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Macro ch 2.pptx

  1. CHAPTER TWO NATIONAL INCOME ACCOUNTING The concept of GDP and GNP •To understand the meaning of GDP and GNP more fully, we turn to national income accounting. • National Income Accounting (NIA): the accounting system used to measure GDP and many related aggregate economic activities. • It is official measurement of flow of income and production in a given economy. •Gross domestic product (GDP) is the market value of all the final goods and services produced within the domestic territory of a country during a year. • In Gross Domestic Product, we include only the goods and services produced within the domestic territory of a country. It includes the incomes locally earned by the non-nationals and excludes the incomes received by the resident nationals from abroad.
  2.  Gross National Product (GNP) is the total market value of all final goods and services produced by residents/ citizens of nations.  We may say it is the Gross Domestic Product at market price plus NFI (net factor income from abroad minus factor income of non-residents in domestic tertiary).  Thus, GNP = GDP + NFI Where, GNP = Gross National Product at market prices GDP = Gross Domestic Product at market prices NFI = Net Factor Income  NFI is the difference between factor income flowing out of the country and flowing into the country.  Alternatively, it is the difference between the factor income by a country’s citizen living abroad and the factor income earned by nonresidents (foreigners) in the domestic territory of that country.  NFI = Factor income earned from abroad by residents – factor income of non-residents in domestic territory  Net factor income from abroad can be positive or negative.  When net factor income from abroad is positive, domestic product is smaller than the national product (or the national product is greater than the domestic product).  And when net factor income from abroad is negative, domestic product is greater than the national product.
  3. Approaches to Measuring GDP/GNP  There are three different phases in circular flow of national income: production, income and expenditure.  Production of goods and services is the result of combined efforts of factors of production (land, labour, capital and entrepreneurs).  The net output emerging from the production process gets distributed in the form of money income (rent, wages, interest and profit) among factors of production.  With these income factors of production we purchase goods and services for final consumption and investment.  In this way income creates expenditure. Expenditure in turn gives rise to further production.  This leads to continuous circular movement of production, income and expenditure.
  4. Income Method  The income method measures national income from the side of payments made to the primary factors of production in the form of rent, wages, interest, and profit for their productive services in an accounting year.  Since the income of factors of production is cost to their employers, so factor income and factor cost are the same.  Thus if the factor incomes of all the producing units generated within the domestic economy are added up, the resulting total will be the domestic income at factor cost.  If we add the value of depreciation and indirect taxes to this, we get GDP. Adding further net factor income from abroad gives us GNP.  Depreciation means loss of the value of fixed capital assets during production.  In other words, depreciation is the value of existing capital stock that has been consumed (used up) in the process of producing output.  Fall in the value of fixed assets due to normal wear and tear and to expected obsolescence is called consumption of fixed capital or depreciation.
  5.  Indirect Business Taxes are taxes levied by the government on production and sale of commodities.  For example, excise duty, sales tax, custom duty, etc. The buyer of a taxed commodity pays the tax indirectly because the tax is included in the price which the buyer pays. The effect of indirect tax is that it increases the price of a commodity.  The following steps are involved in estimating national income by the income method. • Identifying enterprises which employ factors of production (land, labour, capital and entrepreneurships), • Classifying various types of factor payments like rent, wages, interest and profit, • Estimating the amount of factor payments made by each enterprise, • Summing up of all factor payments made within the domestic territory to get the domestic income at factor cost,
  6.  Adding the value of depreciation and indirect taxes to domestic income at factor cost to get GDP MP ,  Estimating net factor income from abroad, which is added to GDP to obtain GNP. To correctly compute national income by the income method, the following precautions need to be taken.  Only factor incomes which are earned by rendering productive services are included. All types of transfer income are not included.  Imputed rent of owner-occupied dwellings and the value of production for self-consumption are included, but the value of self-consumed services is not included.  Income from illegal activities like smuggling, black marketing, etc., as well as windfall gains from lotteries, etc., is not included.
  7.  Example: GDP at market price measured by income approach, of a hypothetical nation.  Types of Income Amount (in millions Birrs)  Compensation of employees84,000  Rental income 9,200  Interest income 12,100  Profits (proprietor’s income) 30,000  Depreciation 10,000  Indirect business taxes 4,000
  8. Expenditure Method  The expenditure method gives us the value of GDP when measured at the point of expenditure. From the expenditure point of view, GDP is gross expenditure on the final use of domestically produced goods and services during a period of account.  Basically the final use of goods and services is for two purposes: consumption purposes for direct satisfaction of wants, and investment purposes, for expanding productive capacity.  And expenditure on them is called final consumption expenditure and final investment
  9.  There are 4 main components of expenditure that adding up and give GDP.  Consumption expenditure( C):It measures the money value of goods and services purchased by households for current use during a time period. In this category we include consumption expenditure by consumer households on all types of consumer goods (i.e., durable, semi-durable, and nondurable goods and services).  Investmentexpenditure (I ) Gross fixed capital formation: Expenditure on it consists of mainly two items Construction, and Machinery and equipment.
  10.  Change in stocks: This refers to the physical change in stocks of inventories like raw material, semi-finished goods and finished goods lying with the producers for smooth working of production processes. It is the difference between the stocks in the beginning of and at the end of the accounting year.  Government final consumption expenditure: It is defined as “Current expenditure on goods and services incurred in providing services of government administrative departments less sales.” It is incurred by general government to satisfy collective needs of the people. For example, government expenditure on health, education, general administration, law and order, etc. belongs to this category.  Net exports (exports less imports): This refers to the difference between the value of exports and value of imports. Note that exports and imports include both material goods as well as services.
  11.  We may thus sum up as follows: GDP=C + Ig + G + (X – M) where C is consumption expenditure, I is Investment expenditure G is Government expenditure and NX is Net export  Example: Calculating GDP by expenditure approach  ExpenditureAmount (in millions of Birr)  1. Personal final consumption expenditure 12,000  Durable goods 4,500  Non durable goods 1,500  Services6,000  2. Government final consumption expenditure 5440  Federal defense1040
  12. 3 Gross fixed capital formation (Gross private Domestic Investment)7410  Construction Expenditure3,940  Machinery equipment Expenditure2,200 (Business fixed investment) Changes in inventories1,270 4. Net Exports -11  Exports 194 Imports 205  GDP: 24,839  •To avoid double counting, expenditure on all intermediate goods and services is excluded.  • Government expenditure on all transfer payments, such as scholarships, unemployment allowances, old age pensions, etc., is excluded because non-productive services are rendered by the recipients in
  13. Production Method (Value Added Method)  In this method two approaches – ‘Final Product Approach’ and ‘Value AddedApproach’ – are adopted.  i. Final Product Approach: According to this approach, in the estimation of  GDP, we include the market value of all final goods and services produced in a country. For example, if we manufacture thread from cotton, cloth from thread and shirts from cloth, here shirts are the final good. Hence, we should include the value of shirts only in the calculation of national income.  Thus, GDP is calculated by multiplying all the final goods and services produced in a country with their respective market prices.  GDP = P (Q) + P (S) Where, P = Market price  Q = Quantity of goods  S = Quantity of services
  14.  Problem of Double Counting in the Final Product Approach: The final product approach cannot be used in actual practice because production is a continuous process and in this process it is difficult to know the final product. It gives rise to the problem of double counting.  What is the problem of double counting? Counting the value of a commodity more than once in the measurement of national income is called double counting.  So far as an individual enterprise is concerned, it considers its output as final product.
  15.  For example, for a farmer, cotton is a final product, for a spinning mill, thread is a final product, for a cloth- mill, cloth is a final product, and for a garment manufacturer, shirts are a final product.  All these enterprises take the sale value of their products as the value of their final output.  Since the above three methods are only different viewpoints of the same flow of goods and services, totals from each method should therefore be equal to each other.  When we take into account the sum total of the value of output of all these individual enterprises in the estimation of national income, it suffers the problem of double counting.  This leads to overestimation of the value of goods and services produced.  To overcome the difficulty of double counting, the value added approach is used.
  16.  ii.Value Added Approach: The value added approach measures the value added (contribution) by each producing enterprise in the production process in the domestic territory of a country in an accounting year.  Value added is defined as the difference between total value of the output of a firm and the value of inputs bought from other firms.  Clearly, the value added approach measures the contribution of each producing unit in the domestic economy without any possibility of double counting.
  17.  The following steps are involved in estimating national income by the value added approach:  Identifying all the producing units in the domestic economy and classifying them into three economic sectors: primary, secondary and territory sectors.  (The primary sector exploits natural resources, the secondary sector transforms one type of commodity into another, and the tertiary sector renders services.),  Estimating the value added by each producing unit. (By deducting intermediate consumption, from value of output, we get the value added.),
  18. • Estimating the value added of each economic sector by summing up the value added of all producing units falling in each industrial sector, • Computing GDP by adding up the value added of all economic sectors. • Estimating net factor income from abroad which is added to GDP to obtain GNP.  Example: Suppose there are four different stages having their own market transactions in production of bread.
  19. Stages values of transaction value added  Farmers grow wheat and sell to miller owner 0.12 0.12  Miller convert wheat to flour and sell to baker 0.28 0.16  The baker bake bread and sell to store owner 0.60 0.32  Store owner sell bread to consumer 0.75 0.15  0.75 = GDP 
  20. OtherSocial Accounts (GNP, NNP, NI, PI and DI)  GNP - Gross National Product It is the total market value of all final goods and services produced by residents/ citizens of nations.  NNP- Net National Product: It is the net market value of all the final goods and services produced by the normal residents of a country during a year. It can be calculated as:  NNP = GNP– Depreciation where Depreciation means loss of the value of fixed capital assets during production.  NI- National income (product) at factor cost expresses national income as the sum of all factor payments. It is income generated by factors owners.  It includes the following components.
  21.  i.. Employment compensation income – wage and salaries ii. Proprietor income – income earned by owner and un corporate business iii. Corporate income (profit) – income earned from corporate business. It includes corporate tax, dividends and retained earning iv. Rental income- income earned from capital assets like machineries v. Net interest – money income paid to savers and loanable funds.
  22.  Personal Income (Y)Personal income is the sum of earned income and transfer income received by persons (households) from all sources within and outside the country.  The point to be noted here is that personal income includes not only factor incomes which are earned from productive services but also transfer incomes (or payments) which are received without rendering any productive service.  It is a receipt concept as compared to national income, which is an earning concept.
  23.  Note that national income is not the sum total of personal incomes, since the former includes only earned incomes, whereas the latter includes earned incomes as well as transfer incomes.  Again, personal income is different from national income because two components of national income, namely, corporate tax and undistributed profit of corporate enterprise are not included in personal income.  The reason is that corporate tax goes to the government and undistributed profit is retained by the company — i.e., these two are not received by households.  Personal Disposable Income (Yd ): Personal disposable income is that part of personal income which is available to the households for disposal as they like .
  24.  Alternatively it is the income which remains with individuals after deduction of taxes and fees of the government.We can say, it is the income which the households can spend on consumption or can save as they please.  Because households utilize personal disposable income for personal expenditure and personal savings, PDI is also equal to personal expenditure + personal savings. Personal disposable income can be arrived at by deducting personal taxes (like income tax, property tax, fire tax, etc.) from personal income.Thus, Personal Disposable Income (Yd ) = personal income (Y) – personal taxes
  25.  Nominal GDPversus Real GDP  Economists use the rules just described to compute GDP, which values the economy’s total output of goods and services.  Economists call the value of goods and services measured at current prices nominal GDP. Notice that nominal GDP can increase either because prices rise or because quantities rise.  It is easy to see that GDP computed this way is not a good gauge of economic well-being.  That is, this measure does not accurately reflect how well the economy can satisfy the demands of households, firms, and the government.  If all prices doubled without any change in quantities, nominal GDP would double.  Yet it would be misleading to say that the economy’s ability to satisfy demands has doubled, because the quantity of every good produced remains the same.
  26.  A better measure of economic well-being would tally the economy’s output of goods and services without being influenced by changes in prices.  For this purpose, economists use real GDP, which is the value of goods and services measured using a constant set of prices.  That is, real GDP shows what would have happened to expenditure on output if quantities had changed but prices had not.  To see how real GDP is computed, imagine we wanted to compare output in 2009 with output in subsequent years for economy.  We could begin by choosing a set of prices, called base-year prices, such as the prices that prevailed in 2009. Goods and services are then added up using these base-year prices to value the different goods in each year.
  27.  Because the prices are held constant, real GDP varies from year to year only if the quantities produced vary.  Because a society’s ability to provide economic satisfaction for its members ultimately depends on the quantities of goods and services produced, real GDP provides a better measure of economic well-being than nominal GDP.  Significance of the Distinction  1 Real GDP (i.e., at constant prices) truly reflects the performance and level of economic growth in an economy, whereas Nominal GDP (i.e., at current prices) does not. Nominal GDP is affected by two factors: Change in physical output, and Change in prices.  If current market prices rise fast, Nominal GDP will also rise fast even though physical output remains the same.  In contrast, real GDP is affected by only one factor, change in physical output because prices are fixed or constant. Thus real GDP can rise only when there is a rise in physical output during a year.
  28.  A country is interested in change in physical output (real GNP) and not in monetary or Nominal GDP because an increase in real GDP leads to a rise in the standard of living of the people.  2 Real GDP is a better tool for making a year-to- year comparison of changes in the physical output of goods and services. A sustained rise in real GNP reflects the economic growth of the country, whereas a continuous fall in real GDP is an indicator of recession, and depression.  3 Real GDP is often used in making international comparisons of economic performance across countries.
  29. GDP Deflator versus CPI • measures price of output of current year relative to base year price • GDP Deflator = where Pc is general current year price, Pb is general base year price Consumer price index (CPI) measures the price of fixed “market basket” of consumer goods and services purchased by consumers relative to the price of that bundle during a particular base year. The base year is a reference year.
  30. • CPI = where Pc is general current year price, Pb is general base year price CPI tells us that how much it costs now to buy products relative to the same products in base year.
  31. Difference between GDP Deflator and CPI  The first difference is that the GDP deflator measures the prices of all goods and services produced, whereas the CPI measures the prices of only the goods and services bought by consumers. Thus, an increase in the price of goods bought only by firms or the government will show up in the GDP deflator but not in the CPI.  The second difference is that the GDP deflator includes only those goods produced domestically. Imported goods are not part of GDP and do not show up in the GDP deflator. Hence, an increase in the price of a Toyota made in Japan and sold in this country affects the CPI, because the Toyota is bought by consumers, but it does not affect the GDP deflator.  The third and most subtle difference results from the way the two measures aggregate the many prices in the economy. The CPI assigns fixed weights to the prices of different goods, whereas the GDP deflator assigns changing weights. In other words, the CPI is computed using a fixed basket of goods, whereas the GDP deflator allows the basket of goods to change over time as the composition of GDP changes.
  32. Unemployment and Inflation Unemployment  Unemployment is a situation in which able bodied persons willing to work at prevailing wage rate do not able to find job.  It is measured by rate of unemployment, which represents the percentage of those people who wants to work but cannot get any job.  Unemployment rate = ( )100 No of unemployed labor force where labour force is all persons over age 16 who are either working for paid job or actively seeking paid employment ( )100 No of unemployed labor force
  33. Types of unemployment  Frictional unemployment. Unemployment at full employment is termed as frictional unemployment.  The reason behind frictional unemployment is that it takes time to match workers with jobs.  The flow of information about job candidates and job vacancies is imperfect.  Geographical mobilties of workers are not instantaneous, in addition workers difference in preference and jobs have different attributes.  For all these reasons, searching for an
  34.  Structural unemployment  Structural unemployment arises due to structural change in dynamic economy and wage rigidity.  Such structural change includes change in the structure or sectorial composition of the economy due to technological change.  That is gradual decline of some kind of industries production and the emergence of new industries.  This situation makes some peoples with certain specific skill out of the labor demand resulting in structural unemployment.  Technological change also alters the demand pattern of different kind of skills.  Some skills become obsolete and less efficient resulting mismatch between labor demand and supply.  The second reason for structural unemployment is wage rigidity. Workers are unemployed sometimes not because of the skill gap at on-going wage rate but, the supply of labor exceeds the demand. The wage rate did not adjust to full employment level due to different factors.
  35. Some of them are presented as follows.  Minimum wage law  Minimum wage law is a law which set a legal minimum wages that firms pay their employee with different skills.  This will cause wage rigidity not to adjust to equilibrium level and creating unemployment.  Unions and collective bargaining  The wages of unionized workers are determined not by the equilibrium of supply and demand.  It is determined by collective bargaining between labor union leader and management.  In most cases they agree on wage above equilibrium level associated with a certain level of unemployment
  36.  Efficiency wage argument  According to efficiency wage theory higher wages make workers more productive.  So if wage increase the productivity of workers, firms will not cut the wage of workers even though there is excess labor supply.  As economists argue high wage increase wage productivity in different ways:  Higher wage enable workers to afford nutritious food and then have better health condition.  If workers become healthier they can supply more labor and effectively undertake different activities they are assigned to.  It also reduce labor turnover.  The more firms pay its workers, the greater their incentive to stay with the firm.  Therefore firms reduce labor turn over (cost and time of hiring and training new workers) by paying their
  37.  High wage reduce adverse selection in labor market. That is higher wage select quality (better performing) workers among less efficient workers.  High wage reduces the problem of moral hazard that exists between workers and firms. This is because when workers paid high wage above equilibrium, it improve workers effort with minimum monitoring.  All the above factors make wage rate rigid above the full employment equilibrium point resulting in structural unemployment.
  38. Cyclic unemployment  Cyclic unemployment is unemployment created associated with short run fluctuation of the economy.  Workers become unemployed for some period when their job evaporates due to recession and returns to job when there is expansion in economic activities.  Seasonal Unemployment  Unemployment occurred due to absence of job in particular season.  5. Disguised unemployment – unemployment occurred when more workers are engaged in job
  39. Inflation  In a broad sense, inflation is defined as a sustained rise in the general level of prices. Two points about this definition need emphasis.  First, the increase price must be a sustained one, and it is not simply a once for all increase in prices.  Second, it must be the general level of prices, which is rising; increase in individual prices, which can be offset by falling in prices of other goods is not considered as an inflation.
  40.  Thus we define inflation rate (Πt) as:  Πt= Pt- pt-1 x100  Pt-1  Where Ptis overall price index (CPI, GDP deflator) for time –t Pt-1 is over all price index for time t-1  Cause of inflation  Theories that deal with the causes of inflation generally classified into two major groups: Demand pull and cost push factors
  41.  (i)Demand pulls factors.  According to demand pull theory of inflation, inflation is the resulted from a rapid increase in demand for goods and services than supply of goods and services (fixed level of goods and services supplied).  Classical and Keynesian school explain differently the reason for increase in demand for goods more rapidly than supply.  For classical economist it is the result of monetary expansion.  Increase in money supply (additional flow of money in the economy) will increase demand for new investment and rises aggregate demand for goods and services.  This can be indicated by upward shift in aggregate demand curve from AD0 to AD1 indicated in the following figure.
  42. Y 1 Y P0 p1 Output/income Figure: 2 demand pulls inflation AD1 AD0 Price
  43.  This will create excess demand in the economy equals to . At equilibrium price, P0 consumers, businesses firms and government would want to purchase Y1 amount, but producer still supply only, amount.  This excess demand causes the price to rises to P1.  If the supply of goods and services is constrained by the predetermined full employment level of output as classical assumed or cannot increase as fast as demand, the excess demand in goods market cause raise in general level of price (inflation) 1 Y Y  Y 1 Y Y  Y
  44.  Classical economists considered an increase in money supply as a cause of increase in aggregate demand and then inflation.  For Keynesian aggregate demand increase also due to an increase in real factors such as increase in consumer demand, investment demand, government expenditure and Net export.  Such change may take place even when supply of money is constant. Inflation for Keynesian model is therefore initiated by fiscal or other non-monetary disturbances that cause excess demand for goods and services.  In general demand pull inflation is inflation initiated by some events, whether monetary, fiscal or private spending behaviour that cause increase in the aggregate demand above aggregate supply at fast rate
  45.  Cost push (supply side) factors  Cost push inflation occurs when different factors which increases cost of production (increases price of input) and other structural bottle neck cause firms to reduce the supply of goods and services below existing demand.  Now let us consider AD-AS model to explain how the above mentioned condition results in inflationary conditions.  As indicated in the following figure. Aggregate supply curve shifts upward from AS to AS1 for a given level of price.  This happens when different factors causes supply of equilibrium output decrease from Y0 to Y1 which result in increase in price due to excess demand created at initial equilibrium level of prices.
  46. • At initial equilibrium price producers supply Y2 amount of output, but consumers, government and business firms wants to purchase Y0–Y2 amount. This excess demand for goods and services push price to increase from P0 to P1. Price AS1 Y1 Y0 P0 P1 AS0 AD Y2 Output/ income Figure: 2.3 cost push inflation
  47.  As indicated above one factor which cause decline in supply of goods and services at on-going demand includes increase in price of input like labour, oil and other raw material, these factors cause increase in cost of production, decrease in labour employment and output supplied.  The other supply side factors is different types of supply shocks which result in unexpected disturbance in supply position of some major commodities or key industrial inputs.  When the shocks reduce the supply of some items that have large weight in price index, there is sudden rise in the general prices of an economy. Such items for example includes food prices due to crop failure and price of industrial input like coal, steel , cement, oil and basic chemicals.
  48.  The rise in price may be also caused by supply bottleneck in domestic economy or international events.  The Sudden rise in the OPEC oil prices during 1970s due to Arab-Israel war can be cited as supply shock that causes inflation.  Most of the inflation theories developed above are based on institutional setting and assumptions relevant to developed western economies.  The search for appropriate explanation to inflation in less developed countries led to the emergence of a new school of economists called the Structuralist theories of inflation.
  49.  According to the Structuralist view, inflation in developing economies is caused mainly by the structural imbalances in these economies. The major structural imbalance includes:  Food scarcity: Defective system of land owner ship, low rate of saving and investment, technological backwardness and low level of agricultural infrastructure causes low food supply against rising demand for food due to increase in population and urbanization.  This will create gap between demand and supply which result in increase in food price.
  50.  Resources imbalance: Most LDCs are surplus in labour but extremely deficient in capital and other complementary resources.  Capital deficiency is caused by low levels of income, saving and investment.  In addition, government of LDCs has experience of gap between its expenditure and revenue.  To finance deficit or the gap, government increase money supply without increasing output.  This will cause difference between supply and demand for goods and services which leads to inflationary condition.
  51.  Foreign exchange bottle necks: LDCS heavily depend on import for the development needs for capital goods, industrial raw materials and other essential goods.  For this reasons, they need foreign exchange. But foreign exchange earnings are very low because of their comparatively low exports.  Their exports are low due to their low exportable surplus, high cost of production, inferior product quality and low competitiveness of their goods in foreign market.  This result in severe scarcity of foreign exchange. Therefore, they are forced to adopt restrictive policy which results in reduction of domestic supply and leads to substantial rise in price.
  52.  Infrastructural bottle necks: LDCs are characterized by inadequate and inefficient industrial infrastructures which cause the growth of industrial output low than rising demand.  On the other hand, growth imperative force call for further investment in infrastructural facilities which fuel expansion of demand, eventually end up with inflation.
  53.  Economic effect of inflation  Generally inflation reduces real money balance or purchasing power of money.  Banks charge their customer a nominal interest rate from their loans. Nominal interest rate however determined based on inflation rate as it is represented by fisher’s equation below.  I= r+П ---------Fisher’s equation  Where I- nominal interest rate, r-real interest rate  П -expected inflation. m p       m p      
  54.  Therefore, increase in inflation will increase in the nominal interest rate and cost of money holding. That is, the opportunity cost of holding money is the interest income for gone by holding liquid money rather than buying government bonds or deposits of bank.  This implies inflation decreases demand for money (cash holding) and changes asset portfolio management.  If the portfolio holding shifts from money to consumer durable, inflation causes decline in economic growth by reducing investment.  But if the portfolio management shifts to capital
  55.  Inflation reduces investment by increasing nominal interest rate and creating uncertainty about macroeconomic policies.  Inflation increases uncertainties about macroeconomic policy and adversely affects the public decision making ability.  Inflation redistributes wealth among individuals.  Unanticipated inflation hurts individuals with fixed income (pension).
  56.  Shoes leather cost of inflation. Inflationary condition lowers the purchasing power of money. So if people hold more money its cost will increase which is measured in terms of interest rate forgone by holding liquid money. Therefore people hold lower money balance on average and they must frequently go to banks to withdraw their money. This will cause different type of cost and metaphorically it is known as shoe leather cost of inflation  High inflation always associated with variability of prices which includes firms to change their price list more frequently and requires printing and distributing new catalogue. This is known as menu cost of inflation.  Some economist believes that moderate level of inflation (2 to 3) percent per year is good to stimulate the economy. That is a moderate level of inflation reduces real wage and then increase level of employment (decreases unemployment) and output.
  57.  Measures to control inflation  Monetary measures  As we discussed before, classical macroeconomists argue that inflation is any time a monetary phenomenon.  That is inflation originate from increase in money supply in excess of its optimal level.  Therefore, they hold the view that control of money supply through appropriate monetary policy (Bank rate, reserve requirement ratio, open market operation) greatly effective in controlling inflation.
  58.  Fiscal measures  Keynesians or fiscalists argue that inflation originates in the real (product) sector due to an increase in aggregate demand in excess of aggregate supply.  The excess demand may result from the increase in expenditure by households, firms and government.  Therefore, fiscal policy or the budgetary measure are a more powerful and effective weapon to control demand pull inflation.  When excess demand is caused by the government expenditure in excess of real output, the most effective policy measure is to cut public expenditure.  On the other hand if the excess demand is caused by the private expenditure, that is, the expenditure by households and firms, taxation of incomes is a more appropriate measure to control inflation since taxation reduces disposable income.
  59.  Price and wage control measures.  Monetary and Fiscal policies are ineffective in controlling cost push inflation.  Thus if the inflationary condition is the result of cost push, it is advisable to introduce price and wage control measures rather than using monetary and fiscal policy.
  60.  Flucuaion in Economic Activities  Economic fluctuations are simply fluctuations in the level of the national income of a country representing growth or contraction. A market economy is not static. It's dynamic.  A rise in national income means an economy is growing, while a decline in national income means that an economy is contracting.  For a whole economy to trend upward or downward, it is necessary to look at the aggregate demand side of the economy and that means looking at what is happening to
  61. The Business cycle  The ups and downs of the economy in the short run are known as business cycle.  It is a regular pattern of expansion and contraction in economic activity around trend growth.  All industrialized societies are subject to recurrent fluctuations in economic activity.  Even though the fluctuation characterizes all macro variables, in most case business cycle primarily represents fluctuation of output or GDP along the trend.
  62.  Phases of Business Cycles  There are four distinct phases of cycles through which economy can be moving. These phases have been called by different names by different economists 1. Depression (Trough) or Lower turning point phase 2. Recovery (Expansion) or upswing phase 3. Boom (Peak) or Upper turning point phase 4. Recession (contraction) or Downswing Phase Depression (Trough) is when the level of economic activity (level of production and employment) at the lowest level.
  63.  Recovery (expansion) Phase is the phase when revival of economic activity makes economy to move to peak. In this phase, both output and employment are increasing. The gap between potential output and actual output closes to zero. Due to high economic activity people enjoy a high standard of living.  Full employment of resources and production implies there is no involuntary unemployment.  Boom (Peak) phase is when the level of economic activity (level of production and employment) is at the highest level.  Recession (contraction) phase is the phase when
  64. Fig: phases of business cycle without growth trend
  65.  Theories of Business Cycles:  There are different schools which explain the cause of cyclic fluctuation of output (economic activity) along the trend. Let us consider some of them.  Keynes argued that a deficiency of spending would tend to depress an economy.  This deficiency might originate from low consumer saving, business investment or insufficient government spending.  Whatever its origins, lack of aggregate demand would cause persistently high unemployment and then depression.  If total spending increases, business firms find themselves profitable to invest and increase output.  To produce more output, business firms employee resource which causes expansion of output.  This fluctuation of output along trend for Keynesian is the result of fluctuation in aggregate demand.
  66.  Monetarist theory of business cycle  The monetarists argue that in the long run output is determined by the supply side of the economy to give a level of output consistent will full employment.  In this case changes in the rate of growth of the money supply only leads to changes in the prices level.  In the short run, however, changes in the money supply can cause fluctuations in the level of output .  Since money and credit affect the ability and willingness to pay of peoples, change in money supply cause change in aggregate demand and then output produced.  That is contraction of money supply causes contraction of the economic activities by contracting aggregate demand (total spending of the economy).  On the other hand expanding money supply causes expansion of aggregate demand through decreasing interest rate and increasing price level
  67. Real business cycle theory  Real business cycle theorists’ emphasizes the real sector as a determinant factor for business cycle.  Fluctuation for level of output and employment along the trend is the result of different real shock hitting the economy.  These real shocks include technological changes, International disturbances, climate changes and other natural disasters. Assume that there is favourable shock to technology.  This will increases labor productivity, labor demand and current real wage resulting in expansion of the total output.  When there are negative technological shocks, the total output produced in the economy declines in the short run. Such response of the economic activities to real shocks causes business cycle.
  68.  Rational expectation theory  A rational expectation model assumes that agents expectation about the future value of macro variables made by the best use of whatever information is available to them and the expectations are formed in a manner consistent with the way the economy actually operate.  The crucial element in this view is how these fluctuations in money are transmitted in to output. In this transmission mechanism individual producers play a key role, since it is their inability to distinguish between changes in general level of price and changes in relative prices when they form expectation give rise to the business cycle.
  69.  The problem faced by producers is that they are not able to observe the aggregate price level in current period, although they assumed to have expectation as to what it will be. If these expectations are correct then there is no business cycle.  That is if expected and actual prices resulted from change in money supply (aggregate demand) are identical then there is no deviation of output from its trend.  Therefore it is the deviation of expected price from the actual price that results in business cycle according to New classical theory.
  70.  Output grows faster than the trend level; if the actual price faster than expected average price.  This is because if suppliers believe they observe their prices rising faster than inflation; they are encouraged to raise output above the trend level.  When they realize that they have made mistakes and that the rise in their prices was just a rise in the average price level, output falls back to its trend rate.  Thus business cycle, are generated by agents’ misperceptions of their prices relative to the average price level.