Macroeconomics ProblemLearning Objectives:At the end of the chapters, students should be able to understand

1. Definition Of Business Cycle 2. Characteristic Of Business Cycle3. Four Phases Of A Business Cycle 4. Definition Of Unemployment 5. Unemployment Rate Formula 6. The Types Of Unemployment 7. The Causes Of Unemployment 8. The Effect Of Unemployment 9. Method To Control The Unemployment 10. Definition Of Inflation 11. Inflation Rate Formula 12. Degree Of Inflation 13. The Types/Causes Of Inflation14. The Effect Of Inflation15. Method To Control The Inflation16. Inflationary Gap vs Deflationary Gap

Introduction

The topic discuss the cause of business cycles so that they can learn how to moderate or avoid recessions and their harmful effects on standards of living. The topic also explain on inflation and unemployment and their effects on individuals, society and the nation. The fiscal policy, monetary policy and steps to reduce inflation and unemployment are also been highlighted.

1. Definition Of Business Cycle

A business cycle refers to the regular fluctuation in economic activity in an economy as a whole.The term business cycle refers to economy-wide fluctuations in production or economic activity particularly with regard to national income, employment and output over several months or years. It is also known as trade cycle or  economic cycle and looks like a wave fluctuate in aggregate output rises for a while, then falls over time.

2. Characteristic Of Business Cycle

The business is never steady. There are always ups and downs in economic activity. In business, there are flourishing activities, which take economy to prosperity and growth whereas there are periods when there is recession, which leads to decline in the employment, income and output. When the economy goes into downswing then there is a stage of recovery to reach a new boom.

the main characteristics of business cycle are as following:1. The fluctuations are wave like movement and are recurrent in nature.2. Business Cycle is characterized by waves of expansion and contraction. 3. There are four phase of business cycle – Peak, Recession, Trough and Recovery.4. Business Cycle is self generating. Every phase has germs of the next phase, that is, expansion has the

germs of the recession in it.

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3. Four Phases Of A Business Cycle

A typical or standard business cycle goes through four different stages or phases. The four phases of the business cycle are prosperity, recession, depression, and recovery. Both business decisions and consumer buying patterns differ at each stage of the business cycle.

1. Phase 1- Prosperity/Boom/Peak

A peak is when business activity reaches a temporary maximum with full employment and near-capacityoutput.where all available resources are employed. The unemployment remains low, strong consumer confidence about the future leads to record purchases, and businesses expand to take advantage of marketplace opportunties. There are more investment coming in and increases pressure on available resources. Thus, it leads to the number of jobs are more than the number of workers thus lead to increase in prices, wages, interest and profit.

2. Phase 2- Recession/Contraction

The second phase is a recession or called a contraction. It is downwards phase in which a business cycle movesfrom a peak to a trough during which output and employment decline.This phase lasting six months or more when there is an increase in the level of unemployment (level of employed is lowest),a reduction in aggregateincome in terms of wage and profit which leads to a decline in consumption expenditure and investment level.Consumers frequently postpone major purchases and shift buying patterns toward basic, functional productscarrying low prices. Businesses mirror these changes in the marketplace by slowing production, postponing expansion plans, reducing inventories, and often cutting the size of their workforce.

3. Phase 3- Depression/Trough

The third phase is called as trough and experience poor economic time. It occurs when the overall level of economic activity fall to the lowest level. Unemployment rates during this phase will be higher and will create many problems. Thus, it is a period of great suffering and hardship to society and the worst phase of a business cycle. The trough is the bottom of the recession period. During this time, the economic slow down continue in a downward spiral over an extended period of time, the economy falls into depression. Most economists believe that society is capable of preventing future depressions through effective economic policies. Thus, it would be followed by an economic recovery

4. Phase 4- Recovery/Expansion

The final phase is a recovery stage where period of revival leading to an upturn of the economy. The business cycle is having an expansion where it moves from a trough to a peak i.e. where output and employment increase The economy’s level of output and employment expands towards full employment during this phase. Government initiate by increasing expenditure, changes in production techniques, new innovations and exploitation of new sources of energy. Thus, stimulate the demand for consumption and increase demands for capital goods. Consequently,, the employment level, output, income, wages, prices and profits begin to increase. In the recovery stage, the economy emerges from recession and consumer spending picks up steam. Even through business often continue to rely on part time and other temporary workers during the early stages of a recovery, unemployment begins to decline, as business activity accelerates and firms seek additional workers to meet growing production demands. Gradually, the concerns of recession begin to disappear, and consumers start purchasing more discretionary items such as vacations and new computer equipment. It is important to note that recovery doesn't necessarily take place at a steady pace.

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Business Cycle and Concept of Potential National Income (Full Employment) and Real National Income

1. Potential National Income is total final goods and services that been produced by the country at full employment level. At this stage, all economic resouces are fully utilized and having minimum level of unemployment rate. A country unemployment rate below or equal 4%i s regarded has achieve full employment.

2. Real National Income is total final goods and services that been produced by the country within a year. Level of income is achieved when part or all resources been utilized in economy.

3. According to Keynes the Real National Income Equilibrium is achieved when the level of income is higher than, or equal ,or below than Potential National Income.

4. Business Cycle cause the Real National Income higher than, or equal ,or below than Potential National Income .

Phase

Unemployment

Inflation Output Status Pt

1 Peak/Boom Lowest Level

Highest Level

Maximum Level

Real Y> Potential Y

A,E,I AD>AS

2 Recession Increases Declines Real Y < Potential Y

B to C F to G

AD< AS

3 Trough Highest Level

Minimum Level

Real Y < Potential Y

C&G AD< AS

4 Recovery Declines Increases Real Y < Potential Y

C to D G to H

AD< AS

Full Employment

- - growth Real Y = Potential Y

B,D,F,H,J

AD=AS

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Potential Y

recovery

Real GDP recession

trough

trough

Year

Potential national income curve is a straight line upward from left to right. It shows the potential of increasing income levels steady through time. An increase in potential national income due to increase in production factors and improvement in technology.

Real National Income is an upward and downward line shows a fluctuating economy . The fluctuations in economic activity is referred to as business cycles or economic swings.

Each business cycle indicating four stages of economic phenomenon : inflation, recession,trough and recovery.Economy is reaching full employment at point B,D, F H and J where Real Y is equal to Potential Y.

From Point A to B , the contraction occurs but still Real Y> Potential Y and there is an excess on Aggregate Demand and economy start to contract and general price level and inflation decreasing.

From Point B to C , the recession occurs and Real Y< Potential Y and there is an excess on Aggregate Supply and economy is real poor condition. Economic recession sart to occur and rate of unemployment keep on increasing

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At point C, the trough takes place and experience poor economic time. when the overall level of economic activity fall to the lowest level at point G where economic recession is great.Unemployment rates during this phase will be higher and will create many problems. Thus, it is a period of great suffering and hardship to society and the worst phase of a business cycle. The trough is the bottom of the recession period.

From Point C to D , the recovery occurs but still Real Y< Potential Y and there is an excess on Aggregate Supply and economy is expanding through government effort, the economy ic begin to recover and reach full equilibrium at point D

From Point D to E , the economy is having an expansion which total output grows rapidly where Real Y> Potential Y and there is an excess on Aggregate Demand and economy is begin to have inflation where general price level continuously increasing.

At point E, the inflation is getting serious and reach the peak and output starts to fall.

From Point A till Point E is a one of business cycle and it keep recurring from year to year and government implement policy to stabilize the economy.This roller-coaster pattern is a recurring cycle. Output growth is measured in real GDP and changes in real GDP are proxy for changes in the quantity of goods and services an economy can produce in a year, for example, tons of rice, units of cars, number of houses built, and other goods as well as services.

4. Definition Of Unemployment

Those who are in the labour force can also be divided into two categories, namely those who are employed and those who are not.We need to defined labour force in order to understand the concept of unemployment such as full employment,unemployment,unemployed,underemployment,discouraged worker and labour force

1. Full Employment

Full Employment is the situation in which all the working labour force are employed to produce goods and services. Full-employment does not mean zero unemployment or 100 per cent of the working labour force.

The natural rate is achieved when labor markets are in balance; the number of job seekers equals the number of job vacancies. At this point the economy’s potential output is being achieved.

2. Unemployment

Unemployment is defined as labour force participants being available and willing to work but unable to finds jobs.

3. Unemployed

The unemployed are people who are registered as able, available and willing to work at the going wage rate but who cannot find work despite an active search for work. Unemployed means those who are not working but are actively looking for jobs.

4. Underemployment

Underemployment is a term used to describe those who take on part-time jobs below their capability but are seeking full-time employment. People with education and skills accept unskilled jobs rather than remain unemployed. For example, a graduate working as a salesperson in a supermarket.

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5. Discouraged Worker

A discouraged worker is an individual who wants to work but has been unsuccessful for a long period of time in finding a job and who has consequently given up on seeking for jobs. Discouraged workers would like to work if job prospects are good.

6. Labour force

The labour force is defined as people from the total population above 16 years of age, who are not in any institution and who are either employed or unemployed but actively seeking employment. So, the labour force consists of employed and unemployed persons. For those 16 years of age who are not in the labour force are students, housewives, pensioners, and discouraged workers.

7. Part-time workers vs full time workers

Part-time workers are those who work less than 35 hours a week. Full-time workers are those who work 35 hours or more in a week.

5. Unemployment Rate Formula

The rate of unemployment is an important guide towards a country’s economic situation. The unemployment rate is defined as the percentage of the labor force that is not employed but actively seeking employment.Unemployment rate (%) = Number of Unemployed X 100% Labour Force

ExampleThe schedule below shows the total production, labour force and total employment in Malaysia in 2007 and 2008.

Year 2007 Year 2008Total Population (million) 27.1 27.7Labour Force (‘000) 10,889.5 11,028.1Employed Person (‘000) 10,538.1 10,659.6Number of unemployed (‘000) 351.4 368.5Source: Labour Force Statistics (2008), Official Website of Department of Statistics Malaysia

The unemployment rate for each year can be calculated as follows:

Unemployment rate for year 2007 = (Total Unemployment/labour force) x 100 = (351.4/10,885.9) x 100

= 3.23%Unemployment rate for year 2008 = (Total Unemployed/labour force) x 100 = (368.5/11,028.1) x 100 = 3.34%

The rate of unemployment will increase when there is a recession and it will decrease when there is economic growth. The rate of unemployment will not become zero even when there is economic growth because there will be some unemployment when there is a change of jobs, or while workers wait for better job opportunities.

6. The Types Of Unemployment

Unemployment takes place when people have no jobs and they are willing and seeking for work. The rate of unemployment will increase when there is a decline in the economy, but unemployment also happens when the

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economic situation is good. It can be analysed in detail when you understand the different types of unemployment. Below are the types of unemployment

1. Frictional Unemployment

Frictional unemployment also known as search unemployment is a normal and transitional unemployment results from bad matches inthe labour market. It occurs when people are in between jobs , or are entering or reentering the labour force. This may even happen in full employment when people quit their jobs for a better position or higher wages or when fresh graduates are actively seeking for a job. This type of unemployment occurs because of workers who are voluntarily between jobs. These job seekers may be temporarily unemployed for a short period of time. It happens when individuals are moving between jobs, careers and locations.Sometimes, people are willing to be unemployed while waiting to get another job and not because they are unable to look for a job. Imperfect information in the labour market may make frictional unemployment worse if the jobless are unaware of the available jobs. Incentives problems can also cause some frictional unemployment as some people actively looking for a new job may opt not to accept paid employment if they believe the tax and benefit system will reduce the net increase in income from taking work. When this happens there are disincentives for the unemployed to accept work. This type of unemployment exists because of friction in the labour market. Jobs may exists but people do not go to take up jobs away from home for domestic reasons such as children's education, family and friendly ties and, housing problem in a new place. According to economists this exists at all times at a rate of 2-3 percent and harms no one. For individuals or groups, it lasts for a few months when people move from job to job for better wages or wait for better opportunities

2. Cyclical Unemployment

Cyclical Unemployment is involuntary unemployment due to a lack of demand for goods and services. This is also known as Keynesian "demand deficient" unemployment.It is caused by economic conditions that go up and down due to downswing in a business cycle or a recession There are fall in aggregate demand leading to a loss of real national output and employment and a slowdown can lead to businesses laying off workers because they lack confidence that demand will recover. Both external and internal factors such as wars, strikes, population changes, political disturbances, floods, droughts, changes in consumption patterns, investment, savings, spending, supply of credit, business outlook etc. bring about this type of unemployment. This type of unemployment was a serious problem before the Second World War. Now it has been largely mastered by Government activity to control the development of cycles

3. Structural/ Technological Unemployment

Structural Unemployment exists when there is structural changes in the economy of a country. This happen because the composition of the labour force does not respond quickly to meet changing demands, technological changes or competition from imported goods and so on. The workers find that their skills, talents and experience are obsolete and unwanted due to changes in technology and consumer demand A worker loses a job because that job is no longer a part of the structure of the economy. When they don’t have the right skills and qualifications for today’s work and the needs of businesses.e.g . computer skills, communication and etc. It is caused by a change in the demand for the products of a given industry. The closing of the particular industry may cause structural changes in the nation's industry as a whole. If labour is specific, it is immobile between industries and unemployment results. The pace of modern technology is so fast that it makes past techniques obsolete, causing unemployment in old industries.Technological Unemployment is a type of unemployment which is caused by changes in the techniques of production. Technological changes are taking place constantly and there is a need for the labour force to keep themselves updated and be responsive to this changes.For example, in the agricultural sector, many unskilled and inadequately educated workers are laid off because of modern mechanization.

4. Casual and Seasonal UnemploymentCasual and Seasonal Unemployment is a kind of regular seasonal changes in employment / labour demand. It arises due to a seasonal variation in the activities of particular industries. This may be caused by climatic changes or changes in fashion or by the inherent nature of the industries themselves . In this type of employment, the labour force is employed at times and unemployed at other times. It affects certain industries more than others like catering and leisure, construction, retailing, tourism and agriculture. One example is a fisherman who is unable to catch fish in winter or in rainy weather. Some occupations are adversely affected by weather conditions and

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workers in these trades expect a certain amount of casual unemployment. Seasonal unemployment often occurs in agriculture, dockyard, hotels, restaurants and construction business. Such unemployment is inevitable and tends to be overcome by casual labour

5. Disguised/Hidden UnemploymentDisguised/Hidden Unemployment is a type of unemployment to be found in the backward and the underdeveloped countries of Asia and Africa. It refers to the mass unemployment and underemployment which prevail in the agricultural sector of an underdeveloped and overpopulated country.

6. Residual UnemploymentResidual Unemployment is a type of unemployment is caused by personal factors such as old age, physical or mental disability, poor work attitudes and inadequate training. 

7. Real Wage UnemploymentReal Wage Unemployment is considered to be the result of real wages being above their market clearing level leading to an excess supply of labour. Some economists believe that the minimum wage risks creating unemployment in industries where international competition from low-labour cost producers is severe. As yet, there is relatively little evidence that the minimum wage has created rising unemployment on the scale that was feared. It created when real wages are maintained above their market clearing level leading to an excess supply of labour at the prevailing wage rate. Some economists believe that unemployment can be created if the national minimum wage is set too high.

7. The Causes Of Unemployment

The main causes of unemployment are obvious when you have no jobs and cannot find the job. In todays modern economy many factors contribute to unemployment. Unemployment causes are varied and due to the following factors

1. Lack of experience

Nowadays, the employer will find the worker who had a lot of experienced one compared to the one without experience. Lack of experience and skills are also causes of graduate unemployment. Generally, most organizations prefer to employ graduates with experience.

2. Lack of social and communication skill

Many employers cited lack of necessary communication skills, poor command of English and lack of confidence during interviews had led to increasing number of unemployed graduates.

3. Wrong course and the poor result

In a Malay Mail article, it was highlighted that a substantial portion of the registered 66,000 unemployed graduates are from some of the most popular courses. Business administration, computer and information technology, and engineering are the most sought-after courses by many school leavers. This has resulted in a high number of unemployment among graduates from these disciplines The bottomline is, students should pick courses based on their capabilities and not based on what's apparently "in-demand" out there (e.g., IT courses).

4. Defective education

The day-to-day education is very defective and is confirmed within the class room only. Its main aim is to acquire certificated only. The present educational system is not job oriented, it is degree oriented. It is defective on the ground that is more general then the vocational. Thus, the people who have getting general education are unable to do any work. They are to be called as good for nothing in the ground that they cannot have any job suits them.

5. Job losers

A job loser is someone who has been involuntarily terminated or laid off from a job, whether temporarily or permanently. There are many reasons for this, example, failure of the worker to fulfil his work

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requirements/conditions or the firm's failure to fulfill its employee's needs. Those who have lost their jobs have two choices either to look for a new job or leave the labour force. Those who leave the labour force are not considered unemployed.

6. Job leavers

here are some who voluntarily leave their jobs and not necessarily because they were laid off. If they were leaving one job because they were accepting another offer, then this would not contribute towards the increase in unemployment rate. The unemployment rate will only increase if these job leavers were still looking for a new job.

7. New entrants and re-entrants

New entrants are those who have just completed their studies and are ready to join the work force. They have never before been employed and are actively seeking employment for the first time. However, while looking for a suitable job, they have to be unemployed

8. The Effect Of Unemployment

Unemployment is a common phenomenon. However, a high unemployment rate will affect a country’s economic growth. The negative effect on unemployment can be breakdown to the negative effect on economy, individual, society and government,.

1. The Negative Effect On Economy

A high rate of unemployment will give a big impact a country’s economic activity. The following shows the negative effects of unemployment on the economy.

1. Ruin the economic growth

High unemployment rate will ruin the economic growth and performance. There will also be excess capacity from the industrial machines. This will indirectly cause a drop in investment level. Serious problem of unemployment in the economy are not conducive for investment because firms still have excess production capacity and there are capital goods and equipment that the firm have abandoned or not fully utilized during the recession. Therefore, new investment is needed to increase output. low level of aggregate spending in an economic recession reduces the impact of the desire of investors to make investments. lack of investment in the economy is to reduce economic growth. Slow economic growth and low output will lead to further depression. The high rate of unemployment and sluggish activities of firms will result in a reduction in their profits. The low profits will reduce the eagerness of investors to make new investments. This will affect national economic growth

2. Wastage of production resources

High rate of unemployment forces the economy to operate at a level below maximum. The wastage of resources bring about output production far lower than the potential output. Unemployment means that labor is not utilized and other factors of production that is the fixed capital such as plant and soil factors such as agricultural land is wasted. This situation will reduce real GNP, thus leading to real GNP < potential GDP High rate of unemployment forces economy to operate at a level below maximum. Unemployment seen as an inefficient way of allocating resources – labour market failure? The result is that firms experience inefficiency in production. Limit the possibility of production is not achieved in the economy. This situation also lowers the current production capacity and thus prevent future economic growth

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3. Fall in National per capita income

Unemployment causes national income that is achieved is lower than the potential of national income. Unemployment resulted in a lower state tax collections. This means that the achieved level of social welfare is lower than the level that may be achieved. Unemployment causes national income is achieved is lower than the potential of national income. Unemployment resulted in a lower state tax collections. This means that the achieved level of social welfare is lower than the level that may be achieved. Unemployment causes national income is achieved is lower than the potential of national income. Unemployment resulted in a lower state tax collections. This means that the achieved level of social welfare is lower than the level that may be achieved

4. Not achieve full employment

This is because there is no labor utilized to lead the country does not achieve economies of scale of production at the potential level that can be achieved . This situation is said to be not reached a level of full employment. This means that the country has lost output and resulted in growth of Gross National Product (GNP) is low. Low GNP will affect the country's per capita income, a measure of standard of living. In general if a country's unemployment rate is within 2% to 4%, the country is deemed to have reached full employment. Unemployment also will widen the income gap between rich and poor to the end will lead to a more complex social problems.

2. The Negative Effect On Individual

Some of the negative effects of unemployment on the individual are:

1. Loss of livelihood and income

Unemployment causes loss of income of individuals. For countries with no unemployment insurance program, individuals must rely on past savings or borrow from relatives and friends to survive will affect their life because they are unable to have a stable income.. Cause hardship, aggravate tensions in family relationships and family and create various types of family problems like divorce and arguments.

2. Loss of job skills

Some skills can only be maintained if they are used or practiced often. Long-term unemployment might cause an individual to lose his/her skills. Labor force have been unemployed will lose skills in performing a job. Skills in performing a job can only be maintain when the skills to use regularly. Skills in certain jobs can only be maintained if they are put into practice.Unemployment that occurs will cause anyone who has a skill that decline. Unemployment can lead to social and political problems. Some skills can only be maintained if they are used or practiced often. Long-term unemployment might cause an individual to lose his/her skills. Umemployed worker may lose their job skills through a lack of application.retraining and educating them may prove expensive .Unemployed laborers who have been long unemployed will lose their skills and employers are forced to retrain workers. This will involve a high cost for the training which resulted in the loss of high competitiveness at international level. As a result, local products can not compete with the cheaper foreign goods and quality of the products.Thus, long-term unemployment will cause the skills of an individual to deteriorate.

3. Loss of confidence

Unemployment has important social costs eg unequal income and diminished social cohesion; loss of status, alienation and frustration. Unemployment also cause loss of self confidence and will lead to depression. Attempts to get a job that has always failed to erode the confidence of the labor force. Unemployed people may also experience depression because of the knowledge and skills acquired from education institutions can not be used to make a living to support themselves and their families.

3. The Negative Effect On Society

Some of the negative effects of unemployment on the society are:

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1. Family dispute

Unemployment will make households will lose income to support family life. As a result, family relationships are affected and in turn destroy the family function in a country. Children will be left without the proper education and proper health facilities without. In the long run it will cause problems of poverty will continue to be inherited to next generation

2. Domestic violence

Temporary unemployment will not ruin the lives of the people as daily activities can be carried out using savings or loans. However, continuous unemployment will create unhealthy side effects such as being forced to partake in illegal activities to obtain money. Loss of income and expenditure requirements will lead to financial problems in the family unemployed. Unemployment increase the number of poor families in the community. Therefore, the increase in the number of unemployed will threaten social peace. Other social problems are theft and robbery

3. Low standard of living

Unemployment means wastage factor of production and the economy is not achieving the maximum production capacity. Real national income is less than the income potential of the country. Standard of living lower than the level that may be achieved if the economy has achieved employment as the amount and type of goods enjoyed by the population is less than if full employment is reached.

4. The Negative Effect On Government

A high rate of unemployment will be hard from government side. Below are the negative effects of unemployment to the government.

i. Threat to political stability

Long-term or continuous unemployment can create chaos and the government will be under pressure and receive criticisms from many parties. This problem indirectly contributes towards social problems and causes an increase in crime rates. Increase in crime rates can cause foreign investors to shy away

Sluggish economic activity and high unemployment rate may rise to grievances against the administration of society. Government inability to address effectively the problem of unemployment will rise to feelings of dissatisfaction and anger of the people. This undermines social and political stability, when criticism and claims will be submitted to the government if the people held demonstrations and strikes and chaos.

ii. Increase criminal rate

As a result of family instability and poverty, people will do whatever activities including economic activities are illegal, fraud, smuggling, black markets, theft, prostitution and so forth. Such activities are difficult to contain by the government and at the same time the government had to provide large expenditures for enforcing the rules, while provision is better used for development of a more worthwhile.

Hard times also force the unemployed to do some criminal activities such as robbery and theft that threatens the social order. In some extreme cases, unemployed workers may join radical groups and engage in troublesome social and political activities. The crime rate would be high if unemployment is high.

iii. Drop in government revenue

Unemployment causes losses in government revenue obtained through personal taxes because many have joined the ranks of the unemployed decrease national income/government revenue obtained from personal taxes. When people are unemployed, the tax collection is also reduced.

iv. Squatters problem

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When income is lost, no longer able to get a good basic facilities. They had to find a cheaper home to create more squatter settlements. Squatter problem does not end here because the lack of basic amenities to create the problem of hygiene and health to the nation. Indirectly, the country will lose attraction.

v. Social and political problems

Slow economic activities and the high rate of unemployment will cause dissatisfaction among the population towards the government. Criticisms and demands will be made to the government and demonstrations may occur, apart from other social problems such as theft and robbery.

vi. Decline of government development activities

Unemployment will cause the decrease in the government revenue through the collection of personal income tax because some citizens do not have employment nor income. This will reduce the government's ability to proceed with national economic development activities since the total revenue received by the government is reduced.

9. Method To Control The Unemployment

Monetary/Financial Policy To Combat Unemployment

Monetary policies which consist of controlling the supply of money by the central bank are enforced by using the different monetary instruments which aim at reducing the supply of money. By applying expansionary Quantitative and Qualitative Monetary Policy will increase money supply and hence increase Aggregate Demand to stimulate economic growth and to control economic recession.

Quantitative Expansionary Monetary Policy

There are various instruments or tools of monetary policies which the central bank employs to achieve the goals of the economic policy that is to combat unemployment as following:

1. Reduce minimum requirement of statutory cash reserve ratio and2. liquidity asset

During recession, the Central Bank will reduce the rate of statutory reserve . Reducing the reserve requirements decreases the amount of required reserves the bank must keep where the need for savings of financial institutions in the central bank will decrease. Following this, the liquidity state of financial institutions will increase as this would increase the ability of bank or other financial intermediary to provide loans to the public and this has the effect of increasing the money supply in the economy.

Besides cash reserves, commercial banks also have to keep liquidated assets issued by Bank Negara Malaysia (BNM) such as treasury bills and government securities. The less required liquidated assets that are held, the more the credit that can be created. The required minimum liquidated assets are fixed by Bank Negara Malaysia and are used as a monetary policy tool to control the Malaysian economic stability

3. Buy government securities in open market operation

Open –market operation is the buying and selling of government securities in the open markets by the central bank so as to influence the size of commercial banks’ deposits.

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In time of deflation, the supply of money has to be pump in the economy. The central bank will buy government securities from the commercial banks and individuals. Payment made will increase cash reserves of commercial banks and thus commercial banks can create more credit, thus, there will be more money spend by public in the economy. The money from the sale can be used by government to sustain its expenses when its expenditure exceeds the revenue from taxes collected (G >T).

4. Decrease bank rate and discount rate operation

During recession, the bank rate will be reduced as more money need to be pump into the economy. With lower bank rate the cost of borrowing is lower, thus more will borrow and more loans will be approved. Consequently, the flow of money from the commercial banks to the public gets increased.

When there is a recession, the central bank can also decrease discount rate. If the ratios of discount rate are reduced, the need for savings of financial institutions in the central bank will fall. Following this, the liquidity state of financial institutions will increase and this will cause the financial institutions to provide more loans to the public.

5. Reduce Interest Rate

During recession, the government can reduce the interest rate. This is to encourage more money to be spent by consumption expenditure of households. The Central Bank may persuade commercial bank to decrease their rate of interest on deposit from the public. This action from commercial bank will reduce the level of savings and increase the purchase of goods and services by public. For example, an reduction of the interest rate on fixed deposits from10 % to 6 %will result in consumer saving less and spending more .Consumers look at interest rates as costs of loans. The lower the interest rate is, the higher the wish of consumers to borrow. The same applies to loan re-payment periods. The longer the re-payment period, the consumers would like to make loans because they can afford to pay a lower monthly installment. Interest rate can be used to influence the cost of borrowing for consumption. A low interest rates might be seen as a requirement for stimulating consumer spending, so as to keep economy expansion. When money supply increases, the interest rate will decrease. This will cause the savings to decrease but encourage investment and consumption. A monetary policy in which a central bank sets low interest so that credit is easily attainable. This make borrowing easy for business, which stimulate investment and expansion of operations.

Qualitative Expansionary Monetary Policy To Combat Unemployment

Expansionary qualitative monetary policy will encourage bank lending in order to stimulate economic growth and to combat economic recession but tightening the loan during inflation. This can be done through selective credit control to determines the type of loan which should be demoted or promoted and moral persuasion where central bank has direct meeting with representatives of commercial banks to explain the condition of economic and financial state of the country and give some recommendation.

A. Selective Credit Controls

Selective credit controls Selective credit controls regulate the extension of credit for particular purpose. Tightening selective credit controls will limit certain types of spending and relaxation will increase spending. The main purpose of performing selective credit control is to ensure that commercial banks provide loans and make investments in accordance with government aspiration. It is not intended to control the total amount of money created by commercial banks through their lending and investment activities but rather on the pattern of loan and investment made by commercial banks. The Central Bank controls the granting of credits which financial institutions give to the public or investors.In the case of deflation or recession or unemployment, relaxation and loosing the selective credit control will increase spending and encouraging activities in economic sectors.

i. Reduce control on margin requirement

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Banks or other financial institutions routinely lend money to customers to buy securities. The "margin" is the portion of a security that the regulated institution's loan is not allowed to cover. In other words, if a bank were allowed to loan up to $80 to a customer eager to buy $100 of stock, the margin would be $20. By increasing or decreasing the margin requirement, the authorities can effectively tighten the money supply.Control of margin requirements limit the volume of loans for purchase of shares. Example: If the margin requirement is 30%, this means that individuals have to pay 30% of the share price and the remaining 70% can be financed through bank loans. Therefore, determination of the lower margin requirements will increase the ability of people to buy shares through a loan.

ii. Reduce control on credit mortgage

Control on credit mortgage is control the loan on buying property through mortgage. During recession, the Central Bank imposes a loose mortgage conditions to encourage the public to buy the property and thus encourage mortgage credit creation process.

iii. Reduce control on credit installmentControl of activities on credit installment affecting purchasing goods trough loan or installment. During recession, credit installment terms loosely as a minimum reduction of advance payments and the extension of repayment period will promote the activities of credit purchases.

iv. Special directive

The central bank will instruct commercial banks to increase the volume of loans given to the public. The central bank will also influence commercial banks to loosen their lending policy such as the need for collateral security, guarantors and other measures, which will encourage borrowings. The central bank may issue special instructions asked commercial banks to allocate a portion of its reserve funds to lend to certain sectors such as agriculture sector involved in food production and small and medium enterprises

B. Moral Persuasion

This policy is carried out by the central bank not to set in writing the things that should be done by commercial banks, but with a direct meeting with the banks. In this meeting the central bank outlines the steps the government and the ongoing assistance that desired by the central bank from commercial banks to ensure the success of these actions. From this meeting the commercial banks will find the steps to the efforts being taken by the government will achieve the purpose and expected impact. This is done by central bank when meeting with representatives of commercial banks. In the meeting, central bank will explain the economic and financial state of the country and ask the commercial banks to take certain steps to overcome any financial and economic problems faced. For example, during economic downturn, commercial banks will take into account the borrower's financial state before forcing him to re-pay his loan. The central bank can also give advice to commercial banks to conduct banking activities in line with government requirements to ensure the success of particular policies.During recession, commercial banks are encouraged to increase lending to certain economic sectors to assist the government in an effort to develop the sector.

Fiscal Policy to combat Unemployment

In recession, the economy suffers from rising unemployment, falling income and shrinking economy activity. The government can implement an expansionary fiscal policy by increasing government expenditure and reducing the tax rate. These measures will encourage economic growth by creating more employment opportunities such as the implementation of major development projects, thus having multiplier effects on small industries.

Expansionary Fiscal Policy or Deficit Budget Policy

This policy is implemented to get the economy out of a slump. This measure will increase the disposable income which will, in turn, lead to an increase in consumption.

1. Increasing Government Expenditure

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Through expansionary fiscal policy, that is by increasing government expenditure, e.g. increasing expenditure to retain those being retrenched. The government will increase public spending by undertaking public works programmes .

2. Increasing Transfer PaymentIncreasing transfer payment, for example, increasing payment to those affected by recession is another strategy as they will now have more money in their pocket thus increasing their spending which will eventually increase aggregate demand in the economy. Similarly, government can help those being retrenched by giving unemployment benefits

3. Decreasing Tax

Tax cuts are essential to spurring economic activities, by putting money in people’s hand they can start spending again, thereby increasing aggregate demand and restoring full employment .The effect of tax cuts would increase the amount of disposable income of individual and business firms.

Direct Control Measures/Policy to combat Unemployment

Measures To Overcome Frictional Unemployment1. Disseminate Labor Market InformationImperfections in the labor market lead to frictional unemployment exists in which unemployment is not aware of existing jobs in the economy. Information about employment opportunities may be disseminated through various channels such as mass media and the internet. Educational institutions can also conduct counseling and career talks for students to expand their knowledge of career fields that can be pursued based on their interests and abilities

2. Increase Labor MobilityLabor mobility and employment mobility is divided into geographical mobility. Occupational mobility of labor refers to the ability to move from one job to another job. Geographical mobility of labor refers to the ability to move from one place to another. Individuals with low job mobility difficult to find employment because they had no other skills needed to switch to another place of employment where employment opportunities exist. Thus, labor mobility should be improved through training to equip workers with other skills and enable them to adjust themselves in accordance with the requirements of the labor market. The government could also encourage the development of the manufacturing sector in the rural areas to overcome the problem of unemployment in rural areas

3. Creation of New Employment Opportunities New employment opportunities should be created to absorb new labor force entry. Through the 9MP, the government aims to increase the value-added sectors of the economy and create a knowledge-based economic activities. Such a move aimed at creating employment opportunities in the field of information and communication technology (ICT), biotechnology, nanotechnology and services. National Biotechnology Policy (NBP), spanning the period of 15 years from 2005 to 2020 is expected to attract the establishment of new companies and create jobs for the population. The planned opening of new land development projects KEJORA region (Johor), KETENGAH (Terengganu), and KESEDAR (Kelantan) has been providing job opportunities especially in rural

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4. Encouraging Foreign Investment Foreign Investment in various economic sectors will stimulate economic activity and create jobs for residents and reduce unemployment problem in the country. To attract foreign investors, the government has provided various types of infrastructure such as transport and electricity and sufficient water to reduce the cost of doing business to foreign investors. Various incentives have been offered to foreign investors such as pioneer status, investment tax allowance and re-establishment of free commercial terms to increase the competitiveness of the country to attract foreign investment

Measures To Overcome Structural and Technological Unemployment

1. Upgrade skill and technical education and RetrainingMany of the new labor force entering the labor market are unemployed due to lack of required skills. The establishment of skills such as Industrial Training Institute, Advanced Technology Training Center (HI-Tech) and Japanese-Malaysia Technical institute also provides training to school leavers with the skills needed by industry. Graduate Training Scheme by the government aims to provide graduates with specific skills to reduce unemployment among graduates. More training and education are provided to the unemployed. this could help improve computer skills and communication. these people will become more confident and employable.

2. Increased investment in worker training: The main shortages are in highly skilled jobs and in areas where living costs are well above the national average. the government has suffered from a shortage of workers in key public sector jobs. Training and education should be given to individuals who have difficulties gaining employment. skills obtained from the training will help them to hold suitable posts. more training and technical education should be provided for individuals who have difficulties securing a job. when people upgrade their skills and increase their knowledge, they will be able to find job easily.

5. Creation of more employment opportunities in various economic sectors

All economic sectors should be developed to support more manpower and thus reduce the rate of unemployment. When economic sectors such as transport, finance, insurance, property and services expand, this will result in more job opportunities for the public

Measures To Overcome Casual and Seasonal Unemployment

1. Diversify economic activity

Seasonal unemployment can be reduced if the unemployed in the primary sector to diversify their economic activities to earn income from other sources when the economy failed to resume daily activities. For example, fishermen who are unable to sea during the monsoon season may be involved in small businesses such as cracker production or sale of cakes. Government can provide financial assistance through government agencies specific to the parties concerned.

2. Development of new land

The opening of new land for the suburban sector will also create job opportunities for the people, especially those in the suburban areas. It will enable them to involve themselves in the agricultural and animal husbandry sector and thus obtain an income. It will also reduce the migration of the people from the suburban areas to towns in search of job opportunities. The development of new land is trough government agencies such as FELDA,RISDA and FELCRA.

Measures To Overcome Disguised/Hidden Unemployment

1. Family planning in long run

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Hidden unemployment occurs when there is an excess number of labor force compared to the total land area in countries that have a larger population. By taking long term measure, each household is encouraged to adopt family planning by birth control in order to slow down an increase in the supply of labour.

2. Modernization of agriculture sector

Modernization of the agriculture sector should be enhanced by the government so that surplus labor is reduced / eliminated.

3. Improve level of educationThe government should also improve the education of the peasant that they changed the attitude of the active in traditional agriculture to modern agriculture / farming.

Measures To Overcome Real Wage Unemployment

1. Restrict Labor Union Activity

Trade unions with many members who have strong bargaining power to demand higher wages. Unions could push employers to set a minimum wage or higher wage than the market wage rate. Wage increases raise the cost of producing output. This causes producers to transfer their manufacturing operations to other countries that have cost relatively lower. This situation reduces the employment opportunities in the country and worsen the unemployment problem. Therefore, the government should curb the activities of trade unions to ensure that the labor wage rate is competitive compared to other countries and not the arbitrary union demanded wage increases without raising their productivity.

10. Definition Of Inflation

Inflation is also a situation where there is ‘too much money chasing too few goods’.Occurs when there is an continuous increase in the general level of price. It reduces a person’s income by reducing the purchasing power of money.

Since inflation refers to a continuous increase in the general price level although the price of every product and service need not increase. Eg: if the inflation rate is 4%, it does not mean that all prices are increasing by 4%. It is only the average increase.

There are the three main criteria to determine inflation are:1. Inflation is the increase in general price level means that all the goods and services in the economy

experienced a rise in prices.2. Inflation is a continuous increase in price level means that the general price level is rising continuously for

the long term3. Inflation is the unlimited increase in price level means that the increase in the general price level is very

high.

In short, the rising level of prices in an economy that does not include the three criteria is not known as inflation. Inflation can also be referred to as a condition in which too much money purchasing too few goods and services.

11. Inflation Rate Formula

The consumer price index is used to measure the rate of inflation. The consumer price index (CPI) is an index that measures changes in the average price of consumer goods and services. The CPI is also called the cost of living

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index. The computation of the CPI will be discussed in the next chapter which deals with simple and weighted price index. The rate of inflation is computed as a percentage change in the CPI from one year to the next.

Inflation rate = CPI this year- CPI previous year/CPI previous year×100

The formula below shows how the rate of inflation is computed.

For example, given that the CPI for the year 2000 was 121 and that for the year 2001,110, the inflation rate using the above formula would be

Inflation rate = 121-110/110×100=10%

The consumer price index is used to measure the rate of inflation. The consumer price index (CFI) is an index that measures changes in the average price of consumer goods and services. The CPI is also called the cost of living index. The rate of inflation is computed as a percentages change in the CPI from one year to the next. The formula below shows how the rate of inflation is computed.

Inflation rate=CPI this year- CPI previous year× 100 CPI previous year

For example, given that the CPI for the year 2000 was 121 and that for the year 2001,110, the inflation rate using the above formula would be

Inflation rate = 121 – 110× 100 110

Disinflation is a reduction in the rate of inflation. For example, if the inflation rate in the year 2000 was 2% and in 2001, 1.5% , it shows a decrease in the inflation rate. Disinflation does not mean that prices are falling but

that at which inflation is increasing is falling.

12. Degree Of Inflation

Inflation can be distinguished based on the increment of e general price level. Based on this concept, inflation can be grouped into 7 main degrees as below.

1. Moderate Inflation:

When the rate of inflation rise by less than 10% per annum (single digit inflation rate), it is known as Moderate Inflation. It is a stable inflation and not a serious economic problem.

2. Creeping Inflation:

This is also known as mild inflation. This type of inflation occurs when the price level persistently gently rises over a period of time at a mild rate. This happen when prices rise by not more than (up to) 3% per annum (year).

3. Galloping Inflation:

If mild inflation is not checked and if it is uncontrollable, it may assume the character of galloping inflation. This happen if prices rise by the double or triple digit range of 20, 100 or 200 percent a year.

4. Stagflation:

It is an economic situation in which inflation and economic stagnation or recession occur simultaneously and remain unchecked for a period of time. Stagflation was witnessed by developed countries in 1970s, when world oil prices rose dramatically. It is a condition when a high rate of inflation happens at the same time that a high rate of unemployment exists.

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5. Hyperinflation:

Hyperinflation refers to a situation where the prices rise at an alarming high rate. It is a stage of very high rate of inflation when prices rise above 1000% per annum (quadruple or four digit inflation rate. The prices rise so fast that it becomes very difficult to measure its magnitude. However, in quantitative terms, During a worst case scenario of hyperinflation, value of national currency (money) of an affected country reduces almost to zero. Paper money becomes worthless and people start trading either in gold and silver or sometimes even use the old barter system of commerce.

6. Repressed Inflation

It is a condition when the value of money or consumer spending power decreases continuously. This condition is not caused by an increase in prices, but by demand blockade by the government through rationing of goods and price controls. During a repressed inflation, the rate of inflation is not too high because it is continually monitored by the government through certain regulations

7. Deflation:

Deflation is the reverse of inflation. It refers to a sustained decline in the price level of goods and services. It occurs when the annual inflation rate falls below zero percent (a negative inflation rate), resulting in an increase in the real value of money. Japan suffered from deflation for almost a decade in 1990s.

13. Type /Causes Of Inflation

1. Demand-Pull Inflation

Demand-pull inflation is likely when there is full employment of resources and aggregate demand is increasing at a time when SRAS is inelastic.

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Demand pull inflation is largely the result of the level of AD being allowed to grow too fast compared to what the supply-side capacity can meet. This conditions is also known as 'too much money chasing too few goods'. The result is excess demand for goods and services and pressure on businesses to raise prices in order to increase their profit margins. Possible causes of demand-pull inflation include consumption, government expenditure, investment and net export. If there is an increase in the AD which exceeds the increase in goods and services supplied, prices will increase. The increase in aggregate demand will cause the economy to be in a state of full employment, unable to satisfy the continuous increase in demand. Thus, when the demand exceeds supply, prices will increase.

It is caused by a rise in AD which may be due to a rise in consumer demand, or an increase in the level of government expenditure, or a rise in investment by firms, or an increase in demand for the country’s exports by people in foreign countries or a combination of the four.

2. Cost Push Inflation

Cost-push inflation is when prices rise due to growing cost of production of goods and services. It refers to an increase in the general price level associated with an increase in the cost of production such as raw materials and wages.

For example, if there is an increase in the prices of raw materials and other components used in theproduction processes of different industries. This might be because of a rise in world commodity prices such as oil, copper and agricultural products used in food processing. Generally, firms will transfer theburden of the cost increase to consumers by increasing the selling price. The firms respond to rising costs, by increasing prices to protect their profit margins.

Similarly, inflation caused by wage increases, which are greater than improvements in productivity leads to a rising labour costs .Wage costs often rise when unemployment is low (skilled workers become scarce and this can drive pay levels higher) and also when people expect higher inflation so they bid for higher pay claims in order to protect their real incomes. This will lead to the unit cost of production also increases. As a result, the prices of end-products or end-services being produced and supplied are consequently hiked.

Cost-push inflation occurs when resource prices rise unexpectedly, could cause both output and employment to decline. Real income falls.

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3. Imported Inflation

Imported inflation is caused by the increase in the price of imported goods which consist of finished goods, partly finished goods and raw materials in the production process. Consumers have to pay a higher price if the imported goods face an increase in price. Producers will transfer part of the cost to consumers by increasing the selling price if the imported input goods undergo an increase in price. 

If a country imports goods from a foreign country, and the prices of imported goods increases due to inflation abroad, then the prices of domestic products using imported goods also rises. This is known as Import Price-Hike Inflation. For e.g. Malaysia imports oil from Iran at $100 per barrel. Oil prices in the international market suddenly increases to $150 per barrel. Now Malaysia to continue its oil imports from Iran has to pay $50 more per barrel to get the same amount of crude oil.

When the imported expensive oil reaches Malaysia , the malaysian consumers also have to pay more and bear the economic burden. Manufacturing and transportation costs also increase due to hike in oil prices. This, consequently, results in a rise in the prices of domestic goods being manufactured and transported. It is the end-consumer in Malaysia , who finally pays and experiences the ultimate pinch of Import Price-Hike Inflation. If the oil prices in the international market fall down then the import price-hike inflation also slows down, and vice-versa.

4. Structural Inflation

Structural inflation occurs because a government pursues an excessively loose monetary policy. That is, if a central bank prints too much money or keeps interest rates too low for too long, the value of each unit of

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currency drops more than it would simply from increased demand. This happen due to the changes in the structure of economic system and the mismanagement of a country’s monetary policy.

14. The Effect /Consequences Of Inflation

Inflation causes the general price level rises. Thus, the real income of the population will decline and to reduce the purchasing power of consumers.

If the economy has reached full employment, inflation will increase the general price level without increasing the total output. As a result, the cost of living increase and the standard of living declined. This is because the amount of the same, the quantity of goods can be purchased decreases.

Positive Effects Of Inflation

Positive impact of inflation on the following: -

Positive Effects Of  InflationInternal External

Fixed Property Owner Term of Trade ImproveShareholders Businessman/ ProducersDebtors /Borrowers

Positive Effects Of The Internal.

1. Fixed Property Owners

In term of distribution of income, the people who stand to gain from continuous inflation are property owners/real estate owners such as land owners and shop owners. This is due to the surge in prices of assets. During inflation, the value of immovable property such as house, land and building will increase. This kind of savings in term of assets and real estate will gain for example, the prices of housing, jewellery will rise and the owners will gain.

2. Shareholders

Shareholder will gain because higher higher profits for companies will mean higher dividend because the share price will rise when inflation is moderate.

3. Businessman/Producer

In term of production and investment, both producers and businessman gain from inflation. Businesses because higher prices than the increase in cost of production. Thus, the trader profits will increase.During inflation, the general level of prices rises and producers make higher profits, lead the producers to increase their level of production and investment.Since the inflation medium to promote investment, national output would increase by a factor of production used in full. As a result of national income increases.The people who stand to gain from continuous inflation. Businessman who earn higher profits from rising prices.

4. Debtor/Borrower/Credit Recipient Profits

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Debtors will gain because as they repay the loan,, it is less than the real value of the principal sum. The size of the debt depreciated in value as result of inflation . Inflation works to the advantage of debtors. Borrowers benefit during period of unexpected inflation because the purchasing power of money borrowed is less than the purchasing power of money repaid to lender. The purchasing power of money borrowed is greater than the purchasing power of money repaid to lender. Those receiving credit, will gain from inflation because the spending power of the money repaid is lower than the spending power at the time of borrowing. Thus, the lender imposes an interest rate on the borrower to cover the loss caused by inflation.

Positive Effects of External

1. Favourable Term of Trade /Improve

Term of Trade can be defined as the exchange rate of export for import, i.e, how much of exports in exchange for a certain amount of import. Because of inflation in the country, the export prices to rise. If the factors do not change, the country's terms of trade improve. In o we pay less for imports than for our exports. In other words, our earnings rise for every unit of export so we can get more import. In monetary terms, This will lead to favourable terms of trade. If external demand for exports is not price elastic, the improve terms of trade due to inflation will improve the country's trade balance.

Negative Effects Of  Inflation

Negative impact of inflation on the following: -

Negative Effects Of  InflationInternal External

Fixed Income Earners/Pensioner Deficit Balance Of TradeBondholders Devaluation in Exchange RateSaversCreditors/Lenders

Negative Effects Of The Internal.

1. Fixed Income Earners/Pensioner Retiree/Fixed Wage Earner

Those who receive a fixed income, for example, employees who receive a fixed wage, pensioners and others will suffer losses. This is because inflation causes their real income down. Fixed-income groups will be hurt because their real income suffers. Their nominal income does not rise with prices. Individuals who receive a fixed income such as salaries and pensions will face a loss if inflation happens. This is because inflation reduces the individual’s real income and the value of money. Those who do not own property such as the lower income group will find their real income decreasing. Consequently, inflation will increase the gap between the differences in incomes and thus worsen income distribution

2. Bondholders

Bondholders tend to lose in an inflation. This is because during inflation, their real profit will decrease because they earn fixed interest.Those receiving fixed interest from bonds suffer losses during inflation. A retired business executive whose current income comes entirely from dividend from Amanah Saham National Berhad.

3. Savers

All savings that has fixed value such as fixed deposits, insurance, mortgage will depreciates in terms of real income. The rising prices will erode away the purchasing power of such savings. Those who save the financial institutions suffered losses due to inflation lowers the real interest rate. Real interest rate = nominal interest rate - the rate inflasi8. If nominal interest rates offered by financial institutions = 10%,

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inflation = 6%, real interest rate = 10% -6% = 4% only. Savers will be hurt by unanticipated inflation, because interest rate returns may not cover the cost of inflation. Their savings will lose purchasing power

4. Creditors/Lenders

The creditors will suffer losses due to the repayment of money they received while inflation has declined.Debtors (borrowers) can be helped and lenders hurt by unanticipated inflation. Interest payments may be less than the inflation rate, so borrowers receive “dear” money and are paying back “cheap” dollars that have less purchasing power for the lender. Individuals who give loans to others will face a loss because the money paid by the borrower in the future will have low spending power owing to inflation. Those receiving credit, will gain from inflation because the spending power of the money repaid is lower than the spending power at the time of borrowing. Thus, the lender imposes an interest rate on the borrower to cover the loss caused by inflation.

Negative Effects Of The External.

1. Deficit Balance Of Trade

Many countries face a deficit balance of trade because import is greater than export, arises because imported products are now cheaper than domestic products. For example, Malaysia is facing inflation but our neighbouring country, Thailand experience no inflation. Thai people will not want to buy from Malaysia. On the other hand, Malaysian will find Thailand goods cheaper, hence they will buy from Thailand. This lead to Malaysia imports will increase. When imports exceeding exports, then the economy will be facing deficit deposit. When inflation occurs in the country, export prices become more expensive. Thus reducing the total exports and thus worsen the country's balance of payments.

2. Devaluation in Exchange Rate

Foreign exchange rates affected when total exports declined due to inflation in the country. This situation devaluing the currency in the country and led to the decline of foreign investment. Other countries will find the currency more expensive and hence, there will be less demand for it.This will eventually lead to a fall in the price of the currency. Inflation devaluing money in the country will increase foreign investment abroad

15. Method to Control Inflation

Monetary/Financial Policy To Combat Inflation

Monetary policies which consist of controlling the supply of money by the central bank are enforced by using the different monetary instruments which aim at reducing the supply of money. By applying contractionary Quantitative and Qualitative Monetary Policy will decrease money supply and credit creation hence decrease Aggregate Demand to stabilize economic situation and to control economic inflation.

Contractionary Quantitative Monetary Policy

There are various instruments or tools of monetary policies which the central bank employs to achieve the goals of the economic policy that is to combat inflation as following:

1. Raising Minimum Requirement Of Statutory Cash Reserve Ratio And Liquidity Asset

During inflation, the Central Bank will increase the rate of statutory reserve and minimum liquidity where the need for savings of financial institutions in the central bank will increase. Following this, the liquidity state of financial institutions will decrease as this would reduce the ability of bank or other financial intermediary to provide loans to the public and this has the effect of decreasing the money supply in the economy.

Besides cash reserves, commercial banks also have to keep liquidated assets issued by Bank Negara Malaysia (BNM) such as treasury bills and government securities. The more required liquidated assets that are held, the

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lesser the credit that can be created. The required minimum liquidated assets are fixed by Bank Negara Malaysia and are used as a monetary policy tool to control the Malaysian economic stability

2. Sell government securities in Open Market Operation

In time of inflation, the money supply has to reduced, the central bank will sell government securities such as short-term bonds or treasury bills to commercial banks or to the public through the banks. This results in transfer of a part of bank deposits to central bank account and reduces the cash reserve of the commercial banks and reduced credit creation capacity of the commercial banks. Cheques are made payable to the central bank. The result is a decrease in consumer expenditure

3. Increase bank rate and discount rate operation

During inflation, a high the bank rate will be imposed by the Central Bank to reduce the loans to the banking sector. This will lead to an increase the cost of borrowing which reduces commercial banks borrowing from the central bank. This is to reduce the money owned by financial institutions, thus reducing loans to the public. Consequently, the flow of money from the commercial banks to the public gets reduced. Therefore, increase in the bank rate discourages borrowing.When the rate of inflation is high, the central bank can also increase discount rate. If the ratios of discount rate are increased, the need for savings of financial institutions in the central bank will increase. Following this, the liquidity state of financial institutions will decrease and this will cause the financial institutions to reduce loans to the public.

4. Raising Interest Rate

The government can increase the interest rate when the inflation rate is high. This is to encourage more money to be deposited in financial institutions rather than to be spent. This will prevent the rise of prices cause by consumption expenditure of households. The Central Bank may persuade commercial bank to increase their rate of interest on deposit from the public. This action from commercial bank will increase the level of savings and decrease the purchase of goods and services from the public. For example, an increase of the interest rate on fixed deposits from 4% to 10%will result in consumer saving more and spending less . The high rate of interest will attract and encourages more people to save and this will increase the level of savings

Consumers look at interest rates as costs of loans. The higher the interest rate is, the lower the wish of consumers to borrow. The same applies to loan re-payment periods. The shorter the re-payment period, the consumers would be deterred to make loans because they cannot afford to pay a higher monthly installment.

Interest rate can be used to influence the cost of borrowing for consumption. A high interest rates might be seen as a requirement for controlling consumer spending, so as to keep down the rate of inflation. When money supply decrease, the interest rate will increases. This will cause the savings to increases. but. discourage investment and consumption. The central bank raises interest rates when it is trying to slow down the economy because of a fear of accelerating inflation.

5. Funding(funding buying long-term bonds)

Funding is a process by which the government sells long-dated debt (national savings security) rather than short-dated debt (treasury bills). Successful funding of the national debt means that the general public buy illiquid securities, which causes a fall in the general public’s deposits and effects the money supply. Funding operation return to the practice of managing the government debt in order to influence the money supply. These operations involve the replacing of maturing debts with longer term securities.Funding is the central bank measures to reduce the production of short-term government securities and increase the production of long-term government securities. The central bank take the action to reduce the circulation of money supply due to excess supply of money for the purpose of fighting inflation.

Contractionary Qualitative Monetary PolicyContractionary Qualitative Monetary Policy will discourage bank to borrow in order to control inflation. Qualitative policy aims at controlling and discouraging activities in specific economic sectors.

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A. Selective Credit Control

Selective credit controls regulate the extension of credit for particular purpose. Tightening selective credit controls will limit certain types of spending. The main purpose of performing selective credit control is to ensure that commercial banks provide loans and make investments in accordance with government aspiration. It is not intended to control the total amount of money created by commercial banks through their lending and investment activities but rather on the pattern of loan and investment made by commercial banks. The Central Bank controls the granting of credits which financial institutions give to the public or investors.

During inflation, tightening selective credit controls will limit certain types of spending. Selective loan control specifies the types of loans which have to be reduced or encouraged.

i. Tighten control on margin requirement

Control of margin requirements limit the volume of loans for purchase of shares. Example: If the margin requirement is 45%, this means that individuals have to pay 45% of the share price and the remaining 55% can be financed through bank loans. Therefore, determination of the higher margin requirements will reduce the ability of people to buy shares through a loan. Such controls reduce the demand for money for speculative purposes and to reduce inflationary pressures.

ii. Tighten control on credit mortgage

Control on credit mortgage is control the loan on buying property through mortgage. During inflation, the Central Bank to impose strict conditions limiting mortgage credit creation process to discourage public from buying the property and thus discourage mortgage credit creation process for the public's ability to obtain loans

iii. Tighten control on credit installment

Control of activities on credit installment affecting purchasing goods trough loan or installment. During Inflation, the stringent conditions of credit installment, such as raising the minimum payment and shorten the repayment period will reduce the activities of credit purchases.

iv. Special directive

The central bank will instruct commercial banks to reduce the volume of loans given to the public. The central bank will also influence commercial banks to restrict their lending policy such as the need for collateral security, guarantors and other measures, which will discourage borrowings.

b. Moral Persuasion

This is done by central bank when meeting with representatives of commercial banks. In the meeting, central bank will explain the economic and financial state of the country and ask the commercial banks to take certain steps to overcome any financial and economic problems faced. The granting of credits should give priority to important development projects which require financial assistance. Conversely, loans for speculation purposes and expenditure on luxurious goods are not encouraged. This strategy focuses on the direction of loans given by the commercial banks. Usually the banking sector is not interested in giving loans to the agricultural sector, food producers and small and medium sized industries. Therefore, central banks can ask commercial banks to allocate certain funds to be given to these loan seekers in productive sectors.

Fiscal Policy to combat Inflation

Contractionary Fiscal Policy or Surplus Budget PolicyThe contractionary fiscal policy or known as surplus budget policy is practiced by the government during inflation. The main aim is to control the excessive demand that causes the general price level to increase. The government can implement a contracting fiscal policy during inflation, which is by increasing taxes or reducing government expenditure or both. When taxes are increased and government expenditure is reduced, aggregate demand will drop, and thus prevent the increase in the price of goods and services.

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1. Decreasing Government ExpenditureA reduction in government expenditure will directly affect aggregate demand. The government will cut the salary of all civil servants and postpone its development project to reduce the purchasing power of the public. A decrease in government spending and an increase in the government’s total tax revenue will produce a surplus budget.

2. Lowering Transfer PaymentDecreasing transfer payment, for example, decreasing payment to those affected by recession is another strategy as they will now have less money in their pocket thus reduce their spending which will eventually decrease aggregate demand in the economy.

3. Increasing TaxBy increasing direct (not indirect) taxes, aggregate demand will drop and thus prevent the increase in the price of goods and services. Consequently, the people’s disposable income of individuals will fall and their consumption of goods and services. . This means that there will be a fall in demand, and with falling demand, prices will fall, ceteris paribus. A highly regressive tax structure can successfully reduce the impact of inflation on the economy.

Direct Control Policy to combat inflation

Direct Control Measures is government intervention on economic activities to ensure fiscal policies and monetary reconsideration will be effective in controlling inflation. Direct control exercised by the government include the following.

Measures To Overcome Demand Pull Inflation:

1. Price control Controlling the Price of Certain Goods where the government can implement a ceiling price policy, which sets the maximum price for certain goods. This will prevent sellers from selling the goods at a higher price than stipulated. As such, producers will no t be able to increase price according to their wishes. The government will control the prices of goods by fixing a floor price and a ceiling price.

2. Rationing

At the time of inflation, governments can control purchasing of essential good by implementing policies through rationing. Rationing can be done by issuing coupons to the public where consumers can purchase limited goods and services using coupon. Total goods to be purchased is limited to the amount stated on the coupon. This policy guarantees that the goods were obtained also by the needs of the poor group.

3. Anti-hoarding campaign

This arises when reports are made against producers and consumers who store goods unnecessarily because such storing can cause an artificial shortage and push prices up.

4. Compulsory savings

To control inflation, it is essential to introduce a compulsory savings plan. This could be by way of a deduction from the salary of workers that is credited to workers’ accounts. In Malaysia, this body is known as the Employees Provident Fund (EPF) where 11% of the workers’ wages are deducted every month. The amount credited into the workers’ savings account can only be withdrawn upon retirement.

5. Increase the production of neccesities goods

At the time of inflation governments can provide the economic resources of the excessive output of goods less important. Government can undertake the manufacturing of essential items so that people can enjoy the output. So, the output level of the essential items can be increased and the prices will be controlled.

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Measures To Overcome Cost Push Inflation:

1. Controlling the increase of salary and wages

Controlling the increase of salary and wages in the market too can assist in the efforts to control inflation. If wages and salaries are not raised, the cost of production and household income will not increase. Thus, producers are not inclined to increase prices. On the other hand, the constant rate of salary of employees reduces the pressure of price increase. Union claim increase in wages when economy has reached full employment is not in line with productivity will increase production costs. Therefore, the government can implement maximum wages policies to control the continuous increment. Wage controls intended to curb manufacturers rising the production costs. The government could also negotiate with trade unions to control wage increases.

2. Controlling prices of raw material

Increase in the price of crude or fuel will increase production costs for firms. The prices of final product will go up as input prices keep on rising. To control the price of raw materials, the government may declare the raw materials as a controlled item. The government could also subsidize the production of raw materials so that the raw materials are now available at a price lower than the equilibrium price.

3. Reduction of import tax on intermediate goods

The imports of intermediate goods is Malaysia's most important and the percentage of the total imports has increased as a result of the rapid development of manufacturing industry. Reduction or exemption of import tax on raw materials, components, machinery and equipment firms will reduce production costs and reduce cost-push inflationary pressures.

4. Encourage the development of technology and labor productivity

Tax incentives given to the creative and innovative firm to promote technological development and improve the efficiency and labor productivity. This will surely will reduce production costs. When the production costs fall , the aggregate supply curve will shift from left to right. Increasing output by tax incentive, encouraging research and development and giving grants tio firms who invest in better technology.

Measures To Overcome Import Push Inflation:

1. Controlling of prices of consumer goods

Government intervention to control prices of imported consumer goods, especially prices of food such as sugar and beef. Government will set the policies on maximum price for consumer goods that are included as a controlled item. Prior to that, the producers must obtain permission from the government to raise the price.

2. Promoting import substitution industries

To reduce dependence on imported goods, the government can take the steps to diversify the economy and encourage the development of import substitution industries. Development of import substitution industries to be more self-reliant and less dependent on foreign countries for industrial materials.

3. Increasing the local products to reduce imports

Measures to increase agricultural production to not only reduce the current account deficit, but also address the problem of inflation, particularly rising prices of imported food. By increasing local food production will lead to reduce dependence on imported food that is vulnerable on the risk with regards to international price.

4. Diversifying sources of imports

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Government and manufacturers may seek to find source of imports which is relatively cheaper in order to overcome the problem of imported inflation.For example, for imported goods on food and agricultural inputs that cannot be produced locally, there must be an efforts to diversify sources of imports, particularly in terms of finding the cheapest one.

5. Strengthening currency value to reduce the cost of imports

Despite the appreciation of the currency could affect the competitiveness of exports, but the value of a strong national currency can also reduce the cost of imported goods, especially raw materials and fuel.

16. Inflationary Gap vs Deflationary Gap

Inflationary gap occurs when aggregate demand (AD) exceeds aggregate supply (AS) at full employment level of output. In this case, money income rises to a higher equilibrium, but real income (being at full employment output level) remains unchanged.

As a result, there is an upward rise in prices because the consumers compete for limited supply of output and bid prices up. In other words, inflationary gap reflects that at full employment level of output, real income cannot rise, but the prices rise to the extent that AD > AS at full employment. Inflationary gap continues to prevail until either AD contracts to the level consistent with the full employment level or AS is expanded through economic growth.When the equilibrium level of output is greater than the natural rate, an Inflationary GAP exists. This is illustrated above, where the equilibrium level of output, Y, exceeds the natural level of output, Yn. When the economy experiences an inflationary gap, a Contractionary Fiscal Policy, such as a decrease in government spending or increase in taxes, or a Contractionary Monetary Policy is appropriate. These policies shift the AD curve to the left.

An inflationary gap can be defined as a situation where national income is in excess of the full employment level Yf e. The increase is only in the increase in general price level but not real increase. It can be caused by excess

demand. When aggregate demand C2+I2+G2+(X2-M2) exceeds full employment level ,there is inflationIn the injection- withdrawal model, inflation occurs when total injections exceed total withdrawal at Ye2. To close the inflationary gap there must be a contractionary policy. Withdrawal must be increased and injections reduced.Calculation on Inflationary GapBelow shows the Aggregate Expenditure on economy having an inflationary gapQuestion 1. Y=AE AE=250 +0.8Y

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AE f

1000 1250 Y Given Y at full employment is at 1000, how much the inflationary gap.Answer:Multiplier = 1 = 1 = 5 1-MPC 1-0.8

Gross National Product Gap = Real Y – Y at full employment = 1250 – 1000 = 250Therefore,Inflationary Gap = Gross National Product Multiplier = 250 = 50 5Question 2Given AE function :AE =300 + 0.75Y. and Aggregate Expenditure function at full employment : AE f = 120 +0.75Y How much the Gross National Product Gap

Answer:Multiplier = 1 = 1 = 4 1-MPC 1-0.75Inflationary Gap = AE– AE f

=(300 + 0.75Y) –(120 +0.75Y ) =180Gross National Product Gap = Inflationary Gap x Multiplier = 180 x 4 = 720

Deflationary Gap:

Deflationary gap prevails when aggregate demand (AD) is less than aggregate supply (AS) at full employment level of output. In this case, income equilibrium occurs while some resources are unemployed.In other, words, deflationary gap depicts unemployment situation attributable to the fact that at full employment level of output, AD <AS.

Thus, deflationary gap is measured as the difference between AD and AS at full employment, Deflationary gap, and the resultant conditions of unemployment and sluggish economic activity, will persist until a higher level of aggregate demand consistent with full employment is achieved.

In Figure 2B, Yf represents full employment output. The position of AS line (i.e., 450 line) is such that at Yp AD is less than AS by the amount BA. Thus, BA is the measure of deflationary gap, which is the same thing as deficient demand measured at Yf.

When the equilibrium level of output is less than the natural rate, as shown below, a Deflationary GAP exists. In the figure, the equilibrium level of output, Y, is less than the natural level of output, Yn.

A deflationary gap calls for an Expansionary Fiscal Policy, such as an increase in government spending or reduction in taxes, or an Expansionary Monetary Policy. Such an expansionary policy shifts the AD curve to the right and increases the equilibrium level of real GDP.

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A deflationary gap can be defined as a situation where the equilibrium level of national income is not at full employment level. Resources are not fully utilized and any increase in national income is a real increase. When aggregate demand C1+I1+G1+(X1-M1) is below full employment level ,there is a deflationary gap

In the injection—withdrawal model, a deflationary gap occurs when total withdrawals are greater than total injections. To close the deflationary gap there must be an expansionary policy. Injections must be increased and withdrawals reduced.

Inflationary Gap Deflationary Gap

Similarity It happens when the aggregate supply differs from the aggregate demandDifference happens when the aggregate demand

is more than the aggregate supplyhappens when the aggregate demand is less than the aggregate supply.

Calculation on Deflationary Gap

Question 1. Y=AE AE f AE=250 +0.8Y

1250 1500 Y

Given Y at full employment is at 1500, how much the deflationary gap.Answer:

Multiplier = 1 = 1 = 5 1-MPC 1-0.8

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Gross National Gap = Y at full employment – Real Y = 1500 – 1250 = 250

Therefore,Deflationary Gap = Gross National Gap = 250 Multiplier 5 = 50

Question 2

Given AE function :AE =120 +0.75Y and Aggregate Expenditure function at full employment : AE f = 300 + 0.75Y. How much the Gross National Gap

Answer:

Multiplier = 1 = 1 = 4 1-MPC 1-0.75

Deflationary Gap = AE f - AE =(300 + 0.75Y) –(120 +0.75Y ) =180Gross National Gap = Deflationary Gap x Multiplier = 180 x 4 = 720

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