I.

What are the main causes and consequences of inflation? How may the authorities attempt to conquer inflation? Use diagrams to illustrate your answer.

1. What is Inflation? Inflation is a rise in the general level of prices for goods and services in an economy over a period of time. When the general prices rise, each unit of currency buys less goods or services. In consequence, inflation reflects in the purchasing power of money. The most common gauge of inflation is known as CPI (consumer price index) which measures the price increase or decrease of basic consumer goods and services. The GDP deflator (growth domestic product deflator) is another way to calculate inflation as it measures the prices of goods that are produced domestically. Inflation decreases the value of your money and increases those of goods and services. 2. Causes of Inflation The British economy has experienced inflation throughout the last thirty years but the rates at which prices have been rising have not been stable. In an open economy price inflation can be caused by a number of factors. Economists divide them into two main groups, demand-pull and cost-push inflation. Cost Push Inflation: Cost-Push Inflation happens when prices instead of being pulled up by high demand are driven up as a result of rise in the cost of production. Businesses respond to rising of production costs by increasing their own prices in order to maintain their profit margins. This can be seen with inelastic products such as the oil markets. When OPEC reduces oil supply due to increases in production costs, prices are artificially driven up and result in a higher price at the pump. There are many reasons why the cost of production could rise: - Rising imported raw materials costs - caused by inflation in countries that are dependent on exports of those commodities or it could be caused by a fall in the value of the pound in the foreign exchange markets which increases the UK price of imported inputs. A good example of cost push inflation was the decision by British Gas and other energy suppliers to raise substantially the prices for gas and electricity that it charges to domestic and industrial consumers during 2005 and 2006. - Rising labour costs - caused by wages increasing which exceed any improvement in productivity. This cause is important in those industries which are labour-intensive. Firms may decide not to pass those higher costs onto their customers but in the long run, wage inflation tends to move closely with price inflation because there are limits to the extent to which any business can absorb higher wage expenses. A good example of this is in China where provinces increase their minimum wage in order to attract new workers. These increases in wages have no consequences in productivity in those firms. Those firms are trying not to pass on those costs to the consumers and in order to keep on doing so manufacturers could look to countries such as Vietnam, Bangladesh and Cambodia where wages are still low. - Higher indirect taxes imposed by the government For example a rise in the rate of exercise duty on cigarettes and alcohol, an increase in fuel duties or perhaps a rise in the standard rate of value added tax or an extension of the VAT products. Depending on the price elasticity of demand and supply for their product, producers can decide to pass on those taxes onto consumers. These products being inelastic governments keep rising taxes on them and suppliers keep passing on the burden of the tax onto consumers. Cost-push inflation can be illustrated by the diagram below.

Price Level or Inflation AS2 Aggregate Supply

Aggregate Demand Real National Income The aggregate supply curve shifts left because of the costs increasing, therefore pushing prices up. Demand Pull Inflation: Demand Pull Inflation occurs when total demand for goods and services exceeds total supply. This type of inflation happens when there has been excessive growth in aggregate demand. The Demand Pull Inflation can be illustrated by the following diagram.

Aggregate Price Level Aggregate Supply

Price 2 Price 1

AD1 GDP Year 1 Year 2

Aggregate Demand 2

Increase in aggregate demand brought by an increase in any factor will cause the aggregate demand curve shift to the right. Increase in aggregate demand causes excess demand and prices are driven up from Price 1 to Price 2. 3. Consequences of Inflation Money Illusion: Inflation has a direct impact in peoples everyday lives. For example, if people experience a rise in their salary but the same rise has occurred during the inflation then there has been no growth in income. That often occurs when inflation is unanticipated but most people are not worried about inflation within the economy. It is mostly anticipated with businesses than people.

Impacts on the Economy: In the case of high inflation or extreme cases hyperinflation can lead to economical breakdown. Low and stable inflation is perceived to have less of a damaging effect than hyper-inflation where prices are out of control. Inflation will have many different effects on both individuals but also on the economy performing as a whole. Impacts on the savers: Inflations leads to a rise in price level so money loses its value. If inflation is high, people may lose confidence in money whereas their savings are severely reduces. Savers will lose out if interest rates are lower than inflation leading to negative real interest rates. Wages: Inflation leads to higher wage demands as people try to maintain their living standards. In order for businesses to give higher wages they have to raise prices to keep their profit margin. Investments: Inflation can impact business planning. Budgeting becomes difficult because of the uncertainty created by rising inflation of both prices and costs. Less investment leads to less growth in the economy in the long run. Unemployment: A higher rate of inflation in a country than another can lead to loss of international competitiveness and by consequence will lower trade performance. The UK has lowered his inflation over the past decades and now believes in monetary stability in order to sustain economic expansion. 4. How may the authorities attempt to conquer inflation? There are two ways of controlling inflation which are monetary measures and fiscal measures. Monetary Measures: The most commonly used method to control inflation is the monetary policy of the central bank of America. Most central banks use high interest rates in as the traditional way to fight inflation. Fiscal Measures: Fiscal measures are to control inflation including taxation, government expenditure and public borrowings. II. What are the main types of unemployment? Explain the competing theories of unemployment. With reference to current unemployment in the UK, discuss which of the theories you find the more appealing. 1. Introduction

The unemployment rate in the United Kingdom was last reported at 8.4 percent in December of 2011. From 1971 until 2010 the United Kingdom's Unemployment Rate averaged 7.22 percent. The inflation rate in United Kingdom was last reported at 3.6 percent in January of 2012. From 1989 until 2010, the average inflation rate in United Kingdom was 2.72 percent. Those numbers indicate that following the increase in unemployment and the impact on society, inflation will play a major role in everyday lives for citizens. Society will have to adapt to rises in prices and those rises in prices will make people spend less and save more which has a direct impact on the commerce in the UK so on the economy. Usually the standard of living rises but our standard of living has never been as hard even in the 1982 recession; The UK standard of living rapidly dropping year after year. (David, 2010) Neil Blake from the Oxford Economics says that it might get even worse in time to come. 2. Categories of Unemployment Frictional Unemployment - It is defined as a state of unemployment where people are moving between jobs and new workers entering the labour force. In an economy where people are free to change their job, frictional unemployment cannot be eliminated and may even be desirable. An example for this could be new graduates who are looking for a job; that period of searching is known as frictional unemployment. Structural Unemployment - It is defined by unemployment that is caused by structural changes in demand patterns. The introduction of new technologies has created a kind of structural unemployment called technology unemployment. For example the introduction of labour saving machines in new

industries is a result of it. Policies to reduce structural unemployment could be training or adult education. Classical unemployment It is defined by the wage rate exceeding the market rate leading to a surplus of labour supplied. Classical unemployment could be known as real wage unemployment because it refers to real wages being too high. Economists argue that if wages were flexible then most unemployment could be solved. Classical unemployment could be illustrated by the bellow diagram. Wage rate Wage 2 Unemployment Supply

Wage 1

Demand Quantity of Labour Q1 Q Q2

Classical unemployment = Q2-Q1 - In a free market the quantity of labour would be Q1. Cyclical unemployment Cyclical unemployment or demand deficient occurs when there is not enough aggregate demand in the economy in order to ensure full employment. It is defined as unemployment that is due to cyclical changes in the economic activity. We are in recession within the United Kingdom and that period of slow growth where there is less demand and higher unemployment is called cyclical unemployment. Cyclical unemployment can be illustrated by the diagram bellow. Price Level Aggregate supply

Price X Price

AD1

Aggregate Demand GDP Y YX

A shift to the right of the aggregate demand curve will push the economy to supply more goods and prices will increase which will lead to a higher growth in the country so higher employment.

3. Theories of unemployment The modern Neo-Keynesian Theory It is a classical view that unemployment is voluntary and requires a supply side policy approach. The Keynesians believed that persistent unemployment was due to the sticky wages, an equilibrium bellow full employment and inadequate aggregate demand. In the 1980s economists began to develop new theories to counter the new classical theory that Unemployment was entirely voluntary and this was based around the Efficiency Wages Model. Efficiency Wages Model This model says that productivity of workers depends on the wages they are given and consequently it is more profitable for firms to pay an efficiency wage that is above the average market wage. The theory also suggests that even with an excess supply of labor, firms are not likely to reduce wages. Hysteresis unemployment theory The theory shows that behavioral and human capital changes among the unemployed, such as losing interest or skill in getting new jobs, could lead to declining chances of becoming employed.

4. Theory of unemployment for the UK. The theory applied to the UK would be more based on the modern Neo-Keynesian theory resulting from the benefit system that is the most generous in the whole world. Six million Britons are living of the benefits and cost the taxpayer nearly 13 billion a year in state handouts. There are those wanting to stay unemployed and not wanting to get back to a job, causing depression, anxiety and a lack of confidence if unemployment has been on a long term especially among young people which would be the hysteresis idea. The weather in the United Kingdom has caused depression among society which leads to alcohol abuse. Alcohol would certainly be less consumed if weather was better whereas time spent in outdoor activities would increase and will lead to a healthier lifestyle. The Alcohol brings 27,2 billion pounds to the United Kingdom and makes people feel more relax and worry less about what is happening in their lives, having a direct result in unemployment. If unemployment was due to a lack of skills would that mean that unemployment is voluntary? Most graduates do not speak a second language and do not have work experience but yet still expects to gain employment. Due to that lack of effort many people are out of work, if employment was necessary to their survival then people would definitely find a job, may be not what they expected but yet still a job.

Reference
David, D. (2010). HARD TIMES. SKY NEWS. Pankhurst, N. (2011, October 12). What prospects for the young unemployed? Retrieved March 15, 2011, from BBC NEWS: http://www.bbc.co.uk/news/uk-15255221