Question

Question 2 [50 Marks] – macroeconomic economic indicators Most developing countries such as South Africa, Zambia, Tanzania, Mozambique, Nigeria etc., are battling to contain inflation at desirable levels. On the other hand, some developed economies are battling with deflation. Using relevant macroeconomic theories to support your arguments: a. Write a detailed review of the challenges posed by deflation within an economy. Your answer should cover all sectors including the business, government and the society as well as other macroeconomic indicators (GDP, unemployment, interest rate, etc.,). [25 Marks] b. As an economist, write a policy brief to the parliament of a country that is attempting to find the correct policy mix to take the country out of a deflationary period. Your policy brief should demonstrate a clear understanding of relevant macroeconomic PBA4801 Economics for Managers Jan 2020 S1 Page 30 of 32 © UNISA Graduate School of Business Leadership models/theories and must cover both fiscal and monetary policies focusing on all actors of the economy (business, public sector, government, society etc.,). [25 Marks]

Answer 1

(a) Deflation is state of economy in which general price level starts declining as oppose to what happens in inflation that is rising general price level. This is usually occurs when an economy is going through a recession where is there is low aggregate demand in the economy. Due to this low aggregate demand the asset prices starts to fall as their demand falls this increase the real debt of borrowers since the value of their collateral falls due to falling prices.

The producers takes this into account and reduces their production level which further causes the demand for investment to fall and unemployment to rise. Which as a result further contributes to the falling aggregate demand. As price are falling people like to hold to their money because they know that the prices in future will further fall so they don't spend their money today.

The financial sector due to this low asset prices fall into debt trap since their assets are the value of the collateral assures against the loan. This causes the default rate to increase and causes liquidity crisis where lending ability of banks reduces significantly. This further contributes to the fall in aggregate demand in the economy, as a result output (GDP) falls and unemployment rises.

As the GDP falls and unemployment rises the government revenue also falls as a result the government expenditure also falls in state of recession and deflation which also contributes to the lower aggregate demand. As prices falls production slows down due to consumer demand because consumers have little incentive to spend today when they know they real purchasing power will be more tomorrow as price falls. The default rate on loans increase as the value of assets fall in economy as a result financial system melts down.

(b) When an economy is going through deflation which is generally related to recession, the correct policy mix to use is expansionary monetary and fiscal policies. The expansionary fiscal policy can be direct tax cut or subsidy or simply increase in government expenditure to boost the aggregate demand in the economy and to help production to take place in the economy. As the production starts the unemployment rate will decrease and also demand for investment will increase.

When this fiscal expansion policy takes place, there will a increase in demand for money in the economy and to take care of this the central bank need expansionary measures such as buying treasury bonds to release fresh amount of money in the economy or it can buy stresses assets to help asset owners to get out of hot water.

The monetary expansion will also help in increasing demand in the economy which will increase output and employment and as output increase the price level will also start to increase. The economy will start to get out of deflation.