National Income, Inflation, Unemployment, Fiscal and Monetary Policy

This article discusses the advantages and disadvantages of the CPI, the impact of inflation on people, flaws of the measure of unemployment, and more.

Running Head: NATIONAL INCOME, FISCAL AND MONETARY POLICY 1
National Income, Inflation, Unemployment, Fiscal and Monetary Policy
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NATIONAL INCOME, FISCAL AND MONETARY POLICY 2
National Income, Inflation, Unemployment, Fiscal and Monetary Policy
Question 6
a. Advantages and disadvantages of the CPI
The CPI is the most commonly used measure of price changes in the economy not
only in Australia but also in other parts of the world. It has the inherent advantages of
consistency and flexibility. It can be said that the index is consistent because it considers
relatively the same basket of goods for a long period. That means that it takes into account
the costs an average consumer faces during that period. Some forms of the index take into
account seasonal adjustments and consumer preferences hence its flexibility.
Nevertheless, the CPI fails to take into account the new products that, are a result of
innovation, coming into the market. Despite a possible shift in preferences in the
consumption of new goods, CPI uses a particular basket of products for an extended period
before recognizing new consumption patterns in the consumer basket(Mankiw,2015). The
CPI counts goods that are consumed by households and ignores the goods produced by
various sectors. It is with this reason that it is widely thought the GDP deflator is dethroning
it as a measure of inflation. Moreover, the CPI does not consider the substitutes of goods in
the consumer basket hence it ends up overstating inflation. Lastly, the index measures the
general rate of inflation and not the changes of inflation rates for a particular individual since
individuals may purchase a set of goods not factor in the consumer basket considered by the
CPI (Cooper &John, 2012).
b. Some people win; some lose during inflation.
The main reason why some people gain while others lose in case of inflation is that
economic transactions involve contracts that are often set over long periods. Additionally,

NATIONAL INCOME, FISCAL AND MONETARY POLICY 3
such contracts are specified in nominal but not real terms, and as such, they are not adjusted
for inflation before its occurrence (Krugman &Wells, 2013). Thus, when inflation occurs,
adjustment of the nominal terms to real terms end up reducing the real value of the
transactions. Illustratively, the debtor pays lower values in real terms in case inflation occurs
after they have borrowed hence playing to a disadvantage of the lenders.
c. Flaws of the measure of unemployment
The Australian measure of unemployment is not close to perfection as expected.
According to Krugman & Wells (2013), the unemployment measure has flaws such as
ignoring the discouraged job seekers. The measure does not include them as workers actively
seeking employment. Secondly, the official figures count the part-time employees at the same
level as full-time employees which further understates the rate of unemployment. The
implication of such flaws is an understated unemployment rate
Question 7
a) There is an increase in government purchase and an expansion in the GDP
b) There is an increase in both tax income and the national income.
c) Exports reduce and therefore a decrease in the national income
d) Both the consumption component and GDP remains unchanged.
e) Purchase of bonds implies more savings and consequently a reduction in private
investments and a reduction in the GDP.
f) Investments increase and therefore GDP increases.
g) Net exports reduce and consequently, the GDP
h) Consumption increases and the GDP declines

NATIONAL INCOME, FISCAL AND MONETARY POLICY 4
i) Investments decrease and so does the GDP.
j) The net exports increase and therefore the GDP increases.
Question 8
e. Problems of using fiscal policy to achieve a precise level of GDP
Some economists have argued that expansionary fiscal policy such as increased
government expenditure crowds out private investments. In case of increased government
purchases, governments are forced to borrow from the private sector hence reducing
investable funds. It is also argued that the time lags affect the effectiveness of fiscal policy. It
may take considerable time for the government to increase spending. Additionally, it will
take time for such a decision to filter through to affect the aggregate demand (Hansen,2013).
Thirdly, the fiscal policy may suffer considerably if the government is misinformed. For
instance, if the government expects a not-forthcoming recession and puts measures to
increase aggregate demand, it may plunge the economy into inflation.
f. Why frictional unemployment is inevitable
Frictional unemployment is unavoidable because there are constant changes in the
economy. Some firms experience expansions whereas others are declining. Such kind of
changes depends on the differences in growth rates of various sectors of the economy.
Therefore, workers keep transitioning between firm, regions and jobs and that constitutes
temporary unemployment (Krugman &Wells, 2013). If all jobs were similar or offering
homogenous conditions and that all prospective workers had such information uniformly,
then people could find jobs in no time. However, the economy is characterized by
inconsistent skills, imperfect knowledge, and constant changes. Workers have to look for
some time before they land jobs.

NATIONAL INCOME, FISCAL AND MONETARY POLICY 5
g. Structural unemployment
Macroeconomic policymakers should worry about structural unemployment because
the economy keeps changing and rapidly and it is long-term unemployment. Therefore, the
effects of structural unemployment may last for a long period. Structural unemployment is
long term unemployment that occurs when more workers are seeking jobs in a given labor
market than jobs are not sufficient at the current wage rate (Krugman&Wells, 2013). The
insufficiency can occur even when the economy is at its peak. Structural unemployment
could be as a result of a decline in a given industry leading to lay off of workers or an
advancement in technology rendering the skills of some workers obsolete. Cyclical
unemployment is the deviation from the natural rate of unemployment in an economy. It
occurs due to contractions and expansions during the business cycle. One major cause of this
type of unemployment is a decline in demand(Diamond,2013).
Question 9
h. Bank Negara Malaysia sells private sector securities worth RM 800 million.
i. According to Mishkin (2016), holding other factors constant, a sale of RM 800 million
securities by the central bank causes an RM 800 million decline in the monetary base.
ii. Short-term market interest rates (the rate at which the banks lend to each other) increases
given that the money supply has decreased due to the monetary base contraction.
iii. Long-term interest rates- The banks have to integrate the cost of borrowing in their
customer lending rates. Therefore, the long-term interest rate goes increasing after the decline
in the monetary base and the money supply in general (Mishkin, 2016).
iv. Given that business firms and individuals find borrowing difficult, the levels of
investment decline and therefore economic activity contracts considerably or grows slowly.

NATIONAL INCOME, FISCAL AND MONETARY POLICY 6
Consumption and investment reduce and therefore, aggregate demand decreases.
Consequently, the rate of inflation falls (Mishkin, 2016).
i. Selling securities in foreign currency
If the Bank Negara sells securities in foreign currency, the effect of the sale is
similar to that of sale of securities denominated in domestic currency. It, therefore, will lead
to a decline in the monetary base, higher interest rates and eventually it will lower the
inflation rates.
j. Tax cuts vs increased expenditure
According to Alesina &Ardagna (2010), tax cuts are likely to cause a more
significant impact on the expansion of the GDP because its effects are felt and seen in a short
while. There is an increase in disposable income for individuals to spend on consumption and
for businesses to invest. That will lead to the growth of consumption, investment and because
of the immediate impact, it has on consumer expectations and incentives. The expenditure
approach to expansion is equally good, but its impact may take a long time before it realizes
its goal.
Question 10
d. Why the shape of the LRAS curve is essential in the Keynesian-Monetarist controversy
The shape of the aggregate supply curve is crucial for both economists because it
helps them to determine the aggregate output and where employment and inflation is likely to
set in after a period of recession. In that case, the total supply curve is horizontal, and an
increase in aggregate demand leads to an increase in real GDP while the price level remains
unchanged. Keynesians believe that supply will eventually create its demand and that that the
wages are downward sticky. The monetarists propose that the prices are flexible and that the

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economy operates at full employment. Thus, according to monetarists, the prices may change
rapidly in a bid to keep the economy at full employment (Mankiw, 2015).
e. Vertical investment demand curve for the Keynesian vs. Monetarists
In the case of a vertical investment demand curve, the Keynesians are likely to be
more correct. In the case of a vertical demand curve, the level of investment is not dependent
on the interest rates as is in the usual case. Therefore, the level of aggregate demand will not
depend on interest rates. As such, monetary policy will be rendered ineffective (McConnell,
Brue&Flynn,2009). Thus, the only other way to alter the level of aggregate demand will be
fiscal policy. It will stimulate economic activity, investment and lead to output, if
expansionary, during a recession.
f. Difference regarding how an increase in money demand causes inflation
Monetarists believe that money growth should be in the same pace as growth of
output. That growth in the supply of money leads to inflation. On their view, Keynesians
believe that money growth does not directly lead to inflation. They propose that some
economic pressures in the economy cause inflation (Mishkin, 2016).

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References
Alesina, A., & Ardagna, S. (2010). Large changes in fiscal policy: taxes versus spending. Tax
policy and the economy, 24(1), 35-68.
Cooper, R., & John, A. (2012). Theory and Applications of Macroeconomics.V.1. Retrieved
from https://2012books.lardbucket.org/pdfs/theory-and-applications-of-
macroeconomics.pdf
Diamond, P. (2013). Cyclical unemployment, structural unemployment. IMF Economic
Review, 61(3), 410-455.
Hansen, A. H. (2013). Fiscal policy & business cycles. London: Routledge.
Krugman, P. & Wells, R. (2013). Economics (3rd ed.). New York: Worth Publishers.
Mankiw, G. N. (2015) Principles of economics (7th ed.). Stamford: Cengage Learning
McConnell, C. R., Brue, S. L., & Flynn, S. M. (2009). Economics: Principles, problems, and
policies (20th ed.). Boston: McGraw-Hill/Irwin.
Mishkin, F. S. (2016). The economics of money, banking, and financial markets (11th ed.)
Boston: Pearson