Question

Your uncle who worked for forty years as a plastic surgeon is now retired. Since his retirement he has become very interested in political economy and has taken Micro and Macro Principles at the local college. Lately, he has become very interested in understanding the macroeconomic consequences of inflation and deflation. Your uncle believes that microeconomics is guided by fundamental economic principles but does not believe that the same is true for macroeconomics. In fact he believes that macroeconomics is mostly a set of anecdotes. As a budding macroeconomist you find this view bothersome and would like to convince your Uncle that his view of macroeconomics is misguided. Given his current interest in deflation and inflation, you decide to write a memo to him that convincingly demonstrates that analysis of the macroeconomic consequences of inflation and deflation is in fact guided by fundamental economic principles.

Write an essay that addresses the issues identified above and any other issues you deem appropriate given that your goal is to use the analysis of the costs of inflation and deflation to demonstrate to your Uncle that macroeconomic analysis is guided by fundamental economic principles.

Answer 1

Inflation refers to the rise in the general price level of an economy. We know that as the demand for a commodity increases the price of the commodity increases too whenever there is a limited supply of the commodity. So in general whenever an economy starts to demand more of various commodities it leads to a general rise in the prices. In order to meet the demand the forms or the suppliers increase their production by employing more labour and capital and demanding more loans for making Investments. The increase in the demand for labour increases the income for the households are the labour providers thereby providing more disposable income to the people. Now the consumer's demand more of goods and services thereby increasing their prices this leads to inflation.  

Similarly deflation is is caused by demand and supply of the commodities and services in an economy. When the demand for goods decreases either due to fall in the income level or maybe due to shift to other substitute commodities price level starts to fall or increases at a decreasing rate leading to inflation. A decrease in aggregate demand causes the the palms to cut back on employment thereby laying of their workers this reduces the income level of the people or the households which in turn decreases there consumption level leading to a fall in aggregate demand. This is a vicious cycle.

Hence we see simple analysis of demand and supply of commodities in an economy explain the causes of inflation and deflation. Therefore it is wrong to say that macroeconomics is not backed by fundamentals of Economics.