INTRODUCTION TO MACROECONOMICS LECTURE NOTES

1. INTRODUCTION
Basic concepts and scope of macroeconomic analysis
Economic Theory
Is a statement that tries to explain economic phenomena, to interpret why and how the
economy behaves and what is the best to solution – how to influence or to solve the economic
phenomena. They are comprehensive system of assumptions, hypotheses, definitions and
instructions what should be done in a certain economic situation.
Economic Models
Economic model is a construct(equation) incorporating two or more variables that: describes
the relationship that exists between the variables; depicts the economic outcome of their
relationships; predicts the effects of changes in the variables on the economic outcome.
Macroeconomics
This is the branch of economics that attempts to analyze and explain the interrelationships
between aggregate (totals) variables such as output, employment, interest rates, money and
prices in the economy. These are the key variables that determine economic activities and
level of national income in an economy. Macroeconomics therefore analyses the performance
of the economy as a whole.

Macroeconomics deals with the following:

(i) Total output of goods and services (GNP)
 What determines the GNP level?
 Why is it that GNP grows at a lower rate in some years than in others?
(ii) Total employment and unemployment levels
 What proportion of total population is unemployed?
 What determines levels of unemployment?
(iii) General price level
 Shows cost of purchasing by a typical consumer
 Estimates inflation and anticipated effects
(iv) Balance of payment problem.
(v) Exchange rates.
Macroeconomic Models
These are simplified explanations or theories of how the economy works, i.e. simplified
explanations of the real word.

For example
The behaviour of consumption spending in an economy can be represented by a simple model
as follows

Ct    Yt  Yt 1
Where
Ct  consumption in the current period
Yt  Current level of income
Yt 1  Pr evious period ' s level of income

This model is a simplification of the real world situation because some factors that are
important in influencing consumption behaviour are excluded. The other factors that affect
level of consumption in the economy include; wage rate, interest rate, price, capital gains,
money stock, attitudes, consumer credit and money illusion among others.

Macroeconomic models help in the forecasting of future trends of the economy.

A model can be tested by how well it can explain past events and if it can predict accurately
the path of the economy.
A good model improves understanding, forecasts and facilitate decision-making by policy
makers.

The major goals/aims of Macroeconomic Policy

Research on other goals apart from these 4
1. Full employment
- Unemployment is where some resources are not optimally utilized and are lying
idle. Full employment is favoured because the greater the level of employment,
the greater the amount of goods and services available in the economy. It is also
argued that the burden of unemployment and loss of goods and services fall
disproportionately on people who are without jobs.
2. Price stability
- Inflation should be avoided at all costs so that prices remain stable and predictable
over time. This is important because inflation affects other people more adversely
than others. For example, people whose incomes rise more rapidly than prices and
those who are able to borrow at relatively low interest rates prior to inflation
benefit from inflation.

3. Economic growth
- Economic growth takes place when real output increases more rapidly than the
increase in population, thus with economic growth the society has more goods and
services at its disposal and a correspondingly higher standard of living.

4. External balance
- If a country has a favourable balance of payment (BOP), its foreign exchange
reserves will increase, hence can import the much needed capital for investment.
Unfavourable BOP would lead to an outflow of foreign exchange to finance the
trade deficit

Importance of Macroeconomics
1. Facilitates estimation of GNP, which aids in the analysis of the economy’s performance;
2. Facilitates the study of the nature and size of material welfare of the society;
3. Knowledge of macroeconomics is important in economic policy formulation by
governments. For example we are able to understand how aggregate variables like GNP,
wage rate, consumption, savings, investment, interest rates etc, will be affected by a
change in government expenditure, tax policy, monetary policy, foreign exchange rates,
4. It predicts the impact of exogenous (external) variables on the endogenous (internal)
variables.eg price of crude oil on prices of products in Kenya.

The limitations of Macroeconomics

1. Macroeconomic theory treats the variables it deals with as internally homogenous and
overlooks the significance of internal composition and structure of such variables
2. It tends to make generalizations about the whole economy based on small samples, yet
the samples may not accurately reflect the overall picture. The propositions that are true
for individuals or small groups are not necessarily true for the economy.
3. The variables may not be functionally related. In such a case, the macroeconomic policies
that are formulated will be erroneous. For example, aggregate consumption will only be
useful for analysis if it is functionally related to levels of income, wealth ,interest rates,
capital gains, relative prices, money stock, attitudes and expectations, consumer credit,
etc
4. Aggregate models that may be derived to explain the behaviour of the economy may end
up not conforming to the real world. For example, the bulk of the macroeconomic theory
developed so far has been relevant to developed countries since most models have been
constructed in those countries. These models are far from reality in developing countries
2. NATIONAL INCOME, OUTPUT AND EXPENDITURE

The circular flow of income

The circular flow model describes the flow of resources, products and incomes among
economic actors.

For simplicity, consider an economy with only two actors; households and firms. They
interact in a circular pattern as in the diagram below

Product

Market

Households Firms

Resource

Markets

The households
- Supply resources (land, labour, capital and entrepreneurial skills) to the resource
markets and receive earnings for those resources
- Demand goods and services from the product markets. make payments for those
goods and services using the incomes they receive
The firms
- Demand resources from the resource markets for production of goods and services
- supply goods and services to the product markets

Products and resources flow in a counterclockwise direction while payments for these items
flow in the opposite direction

The above case assumes an economy with no government and does not participate in foreign
trade. However, many countries trade with others and also have governments that actively
participate in the economic activities. Thus in such an economy there are 4 actors;
Households, firms, government and rest of the world
Circular flow open economy with government
Other than there being only resource and product markets there are also money markets in the
economy. a more elaborate circular flow model would therefore include all these actors and
the markets in which they interact as follows.

Rest of
M The world

I
X
G
Money C+I+G+X-M
C
S Market
Households B Firms

GNP
Disposable Government Taxes
Income
Transfers

C = Consumption expenditure G = Government purchases and Spending

S = Savings M = Imports

I = Investment spending X = Exports

Leakages
These refer to any diversion of aggregate income from the domestic spending i.e. a
withdrawal from the circular flow. They include; Savings (S), Taxes (T), and Imports (M)

Injections
These refer to any payment of income other than by firms or any spending other than by
domestic households on an economy. These include; Investments, Government purchases
including transfers (G), Exports (X),
Three approaches to measurement of National income
(i) Expenditure Approach
Sum up all the market expenditures by final consumers including the purchases of
capital goods by the business community. we include expenditures on final goods and
services only.
AE = C + G + I + (X – M)

(ii) Income Approach

Sum up all the incomes received by individuals and firms. These include; wages,
salaries, profits, interests, rents, e.t.c. Payments or earnings for people who do not
supply goods or services (transfer payments) are excluded.

Aggregate income(Y) = w + r + i + π

(iii) Product or Output Approach

Add contributions of all individuals at each stage of production to total outputs plus
value added of each industry from public, private, and subsistence sectors. We only
consider contribution to production for each firm (Net output). The method is also
referred to as Value Added Approach.

GDP and its related concepts

Gross Domestic Product (GDP)
The total money value of all final goods and services produced in a country’s boundary
during a given period of time usually one year.

Gross National Product (GNP)

The total money value of all final goods and services produced from factors of production
owned by a country’s nationals during a given period of time regardless of where they are
located.

Net National Product (NNP)

The total output of goods and services produced by residents plus the net increase in the
economy’s total capital stock (That is, production of new capital goods in excess of
replacement of depreciated capital goods) during any given period of time. It is computed as
follows;
NNP = GNP – Depreciation (capital consumption allowance)

National income (NI)

This refers to the total amount of income earned by the factors of production in an economy
during a certain period. it is computed thus;
NI = NNP – (indirect taxes ) + (subsidies)

Per capita income

Refers to national income divided by the population of that particular country= NI/Popn

Personal Income (PI)

Refers to the total income of persons or households from all sources before taxation;
computed as;

PI = NI – (retained corporate profits + social insurance payments) + (interest incomes

received by households + transfer payments to households)

Disposable Income
Referred to as the after tax personal; incomes to households. Thus it is computed as;
DI = PI – Personal income taxes. This is the total amount of income which is available for
use by households. This money can either be saved or incurred in the form of consumption
expenditure (DI = C + S)
Difficulties in measuring National income
1. Incomplete Information- some important information may not be available or may be
inaccessible
2. Danger of double counting- Costs of raw materials (intermediate goods) may be
included in national income accounting
3. Unpaid services- Services that people do for themselves and others that are not paid
for are usually excluded from national income accounting
4. Depreciation- Replacement costs for worn out parts may not be considered
 5. Inventory valuation- there are many methods(read on this) that can be used and each
may give different results.
6. Changes in the value of money- changes in the market prices (value) of final products
due to inflation may result into changes in the measure of national income even if real
output may not have changed.

Read on :

Factors determining size of an economy’s National Income

(i) Stock of factors of production in terms of both quality and quantity
- land (fertile or infertile)
- Labour (required skills or not)
- availability of good or bad infrastructure
(ii) the state of technical knowledge
- whether there is know-how or not and whether the technology is appropriate or
not
(iii) Participation rate
- proportion of economically active group compared to the general populace
(iv) political stability
- whether the country is politically stable or not

Uses of National income accounting

 Highlights information about size of various sectors in the economy. For example
GNP gives information about consumer expenditures, taxes and investments
 Highlights information about economic performance of the economy overtime. for
example annual growth rates
 It is an indicator of structural change (transformation) in the economy of a country

National income and social welfare

The question asked here is that; is per capita income /national income a good measure of
material well being of the people?
Per capita income is not a good measure of material well being of the people because of the
following reasons;
 it does not look at the distribution of income within the economy.
 increased national income could be due to increased number of working hours, implying
that people do not have leisure which adversely affect their health conditions.
 It is a measure of production and consumption which are not measures of welfare of
people.
 it does not consider deterioration to the environment through air and water pollution,
deforestation…
 is a statistical device that measure changes in economic activity and thus does not deal
with quality of life.
 it does not account for varying demands for different countries
 there are inaccuracies in computing statistical data thus figures for such income =are
suspect.
 Changes in GNP figures can be due to changes in prices over time but not due to changes
in output.

MONEY AND BANKING

Money and its Basic Functions
Money is an asset that is generally acceptable in transactions. Money can be defined as
narrow or broad money. Narrow money is composed of money balances that are held to carry
out the day-to-day spending. Broad money refers to money balances held as a store of value
in addition to that held for transaction purposes.
Money has four basic functions
1. As a unit of account: it is a unit of measurement and therefore facilitates quick
comparison of the values of various goods and services. It also aids in financial
accounting of business as well as expressing the values of a country’s GNP and
balance of payment.
2. As a store of value: It enables individuals to delay a potential purchase to the most
convenient time by providing them with a way in which to store their purchasing
power. Its efficiency as a store of value however, is affected by inflation.
3. As a medium of exchange: It simplifies the transaction process since the double
coincidence of wants, required for barter is unnecessary.
4. A standard of deferred payment: Since many transactions are conducted on the basis
of credit, it is convenient for the debts to be expressed and payment made in money
 terms. This particular role of money is also affected by inflation, making money less
efficient.

As a medium of exchange, money needs the following properties.

1. Durability: Money needs to be durable to withstand the frequent movement from one
hand to another as a medium of exchange.
2. Acceptability: Money must be acceptable by all those involved in transactions
otherwise it will collapse as a medium of exchange.
3. Divisibility: Money should be divisible to facilitate effective exchange since different
goods and services fetch various prices.
4. Portability: Money should not be cumbersome to carry
5. Liquidity: Money should be liquid i.e. it should be easy to carry out transactions using
it.

Financial Institutions
Properties of Money
Are organizations legally bound to deal with finances. There are three categories of these
institutions namely: -
 Commercial Banks
 Central Bank
 Non-bank financial institutions

A commercial bank is a financial institution, which accepts deposits and gives credit. It
performs three main functions:
 To facilitate exchange of money
 To provide facilities for savings to depositors
 Distribute credit to business enterprise and consumers

Central bank is the financial institution at the center of the banking system. Its functions
include:
 Issue of currency (notes and coins)
 Supervision of banks and other financial institutions
 It is the bankers’ bank (lender of last resort)
  Government’s bank
 Represents the country in international monetary meetings.

Multiplier and accelerator

The multiplier
Multiplier

The multiplier refers to the phenomenon whereby a change in an injection of expenditure (either investment,
government expenditure or exports) will lead to a proportionately larger change (or multiple change) in the level
of national income i.e. the eventual change in national income will be some multiple of the initial change in
spending.

We need to be aware that changes in any of the components of AD (e.g. investment) may have a larger effect on
GDP/GNP than just the value of the change. This is known as the multiplier effect. Let's look at what may
happen if there was an injection of extra money into government provided health care in an economy. Certainly,
some of the money will go to doctors and nurses in the form of a salary increase or to employ new doctors and
nurses, but new building and equipment will probably also be bought. This will boost sales of those making
such items and so allow them to consume more. This 'first round effect' is the big boost to spending within the
economy.

However, doctors eat, drink and consume just like the rest of us and they too will spend some of their salary
increase. The producers of the goods and services they buy will take on more labour and these people will spend
part of their salary and so it goes on. The amount that is passed on will diminish in each successive round of
spending but the overall injection into the economy will be greater than the first sum that was put into it. The
size of the multiplier can be worked out by dividing the increase in national income that eventually occurs by
the increase in injections that caused it.

Multiplier = change in GDP / change in injections

So, for example, if an increase in government spending of $10m caused GDP to rise by $50m, this would be a
multiplier of 5. This would be found by dividing $50m (the change in GDP) by $5m (the initial change in
injection of expenditure).

The key determinants of the value of the multiplier are:

 The size of the savings ratio - the more people save of any increase in income, the less the increase in
spending at each stage of the process.
 The amount spent on imports - if a lot of the extra spending created goes on imported goods and
services, then this money will be lost out of the country and not passed on within the economy.
  The level of taxation - any increase in income will also mean higher tax revenue. However, if the
government use this extra revenue to spend on public sector investment and employment, then this may
help the process continue.

Overall, the value of the multiplier therefore depends on the amount of any increase in income that is spent by
the people receiving it. This is known as the marginal propensity to consume (MPC). The higher the MPC,
the higher the value of the multiplier will be.

Marginal propensity to consume

The marginal propensity to consume is the proportion of each extra Sh of income spent by households. For
example, if a person earns Sh1 more and consumes 70c of it, then the MPC is 0.7.

The value of the multiplier can be calculated from the following formula:

Multiplier = 1 / 1 - MPC = 1 / MPS

Where MPC is marginal propensity to consume and MPS is marginal propensity to save.

But, how exactly is the multiplier determined?

The multiplier effect and the effectiveness of fiscal policy

The multiplier concept may be used to show how the use of fiscal policy to combat unemployment can be very
effective. Expansionary fiscal policy may involve an increase in government expenditure. That will have the
effect of shifting the AD curve to the right. Part of the Keynesian argument concerning the effectiveness of such
a policy relates to the multiplier effect.

The argument is that the government's own expenditure provides only the first round of increased expenditure.
The recipients of increased government contracts or government salaries increase their consumption demand,
and the recipients of this increased purchasing power are in turn able to increase their demand for goods and
services and so on.

The result is that the final increase in AD will therefore be larger than the initial increase in government
expenditure that caused it.
Figure 1 The impact of the multiplier on aggregate demand

In Figure 1 above, an increase in government expenditure shifts the AD curve to the right to ADg. The level of
income therefore rises to Yg. In time, the first round of effects of the increase in government expenditure give
rise to the second and third round effects and so on, such that the final level of aggregate demand is at AD2 and
the level of income is at OY2. The initial change in AD is the distance Y1Yg. The final change in income is
Y1Y2 and so the multiplier will be the final change divided by the initial change that caused it.

Accelerator

We have already looked at how economies tend to grow in cycles - we called this the trade cycle or business
cycle. One of the major factors contributing to this cycle is the instability of investment. When the economy is
doing well, firms will invest to provide the extra capacity they need for increased production. However, when
growth starts to slip, firms will tend to stop investing - in fact investment may become negative. Why invest if
there is no need for extra capacity and you cannot even sell what you are currently making! The changes in
investment during the different phases of the trade cycle may therefore be several times that of the rise or fall in
income.

So we can see that investment depends not so much on the level of income and consumer demand, but on
their rate of change. Firms are investing to provide production capacity and so they will invest according to
how much demand is growing, not according to the actual level of demand. This link between investment and
the rate of change of demand is called the accelerator theory. Fluctuations in investment will be much greater
than those in income, but because investment is an injection into the circular flow of income they will have a
multiplied effect and this will magnify the ups and downs of the trade cycle.

The accelerator principle states that changes in the level of current income, leading to changes in output of
consumer goods, will lead to proportionately greater, or accelerated changes, in the output of capital goods, i.e.
investment.

Importance of the accelerator

The accelerator principle indicates how changes in the level of current income will have an accelerated impact
on the level of investment and is therefore one explanation of economic instability and the upward and
downward swings of the trade cycle.

Accelerator principle - some qualifications

 The upward leverage effect of the accelerator only takes effect if industry is operating at or near full
employment. If industry has excess capacity it can meet a larger demand by increasing output of
underutilised equipment.
 Additional machines will only be ordered when the increased demand is believed to be permanent.
Otherwise firms will deal with additional orders by running down stocks or operating waiting lists.
 There may be an increase in demand for investment goods, but if the capital goods industries are fully
employed, there may be an increase in the prices of capital goods and there could actually be a fall in
demand for capital with more capital saving techniques being adopted. Here the accelerator will be
reduced.

Weaknesses of accelerator theory

The accelerator assumes a fixed relationship between a change in consumption and a change in investment - the
bullet points above show that this is not necessarily the case.

The accelerator principle also ignores the time lags which would probably occur in reality between a change in
consumption and the implementation of any investment decisions.

Business Cycle
A business cycle is a cycle of fluctuations in the Gross Domestic Product (GDP) around its
long-term natural growth rate. It explains the expansion and contraction in economic
activity that an economy experiences over time.
A business cycle is completed when it goes through a single boom and a single contraction in
sequence. The time period to complete this sequence is called the length of the business
cycle. A boom is characterized by a period of rapid economic growth whereas a period of
relatively stagnated economic growth is a recession. These are measured in terms of the
growth of the real GDP, which is inflation-adjusted.
Stages of the Business Cycle
In the diagram above, the straight line in the middle is the steady growth line. The business
cycle moves about the line. Below is a more detailed description of each stage in the
business cycle:

1. Expansion
The first stage in the business cycle is expansion. In this stage, there is an increase in positive
economic indicators such as employment, income, output, wages, profits, demand, and
supply of goods and services. Debtors are generally paying their debts on time, the velocity
of the money supply is high, and investment is high. This process continues as long as
economic conditions are favourable for expansion.

2. Peak
The economy then reaches a saturation point, or peak, which is the second stage of the
business cycle. The maximum limit of growth is attained. The economic indicators do not
grow further and are at their highest. Prices are at their peak. This stage marks the reversal
point in the trend of economic growth. Consumers tend to restructure their budgets at this
point.

3. Recession
The recession is the stage that follows the peak phase. The demand for goods and services
starts declining rapidly and steadily in this phase. Producers do not notice the decrease in
demand instantly and go on producing, which creates a situation of excess supply in the
market. Prices tend to fall. All positive economic indicators such as income, output, wages,
etc., consequently start to fall.

4. Depression
There is a commensurate rise in unemployment. The growth in the economy continues to
decline, and as this falls below the steady growth line, the stage is called a depression.

5. Trough
In the depression stage, the economy’s growth rate becomes negative. There is further decline
until the prices of factors, as well as the demand and supply of goods and services, contract
to reach their lowest point. The economy eventually reaches the trough. It is the negative
saturation point for an economy. There is extensive depletion of national income and
expenditure.

6. Recovery
After the trough, the economy moves to the stage of recovery. In this phase, there is a
turnaround in the economy, and it begins to recover from the negative growth rate. Demand
starts to pick up due to low prices and, consequently, supply begins to increase. The
population develops a positive attitude towards investment and employment and production
starts increasing.
Employment begins to rise and, due to accumulated cash balances with the bankers, lending
also shows positive signals. In this phase, depreciated capital is replaced, leading to new
investments in the production process. Recovery continues until the economy returns to
steady growth levels.
This completes one full business cycle of boom and contraction. The extreme points are the
peak and the trough.

Explanations by Economists
John Keynes explains the occurrence of business cycles is a result of fluctuations in aggregate
demand, which bring the economy to short-term equilibriums that are different from a full-
employment equilibrium.
Keynesian models do not necessarily indicate periodic business cycles but imply cyclical
responses to shocks via multipliers. The extent of these fluctuations depends on the levels of
investment, for that determines the level of aggregate output.
In contrast, economists like Finn E. Kydland and Edward C. Prescott, who are associated
with the Chicago School of Economics, challenge the Keynesian theories. They consider the
fluctuations in the growth of an economy not to be a result of monetary shocks, but a result of
technology shocks, such as innovation.
UNEMPLOYMENT
I. Unemployment
Definition
Unemployment refers to a situation where individuals that are supposed to be used in
production are willing and able to be employed at the existing wage rates, but are unutilized
or underutilized. Unemployment rate is computed as follows
Number unemployed
 100
Total number of workforce

Types of unemployment

1. Open Involuntary Unemployment

This is where people who are not working and are able to work at the existing wage rate
cannot get jobs.

Wage
(w) LS

W1

W0

LD

0 N0 N N1 N (labour)
 LS = labour Supply curve LD = Labour demand curve
N = Equality in the labour market W = Existing wage rate

From the above diagram, it can be observed that:

- People who are not working (N 1 – N0 ) have same qualifications as those who are
working (ON0).
- Wage rate is rigid due to imperfections in the labour market, e.g. government’s
minimum wage rate, presence of labour unions, etc.
2. Open Voluntary Unemployment
- Is where people are able to get jobs at existing wage rate but prefer not to work.
3. Natural rate of unemployment
- This is the level of unemployment that exists when the economy is at full employment,
producing its potential output.
4. Frictional Unemployment
- This is caused by the time lag involved in redeployment of labor. This land of
unemployment is caused by mobility problems in the labor market, which result in
friction in the labor market. This friction is either due to communication problems or
mismatch between job opportunities and job seekers.
5. Seasonal Unemployment
- This arises due to the seasonal nature of some productive activities e.g. production in
the agricultural sector.
6. Structural Unemployment
- Results either from change in demand occasioned by change in consumer tastes and
preferences or from technological change.
7. Cyclical Unemployment
- Is caused by business cycles or swings in the economy e.g. depression and boom
8. Under-employment
- It occurs when people are working less than they would like to work. Or when people
are in jobs that totally underutilize their skills and competence.
9. Disguised Unemployment
- Individuals do not want to do certain jobs because of their qualifications
10. The unemployment of Prematurely Retired
- This occurs when people are retrenched before they attain retirement age.
https://www.youtube.com/watch?v=ENHyev3IqHs

Causes of Unemployment
1. Lack of cooperating factors/inputs
2. rapid population growth
3. Inappropriate technology
4. Relative factor price distortions
5. The education system
6. seasonal nature of production
7. Rural urban migration

Policies for curing Unemployment

1. Wage subsidies. Subsidizing wages means lowering wages hence firms will employ
more people.

LS
Wage

W*

W’
LD’
LD

L L* L’
Labour

If the wages is at W and you subsidize, you are lowering wage rates from W to W’
hence employing more people
2. Restructuring the education system to provide more skills so that people become more
productive.
3. Increasing the number of institutions to train agricultural labour and then subsidize
capital since labour works with it
4. Increasing incentives by changing product prices. This raises the benefits from labour
thus causes a shift in the demand for labour
 5. Import substitution. More people will be employed in the industries that produce what
the country used to import
6. Export promotion. This will expand output hence increase labour employment.

II. Inflation
Definitions

1. General Price level

Price level is the average of current prices across the entire spectrum of goods and services
produced in an economy. In more general terms, price level refers to the price or cost of a
good, service, or commodity in the economy.
The general price level is a hypothetical daily measure of overall prices for some set of goods
and services (the consumer basket), in an economy or monetary union during a given interval,
normalized relative to some base set.
Given the many goods in the market, the government chooses a representative group called a
market basket and calculates the cost of purchasing the items in the basket. The cost of the
market basket of goods and services in the current year is then compared with the cost of the
same basket in a certain base year.

2. Price Index

A price index is a number used to measure the price level. The value of the index is set at
100 in the base year or period. If the price index in a given year exceeds 100 the price level
in that year is higher than it was in the base year. The reverse is true.

3. Inflation

Inflation refers to persistent increase in the general price level over time.

4. Deflation

Deflation refers to persistent downward movement in the general price level overtime for an
aggregate of goods and services.

Forms of Inflation(Level)
1. Creeping
Creeping inflation is when the price rise is 3% or lower and is scheduled to rise in all coming
years. This type of inflation is beneficial for the economy as it promotes demand among
consumers. According to some governments, the price rise of 2% or less benefits the
economy. The consumers are prepared for the price rise and hence buy the product now to
beat future higher prices.

2. Walking
This inflation is between 3 to 10% a year. This is harmful to the economy as it heat s up the
cycle. People are willing to buy more and more to beat future high prices which affect supply
as well. Suppliers can’t keep up the supply drive among people.

3. Galloping
This inflation rises to 10% or more and is absolute havoc to the economy. Money loses its
value very fast and businesses can’t keep up with cost and prices. Investors avoid the country,
the government loses its credibility, and the economy becomes unstable. This inflation at any
cost should be avoided at any cost.

4. Hyperinflation
It is when prices skyrocket more than 50% a month and this situation is infrequent. This
usually happens when the government prints money to pay for wars.

Types of Inflation
Open inflation
Occurs when there are no barriers to price rise and no government controls

Suppressed inflation
Refers to a situation where demand exceeds supply, but the effect in prices is minimized
through the use of instruments like price controls and rationing of essential goods by
government. The symptoms of this type of inflation include long queues, black
markets and diversion of scarce resources away from essential producing industries to other
industries.

Stagflation
Occurs when price increases are accompanied by declining output producing unemployment

Measurement of Inflation

Inflation is measured by:

(i) The consumer price index (CPI) – measures the relative changes in the prices of a
specified set of market basket of consumer goods, which are bought by a typical urban
household regularly.

(ii) The producer price index (PPI) – measures relative changes in the prices of raw
materials, intermediate and finished goods i.e. at all stages of the productive process
rather than at the stage of the ultimate user.

Causes of Inflation
1. Demand-pull Inflation
It arises from a situation in which aggregate demand persistently exceeds aggregate supply at
current prices. In this case, the aggregate demand (C + I + G) line is too high, resulting to
inflammatory pressure.

Price AS

P’

P
AD(2)

AD(1)

Real GDP

Demand-pull inflation is caused by:

(i) Increases in the level of demand for goods and services in a situation of near
employment
(ii) A general shortage of goods and services in times of disaster like floods and
earthquake.
(iii) Export surplus leading to foreign currency inflows that cause increases in the money
supply. These inflows become a source of inflationary pressure.
(iv) Expansion of in government spending by borrowing from the banking system where
this is not matched by an increase output.
2. Cost-Push Inflation
While GDP is below its potential level, costs are increased, perhaps because unions push up
wages, and in an attempt to protect their profit margins firms push up prices. This price
increases affects the cost of other firms and the consumer’s cost of living. As the cost of
living goes up, labourers feel entitles to, and obtains higher wages to offset the higher living
costs. Firms again pass on the cost increase to the consumer in the form of a price increase.
The so-called wage – price spiral is at the heart of cost-push inflation.

AS’
Price

AS

P’

AD

Real GDP

The following factors cause cost-push inflation:

(i) Labour unions asking for higher wages without a corresponding increase in
productivity.
(ii) Manufactures fixing high profit margins.
(iii) An increase in import price of an essential commodity like crude oil that leads to
escalation of prices in the economy
(iv) Government imposing new taxes of higher taxes
(v) Structural rigidities in production that leads to increasing average costs.

Effects of Inflation
Internal Disadvantages
 Income and wealth are redistributed arbitrarily, for inflation imposes a tax on those who
hold money as opposed to those holding real assets.
 Inflation reduces the standard of living of persons dependent on fixed incomes, for
example, pensioners. It benefits debtors and penalizes lenders.
 Interest rates rise, both because people require a higher reward for lending money which
is falling in value and also because the government is forced to take anti-inflationary
measures.
 Investment is discouraged by government anti-inflation policy. In practice, controls
imposed on prices are more effective than those on costs, particularly those on wages.
The result is discouraged because postponing consumption simply means that goods cost
more if bought later.
 Inflation encourages speculation by the purchase of real assets by borrowing rather than
investment by the use of resources in production. Indeed inflation discourages
investment in long-term projects because possible government anti-inflation policies are
difficult to forecast.
 Inefficiency is encouraged because a buoyant seller’ marked blunts competition as higher
prices obtained for their products allow even inefficient firms to survive.
 Inflation generates industrial and social unrest since there is competition for higher
incomes. Thus, because of rising prices, trade unions ask for annual wage rises. Often
demands exceed the rate of inflation, anticipating future rises or seeking a larger share of
the national cake to improve their members’ real standard of living. Those with the most
‘muscle’ gain at the expense of the weaker groups.
 Additional administrative costs are incurred in offsetting go-slow and work to rule
disruptions, allowing for inflation in negotiating contracts and wage rates, revising price
lists and labels, among others.

 The rate of inflation tends to increase, largely because high wage settlements in
anticipation of higher future price help to bring about the very rise in which people fear.

External Effects
Inflation can create serious difficulties for a country that depends on international trade.
These difficulties include:
 Exports tend to decline because they are relatively more expensive in foreign markets.
 Imports tend to increase because foreign goods are relatively cheaper compared to
Kenyan goods.
 Higher money incomes in the economy increase the demand for imports and tend to
decrease exports because the buoyant home market makes it less vital for manufacturers
to seek outlets abroad for their goods.
 An outward movement of capital may take place if price rises continue since foreign
traders and financiers lose confidence in the shilling maintaining its current rate of
exchange.

However, a positive effect of mild demand-pull inflation is that it may lead to higher
investment and therefore higher employment within the economy.

Remedies of Inflation
Fiscal and Monetary Policies
These are also known as demand management polices. They are effective especially against
inflation caused by excess demand.

The fiscal policy measures include:

 A cut in government spending
 Lowering government borrowing
 An increase in taxation
 Introduction of new taxes
These measures directly reduce aggregate demand.
The monetary policy refers to actions that aim at a reduction in money supply or a reduction
in its rate of growth. The measures include:
 Restricting direct lending to government
 Increasing cash or liquidity ratio requirement on commercial banks and financial
institutions thereby reducing their ability to create credit.
 Rising interest rate i.e. the cost of borrowing
 Increasing the cost of overnight borrowing by commercial banks.

Prices and Incomes Policy

This type of action can take a number of forms as summarized below:
 Government impose on firms to avoid unjustified price rises and to unions to avoid
unjustified wage claims.
 The setting up of a prices and incomes board to examine proposed price increases and to
contribute to collective bargaining between employers and unions. SRC in Kenya
 Bringing together of employers’ and unions’ organizations in an attempt to obtain some
voluntary agreement from both parties to keep prices and incomes at current levels.
 The impositions of legislation to regulate or even freeze wages and prices.

Indexation
This policy is sometimes called index linking. It works by linking economic variables for
example wages, salaries, and interest payments to an index of inflation like the consumer
price index. This means that as the price index rises, wages, salaries and interest payment
rises simultaneously.
The Philips Curve

Inflation

Rate

Unemployment

The Philips curve postulates that in general, the rate of inflation fall as unemployment rises
and vice-versa.
The curve therefore shows that there is a trade-off between inflation and unemployment
meaning that a lower rate of inflation could be achieved but only at the cost of higher rate of
unemployment.

The Philips curve thus validates the Keynesian argument that in order to achieve full
employment some level of inflation is unavoidable.
CAT 2 Jan 2025 . Topics : Costs , Profit , Markets , All Macroeconomics including inflation