CAT / FIA FBT Syllabus A. The Business Organisation, Its Stakeholders - Economic Issues - Notes 3 / 4
The impact of economic issues on the individual, the household and the business
Inflation
The inflation rate is the percentage rate of increase in the economy's average level of prices.
A high inflation rate means that prices on average are rising rapidly, while a low inflation rate means that prices on average are rising slowly.
In inflationary periods, retired people or those about to retire are those of the biggest losers since their hard-earned savings will buy less and less as prices go up.
While a high inflation rate harms those who have saved in the past, it helps those who have borrowed.
It is this capricious aspect of inflation, taking from some and giving to others, that makes people dislike inflation.
People want their lives to be predictable, but inflation throws a monkey wrench into individual decision making, creating pervasive uncertainty.
An inflationary gap exists in an economy when aggregate demand (total demand in an economy) is greater than the full employment level of income.
One important measure of the general rate of inflation in the UK used over many years has been the Retail Price Index (RPI).
The RPI measures the percentage changes month by month in the average level of prices of the commodities and services, including housing costs, purchased by the great majority of households in the UK.
The items of expenditure within the RPI are intended to be a representative list of items, current prices for which are collected at regular intervals.
Causes of inflation
Demand pull inflation
Demand pull inflation arises from excess demand over productive capacity of the economy.
It is a situation when demand exceeds supply and prices rise.Demand pull inflation only exists when unemployment is low.
Considering the case scenario in the graph below, P1, that is price 1 was the original price when national income was Y1.
When demand pull takes place, the curve AD1 shifts to AD2 since demand increases (too much money chasing too few goods).
As a result, P1 increases to P2 reflecting inflation and Y1 increases to Y2 reflecting an increase in national income.
When P1 decreases to P3, that means that demand decreased, shifting AD1 to AD3 resulting in a decrease in national income from Y1 to Y3.
In a situation when inflation is rising, demand side policy which is controlled by the government would focus on reducing aggregate demand through tax rise, cuts in government spending and higher interest rates.
This is done in an effort to regularise inflation to control it from continuing to rise.
Cost-push inflation
This is a result of increases in the costs of production thus short-run aggregate supply (SRAS) shifts from SRAS1 to SRAS2. Its effect leaves an increase in price from P1 to P2.
Thus, this increase in price is in fact inflation. Cost-push inflation arises whether or not there is a demand for supply, for example, an increase in the cost of wages.
Imported inflation
Cost of import rises regardless of whether there is a high demand for supply, for example, an increase in oil prices.
The same explanation sticks from point no. 2 case scenario.
Monetary inflation
Monetary inflation means an increase in the supply of money. There is a debate whether an increase in money supply is a cause of inflation or whether an increase in the money supply is a symptom of inflation.
What happens is that the more supply in money, the more people will buy thus demand will increase.
As a result, if this increase in demand occurs faster than the expansion in the supply of goods and services, then, inflation will take place.
Monetarists (supply side view) argue that a good tool to fight such inflation is to decrease the supply of money and increase interest rates.
Expectations effect
Once inflation has started to rise, there may be “expectational inflation”, that is, people will start expecting inflation to rise even higher.
A general held view of future inflation therefore, sets for example, wages accordingly.
This is known as the wage-price spiral.
Unemployment
Unemployment rate is the number of jobless individuals who are actively looking for work divided by the total of those employed and unemployed.
The higher the overall unemployment rate, the harder it is for each individual who wants to find work.
Everyone fears a high unemployment since it raises the chances that they will be laid off from their present work, will be unable to pay their bills etc.
A government can try several options to create jobs or reduce unemployment.
Spending more money directly on jobs
Encouraging growth
Encouraging training in job skills
Offering grant assistance to employers
Encouraging labour mobility
Types of unemployment
category comments real wage unemploymentcaused when the supply of labour exceeds demand but real wages do not fall. caused by strong trade unions which resist a fall in wages.abolishing (put an end to) closed shop agreements and minimumwage regulations are policies which may be directed at reducing realwage to market clearing levels.frictional difficulty in matching quickly workers with jobs. possibly caused by lack of knowledge of job opportunities. usually temporaryseasonal especially in certain trades as farming etc structural occurs during long-term change in conditions. for example, a long-term change in a community that relies on one particular industrytechnological a form of structural that occurs then new technology arises. cyclical or demand-deficientmatches economic climate trends such as boom, decline, recession and recovery. demand for labour fluctuates as demand rises and falls
Stagnation or Stagflation
This is a combination of unacceptably high levels of unemployment and unacceptably high levels of inflation.
During the 1970 in the UK a major rise in the price of crude oil took place.
This meant that the cost of energy rose and therefore rendered some products unprofitable.
National income fell and both prices and unemployment rose. Any long term major increase in costs could have this effect.
International payments Disequilibrium
A “fundamental disequilibrium” exists when outward payments have a continuing tendency not to balance inward payments.
Disequilibrium may occur for various reasons.
Some may be grouped under the head of structural change (resulting from changes in tastes, habits, institutions, technology, etc.).A fundamental imbalance may occur if wages and other costs rise faster in relation to productivity in one country than they do in others. Imbalance may also result when aggregate demand runs above the supply potential of a country, forcing prices up or raising imports.
For example, a war may have a profoundly disturbing effect on a country’s economy