How Does Inflation Affects Gdp Growth Rate

Published Date: 02 Nov 2017

Name

Student ID

Section

Yeoh Wei Wei

J12010032

N1

Ng Eng-Sze

J12009728

N1

Vibbeshanan S/O Surendran

J11008536

N1

Dhanistha Devi A/P Selvaraju

J12011249

A1

Nurul Atikah Binti Sirat

J11008864

N1

Subject Code/Name: ECN2220 Principles of Macroeconomics

Lecturer: Ms Janitha

Date of Submission: 15/4/2013

Comments (to be filled by lecturer):

Assignment Question Number 2

Topic 2: Mock Government Budget (USA, Malaysia or any other country)

• Your group will act as the cabinet members in charge of economic policies

Your members must have a position in the cabinet/ministry of finance

• The members will discuss the current economic situation, and make recommendations for on behalf of the government in term of fiscal and monetary policies.

The project will be presented in the last class.

Things to cover in Topic 2:

The country’s current economic situation, and make recommendations for fiscal and monetary policies.

The country’s main economic challenges, including domestic issues and its relations with the rest of the world.

The government’s proposed responses to these challenges

The assignment must cover the following concepts: GDP , Growth, Unemployment, Inflation and interest rate, fiscal and monetary policy

Table of Contents

Title Page No

Cover Page……………………………………………………………………………. 1

Assignment Question (Number 2)……………………………………………………. 2

Table of Contents……………………………………………………………………. 3

Introduction (Malaysia’s Current Economic Problem-Inflation)……………………... 4

How Does Inflation Affects Gross Domestic Product (GDP) Growth Rate………….. 5-6

How Does Inflation Affects Unemployment Rate……………………………………. 7

How Does Inflation Affects Interest Rate…………………………………………...... 8-9

How To Reduce Inflation Rate Using Monetary Policy & Fiscal Policy……………... 10-14

Conclusion…………………………………………………………………………….. 15

References…………………………………………………………………………….. 16

Introduction

(Malaysia’s Current Economic Problem-Inflation)

Malaysia Inflation Rate

Malaysia has been suffering from inflation rate for the past few months as show above. In the graph above, it seems like Malaysia’s inflation rate has been decreasing, but as time passed, Malaysia’s inflation rate is rising again as of March 2013, at 1.5%. The inflation rate increased 1.5 per cent year-over-year, and 0.2 per cent month-over-month in February 2013, mainly due to a rise in prices for food and non-alcoholic beverages.

The consumer price index (CPI) for the period of January to February 2013 increased by 1.4 per cent to 106.0 compared with that of 104.5 in the same period last year. Compared with the same month in 2012, the CPI for February 2013 registered an increase of 1.5 per cent from 104.5 to 106.1 and when compared with the previous month, the CPI increased by 0.2 per cent.

For the period of January to February 2013, the 1.4 percent increase in the CPI was brought about by increases observed in the indices of all the main groups except those of Clothing & Footwear (-0.8 percent) and Communication (-0.7 percent). Increases among these main groups with high weights were Food & Non-Alcoholic Beverages (+2.8 percent), Households Expenses (+1.4 percent). Other increases were Restaurant & Hotels (+2.1 percent) and Miscellaneous Goods & Services (+1.4 percent).

It said that the demand for food is likely to keep rising as emerging economies continue to consume more due to growing of population and affluence. However, uncertain weather conditions would threaten the supplies and hence drive food commodity prices up, it will then cause inflation rate to increase.

How Does Inflation Affects GDP Growth Rate

Economic growth of any country reflects its capacity to increase production of goods and services. The simplest definition of economic growth can be stated as the increase in the Gross Domestic Product (GDP) of that country. Nominal GDP is usually adjusted for inflation factor to reflect real GDP. Interest rate is one of the macroeconomic growth factors; it’s up and down volatility (projects can be delayed or can be reviewed) is closely related with inflation rates. Its high or low rates also impact the economic boom (high GDP) and extending to influence economic growth rate. In business fields, it is very important to accurately predict interest rate trends.

malaysia-gdp-growth-annual.png

Historically, from 2000 until 2012, Malaysia GDP Annual Growth Rate averaged 4.63. The highest percent recorded is 10.10 percent in the first quarter of 2010, in March and a record the lowest of -6.20 percent in the same month of 2009. Malaysia is a developing economy in Asia which in recent years has successfully transformed from an exporter of raw materials into a diversified economy. The largest sector of the economy is services, accounting for around 54 percent of GDP. Manufacturing sector has been growing in recent years and now accounts for 25 percent of GDP and more than 60 percent of total exports. Mining and quarrying constitutes 9 percent of GDP and agriculture 9 percent.

Historical Data Chart

Bank Negara Malaysia (BNM) forecast that, Malaysia 2013 GDP is expected to increase and to be sustained at between 5 to 6 percent which led by private investment growth amid an improving external trade landscape. Based on the graph above, it shows an increasing in GDP 2012 fourth quarter of 6.4 percent compare to GDP expansion of 5.6 percent in second quarter of 2012. Malaysia needs to maintain the GDP rate at 5 to 6 percent.

Domestic demand is expected to be the main factor of economy although the revised number is slower than in 2012. In 2013, domestic demand is expected to grow 8.1 percent compared to 10.6 percent in 2012. The forecasts for all components of domestic demand were raised for example consumer spending increasing in 7.1 percent compare to 7.7 percent in 2012. Government consumption expenditure will increase 3.6 percent than 5 percent in 2012. The expected investment growth is sustained by both private sector and public sector. Private investment is seen growing at 15.6 percent. However, this show decreasing pattern compare with 22 percent expansion in 2012 while public sector show growing in 7.5 percent compare to 17.1 percent in 2012.

How Does Inflation Affects Unemployment Rate

http://www.tradingeconomics.com/charts/malaysia-unemployment-rate.png?s=maeprate Inflation means a sustained increase in the aggregate or general price level in an economy. Inflation also means there is an increase in the cost of living. "Inflation means that your money won’t buy as much today as you could yesterday. For every country, maintaining a low unemployment rate is the main objective. It is usually believed that inflation and unemployment are inversely proportional.

If the rate of inflation increases suddenly, it temporarily reduces the rate of increase in wages. Consequently, unemployment rate decreases. If the workers are able to cope with the increase in inflation, unemployment rate is also less. However, when they do realize that in order to compensate for the increase in price of commodities, the wages ought to be increased, employment may rise to a considerable extent .This increase in the demand of wages, has a tendency to reverse the unemployment curve where unemployment rise . If the rate of inflation is very high, it does not mean that, there will be a permanent decrease in the rate of unemployment. As a rule, rate of inflation and unemployment adjust themselves to attain the equilibrium state, which is known as the natural rate of unemployment state.

According to the graph above, the Malaysia unemployment rate from July 2011 till Jan 2013, where it shows unemployment rate is never zero and it fluctuates every months. The current statistic shows that, the unemployment rate last year, July 2012 was 3% and then it increased to 3.1%, then decreased to 2.7%, increased again then stayed constant at 3.2% and end of the year it decreased at 2.9%.In the early of the year, January 2013, the rate increases to 3.3% .In short, inflation rises causes unemployment rate to rise as well.

How Does Inflation Affects Interest Rate

The benchmark interest rate in Malaysia was last recorded at 3 percent. Interest Rate in Malaysia is reported by the Bank Negara Malaysia. Historically, from 2004 until 2013, Malaysia Interest Rate averaged 2.92 percent reaching an all-time high of 3.50 percent in April of 2006 and a record low of 2 percent in February of 2009. In Malaysia, the interest rate decisions are taken by The Central Bank of Malaysia (Bank Negara Malaysia). The official interest rate is the Overnight Policy Rate.

The interest rate shown on this chart above refers to the central bank benchmark interest rate. Usually, the central bank benchmark interest rate is the overnight rate at which central banks make loans to the commercial banks under their jurisdiction. Moving the benchmark interest rate, the central bank is able to make an impact on interest rates of commercial banks, inflation level of the country and national currency exchange rate. Reduction of interest rates should bring increase in business activity, a rise in inflation rate and weakening of national currency. In case of increase in interest rates the level of business activity is likely to drop, inflation declines and national currency strengthens.

Moreover, the Fed has the power to control interest rates though government-backed securities. These investment instruments can be bought or sold, depending on what the Fed decides. If the central bank wants to lower interest rates, it buys a lot of securities, infusing the banking system with cash .With more money available, interest rates decrease. If the Fed wants to raise interest rates, it sells securities.

Hence, The Monetary Policy Committee considers the current stance of monetary policy to be appropriate given the outlook for inflation and growth.  In addition to domestic conditions, the Monetary Policy Committee will continue to carefully assess the global economic and financial developments and their implications on the overall outlook for inflation and growth of the Malaysian economy.

How to Use Monetary Policy & Fiscal Policy to Reduce Inflation

Monetary Policy

Over the past few years, Malaysia has been suffering from inflation at a rate of 3.5% as of July 2011 and slowly decreasing to 1.2% as of January 2013 which is a good. But as for March 2013, Malaysia’s inflation rate has been increasing to 1.5% due to the demand for food in the community increases. The main reason is the change in weather conditions that affects the supply of food which leads to an increase in price level for food. In order to reduce inflation, the AD1 must shift to the left which is to the AD2.

Bank Negara Malaysia can play a role in reducing inflation rate by using the monetary policy. Central Bank of Malaysia can help to reduce inflation rate by increasing interest rate, increasing the cost of borrowing so that it can discourage the consumers from borrowing money from the bank and also spending too much on products they demand for.

Increasing interest rate is an effect of a tightened money supply. Removing money from the system will slow inflation simply because if supply of money reduced, the existing money will worth more. Higher interest rates tend to slow down business investment and consumer spending which will cause the economy to slow that will also lower the inflation rate.

A higher interest rate will also make consumers more effective in saving money for future purposes. Consumers need to think twice before spending too much on products which are not necessary such as expensive smart phones, expensive clothing and many more. High interest rate will cause consumers to spend lesser on outputs and this can help consumers to save more money and have more cash in hand, thus reducing inflation rate.

Moreover, an increase in the interest rate reduces the disposable income of those with mortgages. An increase in the payment of mortgage interests automatically decreases the real ‘effective’ disposable income of the house owners, as well as their spending capacities. Acceleration in the mortgage costs also decreases the demand generated in the housing markets.

Furthermore, if the other nation’s products sell at a lower price than domestic products, consumers will increase their demand for imports. If domestic residents’ income rise or domestic inflation rates are higher than other countries, demand for imports will rise. When consumers import more products from a country or invest in that country’s securities, their demand for that currency increases. The increase in demand pushes the price of the currency higher, so our currency will appreciate in terms of value, and this helps to reduce inflation rate.

In short, one of the ways in reducing inflation rate is by using the monetary policy to charge a higher interest rate so that consumers will spend less.

Fiscal Policy

Contractionary Fiscal Policy can also be used to reduce the inflationary problem. This is a form of fiscal policy in which government purchases or an increase in taxes is used to correct the inflationary problem. The increase in taxes provides the household sector with less disposable income that can be used for consumption expenditures, which then reduces aggregate production and employment that leads to further decreases in income, thus reducing inflationary pressure.

One of the fiscal policy tools available to the government sector is government purchases which is also known as government expenditures. Federal government spends mainly on final good and services which is the portion of gross domestic products purchased by the government. An example of the purchases would be on highway constructions whereby the funds will be given to the Department of Transportation.

Contractionary fiscal policy involves a decrease in the funds to agencies like Department of Transportation. So, the agencies will then reduce their purchases which will be resulted in a decrease in aggregate production and income thus the rate of inflation will decline.

While a decrease in fiscal policy have been used frequently over the years to implement contractionary fiscal policy, it involves a lot of process thus the policy maker often go for another fiscal policy tool which is through taxes.

Taxes are primarily personal income levied by the federal government but other taxes are also used. Taxes are involuntarily payments that government imposes on the rest of the economy to generate the revenue needed to provide public goods and to help other government sector to function. Another type of tax would be personal income tax where it is given by members from the household sector.

Contractionary fiscal policy involves an increase of the income taxes or it might just be a one-time surcharge. By increasing the taxes, it provides the household sector with less disposable income that can be used for consumption expenditures which will then reduce the aggregate production and employment which also leads to further decrease in income resulting in reduction of inflationary pressure.

Tax changes may be administratively easier to implement if compared to government purchases but the drawback would be they are less political palatable to political leaders and voters who prefer lower taxes to higher taxes. High taxes have been used before as a part of contractionary policy but it is only used when there are no other ways left.

Inflationary Gap

Contractionary fiscal policy is used to address on how the business cycle gives instability to the problem of inflation. There will be inflationary gap if the current existing aggregate demand’s level is more than what could be produced with the full employment. Looking at the current state Malaysia is having at the moment; inflationary rate needs to be closed.

LRAS is the supply curve in the long run; it marks the full-employment real production. In the long-run, the aggregate market needs full-employment real production. If the SRAS curve which represents the short run real production rises above the LRAS, it will cause an inflationary gap. The aggregate demand curve reveals that in the short run, the level of real production is higher that full employment which is an inflationary situation. Basically, the difference between short-run equilibrium real production and full-employment real production is the inflationary gap.

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Contractionary fiscal’s policy goal is to close the inflationary gap by changing the aggregate expenditures and shifting the aggregate demand curve. In the graph, AD is shifted to AD1 to close the inflationary gap. A decrease in government spending or an increase in taxes may cause a shift from AD to AD1 to close the gap.

Conclusion

In conclusion, Malaysia’s inflation has a really big impact in not only Gross Domestic Product (GDP) growth rate, but also in unemployment rate and interest rate. When there is inflation, the demand for output will decrease. In order to reduce inflation rate, monetary policy and fiscal policy can be used in order to slow down growth and therefore reduce inflation rate.