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CHAPTER II: DATA OF MACROECONOMICS 5) Some goods are not sold in the marketplace and

therefore dont have market prices. We must use

I. Gross domestic products-GDP their imputed value as an estimate of their value. For
example, home ownership and government services.
Gross Domestic Product (GDP) is the market value of
all final goods and services produced within an The value of final goods and services measured at
economy in a given period of time. current prices is called nominal GDP. It can change
over time either because there is a change in the
Income, Expenditure and the Circular Flow amount (real value) of goods and services or a
change in the prices of those goods and services.
There are 2 ways of viewing GDP:
Hence, nominal GDP Y = P y, where P is the price
-Total income of everyone in the economy
level and y is real output and remember we use
output and GDP interchangeably.
-Total expenditure on the economys output of goods
and services
Real GDP or, y = YP is the value of goods and
services measured using a constant set of prices.
For the economy as a whole, income must equal
expenditure. GDP measures the flow of dollars in this
GDP Deflator
GDP Deflator = Nominal / Real GDP
II. Computing GDP
Nominal GDP measures the current dollar value of
1.Rules for computing GDP
the output of the economy.

1) To compute the total value of different goods and

Real GDP measures output valued at constant prices.
services, the national income accounts use market
prices. The GDP deflator, also called the implicit price
deflator for GDP, measures the price of output
Thus, if
relative to its price in the base year. It reflects whats
happening to the overall level of prices in the
GDP = (Price of apples Quantity of apples)
+ (Price of oranges Quantity of oranges)
3. Methods of computing GDP

= ($0.50 4) + ($1.00 3)
GDP = C + I + G + (X-M)

GDP = $5.00 Y = C + I + G + NX

2) Used goods are not included in the calculation of Y Total demand for domestic output (GDP); C
GDP. Consumption spending by households; I Investment
spending by businesses and households; G
3) The treatment of inventories depends on if the
Government purchases of goods and services; NX
goods are stored or if they spoil. If the goods are
Net exports or net foreign demand
stored, their value is included in GDP.
*The Factor Incomes Approach: it measures GDP by
If they spoil, GDP remains unchanged. When the
adding together all the incomes paid by firms to
goods are finally sold out of inventory, they are
households for the services of the factors of
considered used goods (and are not counted).
production they hire. According to this approach,
GDP is the sum of incomes in the economy during a
4) Intermediate goods are not counted in GDP only
given period
the value of final goods. Reason: the value of
intermediate goods is already included in the market
GDP = w + r + i + + D +Te
W: wage, r: rent fixed capital, i: interest, profit,
Value added of a firm equals the value of the firms
D: Depreciation, Te: indirect tax
output less the value of the intermediate goods the
firm purchases.
3. The output approach
Total Value added = Total Revenues Total Cost I.Aggregate Planned Expenditure and
Aggregate Demand
GDP = Value added in all industries
1.Assumptions: a model nearly always starts with
=> GDP = VAT. 1/Value added tax the word assume or suppose. This is an indication
that reality is about to be simplified in order to focus
II. Gross national products)-GNP on the issue at hand

1. Definition: *The Economy Operates at less than full

Employment: this implies that firms are willing to
GNP is the market value of all final goods and supply any amount of the good at a given price P. In
services produced by domestic residents in a given other words, assume that the supply of goods is
period of time. completely elastic at price P. This assumption is
generally valid only in the short run

Closed Economy and No Government: we assume

2. Computing methods: that the economy does not trade with the rest of the
world so that both exports and imports are equal to
GNP = GDP + Tn
zero (X=M=0). We also assume that there is no
government in the economy so that government
Tn: net Income from Abroad
expenditures and taxes are equal to zero (G=T=0).
This implies that aggregate demand is therefore
3 cases :
reduced to the following expression:
+ GNP > GDP (Tn>0): domestic economy has
AD C + I
impacts in other economies.

+ GNP < GDP (Tn<0): foreign economies have 1. Aggregate Planned Expenditure
impacts in domestic economy.
APE reflects the total planned expenditure at each
+ GNP = GDP (Tn=0): no conclusion income, with assumption of given price.

4. Net Economic Welfare -NEW Households: Consumption C = f(Yd): the main

determinant of consumption is surely income, or
GDP, GNP doesnt compute some goods and services more precisely
which arent sold, or illegal transactions or activities
of black market, negative externality C = f1(Y)

NEW = GNP + V1 V2 -Firms: to create the demand through their

I = f2(Y)
+ Value of Rest
APE = C + I = f1(Y) + f2(Y)
+ Value of goods and services which arent sold
1.1. Consumption function
+ Revenues from transactions in black market
C f1 (Y ) C MPC.Yd
The relationship
Negative externality for natural resources, between consumption expenditures and disposable
environment, such as noise traffic jam income, other things remaining the same, is called
consumption function. The consumption function that
NEW reflects welfare better than GNPm but it is very we will use in our model and that shows the positive
difficult to have enough data to compute NEW, link between consumption and disposable income is
therefore, economists still use GDP and GNP. the following (figure)

CHAPTER III: AGGREGATE DEMAND & FISCAL Determinants of Consumption:

+Autonomous Consumption (C): this is the amount +The Marginal Propensity to Save (MPS): the
of consumption expenditure that would take place propensity to save tells us how much people save
even if people had no current disposable income out of an additional unit of income. The assumption
we made earlier that MPC is between zero and one
+Induced Consumption: this is consumption implies that the propensity to save is given by
expenditure that is in excess of autonomous
consumption and that is induced by an increase in (1-MPC) and that it is also between 0 and 1.
disposable income.
The Saving Curve: it traces the relationship
between the level of net saving and income

+Marginal Propensity to Consume (MPC): it is 1.3.Investment function (I): the second

the fraction of a change in disposable income that is expenditure in APE that we will analyse today is
consumed. It is calculated as the change in investment
consumption expenditures (DC) divided by the
change in disposable income (DYd) that brought it *Determinants of Investment: we can distinguish
about. It gives the effect of an additional pound of four major determinants of investment
disposable income on consumption. The MPC
determines the slope of the consumption function +Increased Consumer Demand: investment is to
provide extra capacity. This will only be necessary,
therefore, if consumer demand increases
Y +Expectations: since investment is made in order
to produce output for the future, investment must
depend on firms expectations about future market

0 < MPC< 1: This reflects the fact that people are +Cost and Efficiency of Capital Equipment: if the
likely to consume only part of any increase in income cost of capital equipment goes down or machines
and to save the rest become more efficient, the return on investment will
increase and firms will invest more
+NetPrivateSavings-S: savings by consumers is
equal to their disposable income minus their +Interest rate: the higher the rate of interest, the
consumption more expensive it will be for firms to borrow the
money to finance their investment expenditures and
=> S = Yd - C the less profitable will the investment be

And, by using the definition of disposable income this +Level of Investment in the Economy: in this
identity can be rewritten as: model we will take investment as given or, in other
words, we will regard it as an exogenous variable.
S = Y T C (but T = 0, no government) The main reason for taking investment as given is to
keep our model simple. Thus we will assume that
However, given that there is no government in our
investment is given by a fixed/constant amount (a
simple economy, T=0 and savings are equal to: S =
bar over a variables indicates that the variable is
regarded as an exogenous variable) that does not
change with the level of income in the economy:
1.2.T *The Determination of Equilibrium Output:
he Saving Function: the economys savings When P, w is constant,the equilibrium in the goods
function can be derived by using the private savings market requires that the supply of goods (GDP=Y)
expression and the consumption function: equals the demand for goods (APE):

Y APE M derives from production inputs, or consumptions
of households=>M increases when I or Ye rises.
This equation is called the M = MPM.Y
equilibrium condition. By replacing the above
*MPM (Marginal Propensity to Import): it is the
expression for aggregate planned expenditure in the
fraction of an increase in GDP that is spent on
equilibrium condition we get:
imports. It is calculated as the change in imports
(M) divided by the change in GDP ( Y) that
brought it about, other things remaining the same.
The MPM is a positive number smaller than one
Ye (C I )
1 MPC MPM = M/ Y and 0<MPM <1
As you can see the above
expression is an equation in one endogenous II. Fiscal policy:
variable: Y. Thus we can solve this equation for Y
and this will give us the equilibrium level of output 1. Fiscal policy: Government use taxation and
(Ye) produced in the economy consumption to regulate aggregate demand.

2. Fiscal policy and Budget deficit

State Budget: total sum of revenues and

consumption of Government in given time (one year)
2. APE & Ye in closed economy with a
Government Sector B=T-G

-Firms invest in economy + B = 0: Budget balance

-Government sector expenditure: G + B > 0: Budget surplus

+G will increase APE and will shift the APE curve + B < 0: Budget deficit
+Taxation reduces the level of disposable income
- Real budget deficit: When consumption > revenues
available for consumption and will tend to reduce
APE. Such a reduction in APE is reflected by a
-Cyclic budget deficit: when economy faces
downward rotation of the APE curve. Why?
recession due to cyclic business.

This is due to the fact that taxation reduces the

-Structural budget deficit: is calculated in term of
overall MPC by the household so that for each extra
assumptions with potential output.
pound of income the household will now consume
less since some of the extra income must be paid in where Btt = Bck + Bcc =>Bcc = Btt - Bck
4. How to reduce budget deficit
3. 2. APE & Ye in open-economy with a
Government Sector and foreign trade -Increasing revenues and decreasing consumption

*Assumption: T = t.Y (t- taxrate) -Public debt: Government bond

Economy has 4 sector -Borrowings from foreign countries or international

*C = C + MPC.(Y-T) = C + MPC.(1-t).Y
-Printing money or using reserve from foreign
*I = I currency


*NX=X-M: netexport I. Money

1. The Meaning and functions of Money Cash in circulation with the public and held by banks
and building societies +Banks balances with the
a. Definition of Money: money is any commodity Central Bank
or token that is generally acceptable as the means of
payment. A means of payment is a method of M1 = Cash + Deposit (D: Deposit is unlimited time
settling a debt. In general terms money can be deposit). Liquidity of M1 is smaller than M0 but it is
defined as the stock of assets that can be readily still good to measure the cash in circulation in
used to make transactions. Roughly speaking, the economy.
coins and banknotes in the hands of the public make
up the nations stock of money M2= M1 + limited time deposit: Liquidity of M2 is
very low, therefore, there are some developed
b. Development of money economies such as US and UK where use to measure
the cash in circulation.
Cattle, iron, gold, silver, diamond .and banknote
today *Money can be divided into:

Batter => commodity money=> cash, cheque, credit Fiat Money: money takes different forms.
Money that has no intrinsic value is called fiat money
2. The Functions of Money: money has three main because it is established as money by government
purposes. It is a medium of exchange, a unit of decree, or fiat
account and a store of value
In the UK economy we make transactions with an
2.1. Medium of Exchange: it is an object that is items whose sole function is to act as money: pound
generally accepted in exchange for goods and coins and banknotes. These pieces of paper with the
services. Money acts as such a medium portrait of the queen would have little value if they
were not widely accepted as money.
2.2. Unit of Account (A Means of Evaluation): a
unit of account is an agreed measure for stating the Commodity Money: although fiat money is the
prices of goods and services. It allows the value of norm in most economies today, historically most
one good to be compared with another societies have used for money a commodity with
some intrinsic value.
2.3. Store of Value: any commodity or token that
can be held and exchanged later for goods and Money of this sort is called commodity money and
services is called a store of value. Money acts as a the most widespread example of commodity money
store of value. is gold

Functions of Money II. Central Bank and creation money of

commercial bank
Store of value
1.Banks are the Financial Intermediaries. They are
Unit of account private firms licensed by the Central Bank under the
Banking Act to take deposits and make loans and
Medium of exchange operate in the economy.

International Money Retail Banks: they specialise in providing branch

banking facilities to member of the general public but
The ease with which money is converted into other they do also lend to businesses albeit often on a
things, goods and services is sometimes called short-term basis. They are the most important banks
moneys liquidity. in the UK for the functioning of the economy and for
the implementation of monetary policy
3.Types of Money
2. The creation of Money by commercial banks
*Depend on the Liquidity:
The Creation of Money: banks create money.
M 0= Cash; (Wide Monetary Base) =
However this does not mean that they have smoke-
filled back rooms in which counterfeiters are busily
working. Notice that most money is deposits, not
currency. What banks create is deposits and they do
so by making loans. But the amount of deposits they +To Overseas Central Banks: these are deposits
can create is limited by their reserves in sterling held by overseas authorities as part of
their official reserves and/or purposes of intervening
Change in Deposit in the foreign exchange market in order to influence
Deposit Multiplier the exchange rate of their currency.
Change in Reserves
Th *It Manages the Governments Borrowing
e Deposit Multiplier: this is the amount by which Programme: whenever the government runs a
an increase in bank reserves is multiplied to calculate budget deficit (it spends more than what it receives
the increase in bank deposits. It is given by the in taxes) it will have to finance that deficit by
following formula: borrowing. It can borrow by using bonds (gilts),
National Savings certificates or Treasury bills. The CB
organises this borrowing

1 *It Supervises the Financial System: it advises

Deposit Multiplier banks on good banking practice. It discusses
Desired Reserve Ratio government policy with them and reports back to the
government. It requires banks to maintain adequate
Alternatively, it can also be defined as: liquidity: this is called prudential control.

*It Provides Liquidity to Banks Lender of Last

Resort: it ensures that there is always an adequate
If banks want to keep 10% of their deposits as supply of liquidity to meet the legitimate demands of
reserves, so that the desired reserve ratio is 0.10 depositors in recognised banks
(ra), the deposit multiplier is given by the following
expression: 1/ra =10. *It Operates the Governments Monetary and
Exchange Rate Policy
III. Central Bank and money supply
+Monetary Policy: the CB manipulates the interest
1. Roles of Central Bank rate in the economy and influence the size of the
money supply
*Supervision of Monetary System: the central
bank oversees the whole monetary system and +Exchange Rate Policy: the CB manages the
ensures that banks and financial institutions operate countrys gold and foreign currency reserves
as stably and as efficiently as possible
3. The Supply of Money
*Governments Bank: the central bank is the acts
as the governments agent both as its banker and in *Definition of Money Supply: the quantity of
carrying out monetary policy money available is called the money supply. In an
economy that uses fiat money, such as most
2. Functions of Central Bank economies today, the government controls the
supply of money: legal restrictions give the
*To Issue Notes: the Central Bank is the sole
government a monopoly on the printing of money
issuer of banknotes. The amount of banknotes issued
by Central Bank depends largely on the demand for *Monetary Policy: the control over the money
notes from the general public supply is called monetary policy

*It Acts as a Bank 4. Implement of money supply

+To the Government: the government deposits its a. Measures of Money Supply:
revenues from taxation in the central bank and uses
CB in order to borrow money from the market
Money Currency Demand Deposits
+To other Recognised Banks: all banks licensed
Recall that we can
by CB hold operational balances in the CB. These are
denote money supply as the sum of currency and
used for clearing purposes between the banks and to
provide them with a source of liquidity
Central Bank issues H0, (Basic Money, High Powered and services or using it to purchase financial assets
Money), H0 < M0. Ho is divided into such as bond or shares

U and R 2.Reasons for Holding Money

+ Sectors keep a part of Ho, denote as U. U cant The Transactions Motive: since money is a
create other means of payment and it can be medium of exchange it is required for conducting
decrease due to damages..in the circulation. transactions
Assuption, U is constant.
The Precautionary Motive: unforeseen
+ The rest of Ho denote as R (Ho = U +R). The circumstances can arise, such as a car breakdown.
banking system will use R to create money as Thus individuals often hold some additional money
followings: as a precaution

b. The Central Bank's Policy Tools: there are The Speculative Motive: certain firms and
three main tools that the Central Bank can use to individuals who wish to purchase financial assets
control money supply and implement monetary such as bonds or shares may prefer to wait if they
policy feel that their price is likely to fall. In the meantime
they will hold idle money balances instead
*Reserve Requirements: these are regulations by
the central bank that impose on banks a minimum 3.The Demand for Money Function:
reserve-deposit ratio. An increase in reserve
requirements raises the reserve-deposit ratio and The relationship between the demand for money and
thus lowers the money multiplier and the money the interest rate is described by the demand for
supply money function

*Discount Rate: it is the interest rate that the This expression simply states that the demand for
central bank charges when it makes loans to banks. money is a function (f) of income Y and the interest
Banks borrow from the central bank when they find rate
themselves with too few reserves to meet reserve
requirements. The lower the discount rate, the I = denotes the nominal money demand
cheaper are borrowed reserves and the more banks
borrow at the central banks discount window. Y = denotes nominal income (GDP) and it captures
the overall level of transactions in the economy.
=> discount rate decreases =>the monetary base
and the money supply go up. d. Determinant of money demand

Level of price:

*Open-Market Operations: they are the purchases MDn (nominal Money Demand computing based on
and sales of government bonds by the central bank. researched price (usually higher than based price)

When the central bank buys (sells) bonds from (to) MDn
the public, the pounds it pays (receives) for the P
bonds increase (decrease) the monetary base and MDr MD const
thereby increase (decrease) the money supply.
The term 'Open Market' refers to commercial banks P
and the general CB conducts an open market MDr MD const
operation, it does a transaction with a bank or some M
other business but it does not transact with the Dr (real Money Demand, computing depend on based
government price (constant price).

IV. Money market

1. Money Demand: the demand for money refers

to the desire to hold money: to keep your wealth in
the form of money, rather than spending it on goods

*Interest rate (i) + If I # i0 =>imbalance between supply and demand

which puts pressure to push I up or down to
If increases (decreases) => MD decreases equilibrium point i0. When MS, MD changes
(increases) =>equilibrium point (E) changes which leads to
changes of i0.
*Income (Y)
Y increases (decreases) => MD increases
(decreases) I.Unemployment

Money demand function can be written: Unemployment is the number of people of working
age who are without work, but who are available for
MD = k.Yh.i work at current wage rates. If the figure is to be
expressed as a percentage, then it is a percentage of
k-income-elasticity of MD the total labour force.

h-interest rate elasticity of MD. -The labour force is defined as: those in employment
(including the self-employed, those in the armed
forces and those on government training schemes)
plus those unemployed.
+ i change=>quantity demanded move along MD,
other things being equal.
-The labor force doesnt include people who are out
of working age, students, pupils, invalids. People
+ Y change=>MD shift rightwards or leftwards.
who are at working age but unwilling to work doesnt
Depends on income-elasticity of money demand (k).
belong to labor force

kY 1 2. Computing unemployment rate

i MD
h h
u - Unemployment Rate): to be expressed by
+ Slope
fraction of unemployment with the total labour force.
of MD depends on the interest rate elasticity of
It can be expressed by percentage as the formula
money demand (h).

2. Money supply
u 100%
U (Unemployed):
* The Determinants of Money supply
L (Labor Force):

MS n m H 0
-The level of price:
nominal MS doesnt depend on P but real MS does Unemployment is a problem for the economy
because: because:

Output and incomes are lost.

3. Equilibrium in the Money Market: Human capital depreciates.

The equilibrium in the money market requires that Crime may increase.
money supply be equal to money demand, that
Human dignity suffers.

3. Types and causes of unemployment

This equilibrium condition tells us that the interest
rate must be such that people are willing to hold and
Frictional unemployment occurs when people
amount of money equal to the existing supply. This
leave their jobs, either voluntarily or because they
equilibrium relation is also called LM and will be
are sacked or made redundant, and are then
discussed in more detail in the next lecture.
unemployed for a period of time while they are Pt-1: at previous time
looking for a new job. They may not get the first job
they apply for, despite a vacancy existing. The Pt: : at current time (research time)
employer may continue searching, hoping to find a
better-qualified person. P1Q1 P2 Q2 ... Pn Qn
Structural Unemployment refers to unemployment Q1 Q2 ... Qn
arising because there is a mismatch of skills and job P is to be
opportunities when the pattern of demand and expressed as follows:
production changes. Examples in the UK include
unemployment resulting from a decline in the
production of textiles, shipbuilding, cars, coal and
steel. Those workers who become structurally
unemployed are available for work but they have
either the wrong skills for the jobs available or they k
are in the wrong location. P Q i

Demand-deficient Unemployment is also referred

CPI i 1
to Keynesian unemployment. Demand-deficient P i
unemployment occurs when aggregate demand falls i 1
and wages and prices have not yet adjusted to Actually, P is
restore full employment. Aggregate demand is difficult to compute, we can compute inflation
deficient because it is lower than full-employment as below:
aggregate demand which implies that output is less
than full employment output.

Classical Unemployment describes the

unemployment created when the wage is deliberately
maintained above the level at which the labour
market clears. It can be caused either by the
exercise of trade union power or by minimum wage Where CPI is the consumer price index and t is time.
legislation which enforces a wage in excess of the The consumer price index measures how much more
equilibrium wage rate. a basket of goods that represents goods purchased
by the average householder costs today compared
II. Inflation with some previous time period.

1. Definition n

Inflation is a rise in the average price of goods over GDPn P Q i


D 100% i 1
time. GDPr
The term deflation is used to describe a fall in the
P Qi 1

average price of goods over time. +

GDP (D: Deflator)
Deflation is very rare, but when it occurs it can cause
serious problems in the economy. The inflation rate
is the percentage change in the price level.

Pt Pt 1
gp 100%
Pt 1
Dt Dt 1
2. Computing gp 100%
inflation Dt 1
Gp: price growth rate
reflects changes in prices of total final goods and
services compare with based price, therefore, this
describes inflation rate.
Structural (demand-shift) inflation arises when
the pattern of demand (or supply) changes in the
Why is inflation a problem?: When inflation is economy which results I n some industries
present in the economy, money is losing its value. experiencing increased demand whilst others
The higher the inflation rate, the higher is the rate at experience decreased demand. If prices and wage
which money is losing value and this fact is the rates are inflexible downwards in the contracting
source of the inflation problem. Inflation is said to be industries, and prices and wage rates rise in the
good for borrowers and bad for lenders, and so expanding industries, the overall price and wage
inflation can cause inequalities in the economy. level will rise. The problem will be made worse, the
People on fixed incomes (e.g. pensioners and less elastic is supply to these shifts.
students) tend to suffer most from inflation.
*Expectations are crucial determinants of inflation.
2. Types of inflation Workers and firms take account of the expected rate
of inflation when making decisions. Generally, the
*Moderate Inflation: inflation rate < 10%/nm, higher the expected rate of inflation, the higher will
prices increases slowly.. be the level of pay settlements and price rises, and
hence the higher will be the resulting actual rate of
Moderate inflation can spur production because price inflation.
increases leading to highet profit for
enterprises,therefore, firms will increases quantity.
MS n
MS r MD r kY hi
Galloping Inflation: inflation rate is from 10% to P
99% per year. This type will destroy economy and *Inflation and
curb engines of economy. Money: equilibrium point of money market

Hyper Inflation: is defined as inflation that exceeds

100% percent per year.

Costs such as shoe-leather and menu costs are much

worse with hyperinflation and tax systems are 4.Policies to deal with inflation
grossly distorted. Eventually, when costs become too
great with hyperinflation, the money loses its role as 4.1.Fiscal policy comprises changes in government
store of value, unit of account and medium of expenditure and/or taxation. The aim is to affect the
exchange. Bartering or using commodity money level of AD through a policy known as demand
becomes prevalent. management. In the case of controlling inflation, this
involves reducing government expenditure and/or
*Expected inflation: depends on expectation of increasing taxation in what is called a deflationary
individuals about gp in the future. Its impacts are fiscal policy. Such policies are likely to be effective if
small but help to adjust production cost. inflation has been diagnosed as demand-pull since a
reduction in government expenditure or an increase
+Unexpected inflation: derives from exogenous in income tax will reduce aggregate demand in the
shocks and unexpected factors inside economy. economy.

3. Causes of inflation 4.2.Monetary policy is concerned with influencing

the money supply and the interest rate. In terms of
Demand-pull inflation is caused by continuing
controlling inflation, the government can aim to
rises in AD in the economy. The increase in AD may
reduce the money supply thus reducing spending
be caused by either increases in the money supply
and, therefore, the aggregate demand, or it can
or increases in G-expenditure when the economy is
increase the interest rate so as to increase the cost
close to full employment. In general, demand-pull
of borrowing. Both policies can be seen as
inflation is typically associated with a booming
deflationary monetary policy. Since monetarists view
the growth of the money supply as being the main
cause of inflation, any control of inflation from a
* Cost-push inflation is associated with continuing
monetarist viewpoint must involve control of the
rises in costs. Rises in costs may originate from a
money supply.
number of different sources such as wage increases
and other higher costs of production (e.g. raw
4.3.Prices and incomes policy aim to limit and, in
certain cases, freeze wage and price increases. In
the past they have either been statutory or (2) By encouraging increases in productivity through
voluntary. Statutory prices and incomes policies have the retraining of labour, or by investment grants to
to be enforced by government legislation, such as firms, or by tax incentives, etc.
the EU minimum wage legislation. With a voluntary
prices and incomes policy the government aims to 4.5.Learning to live with inflation involves
control prices and incomes through voluntary accepting the fact that inflation is here to stay when
restraint, possibly by obtaining the support of the standard anti inflationary policy measures appear
unions and employers. ineffective. In such a situation we just have to learn
to live with inflation. Learning to live with inflation
4.4. Supply-side policy is concerned with involves the government, employers and workers
instituting measures aimed at shifting the aggregate taking inflation into account in their everyday
supply curve to the right. Supply-side economics is transactions. For example, the government,
the use of microeconomic incentives to alter the level employers may use indexation in wage/pensions
of full employment and the level of potential output contracts. Indexation is when wages or pensions are
in the economy. If inflation is caused by cost-push increased in line with the current rate of inflation.
pressures, supply-side policy can help to reduce Indexation is aimed at nullifying the effects of
these cost pressures in two ways: inflation.

(1) By reducing the power of trade unions and/or

firms (e.g. by anti-monopoly legislation) and thereby
encouraging more competition in the supply of
labour and/or goods