GDP = Consumption (C) + Investment (I) + Government Expenditure (G) + (Export (X) – Import (Y))
= {$60 + $5 + $8 + ($7- $10)} billion
= ($60 + $5 + $8 – $3) $ billion
=$ 70 billion
Injection = Investment + Government Expenditure + Export
= (5 + 8 +7) $ billion
= $ 20 billion
Withdrawal = Saving + Tax + Import
Given no information on saving and Tax, there is only one source of leakages namely imports.
Therefore, withdrawal = Import = $10 billion
Tax revenue = $ 7 billion
Saving = Tax revenue – government expenditure
= ($7 – $8) billion
= -$1 billion
The negative amount represents dissaving.
If GDP raises to $80 billion, then change in GDP = ($80 -$70) billion = $10 billion
Previously domestic consumption = Total consumption – import
= ($60 – $10) billion
= $50 billion
Now, consumption of domestically produced goods rises to $58 billion
Change in consumption = ($58 – $50) billion
= $8 billion
Initial level of GDP = $80 billion
Export rises by $4 billion
Investment rises by $1 billion
Government expenditure falls by $2 billion
Current GDP = ($80 + $4 + $1- $2) billion
= ($85 – $2) billion
= $83 billion
Therefore, GDP will rises by ($83 – $80) = $3 billion.
Inflation captures gradual increase in the price level. There are both demand and supply side factors that causes price level to rise. When price increases because of an increase in aggregate demand then it is called demand-pull inflation while inflation resulting from an increase in production cost is known as cost-push inflation (Mankiw, 2014).
There are different factors that cause an increase in aggregate demand. Change in any exogenous factor causing an increase in demand shifts the aggregate demand curve to the right. Figure 1 explains this. Suppose there is an increase in aggregate demand shifting the demand curve from AD to AD1. With given aggregate supply, this leads to an increase in price level from P* to P1.
Cost-push inflation resulted from an increase in production cost and raise price through an inward shift of the supply curve. Suppose, in an economy there is a sudden increase in input prices. As a result, there will be contraction of supply seen as a shift of the supply curve from AS to AS1. With a contraction of supply, price will go up from P1to P2.
Economic growth: In a growing economy, demand follows a general increasing trend. When economy grows, then people’s income increases. People become more confident and willing to spend more money on consumption. This raises demand in the economy and price increases.
Expansion of money supply: In times of expansionary monetary policy government increases supply of money (Weale et al., 2015). This means people have more money to spend on goods. This increases demand for goods and services and push-up price level.
Causes of cost-push inflation
Wage inflation: When wage increases, then firm have to pay a high wage to worker. This raises production cost and hence supply contracts (Shapiro,2016). Because of supply shortage price increases.
Natural disaster: In times of natural disaster, there is disruption in production and supply. Because of natural disaster, there is depletion of natural resources. This limits supply of goods and cause inflation.
The policymakers in a nation target to achieve full employment. However, the term full employment does not mean measured unemployment is zero. The zero unemployment is a myth and is an unhealthy sign for the economy. Even a healthy economy has some amount of unemployment. People always make transition between jobs causing frictional unemployment. When unemployment rate is zero or close to zero, then this means there is something odd with dynamic movement of people between jobs. In order to eliminate frictional unemployment the new jobs created should match the skills of those leaving jobs. The frictional unemployment reflects flexibility of the workers to move between jobs. This is the reason macroeconomic policy should not target zero unemployment. Instead, a low unemployment of less than 3% is targeted for a healthy economy. The level of unemployment that an economy always has is called natural rate of unemployment.
The long-term classical model is built with downward sloping aggregate demand curve and a vertical aggregate supply curve. In this mode, the equilibrium is determined only at the level of full employment. If price is above the equilibrium price, then there is an excess supply while below equilibrium there is an excess demand. Therefore, economy is always at full employment level. Any unemployment according to classical economists is only temporary and the autonomous adjustment process restores full employment (O’Brien, 2017). Unemployment in the economy only indicates a disequilibrium phenomenon.
Structural unemployment is the type of unemployment caused from structural mismatch. Structural unemployment occurs when people do not have skills required for specific jobs. Unemployment arises because of a mismatch of skills and geographical location. Cyclical unemployment is resulted from business cycle fluctuation. In times recession, people remain the economy undergoes with a gradual downturn (Petrakis, Kostis& Kafka, 2014).This by pulling down aggregate demand lead to contraction of economic activity. With lower job opportunities, unemployment increases.
Both cyclical and structural unemployment are cause of concern for policymakers. Structural unemployment resulted from mismatch between workers’ skill and available jobs leads to long term unemployment and raises the natural rate of unemployment. For structural unemployment, unemployed workers of one industry should be absorbed by some other sectors of the economy. Here, policymakers or government has very little scope of intervention. However, cyclical unemployment resulted from declining demand during recession can be reduced by taking expansionary policy to stimulate aggregate demand in the economy.
The balance between aggregate demand and aggregate supply determines the macroeconomic equilibrium in an economy. Corresponding to the equilibrium price and income levels are determined (Agénor&Montiel, 2015).An improvement of marketing and management skill will increase the supply of skilled labor force. This in turn increases aggregate supply shifting the AS curve to the right. As the aggregate supply curve shifts, the economic equilibrium shifts from E1 to E2. Accordingly, in the new equilibrium price level declines while GDP increases.
An increase in personal income tax will reduce disposable income of the household. The household now have less income to spend on goods and services. As consumption expenditure decreases, the aggregate demand decreases as well. This is shown from the leftward shift of supply curve from AD to AD1. At new equilibrium E1, both GDP and price decreases.
Net export is an important component of aggregate demand. With increase in export earnings from export increases as well. Given import, this increases net export and shift the demand curve outward from AD1 to AD2. The equilibrium shifts from E1 to E2. At E2, there is an increases in both GDP and price level.
After destruction of capital stocks, suppliers in the economy left with less amount of capital. Capital being one of the major inputs of production, a decrease in capital supply hampers production. The supply curve shifts inward from AS to AS1. With shift of the supply curve price level increases owing to a supply shortage. The level of economic activity decreases as reflected from a decline in GDP.
Large categories: CPI includes a large basket of goods that make it a legit indicator of inflation. CPI includes category like food, beverages, transportation, housing and meditation.
Measurable: As CPI includes only quantifiable objects, it becomes easier to compare price and level of inflation.
Consistency and flexibility: Two-core strength of CPI is consistency and flexibility. CPI measures the costs of a certain basket of good, which remain consistent representing the average cost that consumers face to maintain an average standard of living (Fallis, 2014).The flexibility of CPI is reflected in various versions of CPI that take into account external factors like seasonal adjustment and choice of consumers.
Limitation of Consumer Price Index
Quality of product: CPI measures cost of living and an increase in CPI implies increase in price or inflation. However, it might also be the case that price of the good increase due to an improvement of quality. CPI does not include qualitative aspect.
Fluctuation: During price fluctuation, people changes their preference of goods and services. This is not considered while computing CPI. CPI continues to take the old basket of goods.
Overestimation of inflation: CPI does not take into consideration technological improvement in production of goods.
Inflation that captures variability of price level leads to a change in income distribution of the society. Some people gain while some loses for same level of price increase. The poorer section of the society likely to be suffers from inflation, as they are unable to protect themselves against increasing prices. People in the fixed income groups lose. There are four categories of people suffering from loss in real income. These are salaried people, government bondholders, renter class and pensioners. The gain or lose to wage earners depend on their terms of job contracts and ability to obtain an increase in payment. On the other hand, professional and business people gain from inflation. As price rises faster than cost, profit increases (Schneider, 2014). Inflation causes a redistribution of income from the fixed income people to those earning variable income. Savers are also penalized from inflation as real return from saving decreases during inflation. Lenders are benefitted during inflation at the cost of borrowers.
References
Agénor, P. R., &Montiel, P. J. (2015). Development Macroeconomics Fourth edition. Economics Books.
Fallis, G. (2014). Consumer Price Index. Encyclopedia of Quality of Life and Well-Being Research, 1217-1218.
Mankiw, N. G. (2014). Principles of macroeconomics. Cengage Learning.
O’Brien, D. P. (2017). The classical economists revisited. Princeton University Press.
Petrakis, P. E., Kostis, P. C., & Kafka, K. I. (2014). Structural and Cyclical Unemployment. In The Rebirth of the Greek Labor Market (pp. 39-48). Palgrave Macmillan, New York.
Schneider, M. (2014). Redistribution effects of inflation. Journal of Economic Dynamics and Control, 49, 49-51.
Shapiro, M. D. (2016). Supply shocks in macroeconomics (pp. 1-7). Palgrave Macmillan UK.
Weale, M., Blake, A., Christodoulakis, N., Meade, J. E., & Vines, D. (2015). Macroeconomic policy: inflation, wealth and the exchange rate (Vol. 8). Routledge.
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