ECONOMICS 1A:

Introduction to Economics
Module IV: MEASURING THE MACROECONOMY

SCOPE OF THE MODULE

This module consists of four lessons, namely:
Lesson 1 Estimating National Income
Lesson 2 Income and Consumption
Lesson 3 Income and Investment
Lesson 4 Income and Inflation

OVERVIEW OF THE MODULE

This module concentrates on the fundamental elements underlying macroeconomic
analysis - consumption, investment, price levels - and explains how these elements
affect the nation's income.

OBJECTIVES OF THE MODULE

After studying this module on measuring the macroeconomy, you will be able to:
1. estimate the nation's income by using the income, expenditure, and value-
added approaches;
2. demonstrate understanding on why and how a household's consumption
and/or savings affect the nation's income;
3. demonstrate understanding on why and how investments can affect the
nation's income;
4. demonstrate understanding on why and how inflation can affect the nation's
income.

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 ECONOMICS 1A:
Introduction to Economics
MODULE IV, LESSON 1:
ESTIMATING NATIONAL INCOME

LESSON OBJECTIVES:
After studying this lesson on estimating national income, you will be able to:
1. know the three (3) approaches in GNP computation; and
2. compute for GNP using the 3 approaches.

We recall in Lesson 2 of Module I how an economy works as reflected in the circular

flow model. The model shows that there are 2 important economic units. These are the
firms (producers) and the households (consumers). The firm uses (E) resources owned
by households (HHs) to produce (P) goods and services which the households
consume. This flow is called the flow of goods or the commodity market.
Corresponding to the employment of the resources is the payment (Y) money by the
firms for the use of the resources belonging to the households. We call this Income of
households. Income is used by the household for payment (C) of the goods and
services that firms sell to them. This other parallel flow is called the flow of funds or the
money market. Thus, the economy may be seen to consist of a product market and a
money market.

Households (Resource owners) Firms (Producers)

Figure 4.1: Circular Flow Model

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 Using the above model of the circular flow of goods and funds in the economic
system, one can measure the performance of an ecosystem within a period of time. If
we sum up all the market values (in money terms) of all the final goods and services
produced in a given time, the result is called the Gross National Product.
There are basically three approaches to estimate GNP: the expenditure (or
goods flow) approach, factor payment (or income flow) approach and the
value-added approach.

Expenditure (or goods flow) Approach

One can measure GNP by first summing up the expenditure of the households, the
firms, the government, and the foreign trade sectors when buying final good and
services. Expenditures by households are termed consumption (C).Expenditures by
firms are termed as investments (I) on capital goods. Expenditures of government in
one year is called government spending (G).Dollars earned through our exports less
spending of dollars for imports give us net exports (X-M).
Consumption (or Personal Consumption Expenditure) by households can be
classified into consumer durables, consumer non-durables, and consumer services.
Consumer durables are those goods which can be used over and over again, given the
estimated economic life of a machine. Examples are household appliances,
furnishings, and fixtures. Consumer non-durables, on the other hand, are those goods
which can be used only once. Examples are food and fuel. Lastly, consumer services
include travel expenses, medical and dental fees, and educational expenses.
Investment spending (or Gross Domestic Private Investment) by the firms can
be classified into the following forms: the acquisition of a new durable
equipment/tool/implement for productive purposes, the construction of a new producer's
plant, building, warehouse or residential units, and the increase in stocks/inventories of
the business firm. A school is said to be investing if it buys new IBM computer units for
its computer laboratories. Shoemart Inc. is said to be investing if it builds a new
commercial complex in Cebu City or Baguio City. The United Laboratories (Unilab) is
said to be investing if it manufactures new stocks of generic medicines within affordable
price levels of the low income class of economy.
Government spending (or Government Consumption Expenditure) by the state
can be classified into public consumption and investment goods. Public consumption
goods include postal services, health and medical services, police and fire services, and
national defense protection. On the other hand, public investment goods include the
construction of roads, bridges, dams, parks, ports, airports, and government
buildings.
Net exports can be determined by the difference between the importation and
exportation of goods and services. When a country has trade relations with other
countries, it may buy merchandise or services from other countries - the sum total of

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which constitutes the former country's import of goods and services; or it may sell its
merchandise and services to other countries - the sum total of which constitutes the
former's exports of goods and services.
So summing up Consumption (C), Investment (I), Government spending (G), and net
exports (NX) will give us the gross domestic product (GDP).
Thus: GDP = C + I + G + NX
The next and the final step in computing for GNP is to add to GDP the net factor
income from abroad (NYFA).
What is NYFA? It is likely that foreigners working in the Philippines remit part of what
they earn abroad (outflow). Likewise, we also have Filipinos working abroad who send
part of what they earn to the country (inflow). The difference between inflows and
outflows is the NYFA.
The GNP values based on the expenditure approach are shown in below.
Table 4.1: Measuring GNP by Expenditure Approach
at Current Prices in Million Pesos
Year 2010
Personal Consumption Expenditures 6,192,862
Gross Domestic Private Investment 1,329,737
Government Consumption Expenditures 884,376
Net Export (X-M) 216,854
Statistical Discrepancy (110,792)

Expenditures on Gross Domestic Products 8,513,037

Net Factor Income from Abroad 1,237,157

Expenditures on GNP 9,750,193

At this point, let us further distinguish GNP from GDP. It can be recalled that GNP
like GDP represents the value of final goods and services produced by the economy
during a given period of time. However, GDP are goods produced within the territorial
boundaries of the country using domestically owned factors of production. These goods
and services are produced by Filipinos themselves or by foreigners in the country. In
contrast, GNP are goods and services produced by Filipinos whether these Filipinos are
working in the country or working abroad.

Factor Payment (or Income Flow) Approach

GNP can be estimated by summing up all the payments or incomes of all the
households (i.e., the factor owners in the production process), of all the firms in the

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economy and of the government sector.
GNP = YHH + YFIRMS + YGov 't.
The incomes of the households (YHH) represent the money income of the owners of
the factors of production in the forms of wages/salaries (on labor), rent (on land), net
interest (on capital), and profits (on management). Included here are dividends, too,
which are received by household investors in corporate business ventures.
The income of firms (YFirm) or corporate represents the undistributed money income
of a corporation in the forms of retained earnings, corporate income taxes, and
depreciation allowance. These are "undistributed" in as much as they not declared and
distributed as dividends to the stockholders because the firm opts to use these earnings
for its expansion program (as in the case of retained earnings), of for the maintenance
of its existing capital goods (as in the case of depreciation allowance), or for payment of
taxes to the government (as in the case of corporate income taxes).
Government income (YGov 't) from capital represents the net profit (or loss) of the
governments' vital corporations like the National Power Corporation (NPC), the
Government Service Insurance System (GSIS), the Social Security System (SSS), the
Development Bank of the Philippines (DBP), etc.
Table 4.2: Measuring GNP by Income Approach
at Current Prices in Million Pesos
Year 1986
Factor Income of Households 464, 807
Corporate Income 6,380
Government Income from Capital 12,401
National Income 483,588
Indirect Taxes (net of subsidies) 54,326
Depreciation Allowance 66,283
Gross National Product 604,197

It should be noted that the payments to all the production factors (national income)
does not equal GNP. There is a need to add two market accounts: indirect taxes and
depreciation allowance. Indirect taxes are taxes paid on the sale/purchase of a product
or service by the households. Since this part of the revenue of the firm does not go to
the households but are included in the market price of the product or service, it must be
added to national income, over and above government income from capital to get GNP.
If we use the T-account format in showing the Philippines' income statement, it
would look this way.

EXPENDITURE INCOME

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 Personal Consumption x Factor Income of Households x
Expenditure
Government Consumption x Government Income from Capital x
Expenditure
Gross Domestic Investment x Income of Corporations x
Export MINUS Import x
Expenditures on Gross xxxx National Income xxxx
Domestic Product
Net Factor Income from Abroad x Add: Indirect Taxes xx
Less: Subsidies xx
Depreciation Allowance xx
Gross National Product xxxx Gross National Product xxxx

Value-Added Approach
GNP can also be seen as the sum of all the value-added of all the enterprise in each
stage of production.
The value-added of an enterprise is a measure of the difference between the market
value of all the goods that it produced and the cost of all the goods and materials
produced from other producers.
An illustration of value added is seen in Table 4.3 using the example of a rice
merchant. If a rice merchant does not produce the rice, he may have to buy rice from a
rice wholesaler. The rice wholesaler, on the other hand, purchases it from rice millers,
while the rice miller buys from farmers.
Table 4.3 Measuring GNP by Industrial Origin Approach
at Current prices in Million pesos
INDUSTRY/INDUSTRY GROUP Q1 2007 Q1 2008 Growth Rate (%)
Agriculture/Fishery/Forestry 214,841 251,709 17.2
Industrial Sector 484,440 516,423 6.6
Service Sector 824,795 916,450 11.1

GROSS DOMESTIC PRODUCT 1,524,077 1,684,582 10.5

Net Factor Income from Abroad 129,497 176,135
GROSS NATIONAL PRODUCT 1,653,574 860,717 12.5
GNP is thus computed by summing up all the values at each stage of production.
This is done for all goods and services produced in the economy.

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ECONOMICS 1A, Module 4, Lesson 1
SELF-PROGRESS CHECK TEST

Test I. Matching Type

Column A Column B
_____ 1. consumption expenditure a. GNP= C+I+G+(X-M)+NYFA
_____ 2. expenditures on goods to be b. GNP Deflator
used for the production of future c. prices of a particular base year used
goods and services to deflate GNP
_____ 3. transfer payments d. investment
_____ 4. net exports e. (X-M)
_____ 5. total market value of all final f. disposable income
goods and services
g. method which accounts for the final
_____ 6. factor-income approach to output in claims (income) to the value
measuring national income of that output
_____ 7. personal income from the h. outlays on goods and services for
ownership of factor inputs such current factor services
as rent, wage, interest and profit
i. payments to households other than
_____ 8. amount of current income after current factor services considered
personal tax deductions income not gainfully earned
_____ 9. constant dollars j. income received by individuals
_____ 10. index number used to measure
GNP change brought about by
inflation

Test II. Indicate whether the item is C for personal consumption

expenditures, I for gross domestic investment, G for government consumption
expenditures, NYFA if net factor incomes from abroad, and O if not included in
the consumption of the GNP.
_____ 1. Sale of a second-hand car
_____ 2. Purchase of new office computers by private enterprises
_____ 3. Purchase of a new polo shirt by your brother
_____ 4. Implementation of an irrigation program
_____ 5. Depreciation charges of existing properties
_____ 6. Existing stock of unsold merchandise

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_____ 7. Issuance by the Central Bank of new P 500 bills
_____ 8. Purchase of a lot for the barangay elementary school
_____ 9. Remittances of earnings by an expatriate
_____ 10. A $50 gift received from a godmother in the U.S.A
_____ 11. Purchase of a new pair of shoes for Christmas
_____ 12. Life insurance premium paid by a housewife
_____ 13. Newly constructed residential houses in Ortigas
_____ 14. Purchase of PLDT shares of stock by an investor
_____ 15. Remittances of percentage of profits by multinationals to the mother
company abroad.

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 ECONOMICS 1A:
Introduction to Economics
MODULE IV, LESSON 2:
INCOME AND CONSUMPTION

LESSON OBJECTIVES:
After studying this lesson on income and consumption, you will be able to:
1. explain the relationship between consumption and income level; and
2. explain the relationship between consumption and savings.

In the first lesson, we came to know that in estimating the nation's GNP, the
households serve as the spending unit out of the personal income that they earn as
factor owners. This spending, it can be recalled, is termed personal consumption.
Let us assume, in this lesson, that the economy is operated by only one sector, the
households. Hence, the nation is composed of all households and their income is
termed disposable income (Yd).
A household's disposable income is composed of consumption and savings. A
household's disposable income can either be spent or not spent. Actual spending of the
Yd means actual personal consumption (C); while savings (S) is income not spent.
Disposable Income (Yd) = Consumption (C) + Savings (S)
If the household spends all its income, savings is zero. If it spends more than its
income, it is said to be dissaving. Below we see the other relationships among income,
consumption and savings.
C = Yd – S S = Yd – C C > Yd =
Dissavings
It should be noted that as income increases, consumption and savings increase, too.
Hence, consumption and savings level are directly related to income. The higher the
income level of a nation is, the higher (too) is its capacity to spend on consumer
durables, non-durables, and services. Consequently, the higher the income level is, the
higher is the capacity of a nation to save for future consumption.
Table 4.4: Income-Consumption Schedule
Income (Yd) Consumption (C) Savings (S)
100 100 0
200 180 20
300 260 40

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 400 340 60
500 420 80
600 500 100
700 580 120
800 660 140
900 740 160
1000 820 180

Secondly, one can notice the possibility that a household can consume even at a
zero level of income. This is proven with this mathematical consumption equation.

C  C  C1Yd
where: C = consumption level
C = consumption level independent on disposable income
C1 = marginal propensity to consume (mpc)
d = disposable income.
If we substitute Yd with O, consumption level would be equal to C. This is
consumption for subsistence. Figure 4.2 shows the graphical illustration of this situation.
Figure 4.2

300

200
C

100
Yd

The consumption line starts at 100 when Yd is zero. This is a reality in the
Philippines. Where does the household get the money to buy its needs? There are two
possibilities: the commodity used was given free as a promotion or the household
borrows (umutang in Filipino) from another person now, with a promise to pay the latter
sometime in the near future. Thirdly, we can infer from the above schedule in Table 4.4
that for every increase in income (AY) by P 1.00, consumption increased, (AC) too, by
80%. This percentage change in consumption is called the marginal propensity to
consume. Hence, the marginal propensity to consume (mpc) is 0.80. This means that

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80% of the increased income was added to consumption. Consequently, 20% of the
increased income is added to savings (mps). Hence, the marginal propensity to save
(mps) is 0.20. In summary:
C S
MPC  MPS  1  
Y Y

S
1  MPC  MPS 
Y
C
1  MPS  MPC 
Y
Finally, as reinforcement to the above-mentioned relationship between income and
consumption, a German economist, Ernest Engel (19th century), found a relation
between the level of family income and the consumption of its consumption spending.
His research proved that as the family income level rose, the proportion to total income
of essential items like food increased while non-essential items like recreation are low.
However, as the income of the family increases, the percentage spent on food
decreases. Expenditures for education, housing, and furnishings increase as the
income level increases. This behavior is known as the Engel's Law. The typical Filipino
family is not an exception to this rule.
Based on the above discussion, what determines the level of consumer or
household spending? The most obvious explanation is the level of income. When
people have more income in their pockets, they tend to spend more; when they have
less income, they tend to spend less. What they spend on are actual consumption
expenditures or purchases of any consumption good. How much they can spend or
purchase depends on the size of their disposable income (Y d). Technically speaking, we
say that consumption is a function (f) of (i.e., depends on) income, and this relationship
of consumption to income is called the consumption function: C = f(Yd).
Aside from income, there are other factors that affect this ability to consume. These
are existence of marketing practices, the level of prices in the economy, the
attractiveness of savings, policy changes regarding tax rates and transfer payments. Let
us see how these factors affect one's consumption pattern. The rise of institutions
financing consumption spending, installment selling, charge accounts, and credit cards
have become popular and acceptable as marketing practices have stretched the
capacity of the households to buy, without a change in income.
On the other hand, when prices decline, the amount of money needed to purchase
the same volume of consumer goods is reduced. During inflationary situation the
purchasing power of the peso shrinks fast, thus more money is required for the same
volume of goods bought.
Thirdly, the attractiveness of savings is an important determinant on the ability and

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willingness to spend. Higher interest rates for savings deposits, accessibility to stock
investments, reliability of mutual funds and the availability of housing loans are factors
that serve to divert part of the disposable personal income to these forms of savings on
a more committed basis. It is worthwhile to note the importance of providing access to
cheap, long-term housing loans to a greater segment of society in order to induce
savings and minimize superfluous spending.
Fourthly, changes in the income tax rates for individual taxpayers will affect the
amount of personal disposable income in the opposite directions. Tax cuts can provide
stimulus to consumer spending and can be instrumental in the attainment of full
employment. From the corporate viewpoint, an increase in tax rates would mean
normally lesser income for corporations to distribute to stockholders. Nevertheless, tax
incentives or subsidies to invest may induce corporations to retain more income for
growth purposes, minimizing then the dividends that are distributed to the stockholders.
On the other hand, a change in policy regarding transfer payments (e.g., retirement
benefits, SSS benefits, payments of interest on government issued bonds) will affect the
level of disposable income. Due to inflation, the government may decide to increase the
retirement pensions, thereby increasing the disposable income or it may increase the
SSS rates or Medicare.
How can the government affect consumption? In the short run, the government can
increase the take-home pay of the consumer by reducing tax rates on income, or it can
lend funds to low income groups for purposes of low-cost housing, education, and
calamity rehabilitation. In the long run, the government can help create a big market for
goods by opening communication and transportation networks to remote areas, by
construction of interlinking roads and bridges towards the backward regions.

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ECONOMICS 1A, Module 4, Lesson 2
SELF-PROGRESS CHECK TEST

Test I. Given the income and consumption levels, complete the

table.
INCOME CONSUMPTION SAVINGS MPC MPS
5,000 4,000
6,000 4,800
7,000 5,600
8,000 6,400
9,000 7,200
10,000 8,000

Test II. Indicate whether each of the following increases or decreases the
consumption level. Write your answer on the blank before each
number.
_____ 1. Increase in disposable income
_____ 2. Increase in interest rates
_____ 3. Effective advertising program
_____ 4. Decrease in population
_____ 5. Credit availability
_____ 6. Expectation of price increases
_____ 7. Expectation of income increases
_____ 8. Increase in tax rates
_____ 9. Increase in family income
_____ 10. Improved income distribution

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 ECONOMICS 1A:
Introduction to Economics
MODULE IV, LESSON 3:
INCOME AND INVESTMENT

LESSON OBJECTIVES:
After studying this lesson on income and investment, you will be able to:
1. know and explain the relationship between income and investment;
2. know the factors that determine the amount of investment in the economy.

In estimating the nation's GNP, we have discussed (in the second lesson of this
module) that the household's capacity to spend depends on its disposable income. In
this lesson, we shall focus on the why and the how of the firm's spending on capital
goods, otherwise known as investment.
It can be recalled in the circular flow model that investments are an inflow of funds
into the economic system corresponding to the outflown savings of the households,
businesses and the government. Together all of these sector's savings constitute Net
Domestic Savings.
Figure 4.3: Circular Flow with S - I Flow

Inflow

Households Firms Financial Institutions

S
S

Outflow

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 Savings to Households (Personal Savings) x
Savings to Firms (Corporate Savings) x
Savings to Government (Gen. Gov't Savings) x
Net Domestic Savings xxx
+ Depreciation Allowance x
Gross Domestic Savings xxxxx
+ Net Capital Transfer from Abroad x
+ Net Borrowings Abroad x
Gross National Savings xxxxx

We add depreciation allowance to Net Domestic Savings in as much as the former

adds to the wear and tear value of the existing capital stock which is composed of
existing equipment, machineries, buildings, and inventories. Lastly, if our domestic
savings resources are insufficient to cope with the economy's investment needs, then
we resort to external borrowings to bridge the financing gap. Hence, savings is used to
finance investment spending.
Investment, then, is spending for goods used for future, not current, consumption.
These are goods used to produce other goods. Investment is the process of increasing
the stock of capital - the tools used for production. Investment lies at the heart of the
production process. Capital goods or investment goods, therefore, provide the tools
which labor resource can use to work on the resources of the land in the order to
produce the goods and services that the economy requires.
If we look back at Figure 4.2, what happens to our consumption line (C) and gross
income (Y) when the inflown investible funds enter the economy? Figure 4.4 illustrates
that when an investment (I) is flown into the system, the consumption line (C) would
shift upwards to C + I line. When this happens, and assuming that the consumption
function is unchanged, a rise in the level of investment brings the economy to a higher
level of income from (Y0 to Y1). This can be further clarified in Table 4.5 below. With the
inflow of investment by 40, the economy's capacity is enlarged and the equilibrium is
attained when Y = C + I at level 700 of Y.
Figure 4.4
C
400
C+1
300

200 C

100
45ͦ Gross Income
Yͦ Y
1

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 Table 4.5: Consumption and Investment Schedule
Income (Y) Consumption (C) Investment (I) (C + I)
0 100 40 140
100 180 40 220
200 260 40 300
300 340 40 380
400 420 40 460
500 500 40 540
600 580 40 620
700 660 40 700
800 740 40 780
900 820 40 860
1000 900 40 940

The importance of investment spending in a developing country, like the Philippines,

lies on the movement of the production possibility curve outward (as shown in Figure
4.5), since the addition to the capital stock increases the capability of the economy to
produce more goods and services. Before the infusion of investment into the system,
the economy can produce only a combination of rice and corn along the production
possibility curve (P1P1). When investments come in, the production possibility curve
shifted outward (P2P11) indicating an increase in the capacity of the ecosystem to
produce more of both rice and corn.
Figure 4.5

Rice

P2

P1

P1 P11

What are the determinants of investment spending? What factors motivate a firm to
spend on investment goods? The most popular theory that explains the investment
behavior of business firms in the theory that states: If the expected additional revenue
(profit) of an investment is greater than or equal to the expected additional cost of
this investment, the firm will undertake perceived expansion project(s).

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 Table 4.6 contains a number of feasible expansion projects estimated at about
P580,000 with the expected rate of return per project. To pursue the firm's expansionary
plan, it borrowed from the BPI Agribank (in Cavite) the necessary funds at an interest
rate of 20% per annum. Knowing the cost of funds (20%), the firm would be rational to
invest up to P 530,000 - the total cost of Projects 1, 2, 3 and 4 in as much as the
expected rate of return in these projects is equal and/or greater than the cost of
borrowed funds.
Table 4.6
Project Cost of Investment Cumulative Investment Expected Rate of Return
1 100,000 100,000 35%
2 200,000 300,000 30
3 80,000 380,000 25
4 150,000 530,000 20
5 50,000 580,000 15

In the above illustration, there are two important determinants in this theory of
investment behavior: the expected rate of return and the prevailing rate of interest.
Since the interest rate is indicative of the cost of borrowed funds, the higher the interest
rate, the lesser investible funds are demanded, all the other factors unchanged. Vice
versa, the lower the interest rate, the more investible funds would be demanded to
finance expansion projects.
Thirdly, innovations open new investment opportunities to the business sector. In his
book The Theory of Economic Development, Joseph A. Schumpter identified five types
of innovations:
1. The introduction of a new good, i.e., one with which consumers are not yet
familiar, or of a new quality of a good.
2. The introduction of a new method of production, i.e., one not yet tested by
experience in the branch of manufacture concerned, which need, by no means,
be founded upon a discovery which is scientifically new, and can also exist in a
new way of handling a commodity commercially.
3. The opening of a new product, i.e., a market into which the particular branch of
manufacture of the country in question has not previously entered, whether or not
this market has existed before.
4. The conquest (or development) of a new source of raw materials or half-
manufactured goods, again irrespective of whether this source already exists or
whether it has first to be created.
5. The carrying out of a new organization of any industry.
In the Philippines, innovations of the fourth category are highly profitable investment

20
opportunities because of the financial incentives given to prospective investors by the
Board of Investment's Investment Incentives Act or Omninus Law.
Fourth is the acceleration principle. If a firm experiences an increase in the rate of
sales or output, it would increase the required level of investment as a response to the
increase in demand. Given a specific capital-output ratio (or the required amount of
capital for every unit of output produced), the firm's capacity to increase production
would depend on the replacement investment (replacing machinery and equipment that
wear out) that it will undertake.
Summarizing the above discussion, we can formulate the investment function as
follows:
I = f (profit, interest rate, innovations, acceleration principle)

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ECONOMICS 1A, Module 4, Lesson 3
SELF-PROGRESS CHECK TEST

Test I. Identify as Consumption (C) or Investment (I).

_____ 1. Disposable income
_____ 2. SSS and GSIS contribution
_____ 3. Habits and preference
_____ 4. Profit levels
_____ 5. Expectations on prizes
_____ 6. Savings level
_____ 7. Interest rates on housing loans
_____ 8. Degree of innovations
_____ 9. Expectations on future incomes
_____ 10. Size of population
_____ 11. Demonstration effect
_____ 12. Marginal efficiency of capital
_____ 13. Advertisements
_____ 14. Rate of capital formation
_____ 15. Amount of residential construction

Test II.
A. Given the income and consumption schedules with investment at 1,600
complete the following table:
Income (Y) Consumption (C) Investment (I) C+I
4,000 4,000
5,000 4,800
7,000 5,600
8,000 6,400
9,000 7,200
10,000 8,000

B. What is the equilibrium income?

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 ECONOMICS 1A:
Introduction to Economics
MODULE IV, LESSON 4:
INCOME AND INFLATION

LESSON OBJECTIVES:
After studying this lesson on income and inflation, you will be able to:
1. define what inflation is; and
2. identify and explain the 3 causes of inflation.

Effective 12:00 on November 29, 1989, the prices of oil and oil products
increased by an average of P 1.26. With this price hike, the labor sector cried out and
complained that their income has further eroded. Jeepney drivers and operators
demand for an increase of fifty centavos and "boundary" fees, respectively, because of
the increase in the price of gasoline and motor spare parts. Subsequent increase in the
price of other commodities and services would inevitably be experienced by the
consumers.

CAUSES OF INFLATION
A sustained and general increase of the prices of all or nearly all commodities in the
market is called inflation. What causes inflation? Firstly, inflation occurs when there is
excessive demand relative to the supply of goods. Because of the inability of our
producers to immediately increase the supply of goods and services in the market, the
demand for them goes up, and consequently the prices of these goods and services
also increase. This situation is called demand-pull inflation. Graphically, Figure 4.6
would illustrate the above situation.
Figure 4.6: Demand-Pull Inflation

Price

D2
P2
D1
P1

Quantity
Q1 Q2

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 The increase in demand is shown when the demand curve (D1) shifted to the right
(D2). As a result, given supply S as constant in as much as it cannot increase
production as fast as the change in demand, the price level increases from P1 to P2. In
this situation where demand is greater than the products available, people would be
willing to buy these scarce supplies even at a higher price.
Secondly, inflation occurs when the cost of production, also increases, making the
suppliers unwilling to increase production. This situation is referred to as cost-push
inflation. It occurs when a sudden increase in production cost in major producing
sectors of the economy pushes upward the overall level of prices. In a developing
country, like the Philippines much of the raw materials that the manufacturing sector
needs are imported. Hence, import prices can well be a source of cost-push inflation,
especially since raw materials constitute about 66% of the gross value of the
manufacturing sector's output.
Graphically, Figure 4.7 shows this market behavior. When the cost of production
increases, the supply (S1) curve (willingness of producers) would experience a shift to
the left (S2). As a result, given demand D as constant, the price level increases from P 1
to P2. In the recent increase in oil price, all oil-dependent industries have experienced
an increase in their production cost, over and above the expected adjustments in the
wages or salaries of their human resources. Consequently, this increase in the prices of
labor and raw materials (oil, in the case) would be passed on to the consumers because
the price of their output or supply in the market would be higher in order to maintain a
certain level of marginal profit.
Figure 4.7: Cost-Push Inflation

Price

S2

P2

S1

P1

Quantity
Q1 Q2

24
 The third cause of inflation is explained by the quantity theory of money.
At this point let us recall the relationship between spending and income as seen in
the circular flow diagram. The diagram tells us that total spending is equal to total
income. (Total spending = Total income).
How much is total spending and total income in the economy? Total spending if
viewed from the money side is equal to the money stock (MS) comprising of bills,
currencies, etc. multiplied by the number of times a peso changes hand during the
period (V - velocity).
For example if P500 moves into the hands of 5 persons each doing individual
business transactions, then total spending is equal to P2,500. Total income on the other
hand is computed by multiplying Price (P), the market value of a commodity to the
number of transacted goods (Q). Thus, if a retailer was able to sell 5 kilos of mangoes
for P 30 a kilo, then his total income would be P 150.
From the above discussion, the relationship between total spending and income is
expressed as:
MSV = PQ.
This equation is called the quantity theory of money. This has been used by
economists to explain changes in the general price level.
Velocity (V) is assumed to be constant due to institutional rigidities like payroll
practices, banking hours, etc.
Hence a change in money supply (MS) has to be accompanied by a change in either
P or Q.
If MS increases by 20%, there should be a corresponding increase on the right side
of the equation.
If Q can be increased by 20%, P remains unaffected but if Q cannot be increased, it
is P (price) that has to go up. Inflation then sets in.

EFFECTS OF INFLATION
How does inflation affect the different sectors of the economy? There are people
who register net gains or net losses out of an inflationary situation. Among the inflation
gainers are those people who have flexible incomes. If a businessman's output or
product has an inelastic demand, people would still buy his product even though there
are price changes. Hence, at higher prices, their sale or revenue would register a bigger
gain or profit.
Secondly, the speculators are inflation gainers. When they perceive that prices are
low now, but expect prices to increase in the near future, they usually buy and stock up
goods, but sell these later when prices are heightened. Therefore, products that are
sold out at a higher price level gains bigger marginal income. This is true for people who

25
are into real estate (buy and sell of lands, houses).
Thirdly, the debtors gain from inflation because the value of the money today is less
than the value of money at the time when they borrowed the amount.
On the other hand, inflation is a culprit.
Firstly, people who have fixed incomes are severely affected by increased prices of
goods and services. During inflationary situations, the fixed income earners' capacity to
buy (or purchasing power) is lessened or eroded. Their market baskets would contain
less number of goods. If we use the 1978 value of the peso (Table 4.7) as a base data,
we can infer that the capacity to buy of the same peso in 1985 would only be P 0.28
worth of goods. The pensioners from the SSS or GSIS experience this dilemma. Unless
the benefits received by them are adjusted to the inflation rate, the pensioners would
suffer a net loss.
Secondly, the creditors lose out during inflation because the fixed amount of capital
and interest they lend out would now be valued less. If the interest rate charged by the
creditors is 9% but the inflation rate is 11%, the net loss of the creditor would be 2%.
We can conclude, therefore, that inflation redistributes income - from creditors to
borrowers. To the extent that the poor are debtors and the rich are creditors, we can cite
this as a positive aspect of inflation. However to the extent that the poor and middle
income groups save in the form of government bonds and fixed interest accounts in
banks, inflation is injurious to those income groups.

Table 4.7: Inflation Rate & Purchasing Power of Peso (1974 - 85)
Year Inflation Rate (%) Purchasing Power
1974 - 1.38
1975 8.1 1.29
1976 9.4 1.18
1977 7.4 1.07
1978 9.2 1.00
1979 15.2 0.85
1980 15.5 0.72
1981 11.0 0.64
1982 8.4 0.58
1983 11.6 0.52
1984 49.1 0.35
1985 17.6 0.28

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 Table 4.8

Year-on-Year Inflation Rates in the Philippines, All Items

January 2008 - June 2013
(2006=100)
www.census.gov.ph
Year
Month
2008 2009 2010 2011 2012 2013
January 4.6 7.1 3.9 4.0 4.0 3.0
February 5.1 7.2 3.9 4.7 2.7 3.4
March 5.9 6.7 3.9 4.9 2.6 3.2
April 7.3 5.6 4.0 4.7 3.0 2.6
May 8.2 4.3 3.9 4.9 2.9 2.6
June 9.4 3.2 3.6 5.2 2.8 2.8
July 10.2 2.2 3.7 4.9 3.2
August 10.5 1.7 4.1 4.6 3.8
September 10.1 2.3 3.8 4.7 3.6
October 9.7 2.9 3.3 5.2 3.1
November 9.1 3.5 3.7 4.7 2.8
December 7.8 4.4 3.6 4.2 2.9
Average 8.3 4.2 3.8 4.6 3.2

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ECONOMICS 1A, Module 4, Lesson 4
SELF-PROGRESS CHECK TEST

Test I. On the blank before each number, put a cross (x) on the conditions
that are present during inflation and a zero (0) on those that are not.
_____ 1. High purchasing power of money
_____ 2. High amount of money in circulation
_____ 3. Increased demand for goods
_____ 4. Fixed income earners suffer decrease in value of wages
_____ 5. Low cost of raw materials
_____ 6. Debtors gain by paying loans in lower-valued money
_____ 7. Creditors are encouraged to lend money
_____ 8. Investors but productive capital goods
_____ 9. Increased price level
_____ 10. More goods can be included in the market basket of a family

Test II. True or False

_____ 1. Inflation increased the efficiency of the economy.
_____ 2. Inflation can redistribute income.
_____ 3. If inflation can be anticipated, some people may benefit from it.
_____ 4. Inflation can cause even production in the economy.
_____ 5. Inflation is taxation in disguise.
_____ 6. Inflation can cause higher production levels.
_____ 7. Inflation stimulates the hoarding of basic commodities.
_____ 8. During inflation, real wages of workers are increased.
_____ 9. When money supply equals value of production, prices tend to be
unaffected.
_____ 10. To curb inflation, depositors are encouraged to save.

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ECONOMICS 1A, Module IV
ANSWER KEYS TO THE SELF-PROGRESS CHECK TESTS

Lesson 1
Test I.
1. h 5. a 9. c
2. d 6. g 10. b
3. i 7. j
4. e 8. f

Test II.
1. O 4. G 7. O 10. NFYA 13. I
2. I 5. I 8. G 11. C 14. I
3. C 6. I 9. NFYA 12. C 15. NFYA

Lesson 2
Test I.
INCOME CONSUMPTION SAVINGS MPC MPS
5,000 4,000 1,000 0.80 0.20
6,000 4,800 1,200 0.80 0.20
7,000 5,600 1,400 0.80 0.20
8,000 6,400 1,600 0.80 0.20
9,000 7,200 1,800 0.80 0.20
10,000 8,000 2,000 0.80 0.20

Test II.
1. increase 6. increase
2. decrease 7. increase
3. increase 8. decrease
4. decrease 9. increase
5. increase 10. increase

29
Lesson 3
Test I.
1. C 6. C 11. C
2. C 7. I 12. I
3. C 8. I 13. C
4. I 9. C 14. I
5. C 10. C 15. I

Test II.
A.
Income (Y) Consumption (C) Investment (I) C+I
4,000 4,000 1,600 5,600
5,000 4,800 1,600 6,400
7,000 5,600 1,600 7,200
8,000 6,400 1,600 8,000
9,000 7,200 1,600 8,800
10,000 8,000 1,600 9,600
B. When Y = C + I (or P 8,000), the equilibrium income is achieved.

Lesson 4
Test I.
1. 0 10. 0
2. x
3. x
4. x
5. 0
6. x
7. 0
8. 0
9. x

30
Test II.
1. False
2. True
3. True
4. False
5. False
6. False
7. True
8. False
9. True
10. False

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