Please Answer the following questions.

You need to refer the text book recommended to answer the questions.

1. Explain the meaning of inflation and recession.  (5 marks)

2. Explain the meaning of Fiscal Policy and Monetary Policy. (5 marks)
3. Discuss the types of Fiscal Policy and Monetary Policy to overcome the problem of
recession(or economic downturn). (10 marks)
4. Discuss the types of Fiscal Policy and Monetary Policy to overcome the problem of
inflation. (10 marks)
5. Describe the two types of inflation. Please draw 2 diagrams to answer this question.
(10 marks)
6. Describe the 5 types of unemployment. (10 marks)
Answers :

1. Explain the meaning of inflation and recession

Inflation : inflation is defined as a persistent and sustained increase in the aggregate

or average price level of goods and services in an economy. An inflation implies that
there is an increase in the cost of living that causes lower purchasing power. It is
situation where there is ‘too much money chasing too few goods’. There is, thus, an
inverse relationship between inflation and the value of money. When inflation is high,
the value of money will be lower, and vice versa. With inflation, there is a loss of the
value of a currency because the consumer’s money now will not buy as much today
as it could yesterday.

Recession : Recession is a period during which aggregate output declines. During

the expansion phase of the business cycle, total employment, total production and
sales will experience growth in real terms, after excluding the effect of inflation.
However, the consequences of a recession to the economies are devastating,
whereby they indicate they indicate negative signs of lower demand, fewer output,
laid off workers and finally, create unemployment crisis. The unemployment rate
increases during recession and decreases during a contraction.

2. Explain the meaning of Fiscal Policy and Monetary Policy

Fiscal Policy : Fiscal policy refers to policy which affects the aggregate demand by
altering the balance between government expenditure and taxation. Fiscal policy also
deals with the government management of the economy by varying the size and type
of economy, the type of taxation, public debt, government expenditure and
government revenue.

Monetary policy : Monetary policy refers to a policy used by the central bank to
control the supply of money as an instrument for achieving the ultimate objectives of
the economic policy, such as price stability or low unemployment. The central bank
directly influences economic growth by controlling the amount of liquidity in the
financial system through guiding interest on loans, mortgages and bonds.
3. Discuss the types of Fiscal Policy and Monetary Policy to overcome the problem of
recession (or economic downturn).
i) Expansionary Fiscal Policy
When an economy is in recession or depression, the expansionary fiscal will
be used to stimulate economic activities. Naturally this type of fiscal policy
results in an increase in government spending and lower taxes. A
recessionary or deflationary gap occurs when the actual GDP is below its
long-run level. It shows that aggregate demand at which the GDP is lower
that it would be in a full employment situation. A government will usually
increase their spending which will directly increase the aggregate demand in
order to close this gap, since government spending create demand for goods
and services. The national income will increase through the multiplier effect.
Simultaneously, the government may decide to lower taxes which indirectly
increase the aggregate demand curve by allowing consumers to have more
money at hand to spend and invest. This may result in an increase in
production and an expansion in the economy. The use of this expansionary
fiscal policy will result in a shift of the aggregate demand curve to the right,
thus closing the recessionary gap and promoting economic growth.

ii) Expansionary Monetary Policy

Expansionary Monetary Policy aims to increase money supply, lower the
interest rate and increase aggregate demand. This policy is used to control
the unemployment during recession. The instrument used such as buying
government securities and bonds through open market operations,
decreasing the required reserve ratio and decreasing the bank rate. It will
cause the money supply curve to shift rightward, leading to an increase in real
GDP and, hence, lowering the unemployment level.

4. Discuss the types of Fiscal Policy and Monetary Policy to overcome the problem of
inflation.
i) Contractionary Fiscal Policy
Policy that is used as a macroeconomic instrument by the Federal
government to slow down the economy. Contractionary fiscal policies are
authorized by a government to government expenditure and, eventually, the
spending in the country. This policy is the use of government spending
taxation and transfer payment to shrink the economic output. When an
economy is in a situation. Where its growth is at a rate that rampantly causes
 inflation contractionary fiscal policy may be used to bring it to a more
sustainable level.

ii) Contractionary Monetary Policy

Contractionary Monetary Policy is a policy that aims to decrease money
supply. It is used to control inflation. The instruments used such as first is
selling government bonds through open market operation, second is
increasing the required reserve ratio and third is increasing the bank rate.
This will cause the money supply curve to shift leftward, leading to a decrease
in real GDP and hence, lowering the inflation rate.

5. Describe the two types of inflation. Please draw 2 diagrams to answer this question.
i) Demand-pull inflation
This type of inflation is caused by an increase in the aggregate demand and
the cost push is due to increase in the cost of production while the monetary
inflation is caused by increase in the supply of money. Keynes adapted his
theory of how excess demand can cause inflation in fully employed economy
at the beginning of the World War II. He stated that the demand-pull inflation
occurs when aggregate demand (AD) exceeds the aggregate supply (AS).
As AD = C + I + G + (X – M), any increase of these variables will cause
aggregate demand to rise. For example, a rise in consumer demand (C), or a
rise in investment by firms (I) or an increase in government expenditure (G) or
a rise in net exports (X – M) from foreign countries or any combination of the
four components will shift the AD to curve to the right as shown by diagram
below. For example, with reduction in income tax, it will cause consumption
(C) to rise, a fall in interest rate induces investment (I) while a reduction in
exchange rate encourages more net export (X – M). Hence, all these
economic variable will also stimulate the rise of AD. Among these, the most
important factor is an increase in government expenditure (G) as it has direct
multiplier effect on AD.
According to Keneysian, there are 3 stages occurred in economy. In diagram
below, when the economy is in a recessionary stage, aggregate supply curve
is horizontal. Assuming the initial aggregate demand is at AD 0 aggregate

supply is horizontal supply curve. Hence when AD increase from AD 1 to AD 2,

AD 2 intersect with horizontal AS at the equilibrium price of P0 and in the

equilibrium output of Q 2. Price still remains at P0 because factors of
production are still available in the economy. The rightward shift of AD from
AD 1 to AD 2 only result in the rise of output form Q1 to Q 2 without any price
increase. At the second phase of economy, when there is less idle resources
with decreased unemployment, the AS curve is shaped as upward sloping,
refers as normal AS curve. Hence, referring to diagram below, if AD 2 shift

upwards to AD 3, the price will begin to rise slowly from P0 to P1, output

increase to Q 2. If AD increases further to AD 4, the price level will increase to

P2 and output increase to Q 3. Inflation at this phase is mild and creeping. It is

in the normal economy range.
At the third phase of economy when AS is vertical and constant at full-
employment output, a rightward shift of AD to AD 5 causes the price level to

increase rapidly to P3. A further increase of AD to AD 6 again causes the price

level to increase substantially to P4 . Notice here that output still remains

constant at Y f because resources are fully employed. When industries cannot

respond to changes is AD, price will begin to rise rapidly. This is called
demand-pull inflation as the excess demand will pull the prices up causing the
demand-pull inflation. Hence, the demand-pull inflation is associated with
booming economy. The essence of demand-pull inflation is that ‘too much
spending chasing too few goods’.
ii) Cost-push inflation
This type of inflation occurs when a shortage of supply of labour, shortage of
raw materials, crop failures or capital drives up the cost of production and
decreases aggregate supply, thereby raising the supply level. Aggregate
demand still remains the same, but since there are fewer goods or services,
the supplier can charge more for each unit.
Price increases even before full employment is reached, results in ‘supply
shock’ inflation. This is because the increases in the costs of production are
passed onto the consumers in the form of higher prices. Cost-push inflation
can only occur if demand for the end product of service in inelastic, such as
gasoline, because people cannot find other substitute goods to replace it. If
the demand is elastic, the people will either buy less of the product or switch
to other cheaper goods. Cost-push inflation is shown in diagram below, where
a leftward shift of the aggregate supply raises the price level. The various
factors that cause the leftward shift in the aggregate supply are as follows:
a) Wage costs (wage-push inflation)
Cost-push inflation is due to wage increases that cause businesses to
raise output prices to cover higher labour costs. Higher output prices in
turn will lead to a higher demand for even higher wages. This process is
called the wage-price spiral. The increase in wage level may be due to the
negotiation of a strong trade union, for wage increases higher than the
current inflation rate or the firm itself has increase the wage level to
prevent their workers from moving to other firms. If wages increase more
than productivity, the cost of production will rise, causing the aggregate
supply to decrease and fueling inflation or output prices. In view of this,
the government should use prices and income policies to limit the
freedom of trade unions to raise wages and employers to raise prices.
b) Import prices (import-push inflation)
Import-push inflation is caused by an increase in the prices of imported
raw materials, intermediate goods or final goods and services. With
globalization, many firms import a significant proportion of their raw
materials or semi-finished products. If the import prices increase, then
firms will be forced to increase prices to pay for higher raw materials
costs.
c) Exhaustion of natural resources became scarce, the aggregate supply
curve will shift to the left and price will increase. For example, overfishing
has caused the price of many types of fish and fish-based products to rise
higher each year.
d) Fall in exchange rate
A fall in the external value of country’s currency will worsen inflation as
lower exchange rate will cause imports to become more expensive.
Hence, firms will have to pay more for their imported raw materials or
machinery. This will increase the cost of production and result in a cost-
push inflation.
e) Government regulation or taxation (tax-push inflation)
Producers are allowed to pass on the increase in indirect taxes (taxes on
expenditures) to the consumers and this will push up the selling price of
products in the shops. For examples, taxes on unhealthy products such
as cigarettes and alcohol which were meant to lower the demand for
these goods, can also raise the prices of these products and create
inflation.
 Diagram above shows that the economy is at the normal range of short-run
aggregate supply, with the SRAS curve sloping upwards. It is at the second
phase of the Keynesian economy where full employment, Y f , is yet to be

achieved. The initial economy is at SRAS 0 intersecting with AD 0, with the

equilibrium price of P0 and real output of Y 0. When there is cost-push inflation

due to the increases of costs of production, the short-run aggregate supply
curve will shift leftwards from SRAS 0 to SRAS1, hence pushing the price level

up to P1 and reducing the real output Y 1.

6. Describe the 5 types of unemployment.

i) Classical unemployment
It is also called the real wage unemployment. Arise when trade unions drive
wages in excess of the market clearing levels, resulting in a fall in demand for
labour. Trade unions usually negotiate to increase real wages causing
classical unemployment. Classical unemployment is also caused by
government minimum wage. To reduce classical unemployment, the
government has to control trade unions to prevent wage increments. If real
wages decline, consumer expenditure will reduce which in turn lowers the
quantity demand for labour. Minimum wages has to be reduced, the low-skills
workers will be at a disadvantage.
ii) Frictional unemployment
This refers to short-term or temporary unemployment which occurs when
people enter the labour market to look for jobs or people leave their jobs,
either voluntarily or are asked to go, and are unemployed for a period of time
while they are looking for a new job. Frictional unemployment includes new
entrants such as school-leavers, fresh graduates and re-entrants such as
people who quit their jobs for a better position or higher wages or former
homemakers. Hence, there is a time lag during which a worker is unemployed
when he/she is moving from one job to another. Frictional unemployment also
caused by geographical or occupational immobility of labour. Geographical
 unemployed happens when jobs are available in big cities but unemployed
workers may not be able to move to there due to difficulties in getting housing
or other reasons. Occupational immobility happens when there may be skilled
job available, but many workers do not have the relevant skills. There are few
actions to be taken to overcome this problems. The government can set up
one stop centres for a job seekers, where they match the unemployed to any
suitable job vacancies. It also can be reduced by better advertisement
through newspaper, radio and internet.
iii) Seasonal Unemployment
This happens when certain product cannot be produced during a certain
season. Therefore, many workers are temporarily laid off on a short-term
basis during certain times of the year. It results from regular fluctuations in
weather conditions, climate changes or change in the trend of demand.
Seasonal fluctuations in unemployment occurs in construction workers who
will be unemployed during rainy season, fisherman who are unable to fish
during the monsoon season or in winter and tourist workers who are
unemployed during off-peak periods in some tourist areas. The solution is to
have matching seasonal industries which can share the labour force. More
jobs can be created through diversification and integration of economy in
agricultural, manufacturing, construction, transportation, finance, insurance
and services sectors.
iv) Structural unemployment
Structural unemployment often leads to regional unemployment and the
impact can be quite serious when major industries tend to be heavily
concentrated in certain regions. Regional unemployment occurs when an
industry, which is concentrated in a particular area has to close down.
Structural unemployment is made worse by the geographical or occupational
immobility of workers. To overcome this problem, government can :
a) Set up tor retrain workers in new skills to improve occupational mobility.
b) Encourage workers to move to regions and industries where job are
available.
c) Encourage firms to move into areas where there are high levels of
unemployment by giving tax incentives.
v) Technological unemployment
This problem arises from labour-saving technique of production or new
technology which requires workers with different sets of skills. The workers
who lost their jobs will have to develop new skills and the government can
helpby providing retraining or re-skilling programmes.