the price in the factors of production to rise as firms aim at fulfilling the excess demand.

Question 40

Discuss Cost-push inflation

Answer 40

Cost-push inflation is caused as a result for bargains struck in the factor market, which raise the production costs of employers who pass on the higher costs in the form of higher prices.

In a cost-push inflation model the prices on the market are ‘administered’ by the firms that set them at cost plus profit level. Wages and salaries are ‘administered’ by negotiated agreements.

Those administered prices then cause inflation because:
• Trade unions objective to bargain for better pay and money conditions for it’s members
• Highly centralized nature of most trade unions and collective bargaining
• High percentage of wage and salary costs in the total costs of production

Cost-push inflation can only be sustained in the longer term if it is accompanied by a permissive monetary policy. The only way to counter cost-push inflation is to change the framework in which wages and prices are determined. If expectations are the cause of inflation, those have to be changed

Question 41

Cost–push factors can only create a ___ to inflation if they are accompanied by a ___ that allows an expansion of the money supply – that is, higher wages that result in higher prices must raise the ___ (given by the price level times the level of output) unless offset by a ___ and resultant___. If the money supply is fixed, it is necessary for the ___ of ___ of money to rise to generate the higher level of monetary demand consistent with the higher money value of output.

Answer 41

Cost–push factors can only create a continuing stimulus to inflation if they are accompanied by a permissive monetary policy that allows an expansion of the money supply – that is, higher wages that result in higher prices must raise the money value of output (given by the price level times the level of output) unless offset by a reduced level of output and resultant unemployment. If the money supply is fixed, it is necessary for the velocity of circulation of money to rise to generate the higher level of monetary demand consistent with the higher money value of output.

Question 42

Name the additional factors that can be added to the cost-push hypothesis. Give and example of each.

Answer 42

imported inflation and expectations inflation.

Imported Inflation

First, if the demand for imported goods is relatively price- or income-inelastic, then a rise in the prices of imported goods will be reflected in higher inflation rates. For example, the OPEC cartel caused the world price of oil to rise substantially in the 1970s. For most users of oil and oil-related products, demand is price-inelastic, especially in the short run. In the long run, households and firms can substitute fuel- efficient cars for ‘gas guzzlers’ and switch from oil heating systems to alternative sources of energy; but they can’t in the short run. Thus the large oil price increases of the early 1970s and 1980s affected the inflation rates of oil-importing countries

Expectation Inflation

Second, economists have long been aware of expectations but it is only compara- tively recently that they have incorporated expectations into economic models. The three most common assumptions used in building models including expectations are:

(a) expectations are static;
(b) expectations are adaptive; and
(c) expectations are rational.

The assumption behind static expectations is that tomorrow will be just like today

Under adaptive expectations theory, people would not vary their 2 per cent prediction of the inflation rate until the rate actually rose.

Under rational expectations they would immediately assume that the inflation rate would be 10 per cent and make current decisions with this assumption in mind, e.g. they would assume a 10 per cent inflation rate when bargaining for wage increases.

The favourite example of the advocates of rational expectations is provided by the stock market, which they assume absorbs any information instantaneously, with this information reflected immediately in stock prices. Thus, if you read in today’s newspaper that Hewlett-Packard, the electronics company, is expected to have a ‘good year’ there is no point in rushing out to buy Hewlett-Packard stock

Question 43

Explain Efficient Market Hypothesis.

Answer 43

The theory incorporating rational expectations is known as the Efficient Market Hypothesis, where markets work efficiently in the sense that all information is used to clear any market of excess demand or excess supply, so that the market price reflects equilibrium.

Question 44

Both the income–expenditure and the monetarist approaches to inflation suggest that inflation can only be curbed by reducing demand. While the Keynesian and monetarists’ prescriptions agree on this point, they disagree as to how ___. In general, Keynesians would emphasise the importance of ___, whereas monetarists would emphasise the need to ___

Answer 44

Both the income–expenditure and the monetarist approaches to inflation suggest that inflation can only be curbed by reducing demand. While the Keynesian and monetarists’ prescriptions agree on this point, they disagree as to how demand should be constrained. In general, Keynesians would emphasise the importance of fiscal policy in restraining demand, whereas monetarists would emphasise the need to control the money supply

Question 45

As a demand–pull explanation, three steps were necessary to produce the observed relationship between unemployment and changes in money wages. Discuss.

Answer 45

1. a stable, inverse relationship between the unemployment rate (U) and the excess demand for labour, where U was therefore a proxy for the excess demand for labour, rising when the excess demand for labour fell and falling when the excess demand for labour rose;
2. a stable, positive relationship between the excess demand for labour and the rate of change of money wages, W, rising when the excess demand for labour rose, and vice versa;
3. if steps 1 and 2 had been taken, then there would be a stable, inverse relationship between unemployment and the rate of change of money wages, money wages rising more rapidly when unemployment fell and rising more slowly when un- employment rose.

Question 46

Indeed, it has been suggested that the trade-off between unemployment and the rate of ___ is a transitory phenomenon caused by a failure of ___ immediately to ___ changes. However, while expectations do not adjust instantaneously, they do after some time lag, and when expectations have so adjusted, the temporary trade-off between unemployment and changes in money wages ___ entirely.

Answer 46

Indeed, it has been suggested that the trade-off between unemployment and the rate of change of money wages is a transitory phenomenon caused by a failure of expectations to adjust immediately to price changes. However, while expectations do not adjust instantaneously, they do after some time lag, and when expectations have so adjusted, the temporary trade-off between unemployment and changes in money wages disappears entirely.

Question 47

However, monetarists such as Friedman argue that there is a more funda- mental objection to the Phillips Curve. This analysis, which denies long-run trade- off between ___ and ___, argues that labour is concerned with the behaviour of the real wage and not with the ___. If this is so, a long-run relationship between the rate of unemployment and the rate of change of money wages will only hold when the rate of price inflation is expected to be ___.

Answer 47

However, monetarists such as Friedman argue that there is a more funda- mental objection to the Phillips Curve. This analysis, which denies long-run trade- off between unemployment and money wages, argues that labour is concerned with the behaviour of the real wage and not with the behaviour of the money wage. If this is so, a long-run relationship between the rate of unemployment and the rate of change of money wages will only hold when the rate of price inflation is expected to be zero or negligible.

Question 48

Discuss why Phillips curve will shift to the right.

Answer 48

As soon as a significant rate of price inflation is expected, the short-run relationship between unemployment and money wages will shift to the right – and will shift further to the right the higher is the expected rate of price inflation. In the long run, there is no trade-off between unemployment and the rate of change of money wages, so that the policy maker is quite unable to choose different combinations of money wage changes (and therefore inflation rates) and unemployment

Question 49

Macroeconomic policy cannot affect the ___, only the long-run rate of ___. This being so, the policy maker should choose a zero rate of inflation.

Answer 49

Macroeconomic policy cannot affect the longrun rate of unemployment, only the long-run rate of price inflation. This being so, the policy maker should choose a zero rate of inflation.

Question 50

Friedman suggests that the rate of unemployment can only be reduced below the ___by creating ___, and that it can only be held below that level of ___ by ___ inflation

Answer 50

Friedman suggests that the rate of unemployment can only be reduced below the natural rate of unemployment by creating inflation, and that it can only be held below that level of unemployment by accelerating inflation

More detail:

In simplified terms, we may regard the natural rate of unemploy- ment as unemployment that is not due to deficient demand. The rate of unemployment can be reduced below the natural rate permanently only by measures that reduce the amount of structural and frictional unemployment. For example, anything that improves the flow of information in the labour market is likely to lower the natural rate of unemployment. But the rate of unemployment cannot be pushed below the natural rate of unemployment permanently by demand manage- ment policies.

Question 51

As aggregate demand rises and prices rise, the competition among employers for labour would raise money wages. Discuss.

Answer 51

As aggregate demand rises and prices rise, the competition among employers for labour would raise money wages. So long as the increase in money wages was less than the increase in prices, the real wage would fall and the increase in money wages would be accompanied by a fall in the unemployment rate as employers hired more labour

Of course, this trade-off between the rate of money wages and unemploy- ment would be temporary and would disappear as expectations adjusted to the fact of inflation.

Question 52

In summary, the Friedman view is that employees are concerned with the real wage and that behaviour will adjust, possibly after some time lag, to changes in prices. In consequence, there is no long-run trade-off between the rate of change of money wages and the rate of unemployment. Discuss.

Answer 52

The rate of unemployment cannot be forced much below the natural rate of unemployment, and a freely working market economy will tend to create a situation where unemployment will tend towards the natural rate. In these circumstances, the only proper objective of macroeconomic policy is to produce price stability. The rate of unemployment can only be reduced below the actual rate by microeconomic policies aimed at improv- ing the efficiency of the labour market.

Question 53

Summarise the essential difference between Keynesian economists and the monetarists.

Answer 53

• Monetarists consider that the demand for money is a stable function of a number of variables, such as the level of income, the expected rate of return on money and other assets, and the rate of change in prices. The importance of this assumption of stability is that, once accepted, it implies that the velocity of circu- lation of money, V, will be constant or will be subject only to modest and predictable fluctuation. The Keynesian view is that changes in the velocity of circulation may offset and frustrate monetary policy, in that when M rises V will fall, and vice versa. Hence, in a depression, increases in the money supply find their way into speculative balances and the velocity of circulation will fall, so that the change in the money supply has no effect on the level of aggregate demand.
• Monetarists consider that the demand for and supply of money are in large degree independent of each other; that is, the supply of money is held to be de- termined exogenously to the economic system by the central monetary authority. It follows that, given a stable demand function for money, exogenous increases in the supply of money will increase aggregate demand for goods and services as individuals spend their excess cash balances. The resulting price inflation is thus due to the increased supply of money, and is not due to shifts in the function describing the demand for money. The neo-Keynesian view is that the money supply can be determined endogenous- ly; that is, it may be responsive to economic variables. For example, if the level of money wages rises due to cost–push factors and these higher costs are passed on in higher prices, the central monetary authority may expand the money supply in order to ‘underwrite’ the new higher level of prices. Alternatively, the commercial banks may expand the money supply to satisfy an increased demand for credit. In this case, the money supply would respond to changes in economic variables and would not be determined exogenously to the economic system.

Question 54

The monetarists maintain that changes in the money supply have been the chief cause of ___, causing both major ___ and major ___.

Answer 54

The monetarists maintain that changes in the money supply have been the chief cause of substantial fluctuations in national income, causing both major inflations and major recessions.

Question 55

Changes in the money supply have only a short-term effect on real income and employment, but no lasting long-run effect. Discuss.

Answer 55

in the long run, changes in the money supply influence only the level of prices, so that the proper and only role of monetary policy is price stability, which is achieved by the application of the one simple, automatic, rule.

A review of the empirical evidence suggests three conclusions that would be acceptable to almost all economists:

1. There is no recorded example of any major inflation occurring without an accompanying substantial increase in the money supply.
2. There is no recorded example of any substantial increase in the money supply which has not been accompanied by a major inflation.
3. Given 1 and 2, a high rate of inflation cannot be sustained unless the money supply is expanded significantly.

Question 56

If the money supply is exogenous and fixed by the monetary authority, then it does not rise in line with the increase in money incomes. Discuss.

Answer 56

Higher level of money incomes will result in an increased demand for money for transactions and precautionary purposes and, given a fixed supply of money, the money available for speculative purposes will fall. Consequently, to ensure that households and businesses are content to hold this reduced supply of money for speculative purposes, the rate of interest must rise; and this higher rate of interest will discourage investment, resulting in a fall in aggregate demand.

Question 57

The higher level of money incomes will result in an ___ demand for money for transactions and precautionary purposes and, given a fixed supply of money, the money available for speculative purposes will ___. Consequently, to ensure that households and businesses are content to hold this reduced supply of money for speculative purposes, the ___ must rise; and this higher rate of interest will discourage investment, resulting in a fall in ___.

Answer 57

The higher level of money incomes will result in an increased demand for money for transactions and precautionary purposes and, given a fixed supply of money, the money available for speculative purposes will fall. Consequently, to ensure that households and businesses are content to hold this reduced supply of money for speculative purposes, the rate of interest must rise; and this higher rate of interest will discourage investment, resulting in a fall in aggregate demand.

Question 58

Keynesians might be said to operate with shorter economic and political time horizons than monetarists. Discuss.

Answer 58

Any sharp increase in unemployment would be unac- ceptable, socially undesirable, and a waste of resources. The long-run possibility of greater price stability is not weighted very heavily. Of course, because it is not weighted very heavily, inflation may be more likely, in that people may take action based on their belief that the government will be more anxious to avoid any increase in unemployment rather than maintain price stability. In summary this means that, under a proposed ‘Keynesian’ or ‘full-employment’ government, it may be much more difficult to revise inflationary expectations downwards.

Question 59

Monetarists might be said to operate with longer economic and political time horizons. Discuss.

Answer 59

They believe that in an inflationary situation a restrictionist monetary policy will have short-run costs and that these costs will be higher if inflationary expectations are widely held. If employers and employees adjust their behaviour only slowly in the light of experience, then losses of output and employment will be more substantial and prolonged. On the other hand, monetarists believe that such output and employment losses are temporary phenomena and that the long-run benefit will be price stability.

Question 60

The differences between Keynesians and monetarists are partly based on ___ assessments and partly on ___ judgements

Answer 60

The differences between Keynesians and monetarists are partly based on differ- ent technical assessments and partly on value judgements

Question 61

Discuss the welfare function:

(W = C^0.6I^0.2G^0.2-U - C²- INF³- 10 | Budget Surplus |)

Answer 61

This function explicitly states that consumption (C) investment (I) and government expenditure (G) are all ‘goods’ – they yield plus points. But the form of the function C^0.6I^0.2G^0.2 states something else: it states that for any given GNP equal to C + I + G, the optimal proportions of the three measures

C/GNP, 1/GNP and G/GNP are 60 per cent, 20 per cent and 20 per cent respectively. For example, suppose GNP = 100 = C + I + G.