LECTURE ONE

Distinction between Microeconomics and

Macroeconomics

Introduction
In this lecture we shall discuss the transition from microeconomics to
macroeconomics. Hence we highlight the differences between micro- and
macroeconomics.

Objective
At the end of this lecture, you should be able to:
1. explain the meaning of microeconomics and macroeconomics; and
2. recognize and make a distinction between the two aspects of
economics.

Pre-Test
1. Define the following concepts:
a. Microeconomics
b. Macroeconomics
2. What are the major differences between micro and
macroeconomics?

CONTENT
In microeconomics, the focus of analysis is the individual. In other words,
microeconomics is concerned with the study of economic behaviours of
the individual agents in the economy. In macroeconomics, however, the
focus shifts to the aggregate. The focal point then becomes the economy

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as whole and not individual parts of it.
In reality, there is a thin dividing line between micro and
macroeconomics. However, it is still possible to show some differences
between the two:
1. Microeconomics offers a detailed treatment of one aspect of the
economic system but ignore its interaction with the rest of the
economy. On the other hand, macroeconomics looks at the
interdependency among all sectors of the economy for policy
analysis.
2. While in microeconomics, we are concerned with optimization
decisions households, and firms, in macroeconomics we are more
concerned with general national issues, such as total employment;
money and banking; aggregate national output; the general price
level; etc.
3. In terms of output, microeconomics deals with total output in each
market, while macroeconomics is interested in the aggregate
output in the economy.
4. Macroeconomics focuses on the growth of the total economy while
microeconomics takes a more disaggregated approach by looking
at changes in output in the individual market.
5. In microeconomics, the study of equilibrium conditions are
analysed at a particular period. But it does not explain the time
element. Therefore, microeconomics is considered as a static
analysis. On the other hand, macroeconomics is based on time
lags, rates of change and past and expected value of the variables.
This rough division between micro and macro economics is not
rigid, for the parts affect the whole and the whole affects the part. Just as
we noted earlier, there is a very strong inter-dependency between micro
and macroeconomics. Presently, the branch of economics called General
Equilibrium Theory seeks to bring together the two aspects of economics.
Interestingly also, because macroeconomics focuses more on the economy
as a whole, it receives greater attention from the people since its subject
matter affects their lives directly or indirectly; for example, high
inflationary rate, unemployment rate, recessions in the economy, balance
of payment problem, etc.

2
Macroeconomic Goals and Performances
There are certain goals which every economy desires to achieve. These
are:
1. high levels of employment and production;
2. stable prices;
3. economic growth; and
4. equity in distribution of income.

1. High Levels of Employment and Production

Gross output in an economy is produced by a combination of labour
and capital, which are employed in the production process. The
output of an economy would be maximised if all its factors of
production are all employed and are also efficiently used.
Unfortunately, this is not always obtainable. Modern economics is
characterized by gross unemployment and underemployment of
factors of production, which therefore keep level of output
permanently below potential or maximum output level. Therefore, it
is one of the goals of macroeconomics to see how available level of
output can be brought close to its potential level by minimising
unemployment and underemployment of the main factors of
production.

2. Stable Prices
Every country seeks to control rapid increases or fluctuations in its
price level. This is because rising or fluctuating prices of goods and
services may keep products out of the hands, of those who would
otherwise be able to obtain them and, in so doing, change the
distribution of the goods and services produced by the firms in the
economy. Periods of rising prices are usually associated with the
period of inflation. Inflation occurs when there is a general increase in
the price level. As we shall see later, inflation produces many
negative effects and only little positive effect on an economy. For
instance, it reduces the purchasing power of those on fixed incomes
like the pensioners. Additionally, inflation may also reduce levels of
savings in the economy, since much money would now be required
by households to make their basic purchases.

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 However, despite the debilitating effects of inflation, many
countries have found it difficult to control the rapid rate of inflation in
their domestic economies.

3. Economic Growth
This is the third macroeconomic goal. Economic growth refers to
increases in the real output level. However, a major limitation of this
growth is that it only recognises changes in output level but neglects
other welfare indicators, like, literacy level, life expectancy level,
leisure, poverty level, etc. In addition, it ignores the ever-increasing
pollution and other social costs that may be associated with increasing
output levels. Despite its limitations, economy growth is still
commonly accepted to reflect welfare level and every country desires
a marked increase in her economy growth rate.

4. Distribution of Income
This is another area which has increasingly crept into the realm of
macroeconomics. It is now a stated macroeconomic objective of
every country to promote equity in distribution of income, which is
associated with increasing rate of economic growth

Dependence of microeconomic theory on macroeconomics

Take for instance, when aggregate demand rises during a period of
prosperity, the demand for individual products also rises. If this increase in
demand is due to a reduction in the rate of interest, the demand for
different types of capital goods will go up. This will lead to an increase in
the demand for the particular types of labour needed for the capital goods
industry. If the supply of such labour is less elastic, its wage rate will rise.
The rise in wage rate is made possible by increase in profits as a
consequence of increased demand for capital goods. Thus, a macro
economic change brings about changes in the values of micro economic
variables- in the demand for particular goods, in the wage rate of
particular industries, in the profits of particular firms and industries, and in
the employment position of different groups of workers.

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Dependence of macroeconomic theory on microeconomics
On the other hand, macroeconomic theory is also dependent on
microeconomic analysis. The total is made up of the parts. National
income is the sum of the incomes of individuals, households, firms and
industries. Total savings, total investment and total consumption are the
result of the savings, investment and consumption decisions of individual
industries, firms, households and persons. The general price level is the
average of all prices of individual groups and services. Similarly, the
output of the economy is the sum of the output of all individual producing
units. Thus, the aggregates and averages that are studied in
macroeconomics are nothing but aggregates and averages of the individual
quantities which are studied in microeconomics.

Why Macroeconomists Sometimes Disagree

Macroeconomics is thus the result of a sustained process of construction,
of an interaction between ideas and events. What macroeconomists believe
today is the result of an evolutionary process in which they have
eliminated those ideas that failed and kept those that appear to explain
reality well.
This does not mean that macroeconomics today is ‘right.” Surely, new
event will lead macroeconomists to question some of their thinking: some
may even lead to radical rethinking. Nor does it imply that the lessons of
history and the interactive process between ideas and events are so strong
that all macroeconomists agree on everything. They disagree on many
issues, although often less so than is commonly perceived. When they
disagree, they do so for two very different reasons.
First, even when they share the same view of the way the economy
works, they often disagree on the weight they assign to different
objectives. Some economists are willing to reduce income inequality even
if some of the means needed to achieve is more important. Some
economists put more weight on fighting high unemployment than on
fighting inflation because they see unemployment as a major social evil.
Others put more weight on fighting inflation, which they see as more
dangerous to society. Often, lines of disagreement run along political
lines. For instance, in the United States, Democrats, and economists with
Democratic leanings, usually care more about income inequality and
unemployment; Republicans, and economists with Republican leanings,

5
usually care more about growth and fighting inflation, which they see as
more dangerous to society. The measures that both groups recommended
differ accordingly. As long as people (and these economists) have
different values, these disagreements will remain.
Second, reality often does not speak strongly enough to make all
economists agree. In contrast to researchers in most other applied sciences,
economists cannot do controlled experiments. For instance, when an
engineer wants to find out how the temperature affects the conductivity, of
a material, he builds an experiment in which he changes the temperature,
making sure that everything else remains the same, and looks at the
change in conductivity. But macroeconomists who want to find out for
example, how changes in the money supply affect aggregate activity
cannot perform such controlled experiments; they cannot make the world
stop while they ask the Central Bank of a country to change the money
supply. Or, can they?
Typically changes in the money supply coincide with myriad other
events, ranging from changes in tax legislation, to strike, to unusual
weather, and so on. Thus, to isolate the effect of the change in the money
supply on output, economists must, when the look at their data, control the
other variables that moved at the same time. This is difficult enough, and
it is because of this difficulty, that different economists looking at the
same episode can reach different conclusions. Looking at the same
episode, one economist can see a strong effect of money on activity, while
another sees a weaker effect.
The availability and the study of more and more episodes, and the use
of better and better techniques to examine the data, narrow such
differences of opinion over time. For example, there is large agreement
about the effects of money on economic activity, if not about the specific
channels through which these effects take place. But disagreements do and
will still remain.

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Summary
In this lecture, we have tried to acquaint you with the difference between
micro and macroeconomics. You were told that while the former is
concerned with economic behaviours of individual agents in the economy,
the latter is more concerned with the totality of the economy and therefore
addresses such national issues, as unemployment, economic growth etc.
Dependence of the two theories; microeconomics and macroeconomics on
each other was also brought to the fore by noting that the total is made up
of the parts. Also, the reasons why economists sometime disagree on
economic issues were given in this lecture.

Post-Test
1. Why do you think people are more concerned with macro more
than microeconomics?
2. State four differences between micro and macroeconomics
3. Explain what you understand by interdependence of
microeconomics and macroeconomics?
4. Explain why economists sometimes disagree on economic issues?

7
LECTURE TWO

National Income Accounting

Introduction
Gross domestic product (GDP) measures the value of output produced by
factors of production in the domestic economy over a period of time,
regardless of those who own these factors. Again, you would notice that
the concept of GDP is a flow. It measures output over a period of time.
For the purposes of computation, we only recognize final goods and
services. This is to avoid the problem of double counting and unnecessary
exaggeration of the value of goods and services produced.
In addition, GDP only takes into cognizance payments earned as a
result of only goods and services produced while payments not made in
respect of produced goods and services are not counted. Such uncounted
payments are known as transfer payments.

Objectives
At the end of this lecture, you should be able to:
1. explain with the basic concepts often used in national income
accounting;
2. explain how to compute national income accounting; and
3. discuss the major limitations of using GNP as a measure of
welfare.

Pre-Test
1. Define national income.
2. Distinguish between real and nominal income.

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 3. What are the major limitations of using GNP for the purpose of
international comparison or well-being?
4. What are the different approaches which can be used to measure
national income?

CONTENT
When GNP is measured at current money value, its value is going to be
affected by the price level. It is possible for the value of GNP to double
between two years, but this does not imply that welfare level has
increased. If the price level also doubles over the two years then the value
of GNP has not changed in the two years. Thus, when GNP is valued at
the current price level, it is referred to as nominal or GNP at current
prices. On the other hand, GNP which has been corrected for changes in
the price level is called GNP at real prices or alternatively as real GNP. It
is the actual measure of changes in welfare level over a given period.

Definitions of Relevant Concepts

1. Gross Domestic Product (GDP): This is the monetary value of all
goods and services produced in an economy, irrespective of the
nationalities of those who produced them, over a given period of
time, usually a year.
2. Gross National Product (GNP): This is the monetary value of
goods and services produced by the nationals of a country whether
resident within or outside the country. It is simply GDP plus
income from abroad (i.e. income earned by nationals of the country
resident abroad minus income of foreigners resident within the
country).
3. Net National Product (NNP): This is GNP minus depreciation. It
is the value of national product after making allowances for the
depreciation of the capital used to produce the output.

Limitations of GNP and NNP

There are certain limitations in the use of GNP and NNP as measures of
economic well-being or for the purpose of international comparison of
well-being. Some of these limitations are:

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 1. Population: GNP and NNP are not very meaningful unless one
knows the size of the population of the country in question. For
instance, a country's GNP may be $50 billion but have a
population of 500 million while another country may have a
$20bllion but with a population of 10 million. Clearly, the second
country, though with a smaller GNP has a higher standard of
living. To make inter-country comparison more meaningful, per
capita income (PCI) - GNP divided by the population - is often
used.
2. Leisure: GNP and NNP do not take into account leisure. Usually,
as people become more affluent, they substitute leisure for
increased production. Yet, this increase in leisure time which
contributes to increased well-being does not show up in GNP and
NNP. Neither do the personal satisfaction (or displeasure) people
get from their jobs.
3. Quality Changes: GNP and NNP do not take into account changes
in the quality of goods, unless its price reflects the improvement.
For example, for a brand new type of drug, if the output and cost of
the new drug is the same as the old drug, GNP will not increase,
even though the new drug is twice as effective as the old one.
4. Value and Distribution: Both GNP and NNP say nothing about
the social desirability of the composition and distribution of the
nation's output. Each good and service produced is valued at its
price. If the price of a bible is N100 and that of a pornographic
book is N100, both are valued at N100.00 each and entered into
GNP computation without revealing their relative importance. The
two measures do not reveal how the goods and services produced
are distributed in the society. Are they evenly distributed? Or
distributed in favour of the rich? GNP is silent on these questions.
5. Social Cost: GNP and NNP do not reflect some of the social cost,
arising from the production of goods and services. In particular,
they do not reflect environmental cost of production activities.

Measurement of GNP
There are three basic approaches to measuring GNP.
There are:
1. The Expenditure Approach

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 2. The Income Approach
3. The Output Approach.

We shall examine the above approaches serially.

1. The Expenditure Approach

This involves adding together all the expenditure on final goods and
services. Economists distinguish among four categories of
expenditure:
a. Personal Consumption Expenditure: These include the spending
by households on durable goods, non-durable goods and services.
Personal consumption expenditure usually accounts for the greatest
proportion of total expenditure.
b. Gross Private Domestic Investment: These consist of all
investment spending by firms in the economy. Three broad types
of expenditures are included in this category.
i. all final purchases of tools, equipment and machinery;
ii. all construction expenditures including expenditure on
residential houses; and
iii. the change in total inventories.
c. Government Purchases of Goods and Services: This includes the
expenditures of the Federal, State and Local Governments in the
performance of their functions. However, it excludes transfer
payments, since they do not arise from production processes.
d. Net Exports: This is simply the difference between the country's
exports and her imports.
Thus, GNP using the expenditure approach can be summarised as:
GNP = Personal Consumption Expenditure + Gross Private
Domestic Investment + Government Purchases of Goods
and Services + Net exports.

2. The Income Approach

To use this approach, we simply sum up all the incomes earned by
factors of production - labour, capital, land and entrepreneur, for their
contribution to production of the year's output. This income is of

11
 various types, they are:
a. Compensation of Employees: This is the largest of the income
categories. It includes the wages and salaries that are paid by firms
and government agencies to supplier of labour. In addition, it
comprises a variety of supplementary payments by employers for
the benefit of their employees, such as payments into public and
private pension schemes and welfare funds.
b. Rents: In the present context, rent is defined as payment to
households for the supply of property resources. For example, it
includes house rents received by landlords.
c. Interest: This includes payment of money by enterprises to
suppliers of money capital .Interest paid by the government on
treasury bill, savings, bonds and other securities are excluded on
the grounds that they are not payments for current goods and
services. They are regarded as transfer payments.
d. Proprietors' Income: This consists of net income of
unincorporated businesses. In other words, it consists of the net
income of proprietorships and partnerships.
e. Corporate Profits: This is the net income of corporations. This is
made of three parts:
i. dividends received by stockholders;
ii. retained earnings; and
iii. the amount paid by corporation as income taxes.

All the items discussed above are forms of income. In addition, there
are two non-income items, depreciation and indirect business taxes, that
must be added to the sum of the income items to obtain GNP.
On the basis of the above discussion, GNP via the income approach
can be summarized as:
GNP = Compensation of Employees + Rent + Interest +
Proprietors' Income + Corporate profits + Depreciation +
indirect Business Taxes.

3. The Output (or Value-Added)

This is simply the monetary value of all the value-added to every
sector in the economy. In other words, it is the monetary value of the

12
 contributions of all the output of goods and services by various
sectors, in the economy. It should be noted that the emphasis is on
value-added. Value-added is the amount of value added by a firm or
industry to the total worth of the product.

National Income, Personal Income and Disposable Income

Besides, GNP and NNP, other important national accounting concepts
include national income, personal income and disposable income.

National Income
This is the total amount paid to factors of production - land, labour, capital
and entrepreneur. It is derived from GNP by subtracting from the latter
indirect business taxes and depreciation.

Personal Income
This is the total amount an average individual receives as income. It
differs from national income in two ways. First, some people who have a
claim on income do not actually receive it. For example, although all the
profit of a form belongs to the owners, not all of this is eventually paid out
to them. Second, some people receive income that is not obtained in
exchange for services rendered.
To reconcile personal income and national income, you subtract
corporate profits from national income, and add dividends to the result.
Then you must deduct contributions for social insurance and add
government and business transfer payments.

Disposable Income
This is simply the take home pay of workers. It means the actual income
which can be spent on consumption of individuals and families. The whole
of the personal cannot be spent on consumption, because it is the incomes
that accrue before direct taxes have actually being paid. Therefore, in
order to obtain the disposable income, direct taxes are deducted from
personal income. Thus Disposable income = personal income – direct
taxes

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Nominal and Real GDP
Nominal GDP: This is simply the sum of the quantities of final goods
produced times their current price. A warning is in order here. People
often use the word nominal to denote small amounts. Economists use
nominal for variables expressed in units of the currency of the relevant
country.
Nominal GDP increases over time for two reasons. The first is that the
production of most goods increases over time. The second is that the naira
price of most goods also increases over time. We produce more and more
goods each year, and their naira price increases each year as well. If our
intention is to measure production and its change over time, we need to
eliminate the effect of increasing prices. For this purpose, economists
focus on real rather than nominal GDP.
To construct real GDP, we first choose a base year; we then construct
real GDP in any year as the sum of quantities produced times their price in
the base year. An example will help here. Suppose that an economy
produces two goods, potatoes and cars. In year 0- which we shall take as
the base year – it produces 100,000 pounds of potatoes and sells them at
N100 a pound, and 10 cars that sell for N400, 000 a car. One year later, in
year one, it produces and sells 100, 000 pounds of potatoes at a price of
N120 a pound, and 11 cars at N400, 000 a car. Nominal GDP in year 0
(base year) is thus equal to N5, 000,000 and nominal GDP in year 1 equal
to N230, 000. This information is summarized in table 3.1:
Table 3.1. Nominal GDP in Year 0 and in Year 1.

Year 0
Quantity N Price N Value
Potatoes 100,000 X 100 = 10,000,000
Cars 10 X 400, 000 = 4,000,000
Nominal GDP 14,000,000
Year 1
Quantity N Price N Value
Potatoes 100,000 X 120 12,000,000
Cars 11 X 400,000 4,400,000
Nominal GDP 16,400,000

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 The increase in nominal GDP from year 0 to year 1 is equal to N2,
400,000/N14, 000,000 = 17 per cent. But what is the increase in real
GDP? Let us take year 0 as the base year – that is, let’s add quantities in
both year 0 and 1 using year 0 prices for potatoes and cars. Because we
take year 0 as the base year, real GDP is equal to nominal GDP in year;
real and nominal GDP are always equal in the base year. In year 1, real
GDP is constructed to using year 1 quantities and year 0 prices, so that it is
equal to (100,000 x N100) + (11 x N400, 000) = 14,400,000. The increase
in real GDP is the equal to N400, 000/N14, 000,000 or 2.86 per cent.
Instead of using year 0 as the base year, we could have used year 1, or
indeed any other year. The choice of the base year will typically affect the
measure of real GDP growth. For example, if we had used year 1 as the
base year, real GDP in year 0 would be equal to (100,000 x N120) + (10 x
N400, 000) = N16, 000,000. By construction, real and nominal GDP
would be the same in year 1, both equal to N16, 400,000. The increase in
real GDP would be equal to N400, 000/ N16, 000,000, thus 2.5 percent. It
would thus be smaller than the increase in real GDP we obtained using
year 0 as the base year.

Summary
You have been taken through the main concepts commonly applied in na-
tional income accounting. National income is simply the total income
earned by all the factors of production over a given period of time, usually
a year. There are three basic approaches to measuring GNP. These include
the expenditure approach, the income approach and the output approach.
You were further told that these three approaches would give the same
value for national income after making appropriate adjustments. The
concepts of personnel income and disposable income were clearly
explained. Furthermore, real and nominal GDP were explained and
constructed in a tabular form, while simple calculations were
demonstrated.

Post-Test
1. What is National Income?
2. Distinguish between GNP at current prices and GNP at constant
prices.

15
3. Discuss the three approaches of measuring the national income of a
state.
4. What is the relationship between national income, personal income
and disposable income?
5. Explain the following concepts:
a. GNP
b. NNP
c. Personal Income (PI)
d. Per capita income (PCI)
e. Real GDP and Nominal GDP

16
LECTURE THREE

The Determination of National Income

Introduction
In the previous lecture, you were introduced to the concept of national
income. In most countries today an examination of their GNP for various
years will show the fluctuations which take place in these countries. A
period of rising GNP followed by another period of declining GNP and so
on; however, these fluctuations, cause serious strains on the economy.
In this lecture, we want to explain why national income fluctuates. In
addition, we want to show how it is determined in various types of
economics.

Objectives
At the end of this lecture, you should be able to:
1. explain what the circular flow of income means;
2. explain the equilibrium conditions of a closed economy; and
3. define the concepts of injection and withdrawal.

Pre-Test
1. Draw the circular flow of Income.
2. Describe the equilibrium conditions of a closed economy.
3. Suppose the consumption function is C = 0.8Y and planned
investment is N45m.
a. Draw a diagram showing the aggregate demand schedule.
b. If actual output is 120, what will be the level of unplanned
investment?
4. Define what is meant by equilibrium output.

17
CONTENT
The Circular Flow of Income
The circular flow of income shows the transaction between the agents in
the economy. For instance, in a closed economy if we assume there are
two economic agents, i.e. the household and the firms, the circular flow of
income in that economy can be depicted as follows:

Fig. 4.1: Circular Row of Income in a Two Sector Closed Economy.

The Circular Flow of Income

In the above economy, firms purchase factors of production from the
households and for these they pay incomes to the households. This first
part of the relationship is depicted by the inner flows in the figure above.
On its own part, the households buy goods and services from the firms and
for these they make payments to the firms. Since we assume that there is
no leakage in the economy, then all sides of the transactions must be
equal. This means that the income earned by households must be equal to
the value of output produced by the firms.

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 Fig 4.2 Circular flow of income with injections and leakages

However, if we introduce leakages and injections into our circular

flow of income via savings and investment, then the circular flow in
income would be altered as illustrated in Fig. 4.2
In the economy illustrated by the Fig. 4.2, we assume that households
do not spend all their income on current consumption of goods and
services but save part of it. The amount saved then constitutes a leakage
from the system. On the other side, firms do not sell all their output to
households, some are investment goods. This represents an injection into
the circular flow. An injection is an addition to the income of domestic
firms which does not arise from expenditure of the households or an
addition to the income of households that does not arise from the sale of
factor services to the firms.

Components of Aggregate Demand

In a closed economy and in the absence of government, there are two
sources of demand. There are:
a. Consumption demand, and
b. Investment demand.
This can be represented as
AD = C + I

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 Where AD is aggregate demand; C is consumption demand; and I is
investment
1. Consumption demand: This is the total amount of money spent
by households on goods and services consumed in the economy.
Such goods and services ranges from cars and foods to theatre
performances and electricity. This consumption purchases account
for the highest proportion of aggregate demand.
2. Investment demand: This consists of firms, desired or planned
additions to boost their physical capital (factories and machines)
and to their inventories. Inventories are goods being held for future
production or sale.

Aggregate demand can be illustrated by the following diagram.

Fig. 4.3: Aggregate demand curve in the absence of government and

external sectors.

CASE A: Equilibrium National Income in a Closed Economy (without

the Government)
Earlier on in this lecture, we introduced injections in form of investment
and withdrawal via saving into circular flow of income in a closed
economy. The two are however carried out by different agents in the
economy. However, in such an economy, equilibrium national income
occurs where savings equal investment, that is, withdrawal equals
injection. When savings exceed investment, income falls, this will lead to

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a reduction in households saving and this will continue until the two are
equal. The opposite holds when investment exceeds savings.
The equality between savings and investment could be demonstrated
either statistically or graphically.
Statistically, national income Y is equal to consumption expenditure C,
plus investment expenditure I.
i.e. Y = C + I ………………. (1)
From (1) I = Y – C ………………. (2)

But, we know that income minus consumption is equal to savings;

therefore, equation (2) can be written as
I = S ………………......... (3)
Geometrically, this equality can also be shown as follows:

Fig 4.4 Equilibrium output level at which planned investment equals

planned savings

In the figure above, savings and investments are equal when

investment is N20m. The equilibrium national income at this point is
N100m. The investment curve is a horizontal line because we assume it is
exogenously determined, that is, fixed irrespective of the level of national
income.

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 On the other hand, the savings function is an upward straight line
because we assume savings to be a fixed proportion of a given level of
national income.

The income – Expenditure Approach: This is another graphical method

for showing the equilibrium level of national income. This is illustrated
below:

Fig 4.5 Determination of national Income via the Income-expenditure

approach

The 45° line shows the equality between actual expenditure and actual
income. Points above or below the line shows a combination for which
expenditure exceeds income or expenditure is less than income
respectively. In this figure, the equilibrium level of income is determined
at the point of interaction of the aggregate expenditure function and the
45° line. At this point, the aggregate demand will just be sufficient to buy
up the total of all goods produced. Any other point leads to disequilibrium.

Case B: Equilibrium National Income in a closed economy but with

the presence of the Government
At this juncture, we recognize the presence of the third economic agent,
the government in our analysis. The introduction of the government into
the economy brings into our analysis another type of withdrawal variable
(i.e. taxes) and injection variable (i.e. government expenditure).
The introduction of these variables, however, did not alter the basic
conditions for equilibrium in the economy. The equilibrium conditions
still require the equality of total withdrawals and total injections. Thus, the
equilibrium condition in this economy can be statistically stated as:

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 Injection (I) = Withdrawal (W)
Or I + G = S + T
Where I = Investment expenditure
G = Government expenditure
S = Savings
T = Taxes
The Income-expenditure Approach: In this economy, we now alter the
component of our aggregate demand by now including government
expenditure; thus, AD = C + I + G.
National income will be in equilibrium if aggregate desired
expenditure is equal to national income because in that case, desired
purchase will be exactly equal to total production.

CASE C: Equilibrium National Income in the Open Economy.

We now relax our assumption of a closed economy by allowing for the
influence of foreign trade, that is, imports and exports. The introduction of
imports and exports introduces additional variables into our analysis. We
now have new form of withdrawal, i.e. Imports and another new injection
which is exports. Import constitutes a withdrawal because money spent on
import goes out of the economy and hence constitutes a leakage to the
system. On the other hand, export constitutes an injection into the
economy from the sale of exports.

1. Equilibrium in terms of Withdrawal and Injections

Again, we assume that like other previous injections, export (x) is
fixed, while import like other withdrawals, is allowed to change
proportionally with income. The resulting equilibrium is shown below

Fig. 4.6 Equilibrium in terms of withdrawal and injections

23
 If withdrawals are less than injections, there will be a net
expansionary force in the economy; income will rise. This will also make
tax, savings and imports rise. The expansion will come to a halt when total
withdrawals have risen to the level of total injections and vice versa.
National income will be in equilibrium when total desired
withdrawals equal total
desired injections. Thus, the equilibrium condition is, once again, W = I.
That is,
S + T + M = I + G + X.

2. The Income-Expenditure Approach in an Open Economy

In the open economy, aggregate expenditure includes expenditure by
foreign firms, households and governments on domestically produced
goods and services. This implies that aggregate expenditure includes
export values. At the same time, some consumption expenditure made
by domestic households, firms, and some government expenditure
may go to purchase goods and services produced in foreign countries.
Hence, import values must be excluded from aggregate expenditure.
Thus, we have
AD = C + I + G + (X - M)
Once again, national income will be in the equilibrium when
aggregate desired expenditure is equal to national income. When this
is true, total desired purchases will just be equal to total production.

Fig 4.7 Equilibrium nation income through the Income- expenditure

approach

24
Summary
In the course of this lecture, you have been taught how equilibrium levels
of national income are determined in different economic systems. You
have also been told that the equilibrium conditions in all these different
economic systems are basically the same. These equilibrium conditions
require that; the total withdrawals in the economy must be equal to the
total injections into the economy, and that geometrically, the equilibrium
level of income is determined at the point at which aggregate expenditure
function intersects the 45 line.

Post-Test
1. Construct the circular flow of Income for an open economy,
showing the various withdrawals and injections into the economy.
2. Discuss the equilibrium condition for an open economy.
3. Suppose the consumption function of an open economy is
C = 8 + 0.2Y
a. What is the corresponding savings function?
b. What should be the planned level of investment that will
guarantee equilibrium in the economy?
4. Define the following concepts:
a. injections;
b. withdrawals; and
c. equilibrium output.

25
LECTURE FOUR

The Consumption Function

Introduction
In this lecture, we shall examine one of the most important components of
aggregate expenditure-the consumption function. The shape of this
function is very important for analyzing the impact of government policies
on the economy.
Hence, we shall discuss the important theories of consumption and
also the various factors that affect the consumption function.

Objectives
At the end of this lecture, you should be able to:
1. explain why consumption function is very important in macro-
economics;
2. discuss the three important theories of the consumption function;
and
3. highlight the factors which influence the shape of the consumption
function.

Pre-Test
1. Why is the consumption function very important for policy
planning?
2. Discuss the factors that affect the consumption function.
3. What are the major features of Keynesian theory of the
consumption function?
4. Distinguish between two consumption theories you know.

26
CONTENT
Consumption (c)
The main determinant of consumption is surely income, or more precisely
disposable income, the income that remains once consumers have received
transfers from the government and paid their taxes. When their disposable
income goes up, people buy more goods; when it goes down, they buy
fewer goods. These are other variations that affect consumption; for the
moment, we shall ignore them.
Let C denote consumption and YD denote disposable income. We can
write
C = c(YD)
(+)

This is just a formal way of stating that consumption is a function of

disposable income. The function C(YD) is called the consumption
function. The positive sign below YD means a positive relation between
disposable income and consumptions; It captures the fact that when
disposable income increase, so does consumption. Economists call such an
equation a behavioural equation, to indicate that the equation captures
some aspect of behaviour-in this case, the behaviour of consumers.
It is often useful to be more specific about the form of the function-for
example, to assume that the function is linear. Here is such a case. It is
reasonable to assume that the relation between consumption and
disposable income is given by:
C = co + c1YD
We are assuming now that the function is a linear relation: it is
characterized by two parameters, C o and C1. Let’s look at each in turn. The
parameter C1 is called the marginal propensity to consume. It gives the
effect on consumption of an additional naira of disposable income. If C 1 is
equal to 0.7, then an additional naira of disposable income increases
consumption by N1 x 0.7 = 70 percent. A natural restriction on C 1 is that it
be positive: An increase in disposable income is likely to lead to an
increase in consumption. Another natural restriction is that C 1 be less than
1: people are likely to consume only part of any increase in income, and to
save the rest.
The parameter Co has a simple interpretation. It is what people would
consume if their disposable income in the current year were equal to zero.

27
A natural restriction is that if current income is equal to zero, consumption
is still positive. This implies that C o is positive. How can people have
positive consumption if their income is equal to zero? This is made
possible either by dissaving, borrowing or both. This means that a
consumer can either lean back on what he had saved before or actually go
on borrowing.

Theories of Consumption Function

1. The Keynesian Theory
The basic hypothesis of the Keynesian theory of the consumption
function is that current consumption is related to current income.
Algebraically, this implies that:
C = f(Y)
Where: C is current consumption and Y is current income.
However, more appropriately, the Y in the function is supposed to be
Yd, that is, disposable income.
To fully expose his hypothesis, Keynes introduced two other
concepts: the average and the marginal propensity to consume. Average
propensity to consume (APC) is the proportion of income spent on
consumption. In other words, it is the ratio of consumption expenditure to
total income i.e. APC = C/Y. Marginal propensity to consume (MPC), on
the other hand, measures the relation between changes in consumption,
ΔC and changes in income, ΔY. It is the ratio of ΔC to ΔY (i.e. MPC =
ΔC/ΔY).
Two basic hypotheses provide the core of the Keynesian theory of the
consumption function:
1. There is a break-even level of income at which APC = 1. Below
this level, APC is greater than unity and above it APC is less than
unity.
2. The MPC is greater than zero but less than unity for all levels of
income (see the figures below).

Factors Influencing Consumption

Empirical studies suggest that many factors influence consumption. The
first and arguably the most important factor is the disposable income of
the people. The figures below show the positive relationship between the

28
two variables:

Fig. 5.1: Two possible stages for a consumption function:

1. The MPC is constant but the APC declines:
2. Both the APC and MPC decline as disposable income increases.

The above relationship between consumption and disposable income

assumes other factors affecting consumption are constant. Some other
factors would however, cause a shift in the consumption function. These
factors are the following:
1. Changes in income Distribution: If households have different
MPC, aggregate consumption depends not on aggregate income
but also on the distribution of this income among households.
Changes in the distribution of income will cause a change in the
aggregate level of consumption expenditure associated with any
given level of national income.
2. Changes in the Terms of Credit: Many durable consumer goods
are purchased on credit. If credit becomes more difficult or more
costly to obtain, many households may postpone their planned
credit-financed purchases. There would then be a temporary
reduction in current consumption expenditure until the necessary
extra savings are accumulated.
Monetary authority can by controlling the cost and availability of
credit shifts the consumption function and thus affects aggregate
demand.
3. Changes in Existing Stock of Durable Goods: It is now
recognized that any period in which durables are difficult or
impossible to purchase and monetary savings are accumulated, it is

29
 likely to be followed by a sudden outburst of expenditure on
durables. Therefore, this will shift upwards the consumption
function.
4. Changes in Price Expectation: If households expect inflation to
occur, they would be willing to purchase durable goods, which
they would otherwise not have bought for another one or two
years. In such circumstances, purchases made now yield savings
over purchases in the future.
5. Government Policy: Changes in government policies can also
affect the relation between national income and disposable income;
for example, by altering tax rates. An increase in income tax rate
will, for example, reduce the amount of disposable income that
reaches the hands of the households out of any level of national
income. This will therefore make the consumption function curve
to shift downwards.

Theories of the Consumption Function

The Keynesian theory as enunciated above relates current consumption to
current income. However, empirical studies carried out by researchers
have not supported this theory. This has led to several modifications of the
hypothesis as discussed below.

1. The Permanent Income Hypothesis (PIH) This theory was

developed by Professor Milton Friedman. The hypothesis makes two
important assumptions. First, people's income fluctuates; second,
people dislike fluctuating consumption. Thus, people will always try
to minimize the effect of fluctuation in income on their consumption.
Friedman believes that people's consumption is influenced by their
permanent income, rather than current income as argued by Keynes.
Thus, during period of temporary increase in their income, households
do not increase their consumption by the same proportion. This is
because they perceive such increment as temporary. Therefore, they
will save most of this temporary extra income and put money aside to
see them through the year when income is usually low. People will
only increase their level of consumption if their permanent income
has significantly increased

30
2. The Life-Cycle Hypothesis (LCH) This was jointly developed by
Professors Franco Modigliani and Albert Ando. The theory is very
similar to the PIH. The theory assumes that people have a clear
conception about what their income will be over their lifetime and on
that basis form a lifetime consumption plan.
Just like the permanent income hypothesis, the life cycle
hypothesis suggests that it is average long run income rather than
current income that is likely to determine the total demand for
consumer spending.
The LCH is illustrated by the diagram below

Fig. 5.2: Consumption and the Life Cycle

Fig. 5.2 shows a household actual income over its lifetime. OF is the
household's permanent income. OF is also the maximum amount that the
household could spend on consumption each year without accumulating
debts that are passed on to future generation. If the interest rates were
zero, permanent income would just be the sum of all expected income
divided by the number of expected years of life or simply put average
income over one's life span.

3. The Absolute Income Hypothesis (AIH) Keynes’ consumption

income relationship is known as the absolute income hypothesis,
which states that when income increases consumption also increases,
but by less than the increase in income, and vice versa. This means
that the consumption income relationship is non proportional. James
Tobin and Arthur Smithies tested this hypothesis in separate studies
and came to the conclusion that the short run relationship between

31
 consumption and income is not proportional, but the time series data
show the long run relationship to be proportional. The latter
consumption income behaviour results through an upward shift or
“drift” in the short run non proportional consumption function due to
factors other than income.

4. The Relative Income Hypothesis (RIH) -This theory was developed

by James Duesenberry. It is based on the rejection of the two
fundamental assumptions of the consumption theories of Keynes.
Duesenberry states that (1) every individual’s consumption behaviour
is not independent but interdependent of the behaviour of every other
individual, and (2) that consumption relations are irreversible and not
reversible in time.
In formulating his theory of the consumption function,
Duesenberry writes “A real understanding of the problem of
consumer behaviour must begin with a full recognition of the social
character of consumption patterns. By the social character of
consumption patterns, he means the tendency in human beings not
only to keep up with Joneses but also to surpass the Joneses. In other
words, the tendency is to strive constantly towards a higher
consumption level and to emulate the consumption patterns of one’s
rich neighbours and associates.

Implications of the theories

1. The effect of changes in income on consumption. The major
implication of these theories is that, changes in a household current
income will affect actual consumption only, so far as they affect its
permanent income.
2. Implications on the behaviours of the economy: The theories also
hold that actual consumption is not much affected by temporary
changes in income.
3. The theories lay stress on factors other than income, which affect
the consumer behaviour

32
Summary
In this lecture, we have taught you consumption function. This is the
largest component of aggregate demand. Various theories have sprung up
to explain the behaviour of this important function. There is the theory by
Keynes (Absolute Income Hypothesis), which states that consumption
depends on current income. Other theories, notably the Permanent Income
Hypothesis, the Life-Cycle hypothesis and the Relative Income
Hypothesis however argued that consumption is a function of permanent
rather than current income.

Post-Test
1. Why is the consumption function very important to policy
planning?
2. Discuss factors that affect the consumption function.
3. What are the major features of Keynesian theory on the
consumption function?
4. Distinguish between Keynesian theory and the Life-cycle
hypothesis on consumption function.
5. What are the implications of the theories of consumption
functions?

33
LECTURE FIVE

Investment

Introduction
In the previous lecture, we treated one of the major components of
aggregate expenditure, the consumption function. In the present lecture,
we shall examine another component of aggregate expenditure, that is,
investment. It is divided into three distinct parts, business fixed
investments; residential construction; and net changes in business
inventories. Furthermore, we shall look at the determinants of investment
and also the accelerator principle.

Objectives
At the end of this lecture, you should be able to:
1. explain the meaning and classification of investment;
2. discuss the determinants of investment; and
3. discuss how the accelerator principle operates and its limitation.

Pre-Test
1. What are the major determinants of investment?
2. Define the accelerator principle. How does it operate?
3. What are the limitations of the accelerator principle?
4. What are the effects of expenditure on the level of investment?

34
CONTENT
The Determinants of Investments
Several factors Influence the level of Investment in any country. Chief
among these factors are examined below:
1. The Rate of Interests: This is perhaps the most important
determinant of investment. Most investments are made with
borrowed money for which the borrower must pay a market rate of
interest. Thus, the decision to invest or not depends on whether the
expected rate of return on new investment is greater or less than
the interest rate that must be paid on the amount to be borrowed to
acquire these assets. Logically, the lower the rate of interest the
higher the amount of new investment that will be made. In a
functional form, we expect a negative relationship between in-
vestment (I) and rate of interest (r)
i.e. I = 1/r …………..… (1)
I = f(r) …………..… (2)

Marginal Efficiency of Capital (MEC) and the Rate of Interest

The marginal efficiency of capital is the rate of returns on new investment.
Sometimes, it is also referred to as "expected rate of return over cost” on
new investment. At equilibrium, MEC and the rate of interest will be
equal. This is because firm would continue to make new investments as
long as the rate of return on the new investment is greater than the interest
rates. Since capital is also subject to diminishing returns, we expect the
rate of return on new investments or alternatively the MEC to fall as the
stock of capital increases as shown in the curve below.

Capital

Fig. 6.1: New Investment Expenditure.

35
 The figure above confirms our proposition that the MEC is
negatively related to the stock of capital. For instance, a fall in the rate of
interest from r2 to r1 causes an increase in new investment expenditure
from k1 to K2.

2. The Level of Income

Research studies have shown that the level of income might be a better
inducement to investment than the interest rate. This is because increase in
income will lead to increase in demand for goods and services. Assured of
the presence of a willing demand for their output, businessmen will
undoubtedly be encouraged to increase their investment in order to cash
on the potential increase in their profit level.

3. Changes in Income
This is the accelerator theory. According to this theory, investment is
related to the change in national income. When income is increasing, it is
necessary to invest in order to increase the capacity to produce con-
sumption goods. However, when income is falling, it may not even be
necessary to replace old capital, as it wears out let alone to invest in new
capital
In symbols, I = f (ΔY)
This implies that investment depends on change in output.

How the Accelerator Principle Works

Let's assume that there is a particular constant stock needed to produce a
given level of an industry's output. (The ratio of the value of capital to the
annual value of output is called the capital - output ratio). With this
assumption, suppose that the industry is producing at full capacity and the
demand for its product increases. If the industry is to produce the higher
level of output, its capital stock must increase. This necessitates new
investment.
Table 6.1 provides a simple numerical example of the accelerator. We
assume that it takes N5 of capital to produce N1.00 of output per year. In
year one and two, there is no need for new investment. In year three, an
increase of N10 of sales requires a new investment of N50. The same
thing applies in year four; an increase of N20.00 of sales requires an

36
additional investment of N100.00. As columns (3) and (5) show, the
amount of new investment is proportional to the change in sales. When the
increase in sales tapers off in years seven and nine, investment declines
and eventually becomes zero in year ten.

Table 6.1 An illustration of the accelerator theory of Investment

(1) (2) (3) (4) (5)

Year Annual Changes in Required stock of capital Net investment increases
sales (N) sales assuming a capital in required capital stock
output ratio of 5:1 (N) (N)
1 100 0 500 0
2 100 0 500 0
3 110 10 550 50
4 130 20 650 100
5 160 30 800 150
6 190 30 950 150
7 220 30 1100 150
8 240 20 1200 100
9 250 10 1250 50
10 250 0 1250 0

This idea of accelerator principle that investment depends on the

changes in demand represents an important source of instability in national
income. It combines with the multiplier to generate economic cycles via
the multiplier - accelerator model.

Three general predictions of the accelerator are the following:

1. Rising, rather than high levels of sales are needed to call forth net
investment.
2. For net investment to remain constant, sales must rise by a constant
amount per year.
3. The amount of net investment will be a multiple of an increase in
sales because the capital-output ratio is greater than one.

37
Limitations of the Accelerator
The accelerator model posits a mechanical and rigid response of
investment to changes in sales. It does this by assuming a proportional
relationship between changes in income and size of the desired capital
stock, and by assuming a fixed capital- output ratio. Each of these
assumptions is invalid to some degree.
In the short run, there are many reasons why investment may not
conform to the rigid proportionality implied by the accelerator principle.
The most obvious reason is that the adjustment of actual desired capacity
is asymmetric with respect to positive and negative output changes. When
the economy expands and actual capacity lags behind desired capacity,
business firms expand their capital stock. On the other hand, no firm
would deliberately destroy enough of its machine to bring actual capacity
in line with desired levels when the economy enters a slump and demand
declines.

4. Expectations
Since present investments are usually made in expectation of future
demand, the decision to invest depends on the hope about the future.
When a firm has a high optimism about the future, it can embark on
increased investments presently and vice versa. However, because of
the uncertainty about the future, firms are usually very cautious about
increasing the level of investment they made.

Relationship between savings, investments and the rate of interest

There is a close interdependence between savings, investments and the
rate of interest. We have mentioned in the earlier part of this lecture that
most of the funds used for investment purposes are borrowed from banks
and other sources of credit schemes. Whenever the amount of funds
presently available from all these sources is not enough to sustain the
magnitude of investments the investors in the economy want to make,
there will be competition for available funds. Since the market rate of
interest is however determined by the forces of demand and supply, the
excess demand in the market for funds will therefore push up the market
rate of interest.

38
Financial Theories of Investment
Some economists have laid emphasis on the effects of financial factors on
investment. But we shall study only the profits theory of investment.

The Profits Theory of Investment

The profits theory regards profits, in particular undistributed profits, as a
source of internal funds for financing investment. Investment depends on
profits and profits, in turn, depend on income. In this theory, profits relate
to the level of current profits and of the recent past. If total income and
total profits are high, the retained earnings of firms are also high, and vice
versa. Retained earnings are of great importance for small and large firms
when the capital market is imperfect because it is cheaper to use them.
Thus, if profits are high, the retained earnings are also high. The cost of
capital is low and the optimal capital stock is large. That is why firms
prefer to reinvest their extra profits for making investments instead of
keeping them in banks in order to buy securities or to give dividends to
shareholders. Contrariwise, when their profits fall, they cut their
investment projects. This is the liquidity version of the profits theory.
Another version is that the optimal capital stock is a function of
expected profits. If the aggregate profits in the economy and business
profits are rising, they may lead to the expectation of their continued
increase in the future. Thus, expected profits are some function of actual
profits in the past.
Kt* = f(t-1)
Where Kt* is the optimal capital stock and f(t-1) is some function of
past actual profits.
Edward Shapiro has developed the profits theory of investment in
which total profits vary directly with the income level. For each level of
profits, there is an optimal capital stock. The optimal capital stock varies
directly with the level of profits. The interest rate and the level of profits,
in turn, determine the optimal capital stock. For any particular level of
profits, the higher the interest rate, the smaller will be the optimal capital
stock, and vice versa.

39
Summary
We have discussed yet another component of aggregate expenditure,
investment in this lecture. In the process we defined what investment is all
about; examined the factors that influence the level of investment in any
country, as well as how the principle of accelerator works. We also looked
into the relationship between savings, investment and the rate of interest.
Finally, we discussed the profits theory of investment.

Post-Test
1. Explain the accelerator principle. How does it operate, and what
are its major limitations?
2. Mention and discuss the various factors which influence the level
of investment in an economy?
3. Discuss the relationship between
a. savings and investment
b. marginal efficiency of capital (MEC) and level of new
investment.

40
LECTURE SIX

Government, Aggregate Demand and Fiscal

Policy

Introduction
Government exerts a lot of influence on the circular flow of income.
Through its control over taxes and spending decisions, the government
also influences the behaviours of other economic agents, such as the
households and the firms. Fiscal policy is the use of taxes and government
spending decisions to influence the level of aggregate demand. Therefore,
in this lecture, we shall be looking at the role of government in the
economy, and how it uses its fiscal power to influence the level of
economic activity.

Objectives
At the end of this lecture, you should be able to:
1. define the terms ‘aggregate demand’ and ‘fiscal polity’;
2. explain how the government uses its fiscal policy to influence
aggregate demand; and
3. state the difference between balanced and unbalanced budget.

Pre-Test
1. Explain what you understand by ‘balanced budget’.
2. Define the following terms.
a. balanced budget;
b. balanced budget multiplier;

41
 c. budget surplus; and
d. budget deficit
3. Distinguish between automatic stabilisers and discretionary policy.
4. Describe, with appropriate diagrams, how a government can close
deflationary gap in an economy.

CONTENT
1. The Government and Aggregate Demand
The Aggregate demand (AD) can be defined as:
AD = C + I + G
Where C = Consumption demand
I = Investment demand
G = Government demand for goods and services

Since government demand is one of the components of aggregate

demand, the government can use its tax policy and expenditure
programmes to influence the level of aggregate demand in the economy.
We shall now look at the effects of either of these tools of government on
the level of aggregate demand.

a. The Effect of Taxes on National Income

The government can increase aggregate demand in order to close a
deflationary gap by reducing the tax rates. This will have an indirect
effect on the economy by increasing the level of aggregate disposable
income. And, since consumption demand is a function of disposable
income, this will boost domestic demand and thus lead to increase in
aggregate demand.

42
 Flg.7.1 Using taxes to close deflationary gap

A change in tax rate will not shift the aggregate demand function but
will only alter the slope of the function, since tax revenue will vary with
national income. In Fig. 7.1, reduction in tax rate has increased aggregate
demand from AD1 to AD2 by changing the scope of the function. Thus, the
deflationary gap can be closed.

b. The Effect of Government Expenditure on National Income

An alternative way by which government can increase the aggregate
level of economy is through its expenditure policy. If increased
government expenditure is met by tax revenue, then the effect on
aggregate demand will be minimal. This is because the increase in
government expenditure would have been matched by an equivalent
decrease in private expenditure. The reduction in private expenditure
is called ‘crowding-out effect’.
However, the effect of increase in government expenditure on
aggregate demand function is different from the effect of taxes which
we have just enunciated above. An increase in government
expenditure will shift the aggregate demand function upwards,
parallel to the former one

43
FIG. 7.2 using government expenditure to Fig 7.3. Using government expenditure to
eliminate a deflationary gap eliminate an inflationary gap

Thus, a deflationary gap may be removed by an appropriate increase

in government expenditure or decrease in tax rates. An inflationary gap
may be removed by an appropriate decrease in government expenditure.

2. Comparative Effects of Expenditure and Tax Changes

There is a difference in the comparative effect of government
expenditure and tax revenue of the same amount on aggregate
demand. This is because increase in government expenditure will
have immediate and direct effect on aggregate demand; the same is
not true of taxes. A reduction in taxes of equal amount will not have
same amount of effect on aggregate demand because only part of
extra income realized from reduction in taxes will be spent. For in-
stance, if government expenditure is raised by N100, 000 to close a
deflationary gap, and given that the multiplier is two, the final rise in
national income is N200, 000. On the other hand, if government cuts
income tax rates sufficiently to reduce its revenue by N100, 000
households will have an extra N 100,000 of disposable income.
Consumption expenditure will, however rise, by less than N100, 000
because only part of the extra income will be spent. If marginal
propensity to consume is 0.75, then the final rise in national income
will be N150, 000.

44
The Theory of Fiscal Policy
Balanced and Unbalanced Budgets
People formerly believed that a prudent government must always balance
its budget. But nowadays, it is generally accepted that a government can
run an unbalanced budget in order to stabilize the economy. For example,
a government can run a deficit budget to stimulate the economy during
period of recession.

Definitions
1. A budget is regarded as balanced when its current revenue is equal
to current expenditure.
2. A budget is said to be unbalanced when there is budget deficit or
surplus.
3. Budget surplus occurs when government revenue exceeds its
expenditure.
4. A budget deficit occurs when government revenue falls short of its
expenditure.
A budget can be financed either by raising taxes or through
borrowing. When government spends more without raising its taxes, its
extra expenditure is said to be deficit financed. This deficit can be met by
increase in borrowing either from the central bank of the state or from the
private sector of the economy.

The Balanced Budget Multiplier

What would be the effect of balanced budget spending on aggregate
demand? A natural assumption would be that an equivalent increase in
government spending and taxes would leave aggregate demand and
equilibrium output unchanged. But this is not true. Let's assume that
government finances a new expenditure of N300, 000 by tax revenue of
equal amount. Although, this implies that the budget is balanced, but we
shall soon see that this action has positive effect on aggregate demand.
The increase of N300, 000 in government spending raises aggregate
demand by N300, 000. But since the marginal propensity to consume
(MPC) out of disposable income is less than 1 (say 0.7) this reduction in
income by N300, 000 reduces consumption demand by only N210, 000
(0.7 x 300,000).

45
 Thus, the initial effect of tax and spending package is to increase
aggregate demand by N300, 000 because of government spending but
reduce it by only N210, 000 because higher taxes reduce consumption
demand. Thus, a balanced aggregate demand has increased aggregate
demand by N90, 000 (i.e. N300, 000 - N210, 000). This example
illustrates the principle of balanced budget multiplier, which states that an
increase in government spending, accompanied by an equal increase in
tax, results in an increase in output.

Tools of Fiscal Policy

These tools can be classified into automatic and discretionary measures.

1. Automatic Tools of Fiscal Policy: Built-in Stabiliser

Automatic stabilizers are mechanisms in the economy that reduces the
response of national income to shock. They are automatic since they
are already built-in into the functioning of the economy and, thus,
they do not require deliberate intervention to make them work. Thus,
they tend to cause injections as income falls or withdrawals as
national income rises and vice-versa, without the government making
policy decisions to bring about these changes. Examples of automatic
stabilizers include taxes, national insurance or progressive taxes.
These yield increases when national income rises and decreases when
it falls, thereby respectively bringing about expansionary and
inflationary forces on the economy.

2. Active or Discretionary Fiscal Policy

Although the automatic stabiliser are always at work, government can
embark on active or discretionary fiscal policies which alter spending
levels or tax rates in order to stabilise the level of aggregate demand.
While built-in stabilisers are often designed for short term minor
fluctuations, discretionary fixed policies are used to cater for
persistent fluctuation or gap in the economy. Countercyclical Fiscal
Policy: Automatic and Discretionary Changes
It may be inferred from the relationship between (a) Public
expenditure and GNP; (b) taxation and GNP; that a countercyclical
fiscal policy would require increase in public expenditure and

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reduction in taxation to fight depression, and reduction in public
expenditure and increase in taxation to controlling inflation. In other
words, fighting depression would require deficit budgeting and
control inflation requires surplus budgeting
Some of the budgetary changes are automatic and some are
discretionary. The automatic budgetary adjustment takes place only
when fiscal policy has built-in flexibility. The automatic budgetary
changes should follow the change in GNP. Built-in flexibility in the
fiscal policy implies that as GNP falls, both income and consumption
decline.
Consequently, the revenue from both direct and indirect taxes
declines. Government establishment and committed expenditure
remaining the same, public expenditure exceeds its revenue, and the
budget automatically runs into deficit. This effect is more quick and
powerful in the countries, which provide unemployment allowances
and other relief benefits. When GNP increases, tax base expands and
tax revenue increases. Expenditure level remaining the same, the
budget automatically shows surplus.
The deficit surplus resulting from fluctuation in GNP works as
automatically stabiliser of the economy. However, it is generally
believed that automatic stabilizers prove to be adequate and serve
useful purpose only for short-term fluctuations in the economy.
Automatic stabilizers prove generally to be inadequate to control the
economic fluctuations of larger amplitude; under such conditions,
discretionary changes in budget become necessary.
The discretionary changes in the budget refer to the changes in the
tax structure, and in the level and pattern of public expenditure by the
government on its own discretion. Discretionary changes include
change in tax rate structure, abolition of existing taxes, imposition of
new taxes, increasing and decreasing the public expenditure, changing
the pattern of public expenditure, etc. Discretionary changes are so
designed as to arrest the inflation and deflationary trends in the
economy and to mitigate the destabilising forces, such as, increase or
decrease in aggregate demand.

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Problems in Formulating Counter- Cyclical Fiscal Policy
Formulating a counter-cyclical fiscal policy is not a straight forward affair.
It involves certain complications, which should be born in mind while
devising the tax and expenditure policy to stabilise the economy. Eckstein
has pointed out some complications as follows.
1. All expenditures do not have the same multiplier effect. For
example, transfer payments by the government do not create a
direct demand for goods and services. Some public expenditure
(e.g. free education and hospital facilities) replaces the private
expenditure.
2. Not all tax – changes have the same multiplier effect. For example,
taxes paid by the upper incomes groups have lower multiplier
effect than those paid by lower income groups. This is because of
the differences in their marginal propensity to consume (MPC).
The multiplier effects of indirect taxes are not clearly known.
3. Deficit financing through public borrowing may reduce private
investment. This kind of deficit financing reduces the multiplier
effect.
4. There are practical difficulties in relation to the assessment of time
lags and accuracy of forecasts. Therefore, there is uncertainty in
relation to effectiveness of fiscal policy.

Summary
We have seen in this lecture that government exerts important influence
on the national economy, through the manipulation of its fiscal policy. The
government can increase or decrease aggregate demand in order to close a
deflationary and inflationary gap respectively. There are two types of
fiscal policy. There is the automatic stabiliser and there is also the active
or discretionary policy. While the former is used for short term
fluctuations in the economy, the latter takes care of the more persistent
fluctuations. We also hinted at some problems likely to be encountered in
formulating counter-cyclical fiscal policy.

Post-Test
1. A prudent government must at all times ensure that it operates a
balanced budget: True or False? Explain.

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2. If the government desires to remove unemployment in the
economy by increasing its spending by N1, 000,000, and she raises
money to finance this increased expenditure by raising tax rates
equal to the amount spent, what is the effect of this spending on the
economy?
3. Write short notes on the following:
a. Deficit budget
b. Surplus budget
c. Balanced budget
4. Explain what you understand by ‘tools of fiscal policy’.

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