RESOURCE PACK/ ECONOMICS/A LEVEL

MACROECONOMIC POLICIES, UNEMPLOYMENT AND INFLATION

(a) MACROECONOMIC POLICIES

Governments share the same main objectives of macroeconomic policy regardless of whether they
are developed, emerging or developing economies. In seeking to achieve these macroeconomic
objectives, governments can use a range of policies although each of these policies has its
limitations. There can also be conflicts among policy objectives. The main government
macroeconomic policy objectives are:

• full employment
• low and stable inflation
• equilibrium in the balance of payments position
• sustainable economic growth and avoidance of exchange rate fluctuations.

INTRODUCTION TO FISCAL AND MONETARY POLICIES

Traditionally, fiscal and monetary policies have been used in virtually all types of economies to
manage aggregate demand in order to achieve the government’s macroeconomic objectives.

FISCAL POLICY

Fiscal policy is the way in which governments manage aggregate demand by making changes to
taxation and government expenditure. This is the traditional Keynesian approach. Government
expenditure is financed by tax revenue. If projected government expenditure exceeds projected
revenue from many forms of taxation then there is a budget deficit. This is where the government
sees the need to reflate the economy by increasing aggregate demand. Normally this is in response
to a situation where there is need to expand the economy in order to create more jobs. When
government revenue from taxation exceeds the projected expenditure by the government on social
protection, health care, education, transport and so on then there is budget surplus. Here the
government has identified the need to deflate the economy by cutting back aggregated demand.

MAKE ECONOMICS EASY WITH MR KAYBEE: +263 71 818 1255 (APP/CALL)

 RESOURCE PACK/ ECONOMICS/A LEVEL

SUMMARY

When the government raises direct taxes, it lowers the household disposable incomes and therefore
aggregate demand for goods and services will decrease. The increase in tax will however raise
government revenue. The opposite is also true. An increase in government expenditure has the
effect of raising aggregate demand for goods and services. When this happens firms will have to
raise their supply as well in order to meet the increase in aggregate demand. Thus, through the
multiplier effect, this process will continue. This may also result in an increase in the level of
employment.

MONETARY POLICY

Monetary policies are usually implemented by the central bank of the country. In recent years in a
number of countries, changes in interest rates have been the main policy used to control inflation
and to influence economic activity. An increase in interest rate will tend to reduce aggregate
demand. This is because savings will be encouraged, borrowing discouraged and the spending
power of households who are borrowers will be reduced. This downward pressure on spending is
likely to reduce inflationary pressure but it may have an adverse effect on the balance of payments.
This is because a higher rate of interest will attract hot money flows into the country which will
raise the value of the currency and cause export prices to rise and import prices to fall. However,
there is a time lag between changing interest rates and change taking effect. It may take several
months for interest rate changes to fully work in the economy. A rise in interest rates may hit the
poor more than the rich as they are more likely to be net borrowers. Another monetary policy
instrument is the money supply. The regulation of money supply may bring stability in the
economy through various ways. An increase in money supply will raise aggregate demand for
goods and services. If this is done before full employment level, then the firms will respond to the
increase in households’ demand for goods and services by raising output and this may result in an
increase in the level of employment. However, if money supply increases at full employment level,
it puts pressure on prices to increase resulting in the level of inflation rising. An increase in money
supply may also cause a disequilibrium in the balance of payments by raising the marginal
propensity to import. A decrease in money supply will have opposite effects.

SUMMARY

An increase in interest rates will:

• raise the cost of borrowing and this negatively affects investment.

• raise the cost of borrowing and households will not borrow for consumption.
• since households will not be able to borrow money this will reduce the level of imports.
• encourage savings since it raises the opportunity cost of holding money.

MAKE ECONOMICS EASY WITH MR KAYBEE: +263 71 818 1255 (APP/CALL)

 RESOURCE PACK/ ECONOMICS/A LEVEL

• Attract hot money inflows, lowering the exchange rates and increasing the value of
domestic currency. The opposite is true.

An increase in money supply will:

• increase the level of liquidity in the economy.

• raise aggregate demand for goods and services.
• result in an increase in the level of employment if money supply increases before full
employment.
• if done after full employment, puts pressure on prices to rise and this raises the level of
inflation.
• raise the marginal propensity to import and this may bring about a disequilibrium in the
balance of payments. The opposite is true.

EXCHANGE RATE POLICY

Exchange rate policy covers government decisions on whether to influence the value of its
currency, whether to operate a fixed, managed or floating exchange rate and whether to link its
exchange rate to that of other countries. A government can influence the value of its currency by
changing its interest rate or buying and selling its own currency. Raising the value of the currency
will increase its purchasing power and put downward pressure on inflation. However, it may also
harm its balance of payments position and reduce economic activity. In contrast, reducing the value
of the currency may increase employment and growth, help the balance of payments position but
increase inflationary pressure. Operating a floating exchange rate allows market forces to
determine the value of its currency but may create some uncertainty. A fixed exchange rate
removes uncertainty but to maintain it the government may have to introduce policies which harm
its other macroeconomic objectives. For example, if there is a downward pressure on the exchange
rate, the government may raise taxes to discourage spending and thereby reduce expenditure on
imports. Such a measure may lower economic growth and increase unemployment.

SUPPLY SIDE POLICIES

These are policies designed to increase aggregate supply by improving the workings of product
and factor markets in an economy. Typical supply side policies are increasing incentives to work,
education and training, trade union reform, privatization and regulation. More people may be
encouraged to enter the labour force by cutting income tax and welfare benefits. This will increase
a person’s incentives from work and reduce the return from not working. Improving education and

MAKE ECONOMICS EASY WITH MR KAYBEE: +263 71 818 1255 (APP/CALL)

 RESOURCE PACK/ ECONOMICS/A LEVEL

training will raise workers’ productivity and increase their flexibility and mobility. Trade union
reforms may also increase workers’ flexibility and mobility and cut down on the number of days
lost through strikes. However, some supply side policies may have negative side effects e.g
reducing income tax may encourage some people to work fewer hours if they are currently satisfied
with their earnings. Lowering welfare benefits will not succeed in reducing unemployment if there
are no jobs available. Supply side policies tend to be long term and uncertain in their measurable
outcome as they require structural changes to be made to increase aggregate supply in the economy.

(b) UNEMPLOYMENT
Unemployment is the percentage of the labour force that is not employed but desires to be
employed. The unemployed are people able, available and willing to work at the going wage rate
but cannot find a job despite an active search for work. An economy facing mass unemployment
has an economic and social problem on its hands. The economic problem lies in the fact that some
factors of production are lying underutilized and wasted. Consumers want goods and services,
workers want to provide them, factories and work places are probably lying idle. Unemployment
simply means that scarce human resources are not being utilized produce goods and services to
meet peoples’ needs and wants. The social problem lies in the poverty that unemployment brings
with it and this involves not only a deprivation of material goods and services but also the feelings
of degradation and rejection that the unemployed feel. Poverty, both material and psychological is
the fate of the unemployed.

O A B C

Unemployment will occur if more people are seeking a job than are employed at the current wage
rate. On the diagram above if OC people want a job but only OA people have got jobs the AC
represents the amount of unemployment in the economy at a wage rate OE. Full employment in
the labour market exists where everyone who wants a job at the current wage has got one. However,
each market and industry has its own set of demand and supply curves. There could be
unemployment in one industry but excess demand at the going wage rate in some industries.

MAKE ECONOMICS EASY WITH MR KAYBEE: +263 71 818 1255 (APP/CALL)

 RESOURCE PACK/ ECONOMICS/A LEVEL

TYPES OF UNEMPLOYMENT AND THEIR CAUSES AND REMEDIES.

1. FRICTIONAL UNEMPLOYMENT

This occurs when workers leave or are forced to leave a job and spent some time out of
work looking for or waiting to take up fresh employment. Frictional unemployment results
from the normal turnover of labour. An important source of frictional unemployment is
people who are in the process of changing their jobs and are caught between one job and
the other. Some may quit because they are dissatisfied with the type of work or their
working conditions. Others may be sacked. Whatever the reason, they must search for new
jobs and this takes time. People who are unemployed while searching for jobs are said to
be frictionally unemployed or alternatively in search unemployment. The size of frictional
unemployment depends very much on a number of factors. Firstly, the efficiency of a
system designed to link the employer with the job seeker has an important bearing on the
problem. This will include how well newspapers and other media can communicate and
how well private and public employment agencies link the two sides together. Obviously,
there are search costs involved in terms of lost earnings and travel expenses for such things
as interviews but can be viewed as investment. Improving the flow of information with
regards to the availability of particular employment is one such measure to remedy
frictional unemployment. Another remedy is also the reduction in unemployment related
benefits as helping to encourage the unemployed to seek work. It is however argued that
by reducing unemployment benefits, individuals will spend less time searching for another
job and therefore may end up in less appropriate jobs with a mismatch between their skills
and those required by the job. It is widely recognized by economists that the longer a person
can stay unemployed and still maintain a reasonable standard of living, the higher will be
the frictional unemployment. On the other hand, a reduction in the ratio of benefits to wages
will make unemployment less attractive. For a small minority of the unemployed, increases
in the benefits to wages ratio will mean that they effectively cease to look for work and
prefer to live permanently on welfare. For the majority, it will mean that they are a little
more choosey about the job they take up. This increase in choosiness will lead to an
increase in the average lengthy of time spent unemployed by job seekers.

2. STRUCTURAL UNEMPLOYMENT

Structural unemployment occurs when certain industries decline because of long term
changes in market conditions. For example, over the last 20 years UK motor vehicle
production has declined while car production in the far east has increased, creating
structurally unemployed car workers. The pattern of demand and method of production are
continually changing. There could be a change in the comparative costs of an industry.

MAKE ECONOMICS EASY WITH MR KAYBEE: +263 71 818 1255 (APP/CALL)

 RESOURCE PACK/ ECONOMICS/A LEVEL

Structural unemployment may be a result of technological changes. When technology

changes, this means labour may easily be substituted and so many workers may
unfortunately lose their jobs. Those workers who become structurally unemployed are
available for work but have either the wrong skills for the jobs available or they are in the
wrong location. There is a mismatch between the skills and the location of labour and
unfilled vacancies. Structural change that creates unemployed workers with wrong
characteristics (skills, experience, location) for the available jobs is known as mismatch.
The biggest mismatch is likely that modern industry requires skilled and flexible workers
while the majority of the unemployed are unskilled. A metal worker made redundant in
1980 is unlikely to have found work as an advertising executive even if vacancies existed.
Occupational immobilities is another source of mismatch. This refers to the difficulties in
learning new skills applicable to a new industry, and technological change eg an
unemployed farmer may struggle to find work in high technology industries. The remedy
for structural unemployment involves retraining those made redundant so that they acquire
the skills now required by the growing sectors of the economy. It may also involve the
possible relocation of labour to other areas of the country.

3. DEMAND DEFICIENT (CYCLICAL) UNEMPLOYMENT

This occurs when aggregate demand is too small in relation to aggregate output so that
there is a deficiency of demand for goods and services. Since the demand for labour is a
derived demand, the lack of demand for goods and services will also lead to deficiency of
demand for labour.
E=Y

C + I + G + (X – M) or AD2

C + I + G + (X – M) or AD1

Deflationary gap

450

Qe1 Qe2

Demand deficient unemployment can be defined by making a reference to the diagram

above. The assumption is that the economy is initially at full employment when aggregate
demand consisting of consumer expenditure, investment, government expenditure and net
exports is shown. A decrease in any of the components of aggregate demand will result in
a decrease in aggregate demand at large. The diagram shows that a decrease in aggregate

MAKE ECONOMICS EASY WITH MR KAYBEE: +263 71 818 1255 (APP/CALL)

 RESOURCE PACK/ ECONOMICS/A LEVEL

demand from AD2 to AD1 has resulted in a decrease in full employment output from Qe2
to Qe1. When aggregate demand for goods and services decreases, it leads to a decrease in
demand for labour as firms reduce their output to match the decrease in demand. This leads
to demand deficient unemployment. A decrease in aggregate demand for goods and
services is a result of deflationary measures such as a decrease in money supply or an
increase in direct taxes. It is possible to use fiscal and monetary policy in
order to reduce demand deficient unemployment. Their use is referred to as demand
management and the aim is to influence the total demand for goods and services in the
economy. Fiscal policy can increase aggregate demand either through an increase in total
government expenditure or by a reduction of taxes or both. Monetary policy can also be
applied to reduce demand deficient unemployment. This can be done through increasing
money supply to raise aggregate demand for goods and services. Aggregate demand can
also be influenced by lowering interest rates. This will reduce the cost of borrowing for
consumption and so households will be able to borrow more for consumption raising
aggregate demand in the process.

4. REAL WAGE (CLASSICAL) UNEMPLOYMENT

It is called classical unemployment after the economists in the 1930s who believed that
unemployment was the result of real wages being too high. This can be explained
diagrammatically as follows.

S
Wu ----------------------------------------

We -------------------------------

O Qd Qe Qs

Assuming that the wage rate is Wu, then OQs units of labour will be supplied but only OQd
will be demanded. Hence unemployment of QdQs would exist. Neo classical economists argued
that workers would be prepared to accept lower wage rates in order to keep a job or get a job. If

MAKE ECONOMICS EASY WITH MR KAYBEE: +263 71 818 1255 (APP/CALL)

 RESOURCE PACK/ ECONOMICS/A LEVEL

the wage rates are reduced to We then QeQs of labour would no longer wish to work. On the
demand side, firms would wish to employ an extra QdQe of labour. The result of the reduction in
wages is equilibrium in the labour market. At a wage rate of We, there is no unemployment in the
labour market. Qe is the full employment level of the economy. This is because at the given wage
rate We, everyone who wants the job has got one. Real wage unemployment can also be called
disequilibrium unemployment.

5. TECHNOLOGICAL UNEMPLOYMENT

This refers to unemployment that is regarded as the result of changes in technology. Such
changes in technology may mean that goods and services which previously used labour as
input are now more efficiently produced by using capital equipment or at least less labour
in relation to capital equipment than before the new technology was developed. However,
technical change cannot be avoided. It is arguably an important element in raising
productivity.

6. NATURAL RATE OF UNEMPLOYMENT (NRU)

This is the voluntary unemployment which still exists even if the real wage is at the
equilibrium level which clears the labour market. This can be illustrated diagrammatically
as follows:

Ls

Lf

W ------------------------------- --------
Natural rate of unemployment

Ld

N1 N2

On the diagram above, Ld reflects the marginal revenue product (MRP) of workers i.e the
extra revenue earned from employing the last worker. This is downward slopping in line
with the assumption of diminishing marginal physical product (MPP) for workers. Labour

MAKE ECONOMICS EASY WITH MR KAYBEE: +263 71 818 1255 (APP/CALL)

 RESOURCE PACK/ ECONOMICS/A LEVEL

supply (Ls) represents all those workers willing and able to work at the prevailing wage
rate i.e they have the right skills and are in the right location to accept jobs at a given real
wage. The labour force (Lf) shows the total number of workers who consider themselves
to be members of the labour force at any given real wage. Of course not all of these are
willing and able to accept job offers, perhaps it is because they are still searching for a
better offer or because they have not yet acquired the appropriate skills or are not in an
appropriate location.

At the equilibrium real wage N1 workers are willing and able to accept job offers whereas
N2 workers consider themselves to be members of the labour force. That part of the labour
force unwilling or unable to accept job offers at the equilibrium real wage (N2 – N1) is
called the natural rate of unemployment (NRU). The NRU can be regarded as including
both the frictionally and structurally unemployed. It can be seen that anything that reduces
the labour supply ( i.e the numbers willing and able to accept a job at a given wage rate )
will, other things being equal, cause the NRU to increase. Possible factors may include an
increase in the level and availability of unemployment benefits therefore encouraging the
unemployed members of the labour force to engage in more prolonged search activity. An
increase in trade union power might also reduce the numbers willing and able to accept a
job at a given real wage especially if the trade union is able to restrict the effective labour
supply as part of a strategy for raising wages. A reduced labour supply might also result
from increased technological change or increased global competition both of which change
the nature of the labour market skills required for employment. Higher taxes on earned
income are also likely to reduce the labour supply at any given wage rate. Similarly,
anything that reduces the labour demand will, other things being equal, cause the NRU to
increase. A fall in the marginal revenue product of labour via a fall in marginal physical
productivity or in the product price might be expected to reduce labour demand.

7. SEASONAL UNEMPLYMENT

This occurs because some jobs are dependent upon whether and the season. Workers who
are employed to produce ice cream may lose their jobs in winter and so do producers of
warm clothing in summer.

UNEMPLOYMENT BENEFITS

Workers who lose their jobs receive unemployment benefits. The size of the benefit paid relative
to pay levels is known as replacement ratio. A high replacement ratio raises the NRU. It affects
the willingness of the unemployed to accept job offers and it affects the intensity with which they

MAKE ECONOMICS EASY WITH MR KAYBEE: +263 71 818 1255 (APP/CALL)

 RESOURCE PACK/ ECONOMICS/A LEVEL

search for work. Changes in the replacement ratio do have significant statistical effects on the
NRU. Differences in benefit systems between countries do seem to play a very important role in
explaining international differences in unemployment. Two other factors which have at least a
temporary effect on the NRU are the tax wedge and a terms of trade loss. The tax wedge is the
difference between what an employer has to pay to hire a worker and what the worker receives in
take home pay. Increasing the tax wedge for a given quantity of labour demanded reduces take
home pay. This is likely to increase wage bargaining pressure as a result of workers’ reluctance to
accept lower real wages. However, this has no long term effects on NRU as the tax wedge cannot
keep increasing. The terms of trade loss is also called real exchange rate depreciation. This is
argued to have a similar effect because it raises import prices and it also reduces real wages.

MAKE ECONOMICS EASY WITH MR KAYBEE: +263 71 818 1255 (APP/CALL)

 RESOURCE PACK/ ECONOMICS/A LEVEL
CONTROL OF UNEMPLOYMENT

Macroeconomic policies to deal with unemployment

There are two main strategies for reducing unemployment and these are:

(a) Demand side policies to reduce demand deficient unemployment (unemployment caused
by recession).
(b) Supply side policies to reduce structural unemployment

FISCAL POLICY

In order to reduce demand deficient unemployment, there are two fiscal policy measures which
can be applied. The first option is to raise government expenditure. This will raise aggregate
demand since government expenditure is part of aggregate demand. An increase in government
demand means firms will have to raise output to match an increase in aggregate demand and this
increases demand for labour. Another option is to lower direct taxes. This raises household
disposable incomes, raising aggregate demand for goods and services in the process. This is known
as expansionary fiscal policy.

E=Y

C + I + G2 + (X – M) or AD2

C + I + G1 + (X – M) or AD1

𝟒𝟓𝟎

O Ye Ye1

The diagram above shows that when government expenditure increases from G1 to G2, aggregate
demand also increased from AD1 to AD2. This also has caused equilibrium level of national income
to increase from Ye1 to Ye2.

MAKE ECONOMICS EASY WITH MR KAYBEE: +263 71 818 1255 (APP/CALL)

 RESOURCE PACK/ ECONOMICS/A LEVEL
However,

1. It depends on other components of AD, eg if confidence is low, reducing taxes may not
increase consumer spending because people prefer to save. Also, people may not spend tax
reductions if they will soon be reversed.

2. Fiscal policy may have time lags. A decision to increase government spending may take a
long time to affect demand (AD).

3. If the economy is close to full capacity, an increase in AD will only cause inflation.
Expansionary fiscal policy will only reduce unemployment if there is an output gap or spare
capacity in the economy.

4. Expansionary fiscal policy will require higher government borrowing. This may not be
possible for countries with higher levels of debt.

5. In the long run, expansionary fiscal policy may cause crowding i.e the government
increases spending but because they borrow from the private sector, they have less to spend
and therefore AD doesn’t increase.

MONETARY POLICY

There are two monetary policy instruments which can be applied to reduce unemployment in the
country.

The first option is to reduce interest rates. This has two effects:

(a) It increases investment spending in the economy since the cost of borrowing has decreased.
An increase in investment spending in the economy will result in the increase in aggregate
demand for goods and services which will obviously result in the increase in demand for
labour.
(b) It also makes it easier for households to borrow for consumption purposes. This again raises
aggregate demand for goods and services.

The second option is to increase money supply. This increases the level of liquidity in the economy
which will obviously result in the increase in aggregate demand. This is called expansionary
monetary policy.

With an increase in AD, there will be an increase in real GDP (as long as there is spare capacity
in the economy). If firms produce more, there will be an increase in demand for workers and

MAKE ECONOMICS EASY WITH MR KAYBEE: +263 71 818 1255 (APP/CALL)

 RESOURCE PACK/ ECONOMICS/A LEVEL
therefore lower demand deficient unemployment. Also, with higher aggregate demand and strong
economic growth, fewer firms will go bankrupt meaning fewer job losses.

However,

1. Low interest rates may not help boost spending if banks are still reluctant to lend.

2. Raising money supply is inflationary if done at full employment since aggregate supply
cannot respond to an increase in aggregate demand.

3. Raising money supply may also improve households’ capacity to import and this may cause
disequilibrium in the balance of payments.

4. Lowering interest rates may discourage savings as it reduces the opportunity cost of
holding money. This means banks will find it difficult to mobilize savings which will cause
a very serious problem in the finance sector.

5. Demand side policies can contribute to reducing demand deficient unemployment e.g in a
recession. However, they cannot reduce supply side unemployment. Therefore, their
effectiveness depends on the type of unemployment that occurs.

SUPPLY SIDE POLICIES FOR REDUCING UNEMPLOYMENT

Supply side policies deal with more microeconomic issues. They don’t aim to boost overall
aggregate demand but seek to overcome imperfections in the labour market and reduce
unemployment caused by supply side factors. Supply side unemployment includes frictional,
structural and classical (real wage).

1. Education and training. The aim is to give the long term unemployed new skills which
enable them to find jobs in developing industries e.g retrain unemployed steel workers to
have basic I.T skills which help them find work in the service sector. However, despite
providing education and training schemes, the unemployed may be unable or unwilling to
learn new skills. At best, it will take several years to reduce unemployment.

2. Trade union reforms. If unions can bargain for wages above the market clearing levels,
they will cause real wage unemployment. In this case reducing the influence of trade unions
(or reducing minimum wages) will help solve this real wage unemployment.

MAKE ECONOMICS EASY WITH MR KAYBEE: +263 71 818 1255 (APP/CALL)

 RESOURCE PACK/ ECONOMICS/A LEVEL
3. Employment subsidies. Firms could be given tax breaks or subsidies for taking on long
term unemployed. This helps give them new confidence and on the job training. However,
it will be quite expensive, and it may encourage firms to just replace current workers with
the long term unemployed to benefit from the tax breaks.

4. Improve labour market flexibility. It is argued that higher structural rates of

unemployment in some countries such as the UK is due to restrictive labour markets which
discourage firms from employing workers in the first place. For example abolishing
maximum working weeks and making it easier to hire and fire workers may encourage
more job creation. However, increase labour market flexibility could cause a rise in
temporary employment and greater job insecurity.

5. Stricter benefit requirements. Governments could take a more pro-active role in making
the unemployed accept a job or risk losing benefits. After a certain period, the government
could guarantee a public sector job (e.g cleaning streets). This could significantly reduce
unemployment. However, it may mean the government ends up employing thousands of
people in productive tasks which is very expensive.

6. Improved geographical mobility. Often, the unemployed are more concentrated in certain
regions. To overcome this geographical unemployment, the government could give tax
breaks to firms who set up in depressed areas. Alternatively, they can provide financial
assistance to unemployed workers who move to areas with high unemployment.

7. Maximum working week. It has been suggested that a maximum working week would
lead to firms needing to hire more workers and reduce unemployment. However, a
maximum working week may increase a firm’s costs and therefore they are not willing to
hire more. Also, there is no certainty the firm will respond to a cut in hours by employing
more.

MAKE ECONOMICS EASY WITH MR KAYBEE: +263 71 818 1255 (APP/CALL)

 RESOURCE PACK/ ECONOMICS/A LEVEL

(c) INFLATION

Inflation is a sustained rise in the general level price level. Inflation can come from both the
demand and the supply side of the economy.

What are the main causes of inflation?

Inflation can arise from internal and external events.

(i) A rise in the rate of VAT would also be a cause of increased domestic inflation in the short
term because it increases a firm’s production costs.
(ii) Inflation can also come from external sources, for example a sustained rise in the price of
crude oil or other imported commodities, foodstuffs and beverages.
(iii) Fluctuations in the exchange rate can also affect inflation. For example, a fall in the value
of Zimbabwe dollar against other currencies might cause higher import prices for items
such as foodstuffs from other countries.

CAUSES OF INFLATION

(a) Demand pull inflation

This occurs when aggregate demand is growing at an unsustainable rate leading to

increased pressure on scarce resources and a positive output gap. Generally, demand pull
inflation arises when aggregate demand exceeds the value of output (measured at
constant prices) at full employment. When aggregated demand C + I + G + (X –M)
exceeds output then an inflationary gap will be created especially when aggregated
demand rises above the output level when full employment has already been attained.

MAKE ECONOMICS EASY WITH MR KAYBEE: +263 71 818 1255 (APP/CALL)

 RESOURCE PACK/ ECONOMICS/A LEVEL

E =Y

Inflationary gap C + I + G + (X – M) or AD

450

Yf Ye

The diagram above shows that at full employment aggregate demand (AD) is greater than
output. this exerts pressure on prices to rise as a result of the supply shocks.

When there is excess demand, producers can raise their prices and achieve bigger profit margins.
Demand pull inflation is likely when there is full employment of resources and aggregate supply
is inelastic. Using the shifts in aggregate demand curve and the aggregate supply curve we can
explain the phenomenon of demand pull inflation as follows:

AD4 AS

P2 -------------------------------------------
AD1 AD2 AD3

AD4

P1
AD1 AD2 AD3

Explanation of the diagram

An increase in aggregated demand from AD1 to AD2 will not alter the price level because it is
possible to adjust aggregate supply (AS) in line with the increase in aggregate demand since supply
is perfectly elastic within this output range. In general, supply responds to an increase in aggregate
demand and therefore there will be no inflation. However, an increase in aggregate demand from
AD3 to AD4 will put pressure on prices to rise. When aggregate supply is perfectly inelastic, an

MAKE ECONOMICS EASY WITH MR KAYBEE: +263 71 818 1255 (APP/CALL)

 RESOURCE PACK/ ECONOMICS/A LEVEL
increase in aggregate demand will put pressure on prices to increase. Hence the increase in price
from P1 to P2 on the diagram above. Any further increase in aggregate demand will cause an even
higher price level as firms compete for increasingly scarce resources with which to raise output.

What are the causes of demand pull inflation?

1. A depreciation of the exchange rate increases the price of imports and reduces the foreign
price of a country’s exports. If consumers buy fewer imports while exports grow AD
will rise and there may be a multiplier effect on the level of demand and output.

2. Higher demand from a fiscal stimulus e.g lower direct or indirect taxes or higher
government spending will raise AD and this will cause a rise in inflation especially
aggregate demand increases when the economy is already at full employment.

3. Monetary stimulus to the economy. A fall in interest rates may stimulate too much demand
as households will borrow more for consumption. Monetarist economists believe that
inflation is caused by too much money chasing too few goods and governments can lose
control of inflation if they allow the financial system to expand the money supply too
quickly. An increase in money supply will raise aggregate demand which raises prices
if there is no excess capacity in the economy.

COST PUSH INFLATION

Cost push inflation occurs when firms respond to rising costs by increasing prices in order to
protect their profit margins. There are many reasons why costs might rise.

1 Component costs e.g an increase in the prices of raw materials and other components. This
might be because of a rise in commodity prices such as oil, copper and agricultural products
used in food processing. A good example in Zimbabwe is a surge in the price of imported
wheat which has seen the price bread rising.

2 Rising labour costs. This may be caused by wage increases which are greater than
improvements in productivity. Wage costs often rise when unemployment is low because
skilled workers become scarce and this can drive pay levels higher. Wages might increase
when people expect higher inflation so they ask for more pay in order to protect their real
incomes. Trade unions may use their bargaining power to bid for and achieve increasing
wages. This could be a cause of cost push inflation.

MAKE ECONOMICS EASY WITH MR KAYBEE: +263 71 818 1255 (APP/CALL)

 RESOURCE PACK/ ECONOMICS/A LEVEL
3 Expectations of inflation are important in shaping what actually happens to inflation.
When people see prices rising for everyday items they get concerned about the effects of
inflation on their real standard of living.

4 Higher indirect taxes. For example, a rise in the duty on alcohol, fuels and cigarettes or a
rise in value added tax. Depending on the price elasticity of demand and supply for their
products suppliers may choose to pass on the burden of the tax onto consumers.

5 A fall in the exchange rate. This can cause cost push inflation because it leads to an
increase in the prices of imported products. Such as essential raw materials, components
and finished products.

6 Profit push inflation or monopoly employers. Where dominant firms in the market use
their market power at whatever level of demand to increase prices just to widen their profit
margins. This is usually done by monopolies which take advantage of the absence of
competitors in the industry.

AS2
AS1
P2 ----------------

P1 ----------------------------

Y2 Y1

Cost push inflation occurs when firms respond to rising costs by increasing their prices to
protect profit margins. An increase in the price of inputs such as the price for fuel,
electricity, raw materials etc will result in the decrease in supply. A decrease in supply will
then result in the increase in prices pushing inflation high.

MAKE ECONOMICS EASY WITH MR KAYBEE: +263 71 818 1255 (APP/CALL)

 RESOURCE PACK/ ECONOMICS/A LEVEL

TYPES OF INFLATION

1. Creeping inflation.

Creeping or mild inflation is when prices rise by 3% or less per year. When prices rise by
2% or less, it benefits economic growth. This kind of mild inflation makes consumers
expect that prices will keep going up. That boosts demand. Consumers buy now to beat
higher future prices. That’s how mild inflation drives economic expansion.

2. Walking inflation.

This strong or destructive inflation is between is between 3 – 10% a year. It is harmful to

the economy because it heats up economic growth too fast. People start to buy more than
they need to avoid tomorrow’s much higher expected prices. This increased buying drives
demand even further so that suppliers can’t keep up. As a result, most goods and services
are priced out of the reach of most people.

3. Galloping inflation.

When inflation rises to 10% or more it is called galloping inflation. It wreaks absolute
havoc on the economy. Money loses value so fast that business and employee income can’t
keep up with costs and prices. Foreign investors avoid the country, depriving it of needed
capital. The economy becomes unstable, and government leaders lose credibility.
Galloping inflation must be prevented at all costs.

4. Hyperinflation
Hyperinflation is when prices sky rocket more than 50% a month. Most examples of
hyperinflation occur when governments print money to pay for wars. Zimbabwe’s
inflation is typical of hyperinflation. It has resulted

MAKE ECONOMICS EASY WITH MR KAYBEE: +263 71 818 1255 (APP/CALL)

 RESOURCE PACK/ ECONOMICS/A LEVEL

MACROECONOMIC POLICIES TO DEAL WITH INFLATION

Inflation can be reduced by policies that slow down the growth of AD and or boost the rate of
growth of aggregate supply.

a) Fiscal policy

Controlling aggregate demand is important if inflation is to be controlled. If the government

believes that AD is too high, it may choose to tighten fiscal policy by reducing its own
spending on public and merit goods or welfare payments. It can also choose to raise direct
taxes, leading to a reduction in real disposable income. This is known as tight or
contractionary fiscal policy. The consequence may be that demand and output are lower
which has a negative on jobs and real economic growth in the short term.

b) Monetary policy

A tightening of monetary policy involves the central bank introducing a period of higher
interest rates to reduce consumer and investment spending. Higher interest rates may cause
the exchange rate to appreciate in value bringing about a fall in the cost of imported goods
and services and also a fall in demand for exports (X). The central bank can also reduce
money supply to deflate the economy. This reduces aggregate demand resulting in the
decrease in prices. Increasing interest rates and reducing money supply are part of tight
monetary policy measures to control inflation. It is also called contractionary monetary
policy.

c) Supply side economic policies:

Supply side policies seek to increase productivity, competition and innovation, all of which
can maintain lower prices. These are ways of controlling inflation in the medium term.

These supply side policies include:

1. Privatisation.
This involves selling state owned assets to the private sector. It is argued that the
private sector is more efficient in running businesses because they have a profit
motive to reduce costs and develop better services.

MAKE ECONOMICS EASY WITH MR KAYBEE: +263 71 818 1255 (APP/CALL)

 RESOURCE PACK/ ECONOMICS/A LEVEL

2. Deregulation
This involves reducing barriers to entry to allow new firms to enter the market. This
will make the market more competitive. Competition tends to lead to lower prices
and better quality goods and services.

3. Reducing income tax rates

It is argued that lower income tax increases the incentive for people to work harder,
leading to an increase in labour supply. Similarly, a cut in corporation tax gives
firms more retained profit they can use for investment.

4. Deregulation of labour markets.

Labour markets can be deregulated through policies which will make it easier to
higher and fire workers or reduce maximum working weeks. If it is cheaper to hire
and fire workers, the argument is that it encourages firms to take on more workers
in the first place creating more employment opportunities. However, more flexible
labour markets can cause increased uncertainty and lower productivity.

5. Reducing the power of trade unions.

This can involve legislation which reduces the ability of trade unions to raise wages
above their competitive levels since it will result in the increase in product prices.
Consequently, an increase in wages is associated with some level of unemployment
since employers will be trying to shed off some labour units.

S
WU --------------------------------

W1 ----------------------

D
L1 L* L2
The diagram above shows that when trade unions raised the wage rate from W1 to
Wu, the demand for labour decreased from L* to L1 leaving L* - L1 workers
unemployed. This will obviously affect aggregate supply leading to supply shocks
in the economy. The consequence is the rise in prices leading to an increase in
inflation as well.

MAKE ECONOMICS EASY WITH MR KAYBEE: +263 71 818 1255 (APP/CALL)

 RESOURCE PACK/ ECONOMICS/A LEVEL

6. Reducing unemployment benefits

Lower unemployment benefits may encourage the unemployed to take jobs. The
wage benefit ratio should be reduced in order to motivate job seekers to look for
jobs. A decrease in the wage – benefit ratio will result in the increase in the
opportunity cost of being unemployed. The higher the level of employment, the
higher the level of aggregate supply and the lower the prices leading to a decrease
in inflation.

7. Increase free trade

Low tariff barriers will increase trade and provide an incentive for export firms to
invest. Increasingly important are non-tariff barriers. An increase in exports will
raise aggregate demand leading to an increase in aggregate supply. When supply
increases, average price will decrease leading to a decrease in inflation.

Other supply side policies are:

8. A reduction in company taxes to encourage greater investment.

9. A reduction in taxes which increases risk taking and incentives to work. A

reduction in income taxes can be considered both a fiscal and a supply side
policy.

10. Policies to open the market to more competition to increase supply and lower
prices. Rising productivity will cause an outward shift of aggregate supply.

11. The public sector annual pay rises can be tightly controlled or even frozen. This
reduces the real wage.

ADVANTAGES OF INFLATION

(a) Deflation (ie a fall in prices or negative inflation) is very harmfull.

When prices are falling, people are reluctant to spend money because they feel that goods
will be cheaper in the future, therefore they keep delaying purchases. Also deflation
increases the real value of debt and reduces the disposable income of individuals who are
struggling to pay off their debt.

(b) Moderate inflation enables adjustment of wages

It is argued that a moderate rate of inflation makes it easier to adjust relative wages. For
example, it may be difficult to cut nominal wages because workers resent and resist a
nominal wage cut. But, if average wages are rising due to moderate inflation, it is easier to
increase the wages of productive workers, unproductive workers can have their wages

MAKE ECONOMICS EASY WITH MR KAYBEE: +263 71 818 1255 (APP/CALL)

 RESOURCE PACK/ ECONOMICS/A LEVEL

frozen which is effectively a real wage cut. If we had zero inflation, we could end up with
more real wage unemployment, with firms unable to cut wages to attract workers.

(c) Inflation can boost growth.

At times of very low inflation, the economy may be stuck in a recession. Arguably
targeting a higher rate of inflation can enable a boost in economic growth. This view is
controversial. Not all economists would support targeting a higher inflation rate if the
economy was stuck in a prolonged recession.

(d) Inflation is better than deflation.

A fall in prices can cause an increase in the real debt burden and discourage spending and
investment.

DISADVANTAGES OF INFLATION

(a) Inflation discourages investment and long term economic growth.

This is because of the uncertainty and confusion that is more likely to occur during periods
of high inflation. Low inflation is said to encourage greater stability and encourage firms
to take risks and invest.

(b) Inflation can make an economy uncompetitive

For example, a higher rate of inflation in Zimbabwe can make Zimbabwean exports
uncompetitive leading to lower AD, a current account deficit and lower economic growth.

(c) Inflation reduces the value of savings.

Inflation leads to a fall in the value of money. This makes savings worse off if inflation is
higher than interest rates. High inflation can lead to a redistribution of income in society.
Income is redistributed from the lender to the borrower. Which means those who lend
money are more likely to lose and the borrowers will gain. Often, it is pensioners who lose
out most from inflation. This is particularly a problem if inflation is high and interest rates
low.

(d) The cost of changing prices lists becomes more frequent during high inflation. Not so
significant with modern technology.

(e) Fall in real wages and real incomes. In some circumstances, high inflation can lead to a
fall in real wages and real incomes. If inflation is higher than nominal wages, then real
incomes fall and people will suffer a fall in their standard of living. Fixed income earners

MAKE ECONOMICS EASY WITH MR KAYBEE: +263 71 818 1255 (APP/CALL)

 RESOURCE PACK/ ECONOMICS/A LEVEL

are more affected than profit earners. The salaried will seek higher incomes, the self
employed and companies push the higher cost to their customers by raising prices.

(f) Fall in real interest rates and an increase in nominal rates. Inflation reduces the
opportunity cost of holding money therefore discouraging savings. Those who are in debt
such as companies and individuals who have borrowed and others who need to borrow
will have to seek higher incomes and revenue in order to meet the higher interest
requirements. An increase in interest rates will discourage investment. A fall in investment
will cause a slowdown or even negative growth in the economy.

(g) Balance of payments disequilibrium. Externally, inflation undermines the competitiveness

of a country’s exports. In the long term, export earnings fall as foreigners refuse to buy
domestically produced goods. Local residents will change their preference to relatively cheaper
imports and as a result, the country’s BOP worsens.

MAKE ECONOMICS EASY WITH MR KAYBEE: +263 71 818 1255 (APP/CALL)

 RESOURCE PACK/ ECONOMICS/A LEVEL

THE PHILLIPS CURVE

What is the Phillips curve?

The Phillips curve is an economic concept developed by A.W. Phillips stating that inflation and
unemployment have a stable and inverse relationship. Proponents of demand-pull inflation argue
that the level of unemployment in the economy is a good measure of the level of excess demand.
High levels of unemployment show that there is little or no excess demand and hence inflationary
pressures are minimal. However, as unemployment declines the economy moves nearer to full
employment.

Full explanation of the relationship between unemployment and inflation

Before full employment, there is excess capacity in the economy and therefore aggregate supply
can simply respond to increase in aggregate demand. There is no upward pressure on prices and
hence inflation is very low although unemployment is high. At full employment level,
unemployment is very low and there is excess demand as supply cannot fully respond to changes
in demand. This exerts upward pressure on prices raising inflation.

Generally, low aggregate demand leads to low output. the decrease in output leads to an increase
in unemployment. Low aggregate demand generally leads to a decrease in prices leading to a
decrease in inflation. This is a situation commonly known as deflation. As all industries reach full
capacity, inflationary pressures will really begin to mount. The nearer one gets to full employment,
the more inflation there will be in the economy.

PHILIPS CURVE DIAGRAM

y % ------- B

x % ------------------------A

Unemployment rate

Point A is an indication of a high unemployment rate in an economy. This point corresponds to a

low inflation. Point B represents a low unemployment rate in an economy and corresponds to a
high inflation rate. When an economy is at point A, government introduce expansionary policies
such as cutting taxes and increasing government expenditure in an effort to increase demand in the

MAKE ECONOMICS EASY WITH MR KAYBEE: +263 71 818 1255 (APP/CALL)

 RESOURCE PACK/ ECONOMICS/A LEVEL

market. An increase in aggregate demand causes the economy to shift to a new macroeconomic
equilibrium which corresponds to a higher output level and a higher price. Consequently, firms
hire more workers leading to lower unemployment but a higher inflation rate. Such a short-run
event is shown in a Phillips curve by an upward movement from point A to point B. This scenario
is referred to as demand-pull inflation.

DEFLATIONARY AND INFLATIONARY GAPS

(a) DEFLATIONARY GAP

Deflation means a fall in the price level. This is a negative rate of inflation. A deflationary gap is
the difference between the full employment level of output and actual output. in a recession, the
deflationary gap might be quite substantial, indicative of the high rates of unemployment and under
used resources. A deflationary gap is also known as a negative output gap.

Causes of deflationary gap

• A fall in aggregate demand (AD) due to:

• A fall in investment due to banking collapse and credit crunch.
• A fall in consumer spending e.g higher interest rates, falling wages)
• Economic growth well below the average trend rate of growth ie AD increasing at a slower
rate than productive capacity.

E=Y

C + I + G + (X – M) or AD

deflationary gap

450

Qe1 Yf

If there is insufficient demand in the economy, the equilibrium will occur at a lower level of income
and to the left of a full employment line. At any particular time, there is a level of national income

MAKE ECONOMICS EASY WITH MR KAYBEE: +263 71 818 1255 (APP/CALL)

 RESOURCE PACK/ ECONOMICS/A LEVEL

Yf which is attained, will be sufficient to keep all resources in the economy fully employed. This
is the full employment level of national income. On the diagram above, the full employment line
is represented by the vertical line Yf. The diagram shows that if there is insufficient demand in the
economy, the equilibrium will occur at a lower level of income and to the left of the full
employment line. The distance between the 450 line and AD line at full employment level of
income is referred to as the deflationary gap.

The impact of deflationary gap

If an economy experiences a deflationary gap, then it will have the following impact on the wider
macro economy.

• Rising unemployment. We will get demand deficient unemployment and possibly higher
structural unemployment.
• Low/negative rates of economic growth.
• Negative impact on government’s budget. With lower economic growth, the government
will receive lower tax revenue and lower government spending.
• Low rates of inflation/ disinflation which is deflation. With a deflationary gap, firms
have excess capacity. This tends to put downward pressure on prices and wages.

(b) THE INFLATIONARY GAP

An inflationary gap is the gap between an economy’s full employment real GDP and its real GDP.
In other words, the inflationary gap refers to the difference between the actual gross domestic
product (GDP) and the GDP that would exist if the economy were at full employment. This is also
known as the potential GDP. In the case of an inflationary gap, the real GDP is higher than the
potential GDP. In practice, an inflationary gap happens when demand for goods and services is
greater is greater than production as a result of situations like high employment, high government
expenditure and high levels of trade activity. Then the real GDP ends up higher than the potential
GDP. It is called an inflationary gap because the higher real GDP leads to higher levels of
consumption throughout the economy increasing prices over time. To describe this process more
specifically, consumers experience higher levels of demand for goods and services because there
are more funds available throughout the economy meanwhile supply has not caught up with this
higher demand as production levels do not usually increase as quickly as consumer demand does.
As a result prices increase in order to return the market to equilibrium.

MAKE ECONOMICS EASY WITH MR KAYBEE: +263 71 818 1255 (APP/CALL)

 RESOURCE PACK/ ECONOMICS/A LEVEL

Diagram

E =Y

Inflationary gap C + I + G + (X – M) or AD
e

450

Yf Qe

On the diagram above, the equilibrium level of national income appears to be to the right of the
full employment line. At full employment level, aggregate demand is greater than aggregate
national output, therefore there is pressure on prices to increase. The equilibrium national output,
where AD = AS, appears to the right of the full employment level of output.

MACROECONOMIC POLICIES NEEDED TO CLOSE THE DEFLATIONARY AND

INFLATIONARY GAPS.

The major problem associated with the deflationary gap is that at full employment level, aggregate
demand is lower than real output level being produced therefore the economy is in the recessionary
period. This causes a decrease in prices. In order to close the deflationary gap, policies which seek
to raise the level of AD in the economy should be applied and these are:

(a) FISCAL POLICY

In order to close the deflationary gap, the government can lower taxes in order to raise the
disposable incomes of households. This will raise household consumption spending,
raising AD in the process. The government can also raise government expenditure in order
to raise AD. However, raising government expenditure will, through the multiplier effect,
result in a more than proportionate increase in the real national output which will continue
to widen the deflationary gap. Again, reducing taxes and raising government spending will
plunge the government into a very serious economic problem of a budget deficit. Therefore,
the government will have to borrow from the private sector to cover the deficit. This is
called an expansionary fiscal policy

MAKE ECONOMICS EASY WITH MR KAYBEE: +263 71 818 1255 (APP/CALL)

 RESOURCE PACK/ ECONOMICS/A LEVEL

(b) MONETARY POLICY

The government through the central bank, can lower interest rate. This stimulates
investment and raises investment spending in the economy thereby raising AD. This is
because low interest rates will reduce the cost of borrowing. Lowering interest rates will
also raise households’ consumption expenditure by encouraging households to borrow for
consumption. However, lowering interest rates will discourage savings as the opportunity
cost of holding cash balances decreases. Another option is to raise money supply. This will
raise household consumption expenditure on goods and services. However, raising money
supply has some negative implications as well:

(i) Raising money supply is inflationary. If household demand for goods and services
increases, this will raise prices especially when this happens at full employment.
We will begin to see more money chasing too few goods.

(ii) Raising money supply will raise the level of imports in the country causing balance
of payments disequilibrium.

The policies which can be applied to close the inflationary gap are simply the opposite of
those required to close the deflationary gap.

MAKE ECONOMICS EASY WITH MR KAYBEE: +263 71 818 1255 (APP/CALL)

 RESOURCE PACK/ ECONOMICS/A LEVEL

MULTIPLE CHOICE QUESTIONS

1 Fiscal policy involves the control of

A interest rates by the central bank.

B prices to cushion consumers.
C the government budget.
D wages.

2 Cost-push inflation and demand-pull inflation respectively are caused by

A an increase in aggregate demand and an increase in aggregate supply.

B a decrease in aggregate demand and a decrease in aggregate supply.
C an increase in aggregate supply and decreases in aggregate demand.
D decreases in aggregate supply and increases in aggregate demand.

3 How best can structural unemployment be defined?

A unemployment that arises from changes in the pattern of demand or supply

B unemployment that occurs because some people are virtually unemployable
C unemployment that occurs during the period when workers are looking for a new
job
D unemployment that is associated with industries where the demand for labour is
lower at certain times of the year.

4 The Philips curve relates to which conflicting objectives?

A low unemployment and low inflation.

B low unemployment and high inflation.
C low unemployment and BOP deficit.
D low unemployment and equitable distribution of income.

5 In a country with a population of 20 million, there are 9 million people employed and 1
million unemployed. Calculate the unemployment rate?

A 11%
B 10%
C 9%
D 5%

MAKE ECONOMICS EASY WITH MR KAYBEE: +263 71 818 1255 (APP/CALL)

 RESOURCE PACK/ ECONOMICS/A LEVEL

6 Involuntary unemployment can be a result of

A minimum wage legislation meant to protect the lowly paid.

B employers paying higher than average wage rates to discourage quits.
C the introduction of an incentive scheme by the employer.
D an improvement in conditions of work.

7 Which policy would be most suitable for reducing the unemployment level?

A Increase taxes and increase government expenditure.

B Increase taxes and reduce government expenditure.
C Reduce taxes and increase government expenditure.
D Reduce taxes and reduce government expenditure.

8 Which of the following is not a necessary feature of a monetary union?

A common interest rate policy

B single monetary authority
C freedom of capital movement
D federal government

9 Cost-push inflation is caused by

A an increase in trade unionism

B an increase in bank lending
C an increase in the supply of inputs
D an increase in demand for a country’s exports

10 At full-employment, which policy is most suitable for controlling inflation?

A restricting imports
B increasing tax rates
C increasing exports
D increasing personal tax allowances

11 Frictional unemployment is caused by

A the introduction of new technology.

B a shift in the pattern of consumer demand.
C workers being ill-informed about the labour market.
D employers cutting down their level of production.

MAKE ECONOMICS EASY WITH MR KAYBEE: +263 71 818 1255 (APP/CALL)

 RESOURCE PACK/ ECONOMICS/A LEVEL

12 How would the government deal with the twin evils of hyperinflation and unemployment?

Hyperinflation Unemployment

A tighten import controls lower interest rates

B revalue currency cut government expenditure
C control prices subsidise industries
D ration foreign currency cut government expenditure

13 Which of the following would cause cost-push inflation?

A aa higher level of consumption

B an increase in trade unionism
C an increase in labour productivity
D an appreciation of the exchange rate

14 Zimbabwe’s steel industry is closed down as buyers switch their purchases of steel to
another country. What type of unemployment will result from this?

A cyclical
B frictional
C seasonal
D structural

15 If government would want to reduce the non-accelerating inflation rate of unemployment

(NAIRU), which measure would be inappropriate?

A a reduction in interest rates

B an increase in rates of unemployment benefits
C the abolition of state-imposed minimum wage rates
D the introduction of travel allowances for unemployed workers to search for jobs

16 A tight monetary policy could be offset by

A a budget surplus.
B a decline in the velocity of money.
C an increase in the velocity of money.
D a deterioration in the profit expectations of business.

MAKE ECONOMICS EASY WITH MR KAYBEE: +263 71 818 1255 (APP/CALL)

 RESOURCE PACK/ ECONOMICS/A LEVEL

17 One of the solutions of reducing unemployment is to stimulate aggregate demand. If the

national income is at full employment level, this will lead to a

A balance of payment deficit.

B government budget deficit.
C reduced economic growth.
D rise in inflation.

18 Deflation involves

A decreasing domestic interest rate.

B decreasing level of money supply.
C increasing government expenditure.
D increasing taxes.

19 Which of the following measures is not consistent with a deflationary monetary policy?

A calling for special deposits

B overfunding the fiscal deficit
C central bank purchases of bills on the open market
D an increase in the general level of interest rate

20 Structural unemployment may be reduced by government action in

A reducing short-term interest rates.

B temporarily restricting the immigration of unskilled labour.
C making grants available for the introduction of automated production.
D encouraging greater occupational and geographical mobility of labour.

21 Cost-push inflation may be accelerated as a result of

A a general increase in rates of VAT.

B higher money wages reflecting increases in productivity.
C an increase in the level of gold reserves.
D government decisions to limit production of non-essential goods.

MAKE ECONOMICS EASY WITH MR KAYBEE: +263 71 818 1255 (APP/CALL)

 RESOURCE PACK/ ECONOMICS/A LEVEL

22 Which of the following factors can cause demand-pull inflation?

A a sharp increase in unemployment

B an increase in income tax
C a steep reduction in direct taxation
D a fall in consumption expenditure

23 Frictional unemployment cane be reduced by

A banning retrenchments.
B training job seekers.
C increasing unemployment benefits.
D availing information on jobs available to prospective job seekers.

24 Other things being equal, what is likely to immediately result from a fall in inflation?

A a capital inflow
B an increase in consumption
C an increase in investment
D a fall in unemployment

25 Stagflation refers to

A anticipated rate of inflation.

B stagnation in output combined with increasing inflation.
C low inflation combined with high economic activity.
D high inflation combined with high level of output.

26 Demand-pull inflation is caused by

A an increase in indirect taxes.

B an increase in interest rates.
C a reduction in direct taxes.
D a reduction in the money supply.

27 Overtime, the national rate of unemployment may fall as a result of the following except

A an increase in money supply.

B an increase in the mobility of labour.
C a reduction in state unemployment benefits.
D a reduction in trade union restrictive practices.

MAKE ECONOMICS EASY WITH MR KAYBEE: +263 71 818 1255 (APP/CALL)

 RESOURCE PACK/ ECONOMICS/A LEVEL

28 The diagram shows the rate of wage increase and the rate of unemployment.

O Rate of unemployment

What would cause the curve to shift?

A a rise in unemployment rate

B anticipated fall in inflation rate
C greater differences in regional unemployment
D higher proportion of ununionized labour

29 Below is the demand and supply curve for labour on the market.

SL
W1

W0 -------------------------------

DL

Quantity of labour

What type of unemployment is caused by an increase in the wage rate to W1?

A Frictional
B Classical
C Cyclical
D Structural

MAKE ECONOMICS EASY WITH MR KAYBEE: +263 71 818 1255 (APP/CALL)

 RESOURCE PACK/ ECONOMICS/A LEVEL

30 Demand-pull inflation is shown as a

A rightward shift of the AD curve in the horizontal range of aggregate supply.

B rightward shift of the AS curve in the intermediate range of the aggregate demand.
C leftward shift of the AS curve in the intermediate or vertical range of aggregate
supply.
D rightward shift of the AD curve in the intermediate or vertical range of aggregate
demand.

31 Some economists now believe that a low but positive inflation rate is good for the economy
because workers

A will accept a cut in real wages caused by inflation more readily than they will accept
a cut in nominal wages.
B will accept a cut in real wages caused by a cut in nominal wages more readily than
they would accept a cut in real wages caused by inflation.
C are indifferent between a cut in real wages caused by a cut in nominal wages and a
cut in real wages caused by inflation.
D will accept a cut in nominal wages caused by a cut in real wages more readily than
they would accept a cut in nominal wages caused by inflation.

32 If the money supply increases too rapidly,

A inflationary expectations will rise.

B government spending will decrease.
C bank lending will decrease.
D investment spending will fall.

33 A deflationary gap is measured using the

A rate of deflation.
B rate of unemployment.
C increase in injections needed to reach full employment.
D increase in withdrawals needed to reach full employment.

MAKE ECONOMICS EASY WITH MR KAYBEE: +263 71 818 1255 (APP/CALL)

 RESOURCE PACK/ ECONOMICS/A LEVEL

34 The table below shows categories of goods and services in the consumer basket for an
economy.

Item Weight Current prices (base year = 100)

Food 5 110
Clothing 3 120
All other goods 2 130

What has been the percentage increase in the price index since the base year?

A 17%
B 20%
C 117%
D 120%

35 If the government’s priority is to reduce the natural rate of unemployment, which measure
would be inappropriate?

A a reduction in interest rates.

B a reduction in rates of unemployment benefits.
C the abolition of state-imposed minimum wage rate.
D the introduction of travel allowances for unemployed workers to search for jobs.

36 Economists who favour supply-side policies would tend to support the government playing

A no role in the economy.

B a reduced role in the economy.
C an expanded role in the economy.
D a role in monetary policies only.

37 Privatisation and deregulation of economic activities in an economy are a form of

A fiscal policy.
B indigenisation policy.
C monetary policy.
D supply side policy.

MAKE ECONOMICS EASY WITH MR KAYBEE: +263 71 818 1255 (APP/CALL)

 RESOURCE PACK/ ECONOMICS/A LEVEL

38 Cost-push inflation may be caused by

A an increase in trade union power.

B an appreciation of the exchange rate.
C an increase in labour productivity.
D a higher level of consumption.

39 To reduce cyclical unemployment, the government has to increase

A taxation.
B budget deficit.
C a budget surplus.
D the balance of payments deficit.

40 Assuming the demand for oil is price elastic, the effect on demand-pull inflation and on
cost-push inflation in an oil importing country of an increase in the world price of oil will
be

effect on demand-pull inflation effect on cost-push inflation

A a reduction a reduction
B a reduction an increase
C an increase a reduction
D an increase an increase

41 Cost-push inflation is a result of the following except

A a fall in the exchange rate.

B wages rising faster than productivity.
C rising world prices for major raw materials.
D increased export demand for the country’s output.

42 A deflationary gap in the economy is measured by

A change in injections needed to reach full employment.

B the public sector borrowing requirements.
C the rate of deflation in the economy.
D the rate of unemployment in the economy.

MAKE ECONOMICS EASY WITH MR KAYBEE: +263 71 818 1255 (APP/CALL)

 RESOURCE PACK/ ECONOMICS/A LEVEL

43 Zimbabwe is experiencing a balance of payment deficit and a high rate of inflation rate.

What is the appropriate policy measure to correct the above?

A reduce direct taxes

B remove import duties
C increase domestic interest rates
D increase the money supply in the economy.

44 Technological unemployment in an economy is controlled by

A the provision of retraining schemes.

B reduction in the level of direct taxation.
C a reduction in the level of indirect taxation.
D the provision of loans by banks.

45 The following are supply side policy measures except

A increase in subsidies.
B increase in income tax.
C improved quality of labour.
D privatization and deregulation.

46 A situation where both inflation and unemployment are high is known as

A deflation.
B depression.
C recession.
D stagflation.

47 During an economic recession sales decline leading to some workers losing their jobs. This
type of unemployment is referred to as

A cyclical.
B frictional.
C structural.
D technological.

MAKE ECONOMICS EASY WITH MR KAYBEE: +263 71 818 1255 (APP/CALL)

 RESOURCE PACK/ ECONOMICS/A LEVEL

48 The table shows information in the population of a country.

Class Population in millions

Under 15 20
Employed 16
Pensioners 9
Unemployed 4
Physically unable to work 1
Total population 50

Calculate the unemployment rate.

A 8%
B 10%
C 20%
D 32%

49 Which of the following would be classified as an expansion monetary policy?

A an increase in special deposits

B an increase in interest rates
C an increase in money supply
D an increase in the exchange rate

50 Involuntary unemployment refers to

A the proportion of the workforce which choose to remain unemployed when the
labour market is equilibrium.
B workers who choose not to accept employment at the existing wage rate.
C the proportion of the workforce which is unable to find jobs despite being prepared
to accept work at the existing wage rate.
D workers who lose jobs because wages are at such a high level that demand for labour
is exceeding supply.

MAKE ECONOMICS EASY WITH MR KAYBEE: +263 71 818 1255 (APP/CALL)

 RESOURCE PACK/ ECONOMICS/A LEVEL

51 The data below relates to unemployment levels over a period of 10 years.

Year Number of unemployed

1991 3075
1992 2974
1993 3414
1994 3769
1995 3936
1996 3736
1997 3454
1998 3334
1999 3034
2000 2766

By what percentage did the level of unemployment change from 1991 to 2000?

A It fell by 10.05%
B It rose by 3.35%
C It rose by 11.17&
D It fell by 3.09%

52 The government reduces demand deficiency unemployment through

A contractionary fiscal policy measures.

B contractionary monetary policy measures.
C expansionary fiscal policy measures.
D increase in both direct and indirect taxes.

53 The unemployment rate is 5%. The labour force is 100 million and population is 200
million. Calculate the number of people unemployed.

A 2 million
B 5 million
C 10 million
D 500 million

MAKE ECONOMICS EASY WITH MR KAYBEE: +263 71 818 1255 (APP/CALL)

 RESOURCE PACK/ ECONOMICS/A LEVEL

54

In the diagrams above, an inflationary gap is demonstrated by

A (i) and (iii)

B (ii) and (iv)
C (ii) and (iii)
D (i) and (ii)

55 Weights are used in calculating the consumer price index to reflect the different

A levels of prices for each good.

B number of consumers buying a product
C rate of change in price of each good over time.
D amount of money spent on goods in the consumer basket.

MAKE ECONOMICS EASY WITH MR KAYBEE: +263 71 818 1255 (APP/CALL)

 RESOURCE PACK/ ECONOMICS/A LEVEL

56 Which of the following is a direct measure to control inflation?

A Setting pay limits for workers in civil service.

B Allowing the exchange rate to appreciate.
C Cutting government subsidies to farmers.
D Raising interest rates.

57 A fiscal policy measure to reduce unemployment is to

A increase the size of the budget deficit.

B boost the money supply by relaxing credit controls.
C reduce interest rates.
D increase direct taxes.

58 Which one of the following measures reduces structural unemployment?

A An increase in the interest rates in the economy.

B A reduction in level of direct taxation.
C A reduction in level of indirect taxes.
D An increase in subsidies to producers.

59 Changing of education curriculum to suit the demands of the industry leads to reduction in

A cyclical unemployment.
B frictional unemployment.
C structural unemployment.
D seasonal unemployment.

60 The following information relates to an economy.

Total population 7 000

Total number of unemployed 2 100
Total number of employed 1 400

Unemployment rate is

A 20%
B 30%
C 50%
D 60%

MAKE ECONOMICS EASY WITH MR KAYBEE: +263 71 818 1255 (APP/CALL)

 RESOURCE PACK/ ECONOMICS/A LEVEL

ESSAY QUESTIONS

1. (a) Analyse the consequences of high inflation in an economy [10]

[10]
(b) Discuss the effectiveness of monetary policy in reducing inflation in your economy.[15]

2. (a) Why is inflation often viewed as ‘an enemy of the state’? [10]

(b) Discuss the effectiveness of policies aimed at reducing inflation in your country. [15]

3. (a) Explain the causes of inflation in your country [10]

(b) Discuss whether it is the government’s responsibility, and to what extent should it
intervene, to reduce the rate of inflation. [15]

4. (a) In recent years, the rate of inflation in many countries has been low. Suggest
[12]
possible reasons why rate may be low.

(b) Discuss what policy measures a government may adopt if the rate of inflation were
to become unacceptably high. [13]

5. (a) Explain what causes inflation. [10]

(b) Discuss whether a low rate of inflation should be the economic priority of a
government. [15]

6. (a) Clearly outline the types of inflation affecting your country. [10]

(b) Discuss the effects of inflation to any economy. [15]

7. (a) Explain in detail demand pull and cost push inflation. [10]

(b) Clearly evaluate measures taken by the government to reduce the effects of inflation
in Zimbabwe. [15]

MAKE ECONOMICS EASY WITH MR KAYBEE: +263 71 818 1255 (APP/CALL)

 RESOURCE PACK/ ECONOMICS/A LEVEL

8. (a) Is it important to control the rate of inflation in a country? [10]

(b) Discuss the policies that government could adopt to counter a high rate of inflation.[15]

9. (a) What are the causes of unemployment in your country? [10]

(b) Clearly evaluate the effectiveness of demand – side policies in reducing the level
of unemployment in your country. [15]

10. (a) Explain the following:

(i) Structural unemployment

(ii) Frictional unemployment

(iii) Voluntary unemployment

(iv) Demand deficient unemployment [10]

(b) Evaluate the policies which the government can apply to reduce unemployment in
your country. [15]

10. (a) Distinguish between Real wage and Technological unemployment [10]

(b) Outline the supply side policies which can be adopted to get rid of unemployment. [15]

11. (a) Account for the present level of unemployment in Zimbabwe. [10]

(b) In recent years, a number of countries have experienced a recession. What are the
main characteristics of an economic recession? [15]

12. (a) Explain the relationship that exists between inflation and unemployment. [10]

(b) Why is it necessary for any country to address the issue of unemployment. Explain
the fiscal measures which the government can take to address the issue of
[15]
unemployment in your country.

MAKE ECONOMICS EASY WITH MR KAYBEE: +263 71 818 1255 (APP/CALL)

 RESOURCE PACK/ ECONOMICS/A LEVEL

13. (a) What are the causes of unemployment in your country? [10]

(b) Discuss how the unemployment in your country could be reduced. [15]

14. (a) Explain the:

(i) inflationary gap;

(ii) deflationary gap [10]

(b) Evaluate the effectiveness of policies that can be used to reduce an inflationary gap
in your country. [15]

MAKE ECONOMICS EASY WITH MR KAYBEE: +263 71 818 1255 (APP/CALL)