MACROECONOMIC PRINCIPLES

(EC107)
National Income Accounting
Economic theory is conventionally divided into 2 groups which are:

Microeconomics
Macroeconomics

Microeconomics focuses on individual markets, that is, it looks at the behavior of individual
consumers, households and firms as they interact in the market. It studies the individual demand
for and the supply of goods and services. It examines, for example, the choices that people make
between goods and services, and what determines their relative prices and the relative quantities
produced.
Macroeconomics examines the behavior of the economy as a whole. It looks at the aggregate
demand and the aggregate supply in the economy. It examines national output and its rate of
growth, national employment (and unemployment), and the general level of prices and their rate
of increase (i.e. rate of inflation).
Macroeconomic theory studies the causes of and interrelationships between aggregate
economic phenomena such as inflation, the growth rate of income and the rate of unemployment.
Main macroeconomic indicators are:

Output economic growth

Prices inflation
Employment or unemployment
International trade balance of payments and exchange rate

Government Macroeconomic Policy Objectives

The typical macroeconomic policy objectives that governments pursue are:

High and stable economic growth

A high and stable level of employment
Low inflation or price stability
A satisfactory Balance of Payments position
Exchange rate stability
An equitable distribution of wealth and income

The framework of Economic Policy

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The first task of economic policy is to determine the objectives. Then the target has to be
selected. Targets are the variables through which the government attempts to achieve its
objectives. Targets of policy could be high living standards, high employment and low
unemployment, avoidance of recessions and inflation.
The next task is to choose the instruments to be used in pursuit of the objectives and
these instruments are based upon some available range of measures. The main
instruments of policy are fiscal (government spending and taxes) and monetary (interest
rates and money supply) policies.
The main macroeconomic policy problem is to come up with the right instrument that
will bring about the right outcome.

Main Macroeconomic policies

There are a number of different forms of government macroeconomic policies which are:
1. Fiscal policy
The deliberate manipulation of government income (T) and expenditure (G) so as
to achieve desired economic and social objectives.
One major aim of such budget policies is to control swings in the business cycle
originating in the private economy.
Fiscal policy concerns general budget policies i.e., government taxation and
expenditure policies.
Government may attempt to affect aggregate demand in the economy by a
combination of tax cuts and government spending programs that would increase
national employment and output.
During a recession or lagging economic growth, government may run a budget
deficit (G>T). During periods of inflation, the fiscal remedy may be to increase
taxes in combination with reductions in government spending.
A budget surplus, with tax revenue greater than government expenditures, would
then reduce aggregate spending and choke off both private and public demands.

2. Monetary policy
Refers to attempts to manipulate either the rate of interest (r) or money supply (Ms) so as
to bring about the desired changes in the economy.
It consists of the manipulation of bank reserves through alterations in the discount rate,
open market sales and purchases of securities and changes in reserve requirements.
Financial system reserve changes affect the money stock and interest rates, which can
change private consumption and investment expenditures (aggregate demand) and thus
employment, output and prices.

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In simple terms, both fiscal and monetary policy aim at the same end- control of aggregate
demand and economic activity. Both maybe termed discretionary polices, that is, policies
requiring decisions on the part of parliament or the president- in the case of fiscal policy- and
decisions on the part of the central bank governor concerning monetary policy. Will these
discretionary policies work predictably without creating more economic problems than they
solve?
3) Supply Side Policies
Conflicts in Government Policy

It is important to realize that the objectives may be incompatible. In order to achieve one
goal governments have often been obliged to sacrifice another.
Policies designed to bring about full employment have sometimes generated unacceptable
levels of inflation while policies aimed at eradicating a BOP deficit have restricted the
rate of economic growth and so on.
Policy makers therefore are obliged to establish some scale of priorities.

Government Failure
Government failure occurs when government intervention fails to improve economic efficiency
(welfare) or even reduces it. Government failure occurs because of the following reasons:
1. It is difficult for the government to achieve all its objectives simultaneously.
2. Time lags this is the time taken to recognize that there is a problem, the time taken to
formulate policy measures, the time taken to introduce policies and the time for people
and firms to react to policies. From the time the problem is identified to the time the
policy is implemented, economic circumstances may have changed.
3. Policy constraints there are also practical problems and international constraints. It is
difficult to change much of government expenditure, particularly capital expenditure,
taxation and legislation quickly.
4. Political influences governments tend to introduce harsh measures just after an
election and more popular ones near an election. Economic advisors may recommend
a rise in taxation but if this is just before a general election a government may choose
to ignore the advice.
5. Complexity the real world is a complex and a constantly changing place e.g. with
increasing mobility of money around the world, it is becoming more difficult to
measure and control money supply.
6. Civil servants and politicians self interest- civil servants and politicians may promote
the growth of their own development to pursue their own advancement.
Instruments of Macroeconomic Policies

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These are tools used by the government in order to achieve macroeconomic objectives.
Taxation compulsory transfer of money (or occasionally of goods and services) form
private individuals, institutions, or groups to the government.
Devaluation of exchange rate deliberate reduction of the official rate at which one
currency is exchanged for another by the monetary authorities (central bank) e.g. a
movement of the exchange rate from $1 = 0.6 to $1 = 0.50 represents a devaluation of
the dollar.
Revaluation of the exchange rate deliberate action by monetary authorities (central
bank) to move exchange values of their currencies to higher parities e.g. a movement
from $1 = 0.6 to $1 = 0.80 represents a revaluation of the dollar.
Subsidies subsidies may be regarded as negative taxes. They normally take the form of
payments by the governments to producers and are particularly important in the case of
agricultural products (e.g. wheat, milk, meat etc). The effect of a subsidy is to reduce the
cost of supplying the good.
Interest rate price of borrowed money or the cost of money / the reward of capital.
Government expenditure- is largely expenditure on infrastructural development eg on
roads and communications infrastructure, public works on schools and hospitals etc.

National Income Accounts

Macroeconomics is concerned with the overall economic performance of a national

economy. National income accounting was developed to measure that performance over a
given period of time.
National income statistics are important because they can be used to plot the previous
course of the economy, to make forecasts about the future direction of the economy, to
assist economists in testing various macro models, and to provide parliament and other
administrative agencies with a basis for policy making.
A practical knowledge of these accounts is essential to explaining or predicting important
economic phenomena.

National Income Accounting Variables

Gross National Product (GNP)

GNP is the total market value of final goods and services produced in an economy
during a given period of time.
The word gross indicates that no deduction has been made for that part of total output
which is needed to maintain the nations stock of capital assets. The value of the output

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required to replace obsolete and worn out capital is known as depreciation or capital
consumption.
Total market value means that all of the final goods and services have been valued at
market prices.
We cannot sum the physical amounts of the goods and services produced in an economy
over a period of time. Thus GNP is the value of the goods and services sold in the market.
It is expressed in money terms.

Problems with GNP

There are, however, some goods and services which are produced but not sold in the
market; for example, there are those who grow and consume their own vegetables or who
perform their own housework, such as cooking, sewing, or baby-sitting. These types of
activities are not counted as part of GNP.
Also not counted in measuring GNP are certain goods and services which are sold in the
market but have been declared by society to be illegal. Marijuana and prostitution are
good examples. These activities have been declared illegal by law and since they are not
officially reported measurement is a problem. For this reason, illegal goods or services
are excluded from GNP calculations.
GNP only measures newly produced goods, that is, we do not count used goods.
There are certain types of business and government expenditures which are excluded
from GNP but are added to the households personal income. These expenditures are
referred to as transfer payments. Transfer payments are excluded for they are received for
no work done during the current production period.
Since GNP tends to understate the actual output of the final goods and services produced
in the economy, the national income accountants try to partially offset this by imputing
values to some goods and services not sold in the market. For example, they estimate a
value for owner occupied housing, for food and fuel produced and consumed on a farm,
and for work performed by government employees.
Not counted in GNP are intermediate goods: goods purchased for resale or included in
other products. If intermediate goods were included in estimating GNP, there would be
double counting. To avoid the problem of double counting, national income accountants
only count the value added at each stage of producing the final product.
The value added is the difference between the price of the goods at that stage and the cost
of the goods purchased from the supplier in the previous stage (see notes on output
approach).
GNP is a standard international index of output and should not be thought of as measure
of the economic (social) welfare or well-being of any particular economy. It was never
intended to be an aggregate welfare index.

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GNP or even GNP per capita does not give us any information as to how the total output
is distributed among the households in the economy. Real GNP may be growing, and at
the same time the distribution of income may be becoming more uneven.
GNP does also not indicate what has happened to the quality of goods over time.
An important measure of welfare is also leisure time. There has been a growth of leisure
time with a reduction in the hours of work, and this result is not reflected in calculating
GNP
Along with an increasing GNP, there are associated social costs which are not measured
in GNP. For example, a rising GNP may be associated with higher levels of both air and
water pollution.

Gross Domestic Product

GNP includes the output of every factor of production owned and supplied by residents
of a country regardless of where that factor happened to be located.
GDP is a measure of the final output of goods and services produced during a given
period of time with factors of production located within a country.
To determine GDP, we subtract from GNP the net inflow of income earned on labor and
property owned by domestic residents in foreign countries. Some of the countrys
resources might be overseas and thus earn income for the home country i.e. inflow of
funds
Foreign assets may also exist in the domestic market and their incomes are remitted i.e.
outflow of funds
The net difference between these flows i.e. inflow of funds and outflow of funds gives the
net property income from abroad.
Thus GNP- net property income from abroad = GDP

Methods of Measuring National Income

There are 3 possible approaches to measuring national income.
1. National income may be viewed as the total output from domestically owned resources
during the course of one year (the Output Approach/ Product Approach)
2. National income may be viewed in terms of the incomes earned by the factors of
production engaged in producing the national output. Since the total output/product is
valued at factor cost, it must be exactly the same as the total value of all incomes (wages,

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interest, profit, rent). National income, then, may be measured by totaling these incomes
(the Income Approach).
3. National income may be looked at from the point of view of its disposal. The national
output must either be bought for use or added to stocks. If we assume that net additions to
stocks amount to expenditure by the firm on its own output, we can measure national
income by the total amount of money spent on purchasing the national output (the
Expenditure Approach).
Thus National Output/ National Product National Income National Expenditure

The Circular Flow of National Income

National income can be viewed from two angles (1) the flow of expenditures approach and (2)
the flow of earnings or income approach. The flow of expenditures approach considers total
output or national income from the standpoint of the total amount spent by all economic agents
on the final goods and services. The earnings or income approach looks upon national income or
total output as the sum of the income earned by the factors of production which were employed
in producing the final output of goods and services.

Source: Introductory Economics by G.F. Stanlake & S. J. Grant

The figure shows a model of a simple economy containing only two sectors: (1) a business sector
(firms) and (2) a household sector. On the left hand side of the circular flow diagram, the
business sector produces and sells all of the final goods and services to the household sector. In
return, there is a matched flow of expenditures on final goods and services from the household

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sector to the business sector. The market value of the final output of goods and services is
determined by the household sectors demand for the business sectors supply of the final
product.
The upper loop shows the business sector hiring the services of the factors of production from
the household sector. In return there is a flow of earnings or income to the household sector
which matches the flow of factor services to the business sector. The market value of each factor
is determined by the business sectors demand for and the household sectors supply of the
factors of production.
In all, the flow of expenditures going to the business sector from the household sector (lower
loop) must be numerically identical to the flow of income going from the business sector back to
the household sector (upper loop).

The flow of expenditures approach to gross national product

In national income accounting, the economy is broken down into four sectors. These four
sectors are: (1) household, (2) business, (3) government and (4) foreign.
In the flow of expenditures approach, GNP is determined by adding up the total amount
spent on final goods and services by each sector.
National Income = Personal Consumption (C) + Investment (firms expenditure) +
Government Expenditure (G) + Net Exports (Exports Imports) that is
Y
= C + I + G + (X M)
All expenditure on intermediate goods and services must be excluded.
This method is complicated by indirect taxes e.g. sales tax and subsidies on welfare goods
like food. Thus the value of expenditure is often measured at cost. National income at
factor cost = national income at market prices indirect prices + subsidies

Illustrated Example: the expenditure approach

1. Personal consumption expenditures------------------------------------------1670.1
Durable goods-------------------------------------------210.2
Non-durable goods-------------------------------------674.4
Services--------------------------------------------------785.5
2. Gross private domestic investment-------------------------------------------395.1
Fixed investment----------------------------------------399.0
Non-residential------------------------------------------295.0
Residential-----------------------------------------------104.0
Change in business inventories------------------------3.9
3. Government expenditures------------------------------------------------------534.8
Federal-----------------------------------------------------198.9
State and local---------------------------------------------335.9
4. Net exports of goods and services--------------------------------------------27.5

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Exports------------------------------------------------------341.2
Imports------------------------------------------------------313.6
5. Total expenditures in GNP---------------------------------------------------Source: extracted from DeLorme and Ekelund 1983.

The flow of earnings or income approach to Gross National Product

In this approach, national income is determined by adding up the income earned by the factors of
production (land, labor, capital, entrepreneurial ability) which were employed in producing the
final output of goods and services during a given time period.
All factor incomes are added i.e. rent, wages and salaries, interests, profits and undistributed
surpluses (i.e. income generated in the production process that does not find its way into personal
incomes e.g. ploughed back profits or retained profits and also national reserves)

Transfer incomes / transfer payments / transfer earnings are payments made

without corresponding contribution to current output e.g. unemployment
benefits, retirement pensions / schemers, distributed grants etc must be
excluded.
Net factor income from abroad must be added.
Finally the stock appreciation adjustment must be made in order to eliminate
the element of windfall gain in the profits received.

Example:

1. Compensation of employees------------------------------------------------------1596.5
Wages and salaries-----------------------------------1343.6
Supplements of wages and salaries-----------------252.9
2. Proprietors income-----------------------------------------------------------------130.6
3. Rental income of persons-------------------------------------------------------------31.9
4. Corporate profits---------------------------------------------------------------------181.7
Profits before taxes--------------------------------------------241.2
Inventory valuation adjustment-------------------------- -42.0
Capital consumption adjustment------------------------- -17.5
5. Net interest -------------------------------------------------------------------------

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6.
7.
8.
9.

National income (NI)-------------------------------------------------------------2120.5

Indirect business taxes---------------------------------------------------------------211.7
Business transfer payments-----------------------------------------------------------10.5
Less: subsidies minus current surplus of govt enterprises------------------------ -4.7
Statistical discrepancy------------------------------------------------------------------1.6
Net National Product (NNP)--------------------------------------------------

10. Capital consumption allowances (depreciation)-------------------------- ----Total Gross National Product (GNP)----------------------------------------2627.4
Source: extracted from DeLorme and Ekelund 1983.

The Output Approach

National output is measured by totaling the values of goods and services

produced.
When using this method double counting or multiple counting should be
avoided.
To avoid double counting only the final output or the value added at each
stage of production should be added.
Example
Value of Output
Farmers
Millers
Bakers
Retailers

10
15
25
30

Cost of Intermediate
Goods
0
10
15
25
Total

Value Added
5
10
5
30

Total value added should be used or alternatively the value of the final product
is used which is $30.
To this GDP must be added net property income from abroad.
If the general level of prices has been changing during the course of the year,
it is necessary to make an adjustment for the purely monetary changes in the
value of stocks.
A rise in prices increases the value of existing stocks even when there is no
change in their volume.
In order to obtain an estimate of the real changes in stocks it is necessary to
make a deduction equal to the inflationary increase in value.

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This deduction is described as Stock Appreciation (this would be added

when prices had been falling in official tables.

The relationship of GNP, NNP and National Income

Gross National Product (GNP) and Net National Product (NNP)

GNP less Depreciation = Net National Product (NNP)

Depreciation (capital consumption) is the reduction in the value of an asset through wear
and tear over time.
This has to be taken into account when calculating national income
NNP is the true national income. However it is difficult to accurately estimate the value
of depreciation as a result National Income is often given as GNP.
The total output of capital goods is described as Gross Investment and net additions to the
stock of capital is known as Net Investment.
Gross Investment Depreciation = Net Investment
GNP Depreciation = NNP
GDP Depreciation = Net Domestic Product
NNP consists of all the goods and services becoming available for consumption together
with the net additions to the nations stock of capital. This is the total which is generally
known as National Income.
However it is extremely difficult to obtain an accurate estimate of the annual depreciation
and economists often use the figures for GNP for purposes of analysis.

Uses of National Income Accounts

1. Planning Purposes: Statistics of national income accounts are worthwhile for planning
purposes.
2. Economic Growth Assessment: National income statistics are often used to provide some
indication of changes in the economic welfare of citizens to see if the economy has
grown year after year.
A simple example should make clear the manner in which the national income of one year may
be compared in real terms with that of another year .e.g.

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National Income (m)

Index of Prices

Year 1
10 000
100

Year 2
12 000
105

National Income of Year 2 expressed in terms of the prices ruling in Year 1(base year)
x

= 11 428,5m

The example shows that although the national income in monetary terms had increased by 20%,
in real terms the increase was only 14.3%.
3. Policy formulation and assessment: The government uses national income data in
formulating and assessing economic policy.
4. For making international comparisons: National Income statistics are used for comparing
changes in living standards over time and internationally.
Shortcomings / Problems of national income statistics as a proxy for measuring living
standards
1. The first problem which arises is that of valuation. Total output consists of a vast
range of different goods and services whose quantities cant be added together in
physical units e.g. kilograms of wheat, meters of cloth, tonnes of coal, bales of cotton,
litres of cooking oil. All these commodities have to be converted to money values for
compilation.
2. Self provided commodities e.g. a farmer consuming part of his output. Figures of
such are normally not included in national accounts.
3. Statistics of information about what is produced in rural areas and also in remote
areas e.g. in LDCs is hard to come by.
4. Activities of housewives who also contribute to national income are not included in
national income figures.
5. Informal activities are not included e.g. black market activities, prostitution, thieves,
robbers, foreign currency dealers behind the back door, anti-social devials / practices
etc.
6. Payment in kind e.g. a worker getting his salary plus 5 litres cooking oil, a bag of
mealie-meal, salt, kapenta etc. Figures of payment in kind not included.
7. Double counting / multiple counting.
8. Inflation i.e. the rise in the general price level of goods and services over a period of
time makes national income figures to be misleading. Real figures must be computed.
9. Composition of output not reflected in GNP figures

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Problems encountered when making international comparisons

1. Inflation different countries have different rates of inflation making comparison
difficult.
2. Account should be taken on how the income is spent e.g. GDP for country A = GDP for
country B. If the bulk of income of country A is spent on defense while that of B is spent
on consumer goods then Country Bs standard of living is better than that of Country A.
3. Different people have different tastes so it is difficult to compare and measure
satisfaction.
4. Population growth has to be taken into account when making international comparisons.
Income per head / capita has to be used.
GDP per capita =

5.

6.

7.

8.
9.

The problem of using income per head is that it ignores the distribution of income i.e.
most of the income will be in the hands of a few people.
To compare incomes of different countries effectively we have to also look at the welfare
of citizens e.g. look at things like health standards, leisure, educational standards, life
expectancy, infant mortality rate, birth rate, death rate, literacy rate, number of people per
doctor, number of pupils per teacher, access to clean water etc
Externalities i.e. both positive and negative externalities are not accounted for in the
calculations of the national income. Pollution, noise, congestion and mental strain may be
the by-products of a rapidly increasing national income.
Use of different currencies makes comparisons between countries difficult. The problem
is compounded / worsened by floating exchange rates on a daily basis. International
comparisons also have to be undertaken in a common unit of measurement. For some
time the most widely used unit has been the US Dollar (US$).
Composition of output
Different accounting methods

Alternative measures of living standards

The use of national income figures for the purpose of comparing standards of
living over time and between countries needs to be supplemented by various
social indicators such as :
1. Number of hospital beds
2. Doctors per head of the population
3. Numbers in further education
4. The nature and quality of the different welfare measures.

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5. Measurable economic welfare (MEW). This is an interesting approach which

seeks to cover more of the aspects which affect economic welfare although it
does encounter the difficulty of having to attach a monetary value to non
marketed goods. The aspects of economic welfare included include leisure,
unpaid housework, non marketed goods etc
6. Human Development Index (HDI)
The idea is that human development depends on the quantity of resources
available to people in a country, their ability to use the goods and services and
the time they have to use these goods.
HDI also seeks to give a wider measure of economic welfare. It was
introduced by the United Nations in 1990.
The index is based on 3 sets of indicators i.e. real GDP, adult literacy and
mean years of schooling, life expectancy.
Nominal GDP vs. Real GDP

Using a monetary system of measurement gives rise to certain problems.

Difficulties arise when we wish to compare the national income of one year with
that of another because the value of the money itself may change.
When the general level of prices is changing, the value of money is changing and
the standard of measurement becomes variable.
If the general price level has been changing during the period under consideration,
the figures recorded for the different years will have to be adjusted to take account
of the price changes.
What is needed is a measure of what the national income would have been in the
latter year, had prices remained constant (in real terms) e.g.

National Income (m)

Index of Prices

Year 1
10 000
100

Year 2
12 000
105

National income of Year 2 expressed in terms of the prices ruling in Year 1 =

= 11 428,5m
This example shows that, although the national income in monetary terms had increased
by 20%, in real terms the increase was only about 14.3%.
Nominal GDP is GDP measured at current prices. Nominal GDP is also called money
GDP. It measures GDP in the prices ruling at the time and thus take no account of
inflation.
Real GDP is GDP after allowing for inflation i.e. GDP measured in constant prices i.e. in
terms of the prices ruling in some base year.

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Real GDP for Year 2 =

GDP Deflator

The GDP deflator is the ratio of nominal GDP in a given year to real GDP of that year.

GDP Deflator =

x 100%

x 100%

The deflator measures the change in prices that has occurred below the base year and the
current year e.g. assume:

Bananas
Oranges
Total

x 100%

1987 Nominal GDP

15 at $0.20 $3.00
50 at $0.22 $11.00
$14.00

1993 Nominal GDP

20 at $0.30 $6.00
60 at $0.25 $15.00
$21.00

1993 Real GDP

20 at $0.20 $4.00
60 at $0.22 $13.20
$17.20

The GDP deflator measures the change in prices that has occurred between the base year
and the current year.
We can get the measure of inflation between 1987 and 1993 by comparing the value of
1993 GDP in 1993 prices and 1987 prices.
The ratio of nominal to real GDP in 1993 is 1.22 (=

). In other words output is

22% higher in 1993 when it is valued using the higher prices of 1993 than valued in the
lower prices of 1987.
We ascribe the 22% increase to price increases of inflation over the period 1987 to 1993.
Since the GDP deflator is based on a calculation involving all goods produced in the
economy, it is a widely based index that is frequently used to measure inflation.

The Circular Flow of Income

According to Keynes, the most important determinant of national income is the level
of aggregate demand.
The higher the level of demand, the higher the level of output and employment.

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National Income Determination

The Two Sector Economy
Assumptions of the Model

There are only 2 sectors in the economy: the business sector/firms (B/B) and the public or
household (H/H) sector.
There is no government intervention in this economy i.e. no government expenditure or
taxes.
The economy is closed i.e. no international trade
H/H spend all their income on consumption and they do not save.
Firms pay all their incomes to H/H and there is no investment.
From these simplifying assumptions, the national income identity can be written as
YC+I where Y= national income (real output), C= household consumption expenditures
and I = business investment or YC+S where S= household savings
Subtracting C from both identities we have Y-CIS
Thus we have IS
When we introduce real life economy with injections (investment) and withdrawals
(savings).
Withdrawals are a leakage from the circular flow of income paid out by firms which is
not returned to them through the spending of H/H.
Withdrawals cause national income to contract. Injections are expenditures by firms
which add to the circular flow of income. Injections cause output income to expand.

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Source: Introductory Economics by G.F. Stanlake & S.J. Grant

National Income in a Three Sector Model

Implications
More leakage in the form of taxes.
Another injection in the form of government expenditure (G)
G should equal T to maintain equilibrium.
If G>T it leads to expansionary effect in the economy.
If G<T there is contractionary effect on the economy.
Y = C+S+T withdrawals
E = C+I+G injections
The national income identity can be written as Y=C+I+G where Y is GNP, I is
gross investment, G is government expenditures on goods and services.
Or from the income side, YC+S+T where Y is GNP, C is consumption
expenditures, S is private saving (the sum of household and business saving), and
T is net tax revenues.
Subtracting C from both sides Y-CI+GS+T or I+GS+T

National Income in a Four Sector Model (open economy)

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A closed economy ignores foreign trade.

Open economy include dealings with the outside market foreign trade is introduced in
the form of exports and imports.
Exports are local goods sold in the foreign market.
Imports are foreign goods bought / brought to the home market.

Source: Introductory Economics by G.F. Stanlake & S.J. Grant

Implications

More leakages introduced in the form of imports (M) (i.e. money earned in the domestic
market is spent on goods produced outside the country there is an outflow of funds)
capital.
Additional injections in the form of exports (X) i.e. goods and services produced in the
country are sold to foreigners living outside the country there is an inflow of funds /
capital inflow to maintain equilibrium
M=X
If M > X it leads to a contractionary effect on the economy.
If M < X it leads to an expansionary effect on the economy.

Open Economy

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The national income identity for the flow of expenditures on final product is written as:
Y C+I+G+(X-M) where X-M is net exports. Or YC+S+T or I+G+XS+T+M

A basic model of aggregate demand: the Keynesian Macro model

The 2 sector model

Assumptions:
Money wages and prices are exogenous. The price level and the money wage are held
rigid.
The interest rate is fixed since the monetary side of the economy is excluded.
There is no government sector.
There is no foreign sector
Businesses and households are considered in the model. Businesses however do not save,
but pass all of their earnings over to the households

Defining Variables
Y= national income in real terms
C= real consumption expenditures by households
I= real investment expenditures by businesses

The Equilibrium Level of National Income

1) Expenditure = Output
The national output or national income will be in equilibrium when total planned
expenditure = output that is actually produced.
Total expenditure consists of several elements i.e C + I + G + (X-M)

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The value of national output is in equal to national income, hence the economy will be in
equilibrium when Y = C + I + G + (X-M)

Source: Introductory Economics by G.F. Stanlake & S.J. Grant

National income is measured on the horizontal axis and total planned expenditure at
different levels of national income is measures on the vertical axis.

National income is in equilibrium at OY level of national income.

2) Leakages = Injections
From the circular flow of income, national income will only be stable when total planned
leakages are equal to planned injections i.e
Total planned injections = total planned leakages
I+G+X=S+T+M

Page 20 of 128

The Consumption Function

Consumption is the amounts of money households spend on goods and services to satisfy
their current wants.
The four basic determinants of aggregate demand (or expenditure) are
I.
Consumption (H/H)
II.
Investment (B/B)
III.
Government Expenditure (G)
IV. Net Exports (X M)
Any change in the above results in changes in the level of income e.g. if C increases Y
also increases.
Consumption is the largest component of aggregate demand. It consists of 2 main
categories namely:
I.
Consumption on durables e.g. furniture, cars etc. these are consumed over a long
period of time.
II.
Consumption on non-durables e.g. food, cigarettes, clothes etc i.e. immediate
consumption.
When looking at the consumption function, you are looking at consumption as a function
of disposable income i.e. income after tax has been deducted.
Consumption increases with rising income and therefore has a positive slope that is
sloping upwards from left to right.
Note
As income continues to rise, the percentage spent on basics e.g. food, shelter, clothing etc
tends to fall although more may be spent in monetary terms.

Autonomous Consumption

Autonomous consumption is consumption of goods and services independent of the level

of income i.e. even if income is $0 the consumer my borrow or use past savings to
consume i.e. dissaving

Tabulated Consumption Function

Based on the assumption of no government and no foreign trade.

Y=C+S
S=YC
C=YS
National Income (Y)
0
40

Consumption (C)
30
60

Page 21 of 128

Savings (S)
-30
-20

80
120
160
200

90
120
150
180

-10
0
10
20

Diagrammatically

d = dissaving (c > y)
s = saving (c < y)
B = breakeven (c = y)
The 45 line connects all points where expenditure is equal to income.

The Savings Function

Page 22 of 128

Average Propensity to Consume (APC)

APC is the proportion of disposable income which is consumed.

APC =

Referring to the diagrams above

At B1 C = Y
= 1 APC is unity

At lower levels of income (lower than B)

C>Y- > 1

i.e. APC > 1

At higher levels of income (above B)
C < Y - < 1 APC < 1

Average Propensity to Save (APS)

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It is the proportion of disposable income which is saved.

APS =
Check
Y=C+S

= +
I = APC + APS
Marginal Propensity to Consume (MPC)

MPC is the proportion (fraction) of any increase in income which is consumed.

MPC =

MPC =

MPC for poor people tends to be higher than that of rich people.
Normally MPC falls as income increases i.e. the Law of Diminishing MPC

Marginal Propensity to Save (MPS)

It is the proportion (fraction) of any increase in income that is saved.

MPS =

Check
Y=C+S
But a change in income leads to changes in both consumption and savings.
Y = C + S y
=

I = MPC + MPS

Page 24 of 128

Illustration
Assume constant MPC and MPS (but its unrealistic)
Disposable
Income
(Y)
$10 000
$12 000
$14 000
$16 000
$18 000

Consumption Savings
(C)
(S)

APC

APS

MPC

MPS

11 000
12 600
13 200
14 800
16 400

1.1
1.05
0.94
0.93
0.91

-0.1
-0.05
0.06
0.07
0.09

0.8
0.8
0.8
0.8
0.8

0.2
0.2
0.2
0.2
0.2

-1000
-600
800
1200
1600

The Relationship between the Consumption function, MPS and MPC

Page 25 of 128

Any point on the consumption function (line) gives APC e.g. point P or Q
At P, APC =

At Q, APC =

= MPC
The slope of the consumption function gives the MPC.
The consumption function can also be expressed algebraically as
C = a + bY
Where C = consumption
a = autonomous consumption (not dependent on Y)
b = MPC (slope of the consumption function
Y = disposable income
In this model, there is no government intervention Yd = Y (disposable income)
The relationship between APC and MPC
c = a + by y
= +

(APC) = + b (MPC)
If a = 0
APC = MPC
If a > 0 (positive)
APC > MPC

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If a < 0 (negative)
APC < MPC

Relationship between APS and MPS

S = -a + sY y
=

(APS) =

+ s(MPS)

APS = - + MPS
If a = 0, MPS = APS
If a > 0, MPS > APS
If a < 0, APS > MPS
Determinants / Factors affecting consumption
1. The level of income
2. Availability and cost of credit the easier and cheaper it is to borrow, the more are the
people likely to spend. When people spend more money than they earn, they are
dissaving.
3. The distribution of income a less even distribution of income may reduce spending i.e.
an uneven distribution of Y reduces spending because Y will be in the hands of a few
people who spend less i.e. the MPC of rich people is low.
4. Age structure middle aged people and old people tend to spend a lower proportion of
their income than young people.
5. Inflation the effects are uncertain. If people expect prices to keep increasing in the
future, they are tempted to bring forward their purchases of cars, furniture, imperishable
etc.
6. Indirect taxes a rise in indirect taxes is likely to reduce consumption.

Page 27 of 128

7. Range of goods and services the greater the range of goods and services and the higher
their quality, the more people are likely to spend.
8. Wealth and savings these can help cushion people to maintain their current
consumption in the case of falling incomes.
9. Changes in fashion
10. Adverting
11. Consumer tastes

NB
I.
II.

An increase in income leads to a movement along the consumption function.

A change in any of the above factors will lead to a total shift of the consumption function.

Savings

Savings is income which is not spent but set aside S = Y C

As income increases both the total amount saved and the proportion saved tend to
increase.

Determinants of Savings
1. Level of income as income increases, so does the ability to save.
2. Social attitudes savings are generally low in communities which place a higher value on
leisure and consumption.
3. The financial framework advanced financial systems stimulate savings.
4. The rate of interest higher interest rates attracts savings.
5. Inflation - inflation causes people to reduce their savings in banks. Why hanging onto
money while / when its purchasing power is losing value by the day? The saver will
likely decide to spend money immediately and enjoy its present purchasing power.
6. Much saving is habitual.
7. A larger part of savings is contractional
8. Many people save in order to achieve a definite objective.
9. A large part of total savings is carried out by companies.
10. A part of total saving is made up of government saving.
11. Government policies e.g. government putting policies in place to encourage savings.
12. Speculative motive i.e. people saving in order to make profits out of it.
13. Precautionary motive people save so as to safeguard against / cushion themselves
against unforeseen contingencies or emergencies e.g. sickness, death, unexpected visitors.
Keynesian Consumption Function

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This is the first theory of consumption which was developed by John Maynard
Keynes.
The Keynesian Theory of consumption is also known as Absolute Income
Hypothesis.
The basic hypothesis of Keynesian Theory of Consumption is that current
consumption expenditure is a function of current real income.
The total volume of private expenditure in an economy depends according to Keynes
on the total current disposable income of the people and the proportion of income
which they decide to spend on the consumer goods and services.
This relationship between aggregate consumption demand and aggregate disposable
income is expressed through a consumption function expressed as C = a + bY
Where C = aggregate consumption expenditure, Y = total disposable income, a is a
constant term, b = consumption coefficient ( i.e. the proportion of income spent on
consumption)
According to Keynes, the consumption function stems from a fundamental
psychological law. The law states that propensity to consume (

i.e. MPC

decreases with the increase in income in the SR Period. The law implies that total
consumption increases but not by an equal amount of increase in income.
The absolute income hypothesis makes the following propositions:
1. Consumption increases as disposable income increases, but not by the amount of
absolute increase in income.
2. As the absolute level of disposable income tends to rise, the proportion of income
spent on consumption tends to decrease i.e. MPC decreases as the absolute level
of income rises.
3. Up to a certain level of Y, C > Y.
4. Consumption is a fairly stable function of income.

The Keynesian Consumption Function

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Criticism of the Absolute Income Hypothesis

1. The theory is based more on introspection than observed facts.
2. Kuznets study on disposable income and savings for the period 1869 1929 discovered
that the LR MPC had remained constant and hence equal to APC which contradicted the
3rd property of Keynesian Consumption Function.
3. It is also claimed that the Keynesian Consumption Function applied to pre-war data,
predicted on a consumption level much higher than the aggregate income, which was
seen as an impossibility.
4. Economists have found empirically that the Keynesian Consumption Function may be
applicable to individual consumption behavior but not for the aggregate consumption
expenditure. It is now a convention to use a linear consumption function at the aggregate
level as opposed to a non-linear consumption function proposed by Keynes.
INVESTMENT
Some Basic Concepts
Capital and Investment

Capital means accumulated stock of productive assets. It induces all man-made resources
that can be used in the process of production.
Three main categories of capital are :
a) Machinery and equipment
b) Land and buildings
c) Inventories i.e. stocks or stores of raw materials, components, work in progress or
finished goods.
An expanded definition of capital would include educated and skilled manpower,
consumer durables, research and development. From a nations point of view, public
constructions like roads, railways, airports, dams, barrages, bridges, canals, schools and
hospitals.
Investment is net addition to the stock of capital. While capital is a stock concept,
investment is a flow concept.
Investment is measured per unit of time. Investment is made in various forms of capital.
Investment is expenditure on real capital goods. It is also taken to mean purchase of any
asset or indeed the undertaking of any commitment, which involves an initial sacrifice
followed by subsequent benefits. In theory of income determination, investment means
strictly expenditure on capital goods. In this sense, investment is the amount by which the
stock of capital of a firm or economy changes, once we have allowed for replacement of
capital which is scrapped.

Gross Investment and Net Investment

Page 30 of 128

Gross Investment is the total investment on capital goods per period of time, adjusted for
depreciation. Gross Investment consists of investment:
a) Plant, building, machinery and equipments
b) Inventories
The investment category a) is called gross fixed investment and b) is non-fixed
investment.
Gross investment may be positive or zero. It is zero when capital goods are not being
purchased and worn out capital is not being replaced.
A firm intending to reduce its stock of capital makes zero gross investment. But a firm
intending to maintain its capital stock intact makes gross investment at a rate of
depreciation (i.e. wear and tear of capital stock over a period of time) of machines.
Finally, a firm intending to increase its sock of capital undertakes gross investment at a
rate higher than the rate of depreciation, the rate of capital consumption.
Net investment (IN) is the difference between gross investment (IG) minus depreciation
(D)
IN = I G D

Autonomous and Induced Investment

Autonomous investment is one that takes place due to exogenous factors i.e. factors that
are outside the preview of the investment function.
Technically exogenous factors are those which are generally not included in the
investment function. Such factors may include innovations in the productive technique,
inventions of new production processes, new resources, new products, new markets,
population growth, research and development, expansion plans of business firms etc
Autonomous public investment include expenditure of public buildings, establishment of
public undertakings, construction of roads, railways, dams, bridges, canals and such
overheads as educational institutions, hospitals, parks, tourist resorts etc
Induced investment is one that is induce or affected by endogenous variables i.e. factors
that are included in the investment function e.g. investment may be induced by increase
in income and employment or decrease in the rate of interest.
While induced investment is positively related to income (or output), it is negatively
related to interest rates.
The distinction between autonomous and induced investment can be clarified with the
help of the investment function. A general form of investment function is given as
follows :
I = f ( Y,i )
Where Y = national income
i = interest rate
The variables Y and I included in the investment function are endogenous variables
Investment caused by endogenous variables ( Y and i ) are called induced investment.

Page 31 of 128

On the other hand, investment caused by variables or factors other than Y and i is
autonomous investment.

Investment Decisions

A business firms motive behind investment is to make profit. Profitability of an

investment depends on:
a) Cost of investment i.e. price of the investment goods.
b) Expected income flow from the investment
c) Market rate of interest
Given the investment opportunities and necessary information, investors have to decide
whether or not to invest.
The following are methods used to decide whether or not to invest.
a) Net Profit Value (NPV) method
b) Marginal Efficiency of Capital (MEC) method

Net Profit Value (NPV) Method

The NPV method suggests that an investment project is worth undertaking if its NPV is
considerably greater than its cost of capital.
The NPV is the discounted value of the expected returns from the investment.
Money is now worth more than money in the future, because it could be invested now to
produce a greater sum in the future. The present value of money in the future is calculated
by discounting it at a rate of interest equivalent to the rate at which it could be invested.
The net present value of an investment is the difference between the capital cost of an
investment and the present value of the future cash flows to which the investment will
give rise.

NPV =

Where R1, R2, . , Rn are gross profits arising in years 1, 2, . ,n, Co is the present value
of capital expenditure, and r is the annual interest rate (assumed constant throughout the
period).
If the total expected return (i.e. the total PV) from a capital investment exceeds its total
cost, the capital good is worth buying.

+ . +

- Co

Marginal Efficiency of Capital Method

Keynes defined MEC as that rate of discount which would make the present value of a
series of annuities given by the returns expected from the capital asset during the life just
equal to the cost of capital good.
In simple words, MEC is the rate of discount which makes the discounted present value
of expected stream of income equal to the cost of capital good.

Page 32 of 128

MEC is also known as Internal Rate of Return (IRR) in contrast to the external rate of
return which is the same as market rate of interest. E.g. if the cost of capital having a life
of one year is C and it yield s an income R after one year. And if

=C

Then r in the above equation is equivalent to the MEC. The value r can be worked out as
follows : r = - 1

Using MEC the investment decision rule may be set as follows :

a) If MEC (r) > i, then investment project is worth its cost.
b) If MEC = I, the contemplated investment yields a profit just equal to the market rate
of interest. The project may be or may not be undertaken.
c) If MEC < i, the investment project is unprofitable, net worth its cost. The project has
to be rejected.

The Acceleration Principle

The relationship between investment expenditure and change in output is explained by

the principle of acceleration.
The origin of the principle can be traced back in the writings of Aftalion (1909),
Bickerdike (1914) and Howtrey (1913). The best known formulation of this principle was
however made by J.M. Clark (1917)
The acceleration principle describes the technical relationship between the change in
capital stock and the change in level of output.
Note acceleration principle is a theory of the size of the desired or optimum capital
stock rather than a theory of (net) investment.

The Acceleration Coefficient

To explain the principle of acceleration and the acceleration coefficient, let us first take
the note of the usual simplifying assumptions:
I.
A production function of Cobb Douglas type is given for all firms.
II.
Factors of production are homogenous and perfectly divisible.
III.
Factor prices are given.
IV.
Firms produce at least cost combination of inputs.
V.
There is no excess production capacity.
VI.
Firms estimates of future demand for their products are fairly accurate.
VII. There is no financial constraint funds are easily available.
Suppose the demand for firms product in period t is given by Yt and firms use Kt amount
of capital to produce Yt output. Assuming a give capital output ratio, k, the relationship
between capital stock, Kt, and the output Yt can be expressed as
Kt = kYt

Page 33 of 128

Now let the demand for the product increase in period t+1 to Yt+1 i.e. the demand for output
increases by Yt+1 = Yt+1 - Yt. Given the assumptions (iv) and (v) above, the firms will
be required to increase their stock of capital in period t + 1, to produce additional quantity
demanded.
Suppose firms increase their capital stock form Kt to Kt+1 in period t + 1, then Kt+1 = KYt+1
The relationship between change in capital stock (K) and the change in output (Y)
may be expressed as Kt+1 Kt = k(Yt+1 Yt)
Kt+1 = kYt+1
From the equation above, the capital output ratio (k) is accelerator r acceleration
coefficient.
We know that K = In where subscript n denotes net.
Thus in period t+1 Kt+1 = In = kYt+1
Gross investment (Ig) that equals net investment (In) plus replacement capital in period
t+1 may be expressed as Igt+1 = k(Yt+1 Yt) + Rt+1
It must be noted that the size of k, the accelerator, dpends not only on the capacity of the
capital goods to produce a commodity but also on the period over which capital goods are
acquired and output is measured.

Significance of Acceleration Principle

The acceleration principle has significant implications in :

a) Theories of investment
b) Employment
c) Trade cycles

Factors affecting Investment

1.
2.
3.
4.
5.
6.
7.
8.

Rate of interest
Changes in technology
Changes in cost of capital
Expectations of entrepreneurs
Corporate Tax / Corporation Tax
Government Policies / Government Incentives
Profit Levels
Rate of change of income

Aggregate Demand (AD) and Aggregate Supply (AS)

Just as there are 2 sides to any market, there are also two sides to an economy i.e. the
demand side and the supply side.
Aggregate demand relates to the demand side and aggregate supply to the supply side.

Page 34 of 128

At any given point in time, AD will be equal to the actual output of the economy (real
GDP) and is given by :
AD = C + I + G + ( X-M ) = Real GDP
The aggregate demand curve shows the quantity demanded of real GDP at different
price levels, holding all other factors constant.

The AD curve is downward sloping as a result of 2 separate effects :

1. Real money balance effect (i.e. at lower price levels the real purchasing power of
money balances i.e. currency and bank deposits rise).
2. Substitution effects i.e. a rise in the price level will normally lead to a rise in
interest rates ceteris paribus. This is because given higher prices h/h and firms
have less real purchasing power and therefore they will tend to lend less and wish
to borrow more.

Changes in AD

AD curve shifts due to :

1. Government macroeconomic policy
2. Expectations of firms and households
3. Global trends

Aggregate Supply

Page 35 of 128

As is the total of goods and services produced in the economy at any given time.
The AS available will depend upon the factor of production utilized. These factors are
labour (N), capital (K) and land (L). also important is the state of technology (T)
including the technical know how available in the economy.
The AS relationship can be represented in terms of an aggregate production function that
relates output (Y) to inputs (N, K, L, T) aggregate production function Y (N, K, L, T)
The aggregate production function states that the greater the volume of factor inputs, the
greater the economys output.

Aggregate Supply in the LR period

The LRAS curve shows the relationship between the price level and real GDP in the LR.
The LRAS curve is shown as vertical at the economys full employment GDP. The LRAS
is unaffected by price changes.

AS in the SR period

In the SR period, real GDP may be at r below the potential real GDP at full employment.
A higher AD at a time when AS is below its potential level can be expected to lead more
output produced.
This is illustrated below by an upward sloping SRAS curve.

Page 36 of 128

Macroeconomic equilibrium exists when AD = AS

Shifts in AD or AS curves cause the equilibrium to shift also.

Page 37 of 128

The Multiplier

The multiplier is a measure of the effect on total national income of a unit change in some
component of AD.
The multiplier is the ratio of the resultant change in national income w.r.t the initial
change in injections or leakages.

Multiplier =

There are as many multipliers as there are components of aggregate demand i.e.
1. Consumption expenditure multiplier
2. Investment multiplier
3. Government expenditure multiplier
4. Export multiplier

Deviation of the multiplier (Investment Multiplier)

Y= C+I
Y = C + I

reap MPC =
C = MPCY

Y = MPCY + I
-I = MPCY + Y
I = Y - MPCY

Page 38 of 128

I = Y ( 1 MPC)
= Y

( 1 MPC)

Reap
MPC + MPS = 1
MPS = 1 MPC
Substituting MPS for ( 1 MPC )
The multiplier =

The Working of the Multiplier

The multiplier is based on the principle that one persons expenditure is someone elses
income. So there is a circular flow of income and expenditure. The multiplier assumes
that MPC 0
If MPC = 0, then there would be no multiplier effect since there is no expenditure (no
income).
The multiplier effect will continue until equilibrium is reached / regained i.e. injections
(investment) is equal to withdrawals (savings).

Example

If a firm decides to construct a new bridge costing $1000 then the income of the builders
and suppliers of raw materials will rise by $1000.
However, the process does not stop there. If we assume that the recipients of the $1000
have MPC =

, they will spend $666.67 and save the rest. This spending creates extra

income for another group of people.

If we assume that they also have an MPC of

, they will spend $444.44 of the $666.67

and save the rest. This process will continue, with each new round of spending being
of the previous round.

Page 39 of 128

Thus a long chain of extra income, extra consumption and extra saving is set up.
Increase in income Increase in
Increase in savings
Y
consumption C
S
1st Recipients
1000
666.67
333.33
nd
2 Recipients
666.67
444.44
222.23
rd
3 Recipients
444.44
296.30
148.14
4th Recipients
296.30
197.53
98.77
th
5 Recipients
197.53
131.69
65.84
Total
Y = $3000
C = $2000
S = $1000
This process will come to a halt when the additions to savings total $1000. This is
because the change in savings (S) is now equal to the original change in investment (I)
and therefore the economy is returned to equilibrium because S = I once again i.e.
withdrawals = injections.
At this point the additions to income total $3000. Thus $1000 extra investment has
created $3000 rise in income. Therefore in this case the value of the multiplier = 3.
i.e. multiplier =

=33
Note
1. If investment falls (or any of the components of aggregate demand), national income
also falls by the magnitude or size of the multiplier times change in investment.
2. The greater the withdrawals, the less the multiplier effect i.e. multiplier =
If MPS (withdrawals) increase, the multiplier falls.
The multiplier in a more complex economy

The expression

gives the value of the multiplier, but the proportion of additional

income which is passed on within the system is now reduced by leakages namely savings,
imports and taxation. This means that 1 MPC is no longer equal to MPS.

Page 40 of 128

In fact 1 MPC is equal to that proportion of any increase in income which leaks out of
the circular flow.
As a fraction of additional income, this leakage is equal to MPS + MPM + MPT where:
MPM is marginal propensity to import.
MPT = marginal rate of taxation

The multiplier =

Balanced Budget Multiplier

The multiplier effect on national income of an increase in government expenditure

exactly matched by an increase in taxation, so that the governments budget remains
unchanged.
It might be thought that an increase in government expenditure say $100 million, would
have no net effect on aggregate demand in the economy and that national income would
remain unchanged.
This is not in general the case, however there will usually be an expansionary effect. At
its simplest, the reason for this is that only part of the increase in taxation results in lower
aggregate demand while all the increased expenditure results in increased aggregate
demand so that there is a net injection of demand in the economy, which then has a
multiplier effect.
The balanced budget multiplier results when government expenditure increases or
decreases by exactly the same magnitude of increases and decreases in T.
i.e. G = T
The balanced budget multiplier is always = 1
G = T
Y = G
=1

Inflationary & Deflationary Gaps

Full employment level of national income is the level of national income at which there is
no deficiency of aggregate demand and hence no disequilibrium unemployment.
At full employment level all resources in the economy are fully employed or utilized.
None is lying idle.
Rarely does equilibrium level of income correspond with full employment level.
Full level of GDP can be thought of as measuring full capacity output, i.e. the largest
output of which the economy is capable when all resources are employed for their
feasible limits.

Page 41 of 128

Deflationary Gap

Represents a situation of deficiency in demand in the economy, indicating the amount by

which aggregate demand must be increased and exists when the equilibrium level of
national income is below full employment potential.
To increase aggregate demand to the level required to raise national income and therefore
SRAS to the full employment level, the government could either raise government
expenditure or reduce taxation levels.
Either of these measures would produce a multiple rise in demand through the multiplier
effect.
The shortfall of national expenditure below national income (and injections) below
withdrawals at full employment level of national income.
With deflationary gap aggregate demand is lower than the desired level at full
employment. There is thus unemployment of resources or underutilization of resources.
Aggregate expenditure is less than aggregate output so insufficient demand results.

Page 42 of 128

Inflationary gap represents a situation of excess demand in the economy and reflects the
amount by which aggregate demand must be reduced in order to achieve the full
employment equilibrium level of output with stable prices.
To close this gap, the government could either reduce government expenditure to raise
taxation levels. Again these measures would have the effect of reducing aggregate
demand, this time through a negative multiplier effect.
For the deflationary gap an expansionary fiscal policy measures cause aggregate
expenditure to rise from AE1 to AE2 leading to an increase in real GDP (national income)
from Y1 to YFe.
For the inflationary gap the level of aggregate expenditure is reduced from AE3 to AE4 as
a result of contractionary fiscal policy measures.
The economys full potential output is YFe, any output to the right of this such as Y2
cannot be produced in the SR period.

The Paradox of Thrift

The classical economists argued that saving was a national virtue. More saving would
lead to via lower interest rates to more investment and faster growth.
Keynes was at pains to show the opposite. Saving, far from being a national virtue, could
be a national vice.
Just because something is good for an individual, it does not follow that it is good for
society as a whole ( i.e. the fallacy of composition). This fallacy applies to saving.
If individuals save more, they will increase their consumption possibilities in the future.
If the society saves more, however this may reduce its future income and consumption.
As people save more, they will spend less. There will thus be a multiplied fall in income.
The phenomenon of higher saving leading to lower national income is known as the
paradox of thrift.
But this is not all. Far from the extra saving encouraging more investment, the lower
consumption will discourage firms from investing. If investment falls, the injections line /
curve will shift downwards.
There will then be a further multiplied fall in national income.
The paradox of thrift had in fact been recognized before Keynes, and Keynes himself
referred o various complaints about under consumption that had been made back in the
16th century and 17th century.
But despite these early recognitions of the danger under consumption, the belief that
would increase the prosperity of the nation was central to classical economic thought.
Keynesian Cross Model
MONEY AND BANKING

Money is anything that is generally accepted as a medium of exchange or settling debts.

Page 43 of 128

In the absence of money, exchange must take the form of barter trade i.e. direct exchange
of goods and services.

The great disadvantage of barter trade is that it depends upon a double coincidence of
wants e.g. a hunter who wants to exchange his animal skins for corn must find not
merely a person who wants animal skin but someone who wants animal skin and has
surplus corn for disposal.

Barter will serve mans requirements quite adequately when he provides most of his
needs directly and relies upon market exchanges for very few of the things he wants.

As the extent of specialization increases the barter system proves very inefficient and
frustrating. Barter system of exchange becomes very cumbersome as economic activities
become more specialized.

Time and energy which could be devoted to production is spent on a laborious system of
exchange.

A lot of arguments and disagreements also erupt on the quality of goods to be exchanged.

Money helps to solve all these problems.

A producer can now exchange his goods and services for money and the money can then
be exchanged for whatever goods and services he requires.

The more expensive a product is the higher its value and vice versa i.e. the value of a
product i.e. goods or services is expressed in terms of money.

Functions of Money
1. A medium of exchange one can use money to buy goods and services.
2. A measure of value
3. A store of value wealth can be stored or held in the form of money. Storing wealth as
wheat wheat can decay vs. storing wealth as money can be eroded by inflation.
4. A standard for deferred payments. Goods and services bought on credit can be paid for by
money on a future date.
5. A unit of account money should provide an agreed standard measure i.e. a unit of
account by which the value of different goods and services can be compared. This of
course is not the case in a barter economy in which the value of every good and service
must be individually expressed in terms of all other goods and services.

Page 44 of 128

Characteristics/Qualities/Attributes of Money

Money must have the following characteristics for it to function as money:

1. Acceptability i.e. generally acceptable to all consumer and businesses.
2. Durability must not deteriorate rapidly and lose value while in peoples possession.
3. Homogeneity specific notes and coins must be identical in appearance and value.
4. Divisibility capable of subdivision into smaller units without any loss of value.
5. Portability manageable and easy to carry around and handle.
6. Stability of value must not be eroded or lose value due to inflation.
7. Difficult to counterfeit minimum fraud or forging
8. Scarcity limited in supply.
9. Uniformly specific notes and coins must look the same / identical.
10. Recognizable money must distinguish itself easily from other goods.

Advantages of Money
1. It is universally acceptable as a means of payment.
2. It simplifies transactions.

Disadvantages of Money
1. Value of money can be eroded by inflation.
2. Money can attract attention of thieves.
3. Money is not suitable to be sent or posted to a payee unless if money orders,

telegraphic transfers or registered mail is used and these methods of sending demand
a payment fee it ends up being expensive
The Demand for Money

There is a cost of holding any money balance: the money could have been used to
purchase a bond which would have earned interest.

Page 45 of 128

The opportunity cost of holding money is the rate of interest that could have been used to
purchase an income earning asset.

Money will only be held if it provides services to the holders that are at least as valuable
as the opportunity cost of holding it.

The total amount of money balances that everyone wishes to hold for all purposes is
called the Demand for Money.

Note
The quantity of money is a stock and that the demand for it is demand for stock: people
wish to hold so much money in cash or deposits. This makes the demand for money to
hold different from any commodity/good to consume. The demand for a consumption
commodity is a flow demand and requires a time dimension to make it meaningful i.e. so
many units per week, per month or per year.
Motives for demanding or holding money
1. The transactions demand for money (the transactions motive)

Businesses, firms and people demand money for their day to day needs i.e.
transactionary purposes e.g. buy food, pay transport, buy stationery

The transactions demand for money arises because of the non-synchronization

of payments and receipts.

The larger the value of national income measured in the current price the
larger the value of transaction balances that will be held.

2. The precautionary demand for money

Households and firms may wish to hold additional balances called

precautionary balances in response to the motive for holding money.

Whereas the transaction demand arises from the certainty of nonsynchronization of payments and receipts, the precautionary demand arises
from uncertainty about the degree of non-synchronization.

The precautionary motive arises, therefore out of stochastic disturbances in

the flows of payments and receipts.

The protection provided by any given stock of precautionary balances depends

on the degree to which payments and receipts are subject to haphazard
fluctuations and on the value of the payments and receipts.

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The precautionary demand for money is due to unforeseen contingencies for

e.g. death, accident, illness, unexpected visitors etc

The precautionary demand for money is negatively related to the rate of

interest as well as being positively related to the level of income.

3. The Speculative Demand for Money

A motive for handling money which arises from the possibility that the money value of
other forms of wealth may change.

Thus suppose an individual can hold his wealth either in bonds or in money. If he expects
the price of the bonds to fall in the future, he will wish to switch from bonds to money i.e.
he will sell his bonds. This is because a fall in the price of bonds involves him in loss of
wealth.

On the other hand if he expects the price of bonds to rise he will reduce his holdings of
money and buy bonds. Since his desire to hold money is therefore related to his
expectations of the variations in the value of the other assets and the way in which he can
advantage of them, this part of the individuals money holdings are said to be determined
by the speculative motive.

The speculative motive leads to households and firms to add to their money holdings
until the reduction in risk obtained by the last $1 added is just balanced (in the wealthholders view) by the cost interns of the interest forgone on that $1.

The speculative demand for money has its sources in uncertainty about the future bond
prices. It is negatively related to the rate of interest and positively related to wealth.

Md = MT + MP +MSP

The demand for money is defined as the total amount of money balances that everyone in
the economy wishes to hold.

The 3 motives for holding money can be summarized by listing 3 hypotheses which are:
1. The demand for money is positively related to national income valued in current
prices.
2. The demand for money is negatively related to the rate of interest.
3. The demand for money is positively related to wealth.

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When households and firms decide how much of their monetary assets they will hold as
money rather than as bonds, they are said to be exercising their preference for liquidity.

Liquidity preference refers to the demand to hold wealth as money rather than interest
earning assets.

The real demand for money is given by:

MD = L(Y, r, W)
Where
MD = real demand for money
L = liquidity preference which indicates a functional relation
Y = real national income
r = interest rate
W = real purchasing power of wealth

The nominal demand for money is determined by multiplying the real demand for money
by the price level, P, which makes the nominal demand equal to PL(Y, r, W).

Thus the nominal demand for money varies in proportion to the price level e.g. doubling
the price level doubles nominal demand.

The determinants of MD are Y, r and W.

-The study of the effect of money on the economy is called monetary theory. When economists
mention supply, the word demand is sure to follow. The supply of money is an essential building
block in understanding how monetary policy affects the economy because it suggests the factors
that influence the quantity of money in the economy.
-The demand for money evolve through theories postulated by: The Classicals in the 20th century and pioneering economists were Irving Fischer, Alfred
Marshall and A.C Pigou. They came up with the quantity theory of money.
The Keynesians under John Maynard Keynes. They came up with the Liquidity
Preference Theory
The Monetarists under Milton Friedman came up with the Modern Quantity Theory of
Money.
1) The Classicals Quantity Theory of Money

Page 48 of 128

The quantity theory of money is a theory of how the nominal value of aggregate income
is determined. It also tells us how much money is held for a given amount of aggregate
income. It is also a theory of the demand for money.

The most important feature of this theory is that it suggests that interest rates have no
effect on the demand for money.

The Classicals examined the link between total quantity of money i.e M (money supply)
and the total amount of spending on final goods and services produced in the economy
i.e P x Y where P is the price level and Y is aggregate output or income

Total spending P x Y is also thought of as aggregate nominal income for the economy or
as nominal GDP.

The concept that provides the link between M and P x Y is called velocity of money or
velocity of circulation or simply velocity i.e the rate of turnover of money i.e the
average number of times per year that a unit of currency is spent in buying the total
amount of goods and services produced in the economy or the number of times a unit of
currency changes hands in buying total goods and services produced in the economy over
a given period of time which is usually a year.

Velocity is defined more precisely as total spending (P x Y) divided by the quantity of

money (M):V = P xY/M

Multiplying both sides by M, we obtain the equation of exchange which relates nominal
income to the quantity of money and velocity
i.e M x V = P x Y

The equation of exchange states that the quantity of money multiplied by the number of
times that this money is spent in a given year must be equal to nominal income.

The equation MV = PY is nothing more than an identity.

Fischer reasoned that velocity is determined by the institutions in an economy that affect
transactions.

Quantity Theory of Money

Fishers view that velocity is fairly constant in the short run transforms the equation of
exchange into the quantity theory of money which states that nominal income is
determined solely by movements in the quantity of money.

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When the quantity of money doubles, M x V doubles and so must P x Y, the value of
nominal income.

The Classicals thought that wages and prices were completely flexible, they believed that
the level of aggregate output Y produced in the economy during normal times would
remain at full employment level, so Y in the equation of exchange could be treated as
reasonably constant in the short run.

The quantity theory of money then implies that if M doubles, P must also double in the
short run because V and Y are constant.

For Classical economists, the quantity theory of money provided an explanation of

movements in the price level. Therefore movements in the price level result solely from
changes in the quantity of money.

The Quantity Theory of Money Demand

It tells us how much money is held for a given amount of aggregate income. It is in fact a
theory of the demand for money.

Dividing both sides of the equation of exchange by V

M = 1/V x PY
Where nominal income P x Y is written as PY. When the money market is in equilibrium,
the quantity of money M that people hold is equal to the quantity of money demanded
Md. Therefore replacing Md in the equation by M and using k to represent the quantity
1/V (a constant because V is a constant)
Md = k x PY

The equation above tells us that because k is a constant, the level of transactions
generated by a fixed level of nominal income PY determines the quantity of money M d
that people demand.

Therefore, Fischers quantity theory of money suggests that the demand for money is
purely a function of income and interest rates have no effect on the demand for money.

Keynes Liquidity Preference Theory

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In 1936 John Maynard Keynes abandoned the Classical view that velocity was a constant
and developed a theory of money that emphasized the importance of interest rates.

Keynes called his theory of the demand for money, the liquidity preference theory. He
postulated that there are three motives for holding money i.e
1) The transactions motive
2) The precautionary motive ; and
3) The speculative motive

1) The transactionary motive

People hold money to finance their day to day needs (transactions). Keynes emphasised
that this component of the demand for money is determined primarily by the level of
peoples transactions. But he believed that these transactions were proportional to
income, like the Classicals, he took the transactions component of the demand for money
to be proportional to income.
2) The precautionary motive
Keynes also said that people hold money as a cushion against an unexpected need,
unforeseen contingencies or emergencies e.g unexpected bills, unexpected visitors, death,
accident, hospitalization.
Keynes believed that the amount of precautionary money balances people want to hold is
determined primarily by the level of transactions that they expect to make in the future
and that these transactions are proportional to income. Therefore he postulated the
demand for precautionary money balances is proportional to income.
3) The speculative motive
Keynes agreed with the Classical economists that money is a store of wealth and called
this reason for holding money as the speculative motive. He believed that even though
the wealth component of the demand for money is proportional to income, interest rates
too have an important role to play in being a determinant of the speculative motive of the
demand for money.
From Keynes reasoning, as interest rates rise, the demand for money falls and therefore
money demand is negatively related to the level of interest rates.
Keynes wrote the following demand for money equation known as the liquidity
preference function which says that the demand for real money balances Md/ P is a
function of (is related to) i and Y

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= f(i, Y)

The demand for real money balances is negatively related to interest rate i and positively
related to real income Y.

Friedmans Modern Quantity Theory of Money

In 1956, Milton Friedman developed a theory of the demand for money in a famous
article The quantity theory of money: A restatement
Like his predecessors, Friedman pursued the question of why people choose to hold
money. Instead of analyzing the specific motives for holding money as Keynes did,
Friedman simply stated that the demand for money must be influenced by the same
factors that influence the demand for any asset. Friedman then applied the theory of asset
demand to money.
The theory of asset demand indicates that the demand for money should be a function of
the resources available to individuals (their wealth) and the expected return on money.
Friedman expressed his formulation of the demand for money as follows:
Md/ P = ( Yp, rb-rm, re-rm, e-rm)
+

Where Md/ P = demand for real money balances

Yp = Friedmans measure of wealth known as the permanent income (technically the present
discounted value of all expected future income, but more easily described as expected average
long run income)
rm = expected return on money
rb = expected return on bonds
re = expected return on equity (common stocks)
e = expected inflation rate
The signs underneath the equation indicate whether the demand for money is positively (+)
related or negatively (-) related to the terms that are immediately above them.
Equilibrium in the money market

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It exists where the demand for money is equal to the supply of money. The supply of
money is determined by the monetary authorities and can be taken as fixed in the short
run period. It is identified as a vertical line (MM).
According to Keynes, the transactions and precautionary motives are added together and
are described as active balances. The demand for such balances will not be influenced by
changes in the rate of interest and so it appears as a vertical line L a. The speculative
demand for money is influenced by changes in the rate of interest. There is an inverse
relationship between interest rate and the demand for money. Keynes referred to the
relationship between the quantity of money demanded and the rate of interest as
speculative balances. Speculative balances are often referred to as idle balances.
This analysis indicates that when the quantity of money demanded is related to the rate of
interest, we obtain the demand curve of the normal shape.
At high rates of interest, very little money is demanded for speculative purposes. At low
rates of interest, large amounts of money are demanded.
The speculative demand for money is represented by the curve Li in the diagram below.

Source: Introductory Economics by G.F. Stanlake and S.J. Grant

The Li curve becomes horizontal at a positive rate of interest. This is because it is

believed that some minimum reward for example 2% is required to persuade people to
forgo the advantages of holding money. This is called the liquidity trap i.e the
absorption of any additional money supply into idle balances (i.e speculative) at very low
rate of interest leaving aggregate demand unchanged.
If the demand for active balances La is added to the demand for speculative balances L i
we obtain the total demand curve for money i.e LL as shown by the diagram above.

Page 53 of 128

This is the liquidity preference schedule which tells us how the quantity of money
demanded varies as the rate of interest varies.

Changes in the money market equilibrium are as a result of changes in the determinants of
money demand or money supply.
Determinants of money demand
1)
2)
3)
4)

5)
6)
7)
8)
9)

Real GDP
The price level
Expectations
Transfer costs i.e transfers between non-money and money deposits. Therefore the
demand for money will increase as it becomes more expensive to transfer between money
and non-money accounts. The demand for money will fall if transfer costs decline.
Preferences
Expected rate of inflation
Risk
Liquidity of alternative assets
Efficiency of payment technologies

Effects of changes in the money market

Source: Introductory Economics by G.F. Stanlake & S.J. Grant

Page 54 of 128

1) The effect of changes in money demand

An increase in liquidity preference or money demand brought about by an increase in income or
an increase in prices will raise the liquidity preference curve from LL to L 1 L1 in diagram a). This
causes the rate of interest to rise from OR to OR 1. What happens is that the increased preference
for money balances leads to an increased desire to sell securities and an increased supply of
securities in the market depresses their prices i.e the rate of interest rises. A fall in the liquidity
preference, other things being equal will lower the rate of interest as the demand for securities
increases.
2) The effect of a change in money supply
This is illustrated in diagram b). When the supply of money increases from MM to M 1M1
the rate of interest falls from OR to OR 2. This is because an increase in the supply of
money must leave some groups holding excess money balances (assuming no change in
liquidity preference). People will be holding a greater proportion of their wealth in the
form of money than they wish to hold at current rates of interest.
A fall in the supply of money will leave the community with less money that it wishes to
hold at current interest rates. People will try to increase their money balances by selling
securities and in doing so, they will raise the rate of interest.

Factors affecting money supply

1)
2)
3)
4)
5)
6)

Changes in the reserve deposit ratio

Changes in the currency reserve ratio
Open market operation
Changes in reserve requirement ratio
Changes in discount window borrowing
Changes in the bank rate/ discount rate

Measures of controlling money supply growth

1)
2)
3)
4)
5)

Money supply growth must be controlled. The monetarists advocate that the rate of
money supply growth must match the rate of growth of the economy.
If money supply grows faster than the rate of growth of the economy, the general price
level of goods and services will increase i.e its inflationary.
The following are measures which can be used to control money supply growth. They are
instruments of monetary policy:The rate of interest i.e the bank rate, repo rate, discount rate or minimum lending rate
Open market operations
Special deposits
Funding
Quantitative and qualitative controls

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6) Moral suasion
7) Hire purchase controls
Forms of Money

Credit money

Precious metals e.g. gold, silver, platinum (commodity money)

Coins

Bank notes (flat money)

Full bodied the commodity that is used as money has the same value as money.

Representative full bodied money you do not have to carry gold. You simply
need a paper or a certificate that represents it.

The Supply of Money / Money Stock

Money supply is the amount of money which exists in an economy at any given time.

There is no single definition of exactly what constitutes the money supply. The essence of
money is that it should be generally acceptable as a means of payment.

Measures of Money Supply

Monetary Base
Notes and coins or cash in circulation outside the central bank.
Narrow Money
Reflects the medium of exchange function and thus refers to money balances that are readily
available to finance current spending i.e. balances available for transaction purposes.
Broad Money
Not only includes money balances held for transaction purposes, but incorporates money held as
a form of saving. It provides an indicator of the private sectors holdings of relatively liquid
assets assets which can be converted with relative case and without capital loss into spending
on goods.

There is no single correct measure of money supply; instead, there are several measures
classified along a spectrum or continuum between narrow and broad monetary

Page 56 of 128

aggregates. Narrow measures include only the most liquid assets, the ones most easily
used to spend (currency, checkable deposits). Broader measures add less liquid types of
assets (certificates of deposits) etc.

The different types of money are typically classified as Ms. the Ms usually range
from M0 (narrowest) to M3 (broadest) but which Ms are actually used depends on the
countrys central bank.

M0 in some countries such as UK, M0 includes bank reserves, so M0 is referred to as

the monetary base or narrow money.

Different measures of money supply M1, M2 & M3. M2 and M3 measures of money
supply build on the narrowly defined M1 measure by successively broadening the money
supplying measure. Thus M1 is the narrowest measure of money supply, M2 is broader
than M1 and M3 is the broadest measure.

M1 is the narrowest measure of money supply. It consists of notes (bills of different

denominations) and coins and checkable deposits. The checkable deposits are spilt into2
categories i.e. demand deposits and other checkable deposits (non demand checkable
deposits). M1 also includes travelers checks.

M2 measure of money supply is made broader than the M1 monetary aggregate by

adding additional items that fall under the near money category. M2 includes M1 +
savings deposits, small denomination time deposits.

Time deposits are commonly known as certificate of deposits CDs. A certificate is issued
for a fixed period of time with a specified period of time with a specified maturity date
and a specified interest rate. Unlike savings deposits/accounts, CDs have a predetermined
maturity date and a financial penalty for early withdrawal of funds, making CDs
somewhat less liquid. M2 also includes money market deposit accounts and money
market mutual fund shares (non-institutional) e.g. buying shares on the stock exchange.

M3 measure of money supply further broadens the M2 monetary aggregate by adding

additional assets that are less liquid than those included in M1 and M2.

M3 includes M1 and M2 plus large denomination time deposits. Large denomination

certificates of deposits are usually negotiate certificates of deposits (CDs) that can be sold
in the secondary market before they mature. Thus large denomination negotiable CDs
serve as an alternative to investing in Treasury Bills for corporate treasurers who have
idle funds to invest for a short time.

M3 also include money market mutual fund shares (institutional) and overnight and term
repurchase agreements.

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The Monetary System/ The Financial System / The Banking System

The financial system is made of various financial intermediaries which facilitate financial
transactions and these are:
1) The Central Bank/ The Reserve Bank
Most countries of the world have a central bank which is at the helm of the banking system. The
central bank is responsible for operating the banking and financial system of a country. Its
functions are:a)
b)
c)
d)
e)
f)
g)
h)
i)
j)
k)
l)
m)
n)
o)

Issuing bank notes and coins and reparing tattered ones.

Keeping the governments account and maintain it
Servicing the national debt
Lender of last resort
Supervision of the banking system
The bankers bank
Bankers clearing house
Special advisor to the government
Management of the countrys foreign exchange reserves
Formulation and implementation of monetary policy
Handles the countrys gold output
Manages the countrys balance of payments
Formulation and implementation of the countrys exchange rate policy
Administers the issue of government loans and treasury bills
Manages the countrys domestic and external debt.

2) Commercial Banks/ Retail Banks

These are financial institutions set up to promote and facilitate financial transactions for example
CBZ, Standard Chartered Bank, Barclays Bank, TN Bank, BancABC, Metropolitan Bank.
The following are functions of commercial banks:a) Attracting customer deposits
b) Foreign currency transactions
c) Business and investment advice to customers
d) Provision of night safe
e) Protects customer durables and wills
f) Giving short and long term loans to customers
g) Provision of finance either in the form of loans or overdrafts to help customers finance
their transactions
h) Help business people receive payments for goods sold abroad or locally
i) Help business people make payments for supplies obtained
j) They accept and discount bills of lading and bills of exchange
k) Buying and selling foreign currency
l) Provide limited assurance (bancassurance)

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m) Provide trade financing

n) Sometimes they offer utility account payment services for their clients and act as
collectors of utility funds for utility companies e.g ZESA, ZINWA, Multichoice
o) Provision of telephone banking services
p) Provision of internet banking services

3) Building Societies
Building societies differ from commercial banks in that they do not operate any
current accounts or checking accounts.
They are purely dealers on the domestic market and may not have any correspondent
banking arrangement in other countries.
They usually have very low minimum balance requirements (the poor mans bank)
Building societies typically serve small depositors i.e people in the low income group
who may find commercial banks unattractive due to the requirements imposed by
those banks.
A building society is a financial institution that accepts deposits upon which it pays
interest and makes loans for house purchase secured by mortgages.
They insure mortgaged properties against fire and special risks through their own
insurance companies.
Provide loans to members of the public who wish to purchase their own homes.
Inspect and appraise properties.
4) Merchant Banks
These are financial institutions that deal mainly with international trade. The following are their
functions:

Buying and discounting bills of exchange.

Issuing of letters of credit
Buying and selling foreign currency
Underwrite or guarantee and handle new issues of shares and debentures
Accept money on deposit
Gives investment advise
Arrange mergers and takeovers of companies
Provide corporate short and long term loans
Investment management
Wholesale banking i.e acceptance of very large sums of money as deposits

5) Discount Houses

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These discount a variety of IOUs or promises to pay which are issued by the government, local
authorities, banks and companies. Discounting is the process of buying a security for less than its
face value (or redeemable value).
The following are the functions of discount houses:

Ensure the liquidity of the banking system by accepting short term deposits.
Invest these funds in liquid liabilities of other financial institutions.
Provision of short term loans.
Buy and sell financial assets in order to create a stable and active market for financial
assets
They act as market markers in treasury bills and other short term securities
Assists the government with its borrowing requirements.
They provide a vital link between the central bank and the rest of the banking system.

6) Insurance Companies
7) They sell a number of financial products to their clients. They administer policies,
pension funds and annuities for their clients. These funds are then invested in some safe
investment that would make Development Banks
The main aim of development banks is to look at socio-economic inequalities of the past and
improve the standards of living of people.
8) Post Office Savings Bank
It allows the small saver the chance to invest their monies and the money is invested in
government bonds.
insurance companies not risk their clients money.
9) Pension Funds
The majority of big corporations run pension funds for the benefit of their employees. Normally
the company contributes a certain % of the employees salary and these pension funds are
invested in stocks, bonds and other securities and the companies make a lot of profits. The
pensions will be paid to employees at a later stage in life for example when the employee retires
or the pension is paid to beneficiaries when the employee dies.
10) Finance Houses
They obtain their funds from banks and other sources at concessional rates and then sell the
funds to borrowers at premium rates

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In this case, banks have surplus funds that they are willing to sell to finance houses at a lower
interest rate. In turn, the finance houses would make the funds available to individuals and other
businesses that are in a deficit.
The Banking Sector and the Money Creation Process/ The credit creation process
Banks perform 2 crucial functions which are:1) They receive funds from depositors and in turn provide these depositors with a checkable
source of funds or with interest rate.
2) They use funds they receive from depositors to make loans to borrowers i.e they serve as
intermediaries in the borrowing and lending process.

When banks receive deposits, they do not keep all these deposits on hand because they
know that depositors will not demand all of the deposits at once. Instead banks keep only
a fraction of the deposits that they receive. These deposits that banks keep on hand are
called bank reserves.
When depositors withdraw deposits, they are paid out of the bank reserves. The reserve
requirement is a proportion/ fraction of deposits set aside for withdrawal purposes.
The reserve requirement is determined by the reserve bank or central bank of a country.
Deposits that banks are not required to set aside as reserves can be lent to borrowers in
the form of loans.
Banks earn profits by borrowing funds from depositors at zero or low interest rate and
using these funds to make loans at higher interest rates.
A balance sheet for a typical bank is given in the table below. A balance sheet
summarises the banks assets and liabilities. Assets are the valuable items that the bank
owns and consist primarily of the banks reserves and loans. Liabilities are valuable items
that the bank owes to others and consist primarily of the banks deposit liabilities to its
depositors.
In the table below, the bank assets (reserves and loans) total $1 million. The banks
liabilities (deposits) total $1 million. A banking firms assets must always equal liabilities.

The balance sheet for a typical bank:

Assets

Liabilities

Reserves

$100 000

Loans

$900 000

Deposits

From the table, the reserve requirement is 10%.

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$1 000 000

If the bank receives a deposit of $100 000 from one of its depositors, assuming that the
bank is required to by the reserve bank to set aside 10% of this deposit or $10 000. It then
lends out its excess reserves i.e the remaining $90 000 (or 90%) of the initial deposit.
Suppose that all borrowers deposit their funds into the same bank, the bank will then
receive $90 000 in new deposits of which it sets $90 000 aside as reserves and lends out
all the excess reserves.
Suppose again that all borrowers redeposit their loans in the same bank, that bank sets
aside a portion of these deposits and can lend out the remainder, which again is
redeposited into the bank and the process continues on and on. The repeated chain of
events is summarized in the table below:

Multiple Expansion of Credits

Round

New Deposits

New Reserves

New Loans

$100 000

$10 000

$90 000

$90 000

$9 000

$81 000

$81 000

$8 100

$72 900

$72 900

$7 290

$65 610

$65 610

$6 561

$59 049

00

00

00

TOTAL

$1 000 000

$100 000

$900 000

If one were to follow this multiple deposits expansion process to its completion, the end
result would be that the banks deposits would increase by $1 million [i.e $100 000 x 10
(money multiplier)], loans would increase by $900 000 [i.e $90 000 x 10 (money
multiplier)] and its reserves would increase by $100 000 [i.e $10 000x 10 (money
mulitiplier)], all due to the initial deposit of $100 000.
Credit creation by banks is one of the most important and major source of generating
income by banks. When the reserve requirement is increased by the central bank, it would

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directly affect credit creation by banks because then the lendable funds by banks
decreases and vice versa.
Credit Creation by Banks (another example)

Suppose there are a number of Commercial Banks in the banking system i.e Bank 1,
Bank 2, Bank 3 and so on.
Suppose an individual A makes a deposit of $100 in Bank1. Bank 1 is required to
maintain a cash reserve requirement of 5% which is decided by the central banks
monetary policy.
Bank 1 is required to maintain a cash reserve of $5 (5% of $100). The bank now has
lendable funds of $95 ($100 - $5).
Let Bank 1 lend $95 to a borrower, say B. The method of lending is the same i.e Bank 1
opens an account in the name of the borrower cheque for the loan amount. At the end of
the process of deposits and lending, the balance sheet of the bank reads as given below:

Balance Sheet of Bank 1

Liabilities

Amount

Assts

Amount

As deposit

100

Cash Reserve

Loan to B

95

Total

100

Total

100

Now suppose that money that was borrowed from Bank 1 is paid to individual C in
settlement of his past debts. Individual C deposits the money in his bank say Bank 2.
Now Bank 2 carries out its banking transaction. It keeps a cash reserve of 5% i.e $4.75
(5% of $95) and lends $90.5 to a borrower D. At the end of the process, the balance sheet
for Bank 2 will look like:-

Liabilities

Amount

Assts

Amount

Bs deposit

95

Cash Reserve

4.75

Loan to C

90.5

Total

95

Total

95

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The total amount advanced to D will return ultimately to the banking system, as
described in case of B and the process of deposits and credit creation will continue until
the reserves with the banks are reduced to zero.
The final picture that would emerge at the end of the process of deposit and credit
creation by the banking system is presented in the consolidated balance sheet of all banks
as shown below:-

The combined Balance Sheet of Banks

Bank

Liabilities

Assets

Reserves

Total Assets

Deposits

Credits

Bank 1

100

95

100

Bank 2

95

90.5

4.75

95

Bank 3

90.5

85.98

4.52

90.5

Bank n

00

00

00

00

Total

2 000

1 900

100

2 000

It can be seen from the combined balance sheet that a primary deposit of $100 in Bank 1
leads to the creation of the total deposit of $2 000.
The combined balance sheet also shows that the banks have credited a total credit of $2
000 and maintained a total cash reserve of $100 which equals the primary deposits.
The total deposits created by the commercial banks constitutes the money supply by the
banks

The Deposit Multiplier =

Total Liabilities Deposits = 20 x 100 = 2 000

Total Assets Credits = 95 x = 2000
Total Reserves = 5 x 20 = 100
Total Assets = 100 x 20 = 2000

= 20

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The Money Multiplier

This is the amount by which bank deposits expand in response to an increase in excess reserves.
Money multiplier =
From the example in the table above, the reserve requirement is 10%,
The money multiplier = 1/ 10% = 10
The excess reserves resulting from the initial deposit of $100 000 are $90 000, multiplying
$90000 by the money multiplier 10 yields $900 000, which is the amount of additional deposits
created by the banking system as a result of the initial $100 000 deposit.
In reality, loan recipients do not deposit all of their loans into a bank, they hold a fraction of their
loan funds as currency. If some funds are held as currency, then there is a leakage of money out
of the banking system. In this case the money multiplier will still be greater than 1, but it will be
less than the inverse of the reserve requirement.
The Deposit Multiplier
This is the amount by which an increase in bank reserves is multiplied to calculate the increase in
bank deposits i.e
Deposit Multiplier =
The deposit multiplier is linked to the desired reserve ratio by the following equation,
Deposit Multiplier =

Monetary Base and Bank Reserves

The monetary base is the sum of notes and coins and commercial banks reserves held at
the central bank. The monetary base is held either by banks as reserves or outside the
banks as currency held by the public.
When the monetary base increases, both the bank reserves and currency held by the
public increase. But only the increase in bank reserves can be used by banks to make
loans and create additional money.

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An increase in currency held by the public is called currency drain. A currency drain
reduces the amount of additional money that can be created from a given increase in the
monetary base.
The money multiplier is the amount by which a change in the monetary base is
multiplied to determine the resulting change in the quantity of money.
The money multiplier is equal to the change in the quantity of money divided by the
change in the monetary base.
Money Multiplier =

The money multiplier is related but differs from the deposit multiplier i.e

or

The deposit multiplier is the amount by which a change in bank reserves is multiplied to
determine the change in bank deposits.

The Money Multiplier

The size of the money multiplier depends on:1) The magnitudes of the required reserve ratio
2) The ratio of currency to deposits.
Assuming
R = desired reserves
r = desired reserve ratio
C = currency
c = ratio of currency to deposits
D = deposits
M = the quantity of money
MB = monetary base
Recall the Money Multiplier =
Desired reserves R = Rd and
Currency C = Cd
The quantity of money

M = C + D (substitute C)
M = cD + D
M = (1+c)D .1)

The monetary base

MB = R + C substitute R = rD and C = cD

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MB = rD + cD
MB = (r + c)D2)
Divide equation 1) by equation 2)
Money Multiplier =

Or

M=

x MB

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INFLATION
Definition

Inflation is a situation in which the general price level of goods and services is
persistently moving upwards.
Inflation is a dynamic process in which the general price level of goods and services
moves upwards over a period of time.
Inflation is a steady increase in the supply of money.
Inflation is a situation where demand persistently exceeds supply.
A process of steadily rising prices resulting in diminishing purchasing power of a given
nominal sum of money.

Types of Inflation
1. Hyperinflation
- It is an extreme form of inflation. It takes place when prices shoot up at more than 3 digit
rate per annum.
- During the period of hyperinflation paper money becomes worthless and price increases
get out of hand e.g. Germany experienced hyperinflation in 1923 after the 1st World War.
- Hyperinflation is also called galloping inflation or runaway inflation.
- By the end of 1923 in Germany prices were one million million times greater than the
pre-war level.
- Towards the end of 1923 paper money was losing half or more of its value in one hour
and wages were fixed and paid daily.
- In a hyperinflation situation, you go for shopping pushing a wheelbarrow of money but
coming back home goods not enough to fit your pocket.
- Hungary also experienced also experienced hyperinflation in 1945 1946. The rate of
inflation averaged 20 000 per cent per month for a year and in the last month prices sky
rocketed 42 quadrillion percent.
- In recent times Argentina, Brazil and Peru had hyperinflation in 1989 and 1990 as shown
below.
Country
Argentina
Brazil
Peru
-

1989
3.079,8%
1287,0%
3389,6%

1990
2314,0%
2937,8%
7481,7%

Zaire also experienced hyperinflation during the reign of Mobutu Sese Seko.
Price increases were averaging the range of 4000% to 6000%.

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Zimbabwe experienced the worst hyperinflation during the period 2006 to 2008. Inflation
rate was averaging 56 billion per cent. People would only know the prices of goods and
services at the till.
Prices were no longer stuck on goods and prices were changing and increasing many
times a day.
Under conditions of hyperinflation people lose confidence in the currencys ability to
carry out its functions. It becomes unacceptable as a medium of exchange.

2. Suppressed Inflation
- This refers to a situation where demand persistently exceeds supply but the effect on the
prices is minimised by the use of such devices as price controls or rationing or controlled
distribution of goods through public distribution system or subsidisation of commodities
with high inflation potentials.
- In spite of these control measures, prices do rise and inflation does take place but at a
lower rate than the potential rate in the open system.
3. Creeping Inflation
- Creeping inflation is also called moderate inflation. The annual rate of inflation will be a
single digit.
- During the period of moderate inflation price increases but at a moderate rate.
- The moderate rate may vary from country to country. However, the important feature of
moderate inflation is that it is predictable and people hold money as a store of value.
- The inflation is insidious (unseen but deadly) and persistent e.g. India has had creeping
inflation during the post independence period, except for a few years.
- Most developed countries e.g. the UK and USA also experience creeping inflation.
- After introduction of multicurrency denomination (i.e. dollarization) of the Zimbabwean
economy in 2009 February, the country also experiences creeping inflation.

Basic Theories of Inflation

Types of Inflation / Causes of Inflation
1. Demand Pull Inflation
2. Cost Push Inflation
3. Structuralist Inflation

1. Demand Pull Inflation

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Demand Pull Inflation may be defined as a situation where aggregate demand

persistently exceeds aggregate supply at current prices so that prices are being pulled
upwards.
Demand Pull Inflation can be broken into:
a) Keynesian Theory (Real Theory of Inflation)
This was postulated by John Meynard Keynes.
The Keynesians say that aggregate demand is greater than aggregate
supply, so prices are being pulled upwards.
b) The Monetarist Theory
It was postulated by Milton Friedman.
They believe that inflation arises when there will be too much money
chasing too few goods and services.
The monetarists believe in the quantity theory of money. The quantity
theory of money is based on the belief that the general level of prices
depends on the supply of money: if the money supply increases without a
corresponding increase in the quantity of goods and services produced,
then prices tend to rise.
From the quantity equation of money
MV = PT (postulated by Irvin Fisher)
M = money supply, V = velocity of circulation, P = price level, T =
transactions

P=

Assuming that V is constant.

This implies that the general level of prices P is related to M.
All economists agree that once a nations resources are fully employed, an
increase in demand must lead to an upward movement of prices.

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All Economists agree that once the nations resources are fully employed, an increase in demand
must lead to an upward movement of prices. From the diagram above, the increase in aggregate
demand from AD to AD1 occurring at the full employment level of real national income results in
a rise in the general price level from OP to OP1.

2. Cost Push Inflation

This occurs when prices rise as a result of the costs of production increasing more
rapidly than output.
a. An increase in the costs of imported raw materials (imported inflation)
b. A rise in wages unmatched by a rise in output
c. An increase in profits to meet the demand of shareholders would each tend
to push up prices.
d. An increase in indirect taxes cause the supply curve to shift to the left and
prices increase.

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A rise in costs of production shifts the supply curve to the left and pushing up the general price
level from OP to OP1.

3. Structuralist Inflation / Supply Stock Inflation

Structuralist inflation is caused by structural bottlenecks caused by
underdevelopment in developing countries. Supply shock is caused by unexpected
decline in the supply of major consumer goods or key industrial inputs.
These could be due to :
a. Foreign currency shortages
b. Transport bottlenecks/shortages
c. Urbanisation
d. Housing bottlenecks
Food prices shoot up due to crop failure / drought
Prices of inputs e.g. coal, steel, cement, oil etc go up due to strikes.
Rise in price may be caused by supply bottlenecks in the domestic economy or
international events e.g. wars e.g. sudden rise in OPEC oil prices of 1970s due to Arab
Israel war or current Middle East Crisis.

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4. Expectations induced Inflation

Expectations can play a very important part in the causes of inflation e.g. if
workers expect prices to rise they are likely to react in advance of actual inflation
by demanding higher money wages to retain the real value of their wages.
Similarly if firms expect inflation they are likely to respond by building in
inflationary expectations into their price planning.
Government may anticipate higher costs of running public services and raise taxes
in advance.
Also consumers expecting goods to be more expensive in the future may buy now
rather than delay their spending.
The overall consequences are that the expectation of inflation can induce
inflationary pressures both on the supply and demand side of the economy.

The expectations effect is illustrated in the diagram above.

Anticipated Inflation

If inflation is fully anticipated or foreseen then all individuals and firms in the economy
expect it / foresee it and thus are able to gain full compensation for any consequential
effects.
In this situation, inflation will have no significant effect on the overall wealth of the
economy or on the distribution of income between the various sectors of the economy.
Banks may compensate for anticipated inflation by adjusting nominal interest rates on
savings to ensure that real government returns are not diminished.
Governments may adjust tax thresholds to ensure that there is no fiscal drag effect
resulting from inflation. Fiscal drag refers to the extent to which tax revenues increase
automatically due to a nominal rise in incomes.
Also government may raise level of transfer payments e.g. pensions and unemployment
benefits to ensure that the recipients receive the same real level of income.
In the case of anticipated inflation there will be no inflation or money illusion on the part
of workers and employers. In other words workers do not confuse nominal and real

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wages (the real purchasing power of wages), such that they demand full compensation in
terms of higher nominal wages to offset any anticipated inflation.
Money Illusion - e.g. suppose that your money income and the prices of goods you could buy
were simultaneously doubled. Because your money income has risen you feel richer and now
buy more of luxury goods and less of necessities, you would be said to be suffering from money
illusion, since you have not realised that your real income has remained the same.

Unanticipated Inflation

If the actual rate of inflation is not fully anticipated, then the real level of wages, interest
rates, taxes and transfer payments may be affected.
There are mainly 2 consequences of unanticipated inflation namely redistribution
effects and uncertainty.
Redistribution effects i.e. an arbitrary redistribution of income. There will be gainers and
losers i.e.
a) From lenders to borrowers. With unanticipated inflation the value of debt falls,
borrowers gain. Savers and lenders lose.
b) From those on fixed incomes to those whose income adjusts in line with inflation.
c) From tax payers to government.
Uncertainty unanticipated inflation makes business forward planning more difficult
with respect to future prices, wages, profits etc thus creating uncertainty. Such
uncertainty may in turn discourage investment expenditure by the private sector with
negative consequences for output and long term economic growth.

Consequences of Inflation / Effects of Inflation

1. Effects on the distribution of income
Inflation leads to an arbitrary redistribution of income. Some groups of workers are able to
negotiate larger pay increase because of a strong bargaining position. Others fall behind and their
real income fall e.g. people receiving unemployment benefits and people receiving social
security benefits. With inflation there will be some gainers and losers.
2. Effects on Production
Demand pull inflation results in complacency and inefficiency in a firm. Since the
competitive pressures to improve both the product and performance are greatly
weakened.
With cost push inflation, some firms can no longer absorb some of the higher factor
prices. Hence, firms will try to economise in their production methods and end up
retrenching some workers resulting in an increase in unemployment.

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3. Effects on Balance of Payments (BOP)

For countries which are highly dependent upon a high level of imports or exports
inflation often leads to BOP difficulties.
If other countries are not inflating to the same extent, home produced goods will become
less competitive in foreign markets and foreign goods will become more competitive in
the home market. Exports will decrease and imports will increase. If this process
continues, it leads to BOP deficit on the current account.
4. Effects on Savings
Inflation can lead people to reduce their savings in banks. Why hanging onto money
when its purchasing power is losing value by the day e.g. suppose a savings account
yields 6% interest rate. The 6% interest rate is money earned / nominal. But if inflation
rate goes up to 8%, then the saver is actually losing 2% per year of purchasing power.
The saver is likely to decide to spend money immediately and enjoy its present
purchasing power.
5. Net taxing people who previously did not pay tax
One of the effects of inflation is to net tax some people who previously did not pay income tax
e.g. suppose your first $2000 of income is tax free and income tax is payable at a rate of 25%. If
in Year 1 your income is $2000 you dont pay any tax. By Year 2 prices have risen by 10% and
your income which is now $2200. You now have to pay 25% tax on $200 which reduces your
money income to $2150. $2150 will not purchase as much in Year 2 as $2000 did in Year 1. So
your real income will have fallen.

6. Menu Costs
These are costs associated with having to adjust price lists and labels.
For firms, they would again be the relatively minor costs of having to change the price
labels, or prices in catalogues or on menus or just slot machines and automatic vending
machines.
Terms to Note
Deflation
Deflation is a reduction in the general level of prices Antonym of inflation / opposite
of inflation

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Deflation is a reduction in the level of economic activity in the economy. Deflation

will result in lower levels of national incomes, employment and imports as well as
lower rates of increase of wages and prices.
It may be brought about by monetary policies such as increases in rates of interest and
contraction of money supply, and/or by fiscal policies such as increases in taxation
(direct and indirect) or decreases in government expenditure.
The aims of deflation may be to improve the BOP, partly by reducing aggregate
demand and thus imports and partly by causing disinflation and improving exports.
Deflation is also the adjustment of an economic variable measured in money terms by
a price index (index number) in order to give an estimate of the change of the variable
in real terms.

Stagflation
It is situation in which rapid inflation is accompanied by stagnating or declining output
and employment. It is characteristic of cost push inflation rather than demand pull
inflation.
Companies experience increased costs of raw materials and/or of labour which reduces
their profitability and forces them to raise their own prices and cut investment.
The government is then faced with the dilemma that measures to reduce the rate of
inflation generated in this way may exacerbate unemployment.
Reflation
Macroeconomic policy designed to expand aggregate demand in order to restore full
employment levels of national income.
Typical reflationary measures include expansion the money supply with consequent
reductions in interest rates, increases in government expenditure and reduction in
taxation.
Controlling Inflation / Fighting Inflation / Cures to Inflation
Fighting Demand Pull Inflation
Excess demand is a source of demand pull inflation. Any policy aimed at fighting this
type of inflation must target excess demand.
The Keynesians emphasize fiscal policy i.e. tax changes and government policies to
lower excess demand.
Monetarists emphasize too much money supply as a source of inflation. Hence they
emphasize a stabilised money supply control.
a) Using Fiscal Policy
Aggregate Demand = C + I + G + (X- M)
Any component of aggregate demand can be directly attacked in order to reduce
demand pull inflation.

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Consumption (C) can be reduced by raising indirect taxes. Higher indirect taxes
take money from consumers and reduce their demand or ability to purchase goods
and services.
Investment (I) can be reduced by placing higher corporate taxes on business
profits. This will reduce the amount of money available to businesses for
investment purposes. Investment can also be reduced by increasing interest rates.
This makes it expensive for businesses to borrow money for investment purposes.
Government Expenditure (G) can be reduced by reducing government
expenditure on e.g. public goods, merit goods, highway construction, transfer
payments etc.
Net export i.e Exports Imports (X M) can also be attacked by putting
restrictions on international trade e.g. tariffs, quotas, subsidies, exchange controls
etc. This will reduce imported inflation.

b) Using Monetary Policy

Monetarists propose stabilising and controlling money supply growth rate so that
it matches the rate of growth of the economy prices of goods and services will
not increase.
Monetary policy advocates the use of the following instruments to control money
supply growth:i)
Bank rate/ rediscount rate
ii)
Reserve requirement ratio (RRR)
iii)
Special deposits
iv)
Open Market Operations (OMO)
v)
Moral suasion
vi)
Prime lending rate
vii)
Repo rate
viii) Tight hire purchase facilities
Fighting Cost Push Inflation
a) Wage Price Guidelines
When the government sets up wage price guidelines, it is asking the industry and
labour to stay within set limits in their price and wages policies.
Since the goal is to keep wages and prices from rising too high, the government
will formulate % increases for both labour and businesses for example the
government might determine that 5% increase is a reasonable limit for both wage
and price increases.
Increases can be less than 5%. In order to enforce wage price guidelines, the
government will have to move around and rally to negotiate the acceptable
increases.
b) Wage Price Controls

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The government can implement wage price controls to prevent any wages and
prices rising. The strategy represents a drastic change in economic systems.
When wage price controls are implemented, the market economy ceases to exist.
The economy becomes a command economy.
Examples of wage price controls are maximum, minimum prices and buffer
stocks.

c) Tax Based Income Policies (TIP)

TIP mean using tax as a penalty for raising wages too rapidly or as a reward for
raising wages less rapidly than some target level.
In most cases TIP would affect the employer e.g. suppose its decided through
elected representatives that the acceptable rate of increase in wages and salaries
should be 5%. If businesses give their employees more than 5% wage increase,
corporate tax on their profits will be increased.
If an employer gives his employees less than 5% wage increase, corporate taxes
will be reduced.
Fighting Structuralist Inflation
The only cure for structural and other inflation caused by shortages is time. In the short
run period, people must simply adjust to current reality and new structure.
Eventually the economy will re-gear itself to produce the product that is in short supply.
One possible way of eliminating structuralist inflation is to stockpile raw materials like
oil, uranium, copper and even some agricultural products for reasons of national security
during war / drought.
Indexation
Economists argue that if controlling inflation is not advisable, its adverse effects on
different sections of society can be minimised by a method called indexation.
They suggest that indexation of prices, wages and contractional obligations with a view
to compensating those who lose their real incomes due to inflation.
Indexing is not a mechanism by which wages, prices and contracts are partially or
wholly compensated for changes in the general price level.
Indexation is not a method of controlling inflation. It is a method of adjusting monetary
incomes to as to minimise the undue gains and losses in real incomes of different sections
of the society due to inflation.
The main objective of indexation is to manage social discontent. Its objective is to make
inflation easier to live with.
Indexation of wages is the most important and common practise in many countries where
wage contracts are long term and inflation continues to persist.

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UNEMPLOYMENT
Definition
Unemployment is a situation which exists when members of the labour force wish to
work but cannot obtain a job (i.e. the able bodied people).
Unemployment is a situation where the economically active population fail to find jobs
(i.e. 16-65 years).
Unemployment is the total workforce that is not working at any given time.
Unemployment is the total number of those of working age who are without work, who
are available for work at current wage rates.
Labour force or workforce is the number of people employed plus the number unemployed.
Unemployment rate refers to the % f workforce that is unemployed at any given time.
Unemployment Rate =

x 100

Measuring Unemployment
1. Claimant Count
This includes as unemployed anyone between ages of 18 60 years receiving an
unemployment related benefit such as job-seekers allowance (main official
measure in the UK).
Advantages
a)
b)
c)
d)

Relatively inexpensive to calculate.

Available frequently (normally monthly).
Available quickly.
100% count gives figures for small areas.

Disadvantages
a) Not internationally recognised.
b) Coverage changes whenever administrative system changes, although
recalculation of consistent series allows meaningful comparisons over time.
c) Coverage depends upon administrative rules, may not be suitable for other
purposes.
d) Limited analysis of characteristics of unemployed people.
2. Labour Force Survey

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This uses International Labour Organisations (ILOs) definition of

unemployment which counts as unemployed all those who are actively seeking
and available to start work, whether or not they are claiming unemployment
related benefit.

Advantages
a) Internationally standardised.
b) Usable for inter-country comparisons.
c) Considerable potential for analysis of other labour market characteristics, or of
particular sub-groups.
d) Articulated with data from the same source on employment and the economically
inactive.
Disadvantages
a)
b)
c)
d)

Relatively costly to compile.

Normally less timely.
Subject to sampling and response error.
Not always suitable for small areas due to sampling limitations.

Types and Causes of Unemployment

1. Residual Unemployment
Is made up of people who are virtually unemployable on a permanent basis.
These are people who find it difficult or impossible to cope with the demands of
modern productions methods and the disciplines of organised work.
This may be due to disability.
2. Frictional Unemployment
This arises from immobilities in the labour force.
Labour is not perfectly geographically or occupationally mobile, so people can
remain unemployed despite the fact that there are jobs available either in other
parts of the country, or requiring skills they do not have.
3. Seasonal Unemployment
This occurs in those industries which experience marketed seasonal patterns of
demand.
Industries such as farming, building, tourism etc are affected in this way.
4. Structural Unemployment
This is unemployment which arises from a permanent decline in demand for an
industrys product.

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Much of the fall in demand is as a result of people buying goods from suppliers
elsewhere.
The decline will result in workers employed in that industry being laid off /
retrenched.

5. Technological Unemployment
This arises from introduction of new technology / machinery.
Manufacturers have endlessly found ways of substituting machinery for people in
their production methods and such workers are made redundant e.g. the
introduction of harvesters, computers, industrial sewing machines have led to
many workers being laid off because work will no longer be done manually.
People or workers are being replaced by machinery since machinery do not get
tired i.e. can work 24 hours a day except when being serviced but people get tired.
6. Cyclical Unemployment (Demand Deficiency Unemployment)
It arises due to inadequate demand for goods and services firms will find no
reason to keep on employing workers and hence lay them off to the streets.
7. Search Unemployment
This is a form of frictional unemployment.
It occurs when people who are unemployed do not take the first job on offer but
search for better paid unemployment.
8. Casual Unemployment
This is again a form of frictional unemployment.
There are certain groups of people who are out of work between periods of
employment e.g. singers, actors, footballers etc
9. Disguised Unemployment
A potential addition to the labour force which does not reveal itself unless
opportunities are actually available.
Consequently it does not show up in unemployment statistics e.g. married women
who are full-time housewives.
10. Regional Unemployment
This is linked to structural unemployment.
It arises when declining industry is concentrated in one area.
The region dependent upon the industry may suffer particularly heavy
unemployment because there will be a local multiplier effect arising from the
decline in the income granted by the major industry e.g. the copper belt of
Zambia.

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11. International Unemployment

This arises when workers lose their jobs due to a fall in demand for domestically
produced goods
Stocks and Flows of Unemployment

Unemployment is a stock. It is a measure of the number of people unemployed at

a particular point of time.
However this stock of people is influenced by the flow of people into the stock
and the flow of people leaving the stock.
New people ordering the stock of unemployment will not only be those losing
jobs but previous non-participants in the labour force who are now seeking
employment e.g. students finishing degree courses who cannot find employment.
People who leave the stock may have given up looking for work, may have
retired, may have joined a government scheme or may have entered a higher
education.
Unemployment will rise if the number entering the stock exceeds the number of
new jobs.

Equilibrium Unemployment
Equilibrium unemployment is the unemployment which exists when aggregate demand
for labour (ADL) is equal to aggregate supply of labour (ASL) and vacancies match the
number unemployed.
This is shown in the diagram below:

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ADL = aggregate demand for labour

ASL = aggregate supply of labour
ALK = total labour force
The labour market is in equilibrium at wage rate OW but there is unemployment LLX.
Disequilibrium unemployment occurs when there is disequilibrium in the labour market.
This can be due to the fact that ASL > ADL or ADL >ASL.
Reasons for disequilibrium unemployment are :
a) Trade union power
b) Government set minimum wage rate
c) Growth in labour supply not matched by a rise in aggregate demand for labour.
d) A fall in aggregate demand.

Effects / Consequences of Unemployment

Unemployment has consequences for the unemployed themselves and for the society as a
whole.
Benefits of Unemployment
1. Benefits to those unemployed

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Unemployment gives time to people to explore job opportunities and apply for jobs

(frictional and search unemployment).

Being unemployed may also provide people with more time to pursue their leisure

opportunities.
2. Benefits to the society
Unemployment creates greater flexibility. The economy will be able to expand
relatively quickly and easily if there is a pool of suitably qualified unemployed

workers.
Unemployment also reduces cost push inflation by lowering wage claims, makes
workers more willing to accept new methods of production and more reluctant to take

industrial action.
Note: But however, costs of unemployment exceed any possible benefits.
Costs of Unemployment
1. Costs to the unemployed
People may have more time to pursue leisure activities but they may be

constrained from doing so by lack of income.

Unemployed people also suffer a loss of status as a certain amount of social

stigma is still attached to being unemployed.

Unemployed people are more likely to experience divorce, nervous breakdowns,
bad health and are more likely to attempt suicide than the rest of the adult

population.
Long periods of unemployment reduce the value of human capital i.e. people end

up becoming redundant / useless.

When people are out of work, their skills can become rusty and they miss out on

training in new methods.

The longer the time a person has been out of work, the harder or more difficult

they are likely to find or gain another job.

Unemployed people end up becoming redundant people.
2. Costs to the society
Output is lost due to unemployment. Even if unemployment later falls, the loss of

output can never be regained.

People will enjoy fewer goods and services than they could have consumed with
higher employment. The country will be producing inside the ppf at point X as
shown below.

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Unemployment depresses income and thereby deprives the government of both

direct and indirect tax revenue. While government revenue will fall as
unemployment rises, it will have to increase its spending on unemployment
related benefits.
In recent years, there has been evidence of a link between crime and
unemployment particularly in the case of young unemployed men.
The burden of unemployment is not borne evenly by the society. The young
people from ethnic minorities and those lacking skills are more likely to
experience unemployment.
Unemployment also results in the emergence of corruption because the
unemployed may end up paying bribes to secure employment.

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Unemployment also results in sexual abuse/sexual harassment especially of

women.
Anti-devial practices also emerge e.g. prostitution, robbery, murder etc because
the unemployed will be trying to find a source of income for survival.
Emergence of black markets e.g. doing things at the back door.

Classical Unemployment
Classical economists believe that unemployment occurs when wage rates are too high for firms
to offer sufficient employment to clear the labour market.
Voluntary Unemployment
It is unemployment that results because people choose not to accept the jobs available.
Involuntary unemployment
It occurs when people are actually seeking work but are unable to obtain it.
Solutions to Unemployment / Controlling/ Fighting Unemployment
The Classical Economists
The classical economists believe that unemployment occurs when wage rates are too high
for firms to offer sufficient employment to clear the labour market.
According to this view unemployment can most effectively be reduced by lowering wage
rates.
However lowering wage rates is not easy especially if prices have risen. Those in
employment are unwilling to accept lower wages and many of the unemployed will not
be prepared to take jobs at the lower rate.
The Keynesians
The Keynesians believe that the way to reduce unemployment is to increase aggregate
demand. A government might do this either by reducing taxes and leaving people with
more money to spend on goods and services for consumption, or by increasing
government spending.
This is called demand side economics as it takes the view that the way to solve economic
problems is by managing demand.
New or Neo Classical Economists
They argue that increasing demand will only be successful in reducing unemployment in
the short run period.
In the long run period, it will cause inflation accompanied by a rise in unemployment.
They believe that there is a natural level of unemployment, and barriers exist to prevent
unemployed people from accepting jobs at wage rates necessary to clear the labour
market.

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New classicals consider that unemployment should be tackled form the supply side of
labour, rather than trying to manage demand.
The New Classicals advocated the following policies in order to reduce unemployment.
Increase income thresholds, or reduce rates in the lowest tax band, increase the
level of the minimum wage.
Reduce benefits to the unemployed (Job Seekers Allowance, National Insurance
credits), or ay top-up allowance to those unemployed who accept low paid jobs
(Welfare to Work incentives).
Increase the skills of the unemployed by providing training opportunities both in
full time work and education.

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ECONOMIC GROWTH AND ECONOMIC DEVELOPMENT

Definitions
Economic growth occurs when an economy achieves an increase in income measured by
GNP in excess of its rate of population growth. This will lead to increase in GDP per
capita.
Economic growth is the steady process of increasing productive capacity of the economy
and hence of increasing national income.
Economic growth is any increase in the total output of the economy from one year to
another.
Economic growth is the rate of increase in an economys potential real output (the
volume of output) in the economy over time.
Economic growth can be illustrated by the movement outwards of the ppf. This results in
the supply of more goods and services in the economy.

Development is the process of change and growth which takes place in societies and
countries. Usually development improves the quality of life of the population.

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Development is the process of growth in total per capita income of developing countries,
accompanied by fundamental changes in the structure of their economies.

Causes of Economic Growth / Ways of Promoting Economic Growth

1. Increased skills and education
Education and training are often described as investment in people and people play an
important part in raising the productivity of the labour force. The lack of these facilities
provides a serious barrier to more rapid economic progress in the developing countries.
2. Economies of Scale
Large scale production can raise productivity. There is much more scope for growth
through economies of scale in developing countries than in larger industrialised societies.
3. Investment
For economic growth to take place, there must be net investment i.e. the additions to the
national stock of capital. Increasing the amount of capital per worker is known as capital
deepening and this process should lead to increasing labour productivity. The investment
must be channelled toward sectors such as manufacturing, commercial and agricultural
for economic growth to take place.
4. New Technology
New technology includes such things as new inventions, new techniques of production,
improvements in the design and performance of machinery, better organisation and
management, more efficient factory layouts better training facilities and more efficient
systems of transport and communication. New technology increase the industrys
productive potential leading to economic growth.
5. Reallocation of resources
As economic development takes place, there is a tendency for labour to shift first
from primary production (agriculture, mining etc) to secondary production
(manufacturing) and later to services industries.
Normally output per worker tends to grow rapidly in agriculture and
manufacturing than in the service industry (ies) since it is more difficult for
people such as doctors, teachers and civil servants to raise their productivity. It is
also the case that productivity has tended to rise more rapidly in manufacturing
than in agriculture.
Since the 2nd World War, there has been a substantial movement of labour from
agriculture to manufacturing; there have also been some very high growth rates
recorded.
In the USA and UK, the service sector has tended to grow much faster than other
sectors.
6. Natural Resources
An economy may benefit from the discovery and development of natural resources.
Existence of natural resources offers are important source of economic growth e.g.
discovery of diamonds in Zimbabwe.
Benefits and Costs of Economic Growth

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The Benefits
Generally the standard of living will rise.
People will have more access to goods and services.
Development should lead to more choice not simply in terms of more goods but in
opportunities.
The country becomes independent; its destiny to a greater degree will be in its own
hands. The country ceases to seek for aid e.g. from the IMF, World Bank and other
organisations and NGOs.
With development / economic growth usually comes a whole set of statistics favourable
to peoples well-being e.g. higher life expectancy, better literacy rates, lower child
mortality or IMR, more doctors and nurses per head of population etc. Number of TVs
per 1000 population, number of telephone per 1000 population, teacher/pupil ratio,
doctor/patient ratio.
Economic growth makes it possible to devote more resources to social services without
having to cut private consumption.
The Costs
If economic growth is not planned carefully, then depletion of natural resources is likely
to follow.
Economic growth gives rise to a variety of social costs. Rising incomes make it possible
for more people to own cars but this could lead to problems of pollution and traffic
congestion.
Modern production methods destroy the natural beauty and the ecosystem e.g. modern
methods of agriculture and the installation of oil refineries and generating stations of
power e.g. electricity
The rapid pace of economic change e.g. technical progress makes machines and
production methods obsolete and also make people redundant there will be instability
i.e. booms and slumps in economic activity.
Dual economies can exist within the same country, where one sector thrives whilst
another stagnates due to neglect (e.g. rural vs. urban development).
There can also be social and cultural conflict. Should the country allow the development
of a natural resource such as oil if this means the destruction of a way of life of particular
ethnic groups living in that vicinity?
The benefits of economic growth may not be evenly spread. There are some losers and
gainers.
Economic growth can result in depletion of the ozone layer resulting in global warming
and melting of polar ice.
Preconditions for Economic Growth
1. Human Resources
The quality of human resources can be increased by improvements in education training
and health.
2. Capital Resources
Output per head will increase with capital deepening and with technology.

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3. Natural Resources
Fertile land and favourable climate and good supply of minerals and fuels are obviously
beneficial. However, a number of advanced countries e.g. Israel do not possess good
supply of natural resources.
4. Allocation of Resources
To increase income per head, resources should be moved from low productivity
industries to high productivity industries.
5. Innovation
Economic growth will be stimulated by the adoption of new methods, improved
technology, better communications and advanced management techniques.
6. International trade especially exporting of goods and services. International trade is
considered as an engine for economic growth.
ECONOMIC GROWTH THEORIES
Stages of Economic Growth
There are 5 stages of economic growth which all economies are considered as going through in
their development from fairly poor agricultural societies to highly industrialized mass
consumption economies. These 5 stages were analysed by W.W. Rostow in 1960.
Stage 1 Traditional Society
The economy is dominated by subsistence activity where output is consumed by producers rather
than traded. The trade is carried out by barter where goods are exchanged directly for other
goods. Agriculture is the most important industry and production is labour intensive using only
limited quantities of capital. Resource allocation is determined very much by traditional methods
of production.
Stage 2 Transitional Stage (the preconditions for Take Off)
Increased specialization generates surpluses for trading. There is an emergency of a transport
infrastructure to support trade. As incomes, savings and investment grow, entrepreneurs emerge.
External trade also occurs concentrating on primary products.
Stage 3 Take Off
Industrialization increases with workers switching from the agricultural sector to the
manufacturing sector. Growth is concentrated in a few regions of the country and in one or two
manufacturing industries. The level of investment reaches 10% of GNP. The economic
transitions are accompanied by the evolution of new political and social institutions that support
the industrialization. The growth is self sustaining as investment leads to increasing incomes in
turn generating more savings to finance further investment.
Stage 4 Drive to Maturity

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The economy is diversifying into new areas. Technological innovation is providing a diverse
range of investment opportunities. The economy is producing a wide range of goods and services
and there is less reliance on imports.
Stage 5 Era of High Mass Consumption
The economy is geared towards mass consumption. The consumer durable industries flourish.
The services sector become increasingly dominant.
According to Rostow, development requires substantial investment in capital. For the
economies of developing countries to grow, the right conditions for such, investment
would have to be created. If aid is given or foreign direct investment occurs at stage 3 the
economy needs to have reached stage 2. If stage 2 has been reached, then injections of
investment may lead to rapid growth.
Limitations of Rostows Theory
Many development economists argue that Rostows model was developed with western
cultures in mind and is not applicable to developing countries.
The generalized nature of the theory makes it somewhat limited. It does not set down the
detailed nature of the preconditions for growth.
In reality policy makers are unable to clearly identify the stages as they merge together.
Thus as a predictive model its not very helpful.
Perhaps the main use of the theory is to highlight the need for investment.
Like many other growth models, it is essentially a growth model and does not address the
issue of development in the wider context.
THE HARROD DOMAR GROWTH MODEL
LEWISS DUAL SECTOR MODEL OF DEVELOPMENT (THE THEORY OF TRICKLE
DOWN)
THE DEPENDENCE THEORY
THE CLASSICAL GROWTH THEORY

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ECONOMIC DEVELOPMENT
Economic growth occurs when an economy achieves an increase in income measured by GNP
or GDP in excess of its rate of population growth. This will lead to an increase in GDP per
capita.
Economic development
In its World Development Report in 1991, the World Bank offered the following view of
development:The challenge of development . is to improve the quality of life especially in the worlds poor
countries, a better quality of life generally calls for higher incomes but it involves much more.
It encompasses as ends in themselves better education, higher standards of health and nutrition,
less poverty, a cleaner environment, more quality of opportunity, greater individual freedom and
a richer cultural life
Although the statement acknowledges that economic growth is important, it makes clear
that higher income in itself is not sufficient to ensure that there is a rise in the quality of
life of citizens of a country.
There is a much broader view of development than the one confined to increases in GND.
It is one that provides a focus for those responsible for development policy planning and
moves away from measures designed purely to increase and maintain the economic
growth target.
Todaro states that development must be seen as a multi-dimensional process:Development must represent the whole gamut/ range of change by which an entire social
system, tuned to diverse basic needs and the desire of individuals and social groups within that
system moves away from a condition of life widely perceived as unsatisfactory toward a
situation or condition of life regarded as materially and spiritually better.
According to Todaro and others, the movement to a better life can be analysed and
measured against core values.
1) Sustanance the ability to meet basic needs.
2) Self esteem to be a person.
3) Freedom of servitude to be able to choose
Development is the growth and change in societies and countries. It usually involves some
improvement of peoples lives so that they become better, happier and freer. However some
changes have bad effects and make life worse.
Aspects of development
There are 4 aspects of development which are:1) Economic aspects A country is developed economically when it produces more for
each person and the society gets richer and there are more goods and services being
produced. There is therefore economic growth.
2) Social Aspects A country is developed socially when people have a better standard of
living and their basic needs are more fully met. The basic needs are:-

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a) Food to eat
b) Clean water to drink
c) Shelter for protection
d) Clothes for warmth
e) Basic health
f) Basic education
3) Political aspects a country is developed politically when there is freedom and justice.
People have more control over their lives. They have freedom of movement, association,
speech and people have the right to vote. There is no violation of human rights in terms
of physical and sexual abuse. There are equal opportunities for all i.e people have
political rights.
4) Environmental aspects
A country is said to be developed environmentally if resources on the earths
surface are used and enjoyed by the current generations and also preserved for
future generations.
The resources i.e wildlife, vegetation, minerals, air to breathe, soil etc must not
become extinct in the future.
Future generations must not be jeopardised form seeing present resources eg what
happened to dinosaurs, some wildlife and even vegetation which is now extinct.
The air we breathe must continue to be fresh air even for future generations. There
is currently a lot of emissions of gases into the atmosphere (pollution). The ozone
layer is being destroyed. Polar ice is melting and there are a lot of climatic
changes eg floods etc. There is need to look at sustainable development.
Indicators of comparative development
Classification according to levels of income
Economies are classified according to GNP per capita
There are 3 ways of classifying countries according to GNP per capita which are:1) Low income countries with per capita GDP of $755 or less per annum.
2) Middle Income
a) $756 to $2 995 (lower middle)
b) $2 996b to $9 265 (upper middle)
3. High income $9 266 or above
The income levels are above annual.
The thresholds between the categories are updated each year for international rates of
inflation. As a result the thresholds are constant in real terms over time.
Low and middle income countries are also classified as developing countries.
High income countries are classified as developed countries or advanced countries or
highly industrialized countries.
Classification according to the level of indebtedness
Developing countries can also be classified according to the degree of their
indebtedness.
These categories are:

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1. Severely (or highly) indebted

2. Moderately indebted
3. Less indebted
The categorization depends upon a number of measures of international indebtedness, the
most important of which is devoted to servicing debt.
The fact that such categorization is used is a reflection of the extent to which
international indebtedness is an obstacle to economic development.

Measures of Development
1. IMF classification
a) Industrialized countries
b) Developing countries
c) Transitional economies
2. World Bank and UN Classification
a) High income
b) Middle income
c) Low income
3. UN further classification
a) High human development
b) Medium human development
c) Low human development
Most of these categories are based on income per head measurement.
The UN now sticks to the Human Development Index (HDI).
In 1997, the UN started to publish a new measure i.e. the Human Poverty Index (HPI)
based on people in a country who dont have / reach minimum standards e.g. % of people
without health services adequate supplies of food, shelter and sufficient free time.
Economic Structure
Economic activity can be placed in the following sectors:
1. The Primary sector
2. The Secondary Sector
3. The Tertiary Sector
Developing countries are dependent on the primary sector which account for e.g. 30
60% of GDP.
The tertiary sector / services sector account for a greater % of GDP in developed /
industrialized countries.
As the country develops it moves from primary sector to secondary sector to tertiary
sector.
Characteristics of Developing Countries
1. High birth rates, relatively high death rates and a low life expectancy.
2. Concentration or high dependency on the primary sector compared to the secondary and
tertiary sectors.
3. A poor natural resource endowment.

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4. Underemployment of resources.
5. Social, religious and cultural patterns which often act as a barrier to change and
development.
6. Low levels of investment in human capital.
7. A heavy dependency on a narrow range of export products (usually) primary products.
8. An inadequate industrial and social infrastructure.
9. Low literacy rate and school enrollment.
10. High infant mortality rate.
11. Low GNP per capita.
12. Low energy use.
13. High pupil/teacher ratio.
14. High patient/doctor ratio.
15. A totally inadequate industrial and social infrastructure.
16. Low quality of labour.
Conditions for Development
Human resources.
Capital Resources.
Natural Resources
Allocation of Resources
Innovation
Development Strategies
Increasing primary production
Industrializing through important substitution
Promoting exported growth
Borrowing from abroad
Relying on foreign aid
Population policy i.e. limiting the growth of the population

INTERNATIONAL TRADE
Definition

International trade involves the exchange of goods and services across international
boundaries.
International trade is the exchange of goods and services between one country and
another.

Uniqueness of International Trade

International trade differs from home trade or internal trade in a number of ways:

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There are many restrictions imposed by governments and international organizations on

international trade as opposed to home trade.
Communication may be difficult during the trading process since different countries
speak different languages.
Higher costs may be involved including the possibility of greater transport costs, the need
to translate languages.
Firms may also face differences in technical and legal requirements in overseas markets.
There are also extra costs involved in international trade including wars and families
abroad.
Different units of measurement might be used e.g. kilograms versus pounds, kilometers
versus miles, C versus F etc.
Different exchange rates are used and this is worsened by exchange rate fluctuations.

Why do countries specialise and trade?

Countries specialize and trade because of the benefits of international trade which are:1. To get goods that they cannot produce themselves.
2. To get goods and services which they can produce themselves but can be produced more
cheaply elsewhere.
3. To benefit from economies of scale by mass production because the market is big.
4. To get rid of surplus.
5. T o foster international relations.
6. To earn foreign currency.
7. To achieve economic growth and economic development.
8. Consumers to have a variety of goods and services more choice.
Definition of Terms
Exports
These are goods and services sold to other countries. An export is represented by a flow of
money coming into the country (capital inflow).
Imports
Imports are goods and services bought from other countries. An import is represented by a flow
of money leaving the country and going abroad capital outflow.
Visible trade
It involves trade in goods such as e.g. oil, machinery, groceries, food, chemicals etc. Trade in
goods is called visible trade simply because imports and exports of goods may be seen, touched,
weighed and measured as they pass through the borders or ports.

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Balance of Visible Trade

When a country sells visible exports, it earns money. When it buys imports it pays money.
Therefore the balance of visible trade measures how well a country does overally on visible
trade.
Balance of Visible Trade = Value of visible exports Value of visible imports
if positive favourable
Negative- unfavourable
Invisible Trade
-

Involves the exchange of services i.e. import and export of services such as WABTIC,
tourism, entertainment etc which cant be touched, seen, weighed/measured when they
pass through borders or ports hence the name invisibles.
If a person buys a foreign holiday he is paying for a foreign service which takes money
out of the country and so is an invisible import.
If a buys insurance, he is buying a service which brings money to the country and this is
an invisible export.
How well a country does in invisible trade is measured by the invisible balance.
Invisibles include interests, profits and dividends. A country earns interest on money
saved or loaned abroad, profits from firms owned abroad and dividends on shares held in
foreign companies.
On other hand, a country pays interests and dividends on savings, loans and investments
made by foreigners.
A number of transfers are also made between countries e.g. UK can give aid to
developing countries and also pays contributions to the European Union (EU).
If the Balance of Invisible Trade is positive then the country has a surplus or favourable
BOT.
If the balance is negative, then the country has deficit on the BOT. A deficit means that
the country is losing each year to foreigners i.e. importing more than exporting.
This is said to be unfavourable BOT.

The Mercantilists

During the period 1500 1800, a group of writers appeared in Europe who were
concerned with the process of nation building.
According to the mercantilists, the central question was how a nation could regulate the
domestic and international affairs so as to promote its own interests.
The solution lay in a strong foreign-trade sector.

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If a country could achieve a favourable trade balance (a surplus of exports over imports),
it would realise net payments received from the rest of the world in the form of gold and
silver.
Such revenues would contribute to increased spending and arise in domestic output and
employment.
To promote a favourable trade balance, the mercantilist advocated government regulation
of trade.
Tariffs, quotas and other commercial policing were proposed by mercantilists to minimise
international trade.

The Gains from International Trade

-

In the real world international trade is carried on by a large number of countries in a vast
range of goods and services.
This is a very complex situation but it is possible to gain an understanding of the
principles which underlie this complicated economic structure by using a very simplified
model.

Assumptions
a)
b)
c)
d)

There are two countries, Country A and Country B.

Only 2 commodities are produced i.e. tractors and wool.
There are no barriers to trade and no transport costs.
Resources within each country are easily transferred from one industry to another.

Absolute Advantage Theory by Adam Smith

-

This is the fairly realistic situation where each country is more efficient than the other in
the production of one of the commodities.
Absolute advantage means that given the same amount of resources, Country A can
produce more output compared to Country B.
Country B, we will assume produces wool more efficiently than Country A while Country
A has an absolute advantage in the production of tractors.
Tractors
With x resources 20
Country
A
can
produce (per annum)
With x resources 10
Country
B
can
produce (per annum)

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Wool (bales)
100
50

Country A has an absolute advantage in the production of both commodities i.e. tractors and
wool.
Example
-

Assume that UK and USA both produce 2 commodities i.e. wheat and music centres.
Each country we assume will have 100 workers, half devoted to wheat production and
half to the production of music centres- total output per year for both countries is:

UK
USA
Total
-

Music Centres
50
40
90

Wheat (tonnes)
30
35
65

USA is better than UK at producing wheat. With the same number of workers USA can
produce 5 tonnes more of wheat than UK USA has an absolute advantage over UK in
the production of wheat.
UK has an absolute advantage also in the production of music centres.
If each country specialises or concentrates in the production of one commodity, USA
would concentrate on wheat production only and UK on music centres. The total output
for both countries will rise.

After Specialisation

UK
USA
Total
-

Music Centres produced

by 100 workers (only in
UK)
100
0
100

Wheat (tonnes) produced

by workers (only)
0
70
70

The example assumes that 100 workers can produce twice as much as workers i.e. there
are no diminishing returns to labour.
If UK agrees to trade music centres for 30 tonnes of wheat from USA, each country after
trade is better off.
UK
USA
Total

Music Centres
60
40
100

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Wheat (tonnes)
30
40
70

Each country is better off after compared to the situation before trade.

Comparative Advantage Theory by David Ricardo

-

A country has a comparative advantage over another in the production of a good if it can
produce it at a lower opportunity cost i.e. if it has to forgo less of other goods in order to
produce it.
The Law of Comparative Advantage says trade can benefit all countries if they specialise
in the goods in which they have a comparative advantage.
The principle of comparative advantage says that production of both products will be
increased if each country specialises to some extent in the products in which they have a
comparative cost advantage.
It still benefits countries to specialise and trade even if one does not have an absolute
advantage in the production of a commodity.

Japan
Germany
Total
-

Cars
100
80
180

Televisions
400
160
560

Japan has an absolute advantage in the production of both goods. However in Japan, they
will need to give up 4 televisions to produce one extra car.
In Germany only 2 televisions will have to be given up to produce one extra car.
So Germany has a comparative advantage in car manufacturing while Germany is less
efficient than Japan in producing both goods. It is least efficient in car production.
By specialising in car production, Germany can export cars and import televisions with
their export earnings.
Japan should concentrate n the production of televisions.
Both countries can gain from specialisation and trade.
Opportunity Cost of 1 car in Japan = 4 TVs
Opportunity cost of 1 car in Germany = 2TVs
Therefore Germany produces cars more effectively than Japan. Hence Germany has a
comparative advantage in the production of cars.
Opportunity Cost of 1 TV in Japan =
Opportunity cost of 1TV in Germany =

Cars
Cars

Therefore Japan produces TVs more effectively than Germany. Hence Japan has a
comparative advantage in the production of TVs

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Japan and Germany now specialise, trade and mutually benefit from their comparative
advantages.
Assume that each country has 10x resources and in the absence of international trade
devotes

Cars
Televisions
Japan
500
2000
Germany
300
800
Total
800
2800
If trading possibilities arise, each country will specialise in that industry in which it has a
comparative advantage.

Japan
Germany
Total
-

its resources to each industry.

Cars
200
0
200

Televisions
3200
1600
4800

By partially specialising the more a efficient a country can have more of both
commodities. Thus if Japan devotes 2x resources to cars and 8x resources to TVs while
Germany specialises completely in the production of cars the above situation results.
We now have greater total output of both commodities than that which was obtained
when both countries were producing for only domestic consumption.
The countries i.e. Japan and Germany can now trade and mutually benefit.

Barriers to Trade
-

These are measures taken by countries to control / limit the volume of goods and services
moving between the countries.

Types
1. Tariffs
- A tariff is a tax on the price of imports.
- Tariffs are used to raise the price of imports and make them more expensive compared to
home produced goods in order to stop people from buying them.
- Tariffs encourage retaliation by other countries.
- Tariffs can either be specific or advalorem.
- E.g. of a specific tariff - $100 per unit imported
- E.g. of an advalorem tariff 10% per unit imported
2. Subsidies
- A subsidy is a grant given to an industry by the government so that the industry can lower
its prices.

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3.
4.
5.
6.
7.
8.
9.
-

Subsidies are used to stop consumers from buying foreign imports and making local
goods cheaper.
Subsidies can be applied to domestic goods to prevent foreign competition from
otherwise lower priced imports.
They can also be applied to exports in a process known as dumping.
The goods are dumped at artificially low prices in the foreign market (This, of course is
a means f artificially increasing exports rather than reducing imports).
Quotas
A quota is a physical limit on the number of imports allowed into the country per year. A
quota reduces the quantity of imports without changing prices.
Embargo
An embargo is a complete ban on the imports of certain goods into a country e.g.
stopping imports of dangerous drugs like Heroin, Dagga or Marijuana.
An embargo is also imposed in order to punish a country for political reasons by refusing
to buy its goods and services sanctions.
Foreign Exchange Controls
These include limits on how much foreign exchange can be made available to importers
(financial quotas), or to citizens travelling abroad, or for investment.
Alternatively they may take the form of charges for the purchase of foreign currencies.
Export Taxes
These can be used to increase the price of exports when the country has monopoly power
in their supply.
Import Licensing
The imposition of exchange controls quotas often involves requiring importers to obtain
licenses. This makes it easier for government to enforce its restrictions.
Administrative Barriers
Regulations may be designed to exclude imports e.g. in Germany all lagers not meeting
certain purity standards could be banned.
Taxes may be imposed that favour local products or ingredients.
Procurement Policies
This is where governments favour domestic producers when producers when purchasing
equipment (e.g. defence equipment).

Reasons for Protection

1. To protect infant industries
- Infant industries are newly established. Infant industries normally charge higher prices
than foreign firms.
- They will be unable to sell their goods because they will be more expensive compared to
foreign goods.
- Tariffs or other forms of protection are used to make foreign goods expensive and allow
infant industries to survive.
2. The sterile industry argument

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3.
-

4.
5.
6.
7.
8.
9.
-

This is where industries with a potential comparative advantage have been allowed to run
down and can no longer complete effectively.
They may have considerable potential, but be simply unable to make enough profit to
afford the necessary investment without some temporary protection.
This is one of the most important and powerful arguments used to justify the use of
special protection for the automobile and steel industries in the USA.
To prevent unemployment or to safeguard the interests of workers
Specialisation in producing a certain good or service can result in rising unemployment
for those industries which were producing goods and services but no longer being
produced by the country.
This is because the country has forgone production of some goods and services and is
now producing those goods and services where it has a comparative advantage.
Free trade will always hurt someone.
To prevent dumping
Dumping is when a country sells goods to another country at a price below the average
costs of production.
This may out complete local producers of the country where the goods are being dumped.
Industries will close down resulting in high unemployment.
Dumping may also mean strictly the sale of a commodity on foreign market of a price
below marginal cost.
A country may dump in order to dispose of temporary surpluses in order to avoid a
reduction in home prices and therefore producers income.
Dumping is also practiced in order to dispose poor quality products.
Because other countries are using barriers to trade retaliation
Barriers to trade are used in retaliation to the fact that other countries are using them also.
To prevent overspecialization
Free trade encourages countries to specialise in the production of goods and services in
which they have a comparative advantage.
Specialisation in one or two products can be very dangerous in the modern world as
demand for goods and services always fluctuate.
A fall in demand will result in a fall in export earnings and the country will experience
BOP deficit.
To solve BOP problems
If a country imports more than it exports, this can result in a BOP deficit- restrictions on
trade are used to reduce imports solving BOP problems.
Self sufficiency -To promote a country to be self sufficient rather than to depend on other
countries for the supply of goods and services.
Revenue Purposes
The use of tariffs/customs duties as a means of providing the state with revenue or
increasing foreign currency earnings.
This revenue will be used for development purposes economic growth and economic
development.
Trade is seen as an engine for economic growth and economic development.

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10. Exchange rate management- To stabilize the exchange rate of the country and make it
stronger. Too much or more imports in a country result in a weaker exchange rate.
Restrictions on international trade normally result in a reduction of imports and boost of
exports the exchange rate becomes stronger.
11. For Strategic Reasons
- Some industries such as iron and steel, agriculture, chemicals and scientific instruments
are regarded as strategic industries which are absolutely essential to a nation at war.
- It is regarded as most desirable that such industries should be maintained so as to reduce
a nations dependence on foreign suppliers on strategic materials.
- Where they have not been competitive in world markets these industries have normally
been protected by means of tariffs or quotas.

BALANCE OF PAYMENTS (BOP)

Definition
-

A country engaging in foreign trade will be making payments to foreign countries and
receiving payments from them.
Each nation keeps an account of its transactions with the rest of the world which it
presents in the form of a balance sheet described as the balance of payments.
BOP is a tabulation of the credit and debit transactions of a country with foreign countries
and international institutions drawn up and published in a similar form to the income and
expenditure accounts of companies.
BOP is a record of the countrys transactions with the rest of the world. It deposits in
other countries (debits) and its receipts or deposits from other countries (credits). It also
shows the balance between these debits and credits under various headings.
In an open economy there will be a balance of payments account. This records all the
flows of money between residents of that country and the rest of the world. Receipts of
money from abroad are regarded as credits and are entered into the accounts with a
positive sign.
Outflows of money from the country are regarded as debits and are entered with a
negative sign.
There 3 main parts / components of the BOP:
a) The current account
b) The capital account
c) The financial account
d) The balancing item or net errors and omissions

The Current Account

-

Records payments for imports and exports of goods and services plus incomes flowing
into and out of the country plus net transfers of money into and out of the country.
It is normally divided into 4 subdivisions:
a) The trade in goods account

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This records imports and exports of physical goods (visible trade).

Exports result in an inflow of money and are therefore a credit item.
Imports result in the outflow of money and are therefore a debit item.
The balance of these is called the balance on trade in goods or balance of
visible trade or merchandise balance.
- A surplus is when exports exceed imports.
- A deficit favourable balance of visible trade is when imports exceed exports
and the balance of visible trade is said to be unfavourable.
b) Trade in services account
- This records inputs and exports of services (such as WABTIC, tourism,
entertainment, shipping etc).
- Thus the purchase of a foreign holiday would be a debit since it represents an
outflow of money whereas the purchase by an overseas resident of a UK
insurance policy would be a credit to the UK services account. The
balance is called the services balance.
- The balance of both the goods and services accounts together is known as the
balance of trade (BOT) in goods and services or simply balance of trade.
c) Income Flows
- These consist of wages, interest and profits flowing into and out of the country
e.g. dividends earned by a foreign resident from shares in a UK company
would be an outflow of money (a debit item).
d) Current Transfers of Money
- These include government contributions to and receipts from the EU and
international organizations and international transfers of money by private
individuals and firms.
- Transfers out of the country are debits. Transfers into the country (e.g. money
sent from Greece to a Greek student studying in the UK) would be a credit
item.
The Current Account Balance
-

It is the overall balance of all the above subdivisions.

A current account surplus is where credits exceed debits (i.e. a favourable balance).
A current account deficit is where debits exceed credits (i.e. unfavourable balance).

The Capital Account

-

The capital account records the flow of funds into the country (credits) and out of the
country (debits) associated with the acquisition or disposal of fixed assets (e.g. land), the
transfer of funds by migrants, and the payment of grants by the government for overseas
projects and the receipt of EU money for capital projects (e.g. from the Agricultural
Guidance Fund).

The Financial Account

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The financial account records cross border changes in the holding of shares, property,
bank deposits and loans, government securities etc.
In other words unlike the current account which is concerned with money incomes, the
financial account is concerned with the purchase and sale of assets. The financial account
includes:
a) Investment (Direct and Portfolio)
This account covers primarily long term investment.
i.
Direct Investment
If a foreign company invests money from abroad in one of its
branches or associated companies in the UK, this represents an
inflow of money when the investment is made and is thus a
credit item (any subsequent profit from this investment that
flows abroad will be recorded as an investment income flow on
the current account).
Investment abroad by UK companies represents an outflow of
money when the investment is made. It is thus a debit item.
Direct investment here represents the acquisition or sale of
assets e.g. a factory or farm, not the imports or exports of
equipment.
ii.
Portfolio Investment
This is changes in the holdings of paper assets such as
company shares.
Thus if a UK resident buys shares in an overseas company, this
is an outflow of funds and is hence a debit item.
iii.
Other Financial Flows
These consist primarily of various types of short term monetary
movement between the UK and the rest of the world.
Deposits by overseas residents in banks in the UK and loans to
the UK form abroad are credit items since they represent an
inflow of money.
Deposits by UK residents in overseas banks and loans by UK
banks to overseas residents are debit items.
They represent an outflow of money.
iv.
Flows to and from the reserves
The UK like all other countries holds reserves of gold and
foreign currencies.
Drawing on reserves represents a credit item in the BOP
accounts.
Money drawn from the reserves represents a an inflow to the
BOP (albeit an outflow from the reserves account).
The reserves can thus be used to support a deficit elsewhere in
the BOP.

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 Conversely if there is a surplus elsewhere in the BOP, the Bank

of England can use it to build up reserves.
Building up the reserves counts as a debit item in the BOP
since it represents an outflow from it (to the reserves).
The Balancing Item / Net Errors and Omissions
-

It is impossible to obtain a complete and accurate record of millions of individual

transactions which go to make up the BOP account total credits are not exactly equal to
total debits.
There are numerous errors and omissions which are due to payments not being recorded
and to delays in obtaining information.
It is for this reason that, as more information becomes available, the BOP figures are
subject to the revision in the months following the original publication.
The balancing item represents the total of the errors and omissions. It is the amount
which is required to bring the recorded BOP into balance.
The inclusion of the balancing item makes the sum of the credit and debit items equal to
zero.
A positive balancing item means that there has been unrecorded net inflow of foreign
currency.

Dealing with BOP deficit

Causes of deficits on the current account balance
-

Whilst the overall BOP must balance, sections may be in deficit or in surplus.
Most attention is usually paid to the current account position and particularly to current
account deficits.
A deficit on the current account may arise from high income levels in the home country.
This is because when incomes are high people will usually buy more goods and services.
Some of these will come from abroad, thereby increasing imports and some from
domestic producers, thereby possibly reducing exports.
In addition to increasing the imports of finished manufactured goods, high incomes may
also increase expenditure on imported raw materials as domestic firms expand output to
meet higher home demand.
In contrast it is when income levels abroad are low that a deficit may arise. This is
because overseas countries are likely to import less and to compete more vigorously in
the export market.
An overvalued exchange rate will also lead to problems with exports being relatively
high in price and imports being relatively cheap.
The country may be producing products of low quality, its costs of production may be
higher and it may be producing products in low world demand.

Effects of deficits and surpluses on the current account balance

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The effects will depend on the size and cause and duration of the deficit or surplus.
In the short term a deficit will increase living standards because the country will be
consuming more goods and services than it was producing. If the deficit is not covered by
an inflow of overseas investment, it will have to be financed by drawing on reserves or
by borrowing. Reserves are not finite and it may be difficult to find willing lenders.
In addition borrowing and attracting overseas investment will involve an outflow of
interests, profits and dividends in the future thereby weakening the invisible balance.
A deficit on the current account balance will reduce the money supply if it is not offset by
changes in monetary policy of net transactions in assets and liabilities. It will reduce
inflationary pressure as it involves a net leakage on demand.
In contrast a surplus involves a net injection of extra demand in the economy. It is often
taken to be a sign of economic strength.

Equilibrium in the BOP

- Although the BOP always balances, this does not mean that it is always in equilibrium.
- Common belief is that the BOP situation is satisfactory when it shows a surplus but world
exports and world imports must be identically equal.
- If a nation is in surplus, there must be a corresponding deficit somewhere in the world
because all nations cannot achieve surplus simultaneously.
Measures which the government can put in place to correct a BOP deficit
a) Trade restrictions e.g. tariffs, quotas, embargoes etc.
b) Devaluation of the exchange rate.
c) Export oriented industrialization i.e. promoting industries which produce for export
purposes.
d) Import substitution industrialization. A strategy of restricting imports of manufactured
goods and using the foreign exchange saved to build up domestic substitute industries.
e) Use of subsidies and interest rates.
Or simply speaking 4 major policies can be used:
a) Monetary Policy
b) Fiscal Policy
c) Exchange Rate Policy
d) Supply side policies i.e. government policy that attempts to alter the level of
aggregate supply directly.

EXCHANGE RATES
-

Money used in a country is called the currency of that country

Currency refers to notes and coins that are the current medium of exchange in a
country (Money Supply).

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Currencies are exchanged on the foreign exchange market, but what determines the rate
at which they exchange for one another? It is the forces of supplies and demand which
determine the price of one currency in relation to the other currencies.
- The exchange rate is the price (rate) at which one currency is exchanged for another
currency, for gold or special drawing rights (i.e. the instruments for financing
international trade in the post war period were predominantly the reserve currencies such
as $, and gold).
- The exchange rate is the relationship at which one currency can be exchanged for another
currency. The rate is expressed as the amount of one currency that is necessary to
purchase one unit of another currency (e.g. $1.60 = 1).
Reserve Currency / Reserves / Foreign Reserves
- A currency which governments and international institutions are willing to hold in their
gold and foreign exchange reserves and which finances a significant proportion of
international trade).
- Foreign reserves also refer to the sum, total or basket of foreign currencies held by the
central bank of a country.
Types of Exchange Rates
1. Free, fluctuating or floating exchange rate
- This means the existence of free or competitive foreign exchange market where the price
of one currency in terms of another is determined by the forces of demand and supply
operating without any official interference.
- For example the value of the in terms of the $ would depend upon the demand for s
from holders of $s and the supply of s from holders of the sterling who want to buy $s.
- British residents trying to buy goods and services will be supplying s to the foreign
exchange market (and demanding foreign currencies) while overseas residents wishing to
buy goods and services will be demanding s (and supplying foreign currencies)
- There will be some equilibrium price (i.e. the exchange rate) which equates the two
forces of supply and demand.
- The price of s will be expressed in terms of foreign currencies. These can also be
referred to as free or floating or fluctuating exchange rates.

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Source: Introductory Economics by G.F Stanlake & S.J. Grant

-

The diagram shows the equilibrium price of s in terms of US$.

If the demand for s increases maybe due to improvement in the quality of UK goods and
hence their popularity, its price will rise. This will in turn cause supply to extend as forex
dealers will become more willing to sell the currency at a higher price. The demand curve
will shift to the right.

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Source: Introductory Economics by G.F Stanlake & S.J. Grant

-

Thus the foreign change value of a national currency will be closely related to that:
Countrys balance between Xs and MS.
Capital transactions between that country and the rest of world.
Activities of speculators. Speculators buy and sell foreign currencies with a view
of making capital gain. They buy when the value of a currency is expected to fall
e.g. if the exchange value of the is expected to rise and in fact does rise from say
1 = $1.5 to 1 = $2 then someone who transfers $15 000 into s at a higher rate
will make a profit of $5 000.
These transactions when carried out on a large scale can make a significant
influence on exchange rates.

Advantages of Floating Exchange Rates

-

Floating exchange rates provide kind of automatic mechanism for keeping the BOP in
equilibrium. If a government if confident a floating exchange rate will ensure BOP
equilibrium, it will not have to hold reserves of foreign currency.
A floating exchange rate stops the exchange rate being a target. The government will not
have to introduce measures to protect the value of the currency at a fixed rate which
might threaten other objectives.

Page 112 of 128

Automatic Correction
The government simply lets the exchange rate move freely to the equilibrium. In this way
BOP disequilibria are automatically and instantaneously corrected without the need for
specific government policies policies that under other systems can be mishandled.
No problem of international liquidity and reserves
Since there is no central bank intervention in the foreign exchange market, there is no
need to hold reserves. A currency is automatically convertible at the current market
exchange rate. International trade is thereby financed.
Insulation from external economic events
A country is not tied to possibly unacceptably high world inflation rate, as it is under
fixed exchange rate. It is also to some extent protected against world economic
fluctuations and shocks.
Governments were free to chose their domestic policy
Under a floating rate, a government can choose whatever level of domestic demand it
considers appropriate, and simply leave exchange rate movements to take care of any
BOP effects. This is a major advantage especially when the effectiveness of deflation is
reduced by downward wage and price rigidity, and when competitive deflation between
countries may end up causing a world recession.

Disadvantages of free floating exchange rates

-

Floating exchange rates add a further element of uncertainty on international trading. The
world prices of commodities are far from stable and traders are obliged to accept a high
degree of risk on this account. Costs of production of firms are also affected. Buyers have
2 prices to watch i.e. the foreign price of the commodity and the price of the foreign
currency.
There is a lot of uncertainty and instability associated with floating exchange rates. This
acts as a major deterrent to the growth of world trade and in particular it discourages long
term contracts.
The external prices of home produced goods will be subject to constant change and this
will lead to a very unstable pattern of demand. This makes production planning very
difficult because economic resources are not sufficiently mobile to cope with this type of
situation without imposing some hardship e.g. a much greater uncertainty about
employment prospects.
The depreciation of the currency in the foreign exchange market will make imports
dearer and this could lead to cost push inflation.
A floating exchange rate cannot insulate or protect the home economy from external
forces.

Managed Exchange Rates

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Although market forces are the main determinant of floating exchange rates, there are
times when central banks try to influence the market rate.
Governments do this by adjusting interest rates or by intervening directly in the foreign
exchange market i.e. by reducing or increasing foreign exchange reserves.
If the central bank does not intervene in the market, it is described as clean floating and if
the central bank does not intervene, it is described as dirty floating.
Government attempts to manage the exchange rate in order to smooth out fluctuations
around what is believed to be the equilibrium rate of exchange rate.
Since floating exchange rates can sometimes overshoot due to forces of supply and
demand, they can create some imbalances which can result in exports being halved or
doubled some official intervention in the foreign exchange market may be designed to
offset the overshooting to some extent.
If the country decides to adopt a managed floating system, how could the central bank
prevent the exchange rate from falling? There are two main methods:
a) Using reserves on foreign loans to purchase domestic currency on the foreign
exchange market.
b) Raising interest rates to attract short term financial inflows.

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Above the equilibrium price, there is excess supply of - the central bank in UK will buy
the excess of .
Below the equilibrium there is excess demand for s the central bank will supply s to
meet the excess demand.
If a currency beings to move outside the managed floating band, the country is expected
to take action to bring it into line for instance if the exchange rate is falling near to its
lower limit a country would be expected to buy its currency and if this failed, to raise its
domestic interest rate.

Source: Introductory Economics by G.F. Stanlake & S.J. Grant

-

The diagram above shows how an increase in the supply of the currency, arising for
instance from an increase in demand for imports, would lower the price of the currency
and place it outside the set band.
To avoid this, the government of the country concerned, possibly with the support of
other member governments steps in and buys the currency. This shifts the demand curve
to D1D1 and keeps the value of the exchange rate within the set band.

Fixed Exchange Rates

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In a typical fixed exchange rate system, the countries must fix the values of their
currencies in terms of common standards.
In order to maintain currency at a fixed value, the monetary authorities of a country must
stand ready to buy and sell the currency at a fixed price.
This means that they must have large supplies of their own currency, gold and convertible
currencies i.e. foreign reserves in order to remove any excess demand or supply at the
fixed price.

Source: Introductory Economics by G.F. Stanlake & S.J. Grant

-

We assume that UK authorities have agreed to maintain the fixed exchange rate of 1 =
$2

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Initially the market is in equilibrium at this price. If imports increase and the supply curve
shifts from SS to S1S1. In the absence of any intervention by the authorities the price
would fall to 1 = US$1.5
The authorities however enter the market and buy s raising demand from DD to D 1D1
and maintaining the exchange rate at 1 = $2.
When authorities are intervening to buy the domestic currency, they are of cause
spending the official reserves of foreign currency and gold.
Similarly when the demand for the currency exceeds it supply at the fixed price, the
monetary authorities will be selling home currency on the foreign exchange market and
hence replenishing the reserves of foreign currency.

Advantages of Fixed Exchange Rate

-

It removes the uncertainty associated with the floating exchange rates. The negotiation of
long term contracts, the granting of long term credits, the undertaking of the long term
investment overseas are less risky when there is confidence in the stability of the
exchange rate.
A fixed exchange rate imposes discipline on a country to avoid inflation. This is because
it will not be able to rely on a fall in the exchange rate to regain competitiveness lost
through inflation.
Certainty- with fixed exchange rates, international trade and investment become less
risky, since profits are not affected by movements in the exchange rate.
Little or no speculation- provided the rate is absolutely fixed and people believe that it
will remain so there is no point in speculating.
Automatic correction of errors- if the central bank allows the money supply to expand too
fast, the resulting extra demand and lower interest rates will lead to a BOP deficit. This
will force the central bank to intervene to support the exchange rate. Either it must buy
the domestic currency on the foreign exchange market, thereby causing money supplies
to fall again (unless it sterilises the effect) or it must raise interest rates. Either way this
will have the effect of correcting the error.
Prevents governments from pursuing irresponsible macroeconomic policies- if a
government deliberately and excessively expands aggregate demand perhaps in an
attempt to gain short term popularity with the electorate the resulting balance of
payments deficit will force it to constrain demand again (unless it resorts to import
controls).

Disadvantages of Fixed Exchange Rate

-

The burden of adjusting BOP disequilibrium tends to fall on the economy unlike with a
floating exchange rate where the burden falls on the exchange rate itself. A country with a
persistent deficit would soon exhaust its foreign currency reserves and the monetary
authorities will have to resort to borrowing from say the IMF and World Bank.

Page 117 of 128

If say fiscal measures are used like tariffs and quotas to reduce demand for imports, these
measures are likely to be inflationary as prices will go up.
Higher interest rates may be used to attract short term capital from abroad. This will
improve the BOP but it will also raise home costs and discourage investment.
The New Classical Economists criticise fixed exchange rates on 2 grounds:
Fixed exchange rates make monetary policy ineffective interest rates are pegged
to world levels and thus money supply is infinitely elastic and depends purely on
the demand for money. As a result the central bank cannot control inflation by
attempts to control money supplies.
Fixed exchange rates contradict the objective of having free markets why fix the
exchange rate when a simple depreciation or appreciation can correct
disequilibrium. The exchange rate must be left to adjust due to forces of supply
and demand i.e. the invisible hand must be left to play its role.

The Keynesian View

-

In the Keynesian world, wages and prices are relatively sticky and demand deficient
unemployment and cost push inflation may persist. In this world there is no guarantee
achieving both internal and external balance simultaneously when exchange rates are
fixed. This leads to the following problems:
a) Balance of payments deficits cal lead to a recession.
b) Competitive deflations leading to world depression.
c) Problems of international liquidity.
d) Instability to adjust shocks.
e) Speculation
f) Postscripts

Terms to note
Revaluation versus Devaluation
- Revaluation involves deliberate action by monetary authorities to move the exchange
values of their currencies to higher parities.
- Revaluation makes exports relatively dearer (in terms of foreign currencies) and imports
relatively cheap in term of the home currency.
- Since BOP surplus is widely regarded as a sign of success, surplus countries are usually
reluctant to revalue, but if they do not, they are perpetuating the imbalance of world trade
and in other countries in persistent deficit may be forced to resort to the use of trade
restrictions.
- Devaluation involves deliberate action by monetary authorities to lower the exchange
value of their currencies in terms of other currencies e.g. BWPI = ZAR1.50 to BWPI =
ZAR1.20

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Devaluation makes exports relatively cheaper and imports expensive devaluation

discourages imports and corrects BOP deficits.

Appreciation versus Depreciation of Exchange Rates

- Appreciation is the gain in value of a currency due to forces of supply and demand
without any intervention by the government and monetary authorities of a country e.g. 1
= US$1.5 and after appreciation the exchange rate is 1 = US$2, then the pound () is
said to have appreciated.
- Depreciation is the loss of value of a currency due to forces of supply and demand
without any intervention by the government or any monetary authorities of a country e.g.
before 1 = $1.50 and after depreciation the exchange rate is 1 = $1.2. The is said to
have depreciated.
Effective Exchange Rates
- For any given currency, there is large number of exchange rates. The external value of the
may be expressed in terms of $, , ZAR, BWP etc.
- Effective exchange rates are a way of measuring a currencys external value in terms of
other currencies. E.g. 1 =? US$, 1 =? , 1 =? ZAR, 1 =? BWP.
Purchasing Power Parity Theory
- A theory which states that the exchange rate between one currency and another is in
equilibrium when their domestic purchasing power at that rate of exchange are equivalent
e.g. the rate of exchange 1 = US$1.70 would be in equilibrium if 1 will buy that same
goods in the UK as $1.70 will buy in the US. If this holds true, purchasing power parity
exists.
- The basic mechanism implied by the theory is that, give complete freedom of action, if
$1.70 buys more in the US than 1 does in the UK, it would pay to convert s into $s and
but from the US rather than in the UK. The switch in demand would raise prices in the
US and lower them in the UK and at the same time lower the UK exchange rate until
equilibrium and parity are re-established.
- Purchasing Power Parity (PPP) means equal value of money.
Factors underlying fluctuations in exchange rates
1)
2)
3)
4)
5)
6)

Demand and supply factors.

Activities of speculators.
The balance between exports and imports of a country.
Capital transactions between that country and the rest of the world.
Political shocks/influences
Exogenous shocks e.g droughts, earthquakes, floods etc or simply natural disasters.

The Purchasing Power Parity (PPP)

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The PPP argues that exchange rates will be in equilibrium when people are able to buy
the same basket of products in any country with a given amount of money e.g. if a basket
of goods costs 200 in the UK and $300 in the USA the equilibrium exchange rate
would be 1 = US$1.5

Overvalued Exchange Rate versus Undervalued Exchange Rate

Overvalued Exchange Rate
- It is a situation in which the exchange rate of a country exceeds what the open market is
willing to pay. For example, currency overvaluation may occur when central banks buy
more of a currency that they ordinarily do when other trading is flat.
- Currency overvaluation makes a countrys exports more expensive and may thus be
detrimental to international trade.
Currency Overvaluation
- A currency is considered overvalued if private demand for the currency at the going
exchange rate is less than total private supply (i.e. central banks are buying up the
difference, supporting the value of the currency through foreign exchange intervention).
- A currency is considered overvalued if the currency value exceeds the purchasing power
parity.
Problems of Overvalued Exchange rate
- An overvalued rate implies that a countrys currency is too high for the state of the
economy.
- An overvalued exchange rate means that the countrys exports will be relatively
expensive and imports cheaper.
- An overvalued exchange rate tends to depress domestic demand and encourage spending
on imports.
- An overvalued exchange rate can also be measured by looking at the purchasing power
parity (PPP). An overvalued exchange rate will mean goods are relatively more expensive
in that country (a more sophisticated form of PPP also takes into account difference in
real GDP per capita).
- An overvalued exchange rate is particularly a problem during a period of sluggish
growth. If the economy is booming, an overvalued exchange rate can help reduce
inflationary pressure, but in a recession an overvalued exchange rate can cause
deflationary pressures.
- Governments can deal with overvalued exchange rate in 3 ways.
1. Devalue the currency
2. The country should restrict international transactions
3. The government can buy (or demand) its own currency to make the fundamental
value equal to the official rate.
Undervalued Exchange Rate

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This is when the official rate of the currency is below it fundamental value, the currency
is said to be undervalued.
The government has 3 choices for dealing with an undervalued currency:
1. The government could revalue the currency, increasing the official rate to the
fundamental value.
2. The government could ease restrictions on international transactions.
3. The government can continue to acquire official reserve assets.

Advantages of Undervalued Exchanged Rate

- Exports would be cheaper for other countries to buy; they would want to buy from you,
increasing demand and increasing trade revenue.
Disadvantages of Undervalued Exchange Rate
- Imports would become expensive to buy, the country would have to pay more than usual
for foreign goods, this would be discouraging and the country may look towards buying
cheapest goods. So the quality of goods would suffer just to compensate for price.
E.g. of an undervalued exchange rate is the Chinese Yuan.

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MACROECONOMIC MANAGEMENT
Objectives of Macro-Economic Policy
The objectives of macro-economic policy are:
1. A high level and rapid growth of output.
2. Low unemployment.
3. Stable prices or low inflation
4. Balance of payments equilibrium
5. Equitable distribution of income and wealth.
6. Exchange rate stability
Output
The ultimate objective of economic activity is to provide the goods and services that the
population desires.
The most comprehensive measure of total output in an economy is the Gross Domestic
Product (GDP).
GDP is the measure of market value of all final goods and services e.g. cars, donkey rides
and so on produced in a country during a year.
Potential GDP represents the maximum sustainable level of output that the economy can
produce.
When and economy is operating at its potential, there are high levels of utilisation of the
labour force and capital stock.
When output rises above potential output, price inflation tends to rise, while below
potential level of output leads to high unemployment.
Potential output is determined by the economys productive capacity which depends upon
the inputs available (capital, labour, land etc) and the economys technological efficiency.
High Employment, Low Unemployment
Of all the macroeconomic indicators, employment and unemployment are most directly
felt by individuals.
People want to be able to get high paying jobs without searching or waiting too long and
they want to have job security and good benefits.
In macroeconomic terms, there are the objectives of high unemployment which is
counterpart of low unemployment.
Unemployment Rate
It is the percentage of the labour force that is unemployed.
The labour force includes all employed persons and those unemployed individuals who
are seeking jobs.
It excludes those without work who are not looking for jobs.

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The unemployment rate tends to reflect the state of the business cycle: when output is
falling, the demand for labour falls and the unemployment and the unemployment rate
rises.

Price Stability
The third macroeconomic policy objective is to maintain price stability.
The term means that the overall price level is either unchanged or rising very slowly.
To track prices government statisticians construct price indexes or measures of the overall
price level.
An important example is the consumer price index (CPI) which measures the average
price of goods and services bought by consumers.
Economists measure price stability by looking at the inflation rate of rate of inflation.
The inflation rate is the percentage change in the overall level of prices from one year to
the next.
A deflation occurs when prices decline (which means that the rate of inflation is
negative).
Price stability is important because a smoothly functioning market system requires that
prices accurately and easily convey information about relative scarcities.
The Tools of Macroeconomic Policy
A policy instrument is an economic variable under the control of the government that
can affect one or more of the macroeconomic policy are:
1. Fiscal Policy
2. Monetary Policy
Fiscal Policy
Fiscal policy denotes the use of taxes and government expenditures.
Government expenditures come in two distinct forms.
First there government purchases.
These compromise spending on goods and services purchases of goods and
payments of salaries.
In addition, there are government transfer payments, which boost the incomes of
targeted groups such as the elderly or the unemployed.
The other part of fiscal policy, taxation, affects the overall economy in two ways.
To begin with taxes affect peoples incomes.
By leaving households with more or less disposable or spendable income, taxes tend
to affect the amount people spend on goods and services as well as the amount of
private savings.
Private consumption and saving have important effects on investment and output in
the short run and long run.
In addition taxes affect the prices of goods and factors of production and thereby
affect incentives and behavior.

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There are three major functions of the fiscal policy:

1. Allocation function The allocation function of the fiscal policy in related to
ensuring that there is equitable resources distribution between the public sector and
the private sector.
2. Stabilisation The role of stabilisation as a function of fiscal policy aims at ensuring
that there is stability in employment and price stability.
3. Distribution The distribution role of the fiscal policy aims at ensuring equitable
distribution. It involves transfer from those with plenty to those less privileged. This
has to do with taxation in the manner that income is equitably distributed through
various measures that may be adopted.
Monetary Policy
The second major instrument of macroeconomic policy is monetary policy, which the
government (through its central bank) conducts through managing the nations money,
credit and banking system.
Zimbabwe Macroeconomic History since 1980

Zimbabwe at independence in 1980 inherited a dual economy characterized by a well

developed modern sector and a largely poor rural sector that employed about 80% of the
labour force.
The new government maintained the variety controls used by Smiths regime. These were
done in context of command economy.
The country experienced very high growth rates of 10.7% and 9.7% in 1980 and 1981
respectively.
The government in the 1980s recorded very high achievements in the educational and
health sectors. However these achievements in the social sector did not match with what
was going on in the productive sector. The country was producing over 200 000 school
leavers while the economy was creating less than 35 000 new jobs. There was a
diminishing demand of Zimbabwean exports, a decline in investment and capital
formation, severe shortages of foreign currency. Their combination brought in recession
and the country had no option but to settle for International Monetary Fund (IMF)
initiated Economic Structural Adjustment Programme (ESAP).

Economic Structural Adjustment Programme (ESAP) (1990 - 1995)

The program entailed the following:
1. Economic Liberalisation meant to move away from important substitution strategy
to an open market driven economy.
2. Implementation of Monetary Policy Reform market based interest rates and
liberalisation of the financial sector.

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3. Opening up of one stop investment centre.

4. Commercialisation of the parastatals.
5. Liberalisation of labour market.

ESAP failed miserably and led to a decline in job security in the public sector and
working up of some industries.
The government failed to meet the domestic logic of the reforms. It failed to
implement fiscal stabilisation as a result deficit increased to 8% against the target
of 5%.

Zimbabwe Programme for Economic and Social Transformation (ZIMPREST) (20002005)

The government abandoned ESAP and came up with its own program
ZIMPREST.
It was short-lived due to its failure to have any impact because its donors shunned
it.
ZIMPREST failed in the same way as ESAP due to government fiscal indiscipline
as a result of not compromising macro-economic fundamentals leading to high
inflation, depleted foreign currency reserves, disequilibrium in the Balance Of
Payment (BOP) and declining economic growth.

Crisis Period Era (1997 2008)

The 14th of November 1997 is the day known as Black Friday when the
domestic currency crashed caused by unplanned grant payments to excombatants. In addition Zimbabwe rendered a hand in 1998 by sending troops
in DRC Congo which further increased budget deficit.
As a result GDP declined from 0% in 1998 to -7.4% in 2000 further declining
to -10.4% in 2003. Real GDP growth averages -5.9% was achieved between
the periods 2005 2007.
The period from 2000 saw decline in economic activity due to land reform
programme when production decreased on farm and further effects due to
sanctions imposed on the country. The effects spread to all the sectors.
The period up to 2008 saw increasing quasi fiscal activities by the central
bank which further fuelled the decline of the economy high inflation low
capacity utilisation.
In 2009 government adopted multi-currency regime when it abandoned the
Zimbabwean dollar.

Short Term Emergency Recovery Programme (STERP) I

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On the 15th of September 2008, 3 political parties signed a Global Political

Agreement (GPA).
The inclusive government took office in the context of an economy that had many
challenges high inflation, negative GDP, massive devaluation of currency, low
productivity, loss of jobs, food shortages, poverty, massive de-industrialization
and general despondency.
As part of its obligation to address the economic crisis, government came with
Short Term Emergency Recovery Programme (STERP) which covered period
February to December 2009.
The objectives and key goals of STERP were:
1. Stabilize the macro and micro-economy.
2. Recover the levels of savings.
3. Investment and growth.
4. Lay the basis of a more transformative midterm to long term economic
programme that will turn Zimbabwe into a progressive development state

Key Priority Areas of STERP

a) Political and Governance Issues
i.
Strengthening governance and accountability.
ii.
Promoting governance and rule of law.
iii.
Promoting equality and fairness.
b) Social Protection
i.
Food and humanitarian assistance.
ii.
Education.
iii.
Health.
iv.
Strategically targeted vulnerable sectors.
c) Stabilisation
i.
Implementation of a growth oriented recovery programme.
ii.
Restoring the value of the local currency and guaranteeing its stability.
iii.
Increasing capacity utilisation in all sectors of the economy and hence
creation of jobs.
iv.
Ensuring adequate availability of essential commodities such as food, fuel and
electricity.
v.
Rehabilitation of collapsed social, health and education sectors.
vi.
Ensuring adequate water supply.
STERP was expected to create an economy with the following:
a. Able to sustain itself through food self sufficiency.
b. Weaned off the current price distortions.
c. That creates jobs and employment opportunities.
d. Confers equal opportunities and treatment to all its citizens.
e. That accepts the equality and central role of women and mainstream gender in all
facets of the same.
f. That takes cognizance of the environment and global environment changes.

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g.
h.
i.
j.
k.
l.

With functional infrastructure such as roads, water and telecommunications.

That is people centered and inward looking.
That guarantees freedom of expression and property rights.
That generates confidence and inter-sectored synergies.
That reduces poverty.
That is free of any sanctions and measures and is totally integrated in the region.

Performance of STERP I
Although there have been some achievements of STERP such stabilising the economy
through reduction of inflation and availability of products, the programme failed to
achieve the targets.
The program has not been supported by the donor community hence lacked resources to
implement various programs.
The program had a shortfall in that it was not clear how it was going to achieve its stated
targets.
The fact that the inclusive government came up with another STERP II is itself an
admission of the failure of the program otherwise they wouldnt be STERP II if STERP I
was successful.
Three Year Macroeconomic Policy and Budget Framework 2010 2012
STERP II
1. The Three Year Macroeconomic Policy and Budget Framework for the years 2010-2012
anchors the three year rolling budget formulation.
2. It will attend to the outstanding objective, agenda and commitment of STERP I, also
embracing other growth-oriented stabilisation measures.
3. The Three Year Macro-Economic Policy and Budget Framework also draw from various
sectoral and cluster development strategies.
4. The targets set for the three years and consolidated into comprehensive work programs
over the priorities of government have all been linked to budget process.
5. STERP II will carry out land audit, address the security of tenure, arresting further farm
disruptions and putting in place market based funding arrangements for agriculture,
targeted at achieving agricultural annual growth rates of above 20%.
6. Containing inflation within the single digit levels for the period 2010-2012.
7. Government maintains in principle the use of multiple currencies form 2012-2012.
8. Government will review tax holidays and other business tax incentives and implement an
appropriate corporate tax rate.
9. The implementation of incentives for attracting financial resources outside the banking
system.
10. The financial institutions will be required to inject fresh capital to meet minimum capital
requirement.
11. The establishment of Securities Commission to work on rules and registration, licensing
corporate governance, insides trading mergers and acquisition.

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12. STERP II builds on STERP I efforts to restore the ability of mining houses to begin
realizing adequate revenues to cover production costs and allow for surpluses.
13. Mining activity is therefore projected to grow by 40%, 17% and 15% in 2010, 2011 and
2012 respectively.
14. Formulation of diamond policy to provide further guidelines for exploration.
15. STERP II targets to increase capacity utilisation levels from current levels to 75% by
December 2010 and 100% by December 2011.
16. Government shall enact national trade policy which will focus on exports promotion
integrated with the industrialization development strategy, who focus on attaining a
higher industrial productivity and output.
17. STERP II will prioritise image building, marketing, product re-branding, improving
access to tourist destinations, and investment in tourism infrastructure.
18. The government will enact the SMEs Bill and finalise the review of the SMEs Policy
and strategy framework including the establishment of an SME Observatory Unit and
conclusion of SMEs consensus.
19. Given resource constraints in government and at ZESA, involvement of private players
with capacity t refurbish, lease and operationalise idle thermal power stations will be
instituted.
20. Investment in transport, infrastructure and services across the main modes of transport
road, rail, air inland, water and pipeline will be made.
21. STERP II will focus on three critical health delivery areas relating to human resources,
medicines and medical supplies as well as medical equipment and infrastructure.
Shortcomings of STERP II
1. STERP II ahs shortcoming originating from the period it is to be implemented e.g. 3
years. This should be a period of Medium Term Plan not Short Term Plan.
2. It has overlapping lists of targets with no specific plans and strategies to achieve them.
3. It lacks resources just as STERP I was hence it is likely not to achieve its goals and
targets.
MEDIUM TERM PLAN (MTP)- (2011-2015)

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