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BBEK4203 PRINCIPLES OF MACROECONOMICS Munzarina Ahmad Samidi Norehan Abdullah Jamal Ali Zalina Mohd. Mohaideen Wan Azman Saini Wan Ngah Dr Law Siong Hook

Copyright © Open University Malaysia (OUM), July 2010, BBEK4203 All rights reserved. No part of this work may be reproduced in any form or by any means without the written permission of the President, Open University Malaysia (OUM). Version March 2010

Project Directors: Prof Dr Mansor Fadzil Prof Dr Zakaria Ismail Open University Malaysia Module Writers: Munzarina Ahmad Samidi (Leader) Norehan Abdullah Jamal Ali Zalina Mohd. Mohaideen Universiti Utara Malaysia Co-Writers: Wan Azman Saini Wan Ngah Dr Law Siong Hook Universiti Putra Malaysia Moderator: Lilian Kek Siew Yick Open University Malaysia Translated & Edited: Pearson (M) Sdn. Bhd. Printed by: Meteor Doc. Sdn. Bhd. Lot 47-48, Jalan SR 1/9, Seksyen 9, Jalan Serdang Raya, Taman Serdang Raya, 43300 Seri Kembangan, Selangor Darul Ehsan

First Printing, August 2007 Sixth Printing, March 2010 Seventh Printing, July 2010

Table of Contents Course Guide ix-xvi

Topic 1 Introduction to Macroeconomics 1 1.1 Macroeconomics 2 1.1.1 Issues in Macroeconomic Analysis 2 1.2 Macroeconomics Policies 6 1.3 Objectives of Macroeconomics 7 1.4 Business Cycle 8 1.4.1 Phases in Economic Activities 8 1.5 What Do Macroeconomists Do? 11 1.6 Classical versus Keynesian Views 11 1.7 Aggregate Demand and Aggregate Supply 12 Summary 14 Key Terms 14

Topic 2 National Production 15 2.1 Circular Flow of Income Model 16 2.2 Gross Domestic Product 17 2.2.1 Total Value of Production 18 2.2.2 What are the Final Goods and Services Produced? 18 2.2.3 Where are They Being Produced? 19 2.2.4 When are They Produced? 19 2.3 Gross National Product 20 2.4 Method of Calculating GDP 21 2.4.1 Expenditure Approach 21 2.4.2 Production Approach 24 2.4.3 Income Approach 25 2.5 Adjusting Factor Cost to Market Price 27 2.6 Economic Activities that are Not Included 28 2.6.1 Traditional FarmerÊs Agricultural Produce 29 2.6.2 Illegal Activities 29 2.6.3 Productive Activities that are Not Paid 30 2.6.4 Non-cash Reward 30 2.7 Real GDP and Nominal GDP 30 2.8 National Production Data Usage 32 2.9 Factors Affecting National Production Level 34 2.9.1 Internal Factors 34 2.9.2 External Factors 34

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2.10 The Problems in Calculating National Production 35 2.11 Business Cycle 37 Summary 38 Key Terms 38 Topic 3 Determinant of Equilibrium Income Theory 39 3.1 Two-sector Economy 39 3.1.1 Circular Flow of Income 40 3.1.2 Consumption, Savings and Disposable Income 45 3.1.3 National Income Equilibrium 46 3.1.4 Change in Aggregate Demand 49 3.1.5 The Effects of Multiplier 50 3.2 Three-sector Economy 52 3.2.1 Circular Flow of Income 52 3.2.2 Government and Fiscal Policy 53 3.2.3 Consumption, Savings and Taxes 55 3.2.4 National Income Equilibrium 56 3.2.5 Change in Aggregate Demand 58 3.2.6 Multiplier Effect 59 3.3 Four-sector Economy 61 3.3.1 Import and Export 62 3.3.2 National Income Equilibrium 63 3.3.3 Change in Aggregate Demand 64 3.3.4 Multiplier Effect 65 3.4 Fiscal Policy and Economic Problems 67 3.4.1 Fiscal Policy 67 3.4.2 Inflationary and Deflationary Gap 68 3.4.3 Solving Inflationary and Deflationary Gaps 70 Summary 72 Key Terms 73 Topic 4 Money and Banking System 74 4.1 Money and Banking System 75 4.1.1 Definition of Money 75 4.1.2 Features of Money 75 4.1.3 Functions of Money 76 4.2 Financial Institutions and Banking System 77 4.2.1 Banking System 78 4.2.2 Non-bank Financial Institutions 81 4.2.3 Non-bank Financial Intermediaries 81 4.2.4 Islamic Banking 82 4.3 Credit Creation Process 84 4.3.1 Credit Creation Process An Example 84

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4.4 Monetary Policy 88 4.4.1 Quantitative Monetary Policy 88 4.4.2 Qualitative Monetary Policy 89 4.5 Money Demand (Md) 90 4.5.1 Transactions Demand 90 4.5.2 Precautionary Motives 91 4.5.3 Speculative Demand 91 4.6 Money Supply 93 4.6.1 Narrow Measure of MoneyÊs Functions 94 4.6.2 Broad Measure of Money Supply 94 4.6.3 The Broadest Measure of Money Supply 95 4.7 Equilibrium in the Money Market and Interest Rate 96 Summary 98 Key Terms 101 Topic 5 Aggregate Demand and Supply 101 5.1 Aggregate Demand 102 5.1.1 Constructing the Aggregate Demand Curve 105 (AD) 5.1.2 Aggregate Demand Determinants 107

5.1.3 The Movement of Aggregate Demand 111 Curve and the Aggregate Expenditure Model 111

5.2 Aggregate Supply (AS) 112 5.2.1 Short-run Aggregate Supply 113 5.2.2 Determinants of Aggregate Supply Curve 114 5.3 Production Level and Equilibrium Price 117 5.3.1 Changes in Equilibrium 117 5.4 Aggregate Demand and Aggregate Supply: Fiscal 120

Policy and Monetary Policy 5.5 Constructing Long-run Aggregate Supply Curve 122 5.5.1 Long-run Aggregate Supply Curve 124 Summary 125 Key Terms 127 Topic 6 Unemployment and Inflation 127 6.1 Unemployment 128 6.2 Measuring Unemployment Rate 129 6.3 Labour Force Participation Rate 131 6.4 Discouraged Worker 131 6.5 Part-time Workers 132 6.6 The Types of Unemployment 133 6.6.1 Frictional Unemployment 133 6.6.2 Structural Unemployment 134 6.6.3 Cyclical Unemployment 134

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6.7 Full Employment and Natural Unemployment Rate 135 6.8 Reasons for Unemployment 136 6.8.1 Job Losers 137 6.8.2 Job Leavers 137 6.8.3 New Entrants and Re-entrants 138 6.9 Effects of Unemployment 138 6.9.1 Negative Effects on the Economy 139 6.9.2 Negative Effects on the Individual and 139 Population 6.10 Inflation 140 6.11 Consumer Price Index (CPI) 141 6.12 Calculation of CPI 141 6.12.1 Calculate the Cost of CPI Consumer Basket at 142 Base Year Price 6.12.2 Calculate the cost of CPI Consumer Basket at 142

Current Year Price 6.12.3 Calculate the CPI for Base Year and Current Year 143

6.13 Calculating the Inflation Rate 144 6.14 Effects of Inflation 145 6.14.1 Effects of Inflation on Total Production 145 6.14.2 Effects of Inflation on Savings and Investment 145 6.14.3 Effects of Inflation on Income Distribution and 146 Economic Wealth 6.14.4 Effects of Inflation on a CountryÊs Balance 146 of Payments 6.15 CPI and Living Costs 147 6.16 Factors that Cause Inflation 149 6.16.1 Demand Pull/Excess Demand 149 6.16.2 Increase in Costs 150 6.16.3 Supply Shock 151 6.16.4 Adaptive Expectations 151 Summary 153 Key Terms 153 Topic 7 International Trade 153 7.1 Why Do Countries Trade? 154 7.1.1 Possession of Different Production Factors 154 7.1.2 Different Climate 155 7.1.3 Different Labour Skills 156 7.1.4 Different Consumption Patterns 156 7.2 Absolute Advantage 157 7.3 Comparative Advantage 159 7.4 Benefits of International Trade 160 7.5 International Trade Barriers 162

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7.5.1 Tariffs 162 7.5.2 Quotas 163 7.5.3 Foreign Currency Control 163 7.5.4 Other Restrictions 164 7.6 Terms of Trade 165 7.6.1 Price 165 7.6.2 Goods 165 7.7 Why are Protection Policies Needed? 166 7.7.1 Protect New Industries 167 7.7.2 National Security 167 7.7.3 Diversify Economic Activities 167 7.7.4 Protect Resources 168 7.7.5 Anti-dumping 168 Summary 168 Key Terms 169 Topic 8 International Finance 170 8.1 Foreign Exchange Rate 170 8.2 How is the Foreign Exchange Rate Determined? 172 8.3 Change in Demand or Supply 173 8.4 Factors that Influence the Foreign Exchange Rate 174 8.4.1 The Price of Traded Goods 175 8.4.2 Inflation Level 175 8.4.3 Interest Rate 175 8.4.4 Income of the People in a Country 176 8.5 Balance of Payments 176 8.5.1 Current Account 177

8.5.2 Capital Account 178 8.5.3 Official Settlement Account 180 Summary 182 Key Terms 182 Answers 183

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COURSE GUIDE

PANDUAN KURSUS x

COURSE GUIDE xi

COURSE GUIDE DESCRIPTION

You must read this Course Guide carefully from the beginning to the end. It tells you briefly what the course is about and how you can work your way through the course material. It also suggests the amount of time you are likely to spend in order to complete the course successfully. Please keep on referring to the Course Guide as you go through the course material as it will help you to clarify important study components or points that you might miss or overlook.

INTRODUCTION

BBEK4203 Principles of Macroeconomics is one of the courses offered by the Faculty of Business and Management at Open University Malaysia (OUM). This course is worth 3 credit hours and should be covered over 15 weeks.

COURSE AUDIENCE

This is a core course for all students pursuing the degree in Bachelor of Management, Bachelor of Business Administration, Bachelor of Human Resource Management, Bachelor of Accountancy, Bachelor of Hospitality Management and Bachelor of Tourism Management program. As an open and distance learner, you should be able to learn independently and optimise the learning modes and environment available to you. Before you begin this course, please confirm the course material, the course requirements and how the course is conducted.

STUDY SCHEDULE

It is a standard OUM practice that learners accumulate 40 study hours for every credit hour. As such, for a three-credit hour course, you are expected to spend 120 study hours. Table 1 gives an estimation of how the 120 study hours could be accumulated.

COURSE GUIDE xii

Table 1: Estimation of Time Accumulation of Study Hours.

STUDY ACTIVITIES STUDY HOURS

Briefly go through the course content and participate in initial discussion 3

Study the module 60

Attend 3 to 5 tutorial sessions 10

Online participation 12

Revision 15

Assignment(s), Test(s) and Examination(s) 20

TOTAL STUDY HOURS ACCUMULATED 120

LEARNING OUTCOMES

By the end of this course, you should be able to:

1. Explain the reasons stabilisation policies is designed in a country;

2. Discuss the factors determining the countryÊs income and the aggregate demand and aggregate supply theories;

3. Explore the reasons international trade to take place in a country;

4. Assess factors in determining the foreign currency exchange rate in the foreign exchange rate market;

5. Apply the functions of financial and banking systems in the monetary policies taken by the Central Bank to stabilise the economy; and

6. Analyse the era changing of the current economic conditions in a country together with the policies taken by the government.

COURSE GUIDE xiii

COURSE SYNOPSIS

This course is divided into 8 topics. The synopsis for each topic is presented below: Topic 1 introduces the field of economics from its macro aspect. In this topic, students will be exposed to basic concepts that are often used in the economics context such as employment, unemployment, inflation, price level, financial policy and fiscal policy. Students will be able to understand in detail about the economic cycle which is divided into a few phases. Besides that, students will also study the basics of aggregate supply and demand plus the views of classical and Keynesian economists. Topic 2 introduces one of the important concepts in macroeconomics, which is national production. This topic explains about the circular flow of income model which connects households and firms. The topic also discusses the method of calculating GDP, the usage of national production data and problems in calculating the national production. Topic 3 focuses on the determinant of national income equilibrium in a two-sector, three-sector and four-sector economy. Students will be able to understand how aggregate demand components such as consumption, investment, government expenditure and net export affect the national income equilibrium. Besides this, students will be exposed to AD-AS model and injection-leakage model that are used to calculate equilibrium level. The concept of multiplier is also explained in this topic. Lastly, this topic also describes two main fiscal tools in achieving government objectives, namely, government expenditure and taxes; through automatic and fiscal policies and discretionary fiscal policies. Topic 4 discussion focuses on money and the banking system in Malaysia. Students will be introduced to the term economy. This topic also explains in detail the banking system which covers financial institutions, non-bank financial institutions, non-bank financial intermediaries and the Islamic banks. Students will also learn the credit creation process. Also in this topic, the quantitative and qualitative financial policies are discussed. Students will know the reasons for money demand and the terms used for the various categories of money supply. Besides that, this topic also discusses equilibrium in the money market and its relationship with interest rates. Topic 5 focuses on aggregate demand and supply. From the aspect of aggregate demand, students will learn factors that cause the aggregate demand curve to slope negatively, components of aggregate demand such as consumption (C),

COURSE GUIDE xiv

investment (I), government expenditure (G) and net export (X M), and determinants of the aggregate demand curve. This topic also discusses short-term aggregate supply curve and its determinants. Students also learn how production level and equilibrium price are determined and how an AD-AS model is used to analyse the effects of budget policy and financial policy. Lastly, the construction of long-term aggregate supply curve is also explained in this topic. Topic 6 discusses two important variables in the economy, namely, unemployment and inflation. In this topic, students will learn to categorise citizens of a country into specific groups such as population of working age group, labour force, unemployed, employed, discouraged workers and part-time workers. The way to calculate the rate of unemployment and the rate of participation in the labour force are also explained. Students will also know three types of unemployment that exist in the economy, the reasons for unemployment and effect of unemployment on the economy, individual and society. Topic 7 introduces the concept of international trade. In this topic, students learn about the factors that encourage international trade such as different climates, production factors, different labour skills and consumption patterns. Besides that, two important concepts in international trade; absolute advantage and comparative advantage are also discussed. Students will also be exposed to topics such as the benefits of doing international trade, international trade barriers, terms of trade and the reasons for implementing protection policies. Topic 8 focuses on international finance. Students will be introduced to the importance of foreign exchange rates and how this rate is determined in international trade. Besides that, this topic also discusses factors that influence foreign exchange rate. In this topic too, students will learn the concept of balance of payment and its components such as current account, capital account and official settlement account.

TEXT ARRANGEMENT GUIDE

Before you go through this module, it is important that you note the text arrangement. Understanding the text arrangement should help you to organise your study of this course to be more objective and more effective. Generally, the text arrangement for each topic is as follows: Learning Outcomes: This section refers to what you should achieve after you have completely gone through a topic. As you go through each topic, you should frequently refer to these learning outcomes. By doing this, you can continuously gauge your progress of digesting the topic.

COURSE GUIDE xv

Self-Check: This component of the module is inserted at strategic locations throughout the module. It is inserted after you have gone through one sub-section or sometimes a few sub-sections. It usually comes in the form of a question that may require you to stop your reading and start thinking. When you come across this component, try to reflect on what you have already gone through. When you attempt to answer the question prompted, you should be able to gauge whether you have understood what you have read (clearly, vaguely or worse you might find out that you had not comprehended or retained the sub-section(s) that you had just gone through). Most of the time, the answers to the questions can be found directly from the module itself. Activity: Like Self-Check, activities are also placed at various locations or junctures throughout the module. Compared to Self-Check, Activity can appear in various forms such as questions, short case studies or it may even ask you to conduct an observation or research. Activity may also ask your opinion and evaluation on a given scenario. When you come across an Activity, you should try to widen what you have gathered from the module and introduce it to real situations. You should engage yourself in higher order thinking where you might be required to analyse, synthesise and evaluate instead of just having to recall and define. Summary: You can find this component at the end of each topic. This component helps you to recap the whole topic. By going through the summary, you should be able to gauge your knowledge retention level. Should you find points inside the summary that you do not fully understand, it would be a good idea for you to revisit the details from the module. Key Terms: This component can be found at the end of each topic. You should go through this component to remind yourself of important terms or jargons used throughout the module. Should you find terms here that you are not able to explain, you should look for the terms from the module. References: References is where a list of relevant and useful textbooks, journals, articles, electronic contents or sources can be found. This list can appear in a few locations such as in the Course Guide (at References section), at the end of every topic or at the back of the module. You are encouraged to read and refer to the suggested sources to elicit the additional information needed as well as to enhance your overall understanding of the course.

COURSE GUIDE xvi

PRIOR KNOWLEDGE

Learners of this course are required to pass BBEK1103 Principles of Microeconomics course.

ASSESSMENT METHOD

The assessment method and evaluation distribution for this course is as follows:

Mid Term 40%

Final Examination 60%

TOTAL 100%

REFERENCES

Case, K. E., & Fair, R. C. (2006). Principles of economics (8th ed.). New Jersey: Prentice Hall.

Mankiw, N. G. (2008). Principles of economics (5rd ed). Harcourt College Publisher.

McEachern, W. (2008). Economics: A contemporary introduction (8th ed.). Kentucky: Thomson South-Western College Publisher.

Sloman, J., & Sutcliffe, M. (2002). Economics (4th ed.). New Jersey: FT Prentice Hall.

INTRODUCTION

Macroeconomics is an analysis of a countryÊs economic structure and performance and the governmentÊs policies in affecting its economic conditions. Economists are interested to know the factors that contribute towards a countryÊs economic growth because if the economy progresses, it will provide more job opportunities, goods and services and eventually raise the peopleÊs standard of living. Macroeconomics can progress as it tests a particular theory to see how the overall economy functions, whereby the theory is used to forecast the effects of a particular policy and event that was carried out.

TTooppiicc

11

Introduction to Macroeconomics

LEARNING OUTCOMES By the end of this topic, you should be able to:

1. Define macroeconomics;

2. Discuss five main issues in the study of macroeconomics;

3. Elaborate on the two main macroeconomic policies, namely the financial policy and the fiscal policy;

4. Discuss three objectives of macroeconomics;

5. Describe the economic phases in the business cycle;

6. Differentiate between classical and Keynesian economic theories in relation to macroeconomics; and

7. Examine the meaning of aggregate demand and aggregate supply in economics.

TOPIC 1 INTRODUCTION TO MACROECONOMICS

2

MACROECONOMICS

Economists define macroeconomics as a field of economics that studies the relationship between aggregate variables such as income, purchasing power, price and money. This means macroeconomics examines the function of the economy as a whole system, looking at how demand and supply of products, services and resources are determined and factors that influence them.

1.1.1 Issues in Macroeconomic Analysis

The issues in macroeconomic analysis are stated below: (a) What are the Determinants of Economic Growth and Living Standards in a

Country? Since a century ago, developed nations have achieved a high rate of economic growth which in turn raised their peopleÊs standard of living. Macroeconomics examines the reasons behind the speedy economic growth in the developed nations and understands the reason why this growth is different between the various countries.

Figure 1.1: MalaysiaÊs real output

Figure 1.1 shows MalaysiaÊs real output (measured using the real gross domestic product) from years 1960 to 2000. This shows a steady increase in the countryÊs output whereas there is a decline in the economy from 1974 until 1975 (oil crisis); from 1985 until 1986 (commodity price crisis) and from 1997 until 1998 (Asian financial crisis).

1.1

TOPIC 1 INTRODUCTION TO MACROECONOMICS 3

(b) Productivity The average labour productivity or the output of a single worker is important to determine the standard of living. Macroeconomics will question the factors which decide on the employee productivity growth rate.

Figure 1.2: Productivity per employee in Malaysia

Figure 1.2 shows the average productivity per employee in Malaysia from the year 1960 to 2000. This is also increasing except for the years between 1974 and 1975, 1985 and 1986 and 1997 and 1998 due to the economic downturn.

(c) What is the Cause of Decline and Growth in an Economy? Any economy will surely go through decline and growth. In relation to this, macroeconomics will look at the causes of these changes in the economy and the government policies that can be implemented to overcome an economic problem.

ACTIVITY 1.1

Can employee productivity decline even if there is an increase in total output?


4

Figure 1.3: Rate of economic growth in Malaysia

Figure 1.3 shows the rate of economic growth in Malaysia for the years 1960 to 2000. It shows the economic growth and decline. For example, an obvious economic downturn in Malaysia happened during the years 1974 to 1975 owing to the oil crisis; in 1985 to 1986 due to the commodity price crisis; and in 1997 to 1998 because of the currency crisis in Asia. These three situations slowed down the Malaysian economy, causing the growth rate to be in the negative during the years 1985 and 1998.

(d) What are Factors Affecting Unemployment?

Rate of unemployment means there is an available work force that wants to work but has no jobs. The rate of unemployment will increase when there is a decline in the economy, but unemployment also happens when the economic situation is good. Macroeconomics will examine the reasons for unemployment, types of unemployment and ways to overcome unemployment.

Figure 1.4: Rate of unemployment in Malaysia


Figure 1.4 shows the rate of unemployment in Malaysia from the years 1984 to 2000, whereby the rate of unemployment was highest during the years 1985 to 1986 due to the economic downturn (the fall in commodity prices). After 1986, the rate declined but rose again from 1998 to 1999 due to the Asian financial crisis. The rate then dropped again in 2000.

(e) What are Factors that Cause the General Price Levels or Inflation to Rise?

Inflation is an increase in the general price level which is usually measured by changes in the Consumer Price Index. The questions asked in a macroeconomics analysis are:

What are the factors affecting inflation? Why does inflation rate differ from time to time? Why does inflation rate differ from one country to another?

Figure 1.5: Rate of inflation in Malaysia

Figure 1.5 shows the rate of inflation in Malaysia from 1960 to 2000. The highest rate of inflation was recorded for the year 1974 owing to an increase in the oil price crisis, followed by the second oil price crisis in 1981. After 1981, the rate of inflation in Malaysia was low and was less than 5%.

ACTIVITY 1.2

In Malaysia, prices were higher in 2003 compared to prices in 1980. Does this mean that the quality of life of Malaysians was much better in 1980? Do you agree? Give your reasons.


6

MACROECONOMICS POLICIES

The study of macroeconomics relates to the economic growth of a country. Although many factors contribute towards economic growth such as natural resources, human resources, capital stocks, technology, and peopleÊs choice of economy, government policies also play an important role in this aspect. Therefore, it is also important for you to understand the effects of the many policies and the need to develop a better policy as this is an important aim in macroeconomics. Macroeconomic policies affect the overall performance of the economy. Two main macroeconomics policies are the financial policy or monetary policy and fiscal policy. (a) Financial Policy/Monetary Policy

Economists believe that changes in the money supply will influence important macroeconomics variables such as national output, labour force, interest rate, inflation, share prices and foreign currency exchange. Financial policy is controlled by the central bank which acts as a government agency (in Malaysia, it is dealt with by Bank Negara). Figure 1.6 shows the money supply M2 in Malaysia from 1960 to 2000, whereby there was a steady increase especially in the 1990s.

Financial policy influences the supply of money in the economy.

1.2

EXERCISE 1.1

Define inflation. Compare the rate of inflation in Malaysia before and after the Asian financial crisis which lasted from 1997 to 1998.


Figure 1.6: Money Supply M2 in Malaysia

(b) Fiscal Policy A good balance between government expenditure and government revenue is important. When government spends more than the income tax collected, it suffers a budget deficit. Meanwhile, if the governmentÊs revenue is more than its expenditure, then the government will have a budget surplus.

OBJECTIVES OF MACROECONOMICS

Among the vital objectives of macroeconomics to be achieved are: (a) Achieving Full Employment

This does not mean that there will be no unemployment at all or that the rate of unemployment will be zero in a country. Basically, economists agree that there can still be unemployment although the economy is at a level where it has achieved full employment, meaning that where those who are able and willing to have a job can get one. Topic 6 will discuss further the concept and issues of unemployment.

1.3

SELF-CHECK 1.1

What is the difference between financial/monetary policy and fiscal policy?


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(b) Price Stability Generally, price stability means there are no changes in general price levels. This also means that the prices of some goods and services may increase, while some other prices may drop at the same time. When prices remain largely stable, there is no rapid inflation or deflation.

(c) Good Economic Growth

Achieving good economic growth is also one of the aims of macroeconomics. This would mean there is an increase in the real per capita income from year to year.

BUSINESS CYCLE

Before we discuss the meaning of the business cycle, think for a moment of the meaning of a booming economy and economic downturn/recession.

Economic growth and recession generally involves the entire country and the world, where you will find that it affects almost all economic activities, not just confined to purchasing power and production.

1.4.1 Phases in Economic Activities

Economic activities can be divided into two main phases, namely the expansion (growth) phase and the contraction (recession) phase. (a) Expansion Phase

A phase where economic activities are on the rise as shown by the growth in domestic production.

1.4

ACTIVITY 1.3

Referring to websites of Bank Negara: www.bnm.gov.my and the National Statistics Department: www.statistics.gov.my, what is the inflation rate and unemployment rate in Malaysia in 2004?

Business cycle is the recurring and fluctuating levels of economic activity that an economy experiences over a long period of time.


(b) Contraction Phase There are two types of contraction, namely:

(i) Depression If the economic downturn is very bad, then it is known as depression. Although there is no official definition, depression is a sudden depreciation in the national production, followed by an increase in the unemployment rate, which lasts for more than a year.

(ii) Recession Recession is a more moderate economic slowdown, which involves a decrease in total production and purchasing power, usually lasting for at least six months.

Figure 1.7 shows a summary of various phases in economic activities.

Figure 1.7: Summary of phases in economic activities

Figure 1.8: Business cycle


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With reference to Figure 1.8, the business cycle shows economic activities and movements along the long-term growth trend line. Recession will occur when the previous economic expansion has reached its peak and has fallen into a pit, which is the trough. Economy will then begin to boom again after experiencing a recession and it will continue to grow until it reaches a new peak. Therefore, the point from one peak to another peak is called a cycle. Similarly, the point from one trough to the next one is also a complete cycle. Figure 1.9 shows the business cycle in Malaysia from 1960 to 2000 which is reflected through the actual national output growth rate. Referring to the same figure, we can see that Malaysia suffered a recession during the years between 1974 and 1975, 1985 and 1986 and 1997 and 1998 when the economy was at the trough level in those periods.

Figure 1.9: Business cycle in Malaysia

ACTIVITY 1.4

In your opinion, is the Malaysian economy currently in the level of expansion? What do you understand by the terms recession, trough and recovery?

EXERCISE 1.2

What does business cycle mean? How does the change in the unemployment rate relate to business cycle? Can the unemployment rate become zero?


WHAT DO MACROECONOMISTS DO?

Macroeconomists will use their expertise to do: (a) Macroeconomic forecasting (b) Macroeconomic analysis (c) Macroeconomic research (d) Develop and test an economic theory (e) Collect data

CLASSICAL VERSUS KEYNESIAN VIEWS

The classical view is based on the notion that individuals and firms or businesses act in accordance with their own interests and wants. Wages and prices will change rapidly to achieve market equilibrium. Classical view can be seen as an „invisible hand‰ whereby free market economy will solve all problems on its own and government intervention in the economy is restricted. The Keynesian theory states that wages and prices do not change rapidly and do not believe that the „invisible hand‰ can solve all problems effectively. The view stated is that because wages and prices change rather slowly, unemployment will remain at a high rate for a longer period of time. Keynesians believe that government intervention will definitely help improve a countryÊs economic performance.

1.6

1.5

EXERCISE 1.3

List down the main activities of macroeconomists. What is the role of their analysis in each of these activities?

EXERCISE 1.4

Compare the classical and Keynesian views on the changes in wages and prices. What are the implications of these different views?


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AGGREGATE DEMAND AND AGGREGATE SUPPLY

In this section, we will learn about: (a) Aggregate Output and Price Level

Price level in the economy is the weighted average of the prices of all goods and services such as food, housing, clothes, entertainment, transport, medical and all other products.

(b) Aggregate Demand Curve

Figure 1.10 shows an aggregate demand curve (AD).

Figure 1.10: Aggregate demand curve

Aggregate demand is the total amount of goods and services demanded in the economy at a given overall price level and in a given time period.

Aggregate output is the economyÊs total production, which means the total sum of an economyÊs production of goods and services in a given period.

1.7

Aggregate demand curve is a graph showing the connection between price level of economy with the total aggregate output in a given period, assuming that all other factors remain the same.


The figure above shows the aggregate demand curve, where the vertical axis (y-axis) shows the average price level, whereas the horizontal axis (x-axis) shows the aggregate output or the actual Gross Domestic Product (GDP) which will be discussed at length in Topic 2. The negative slope of the aggregate demand curve captures the inverse relation between the aggregate output and the price level. This means that if the price level drops, consumers will demand more goods and services, thus increasing expenditure.

(c) Aggregate Supply Curve

Aggregate supply curve shows the output quantity that firms are willing to provide at a particular price level. Normally, there is a positive relationship between the aggregate supply and price level.

(d) Equilibrium The intersection of aggregate demand and supply will determine a balance between price level and economic output, as shown in Figure 1.11.

Figure 1.11: Equilibrium

Referring to the curve above, equilibrium is attained at „E‰ where the AD curve and the AS curve meet. The equilibrium price level is at P*, while the equilibrium aggregate output is at Q*.


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• Macroeconomics is a field related to the connection between aggregate variables that analyse the economy as a whole system.

• Macroeconomics focuses on national economic growth which is measured based on national income.

• Two important macroeconomic policies are financial policy and fiscal policy. These policies will be used to achieve macroeconomics objectives, such as full employment, price stability and satisfactory economic growth.

• Economic changes related to the increase and decrease in output can be seen from the business cycle aspect.

• Normally, the business cycle has two important phases Expansion and contraction. This can be seen in detail from its different levels Peak, recession, trough, recovery and expansion.

• This topic also discusses two macroeconomic views Classical and Keynesian.

• Aggregate demand curve has a negative slope which shows the inverse relation between the price level and the aggregate output demanded.

• Meanwhile, aggregate supply curve shows a positive relationship between price level and aggregate output quantity supplied. The interaction between both these curves will determine a balance between price level and aggregate output in the economy as a whole.

Depression Equilibrium Financial policy

Fiscal policy Productivity Recession

INTRODUCTION

Macroeconomics theory began blooming and became popular following the recession in 1929. The economic downturn continued for more than five years and recorded an unemployment rate of up to 25% in the United States of America. This meant that every one out of four persons was unemployed or did not work and that was indeed a very high rate of unemployment. Therefore, famous economists headed by English economist John Maynard Keynes, suggested that a macro view is taken to solve problems. This view is used since the microeconomics theory used prior to this could not overcome the high unemployment rate. Hence the macroeconomics theory started to flourish. From time to time, other problems such as inflation and deficit cropped up which needed to be solved using the macro view. Without inflation and unemployment, the system of free market economy does not guarantee stability in the economic

TTooppiicc

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National Production


1. Explain the circular flow of the income model;

2. Discuss the concept of national product and the differences between gross national product and gross domestic product;

3. Illustrate how gross domestic product is calculated;

4. Distinguish the difference between nominal national production and actual national production; and

5. Solve problems that arise during the measurement of national production.

TOPIC 2 NATIONAL PRODUCTION

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activity that is carried out. The existence of such problems helps open up more room for macroeconomics to grow. In this topic, focus will be on the main macroeconomics issue, which is the national production.

CIRCULAR FLOW OF INCOME MODEL

The main aim of a countryÊs economic activity is to ensure that all its peopleÊs needs for goods and services are satisfied. Nothing is more important than providing shelter, food, clothing, education and recreation for each and every citizen. Before you continue reading, think for just a moment as to how economic activities are measured. A countryÊs economic activity is usually measured based on the countryÊs overall output.

Before understanding further about the concept of national production, it is important for you to understand circular flow of income model as shown in Figure 2.1. The model shows the simplest economic activity involving two parties, namely the household and the firm.

Figure 2.1: Circular flow of income model

2.1

National production or national output means the same, namely it refers to the final products/goods and services produced by a country for a specific period of time, such as a year.

TOPIC 2 NATIONAL PRODUCTION 17

Figure 2.1 shows the circulation of physical goods (products and resources) and cash between households and firms. Every circulation of physical goods will be followed by a circulation of cash in the opposite direction. The circulation of resources (production factors such as land, capital, labour and entrepreneurs) from households to firms will be followed by cash being circulated from the firms to the households. Resources possessed by households that are utilised by firms in the production process will be paid for by the firms. The circulation of goods from the firms to households will also be followed by circulation of cash from households to the firms, which represents the payment for the goods purchased by households from the firms.

GROSS DOMESTIC PRODUCT

Every country has its own method of evaluating its own economic activity. One thing is for sure, the process undertaken to do this is certainly not a simple one. The same goes for Malaysia. Malaysia has its own method of measuring the drop in profit and the ins and outs of practiced economic activities. Have you ever given it a thought. How does the Malaysian government measure national production? One national production concept that Malaysia applies is the Gross Domestic Product (GDP).

2.2

ACTIVITY 2.1

We always hear the term „gross domestic product‰ being mentioned in economic news over the electronic media. What do you understand about gross domestic product?


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Figure 2.2 shows the four important elements of GDP.

Figure 2.2: The four elements of GDP

The explanation for the four elements of GDP are as follows:

2.2.1 Total Value of Production

In order to calculate the total value of production, you will have to add the value of all the goods. For example, value of an orange to be added to the value of a computer, a car, a washing machine and so on. GDP values of goods are based on their market prices. The market price is the price at which a good, service or asset is exchanged in a market system. Example If an orange is sold for 30sen and the price of a computer is RM1,000, then the value of 100 oranges and five computers are RM5,030, which is equivalent to RM30 for the oranges and RM5,000 for the computer.

2.2.2 What are the Final Goods and Services Produced?

The GDP calculations only take into account the market price of the final goods and services. Final goods and services are those that are actually used or consumed by individuals, households, firms or the government and will not be

Gross domestic product (GDP) means the total market value of all the goods and services produced within the borders of a nation during a specified period.


used as components in producing other goods and services. In other words, it is not intermediate goods and services. Example Proton Waja (MalaysiaÊs national car) is the final product but the tyre it uses is an intermediate good. GDP only considers the goods that are being sold in the market. Therefore, goods produced for your own consumption are not taken into account by GDP.

2.2.3 Where are They Being Produced?

Only goods and services produced within the boundaries of a country will become part of the GDP of that country. Therefore, goods and services produced in Malaysia are part of MalaysiaÊs GDP. Example Nike, an American company, produces clothing in Malaysia. The value of the clothing produced in Malaysia is part of MalaysiaÊs GDP and not the GDP of the United States. Petronas, a Malaysian oil company, produces oil in Vietnam and contributes towards VietnamÊs GDP and not ours.

2.2.4 When are They Produced?

GDP concerns only the production of new goods and services during a particular period. Usually, the period is every three months or a year. Only the final products and services produced during that period of time will be taken into consideration for the GDP. GDP not only measures the total value of production, it also calculates the total revenue and total expenditure of a country. Example In Malaysia, Bank Negara uses the quarterly data to detect any changes in short-term economic activities. Economists on the other hand, use annual data to evaluate the growth in long-term economic activities.


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GROSS NATIONAL PRODUCT

What do you understand about gross national product? How is it different from GDP? Another concept used to measure the production of a country is the Gross National Product (GNP). In other words, GNP does not take into account value of output produced by a foreign firm even though the production operation is carried out within the country.

For example, the value of clothing produced by Nike in Malaysia is not included in the calculations for MalaysiaÊs GNP. Instead it is used in the calculations of AmericaÊs GNP.

2.3

Gross national product (GNP) means total market value of goods and services produced by a countryÊs nationals using their own resources, regardless of whether the production operations are carried out within or outside the country.

EXERCISE 2.1

True (T) or False (F) Statements

1. National production means goods and services produced within the borders of a nation during a specified period.

2. In measuring the value of production, GDP values them during a certain time frame only. Usually, the period is every six months or three years.

3. Gucci is an American brand. The value of clothing they produce in Malaysia is part of AmericaÊs GDP and not ours.

4. Goods and services produced in Singapore are counted as part of SingaporeÊs GDP.

5. In order to calculate national production value, GDP values the goods based on the market price.


Similarly, the petroleum produced by PETRONAS in Vietnam is not added into VietnamÊs GNP. Instead it is added to ours.

METHOD OF CALCULATING GDP

Generally, there are three approaches for measuring GDP, namely expenditure approach, production approach and income approach. Although the methods are different, they give the same value.

2.4.1 Expenditure Approach

2.4

GNP = GDP + income earned by domestic residents through foreign investments - income earned by foreign investors in the domestic market

ACTIVITY 2.2

While walking in shopping malls, you must have seen business premises of branded goods like GUCCI, Laura Ashley, GUESS, Dorothy Perkins, TOPSHOP, NIKE, Dunhill and such. After studying the concepts of GDP and GNP, give your opinion, what are the contributions made by those businesses towards MalaysiaÊs economic growth?

EXERCISE 2.2

1. State the difference between GDP and GNP.

2. A product was made in 2002 but sold in 2003. Which year will it be accounted into for the purpose of calculating the GDP?

3. For a developing nation like Malaysia, which value would be higher, GDP or GNP?

Expenditure approach sums up the total expenditure in a country (of individuals, firms and government). The total is derived from the final demand for goods and services.


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There are four groups that purchase final goods and services, namely, households, firms, government and overseas consumers. The expenditure of these four groups can be divided into four categories, namely, personal consumption expenditures, investment, government purchases of final goods and services, and net exports. Figure 2.3 shows the four categories of expenditure.

Figure 2.3: Four categories of expenditure

The description for each category of expenditure is shown in Table 2.1.

Table 2.1: Description of Four Categories of Expenditure

Expenditure Description

Personal consumption expenditures

Expenditures by households on final goods and services. This includes expenses for food, laundry, rental and so on.

Investment

Investment by firms on capital equipment like machines, and buildings, and addition to inventories. Production that cannot be sold also adds on to the inventory and thus, is included in investment. Purchase of shares and bonds are not considered as investments since these are not purchase of final goods or services.


Government purchases of final goods and services

Central and local government purchases of goods and services from the private sector. In order to function effectively, government has to purchase goods and services produced by firms. For example, government buys computers, paper, pens and ammunition. All these goods are necessary for the government to function effectively. Some goods produced locally cannot be sold in the country. Similarly, some goods required by the people are not produced locally and therefore, need to be imported from overseas.

Net exports Total exports minus total imports. If total value of exports exceeds total imports, then the net exports is a positive value. Instead, if the exports value is less than the imports value, then the net exports is a negative figure.

Therefore, the total expenditure for the final goods and services produced by a country is the sum after adding all the four categories listed below. • Personal consumption expenditures = C • Investment = I • Government purchases of final goods and services = G • Net Exports = X M

Total expenditure represents the value/sum received by the firms that produce the final goods and services.

Total Expenditure = C + I + G + (X M) = GDP


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2.4.2 Production Approach

Figure 2.4: Production approach

According to the production approach, all the value of final goods and services from the various economic sectors are added. Figure 2.4 shows the example of sectors found in Malaysia. For your information, in Malaysia, the economic sector can be divided into three groups, namely, the main sector, the industrial sector and the service sector. The information on the value of production in each of these sectors is obtained through census. This approach uses the concept of adding up all the values so as to avoid the problem of counting a value twice.

This will cause the GDP to be over estimated and the value will not reflect the actual figure. To make it easier for you to understand, refer to the following case scenario. Table 2.2 is a guide to the scenario.

The problem of counting a value twice is a situation whereby the value of a good is counted more than once when measuring the GDP.


Table 2.2: Value Added Method

Process Value Add (RM) Value Add (RM)

Firm I Cotton to thread Firm II Thread to cloth Firm III Cloth to dress

TOTAL

100 150 230

100 50 80

230 Example Assume that there are three steps to produce a dress. In the first process, cotton is processed into thread and sold to Firm II for RM100. At this stage, a value of RM100 is produced (assuming that the cotton is obtained for free). Firm II then produces cloth using the thread and sells it to Firm III for RM150. This process had added a value of RM50 to the original RM100. Subsequently, cloth is made into a dress in this third stage of production. This dress is then sold by Firm III to consumers for the price of RM230. Therefore, a value of RM80 has been added on to the price for which the cloth was purchased. According to the production approach, only the final value of production is taken into account when calculating the national income. In this case, only the final figure of RM230 is taken. If the values of the intermediate goods are considered (example, the 100 + 150 + 230), this would mean the values are added twice and the national income would be over estimated.

2.4.3 Income Approach

Measuring GDP using the income approach means to sum up the incomes that firms pay households for the factors of production they hire, for example, labour, land, capital and entrepreneurs. This approach divides income into five categories as shown in Table 2.3.


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Table 2.3: Five Categories of Income Approach

Income Approach Explanation

Compensation of employees

Compensation of employees mean wages paid to the employees. It includes net wages and salaries added to fringe benefits paid by the employer such as health insurance, social security contributions and gratuities/pension fund contributions.

Net interest Net interest means the interest payments by the bank to the customers/households on the deposits. This payment must deduct the interest paid by customers/households for loans taken.

Rental income Rental income means total rent collected for the use of land and other inputs. It includes payment of house rental and estimated rental which should be paid by those who live in their own homes.

Corporate profits Corporate profits mean the measure of profit earned by the household sector for supplying entrepreneurship services through corporations. The corporate profits paid as dividends and profits that are not divided are considered income.

ProprietorsÊ income Proprietor means someone who owns his own business. His/her income includes the total of all four sources of income stated above. ProprietorsÊ income is difficult to be divided into compensation of employees, rental income and profits. Therefore, it is joined into a single category and named proprietorsÊ income.

We can conclude that the national income is measured by adding the total of all income above.


ADJUSTING FACTOR COST TO MARKET PRICE

In the process of calculating the GDP, the expenditure approach values the goods and services at market rates whereas income approach values them based on factor cost of production used to produce the goods and services. Indirect taxes and subsidies are two elements that differentiate market prices from the factor cost. Sales tax causes the value of market prices to be more than the factor cost whereas subsidies make the factor cost higher than market prices. In order to adjust the factor cost to market prices, indirect taxes has to be added and subsidies have to be deducted as shown below.

2.5

National Income


+ Net interest

+ Rental income

+ Corporate profits

+ ProprietorsÊ income

= GDP

SELF-CHECK 2.1

With your understanding of the income approach, give the meanings of each method below. You can refer to the answers in this topic.

Income Approach Category Meaning


Net interest

Rental income

Corporate profits

ProprietorsÊ income


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Example Information below concerns the national income of X. GDP at factor cost [GDP (fc)] = RM100 million Indirect taxes = RM25 million Subsidies = RM7 million What is the value of GDP for the country X at market price? Answer GDP(mp) = GDPfc + indirect taxes subsidies = RM100 million + RM25 million RM7 million = RM118 million Therefore, GDP at market price for country X is RM118 million.

ECONOMIC ACTIVITIES THAT ARE NOT INCLUDED

2.6

Factor Cost + (Indirect Taxes Subsidies) = Market Price

EXERCISE 2.3

1. State three methods for calculating GDP.

2. How can the value of factor cost be adjusted to market value?

ACTIVITY 2.3

What is your opinion on the traditional agricultural produce that is being carried out in the villages? This is because there are farmers who do not sell their agricultural produce and instead consume them for their household needs. How can measurement be done?


In measuring the GDP, only the production value from economic activities that are productive, legal and marketed are considered. There are economic activities that are unproductive, illegal and not marketed. Below are examples of such activities which are not included in the calculation of GDP.

2.6.1 Traditional Farmer’s Agricultural Produce

In traditional farming, some of the output produced is used for farmers own consumption. Although this economic activity is productive, it is not marketed. Therefore, this type of farming on a smaller scale is not included in the calculation of GDP. Figure 2.5 shows an example of traditional farming.

Figure 2.5: Planting paddy is an example of traditional farming

Source: Http://images.google.com.my

2.6.2 Illegal Activities

Although activities such as drug trafficking, prostitution, gambling or black market trade are all productive, they are not included in the calculation of GDP because these activities are illegal. Figure 2.6 shows an illegal activity.

Figure 2.6: Drugs is one example of an illegal activity that is not included in the

calculation of GDP Source: Http://news.bbc.co.uk/olmedia/1045000/images/


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2.6.3 Productive Activities that are Not Paid

There are productive activities that are not paid for. For example, housework done by a housewife is not paid for and thus, makes it difficult to be valued. Therefore, it is not included in the calculations of GDP. However, if the job is given to a maid and she is paid for the work done, then it will be accounted for in the GDP.

2.6.4 Non-cash Reward

It is quite normal for a company manager to receive partial benefits in the form of something other than cash, for example, free stay in a hotel or transportation. Although it increases his real income, it is still not included in the calculations for GDP.

REAL GDP AND NOMINAL GDP

The value of GDP for a country changes from time to time. The same goes for prices that keep fluctuating from time to time. Information pertaining to the increase in production is important. Thus, the element of change in pricing has to be set aside from the national production value. The isolated data which shows the price difference is more meaningful to economists and policy-makers as it reflects the actual economic activities.

2.7

Real GDP means the GDP value does not have any element of price change in its calculations. The GDP is measured based on fixed prices.

Nominal GDP means measuring the value of all the goods and services produced expressed in current prices. Price change will affect the GDP value.

ACTIVITY 2.4

You have studied the economic activities that are not included in the measurement of national production. In your opinion, how does the black market activity of producing illegal and pirated VCDs affect the economic growth especially in Malaysia?


To make it easier for you to understand these two concepts, refer to Table 2.4. Imagine that country X which only produces two goods, namely food and clothing. Table 2.4 shows the quantity and prices for these two items for the years 2001 and 2002.

Table 2.4: Quantity and Prices

Quantity (Unit) Price Year

Food Clothing Food Clothing

2001 5 10 RM20 RM15

2002 7 12 RM22 RM15

Based on the information in Table 2.4, the nominal GDP value, which is the value of goods produced for a specific year for a country during 2001 and 2002, is stated below.

Since the price used is the same, which is the price for the year 2001, therefore the values of real GDP and nominal GDP are the same RM250. Based on the pricing for 2001, the real GDP value for 2002 is:

Comparatively, the value of real GDP for the year 2002 is lower than the nominal GDP value for the same year. This is owing to the increase in food prices from 2001 to 2002. Real GDP can be measured using a constant price at any year. In the present situation, the real GDP can also be measured based on the 2002 pricing.

Year 2001 (5 Food × RM20) + (10 Clothing × RM15) = RM250. Year 2002 (7 Food × RM22) + (12 Clothing × RM15) = RM334. While the Real GDP for the year 2001 based on the price for 2001 is: (5 Food × RM20) + (10 Clothing × RM15) = RM250.

(7 Food × RM20) + (12 Clothing × RM15) = RM320.


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The rate of growth in real GDP between 2001 and 2002 can be calculated as below.

The value of 28% shows the average growth rate for both food and clothing for country X.

NATIONAL PRODUCTION DATA USAGE

National production data reflects a countryÊs overall economic activities. It is very useful for many parties, including the government, policy-makers and Bank Negara. Figure 2.7 shows five main usages of the national production data.

Figure 2.7: National production data usage

2.8

(RM320 RM250) / RM250 x 100 = 28%.

EXERCISE 2.4

1. State the types of activities that are not included in the calculation of national production.

2. What is the difference between real GDP and nominal GDP?


These above statements are below: (a) To Measure Economic Performance The economic growth rate can be calculated by comparing the current

national production data with that of the previous year. The information regarding the economic growth rate helps the government make comparisons with other countries.

(b) To Facilitate Policy-makers to Plan Policy-makers need the national production data to draft economic policies

for the coming years. The national production is an important guide that provides details about a countryÊs economic performance and therefore, is vital for planning purposes.

(c) To Show or Indicate the Success or Failure of Government Policies The government is able to evaluate the effectiveness of an economic policy

that has been implemented based on the information about national production. It also allows the government to look at any economic problems that may have arisen, and find ways to solve these problems.

(d) To Measure the PeopleÊs Standard of Living The national production data is used to measure the standard of living of

the citizens of a country. Normally, the value of Real GNP or Real GDP per capita is used as a measuring yardstick. With this data, one can compare the peopleÊs standard of living from time to time or compare with people living in other countries.

(e) To Evaluate Contributions of Economic Sectors toward the CountryÊs

Economy Based on the production approach, the contributions made by each

economic sector towards the overall economic growth can be evaluated. The government can determine the sectors that are considered the backbone of the countryÊs economy. Based on each sectorÊs performance, the government can also assess the success or failure of its policies with regard to each sector.


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FACTORS AFFECTING NATIONAL PRODUCTION LEVEL

The national production level of a country fluctuates all the time. The national production of developed nations such as United States of America and Japan are higher compared with national production of developing countries like Sri Lanka and Thailand. The level of a countryÊs national production depends on these factors:

2.9.1 Internal Factors

One of the internal factors that affects the level of national production are natural resources such as petroleum and gas. Countries that are rich with natural resources are bound to have a higher national production level compared to countries that have no natural resources at all. Energy or labour factor play an important role in contributing towards national production. Countries that have hardworking and capable employees like Japan will definitely increase the national production level compared to nations with lazy and unproductive labourers. Besides these, total capital owned by a country also affects the level of national production. Countries that have less capital cannot afford to produce large output compared to countries that have a more capital. The level of technology also determines the national production level. Countries that have the knowledge and technological advancement are able to produce goods and services using faster and more efficient methods.

2.9.2 External Factors

Foreign investment plays an important role in increasing national income and economic growth of a country. Foreign investment, whether directly or indirectly, contributes towards a countryÊs economic growth and income level. Terms of trade also affects the income of a country.

2.9

Terms of trade is the ratio of the price a country receives for its export commodity to the price it pays for its import commodity.


Terms of trade are good if it shows that a country is receiving more import quantity compared to its export quantity. This means it has to pay less for the products it imports, that is, it has to give up less exports for the imports it receives. Receiving assistance from other countries can also improve the recipient countryÊs standard of living. For example, assistance provided by international organisations and developed nations can help reduce the rate of poverty in poor countries. National production of developing countries can be improved with the help from other countries.

THE PROBLEMS IN CALCULATING NATIONAL PRODUCTION

The calculation of national production is a very complicated process and many problems arise during this process. Figure 2.8 shows four problems that usually surface during the process of calculating national production.

2.10

EXERCISE 2.5

1. What is the use of national production data?

2. Discuss factors that affect the income level of a country.

ACTIVITY 2.5

The process of calculating national production is not an easy one. Many times unforeseen problems turn up and make matters more difficult. Before you begin reading, try to identify problems that you usually read about in the newspapers and compare your opinions with what you will be studying.


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Figure 2.8: Problems in calculating national production

All four problems are discussed below. (a) Gathering of Information Gathering information or data is difficult as there are some parties such as

small-time businessmen and farmers who do not keep detailed records of their economic activities. The production value obtained from them is usually an estimated figure. Mistakes happen when classifying this information, which could cause some confusion in the calculating process.

(b) The Problem of Counting Twice/Double Counting The difficulty in identifying final goods and intermediate goods might lead

to the problems of double counting. A product can be classified as either a final or an intermediate good depending on its usage. For example, flour purchased by a housewife is considered a final product. However, flour purchased by a baker is considered an intermediate product.

(c) Determining the Prices of Goods Usually, prices of goods differ from one area to another. In addition to that,

prices of certain goods are always changing such as the price of palm oil which changes everyday. Thus, the difficulty arises in determining the prices that should be taken into account in calculating national production.

(d) Depreciation (Devaluation) It is difficult to calculate depreciation because there are no detailed records

about depreciation for some economic activities. Besides this, there are many different methods of calculating depreciation and each method gives a different figure.


BUSINESS CYCLE

Usually, it lasts for a period of two to ten years, accompanied by expansion and contraction of various sectors in an economy.

Figure 2.9: Business cycle

Figure 2.9 shows a business cycle. The five stages of the business cycle are peak, trough, recovery, growth (expansion) and recession (contraction). The points between the stages are indicated by peaks and troughs. The most important phases in a business cycle are growth (expansion) and recession (contraction). An economy is said to have achieved a full cycle when the economy has gone through the five stages. For example, a business cycle that starts at the peak is complete when it ends at the next peak. Recession starts at the peak and ends at the trough. Recession occurs when the value of real national production drops for two quarters of a year in a row. The main characteristics of a recession include a decrease in demand for labour, and reduction in spending by the consumer. Recession is also reflected in the drop in firmsÊ profits. Since consumer spending decreases during recession, all the firmsÊ unsold products increase and this will raise the firmsÊ inventories.

2.11

ACTIVITY 2.6

Based on your understanding of the problems that usually arise in calculating national production, try to identify if there are any problems that were not mentioned and list them down.

Business cycle can be defined as periodic fluctuation in the rate of economic activity, as measured by levels of employment, prices and production.


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Expansion, on the other hand begins at the trough and ends at the peak. The early stage of expansion is called recovery. This happens when national production actually increases for six months continuously. A growth in the economy reflects the increase in business sector confidence, a hike in investment and a demand for labour. As income increases, peoples spending power increase too. FirmsÊ profits also will increase and inventories reduce.

• This topic discussed important economic variables, namely, national production. The circular flow of income model is used to explain the relationship between income and expenditure.

• There are three approaches for measuring Gross Domestic Product (GDP), namely, expenditure approach, production approach and income approach. Although these three approaches are different, they give the same GDP value. Besides that, the difference between the Real GDP and Nominal GDP was also explained.

• This topic also discussed the national production data usage, factors that affect the national production level and problems faced in calculating national production. The topic ended with an explanation of a business cycle and its five phases.

Business cycle Expenditure approach Gross domestic product (GDP) National production

Nominal GDP

Production approach

Real GDP

EXERCISE 2.6

1. There are many problems that have to be dealt with in the calculation of national production. Explain the usual problems that arise.

2. Define business cycle and discuss the five phases in a business cycle.

INTRODUCTION

In this part, we will discuss the equilibrium income theory. At the beginning of this topic, you will be introduced to the equilibrium of a two sector economy, followed by a three and a four sector economy. Part two of this topic will discuss the fiscal policy and how it can used to solve inflation and deflation.

TWO-SECTOR ECONOMY

Balance in the countryÊs economy is closely related to circular flow of income which includes a macroeconomics market, a goods and services market, a financial market and a labour market.

3.1

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Determinant of Equilibrium Income Theory


1. Discuss the characteristics of two, three and four sector economy;

2. Analyse the determinant of equilibrium income for two, three and four sector economy; and

3. Examine the role of fiscal policy in solving economic problems.

TOPIC 3 DETERMINANT OF EQUILIBRIUM INCOME THEORY

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A two-sector economy is made up of household and firms as shown in Table 3.1.

Table 3.1: Two-Sector Economy

Sector Explanation

Household Economic units that own the factors of production. Decides on the use of goods and services and savings. Has the role of supplying services to the firms.

Firms Economic units that decide on the production. It buys the factors/resources from the household and sells/supplies the goods and services to the household sector.

3.1.1 Circular Flow of Income

Circular flow of income between sectors and both the goods and labour market involve a physical flow (of goods and services) and cash flow (in the form of fee, rental, interest, profits, and payment for the use of goods and services). The flow can be seen in Figure 3.1.

Figure 3.1: Two-sector economy circular flow of income

Firms produce a certain quantity of goods and services in a given period known as the aggregate output (Y). Since each ringgit spent is received as income by someone else, therefore the aggregate output and aggregate income are the same. Four important concepts in a two-economic sector circular flow of income: (a) Consumption; (b) Savings; (c) Investment; and (d) Disposable income.

TOPIC 3 DETERMINANT OF EQUILIBRIUM INCOME THEORY 41

Let us analyse these concepts one by one. (a) Consumption (C)

The aggregate consumption (total consumption expenditure) for a specific period depends on household income, wealth, interest rate and household thinking about the future.

We realise that the more an individualÊs income is, the higher are his expenses. This concept is applicable for the overall economy. There exists a positive relationship between aggregate income and aggregate consumption.

The function of consumption shows the connection between consumption and income.

C = a + bYd

where C = consumption a = autonomous consumption b = marginal propensity of consumption (MPC) Yd = disposable income Autonomous consumption (a) refers to consumption that does not depend on income. It exists even when Y = 0, meaning that the household spends even when there is no income. Marginal propensity of consumption (b) measures the ratio of change in consumption to the change in income. The formula to calculate MPC is shown below:

MPC = Δ

=Δ

Change in consumption CChange in income Y

The component consumption (C) refers to household expenditure, namely, all the household expenditure to buy goods and services with the income they obtain.


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The ratio of total consumption to the total income is measured through Average Propensity of Consumption.

Consumption function is plotted in Figure 3.2 below.

Figure 3.2: Consumption function

Disposable income is the net income remaining after taxes are paid (Y T). This income can be used to buy goods and services. As the government sector does not exist in a two-sector economy, taxes T = 0, and therefore Yd = Y.

(b) Savings (S) In the two-sector economy, which does not involve international trade, households can do two things with their income; either spend it on consumption or save it. In other words, savings is a part of income which is not being used by households to buy goods and services. Savings function is the relationship between disposable income and savings. Since disposable income equals the total of consumption and savings, therefore:

APC = =Total consumption C

Total income Y

Yd = C + S

Yd = a + bYd + S


Therefore, savings function is:

whereby S = savings -a = negative savings (1-b) = marginal propensity to save (MPS) Yd = disposable income

Savings function can be seen in Figure 3.3.

Figure 3.3: Savings function

Negative savings (-a) is the value when Y=0. The marginal propensity to save (MPS)

[1 b] shows the ratio between increases in savings and increases in income.

The ratio between savings and income is referred to as the Average Propensity of Savings (APS).

Savings by households and firms are considered leakages in the circular flow of income.

S = a + (1 b)Yd

MPS = Δ=Δ

Change in savings SChange in income Y

APS = =Total savings STotal income Y


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(c) Investment (I) Investment is the main type of expenditure for firms.

Investment specifically includes constructing a building, factory and house, purchasing capital goods such as machines, and adding net inventories or goods stock. In an economy, real investment differs with planned investment because the change in a firmÊs inventory is a part of real investment and the change in inventory is not wholly under the control of the firm. Change or increase and decreases of inventories sometimes depend on household decisions regarding their consumption. However, the letter ÂIÊ usually refers to planned investment only. Investment is divided into two types: (i) Induced investment; and (ii) Autonomous investment.

Factors affecting induced investment are income profits and growth in residents. The growth in number of people will cause production of goods and services to increase.

Investment is defined as a firmÊs expenditure in purchasing a stock of capital goods and/or technology - goods which are not consumed but instead used in future production of goods and services.

Autonomous investment is affected by factors other than national income, for instance interest rates, level of technological advancements, and expectations.

Induced investment depends on national income. Changes in income induce changes in investment.


The functions of induced investments and autonomous investments are shown in Figure 3.4.

Figure 3.4: Autonomous investment and induced investment

3.1.2 Consumption, Savings and Disposable Income

The relationship between income, savings and disposable income is shown below:

whereby Y = Yd, C = f(Yd), S = f(Yd) When the equation is divided by Y, then

that is 1 = APC +APS If there is a change in the level of income, then

ΔY = ΔC + ΔS

Y C S= +

Y Y Y

Yb = C + S


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1 = MPC +MPS

MPC = 1 MPS MPS = 1 MPC

When the equation is divided by �Y, then

that is

MPC is the percentage or portion of additional income that is used for consumption expenditures. MPS is the percentage or portion of additional income that is used for savings. Since all income in the economy must either be spent or saved, therefore MPC + MPS = 1. It can also be written as or

3.1.3 National Income Equilibrium

Before national income equilibrium is obtained, you need to know the conditions of national income equilibrium. The terms and conditions of national income equilibrium is aggregate demand (AD) = aggregate supply (AS). In a two-sector economy, aggregate demand is made up of consumption and investment, namely:

Aggregate supply is the total goods and services produced within the country, that is:

therefore, AS = Y

Δ Δ Δ= +

Δ Δ ΔY C SY Y Y

AD = C + I

AS = National production = National income


Since AD = AS, the terms and conditions of equilibrium is written as:

In a non-balanced state, for instance when the aggregate expenditure is more than the aggregate output, there will be an unforeseen drop in inventory. Firms will react by increasing output. This will help increase income and eventually the level of consumption. This process will continue until the level of equilibrium is achieved. Since C + I = Y = C + S, therefore the condition of equilibrium can also be written as:

The level of national income equilibrium can be determined by three methods: • Using a table; • A figure/graph; and • A mathematical equation. (a) Table

If MPC = 0.75 consumption is RM 500 million when income equals to zero and autonomous investment is RM200 million.

Therefore C = 500 + 0.75Yd and S = -500 + 0.25Yd. By varying the value of Y in the equation, Table 3.2 is obtained.

Table 3.2: Determinants of Equilibrium in a Two-Sector Economy

Y = AS Consumption (C) Investment (I) Savings (S) AD = C + I

0 500 200 500 700

700 1,025 200 -325 1,225

1,400 1,550 200 -150 1,750

2,100 2,075 200 25 2,275

2,800 2,600 200 200 2,800

3,500 3,125 200 375 3,325

4,200 3,650 200 550 3,850

Equation Injection = Leakage I = S

Equation AD = AS

Y = C + I


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National income equilibrium exists at Y = 2,800 when the conditions AD = AS and I = S are satisfied.

What happens when Y is not equal to 2,800?

If the income is lower than 2,800, it will form an unstable condition because AD>AS. This will encourage firms to increase production and economic activities will increase until AD=AS is achieved. If income exceeds 2,800, it will also form an unstable condition because AS>AD. This means national output exceeds the planned aggregate expenditure. As supply exceeds demand, firms will reduce their production until a balance of AD=AS is achieved.

(b) Figure/Graph

The equation AD = AS involves the curve Y = AS and AD = C + I. Equilibrium is achieved at the point when both the curves meet, which is at e and income at Ye (Figure 3.5).

Figure 3.5: National income equilibrium

Whereas, the injection-leakage approach involves the savings curve S and investment curve I. The equilibrium is shown at the point both the curves meet.

(c) Mathematical Equation

Using the same value, whereby the consumption and savings functions are: C = 500 + 0.75Yd S = 500 + 0.25Yd


Because Y = C + I, therefore: Y = 500 + 0.75Y + 200 Y = 700 + 0.75Y Y 0.75Y = 700 Y = 700/0.25 = 2,800

Or by using the injection-leakage method (I = S), therefore

200 = 500 + 0.25Y 0.25 Y = 700 Y = 700/0.25

Y = 2,800

3.1.4 Change in Aggregate Demand

Change in aggregate demand will change the level of national income to equilibrium. In a two-sector economy, this happens when factors affecting consumption and investment change. The effects of change in AD (change in investment) are shown in Figures 3.6 and 3.7.

Figure 3.6: The effects of change in AD using the AD = AS approach


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Figure 3.7: The effects of change in AD using the injection = Leakage approach

3.1.5 The Effects of Multiplier

Multiplier measures the effects of change in one variable against another variable.

The size of the multiplier is obtained using the following formula:

Multiplier effect causes the income to change at a higher rate compared to the change in AD earlier. In a two-sector economy, changes in the AD component focuses on the level of investment (I).

Multiplier value (K) = 1/(1-MPC) or 1/MPS.

The effects of multiplier can be defined as the ratio of increase in income or national production to increase in aggregate demand (AD).


Example To understand the multiplier process, assume MPC = 0.8 and change in investment = RM150 million. It is found that the multiplier value K = 1/0.2 = 5. This size shows that the change in investment will change the value of income, consumption and savings five times over. Therefore change in Y = multiplier value change in investment ΔY = K ΔI = 5 RM 150 million = RM 750 million Assuming the original equilibrium level as RM2,500 million, therefore the new national income level is: Y = 2,500 + 750 = RM3,250 million.

SELF-CHECK 3.1

Reflect on what you have studied so far. What are the characteristics of a two-sector economy?

EXERCISE 3.1

1. In a two-sector economy, explain the relationship between consumption, savings and disposable income.

2. Give the definition of the concept of multiplier and state how size of multiplier is obtained.

3. In a simple model, if C = 100 + 0.8Y and I = 50, calculate the equilibrium level of output.

4. If MPC = 0.75, the marginal propensity to save has to be _________________.

5. Increase in autonomous consumption will move the aggregate consumption curve to _______________________.

6. Marginal propensity of consumption is known as ________________________.

7. What will happen when the level of output exceeds demand?


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THREE-SECTOR ECONOMY

Three-sector economy, also known as a closed economy, includes three sectors: (a) Household sector; (b) Firms/business sector; and (c) Government sector.

Government can influence the economic activities through two specific policies: • Fiscal policy; and • Financial policy.

Government intervention directly exists in economic activities through activities such as government expenditure (G) and the creation of a government income source through the collection of taxes (T).

Government expenditure (G) includes governmentÊs spending when purchasing goods and services, public investment expenditure and moving costs. Government obtains income from taxes collected from households and firms.

3.2.1 Circular Flow of Income

There are three new flows in the three-sector economy circular flow of income, as shown in Table 3.3.

Table 3.3: Three-sector Economy Circular Flow of Income

Type of Flow Explanation

Payment in exchange for goods and services

This flow exists because government purchases goods and capital from the business sector (firms).

Payment in exchange for factors of production from where tax is collected

This flow exists because of government spending on factors of production offered by household sector.

Taxes Government collects taxes from households and the business sectors.

Financial policy refers to a government tool which controls money supply.

3.2

Fiscal policy refers to government actions in making purchases and imposing taxes.


The three-sector economy circular flow of income is shown in Figure 3.8.

Figure 3.8: Three-sector economy circular flow of income

3.2.2 Government and Fiscal Policy

Besides the four minor concepts that were discussed in the two-sector economy, namely, disposable income (Y), consumption (C), savings (S) and investment (I), there are two more important concepts to be added to a three-sector economy, namely government expenditure (G) and taxes (T). (a) Government Expenditure

This refers to public expenditure done by the government to prepare amenities for the public. Government expenditure can be seen based on three perspectives, namely: (i) GovernmentÊs expenditure in purchasing goods and services

produced by the business sector (firms); (ii) GovernmentÊs expenditure in paying for factors of production or

labour force provided by the household sector; and (iii) Government expenditure in the form of moving costs such as

pensions, scholarships and so on.

Government expenditure is considered injection as it will bring an incoming flow of income into the circular flow of income.


54

Generally, government expenditure (G) depends on a few factors such as: (i) Expected tax revenue; (ii) Economic aim to reduce the unemployment rate; and (iii) Political situation and peace increased expenses during an election

campaign. The financial sources that cover government expenses are obtained mainly from taxes, domestic loans, for example, from the Central Bank and KWSP, loans from overseas such as IMF or sale of bonds and so on. Government expenditure is determined by the government exogenously.

(b) Taxes (T)

Tax is a leakage in the circular flow of national income.

Taxes can be categorised into two: direct taxes and indirect taxes as shown in Table 3.4.

Table 3.4: Explanation on Direct Taxes and Indirect Taxes

Direct Taxes Indirect Taxes

Taxes that are collected directly from the payee and the responsibility of payment cannot be transferred to someone else. Example: personal income tax.

Taxes that can be shared or transferred to someone else. Example: export duty, import duty, excise duty, sales tax and service tax.

In an economy, there are three types of taxes imposed: (i) Progressive tax; (ii) Regressive tax; and (iii) Proportional tax.

Taxes are compulsory payment in the form of cash or kind imposed by the government on households and firms to support government expenditure.


Refer to Table 3.5 below.

Table 3.5: Types of Taxes

Types of Taxes Explanation

Progressive tax Tax rate increases with income.

Regressive tax Tax rate decreases with income.

Proportional tax Everyone pays the same percentage of income in taxes regardless of income level. So, even if income increases, the tax rate will remain the same. However, the amount of tax to be paid increases.

The proportional tax function shows the relationship between taxes and income.

whereby T = level of taxes s = autonomous taxes t = marginal propensity to tax (MPT) Y = income Autonomous taxes (s) do not depend on income. It exists even when Y=0, meaning that households must pay tax even if they do not have an income. Marginal propensity to tax (t) measures the increase in tax due to the increase in income.

3.2.3 Consumption, Savings and Taxes

The relationship between consumption, savings and taxes is seen from the effects of a fixed tax on the value of consumption and savings. Fixed tax on households and firms will reduce the disposable income and subsequently influence consumption and savings. Function of consumption with tax:

C = a + bYd C = a + b(Y T)

T = s + tY


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Function of savings with tax: S = a + (1 b)(Y T) C = a + b(Y T)

For example, if a = 9,000, MPC = 0.75 , T = 6,000

(a) In an equation without tax, when Y= 6000, value of Consumption C = 9,000 + 0.75Y = 9,000 + 0.75(6,000) = 13,500 Savings S = 9,000 + 0.25Y = 9,000 + 0.25(6000) = 7,500

(b) In an equation with fixed tax: C = 9,000 + 0.75(Y 6,000) C = 4,500 + 0.75Y S = 9,000 + 0.25(Y 6,000) S = 10,500 + 0.25Y

If Y = 6000, then the value of consumption C = 9000 and value of savings S = 9000. So, it is quite obvious that the imposition of tax decreases the value of consumption and savings.


In a three-sector economy, the components of AD include consumption, investment and government expenditure. Therefore the equilibrium condition is written as:

Besides consumption, income is also used for savings and payment of taxes. Therefore the equilibrium condition can also be written as:

Here, national income equilibrium is calculated using two main methods: • Figure; and • Mathematical equation. If its given that a = RM900 million, MPC = 0.75 I = 150 million, G = 600 million, T = 600 million

Equation Injections = Leakages I + G = S + T

Equation AD = AS Y = C + I + G


Consumption function = 900 + 0.75 (Y 600) = 450 + 0.75 Y Savings function = 900 + 0.25 (Y 600) = 1,050 + 0.25Y (a) Figure

Income equilibrium uses the equilibrium condition AD = AS and injection = leakage as shown in Figure 3.9. (i) AD = AS approach (ii) Injection = Leakage approach

Figure 3.9: National income equilibrium

(b) Mathematical Equation National income at equilibrium uses the AD = AS approach as shown below:

Y = C + I + G Y = 450 + 0.75Y + 150 + 600 Y 0.75Y = 1,200 Y = 1,200/0.25 = 4,800

The injection = leakages approach also gives the same answer: I + G = S + T 150 + 600 = 1,050 + 0.25Y + 600 750 + 1,050 600 = 0.25Y 1,200/0.25 = Y Y = 4,800

To double check your answer when calculating national income at equilibrium, you can use both the approaches and you must obtain the same answer. If you get different answers, then there must be some mistake in your calculation.


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Prior to this, the calculation of national income equilibrium include a fixed tax or a lump sum. Now, let us look at the calculations for the national income equilibrium when there is induced tax function. What is the level of the national income equilibrium for the following problem? Consumption function (C) = 70 + 0.9Yd Tax function (T) = 25 + 0.2Y Government expenditure (G) = 20 Investment (I) = 35

Equilibrium for a three-sector economy using the AD = AS method

Y = C + I + G Y = (70 + 0.9Yd) + 35 + 20 Y = 125 + 0.9 (Y T) Y = 125 + 0.9Y 0.9T Y = 125 + 0.9Y 0.9(25 + 0.2Y) Y = 102.5 + 0.72Y (1 0.72)Y = 102.5 Y = 102.5/0.28

= 366.07 Using the injection = leakages method:

I + G = S + T 35 + 20 = ( 70 + 0.1Yd) + (25 + 0.2Y) 55 = 70+0.1 (Y T) + (25 + 0.2Y) 55 = 70 + 0.1 (Y 25 0.2Y) + 25 + 0.2Y 100 = 2.5 + 0.08Y + 0.2Y 102.5 = 0.28Y 102.5/0.28 = Y

Y = 366.07


Change in government expenditure can cause a change in AD and subsequently a change in the level of equilibrium income. In Figure 3.10, B represents the original equilibrium point where AD = AS and the income level = Yoriginal.


If there is a change in government expenditure, namely an increase of �G, the AD0 curve will move to AD1. A new equilibrium point will emerge in C when AD11 crosses AS at Y1. Instead a drop in government expenditure by �G will cause AD0 curve to move downwards to AD2. A new equilibrium point is reached at A when AD2 crosses AS at income level Y2.

Figure 3.10: The effects of change in government expenditure

3.2.6 Multiplier Effect

In a three-sector economy, there are two types of multiplier: • Government expenditure multiplier; and • Tax multiplier. (a) Government Expenditure Multiplier

(same as investment multiplier)

Change in income, �ΔY = KG x �ΔG Using the same example, if government reduces G from RM600 million to RM400 million, (ΔG = 200) �ΔY = 1/0.25 x ΔG = 4 x 200 = 800

Government multiplier (K G) = 1/1 MPC or 1/MPS.


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Therefore the value of national income at the new equilibrium is: Ynew = Yoriginal +ΔY = 4,800 800 = 4,000

It is found that the drop in government expenditure has caused the value of national income to drop as well.

(b) Tax multiplier

Using the same example, if government reduces tax amounting to RM150 million, which means it reduces from RM600 to RM450, then the value of KT = -0.5/0.25 = -3 and the change in equilibrium income and �ΔY = 3 x 150 = 450.

Therefore, the new value of Y = Yoriginal + ΔY = 4,800 + 450 = 5,250

The calculation above shows that a decrease in tax will increase the national income.

The change in income level, �ΔY = KT x �ΔT.

Tax multiplier (KT) = - MPC/1-MPC or -MPC/MPS.

EXERCISE 3.2

1. Elaborate on the two additional concepts due to the existence of government sector in a three-sector economy.

2. State the equilibrium condition of a three-sector economy using the injections = leakages approach.

3. An economy has MPC = 0.6, what is the value of government expenditure multiplier?

4. Assume that MPC = 0.4. Government increases its expenditure totaling RM2 million and taxes amounting to RM1 million. What will happen to the income level at equilibrium?


FOUR-SECTOR ECONOMY

The four-sector economy is known as an open economy as the nationÊs involvement with foreign/international economy is also taken into consideration. International business activities such as imports and exports of goods and services influence the economic circular flow of income. This can be seen in Figure 3.11.

Figure 3.11: Circular flow of open economy

In a four-sector economy, the relationship between the role-players in the economy, namely households, firms, governments and overseas sectors include activities in three main markets. They are the goods and services market, labour market and financial market. Figure 3.12 shows the players and market in the four-sector economy or open economy.

Figure 3.12: Players and market in an open economy

3.3


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3.3.1 Import and Export

You would have definitely heard or read about import and export activity in a countryÊs economy. What do you understand from the terms export and import?

In the circular flow of national income, component export is an injection because it causes money flow from outside to inside the country, whereas import is a leakage as it involves money flowing out of the country.

Component import can be divided into fixed import and proportionate import. Component export is determined exogenously. The discussion in this topic involves component fixed import and proportionate import. Proportionate import function shows the relationship between import and income.

Whereby M = export level n = autonomous import m = marginal propensity to import

M = n + mY

Net Export (X M) = The value of all goods and services produced within the country to be sold overseas MINUS Value of all goods and services produced overseas that are purchased by local people.

Export (X) is the sale of goods and services to foreign countries, whether it be consumer products, capital goods or raw material.

Import (M) is the purchase of goods and services produced by a foreign country. Goods that are imported include consumer products, capital goods and raw material.



In a four-sector economy, components of AD are made up of consumption, investment, government expenditure and net export. Therefore the equilibrium condition is written as:

where X = X0 and M = M0 The equilibrium condition can also be written as:

Let us look at an example of an open economy model as below: C = 500 + 0.5Yd T = 100, G = 100, I = 100 X = 100 and M = 50 Using the AD = AS approach, Y = C + I + G + X M Y = 500 + 0.5 (Y 100) + 100 + 100 + 100 50 Y = 750 + 0.5Y 50 0.5Y = 700 Y = 700/0.5 Y = 1,400 Using the injections = leakages approach, S + T + M = I + G + X 500 +0.5 (Y T) + 100 + 50 = 100 + 100 + 100 0.5Y 50 = 300 + 500 150 Y = 700/0.5 Y = 1,400 Now let us look at the same economy model but with proportionate import function.

Equation Injections = Leakages I + G + X = S + T + M

Equation AD = AS Y = C + I + G + X M


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An open economy model is given as below. Calculate the level of output or national income equilibrium. C = 500 + 0.5Yd T = 100 G = 100 I = 100 X = 100 M = 50 + 0.2Y Using the AD = AS approach, Y = C + I + G + X M Y = 500 + 0.5 (Y T) + 100 + 100 + 100 (50 0.2Y) Y = 750 + 0.5Y 50 0.2Y (1 0.3Y) = 700 Y = 700/0.7 = 1,000 Using the injections = leakages approach, S + T + M = I + G + X 500 + 0.5 (Y T) + 100 + (50 + 0.2Y) = 100 + 100 + 100 0.7Y 50 = 300 + 500 150 Y = 700/0.7 = 1,000 Both these examples clearly show the negative connection between imports and equilibrium level of national income. This means that any increase in import will reduce the equilibrium level of national income. Instead, a drop in imports will help increase the equilibrium level of national income.


A change in nationÊs export and import can cause a change in AD and subsequently change the level of income equilibrium. In Figure 3.13, point B is the original equilibrium level where AD = AS and income level = Y original. If a positive change happens, meaning the net export is higher (X > M), then the AD0 curve will move to AD1. A new equilibrium will be achieved at point C when AD1 crosses AS at Y1.


Figure 3.13: The effects of change in net export

Instead if there is a negative change where total imports exceed total exports (X<M), the AD0 curve will move downwards to AD2. A new equilibrium will be achieved at point A when AD2 crosses AS at income level Y2.

3.3.4 Multiplier Effect

Besides investment multiplier, government expenditure and taxes which you have studied in the previous section, there are two additional multipliers in a four-sector economy, namely the export multiplier and the import multiplier. (a) Export Multiplier

Change in income, ��Y = KX x �X

Using the same example, if export increases by RM100 million, (�X = 100), ��Y = 1/0.5 x �X = 2 x 100 = 200

Then the national income value at a new equilibrium will be: Ynew = Yoriginal + 200 = 1,400 + 200 = 1,600

Working as an injection in the circular flow of national income, increase in export value raises the national income value.

Export Multiplier (KX) = 1/1- MPC or 1/MPS


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(b) Import Multiplier

Using the same example, if there is an increase in imports amounting to RM50 million, then the value of KT = 0.50/0.50 = 1 and the change in equilibrium income, �Y = -1 x 50 = -50.

Therefore value of Ynew = Yoriginal + �Y = 1,400 50 = 1,350

The calculations above show that an increase in imports will reduce the national income value.

Change in income level, ΔY = KM x ΔM

Import Multiplier (KM) = MPC/1 MPC or MPC/MPS

SELF-CHECK 3.2

Compare the characteristics that differentiate a three-sector economy from a four-sector economy.

EXERCISE 3.3

1. List down all the players in a four-sector economy and explain the additional two concepts that exist in this sector compared to a three- sector economy.

2. What are the national income equilibrium conditions for a four- sector economy?

3. An increase in the export level will ________the national output level whereas an increase in the import level ________ the national output level.

4. In an open economy, MPC = 0.9 and marginal propensity to import is 0.3. How much should the total export be added or increased in order to increase the output level to 200?


FISCAL POLICY AND ECONOMIC PROBLEMS

Fiscal policy is a macroeconomic policy tool that can be used to achieve government objectives or economic goals such as higher employment rates, stable inflation rates, and encouraging economic growth.

3.4.1 Fiscal Policy

The fiscal policy consists of two main tools, namely government expenditure and taxes. The fiscal policy mechanism is made up of automatic fiscal policy and discretionary fiscal policy (Figure 3.14).

Figure 3.14: Fiscal policy

This policy is much easier but it is not able to overcome problems such as unemployment and inflation. Basically, it depends on a countryÊs tax structure.

3.4

Automatic fiscal policy is a stabiliser that operates automatically to slow down the expansion during economic growth and slow down the regression during economic recession.

ACTIVITY 3.1

In achieving government objective, government uses a few policies. Can you identify any policies involved?


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Discretionary fiscal policy is done on an „ad-hoc‰ basis as and when required. Discretionary fiscal policy is divided into three types as shown in Table 3.6.

Table 3.6: Discretionary Fiscal Policy

Discretionary policy Explanation

Budget deficit policy The state of a governmentÊs budget when government revenue is less than its expenditure. It is carried out by reducing taxes, increasing government expenditure or both to overcome deflation and unemployment.

Budget surplus policy The state of governmentÊs budget when government revenue exceeds its expenditure. It is carried out through an increase, decrease in government expenditure or both to overcome inflation.

Balanced budget policy The state of governmentÊs budget where the government revenue equals its expenditure. It is carried out when level of full employment is achieved and it aims to ensure economic stability and strengthen governmentÊs financial position.

The effects of government fiscal policy that can influence the economic condition can be seen in inflationary and deflationary gaps.

3.4.2 Inflationary and Deflationary Gap

What is an inflationary gap?

This situation exists in an economy that has achieved full employment. As all the resources have been used at this point, increase in demand will cause a hike in production cost. This will then plunge into inflation.

Discretionary fiscal policy refers to a situation when the government makes some changes in taxes and government expenditure to overcome economic problems that cannot be handled through automatic fiscal policy.

An inflationary gap is defined as a situation when the real aggregate demand is more than the aggregate demand required at full-employment.


Referring to Figure 3.15, at aggregate demand AD, equilibrium is reached at point E which is at income level Y. Level Y exceeds the potential income level or YF. The difference between A and E1 shows the inflationary gap. The problem of inflationary gap can be overcome by reducing government expenditure or investment.

Figure 3.15: Inflationary gap

(a) What is a Deflationary Gap?

Deflationary gap is the opposite of an inflationary gap.

An economy is in a state of deflationary gap when the resources are not used fully and unemployment can still happen. In Figure 3.16, the AD curve is the real demand curve and �DGTP is the curve for aggregate demand required at full-employment. At aggregate demand AD, the equilibrium level is at E, which is at income level Y. Therefore this level is less than the potential national income level or YF.

Deflationary gap is defined as a situation when the real aggregate demand is less than the aggregate demand required at full-employment.


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Figure 3.16: Deflationary gap

3.4.3 Solving Inflationary and Deflationary Gaps

The value of inflationary or deflationary gaps can be measured using the formula below: Inflationary or Deflationary Gap = GNP gap/Multiplier

= ( )

−−

F realY Y1/ 1 MPC

(a) Case of Inflationary Gap If the national income at real equilibrium is RM3,000 million, more than the

national income at full employment totaling RM2,000 million and MPC is 0.8.

Inflationary Gap = (2,000 3,000)/ (1/0.2)

= 1,000/5 = 200 million

Two fiscal policy tools mentioned above can be used, namely either by reducing government expenditure or increasing tax.

(i) Reducing government expenditure

Change in income, �Y = K G x �G

Therefore 1,000 = 1/MPS x �G 1,000 = 1/0.2 x �G ��G = 200


It is found that government expenditure has to be reduced amounting to RM200 million, the same value as the inflationary gap to close the gap.

(ii) Increasing taxes

Change in income, �Y = K T x �T

Therefore, 1,000 = MPC/MPS x �T 1,000 = 0.8/0.2 x �T � � T = 250 This means that taxes have to be increased totaling RM250 million to close the inflationary gap.

(b) Case of Deflationary Gap

Now, if the national income at real equilibrium level is RM1,500 million, more than the national income at full employment is RM2,000 million and MPC is 0.8.

Deflationary gap = (2,000 1,500)/ (1/0.2) = 500/5 = 100 million

Two fiscal policy tools can be used, namely an increase government expenditure or a reduction in taxes. (i) Increase government expenditure

Change in income, �Y = K G x ��G

Therefore, 100 = 1/MPS x �G 100 = 1/0.2 x �G � G = 20

It is found that government expenditure has to be increased by RM20 million, the same value with the deflationary gap to close the gap.

(ii) Reduce taxes

Change in income, ��Y = K T x ��T

Therefore, 100 = -MPC/MPS x �T 100 = -0.8/0.2 x �T � � T = -25


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This means that taxes have to be reduced by RM25 million to close the inflationary gap. You now understand the problems of inflationary and deflationary gaps. The role of the fiscal policy in handling these problems can be divided into two, namely, either using government expenditure tools or the tax system or in certain specific cases, the government can also change these fiscal tools to achieve economic goals.

• In this topic, you have studied the determinant of national income equilibrium theory whereby a two-sector economy, a three-sector economy and a four-sector economy are discussed.

• In determining the national income equilibrium, it can be summarised as:

AD = AS Approach Injections = Leakages Approach

Two-sector economy Y = C + I I = S

Three-sector economy Y = C + I + G I + G = S + T

Four-sector economy Y = C + I + G + X - M I + G + X = S + T + M

• The main focus is on fiscal policies that are used to solve the inflationary and deflationary gap problems.

SELF-CHECK 3.3

Explain the role of fiscal policy in overcoming the problems of economic gaps.

EXERCISE 3.4

1. Provide the definition of fiscal policy and state two tools of this policy.

2. Explain the discretionary fiscal policy.

3. Explain the similarity and difference between inflationary and deflationary gaps.


Consumption Deflationary gap Effect of multiplier Export Firms Fiscal policy

Household Import Inflationary gap Investment Taxes

INTRODUCTION

Surely you are aware of what money is and its functions. But do you know what its function is in the economy? The first part of this topic explains the definition and widely accepted features of money as a mode of exchange. The four main functions of money are also discussed. Besides that, students will also be introduced to financial institutions and the banking system in this country. The roles and functions of every financial institute is explained in detail.

TTooppiicc

44

Money and Banking System


1. Discuss the four functions of money;

2. Explain the functions of financial institutions and banking system in Malaysia;

3. Illustrate the credit creation process;

4. Analyse the financial policies practiced based in three economic situations;

5. Appraise the main aims of keeping money;

6. Differentiate between money supply concepts, M1, M2 and M3; and

7. Describe how equilibrium in the money market is achieved and its connection with interest rates.

TOPIC 4 MONEY AND BANKING SYSTEM

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This part also explains the credit creation process and the monetary policies practiced by central banks, in this country is the Bank Negara Malaysia, that controls money supply in the market. The second part focuses on money demand, money supply and market equilibrium along with its connection to interest rates.

MONEY AND BANKING SYSTEM

„Money‰ is a term that needs no explanation among the public. What thought crosses your mind when you see this topic? What is the relationship between money and the banking system?

4.1.1 Definition of Money

For something to be accepted as money, it must have certain qualities or features that are universally accepted. It has to have a stable value, last long, and be difficult to forge. It most be easy to be carry around and can be divided into smaller units.

4.1.2 Features of Money

The features of money are shown in Figure 4.1.

Figure 4.1: Features of money

4.1

Money can be defined as something that is universally accepted as a mode of exchange.


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4.1.3 Functions of Money

Basically, money has four important functions as shown in Figure 4.2.

Figure 4.2: Functions of money

Let us analyse in detail each of these functions in detail. (a) Medium of Exchange Money is very important to purchase goods and services. With money, the

buying and selling of goods and services become easy as a price system can be formed. Retailers can do business with wholesalers of sugar, rice, flour, tinned food, cooking oil and such with great ease because of the existence of money. Similarly, with money, consumers can purchase what they need easily from businessmen. This situation is completely different from the barter system because in a barter system, you have to be sure that the other party wants what you have to offer. For example, if someone has flour and wants rice, he has to find someone else who has rice and wants the flour. This makes it difficult to do business.

(b) Unit of Account Money is being used as the common benchmark to designate the prices of

goods throughout the economy. Unit of account or measure of value means money is functioning as the measuring unit for prices. In other words, prices of goods are stated in terms of the monetary unit. Just like weight is measured in kilograms, and distance in kilometers, we can use Ringgit Malaysia (RM) to measure the value of goods and services. This makes the accounting system much simpler. The measurement of goods, services and wealth can be done using the same measuring unit, which is money.


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(c) Store of Value As money is an easily exchangeable asset, it is perfect to be stored and used

in the future. Thus, economic sectors, such as households, firms, governments and overseas segments are willing to save and borrow.

(d) Standard of Deferred Payment Money is used as a standard benchmark for specifying future payments for

current purchases, that is, buying now and paying later. Similarly loans from financial institutions can be quantified with the rate of money.

FINANCIAL INSTITUTIONS AND BANKING SYSTEM

Financial institutions in this country are now divided into four types as shown in Figure 4.3.

Figure 4.3: Four types of financial institutions in Malaysia

4.2

EXERCISE 4.1

1. What is the definition of money? State the features of money.

2. Explain four main functions of money.


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4.2.1 Banking System

(a) The Central Bank In Malaysia, the central bank is Bank Negara Malaysia (BNM). BNM was formed on 26 January 1959. BNM belongs to and is controlled by the government of Malaysia. It is a non-profit institution. The objectives of forming BNM are:

(i) To issue currency and safeguard the value of the currency Only BNM has the right to print money and safeguard the value of the currency. The Ringgit Malaysia has security features to prevent any attempt to print false currency.

(ii) To keep sufficient reserves to safeguard the value of currency In international trade activities, there will be demand and supply of Ringgit Malaysia when import and export activities take place. Therefore, BNM must have sufficient foreign reserves of currencies from countries that constantly do business with Malaysia to ensure the value of Ringgit Malaysia is stable and does not undergo much change compared with other major currencies around the world.

(iii) Control and supervise all activities of financial institutions Two main policies in controlling economic activities are a monetary policy and a fiscal policy. Monetary policies carried out by BNM aims at overcoming economic problems such as inflation, unemployment, or recession. In such situations, BNM will control the money flow in the market.

(iv) To act as a banker to commercial banks, merchant banks, financial institutions and discount houses If the financial institutions have an overflow of deposits, they can keep them in BNM. Similarly, if the financial institutions are having difficulties, they can ask BNM for advice or assistance, for instance during the financial crisis in 1997.

(v) To act as a banker and financial adviser to the government BNM is responsible for government accounts such as receiving and making payments on behalf of the government. BNM is also responsible to sell and buy liquid assets that it produces.

(vi) To promote monetary stability in the country by creating a good credit situation To ensure that the countryÊs financial situation in is good condition, government uses BNM as a control body to set the interest rates and other terms and conditions in borrowing-lending activities.


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(b) Commercial Banks The functions of commercial banks are shown in Figure 4.4.

Figure 4.4: Functions of commercial bank

Commercial banks are also one of the most important and biggest group of financial institutions in a country. Examples of commercial banks in Malaysia include Malayan Banking Berhad, Bumiputera-Commerce Bank Bhd, RHB Bank Bhd and Public Bank Bhd.

A commercial bank has six functions. These are:

(i) Receive deposits or savings Commercial banks receive deposits and savings from individuals and businesses. There are a few types of deposits received by the bank such as current deposits, savings deposits, fixed deposits and others.

A commercial bank is a financial institution owned by the private sector to provide financial services with the objective of making profits.

ACTIVITY 4.1

This website is the official website of Bank Negara Malaysia. Surf the website to obtain further information about the functions and importance of Bank Negara. http://www.bnm.gov.my.


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Commercial banks do not give interests for current savings but the account holder has the right to withdraw his savings by using cheques.

Fixed deposits are savings for a specific time period (a month, three months, six months, a year, etc.). If the account holder wishes to withdraw his money before the specified timeline, then he will have to pay a fee to the bank. The bank also receives savings deposits, which are given interest on by the bank and can be withdrawn at anytime. However the accounts have no cheque facility.

(ii) Provide loans The activity of providing loans is one of the commercial bankÊs

important functions. The loans are differentiated based on time, either short-term or a long-term loan. Generally, commercial banks provide loans through three main methods current account, overdraft facility and discounted bills of exchange.

(iii) Making and receiving payments on behalf of clients Current account holders can make payments using cheques. When the cheque is issued, the bank will pay the cheque holder based on the amount stated on the cheque. On the other hand, if the account holder receives a cheque and he deposits it into his account then the other issuing bank makes the payment to him. Once the cheques have been cleared, the banks will credit the total value of the cheques from other banks into the clientÊs current account.

(iv) Issue cashierÊs cheques and bank drafts Commercial banks can issue cashierÊs cheques and bank drafts to their clients. CashierÊs cheques are issued by the bank and can be exchanged for cash.

A bank draft is a cheque issued by the bank upon request from a client. A bank draft will instruct banks or its branches to pay a certain sum of money as stated on the bank draft to a specific person.

(v) Carrying out investment activities Commercial banks carry out investment through asset purchase that results in returns in the form of interests in the open market with the aim of making profits. For example, commercial banks in Malaysia invest in treasury bills and Malaysian government securities.

(vi) Preparing other services Besides all the functions mentioned earlier, commercial banks also provide other different services. Commercial banks can offer advice to clients who wish to invest. The banks can also manage your car loan installments and insurance premiums.


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Commercial banks also act as trustees to administer a clientÊs property. The banks are also safe vaults to keep valuable things and important documents in their safe deposit boxes. In addition to that, commercial banks provide currency exchange services. The banks will buy the foreign currency from the client and give them the Ringgit Malaysia in an exchange based on the fixed exchange rate.

4.2.2 Non-bank Financial Institutions

(a) Financial Firms Financial firms began operations since 1960 under Bank Negara MalaysiaÊs supervision. The types of deposit received by the financial firms are savings deposits and fixed deposits. As far as credit activities are concerned, financial firms specialise in providing loans for vehicle hire purchase, mortgage and loans to purchase houses.

The characteristics of financial firms are almost the same as savings banks. These firms allow the general public to make two types of savings, namely, fixed deposit and savings deposits.

(b) Merchant Bank

This bank does not take any money from the public for savings purposes. To a large extent, savings in this bank is obtained from savings made by commercial banks, financial firms and large public listed companies. The giving of loans is also focused on large industries. Examples of merchant banks are Commercial International Merchant Bank and Arab-Malaysian Merchant Bank.

4.2.3 Non-bank Financial Intermediaries

ACTIVITY 4.2

Think of three examples of insurance companies in Malaysia.


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(a) Insurance Companies This company collects money in various forms. The main form is through life insurance. Other forms are insurances against theft, fire and accidents. Insurance companies guarantee to pay compensation to the affected parties when these incidents happen. For this guarantee, those parties seeking this guarantee (insurance) have to pay a total sum of money called a premium to the insurance companies.

(b) Savings Bank

Savings banks are not allowed to issue cheques. Therefore, the types of deposit facilities offered by the banks are fixed deposits and savings deposits. Examples of such banks in Malaysia are Bank Rakyat, Bank Pertanian Malaysia and Bank Simpanan Nasional.

(c) Other Financial Bodies Besides all the financial bodies explained earlier, there are different types of financial bodies in the economy. However, their roles are not as significant as what has been mentioned earlier. Most of these financial bodies focus on some specific activity. Examples of these are Employees Provident Fund Scheme (Kumpulan Wang Simpanan Pekerja), Lembaga Urusan Tabung Haji, Permodalan Nasional Berhad, Koperasi and Syarikat Perumahan Malaysia.

Banks will use the money deposited in their current accounts, savings and fixed deposits to loan to clients who require financial assistance. The banks will charge interest at a certain rate, either based on the conventional or no interest banking systems. Banks can also be directly involved in investing in economic projects.

4.2.4 Islamic Banking

Bank Islam Malaysia Berhad (BIMB) was set up on 1 March 1983 as a public listed company under the Companies Act 1965. BIMB is involved in the main market by providing services through four accounts Savings, current, investment and special investment. The accounts are managed according to syariah principles. BIMB is also involved in expanding money based on syariah principles. Figure 4.5 shows the types of loan schemes offered by BIMB.


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Figure 4.5: Types of financial support offered by BIMB

SELF-CHECK 4.1

After studying the four types of financial institutions, try to compare all the three financial institutions mentioned with Islamic banks. What are the obvious differences? Give your opinion.

ACTIVITY 4.3

The following website is the website of Bank Islam in Malaysia. Surf this website to obtain full exposure on the functions of Bank Islam. http://www.bankislam.com.my.

EXERCISE 4.2

1. Explain the function of BNM in controlling and supervising all activities of financial institutions.

2. List three types of deposits accepted by commercial banks. Differentiate amongst the three types of deposits.


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CREDIT CREATION PROCESS

Credit creation is a unique function of commercial banks. Because commercial banks can afford to give credits to clients, money supply in the market has increased. The way to increase money supply is by receiving deposits from clients who have extra money and give credit to clients who have insufficient money. Therefore, credit creation can be explained as a process where a small deposit results in a larger money supply in the economy. In order for the credit creation process to take place, we assume the banking system has to abide by certain rules: (a) Required reserve rate is fixed by central bank; (b) All excess reserve is loaned to bankÊs clients; (c) All purchase of goods is done by cheques; and (d) All total reserve are in the form of current deposits.

4.3.1 Credit Creation Process – An Example

Assume that: (a) Required reserve rate (RR) is fixed at 10% of the total deposit (for all banks); (b) Excess reserve (ER) is given as loans to clients; (c) All transactions use cheques. There is no leakage in the banking system; (d) There are only two forms of assets, namely, cash reserve and loan; and (e) There are many banks in the economic system and each consumer saves his

money in a different bank.

4.3

ACTIVITY 4.4

Do you know that credit can be created? Try to explain the credit creation that is practiced in commercial banks.


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In order to understand the credit creation process, look at this example: Example A businessman, Encik Mohd Akib saves RM1,000 in Bank A. When Bank A receives this money, it will record this sum as an asset in the form of cash RM1,000 and liability in the form of Deposit RM1,000. Asset shows that the money/property belongs to the bank whereas the deposit shows the bankÊs liability. The bankÊs balance sheet is shown below:

Balance Sheet of Bank A Asset Liability Cash RM1,000 Deposit RM1,000

Total Reserves = Required Reserve + Excess Reserve

Required reserve = 10% Total reserve = 10% x RM1,000 = RM100

Excess Reserve = Total Reserve Required reserve = RM1,000 (10% x RM1,000) = RM1,000 RM100

= RM900 Let us say that Bank A gives excess reserve amounting to RM900 as loans to another businessman (Mohd Arif). After the loan is given, Bank AÊs balance sheet will be as below:

Balance Sheet of Bank A

Asset Liability

Reserves 10% Loans 90%

RM100 RM900

Deposit RM1,000

Total RM1,000 Total RM1,000


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Mohd Arif receives a cheque from Bank A and he can either deposit the cheque into the same bank or into another bank, or spend it to purchase goods and services. LetÊs say that Mohd Arif bought a TV set from a TV vendor (Encik Vellu) for RM900. Encik Vellu then deposits the money into Bank B. Bank BÊs balance sheet will become as shown below:

Balance Sheet of Bank B

Asset Liability

Cash RM900 Deposit 900

Excess reserve = Total reserves Required reserve = RM900 (10% x RM900) = RM900 RM90 = RM810 From the total reserves of RM900, the excess reserves amounting to RM810 has been loaned to Miss Chin by Bank B because the bank has to prepare 10% of the total reserves as cash reserve (RM90). Bank BÊs balance sheet is shown below after the loan is given:

Balance Sheet of Bank B

Asset Liability


RM90 RM810

Deposit RM900

Total RM900 Total RM900

After receiving the cheque from Bank B, Miss Chin keeps it in Bank C. Subsequently the same process takes place whereby Bank C will give excess reserve loan of 90% from the original deposit. After giving the loan, Bank CÊs balance sheet will be as follows:

Balance Sheet of Bank C

Asset Liability


RM81 RM729

Deposit RM810

Total RM810 Total RM810


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This process will continue until the total value of money created becomes smaller. The process will stop when excess reserves become zero. The entire process is shown in Table 4.1.

Table 4.1: Credit Creation Process

Bank Total Reserves

(RM)

Required Reserve 10% of Total

Reserves (RM)

Excess Reserve (ER) (RM)

A 1,000 100 900 B 900 90 810 C 810 81 729 D 729 72.90 656.10 E 656.10 65.60 590.50 : : : : : : : :

Total 5,904.90 49.49 5,314.40 Other banks

TOTAL

10,000

1,000

9,000 Here, it is found that the total credit created by the banking system doubled, depending on the percentage of reserves fixed by the central bank. By fixing the rate of required reserve at 10%, the credit creation doubles 10 times over. Therefore, money supply in the economy has increased. The total increase of money supply in the whole banking system can be calculated using this formula:

Money Supply (total created deposit) = ×1

initial depositReserve rate

= 1

1,00010%

×

= RM10,000 This means with the rate of required reserve at 10%, the money multiplier made the money supply increase 10 times more.

Money multiplier = 1/ rate of required reserve = 1/10% = 1/0.1 = 10

Total money created = Money supply Initial deposit

= RM10,000 RM1,000 = RM9,000


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MONETARY POLICY

4.4.1 Quantitative Monetary Policy

Do you know what is meant by a Quantitative Monetary Policy? (a) The Rate of Fixed Required Reserves

The relationship between the rate of cash required reserves and total money supply is in the negative. The higher the rate of cash reserves, the lower the credit that can be created and vice versa.

Look at this example:

Case 1:

The Rate of Cash Required Reserves is 10%, Initial

Deposit is RM100

Case 2: The Rate of Cash Required

Reserves is 20%, Initial Deposit is RM100

Money Supply ×

= ×

=

1initial deposit

Reserve rate

1100

10%

RM1,000

×

= ×

=

1initial deposit

Reserve rate

1100

20%

RM500

Total money created

= RM1,000 RM100 = RM900

= RM500 RM100 = RM400

The sample above shows that when the rate of required reserves is increased from 10% to 20%, the credit creation reduces from RM900 to RM400.

4.4

EXERCISE 4.3

If BNM fixes the rate of required reserves at 25% or 0.25 from the total deposits:

(a) How much is the deposit multiplier?

(b) How much of money supply can be created with an initial deposit of RM2,000.00?


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(b) Open Market Operations Besides cash reserves, commercial banks also have to keep liquidated assets issued by Bank Negara Malaysia (BNM) such as treasury bills and government securities. The more required liquidated assets that are held, the lesser the credit that can be created. The required minimum liquidated assets are fixed by Bank Negara Malaysia and are used as a monetary policy tool to control the Malaysian economic stability.

In the open market operations, besides commercial banks, BNM also sells treasury bills and government securities to the general public, firms, Employees Provident Fund Scheme and Pensions Fund. The money from the sale can be used by government to sustain its expenses when its expenditure exceeds the revenue from taxes collected (G >T).

(c) Fixed Interest Rates and Re-payment Periods

Consumers look at interest rates as costs of loans. The higher the interest rate, the lower the wish of consumers to borrow. The same applies to loan re-payment periods. The shorter the re-payment period, the consumers would be deterred from taking loans because they cannot afford to pay a high monthly installment.

4.4.2 Qualitative Monetary Policy

After studying the quantitative policy, let us look now at qualitative policy. Qualitative policy aims at controlling and encouraging activities in specific economic sectors. (a) Moral Persuasion

This is done by a central bank when meeting with representatives of commercial banks. During the meeting, the central bank will explain the economic and financial state of the country and ask the commercial banks to take certain steps to overcome any financial and economic problems faced. For example, during an economic downturn, commercial banks will take into account the borrowerÊs financial state before forcing him to re-pay his loan.

(b) Monitoring the Bank Loan Portfolio Choice

This strategy focuses on the direction of loans given by the commercial banks. Usually the banking sector is not interested in giving loans to the agricultural sector, food producers and small and medium sized industries. Therefore, central banks can ask commercial banks to allocate certain funds to be given to these loan seekers.


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MONEY DEMAND (MD)

We know that people demand money when they have certain reasons to do so, for example, buying provisions or purchasing a car. According to John Maynard Keynes, a famous English economist, money demand exists for three main reasons, namely for transactions demands, precautionary motives and speculative demands.

4.5.1 Transactions Demand

In our daily life, we usually see people buying things that they need, either from the market, supermarket or night market. As money is a commonly accepted mode of exchange in any transaction, therefore people will have to hold a certain amount of money to pay for the goods and services. How much money a person holds onto depends upon the value of the transactions that are anticipated, the frequency of the transactions and of course their total income. We will find out that when the level of income increases, so does the amount of money held for transaction purposes. On the contrary, when the level of income drops, the amount of money held for transactions also reduces. Therefore, the quantity of money demand for transactions is proportional to the income level.

4.5

EXERCISE 4.4

1. A bank manager says to you that his bank does not create money, instead it only gives loans from the money deposited by the bankÊs clients. How do you explain to him that in actual fact, the bank does create money?

2. Government finds that industries based on agriculture such as producing paddy and oil palm are still important for MalaysiaÊs economic growth. Suggest a financial policy that can be implemented to encourage the growth of such industries.

ACTIVITY 4.5

Money is needed for our daily existence. So, what is the use of money? What will happen if there is no money system being practiced? Discuss.


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Money demand for transactions purposes is usually considered the main motive for money demand and this can be planned. Besides this, people will also have to set aside some money for rainy days, to be used for expenses that cannot be pre-planned. This is called money demand for precautionary motives.

4.5.2 Precautionary Motives

In our daily life, we usually face unforeseen events. These unexpected events usually make it difficult for us to plan our expenses. An example is when you are retrenched because the company suffered losses due to recession. While looking for a new job, you will probably have to use up your savings for your daily expenditures. Therefore, you should keep aside a portion of your income/salary for any unforeseen expenditures. As a conclusion, how much money a person holds as a precautionary measure depends on level of income. The higher the income, the more money would be saved for this purpose. As the money demand for both unforeseen events and transactions depend on income, therefore the money demand for both these purposes can be joined. In the following discussion, both these components are referred to as demand for transactions.

4.5.3 Speculative Demand

Money demand is also made for speculations. This is based on motive for profits. After setting aside money for transactions and precautionary measures, people have a choice to hold the remainder of their money by purchasing other financial assets such as shares and bonds, which will give them profits in return. The speculative process takes place when a person buys shares or bonds at a low price and the sells them at a higher price in the future. For this, the bonds have to be purchased when the interest rate is highest because the price of bonds will be lowest at that stage. The bonds should then be sold when the interest rate is lowest because the price of bonds will be highest at this time. There is an inverse relationship between interest rates and price of bonds. Therefore, when interest rates are low, it is the perfect time to hold money and not bonds as the returns for the bonds are low. From the above explanation, you can draw a curve showing the negative relationship between speculative money demand and interest rates, as shown in Figure 4.6.


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Figure 4.6: Money demand curve for speculation purposes

From Figure 4.6, we can see that when the interest rate is low (r0) the money demand is M0. If the interest rate goes up to r1, then the money demand will decrease to M1. Therefore, we can conclude that money demand for speculation depends on interest rates. When the interest rate is high, people will purchase the bonds as bonds are cheap at this point in time, and then sell the bonds when the interest rate is lowest, to obtain profits. Therefore, when the interest rate is high, people hold more bonds and less money. Instead when the interest rate is low, r0, the bonds are more expensive. Thus, more people will choose to keep the money. After analysing the three categories of money demand in the economy, we can come up with an equation.

whereby

Md = Total money demand Md

t = Money demand for transactions Md

s = Money demand for speculations Therefore, money demand curve (Md) in the economy is a combination of money demand for transactions curve (Md

t) and money demand for speculations curve (Md

s). This is shown in Figure 4.7.

Md = Mdt + Md

s


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Figure 4.7: Money demand curve

From Figure 4.7 above, Mdt is the money demand for transactions curve [Figure

4.7 (a)]. This curve is more of a straight vertical line which shows that money demand for transaction purposes are not influenced by interest rates. Whereas Md

s is money demand for speculations curve and goes downwards from left to right [Figure 4.7(b)]. This shows that money demand for speculative purposes depends on interest rates. By combining both these curves, the money demand curve Md will be drawn as shown in Figure 4.7(c).

MONEY SUPPLY

Money demand was discussed in the prior section. Let us look at the topic of money supply.

Money supply can be categorised into three components as shown in Figure 4.8.

Figure 4.8: Components of money supply

4.6

EXERCISE 4.5

1. What is meant by money demand for precautionary purposes?

2. What factors influence the money demand for precautionary purposes?


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4.6.1 Narrow Measure of Money’s Functions

According to economists, narrow measure of money supply is M1, and it includes two forms, all physical money like cash and currency plus demand deposits or current deposits. (a) Cash and Currency

It includes coins and currency issued by Bank Negara Malaysia. Coins are issued in the form of specific metal such as nickel and bronze. In Malaysia, coins are available in several denominations - 1 sen, 5 sen, 20 sen, 50 sen and RM1.

(b) Current Deposit

It is a deposit made by an individual or private sector in commercial banks that allows them to withdraw money from the account using cheques.

Table 4.2 illustrates the cash and currency and current deposit.

Table 4.2: Narrow Measure of Money Supply (M1), 1970 2000

Cash and Currency Current Deposit

Year Total RM Million % RM Million %

1970 2,032.5 1,000.2 49.2 1,032.3 51.8

1975 4,348.8 2,239.0 51.5 2,109.8 49.5

1980 9,761.4 4,757.9 48.7 5,003.5 51.3

1985 13,578.9 6,220.2 45.8 7,358.7 54.2

1990 24,240.5 10,059.2 41.5 14,181.3 58.5

1995 51,923 17,479.1 33.6 34,444.8 66.4

2000 78,216.4 22,262.8 28.4 55,953.6 71.6

Source: Bank Negara Malaysia (Quarterly Bulletin 2001)

4.6.2 Broad Measure of Money Supply

The definition of broad measure of money supply is known as M2, which covers M1 and illiquid assets. This is shown in Figure 4.9.


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Figure 4.9: Illiquid assets

Savings deposits, fixed deposits, Bank Negara Malaysia certificates and Certificates of Deposit are illiquid assets as they cannot be accepted directly in all transactions. They will have to be converted to cash first before they can be used in transactions.

4.6.3 The Broadest Measure of Money Supply

This is referred to as M3, which includes M2 and large time deposits of private sectors in non-bank institutions such as merchant banks, financial firms, discount companies and Islamic bank.

Table 4.3: Money Supply M1, M2 and M3, 1970 2000

Year Money Supply M1

Money Supply M2

Money Supply M3

1970 2,032.5 4,122.3 n.d

1975 4,348.8 9,981.5 11,322.7

1980 9,761.4 27,991.8 32,687.6

1985 13,578.9 50,412.2 65,607.7

1990 24,240.5 83,902.9 115,435.7

1995 51,923 198,873.3 271,948.4

2000 78,216.4 354,702.1 456.496.3

Source: Bank Negara Malaysia (Quarterly Bulletin 2001)


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Notes: (i) Includes M1 plus savings deposits and fixed deposits of private sectors in Bank Negara Malaysia and commercial banks, Bank Negara Malaysia certificates and Certificates of Deposit.

(ii) Includes cash and currency in circulation and all private sector deposits with Bank Negara Malaysia, merchant banks, and discount companies not inclusive of deposits between these financial institutions.

n.d = there is no data

EQUILIBRIUM IN THE MONEY MARKET AND INTEREST RATE

Equilibrium in the money market and interest rate occurs when the money demand curve and money supply curve overlaps. We have been informed that money supply is determined by the central bank. The money supply curve is a straight vertical line. This shows that the quantity of money supply is not influenced by interest rate. Whereas the money demand curve is inversely related to interest rate. Figure 4.10 explains the method in which equilibrium in the interest rate is determined.

Figure 4.10: Determining equilibrium in the interest rate

As shown in Figure 4.10, Ms is the money supply curve and Md is the money demand curve. When the money supply curve crosses the money demand curve, the equilibrium level of interest rate in the economy is formed. We find that r* is the interest rate equilibrium that makes total money supply equivalent to total money demand, amounting to M*. How is the money market maintained so that interest rate stays at equilibrium level?

4.7


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To understand this, now assume that interest rate remains at r2. At that level, money supply exceeds money demand. Here, out of the total M* that is supplied, only M2 is held by the people. This means there is an excess of money supply, M* - M2. To use up this excess money supply, the general public will use it to buy financial assets such as bonds because bonds can be purchased at a low price when the interest rate is high (r2). Therefore, many people will be tempted to buy bonds when interest rate is at r2. This will increase the demand for bonds and eventually the price of bonds will increase as well. As the prices of bonds are inversely related to interest rates, therefore the interest rates will fall. The interest rate will keep dropping until total money demand equals to total money supplied. Equilibrium of the interest rate r* will be formed. Now, assume that the interest rate is at r1, which is a situation when money demand exceeds money supply. In order to fulfil the increase in money demand, people will sell their bonds because when interest rate is low (r1), the price of bonds are higher. Therefore, at this rate (r1), there exists an excess supply of bonds which will cause the price of bonds to drop, and interest rate to go up. This interest rate will increase until an equilibrium is formed in the money market, which means the quantity of money supply equals the quantity of money demand and equilibrium of the interest rate is formed at r*. Therefore, it can be concluded that interest rate equilibrium can be achieved when money supply equals to money demand or when the money supply curve and the money demand curve overlaps, at r*. If there is extra money demand or supply, an adjustment happens until money demand (Md) equals to money supply (Ms). Therefore, it can be concluded that interest rate equilibrium can be achieved when money supply equals to money demand or when the money supply curve and the money demand curve overlaps, at r*. If there is extra money demand or supply, an adjustment happens until money demand (Md) equals to money supply (Ms).


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• Money can be defined as something that is widely accepted by the general public as a medium of exchange. Features of money include being widely accepted, legal tender, durable, divisible, portable and homogeneous. Four main functions of money include being the medium of exchange, unit of account, store of value and standard of deferred payment.

• The central bank in Malaysia is the Bank Negara Malaysia. Its functions include:

(i) To issue currency and safeguard the value of the currency; (ii) Keep sufficient reserves to safeguard the value of currency; (iii) Control and supervise all activities of financial institutions; (iv) To act as a banker to commercial banks, merchant banks, financial

institutions and discount houses; (v) To act as a banker and financial adviser to the Government; and (vi) To promote monetary stability in the country by creating a good

credit situation.

EXERCISE 4.6

1. What is meant by current deposit?

2. What happens to bonds market and interest rate when money supply exceeds money demand?

3. In country X, smart card has replaced the usage of currency and demand for money has reduced. The new smart card has boosted the economy and the GDP has gone up.

(a) Using a money demand graph, draw a new money demand curve with the information given.

(b) Assume that the central bank in that country wants to stop the interest rate from changing, what should be done towards the money supply?

(c) Which monetary policy should the central bank practice, an expansionary policy, or a contractionary policy, where an expansionary policy increases the total supply of money in the economy, and a contractionary policy decreases the total money supply.


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• The Islamic Bank provides loan services in accordance with syariah principles such as Al-Mudharabah, Al-Musyakarah, Al-Bai Bithaman Ajil, Al-Ijarah and Al-Ijarah Thumma Al-Bai.

• There are two monetary policies to control and change the quantity of money supply in the market, namely, Quantitative policy and Qualitative policy. Money demand usually has three main objectives For transaction purposes, precautionary measures and speculative purposes. Money supply is divided into three groups Narrow measure, broad measure and broadest measure. Credit creation is a way to increase money supply in the market. Equilibrium in the money market and interest rate occurs when the money demand curve and the money supply curve overlap.

• Refer to the figure below to have a full understanding of Topic 4.


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• Commercial banks perform the following functions: (i) Receive deposits or savings (ii) Provide loans (iii) Making and receiving payments on behalf of clients (iv) Issue cashierÊs cheques and bank drafts (v) Carrying out investment activities (vi) Preparing other services

Money Commercial bank

Current deposit Money supply

INTRODUCTION

Earlier, you were introduced to supply and demand. Knowledge about factors that affect or influence money demand and supply is important to understand their effect on interest rate, investment and national income. This section will explain the concept of aggregate demand and supply.

TTooppiicc

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Aggregate Demand and Supply


1. Explain the meaning of the term aggregate demand and the aggregate components;

2. Assess the factors that cause the aggregate demand curve to move downwards;

3. Examine the aggregate demand determinant;

4. Explore the meaning of the term aggregate supply and the aggregate supply curve in short-term;

5. Depict how level of production and price equilibrium is determined;

6. Examine the budget policy and financial policy; and

7. Comment the formation of long-term aggregate supply curve.

TOPIC 5 AGGREGATE DEMAND AND SUPPLY

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AGGREGATE DEMAND

What do you understand about aggregate demand?

Usually, aggregate demand is shown using a curve or table that shows the various types of goods and services (real production) that are collectively purchased by consumers at a certain price level. Aggregate demand curve (AD) that is sloping downwards shows a negative relationship between price and production level, assuming that all other factors remain the same (unchanged). When the prices are low, the demand for production is high. Vice versa, when prices are high, demand for production is low. Although both the aggregate demand curve (AD) and aggregate market curve look the same, but the factors influencing the curves to slope downwards are different. The market demand curve slopes negatively because of the substitution effect and income effect. The factors that cause the aggregate demand curve to slope negatively are shown below in Figure 5.1.

Figure 5.1: Factors underlying the negative slope of the AD curve

Now, let us look at the important explanation on the factors that make the aggregate demand curve slope negatively.

5.1

Aggregate demand is the total demand for goods and services in the economy during a specific time period.

TOPIC 5 AGGREGATE DEMAND AND SUPPLY 103

(a) Real-balance Effect The expenditure or consumption by consumers depends on how much of

money they have. This is a positive relationship. The more money you have, the more you spend.

However, thereÊs a negative relationship between price level and consumer wealth. If price level increases, the real purchasing power reduces and money cannot buy as many goods and services. On the contrary, if the price drops, then the purchasing power increases. We look at this example:

If Ahmad has RM5,000 and the price level has increased by 10%, then the value of AhmadÊs money has decreased by 10% because the price of the goods he wishes to buy has gone up by 10%. Therefore, an increase in price causes the purchasing power to drop. This will indirectly reduce consumption and production. Thus, the real-balance effect brings about a negative relationship between price and production. However, if the increase in general pricing is the same as the increase in share prices or properties prices, that means the real value of the shares and properties have not changed.

(b) Interest Rate Effect

Changes in interest rates can have a big impact on consumption and investment expenditures. The interest rate tends to increase and decrease as the price level increases and decreases. This means that a higher price level induces a higher interest rate which raises the cost of borrowing and discourages investment and consumption spending. A lower price level has the opposite result. Assuming that money supply remains the same, when price level increases, money demand also increases and when that happens, interest rates also go up. For example, if price goes up, money demand will move up from 0

dM to 1dM . Assuming money supply Ms is fixed, interest

rate will increase from r0 to r1. This phenomenon is shown in Figure 5.2.

Having money also refers to wealth and how much bonds, shares, house or physical assets one possesses. The amount of wealth owned depends on the price level.


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Figure 5.2: Changes in interest rates

The change in interest rate will effect the consumption of households and firms. For example, say the interest rate is 15% per annum. At the same time, the rate of returns the firms obtain from capital purchase is 20%. This definitely allows the firms to reap some profits because the investment returns exceed the interest rates. This will encourage firms to increase investment. If the reverse were to happen, the interest rate at 15% and the rate of returns only 10%, then the firms will reduce their investments. This decision will make them reduce their production too.

When interest rate is high, households will delay consumption or purchase. Households accept an increase in interest rates as an indication of increase in expenses and costs. For instance, consumers may delay purchasing a house because of the high interest rate and vice versa.

In conclusion, increase in price will push money demand upward and eventually cause a hike in interest rates (assuming money supply remains the same). Finally, the effect of demand for production will reduce.

(c) Net-export Effect

The total export and import in an economy depends on domestic and foreign prices. If Malaysian goods are expensive, Malaysia will import more from overseas. This will reduce the value of net export. Generally, the relative increase of domestic price levels will reduce exports and the aggregate demand on production. Instead, the relative decrease of domestic price levels will increase exports and aggregate demand on production.


From the explanation above, it can be concluded that the Aggregate Demand curve (AD) is not a combination of individual demand curves. The AD curve has a negative slope because of the real-balance effect, interest rate effect and net-export effect.

5.1.1 Constructing the Aggregate Demand Curve (AD)

How do we construct the aggregate demand curve? The AD curve can be constructed from the aggregate expenditure model. The aggregate expenditure components can be seen in Figure 5.3. Whereas the aggregate demand (AD) is the total demand for goods and services in the economy.

Figure 5.3: Aggregate expenditure components

Both of these are different but connected, because at every point along the AD curve, the demanded quantity is the same as the aggregate expenditure. [C + l + G + (X M)]. In the analysis on how to draw the AD curve, we have to assume that the fiscal policy and monetary policy are fixed. In Figure 5.4, (a) shows the money market, (b) shows the investment curve that reflects the negative relationship between interest rates and investment levels, (c) is the aggregate expenditure model or market for goods and (d) is the aggregate demand curve that shows the inverse relationship between prices and quantity of production demanded.


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Figure 5.4: Constructing the Aggregate Demand Curve (AD)

We assume the original equilibrium is at E0, which is at price P0, and production Y0, interest rate r0, quantity of money M0, investment level I0, and aggregate expenditure AE0. The change in price will influence the real value of wealth or charity, interest rate, and net export. If the price goes up, the real value of charity or wealth and net exports will reduce. But interest rate will increase and vice versa. If price moves up to P1, the quantity of money demand will increase as more money will be needed for expenditure. Therefore, the Md

0 curve will shift to Md1, creating an increase in money

demand, assuming that money supply is fixed. In order to achieve equilibrium in the money market, interest rate increases to r1. The subsequent increase in interest rate will bring down investments to I1. The same goes for consumption and net export. This situation is shown by the shift AE0 to AE1 (P1) and the decrease in production level to Y1 [Figure 5.4 (c)]. If price goes down to P2, the opposite will happen. The production level will go up to Y2 at the equilibrium point E2 [Figure 5.4 (c)]. In Figure 5.4 (d), if the points a, b and c are joined, a negatively sloped AD curve can be seen, which shows an inverse relationship between price and production level (Y). We can summarise that an increase in price level will cause the AE curve to shift downwards and a reduction in production Y. On the contrary, a decrease in price will cause AE to shift upwards and an increase in production Y.


5.1.2 Aggregate Demand Determinants

The AD curve shows a negative relationship between price and income. Therefore, any changes in price will cause a change in aggregate demand, which is a change in the aggregate demand production quantity. This change happens all along the AD curve, assuming that all other factors are fixed (ceteris paribus). Actually, besides price, there are a few other factors that can influence aggregate demand (AD). These factors are shown in Figure 5.3. The factors work through four aggregate expenditure categories · Consumption (C), investment (I), government purchases (G) and net exports (X M). Now, we will look closely at these factors. (a) Consumption Expenditures (C)

Consumption expenditures are usually connected to households. Among the factors that influence consumption and cause the AD curve to shift either to the left or right, are: (i) ConsumerÊs wealth; (ii) Consumer expectations; (iii) Household debts; and (iv) Taxes.

Let us now look at each of these factors in detail.

(i) Consumers wealth This includes financial assets (stocks, bonds and shares) and physical assets (house and land). Decrease in the real value of assets will encourage more people to save and spend less in order to improve their economic situation. They will reduce their expenses and the AD curve will move to the left. If the reverse happens, the AD curve will shift to the right.

Reminder: This concept differs from the concepts of wealth and real-balance because here, the AD curve changes when there is a change in price.

The change in real wealth does not depend on a price change but non-price factors that cause shifts in the AD curve. For example, reduction in price or real value of a house will decrease the consumerÊs economic condition although the price level does not increase.


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(ii) Consumer expectations Consumer expectations focus on real income. Expectations of future economic conditions are an important determinant. If households expect real income to increase in the future, then they are inclined to buy more today, causing consumption expenditures and aggregate demand to increase, shifting the AD curve to the right. If real income is expected to fall, consumers will avoid spending. So, the AD curve will move to the left.

(iii) Household debts Consumers with hefty debts will reduce their expenses because their income or money will be used to settle their debts. Therefore, consumer expenditure will decrease. This drop is shown by the shifting of AD curve to the left.

(iv) Taxes Income tax is a leakage in consumer income. The hike in income tax

rate will reduce peopleÊs disposable income. This phenomenon will cause a drop in expenditure and the AD curve will move to the left.

(b) Investment Expenditures

Investment expenditures are usually incurred by firms. The changes in purchasing capital goods and other investments will cause the AD curve to move either to the left or to the right.

The change in investment can be caused by: (i) Interest rate; (ii) Expected returns from investment projects; (iii) Business tax; (iv) The level of excess capacity; and (v) Technology. Let us look at each of these factors one by one in Table 5.1.


Table 5.1: Factors that Cause Changes in Investment

Factor Explanation

Interest rate The increase in interest rates due to other reasons besides pricing, will cause the AD curve to shift. For instance, hike in money supply will cause the interest rate to drop. This phenomenon will create an increase in investment. Therefore, the AD curve will move to the right and the reverse situation will cause it to move to the left.

Expected returns from investment projects

High returns from an investment project means profit to firms. If the expected returns are high, then firms will increase investment, namely, buying of capital goods. This will increase firmsÊ expenditure and the AD curve will shift to the right. The reverse situation will make the curve move to the left.

Business tax

Business tax is a leakage to the firm. The high rate of business tax will reduce profit after tax. This factor will eventually decrease the incentives for the firm to increase investment. Therefore, a firmÊs expenditure reduces and the AD curve moves to the left and vice versa.

The level of excess capacity

This means there are excess production resources that are not used. Higher excess capacity will slow down the demand for new capital goods and reduce the aggregate demand as shown by the shift of the AD curve to the left. If the firm collectively finds that capacity level is low, then the firm will increase its purchase of capital goods and build new premises. This will increase the firmÊs expenditure and the AD curve will move to the right.

Technology The discovery of new technology will increase investment expenditure and hike up the aggregate expenditure (AD curve will move to the right). For instance, with the discovery of new technology in the automobile industry, more money will be invested in this industry. This phenomenon will cause the AD curve to move to the right.


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(c) Government Purchases (G) In order to explain government purchases, let us take the example of providing infrastructure facilities. If government increases its expenses in providing infrastructure through an expansionary fiscal policy, the AD curve will shift to the right. Instead, if the government practices a contractionary fiscal policy, then the AD curve will move to the left.

(d) Net Exports (X-M)

The change in exports connected to the movements of the AD curve is influenced by factors other than price. Refer to Table 5.2.

Table 5.2: Factors that Cause Changes in Exports Except Price

Factors Explanation

Foreign income When the income of foreigners is high, their demand is relatively high as well, whether it is for domestic or foreign goods. The increase in demand for foreign goods will increase the exports of the exporter country (assuming that exporter country imports less). The increase in net exports is shown in the shift of the AD curve to the right. If the income in foreign countries is low, then the net exports will decrease and the AD curve will move to the left.

Foreign currency exchange

The change in foreign currency exchange rates also influences net exports and aggregate demand (AD). For example, the exchange rate between Ringgit Malaysia and American Dollar (exchange rate E = RM/Dollar). If the value of the Ringgit deteriorates, then the rate of exchange has increased. Americans can get more Ringgit. Whereas, Malaysians will get fewer Dollars. The deterioration in the value of the Ringgit will make Malaysian goods relatively cheaper compared to American goods. Therefore, MalaysiaÊs net exports will increase (assuming that our imports are less than the exports). This phenomenon will move the AD curve to the right. The reverse situation will make the curve move the other way.

Based on the explanation above, the movement of AD curve is shown in Figure 5.5. The original AD curve is at AD0. The shift to the right is from AD0 to AD1. The shift to the left is from AD0 to AD2.


Figure 5.5: Movements of AD curve

From this discussion, we can now conclude that the price factor will cause changes along the aggregate demand curve (AD), which means changes in the production quantity demanded. Subsequently, factors other than price, namely, aggregate expenditure components such as consumption (C), investment (I), government purchases/expenditure (G) and net exports (X-M) will cause the AD curve to shift either to the left or right.

5.1.3 The Movement of Aggregate Demand Curve and the Aggregate Expenditure Model

Try to remember the aggregate expenditure components that we had discussed earlier. Aggregate expenditure includes consumption (C), investment (I), government purchases (G) and net exports (X-M). If a change happens in one of those components, the AD curve will shift, assuming that the price level is fixed. From Figure 5.6, we assume the original equilibrium is at AE0 that produces real production (Y) at Y0 and the AD curve is AD0. If investors are optimistic and expect profits to increase in the future, then the investment level will increase as well. This is shown by the movement of the curve AE0 to AE1, with the price fixed at P0 and the new production level is achieved at Y1. In line with this, the AD curve also moves to the right to AD1 (Look at Figure 5.6). The actual increase in investment is shown by the AD curve shifting from AD0 to the dotted line. However, the multiplier process has caused AD to move to AD1 and production to increase from Y0 to Y1. Therefore, the rise in investment will shift the AD curve to the right. The distance between AD0 and AD1 is the increase in investment (I) times the multiplier value k (Δl x k). The movement of AE and AD are towards the same direction.


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whereby k is the multiplier.

Figure 5.6: The movement of AD curve and AE model

AGGREGATE SUPPLY (AS)

Prior to this, you were exposed to demand. Now, let us look at the definition of aggregate supply.

This definition is an analogy to the definition of an individual supply of goods and services. The AS curve slopes positively, showing the positive relationship between price and production quantity supplied, assuming ceteris paribus.

Aggregate supply means the total of real production of final goods and services available in the economy.

5.2

The distance of AD0 to AD1 = Δl × k.


The AS curve is reflected in a table or curve that shows the real production level (Y) that is produced and supplied by the firms at various price levels, while other factors remain fixed (ceteris paribus). However, the AS curve is not a combination of individual supply curves in the economy.

5.2.1 Short-run Aggregate Supply

Aggregate supply curve (AS) can be divided into three parts, namely: (a) Horizontal (Keynesian); (b) Upward sloping; and (c) Vertical (classical). Figure 5.7 shows three parts of the AS curve. How can this situation exist?

Figure 5.7: Short-run aggregate supply curve

(a) Horizontal Section (Keynesian) This part shows that the economy is suffering from a recession. Faced with falling economic activity, resource employment and real production tend to fall. When there is increase in production, there is no increase in price. This situation relates to the Keynes analysis during the recession that took place in the 1930s. In line with that, this section is named the Keynesian section. Increase in production will not cause the price level to rise because unused resources (labour and raw material) will be used to increase production. So, the overall average cost is constant. Therefore, there is no reason for the price to go up as there is no increase in the average cost of production.


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This level also shows the position when the production quantity is reduced. However, the production price level and input does not decline. This means that production and employment may reduce but the price of input and production may be difficult to change.

(b) Upward Sloping Section At this level, the production increases from Y0 to Y1 and the production factor relatively decreases. Firms will compete against each other for resources that are scarce. This will cause the input price to rise, meaning the cost of production will increase. To overcome the increase in cost of production, firms will increase the production price as an incentive to increase production. Therefore, at this level, there will be a direct connection between real production (Y) and price level. The increase in production from Y0 to Y1 will cause a hike in price from P0 to P1.

(c) Vertical Section (Classical)

At this level, the economy has achieved full employment (Y1). Here, it is difficult to increase production unless there is a price increase. Therefore, the AS curve is vertical. This part is also known as the classical section because it is in relation to the theories by classical economists who opined that the economy always operates at full employment. Firms will compete to get resources and increase production. But this will cause losses to some firms as the competition will increase the production costs and price levels. The actual production will not change however, which means the price increases to P2 but the production remains at Y1. This situation accelerates the inflation process.

5.2.2 Determinants of Aggregate Supply Curve

From the positive slope of the AS curve, we can see that price is one of the determinants of the AS curve. However, change in prices will only bring about changes along the aggregate supply curve, i.e. changes in the production quantity supplied. For instance, when price goes up from P0 to P1, the production quantity supplied will increase from Y0 to Y1 (refer to Figure 5.7).

ACTIVITY 5.1

Price can shift the aggregate supply curve (AS) either to the left or right. Try to identify other factors other than the price factor.


Besides the price factor, other factors that can cause the AS curve to shift either to the left or right are: (a) Input price; (b) Productivity; (c) Government policy; and (d) Environment. (a) Input Price

(i) Domestic resource This resource includes land, labour, capital and entrepreneurs. The

innovation in this resource can reduce the price of the resource. For example, there is an increase of women participation in the labour market. This phenomenon will increase the labour supply and eventually cause the production cost per unit to drop. The drop in production costs will become an incentive for firms to increase production, as shown by the AS curve moving to the right. The reverse position will cause the curve to shift to the left.

(ii) Imported resource In the production process that uses imported resources, the rise in

input price, a cost shock, will cause the AS curve to shift to the left. When the reverse happens, the AS curve will move to the right.

(b) Productivity Productivity measures the average real production (total production

divided by total input). An increase in productivity means the economy enjoys a large amount of real production based on limited resources. For example, in order to produce 10 units of production, if you need total input of five units at RM2 per unit, then the productivity and average costs are calculated as:

Productivity = Total production

Total input

= 10

25=

Average cost = Total cost

Total production

= RM2 5

10×

= RM1


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If firms intend to increase production to 20 units at the same price and unit input, the productivity value is 4, which is 20/5 and the cost per unit is RM0.50. Therefore, productivity increases from 2 to 4 and production cost reduces from RM1 to RM0.50. This means productivity doubles and production cost per unit drops by half. This situation will cause the AS curve to shift to the right. Instead, if productivity drops, the reverse will happen.

(c) Government Policy

(i) Business subsidies and taxes Increase in business tax such as excise sales tax will increase production cost. This will cause the AS curve to move to the left. If the government provides subsidies, it will reduce the burden or production costs, and this is shown by the AS curve shifting to the right.

(ii) Regulation Usually, the government will control the production of certain products. In order to fulfill government regulations, firms are forced to allocate some money to carry out control activities. For instance, each firm is required to form a quality control unit. This will increase the firmÊs cost of operations and the AS curve will shift to the left. Firms in the supply side are not confined by government regulations and thus, the AS curve moves to the right.

(d) Environment

Environment includes weather, natural disasters and wars. For example, during the monsoon season, fishermen cannot go out to sea. This will cause a reduction in seafood supply, as shown in the movement of the AS curve to the left. Instead, when there is no monsoon season, supply will increase and the AS curve will shift to the right. The movement of the AS curve to left and right can be seen in Figure 5.8. The shift to the right is from AS0 to AS1, whereas shift to the left is from AS0 to AS2.

Figure 5.8: The movement of Aggregate Supply Curve (AS)


PRODUCTION LEVEL AND EQUILIBRIUM PRICE

How do we determine the production level and equilibrium price? What are the factors involved in determining these? Equilibrium happens at the point where the AD curve and AS curve meet. (Figure 5.9).

Figure 5.9: Equilibrium price and production

Equilibrium price and production is achieved at Pe and Ye. If the price level exceeds Pe, for example if it is at P1, then there will be excess aggregate supply amounting to Y0Y1. At this price level, consumers only demand Y0 but firms supply Y1. This situation will force the price level to fall again to equilibrium price Pe. If the price level is lower than Pe, for instance, if it is at P2, then there will be an excess demand totaling Y0Y1. At a price lower than the equilibrium price, the quality demanded will increase but the quantity supplied will decrease. This phenomenon will force the price level to rise towards the equilibrium price, Pe. The equilibrium price and production is achieved at the point where the AD curve and the AS curve meet, which is at price Pe and production Ye.

5.3.1 Changes in Equilibrium

Changes in equilibrium can happen due to changes in the AD and AS curves. (a) Changes in Aggregate Demand

In an analysis, we assume the AS curve does not change. The change in AD curve happens if there is a change in one of the aggregate expenditure a

5.3


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components or the AD determinant factor other than price level. The effect of a change in the AD curve depends on the part of the AS curve which crosses the AD curve. The analysis is based on Figure 5.10.

At the horizontal section (Keynesian), we assume the original equilibrium is at AD0 and AS0 (P0 and Y0). The changes in AD will affect the price. For example, if the government increases its expenditure (G), the AD curve will move from AD0 to AD1. This affects the production which will increase to Y1, but the price level will remain at P0. This is because the unused resources will be used to increase production while maintaining the production cost per unit.

Figure 5.10: Movements of AD curve

Therefore, the price level does not rise because there is no increase in the average production cost per unit. If equilibrium happens in the upward sloping section, at the original equilibrium AD2 and AS0 (P2 and Y2), the increase in government expenditure will shift the AD curve from AD2 to AD3. This will cause a hike in the price and production levels to P3 and Y3. The increase in price happens because there is a shortage in resources. Assume that the original equilibrium at the vertical section as AD4 and AS0 (P4 and Y4). The increase in government expenditure will cause the AD curve to shift to AD5 and the price level will increase to P5 but production level remains at Y4 (production at full employment).


If the reverse happens, the AD curve will move to the left. As a conclusion, it can be seen that movement of the AD curve will bring about changes in price and quantity. However, the final effect depends on the section of the AS curve which overlaps the AD curve.

(b) Changes in Aggregate Supply (AS) Equilibrium price and output quantity for goods and services change when the aggregate supply curve shifts. The movement in the AS curve is due to several determinant factors other than price level. This analysis is based on equilibrium at the upward sloping section of the AS curve, assuming that the AD curve is fixed (refer to Figure 5.11)

Figure 5.11: Movements of AS curve

We assume that the original equilibrium is at AS0 and AD0 (P0 and Y0). If there is an increase in technology or productivity, the AS curve will shift to AS1. This phenomenon will cause an increase in production level to Y1 and a decrease in price to P1. If the reverse happens, for example, the rise in production costs will shift the AS curve to the left to AS2. The effect of this is the increase in price to P2 and decrease in production to Y2. In the horizontal and vertical sections, the effect is the same. The movement of AS to the right brings a hike in production and a price drop. Whereas when AS shifts to the left, the price will go up and production will drop.


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AGGREGATE DEMAND AND AGGREGATE SUPPLY: FISCAL POLICY AND MONETARY POLICY

The AD and AS model or approach can be used to analyse the effects of budget policy and financial policy (refer to Figure 5.12).

Figure 5.12: Policy components

This policy is divided into two, namely the expansionary policy and the contractionary policy. Expansionary policy will shift the AD curve to the right, whereas the contractionary policy will move the AD curve to the left. This phenomenon will eventually change the equilibrium price level and production quantity. The effects of a fiscal or monetary policy can be analysed based on Figure 5.13. Assume the economy is short-termed and the original equilibrium is at AD0 and AS0 (P0 and Y0) at the upward sloping section, or the economy has not achieved full employment.

5.4

ACTIVITY 5.2

Give your analysis of other aggregate demand determinant factors.


Figure 5.13: The effects of fiscal and monetary policy and movements in the curve

If expansionary monetary or fiscal policy is carried out, the AD curve will shift to the right, from AD0 to AD1. Price and production will increase to P1 and Y1. On the contrary, contractionary fiscal policy will shift the AD curve to the left from AD0 to AD2. Price level and production will drop to P2 and Y2. If the economy operates at full employment, at the vertical section of the AS curve, the effects of the fiscal policy will differ. Assume the original equilibrium is at AS0 and AD4 (P4 and Y4). Expansionary fiscal policy (assuming that the monetary policy is fixed) will move the AD curve to the right to AD5. This expansion will not cause an increase in output because all resources have been used for production. Therefore, expansionary budget policy, which is the shift of AD4 curve to AD5 with a fixed monetary policy will cause a hike in interest rates. Increase in interest rates will reduce investment, and eventually there will be a drop in production level. Increase in government expenditure (G) is the same as a drop in investment (I), and therefore there is no change in production level. The final effect is the increase in price from P4 to P5 but production is fixed at Y4. When there is a recession (horizontal section), expansionary or contractionary; fiscal or monetary policy will only change the production level (fixed price level). Based on Figure 5.13, we assume the original equilibrium as AS0 and AD6. If an expansionary fiscal or monetary policy is practiced, the AD curve will move to the right from AD6 to AD7. The price level will remain at P6 but the production level will increase to Y7. If a contractionary policy is implemented, the production level will drop to Y8.


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CONSTRUCTING LONG-RUN AGGREGATE SUPPLY CURVE

In the short-run, the changes in cost and price does not happen hand in hand. At the upward sloping section of the aggregate supply curve (AS), the increase in cost is higher than the increase in production. Therefore, increase in price is higher than the increase in production level. In the long-run, adjustments can be made to suit the changes that occur based on knowledge of real price level. The adjustment is made so that there are no surprises regarding the price in the long-run. The construction of long-run aggregate supply curve can be analysed based on Figure 5.14. Assume that the original short-term AS curve is AS0. Equilibrium is achieved at point a with price and productions levels at P0 and Y0. Y0 is the potential production level and P0 is the expected price. If the aggregate demand rises, as shown by movement of curve AD0 to AD1, the new short-run equilibrium is achieved at point b (P1 and Y1). Short-term real price level exceeds the expected price and the production level is more than the potential production. This excess total is known as the expansionary gap, which amounts to Y0Y1.

Figure 5.14: Long-run AS curve

When real production exceeds potential production, the actual unemployment rate will be lesser than the natural unemployment rate. Therefore, there will be overtime for labour and capital. Since price in the short-run is more than the expected price, the nominal fee at expected price P0 drops. Besides this, when real production exceeds potential production, the pressure of inflation begins to set in. The more the short-run production exceeds the potential production, the expansionary gap becomes bigger and the pressure for price increase also rises.

5.5


Long-run is the period when firms and resource suppliers (production factors) know the market situation, specifically the aggregate demand and real price level. Firms and resource suppliers have the time to bargain based on the actual price. The price hike to P1 has dragged down the value of real nominal fee. Employees now will bargain with the firms to obtain a higher fee. If this process succeeds, it will increase the firmsÊ production costs. The increase in costs will shift the AS curve to AS1 (to the left) (assuming that the increase in price is adjusted by the cost hike at the same rate). The new equilibrium is achieved at AD1 and AS1 (P2 and Y0). At this new equilibrium (point c), only the price is found to have increased but the production remained the same at Y0 and the real price is the same as the expected price. Therefore, this equilibrium is for both short-run and long-run. If the reverse happens, which means a drop in demand as shown by movement of AD curve to the left (AD2), the new price and production levels are achieved at point d (P3 and Y2). P3 is the real price level which is less than the expected price (P0) and Y2 is the real production level which is lower than the potential production (Y0). This total is known as a contractionary gap amounting to Y2Y0 and the unemployment rate exceeds the natural unemployment rate. This situation encourages an increase in the real fee during the short-run. In the long-run, producers are unwilling to pay fee at a high nominal fee due to the actual price level which is lower than the expected price and the unemployment rate which is higher than the natural rate. With high unemployment rate, those who are unemployed will compete with one another to obtain a job and they are willing to receive a low fee (assuming the price and fee levels are flexible). A low nominal fee rate will reduce the firmÊs production costs. This is shown through the movement of the AS curve to the right to AS2. The new equilibrium is achieved at point e (AS2 and AD2). The price level drops to P4 and production falls back to potential production (drop in price equals drop in fee level). Since expected price is the same as the real price, the short-run and long-run equilibrium are both at point e. Generally, what has happened at points a, c and e are: (a) The real price level equals the expected price level; and (b) Production quantity demanded and supplied in the short-run is the same

with that in the long-run.


124

Summarily, actual production can be more or less than the potential production in the short-run, but not the case in the long-run. Equilibrium in the long-run is achieved when the AD curve crosses the potential output vertical line. If the points a, c and e are joined, the vertical long-run AS curve (LRAS) can be seen.

5.5.1 Long-run Aggregate Supply Curve

Long-run Aggregate Supply Curve is vertical because in the long-run, adjustments will take place. We know that fiscal and monetary policies will shift the AD curve. Based on Figure 5.15, assume the original equilibrium as AS0 and AD0 (P0 and Y0). If an expansionary budget or financial policy is implemented, the policy will make the AD curve shift to AD1. The new equilibrium price and production will be P1 and Y0, which mean the production level remains the same, only the price increases. If contractionary fiscal or monetary policy is implemented, the AD curve will shift to the left (AD2). The new price and production level will be P2 and Y0.

Figure 5.15: Long-run aggregate supply curve and policy effects

Conclusively, in the long-run, whether an expansionary or contractionary policy is implemented, only the price level changes.


• Aggregate demand is the total demand for goods and services by consumers in an economy.

• An aggregate demand curve (AD) is negatively sloped, showing the negative relationship between price and production level, assuming that all other factors are fixed (not changed).

• Factors that cause the aggregate demand curve to slope negatively are the Real-Balance effect, the Interest rate effect and the Net-Export effect.

• Aggregate expenditure is the total expenses of households, firms, government and foreign sectors.Aggregate supply means the total supply of goods and services in an economy.

• Aggregate supply can be divided into three sections, namely, horizontal (Keynesian), upward sloping and vertical (Classic). Aggregate supply is determined by input price, productivity, government policy and environment.

• Changes in equilibrium can take place due to changes in aggregate demand and aggregate supply curves.

• Fiscal policy involves government expenditure and taxes, whereas monetary policy involves money supply. There are two types of policy, namely, expansionary and contractionary.

• Expansionary policy will shift the AD curve to the right, whereas contractionary policy will move the AD curve to the left.

EXERCISE 5.1

1. What is shown by the aggregate demand curve that is sloping negatively from left to right?

2. Explain four factors that influence changes in the aggregate supply curve either to the left or right.

3. What is meant by macroeconomic equilibrium in the short-run?

4. If the government of Malaysia increases its expenses by buying more goods and services, is this change a fiscal policy or monetary policy? Why?

5. Why is the long-run aggregate supply curve vertical?


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• The long-run aggregate supply curve is vertical because in the long-run adjustments will be made.

• Let us look at the summary in the form of this Figure:

Aggregate demand Aggregate supply Classical

Consumer wealth Keynesian Net export

INTRODUCTION

When an economic activity level is evaluated, individuals not only look at the countryÊs production or output but other factors are considered as well. Besides national production, information on unemployment and inflation are also important. Unemployment is an important guide pertaining to the labour market. Whereas, inflation shows the countryÊs overall price level. Before the 1920s, issues related to unemployment and inflation were not hot topics of discussion. Only after the of 1929 recession great did, these issues became increasingly important and the focus of economists.

TTooppiicc

66

Unemployment and Inflation


1. Describe the concept of unemployment and how to measure unemployment rate;

2. Assess the sources and effects of unemployment;

3. Examine the concept of inflation and Consumer Price Index (CPI);

4. Depict how inflation rate is measured; and

5. Appraise factors that cause inflation and effects of inflation.

TOPIC 6 UNEMPLOYMENT AND INFLATION

128

UNEMPLOYMENT

Do you work? Or are you still in the process of looking for a job? Are you a housewife or a university student? We often hear the term ÂunemploymentÊ being mentioned, but how much do we understand about its actual meaning? In order for you to understand the concept of unemployment, several other factors that are related to unemployment will be discussed at length. Basically, the population of a country is divided into two, namely: (i) Population of working age group; and (ii) Others (includes those who are too young to work and those who are ill or

cannot afford to work).

As summarised in Figure 6.1, the working age group is divided into two categories, namely those who are not in the labour force and those who are in the labour force. Those who are not in the labour force include mostly full-time students, retirees and housewives.

Figure 6.1: Population of working age group

Working age group = Those who are not in the labour force + those who are in the labour force

Working age group means number of persons who are 16 years old and above, who have never been sentenced to prison, have never been admitted into a hospital or other care centres.

Population = Working age group + Others

6.1

TOPIC 6 UNEMPLOYMENT AND INFLATION 129

Those who are in the labour force can also be divided into two categories, namely those who are employed and those who are not.

Figure 6.2 shows the composition of employment in Malaysia for the year 2001 based on 24.01 million population.

Figure 6.2: Employment in Malaysia for the year 2001

MEASURING UNEMPLOYMENT RATE

„Merger may produce efficiency and lower costs. However, if you look at it from a different aspect, reduction of costs may also mean termination of employees and unemployment.

Although the cost of producing the goods have been reduced due to increased efficiency, the product itself will become too expensive to be purchased by many who have lost their jobs. Therefore, we need to think in detail the meaning of the term globalisation so commonly used in current times. We do not want to see unemployment increasing in a global world controlled by giant companies.‰

Extracted from Malaysian Prime MinisterÊs speech.

From Buletin Utama (Main Bulletin) TV3

6.2

Labour force = Employed + Unemployed

In the economics context, unemployed means those who are not working but are actively looking for jobs.


130

The rate of unemployment is an important guide towards a countryÊs economic situation. Using the following formula, the unemployment rate measures the percentage of the labour force from those who are not working.

Unemployment rate =Number of unemployed persons ×100.

Labour force

Based on the information from Figure 6.2, the unemployment rate in Malaysia for the year 2001 is:

Unemployment rate =0.35 million ×100 = 3.54%.

0.35 million + 9.54 million

Figure 6.3 shows unemployment rate in Malaysia from 1990 to 2000.

Figure 6.3: Unemployment rate in Malaysia for period 1990-2000

EXERCISE 6.1

1. What is meant by unemployment?

2. A country reports its unemployment rate as 4%. What is meant by this value?


LABOUR FORCE PARTICIPATION RATE

The formula below shows how the labour force participation rate is measured:

Labour force participation rate =Labour force ×100.

Working age group population

Increase in labour force participation rate may be due to expansionary economic conditions. Whereas, it may drop because of an increase in the number of retirees or those who are continuing education or the number of the older generation in given the population has increased.

DISCOURAGED WORKER

Usually, a discouraged worker will provide excuses that he/she has tried to look for a job but is disappointed or he/she feels that the current labour market is not good. Therefore, any efforts to look for a job will be unfruitful. Since a discouraged worker does not make an effort to look for a job in the last four weeks, census will classify him/her as a discouraged worker and not an unemployed person. Therefore, this group is not included in the labour force. There are some sectors who think that discouraged workers should be classified as unemployed persons in order to give a more accurate picture of the labour force situation.

6.4

6.3

A discouraged worker is someone who is unemployed, ready to work but does not make an effort at finding a job in the last four weeks.

Labour force participation rate measures the percentage from the working age group population who are in the labour force group.

ACTIVITY 6.1

In your opinion, should discouraged workers be classified as unemployed persons? Why? Give your reasons.


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PART-TIME WORKERS

Have you ever worked part-time? What is the difference between a full-time worker and a part-time worker?

Part-time workers can be divided into two categories, namely, those due to economic factors and those that are due to non-economic factors. Table 6.1 shows the difference between these two categories.

Table 6.1: Differences between Part-time Workers Due to Economic Factors and Part-time Workers Due to Non-economic Factors

Part-time Workers Due to Economic Factors

Part-time Workers Due to Non- Economic Factors

They are called non-voluntary part-time workers.

They are not interested to get a full-time job.

Work between 1 and 34 hours. Not ready to undertake an available job.

At the same time, they try to be full-time workers.

They failed to get time to work.

Include those who:

• Have medical problems; have family commitments; and

• Have limited time due to studies.

6.5

Part-time workers are those who work less than 35 hours a week. Full-time workers are those who work 35 hours or more in a week.

ACTIVITY 6.2

Assume you are a part-time worker. You are not tied down by any long-term contract and you get good payments from your efforts working for many different companies. One day, you are offered a full-time job with one of the companies at which you were working with part-time. What are factors that help you decide? What would be your decision?


To test your understanding, try this exercise.

THE TYPES OF UNEMPLOYMENT

The unemployment issue is one of the most important economic issues. It can be analysed in detail when you understand the different types of unemployment. As shown in Figure 6.4, generally, there are three types of unemployment, namely frictional unemployment, structural unemployment and cyclical unemployment.

Figure 6.4: Types of unemployment

The following are explanations for each type of unemployment.

6.6.1 Frictional Unemployment

Figure 6.5: Frictional unemployment

6.6

EXERCISE 6.2

1. State the difference between a discouraged worker and an unemployed worker.

2. What is the main difference between a full-time worker and a part-time worker?


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Let us ponder on Figure 6.5. Sometimes, people are willing to be unemployed while waiting to get another job and not because they are unable to look for a job. Usually, frictional unemployment will continue to exist all the time, especially when the economy is having a continuous rapid growth. This unemployment will exist even when the economy is at full employment. However, as this unemployment is short-termed, it is not considered a serious problem.

6.6.2 Structural Unemployment

Economic growth of a country will usually be followed by structural changes and changes in economic activities. For example, in Malaysia, in the early 1980s, the industrial sector became more prominent compared to the agricultural sector. This caused some workers to be laid off because skills possessed by farmers could not be used in the industrial sector. There are various factors that cause structural economic changes in a country such as changes in consumer preference and technology advancement.

6.6.3 Cyclical Unemployment

When there is a recession, demand for goods and services will decrease. This will force firms to reduce their production and thus, cut down on their labour.

Cyclical unemployment is caused by economic conditions that go up and down. It occurs when the unemployment rate moves in the opposite direction as the GDP growth rate. So when GDP growth is small (or negative) unemployment is high.

Structural unemployment happens because workers do not have the expertise and the ability to work in a new sector. It usually exists for a longer period of time and a government policy has to be implemented to overcome this problem.

Frictional unemployment or normal unemployment exists only for a short period. It happens when individuals are moving between jobs, careers and locations.


For instance, when recession hit the Asian region in 1998 because of the currency crisis, many workers had to be laid off. In order to overcome unemployment caused by private sector demands, governments had to increase expenditure through a fiscal policy. The increase in government expenditure will create new job opportunities and subsequently, reduce unemployment rate.

FULL EMPLOYMENT AND NATURAL UNEMPLOYMENT RATE

Full employment is an economic condition whereby every individual who wants a job at current market salary/wage gets a job. One of the main economic goals of a country is to achieve full employment.

6.7

SELF-CHECK 6.1

Write down the types of unemployment in the space given below based on the statements given in the table.

No. Questions Your Answer

1. This type of unemployment is due to the unstable economic condition, going up and down.

2. This type of unemployment is short-termed and is not considered serious.

3. This type of unemployment happens because workers do not have the expertise and the ability to work in a new sector.

4. This type usually exists for a longer period of time and the government has to find a way to solve this problem.

5. This type of unemployment usually exists.


136

Full employment can also be defined based on natural unemployment rate. Natural unemployment rate equals to structural unemployment plus frictional unemployment.

Full employment is achieved when real unemployment rate is the same as the natural unemployment rate. This means, when the real unemployment rate of a country at a specific time only consists of structural and frictional unemployment, then the country has achieved full employment. In other words, cyclical unemployment does not exist at full employment level. Each country has a different natural unemployment rate depending on various economic factors. For instance, the natural unemployment rate in Malaysia is between 3% and 4%. The rate in the United States of America is between 4% and 5%, whereas in Europe, the rate is between 7% and 8%.

REASONS FOR UNEMPLOYMENT

An unemployed person is one who has the necessary qualification to work, is willing to work and agrees to work for the market wage but unfortunately does not get any job. There are three main reasons for being unemployed, namely: • Job losers; • Job leavers; and • New entrants and re-entrants.

Structural unemployment + Frictional unemployment

= Natural Unemployment Rate

6.8

EXERCISE 6.3

1. Describe three types of unemployment.

2. What does natural unemployment rate mean?

3. What is meant by full employment and how is it related to natural unemployment rate mean?


6.8.1 Job Losers

Figure 6.6: Job loser

Reflect on Figure 6.6, a job loser is someone who has been involuntarily terminated or laid off from a job, whether temporarily or permanently. There are many reasons for this, example, failure of the worker to fulfil his work requirements/conditions or the firmÊs failure to fulfil its employeeÊs needs. Those who have lost their jobs have two choices either to look for a new job or leave the labour force. Those who leave the labour force are not considered unemployed.

6.8.2 Job Leavers

There are some who voluntarily leave their jobs and not necessarily because they were laid off. If they were leaving one job because they were accepting another offer, then this would not contribute towards the increase in unemployment rate. The unemployment rate will only increase if these job leavers were still looking for a new job.

ACTIVITY 6.3

Try to think of the psychological effects on a person who has lost his job. What are the pressure and problems he faces? Who can they discuss this with? Discuss.


138

6.8.3 New Entrants and Re-entrants

New entrants are those who have just completed their studies and are ready to join the work force. They have never before been employed and are actively seeking employment for the first time. However, while looking for a suitable job, they have to be unemployed. Re-entrants are those who had previously been classified as employed, but have been out of the labour force for a period of time before actively seeking employment once again. Usually, they will have to be unemployed while trying for a new job.

EFFECTS OF UNEMPLOYMENT

Unemployment is a common phenomenon. However, a high unemployment rate will affect a countryÊs economic growth. Do you know how much unemployment can affect or influence our countryÊs economic growth? Many are of the opinion that frictional unemployment is just a short-term phenomenon and need not be worried about. This unemployment also happens due to the economic growth of a country. However, unemployment due to reduced job opportunities caused by recession such as cyclical unemployment, will bring about negative effects on the countryÊs economic stability. The negative effects of unemployment can be divided into two, namely, effects on the economy and effects on the individual and population.

6.9

ACTIVITY 6.4

Do you know that there are 50,000 graduates who do not work in Malaysia at this time? Newspapers have reported that almost all of them are not actively looking for jobs.

Are you also aware that some graduates are very choosy of the kinds of jobs they do, wanting to hold a high position, or insisting on being paid a lot higher than the market rate despite not having any experience? What is your opinion about this scenario? State your opinion.


6.9.1 Negative Effects on the Economy

A high rate of unemployment will ruin a countryÊs economic growth. Table 6.2 shows the negative effects of unemployment on the economy.

Table 6.2: The Negative Effects of Unemployment on the Economy

Negative Effects Description

Unemployment does not encourage economic growth

High unemployment rate will ruin the economic growth and performance. There will also be excess capacity from the industrial machines. This will indirectly cause a drop in investment level.

Drop in Government Revenue

When people are unemployed, the tax collection is also reduced. Government then has to reduce its expenditure to boost economic growth.

Wastage of production resources

High rate of unemployment forces the economy to operate at a level below maximum. The wastage of resources bring about output production far lower than the potential output.

6.9.2 Negative Effects on the Individual and Population

Besides the negative effects on the economy, as stressed in an earlier part of this topic, unemployment also affects the social life of an individual, the community and the population as a whole. Table 6.3 shows the negative effects of unemployment towards individuals and the population.

Table 6.3: Negative Effects of Unemployment on Individual and Population


Loss of job Temporary unemployment will not ruin the lives of the people as daily activities can be carried out using savings or loans. However, continuous unemployment will create unhealthy side effects such as being forced to partake in illegal activities to obtain money.

Loss of Skills Some skills can only be maintained if they are used or practiced often. Long-term unemployment might cause an individual to lose his/her skills.


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Political Instability

Long-term or continuous unemployment can create chaos and the government will be under pressure and receive criticisms from many parties. This problem indirectly contributes towards social problems and causes an increase in crime rates. Increase in crime rates can cause foreign investors to shy away.

INFLATION

Generally, inflation means „continued increase in general price levels‰. General price reflects the price level for all goods and services that exist in the economy at any given time. Do you know the method used in Malaysia to measure the general price level?

Inflation is one of the important topics of discussion in economics. Rise in price does not refer to any specific item or product. It refers to price in general which is measured based on the price index. There are a few price indexes that are commonly used to portray the general price level and one that is frequently used is the consumer price index (CPI).

6.10

Inflation can be defined as continued increase in general price level of goods.

EXERCISE 6.4

1. What are the reasons for unemployment?

2. What are the negative effects of unemployment on the economy?

ACTIVITY 6.5

Visit this website to gather more information about inflation: http://www.sabah.org.my/bm/konsumer/panduan_pengguna/inflasi.asp


CONSUMER PRICE INDEX (CPI)

CPI is usually used by the government and the private sector to measure the price level paid by consumers.

Figure 6.7 shows an example of CPI.

Figure 6.7: Composition of goods in Malaysian consumer basket

CALCULATION OF CPI

The process of calculating the actual CPI is a complicated one because the consumer basket has many goods. In order to give a clear and easy picture of how the CPI is formed, let us look at a model of two goods. Assume that the

6.12

6.11

CPI is a measure to track changes in prices of goods and services purchased by households, i.e. of the consumer basket. The composition of goods in the consumer basket is fixed based on consumer spending patterns.

EXERCISE 6.5

1. Price hike is always related to inflation. However, not all price hikes mean inflation. Describe the situation where price hikes can be concluded as inflation.

2. What are the main components in the consumer basket for a Malaysian CPI?


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consumer basket has two goods, apple and laundry service. The year 2000 is picked as the base period/ year for comparison purposes, whereas the current year is 2001. Basically, there are three main steps in the calculation of CPI, namely: (a) Calculate the cost of CPI consumer basket at base year price. (b) Calculate the cost of CPI consumer basket at current year price. (c) Calculate the CPI for base year and current year.

6.12.1 Calculate the Cost of CPI Consumer Basket at Base Year Price

At the base year, a consumer buys 10 apples and consumes 5kg rice. The apples cost RM0.50 per apple and the rice cost RM1 a kilogram. Table 6.4 shows consumer expenditure information for the base year.

Table 6.4: Cost of CPI Consumer Basket at Base Year Price

Consumer Basket

Item Quantity Price Cost of Basket

Apple 10 RM0.50/fruit RM5.00

Rice 5 RM1.00/kg RM5.00

Cost of CPI basket at base year price RM10.00

Based on the information above, the consumer spent RM5 on apples and RM5 on rice. The total consumer expenditure that year was RM10.

6.12.2 Calculate the Cost of CPI Consumer Basket at Current Year Price

The cost of the consumer basket for the current year is calculated after counting the cost of the consumer basket for the base year. During the current year, the quantity of goods purchased did not change. However, the price of apples increased to 60 sen a fruit and the price of rice increased to RM1.10 per kilogram. Table 6.5 provides information regarding the apple and laundry service for the current year.


Table 6.5: Cost of CPI Consumer Basket at Current Year Price

CPI Basket

Item Quantity Price

Cost of CPI Basket

Apple 10 RM0.60/fruit RM6.00

Rice 5 RM1.10/kg RM5.50

Cost of CPI basket at current year price RM11.50

Overall, the consumer spent RM11.50 to purchase the same amount of apples and rice. RM6 was spent on apples and RM5.50 was spent on rice.

6.12.3 Calculate the CPI for Base Year and Current Year

After calculating the cost of the CPI basket at base year price and current year price, the next step would be to calculate the CPI for both years. The formula to calculate the CPI for base year and current year is: Therefore, CPI for the year 2000 is: Whereas CPI for the year 2001 is: Based on the CPI that has been calculated, it can be concluded that the average price of goods and services for the year 2001 is 15% higher when compared to the year 2000.

CPI = ×Cost of CPI basket at current year price

100Cost of CPI basket at base year price

CPI for year 2000 = × =10

100 10010

CPI for year 2001 = × =11.50

100 11510


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CALCULATING THE INFLATION RATE

Inflation rate is one of the important guides in an economy. It is used by various parties including the government and policy-makers to evaluate the price changes in a country. Basically, inflation rate measures the percentage increase in the price of goods and services (CPI) over a given period of time. The following formula is used to calculate inflation rate:

For instance, in the year 2000, the CPI value is 100. The CPI value for 1999 is 94. Based on this information, the inflation rate for the year 2000 can be measured like this:

Conclusively, the average price of the consumer basket for the year 2000 is 6.38% higher than the year 1999. In order to obtain the same quantity of goods as in 1999, consumers have to increase their spending by 6.38%. Figure 6.8 shows the inflation rate in Malaysia from 1970 to 2000.

Figure 6.8: Inflation rate in Malaysia from 1970 to 2000

Inflation Rate for 2000 =

−×

100 94100

94 = 6.38%.

New CPI - Old CPIInflation Rate = x100

Old CPI

6.13


Referring to Figure 6.8, the highest inflation rate in Malaysia was in 1998, when it was about 5.3%. This is because of the currency crisis that hit the Asian region. Except for 1998, the inflation rate for the remaining years were below 5%. This is quite low compared with other countries. The low inflation rate is due to the effectiveness of the policies implemented by the government in order to curb inflation in our country.

EFFECTS OF INFLATION

Besides unemployment, inflation is also another serious economic problem. Inflation not only affects economic activities, it also has an impact on an individual and societyÊs welfare. The following are the effects of inflation:

6.14.1 Effects of Inflation on Total Production

In the short-term, inflation will encourage an increase in national production if the factors of production are not fully utilised. Price hikes are a sign to producers that they can reap more profits if they increase production.

However, if production is already utilising full resources, then inflation will only increase the price and not the production. Therefore, only medium-sized inflation which has not utilised full resources will bring about an increase in national production.

6.14.2 Effects of Inflation on Savings and Investment

Inflation causes purchasing power to shrink (drop in the value of money). This means that those who hold wealth in the form of cash will suffer losses. This situation encourages people to spend, and hence reduce savings.

Besides that, inflation also encourages people to use their savings to purchase shares and assets like properties. This is because during inflation, prices of assets are prone to increase. The increase in price level also encourages firms to start new investments because of the increased profits. This usually happens when the economy is expanding.

6.14

EXERCISE 6.6

1. Explain three steps needed to calculate CPI with suitable examples.

2. State the formula to calculate inflation rate.


146

6.14.3 Effects of Inflation on Income Distribution and Economic Wealth

Inflation affects different people in different ways. Those who work for a fixed salary will suffer losses. This is because price hikes will deteriorate the value of money. Individuals with fixed salaries will suffer from reduced purchasing power. The same effect is on retirees who are paid pensions. Those who are fond of saving money (either in a savings account or through purchase of government bonds), also suffer losses. The interest rates received on their savings could be lower than the inflation rate. Those who make money when inflation hits are businessmen. At that time, they will increase the price at a higher rate compared to the rate of increase in production costs. This situation allows businessmen to obtain higher profits. Besides this, inflation also brings profits for those who own shares and permanent assets like houses and buildings. Shareholders will get higher returns when the company makes profits. Those who own properties, such as land and houses, will get more profits because the properties will be priced higher during inflation. Inflation also causes uneven distribution of income between those who borrowed money and those who lent out money. Those who borrowed will reap some benefits because the actual value of the repayment will deteriorate. Although the amount repaid will be the same, the actual value of the sum (measured based on quantity of goods that can be purchased) has decreased. Therefore, those who lent out money will suffer some losses because the amount now has lower purchasing power.

6.14.4 Effects of Inflation on a Country’s Balance of Payments

Inflation causes local products to become more expensive in foreign markets and foreign products will become cheaper in local markets. This will cause an increase in imports and a decrease in exports. This will bring about a balance of trade deficit. This means cash outflow is more than cash inflow into the country. If the capital account balance does not change, it will cause the countryÊs balance of payments to suffer a deficit.


However, if other factors do not change, the rise in export price and the drop in import price of a country will create better trade conditions. This means that with the same export quantity, the country can obtain more import quantity compared to before. This situation happens only if demand to export the countryÊs goods remain fixed.

CPI AND LIVING COSTS

The CPI is frequently called a cost-of-living index, which measures the change or increase in money that is needed to maintain the existing lifestyle. However, the usage of CPI in measuring living costs does not reflect the consumerÊs complete standard of living. This is because CPI has some problems and weaknesses. Six problems and weaknesses have been listed down below in Figure 6.9. The explanation for these problems and weaknesses are in Table 6.6.

Figure 6.9: Problems related to CPI

6.15


148

Table 6.6: Weaknesses of CPI

Weaknesses of CPI

Description

Choice of goods and services

The goods chosen must reflect the societyÊs expenditure pattern. However, this expenditure pattern is not permanent and keeps changing in line with peoplesÊ preferences. CPI failed to take into consideration these changes.

The price difference of goods and services

This problem arises due to the price difference in goods and services according to the time and place. For instance, a new product like a computer will cost more than a typewriter, and this makes it more difficult to make comparisons with the earlier year.

The change in quality of goods and services

It is only fair that prices of goods and services increase due to better quality. This does not mean that purchasing power has weakened because the price hike is in line with increase in quality. However, the CPI failed to take into account changes in quality of goods and services. And another question that we need to ask is whether the change in quality is much bigger than the change in living costs?

Choice of base year

The base year is chosen based on the price stability in that year. The choice of base year is needed for purposes of comparison. However, it is a little difficult to choose any particular year that has price stability because inflation and deflation happen all the time.

Not taking into account opportunity costs

People now have a choice as to where they would like to go to purchase goods and services. For example, people are now more interested in going to hypermarkets that give discounts compared with small shops nearby. This shows that CPI does not look at opportunity costs and only considers the absolute costs.

Over-valued or undervalued estimation

Due to some problems in calculations mentioned earlier, the calculated CPI may have some mistakes. Therefore, information about the inflation rate of a country is not accurate because the figure may have been over-valued or undervalued.


FACTORS THAT CAUSE INFLATION

There are various factors that can cause inflation. Figure 6.10 lists down these factors.

Figure 6.10: Factors that cause inflation

6.16.1 Demand-Pull/Excess Demand

Inflation that is caused by high or excess demand is called demand-pull inflation.

This inflation happens when excess demand at full employment level causes an increase in the average price. Referring to Figure 6.11, the increase in demand from AD to ADÊ at full employment output level (Y*) causes a price hike from P to PÊ.

6.16

Demand-pull inflation is defined as a situation where „a lot of money is used to obtain a small quantity of goods.‰

ACTIVITY 6.6

You have studied the concept of inflation. Think for a moment, in what situations can inflation happen and as a consumer, how would you react to inflation?


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Figure 6.11: Demand-pull inflation

6.16.2 Increase in Costs

For example, when the workers union demands a salary hike, this increases the firmÊs production costs. The increase in costs will decrease supply at every price level. Refer to Figure 6.12. This causes the supply curve to move left from AS to ASÊ and price increases from P to PÊ. This situation will continue because an increase in the price of goods will cause a drop in an individualÊs real income.

Increase in production costs will force producers to shift their burden to the consumers by increasing the sale prices. This inflation is called Cost-push inflation.


Figure 6.12: Cost push inflation

6.16.3 Supply Shock

Supply shock can cause a drastic change in production costs of basic goods. For instance, long and terrible drought can be disastrous to the agricultural sector. It can cause an increase in food price. When petrol prices go up, most firms that use petrol for their production also suffer as their costs increase as well. This will eventually make the end product much more expensive and inflation happens as a result of this.

6.16.4 Adaptive Expectations

Inflation may happen if consumers expect it to happen. This psychological factor is an important factor in the field of social science. If people expect prices to go up, they will purchase goods before the price increases. Increase in demand causes prices to go up and inflation to occur. Inflation due to this psychological factor is called adaptive expectation inflation.


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• This topic discussed two main problems in macroeconomics, namely unemployment and inflation.

• The discussion begins with a description of the unemployment concept and the methods to measure it.

• There are three types of unemployment, structural, frictional and cyclical.

• The relationship between full employment and natural unemployment rate is also explained.

• The topic ends with a discussion on the reasons for and effects of unemployment.

• The second part discussed inflation, consumer price index, CPI measurement, calculation of inflation rate and effects of inflation.

• The relationship between the consumer price index and cost of living is also described. This topic ends with explanations on factors that cause inflation.

Cyclical umemployment Demand-pull inflation Frictional unemployment Full employment

Full-time worker Part-time worker Structural unemployment Working age group

INTRODUCTION

These days, most countries are involved in international economic activities. A country does not only produce goods for local consumption, some of the products are exported to other countries. Those goods that cannot be produced locally are imported from other countries. This process of exchanging goods or sale-purchase transactions for goods and services between two or more countries is called international trade. Basically, international economic activities refer to economic activities with other countries. Each country depends on the other to get goods and services and to carry out other economic activities such as investment and production. The advancement in computer technology and communication, and the reduction in trade restrictions make it possible to carry out international trade with ease. This topic will focus on discussions about international trade.

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International Trade


1. Define the term international trade;

2. Discuss why countries trade:

3. Differentiate between absolute advantage and comparative advantage; and

4. Assess the types of trade restrictions.

TOPIC 7 INTERNATIONAL TRADE

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WHY DO COUNTRIES TRADE?

Trade is important for a country. Without trade, a country cannot diversify its productions. Before you start reading, try to think of one important factor why trade is needed, especially international trade carried out in a country like Malaysia. Generally, there are a few main factors that encourage international trade between one country and another. Refer to Figure 7.1.

Figure 7.1: Main factors that encourage international trade

Detailed explanation for all factors are given below:

7.1.1 Possession of Different Production Factors

Each country has its own factors of production, different in type, quality and quantity. This differences are the main factor why countries conduct trade with one another. Different factors of production makes each country focus on different types of production. For instance, countries that have capital and high technological knowledge like Japan and United States of America, will focus on industrial products. Figure 7.2 shows the example of the automobile industry which requires high capital and technology. Countries that are rich with natural resources like Malaysia and China, will focus on producing main goods. Because each country produces different types of goods, each country will carry out international trade to obtain goods that are not produced locally.

7.1

TOPIC 7 INTERNATIONAL TRADE 155

Figure 7.2: Automobile industry

Source: http://images.google.com.my

7.1.2 Different Climate

Difference in climate makes every country concentrate on producing different types of product. For instance, the hot and wet climate found in most of Southeast Asian countries, makes countries like Malaysia, Indonesia and Thailand focus on rubber plantation. Figure 7.3 shows an oil palm estate. Oil palm is one of the commodity crops in Malaysia. The cold climate in Australia and New Zealand allows both these countries to focus on the production of fruits like apples and oranges. So, different climates cause the production of different goods. The difference in agriculture produce encourages countries to trade with one another. Figure 7.4 shows grapes, which are one of the fruits planted in countries with cold climate.

Figure 7.3: Oil palm is a commodity crop in tropical countries

Source: http://www.pnm.co.id/images//berita/sawit.jpg


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Figure 7.4: Grapes is one of the fruits produced in countries with cold climate

Source: http://images.google.com.my

7.1.3 Different Labour Skills

Every country has its own level of labour skills. For instance, countries like Japan, United States of America and Singapore have a skilled labour force in their industrial sector. Therefore, these countries focus on production of industrial goods. Other countries like New Zealand, Australia, China and Malaysia have a skilled labour force in agricultural sector. The difference in labour skills causes the production of different types of goods and encourages international trade.

7.1.4 Different Consumption Patterns

Normally, different societies have different tastes, preferences and spending patterns. This situation causes the production of goods in accordance with the societyÊs needs and preference. Therefore, each country will produce different types of goods. The different types of goods produced encourage international trade.

ACTIVITY 7.1

Most of the labour force in Malaysia currently is from overseas such as Indonesia, Vietnam, India and Philippines. What is the effect on our local skills and expertise by these foreign workers flooding our job market?


ABSOLUTE ADVANTAGE

In order to make it easier for you to understand the concept of absolute advantage, we will use one scenario. Assume two countries, X and Y, produce two types of products, oranges and apples. Table 7.1 shows the output quantity produced by each country using the same resource. Country X can produce 100 oranges or 10 apples using this resource. Meanwhile Country Y can produce 50 oranges or 20 apples.

Table 7.1: Absolute Advantage for Country X and Y

Country Orange Apple

X 100 10

Y 50 20

Table 7.1 clearly shows that Country X is more efficient at producing oranges and Country Y is better at producing apples. So, each country has an absolute advantage.

This situation could be due to the possession of natural resources or high production efficiency. Country X is said to have an absolute advantage in the production of oranges and Country Y has an absolute advantage in the production of apples. So, Country X will specialise in producing oranges while Country Y will focus on producing apples. The question now is, how much is the suitable exchange rate for these two countries to trade?

7.2

Absolute advantage is defined as a countryÊs ability to produce more of the product than another country can, with the same amount of resources.

EXERCISE 7.1

1. What do you understand from the term international trade?

2. Describe factors that encourage international trade.


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Assume 30 oranges are exchanged for 10 apples. What will happen to Country Y if all the resources are utilised to produce apples and exchange it with the oranges produced by Country X? With this rate, Country Y will get 60 oranges, which means it gets 10 fruits more than if it produced the oranges by itself. Besides that, Country X also benefits from this specialisation. Through this trade, Country X exchanged 60 oranges for 20 apples. Besides still having a remainder of 40 oranges, Country X also received 10 more apples than if it had produced the apples by itself. Conclusively, Country X received an excess of 40 oranges and 10 apples after carrying out trade with Country Y. Meanwhile, Country Y also got 10 oranges extra from the trade. This shows that both the countries benefited from the trade. There is no reason for the benefit to be equally divided. Instead, both countries got more goods after the trade. By specialising in the production of one product, and carrying out trade, both the countries obtained more goods compared with the situation if both the countries produced both the goods on their own.

Assume two countries M and R produce two types of goods but the output quantity is different. Table 7.2 shows the quantity of goods that can be produced using the same specified quantity of resource.

Table 7.2: Absolute Advantage for Country M and R

Country Orange Apple

M 100 20

R 30 10

Table 7.2 shows Country M can produce 100 oranges or 20 apples. Country R can produce 30 oranges or 10 apples. It is noted that Country M has an absolute advantage over Country R for the production of both oranges and apples. In this situation, is it necessary for the countries to specialise and trade? Assume that trade is agreed upon at the rate of 40 oranges to 10 apples. Although Country R does not have absolute advantage, if it produces 10 apples, then it can exchange them for 40 oranges. The oranges it gets will definitely be more than the amount it is able to produce on its own. However, Country M can afford to let go of 10 apples to produce 50 more oranges and exchange 40 oranges to get 10 apples. In this way, Country M gets 10 more oranges. This shows that although a country does not have absolute advantage, specialisation and trade can still be practiced and they benefit both countries.


COMPARATIVE ADVANTAGE

Possibly trade is not determined by the production efficiency of certain goods but more of the opportunity cost after producing the goods compared with other countries. A country is said to have a comparative advantage in the production of certain goods if the opportunity cost is lower than in other countries. Table 7.3 shows the opportunity cost for the production of apples in the unit quantity of oranges that had to be given up.

Table 7.3: Comparative Advantage for Apples

Country Opportunity Cost of 1 Apple

M 5 oranges (100/20)

R 3 oranges (30/10)

Country M is forced to give up five oranges to produce one apple. Whereas, Country R had to give up three oranges to produce one apple. This difference allows for specialisation and trade is carried out between the two countries. Relatively, Country R is more efficient in producing apples. Although it does not have an absolute advantage, Country R has a comparative advantage in producing apples. Table 7.4 shows opportunity cost in the production of oranges in the quantity of apples that had to be given up. Since Country R has a comparative advantage in producing apples, Country M will have a comparative advantage in producing oranges. Table 7.4 shows that the opportunity cost for Country M to produce oranges is 1/5 apples. Whereas, it is 1/3 apples for Country R. Because 1/5 is smaller than 1/3, Country M has to sacrifice a little apple to produce oranges compared with Country R. Relatively, Country M is more efficient in the production of oranges.

Table 7.4: Comparative Advantage for Oranges

Country Opportunity Cost of 1 Orange

M 1/5 Apples (20/100)

R 1/3 oranges (10/30)

7.3

Comparative advantage refers to a countryÊs ability to produce a product with lower relative cost compared with other countries.


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As a conclusion, comparative advantage is an important condition for specialisation and trade, not absolute advantage. What is important is which country can afford to produce a product with relative efficiency and not which country can produce a cheaper product.

Whether trade or not, depends on the opportunity cost and not the quantity of resources utilised in the production. A country will specialise in the production of goods for which it has a lower opportunity cost compared with other countries.

BENEFITS OF INTERNATIONAL TRADE

Almost all the countries worldwide carry out international trade. This is because international trade benefits those countries involved. The benefits derived from international trade are stated in Figure 7.5.

Figure 7.5: Benefits of international trade

7.4

EXERCISE 7.2

1. Provide the definitions of absolute advantage and comparative advantage.

2. What is the difference between the concepts of absolute advantage and comparative advantage?

ACTIVITY 7.2

International trade existed since the Malacca Malay Sultanate era. Try to think what could have been the benefits gained from international trade at that time and try to compare with the benefits of international trade at present times.


Table 7.5 gives detailed explanation of all the benefits mentioned above.

Table 7.5: The Benefits of International Trade

The Benefits of International Trade

Description

Acquire Goods that Cannot Be Produced Locally

People in every country need a variety of goods. However, every country is unable to produce all the goods wanted and needed. Therefore, trade between countries is carried out to acquire goods that cannot be produced locally.

For instance, Malaysia specialises in the production of oil palm, rubber and other plantations to be exported to other countries. In return, Malaysia obtains goods that cannot be produced in this country such as aeroplanes, apples and oranges.

Widen the Market for Local products

A countryÊs production can be marketed widely through international trade. Goods that are locally made can be exported to other countries. A higher production quantity will help to efficiently utilise factors of production.

This will reduce the cost of production and the price. It will increase the living conditions of the people.

Increase Efficiency in Usage of Production Factors

International trade encourages specialisation. Specialisation means each country specialises in producing a particular product which it can do efficiently. This will ensure efficiency in usage of production factors.

Acquire Modern Technology

International trade allows modern technology to be imported from developed countries to developing countries. Modern technology will enable developing countries to increase their production capabilities. International trade also allows developing countries to enjoy the usage of high technology products like computers, digital cameras and such.


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INTERNATIONAL TRADE BARRIERS

International trade is often related to loss of jobs for local people. For instance, if free enterprise is allowed for the automotive industry, then the Proton factory may have to be shut down due to its inability to compete with foreign automotive companies. This will directly cause many of our local workers to lose their jobs and eventually the unemployment rate will rise. In order to overcome this problem, the government will have to intervene by imposing a free trade barrier. There are a few methods used by the government like tariffs, quotas, foreign currency control and other restrictions to control international trade.

7.5.1 Tariffs

Tariff can be divided into two types, namely ad-valorem tariff and specific tariff. Refer to Table 7.6 to identify the differences in these two tariffs.

7.5

Tariff is a tax on foreign goods upon importation.

ACTIVITY 7.3

There are also other benefits from international trade. Try to list down other benefits and discuss your list with your classmates.

ACTIVITY 7.4

International Trade Barriers are efforts made by a country to restrict or reduce the total imported goods from other countries. Other countries that wish to carry out trade with Malaysia for example, will have to go through the international trade barriers implemented by the government of Malaysia. Try to think of the effects on local production if Malaysia does not implement any trade barrier on foreign countries.


Table 7.6: Types of Tariffs

Types of Tariffs

Ad-Valorem Tariff Specific Tariff

Explanation Import tax that is calculated based on the percentage of the value of the imported goods.

Fixed tax figure that does not depend on the value of the imported goods. Although the value of goods keep changing, the total tax imposed is fixed.

Example If the import tax for a car is 50%, then the tax that is imposed on a RM20,000 imported car is RM10,000.

One tonne of teak wood was imposed an import tax of RM200. It does not matter whether the price of the teak wood increases or decreases, the tax imposed is the same at the rate of RM200 per tonne.

Tariff will cause the cost of imported goods to go up and this means the price of the goods will increase as well. Indirectly, it reduces the local consumersÊ intention to purchase the imported goods.

7.5.2 Quotas

Implementation of quotas will not influence government revenue. In fact, quotas provide protection for local firms. There is no more competition from foreign firms once the quota is fulfilled. The main effect of quota is that it increases the price of the imported goods. But because of the limited quantity of goods, consumers are willing to spend a lot of money to get these products.

7.5.3 Foreign Currency Control

Besides tariffs and quotas, governments can also control the foreign currency used for import. Government can impose various forms of controls to influence international trade activities such as import.

Quota is the maximum limit set on the quantity of a good that can be imported into a country in a given period of time.


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Among the methods used to control the quantity of goods imported is by controlling the total foreign currency that is usually used to import the goods. Another alternative is by selling the foreign currency at a higher rate compared with the market rate. In Malaysia, the authorised body responsible to deal with foreign currencies is the Bursa Malaysia (refer Figure 7.6).

Figure 7.6: The website of Malaysia Exchange

Source: http://www.bursamalaysia.com/

7.5.4 Other Restrictions

Besides these, the government can also use other methods to reduce usage of imported goods. For example, the government can direct all its departments to use only locally made products such as using the national car Proton. Government can also direct financial institutions such as banks to reduce the giving of loans to support purchase of imported goods.

EXERCISE 7.3

1. Discuss four benefits of international trade.

2. What are the methods undertaken to restrict free trade between countries?


TERMS OF TRADE

Trade will only take place if it benefits both countries that carry out trading. The exchange rate agreed upon by both countries are called terms of trade.

There are two methods of measuring terms of trade for a country: (a) Price (b) Goods

7.6.1 Price

The terms of trade can be measured using this formula:

Px = Export price Pm = Import price

When export price drops and import price goes up or does not change, the price terms of trade for that country will deteriorate. Instead, when export price increases or does not change and import price reduces, the price terms of trade will increase.

7.6.2 Goods

Goods terms of trade measures the ratio of quantity of export commodity to quantity of import commodity in a country.

Price terms of trade means the ratio of price of export commodity to price of import commodity in a country.

Price terms of trade = Px / Pm

7.6

Terms of trade can be defined as the ratio of price or quantity of export commodity to price or quantity of import commodity.


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Goods terms of trade can be measured with the following formula:

Qx = Export quantity Qm = Import quantity

When the same export quantity can obtain a lesser import quantity, the goods terms of trade will increase. Instead, when the same export quantity can obtain more import quantity or lower export quantity can obtain the same import quantity, then the goods terms of trade will drop.

WHY ARE PROTECTION POLICIES NEEDED?

Although it is agreed that international trade can increase the welfare of the trading countries, there are some countries still implementing protectionism economic policy of restraining free trade between nations. Refer to Figure 7.7 to identify reasons why protection policies are needed.

Figure 7.7: Reasons why protection policies are needed

The explanation for all the reasons are given below.

Goods terms of trade = Qx / Qm

7.7


7.7.1 Protect New Industries

Each country has a new industry to promote. New industries are not ready to compete with foreign firms and need government assistance and support to continue their operations. Without the governmentÊs help, they could face strong competition and may even have to be shut down if they fail to survive the competition. For instance, in the mid 1980s, the automobile industry in Malaysia was still new and needed government assistance. This industry was in its infancy stage and was not ready to compete with foreign giant firms such as Ford Company and General Motors. In the beginning, the industry was not competitive in many aspects such as price, cost of production and product quality.

7.7.2 National Security

Certain goods used by citizens have to be produced by the individual countries themselves. These countries cannot depend on other countries to produce such goods. This could be for security reasons. For instance, if Malaysia depends on Thailand fully to get its supply of rice, and if war takes place between Malaysia and Thailand, then this could affect our national security as Thailand can restrict the supply of rice to Malaysia.

7.7.3 Diversify Economic Activities

Trade restrictions are also necessary to diversify a countryÊs economic activities, which will contribute towards national income through foreign exchange. If a country depends a lot on specific export industry, it can cause a decrease in national income if the industry deteriorates. For example, Malaysia exports palm oil overseas. If the price of palm oil in international market drops suddenly and Malaysia does not have another source of income, then Malaysia will have no choice but to only depend on the export of oil palm. Therefore, protection is required for other industries to diversify the countryÊs economic activities.


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7.7.4 Protect Resources

Protectionism can also be used to protect local industries and its resources. When consumers start depending on imported goods, it will not encourage domestic economic activities. This will affect the demand for local sources of production including labour force. This will cause the unemployment rate to go up. Other related social problems such as robberies, thefts and political instability will emerge.

7.7.5 Anti-dumping

This situation will encourage imports. If this continues, it will seriously affect the local industry. Therefore, protection policies are needed to look after the welfare of the local industries because they contribute towards a countryÊs economy.

• This topic discussed the topic of international trade. Factors that encourage countries to trade with one another are possession of different production factors, climate, labour skills and different consumption pattern.

Anti-dumping refers to the activities of foreign firms that have excess production and sells this to other countries for a much cheaper price compared with the price sold in its own country.

ACTIVITY 7.5

Try to list other reasons why protectionism and trade restrictions are needed. Discuss your answers with your classmates.

EXERCISE 7.4

1. What is the meaning of terms of trade?

2. Why is a protection policy needed?


• The concepts of absolute advantage and comparative advantage were also described.

• There are a few barriers that are commonly used in international trade such as tariffs, quotas, foreign currency control and other restrictions for various reasons. The reason being to protect new industries, national security, diversify a countryÊs economic activities and avoid dumping.

Absolute advantage Anti-dumping Comparative advantage Good term of trade

Price term of trade Quota Tariff Term of trade

INTRODUCTION

Import and export are important activities for an open economy. Besides these, there are other international transactions that are equally important to the economy such as purchase of bonds, shares and other foreign financial assets. Most international transactions involve the payment flow between countries. For this purpose, the mechanism to determine the value of foreign currency is required. The value of currency is very important to determine exports, imports and a countryÊs foreign investment. For instance, the value of the Ringgit compared with American Dollar, Japanese Yen and Euro are important for MalaysiaÊs international transactions. This topic is divided into two parts. The first part focuses on the foreign exchange rate. This covers the process of determining the foreign exchange rate and the factors that influence it. The second part explains how each international transaction influences the payment flow between countries. The classification of this transaction is also explained. The second part specifically discusses balance of payments accounts, issues and concepts related to it.

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International Finance


1. Explain the meaning of foreign exchange rate and how this is determined;

2. Assess factors that influence the foreign exchange rate; and

3. Evaluate the use of balance of payments and its components.

TOPIC 8 INTERNATIONAL FINANCE 171

FOREIGN EXCHANGE RATE

Almost all countries have their own currency. In order to carry out international trade with different currencies, one currency has to be exchanged with another currency.

For example, Proton company agreed to sell a Wira car for RM30,000 to a dealer in America. If the foreign exchange rate between American Dollar and Ringgit is RM2.50 to US$1, then the dealer in America has to pay US$12,000 to purchase a Proton Wira car. Since trade is carried out with countries using different currencies, foreign exchange rate plays a vital role in influencing international trade. If the foreign exchange rate increases from RM2.50 to RM2.60 for US$1, then the value of the Dollar has increased compared with the Ringgit. In other words, the value of the Ringgit has depreciated. This is because with US$1, the holder can now get more Ringgit. Instead, if the foreign exchange rate drops from RM2.50 to RM2.40 for US$1, then the value of the Dollar has depreciated compared with Ringgit. In other words, the value of the Ringgit has increased compared to the the Dollar because one Dollar can now be purchased with just RM2.40. In this topic, the foreign exchange rate is stated in Ringgit for every unit of Dollar, such as RM2.50 for US$1. Actually, the foreign exchange rate can also be stated in Dollar for every Ringgit such as US$0.40 for every Ringgit. This means that US$0.40 can be exchanged for RM1. This figure is obtained by dividing US$1 with RM2.50, which equals to US$0.40.

8.1

Foreign exchange rate refers to the rate at which one currency may be converted into another.

ACTIVITY 8.1

In your opinion, how important is the foreign exchange rate to a government that sponsors its studentsÊ costs of education overseas?

TOPIC 8 INTERNATIONAL FINANCE

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HOW IS THE FOREIGN EXCHANGE RATE DETERMINED?

The foreign exchange rate is determined in the currency market. In order to understand the determination of the foreign exchange rate, the demand and supply models are used. Figure 8.1 shows the demand and supply for the Dollar compared with Ringgit. The vertical axis represents the foreign exchange rate that is stated in Ringgit for every Dollar. The supply curve shows the quantity of Dollar supplied to be converted into Ringgit. Americans have to get Ringgit in order to purchase goods from Malaysia. Demand curve shows the quantity of Dollar that is demanded to exchange with Ringgit. If an individual or firm from Malaysia wants to buy a product made in America, they will have to get Dollars and exchange it with Ringgit. The equilibrium value is RM2.50 for US$1. If the exchange rate increases to RM3.00 for US$1, then the value of Dollar has appreciated compared with Ringgit because every US$1 can get RM3.00. In reverse, if the exchange rate drops to RM2.00 for US$1, then the value of Ringgit has increased compared to the Dollar.

Figure 8.1: Determinant of foreign exchange rate

8.2


CHANGES IN DEMAND OR SUPPLY

Changes in demand or supply will cause changes in the equilibrium foreign exchange rate. Figure 8.2 shows an increased demand for the Dollar. Notice that original demand curve D moved to the right to DÊ. This makes the equilibrium foreign exchange rate increase from RM2.50/US$1 to RM2.75/US$1 (now US$1 equals to RM2.75). Increase in demand pushes up the value of the Dollar because more Ringgit can be obtained with US$1. In other words, value of the Ringgit depreciated compared with the Dollar.

Figure 8.2: Increase in demand for Dollar

Figure 8.3 shows the effect of increase in supply of the Dollar compared with the Ringgit. This increase causes the original supply curve S to move to SÊ and achieve a new equilibrium rate at RM2.25/ US$1. At this level, US$1 can only be exchanged with RM2.25. This is a little more compared with the rate of RM2.50/US$1. In other words, the value of the Dollar has depreciated compared with the Ringgit or the value of the Ringgit has gone up compared to the Dollar.

8.3

EXERCISE 8.1

1. Provide the definition of foreign exchange rate.

2. How does the market mechanism determine the foreign exchange rate?


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Figure 8.3: Increase in supply of Dollar

FACTORS THAT INFLUENCE THE FOREIGN EXCHANGE RATE

Equilibrium foreign exchange rate will change if demand or supply changes. There are four factors that can influence demand and supply of any currency. Refer to Figure 8.4 to identify the four factors that influence the foreign exchange rate.

Figure 8.4: Factors that influence foreign exchange rate

The explanation for each factor is given below:

8.4

ACTIVITY 8.2

Imagine that you are a money changer in Kuala Lumpur. Imagine how the international trade activities in Malaysia can influence your business. How far would you value your profits?


8.4.1 The Price of Traded Goods

The price of traded goods is the main determining factor for demand and supply. If local goods can be sold cheaper than goods from other countries, it will increase exports and eventually, cause a hike in the demand for local currency. This means the value of local currency will increase compared with other currencies. Instead, if the price of imported goods is cheaper, it will encourage demand for foreign currency through increase in imports. This will make the value of foreign currency to go up and the value of local currency to drop.

8.4.2 Inflation Level

There are two reasons why the value of currency can drop. Firstly, high inflation level will make the local products become more expensive compared with imported goods. The difference in price will encourage consumers to purchase imported goods, which will directly increase the value and demand for foreign currency. Secondly, inflation not only affects the price of goods sold domestically, but also the price of goods exported. Exported goods will become more expensive and this will cause a decline in the demand for local currency. Eventually, the value of local currency will deteriorate.

8.4.3 Interest Rate

Among the important factors that influence the movement of capital is the interest rate.

High interest rates shows profitable investment returns and this increases capital inflow. Increase in capital inflow will cause an increase in demand for local currency and this will eventually increase the value of local currency compared with foreign currency. Instead, low interest rates compared with other countries will encourage capital outflow. This will reduce demand and subsequently, the value of the local currency. Demand for foreign currency will increase because investors will invest in countries that offer a higher interest rate.

The interest rate reflects the rate of returns on the investment made.


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8.4.4 Income of the People in a Country

The average income of the people in a country influences their expenditure pattern. For those who have high incomes, they prefer to import goods from overseas because they have a higher purchasing power. This will increase the demand for foreign currency. Instead, low incomes encourage them to buy only locally produced goods.

BALANCE OF PAYMENTS

A countryÊs balance of payments refers to balance of financial records showing the total inflow of money into the country and the total money outflow paid to other countries. The financial records can be either classified as credit or debit depending on the type of international transactions that are carried out.

8.5

Credit transactions record receipt of money from other countries. Whereas, debit transactions record payments made to other countries.

The balance of payments is a systematic record of a nation's total payments to foreign countries, including the price of imports and the outflow of capital and gold, along with the total receipts from abroad, including the price of exports and the inflow of capital and gold.

EXERCISE 8.2

List and discuss four factors that influence foreign exchange rates.

ACTIVITY 8.3

Look at the website of Ministry of Domestic Trade and Consumer Affairs. There are many articles there for you to read and these can be used to guide additional information when you answer questions. http://www.kpdnhep.gov.my


The credit transactions will be marked positive (+) in the balance of payments account. Credit transactions include exported goods and services, receipt of transfer payment/gifts, and any capital inflow. The debit transaction will be marked negative (-) in the balance of payments account. Among the debited transactions include import of goods and services, giving of gifts to other countries and the capital outflow. Figure 8.5 shows the categories of balance of payments.

Figure 8.5: Categories of balance of payments

8.5.1 Current Account

The current account records all transactions on exports and imports of goods and services plus net international transfers (public or private gifts or donations). A current account is divided into three smaller accounts, namely the trade account, services account and the transfer of payments account. This is shown in Figure 8.6.

Figure 8.6: Three small accounts in current account


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Table 8.1 gives the description of the three small accounts in current account.

Table 8.1: Types of Current Small Accounts

Types of Current Small Accounts

Description

Trade Account Trade account records the total exports and imports for produce of agriculture, industrial, mining and various other traded goods.

The difference between export value and import value is known as the balance of trade. A positive balance of trade is known as a trade surplus and consists of exports more than imports; a negative balance of trade is known as a trade deficit or informally, as a trade gap.

Services account Services account records the total exports and imports for services that include payments for transportation, insurance, tourist expenditure and investment income.

The difference between the export value and import value of services is called the balance of services. A positive balance is known as a services surplus and consists of exports more than imports; a negative balance is known as a services deficit which means imports exceed exports.

Transfer of payments account

Transfer of payments account records all transfer payments made or received by the government and the private sector.

Transfer payments include giving (receiving) assistance and gifts to (from) other countries. Transfer payments do not get any payment in return, whether in cash or kind. For example, the humanitarian channel given by Malaysia to Afghanistan is a transfer of payment.

The three transactions above when placed together is called current balance like given in formula below.

Trade account + services account + transfer of payments account

= CURRENT BALANCE


8.5.2 Capital Account

The capital account records the net result of public and private international investments flowing in and out of a country. Investment and loans from overseas are recorded as credits in a countryÊs capital account. Investment and loans given to other countries are recorded as debits. As shown in Figure 8.7, capital account is divided into two smaller accounts, namely, long-term capital account and short-term capital account.

Figure 8.7: Types of capital accounts

(a) Long-term Capital Account A long-term capital account covers all forms of capital inflow and outflow in a country which has the maturity date of more than a year. It includes official long-term capital and private long-term capital. Refer to Table 8.2 for explanations.

Table 8.2: Types of Long-term Capital Account

Types of Capital Account

Explanation

Official long-term capital

The movement of official long-term capital are the loans and payments between governments of one country and another or international financial bodies. One example is the loan taken by the Malaysian government from Japan and the World Bank.

Private long-term capital

The movement of private long-term capital can be divided into two types, namely, direct investment and portfolio investment. Direct investment means investing in asset ownership such as building new firms in other countries together with ownership control.

Portfolio investment is the purchase of shares and bonds but the government guarantee letter does not include ownership control.


180

(b) Short-term Capital Account

A short-term Capital Account covers all types of capital inflow and outflow in a country with a maturity date of less than a year. Short-term Capital Account include official and private short-term capital. Refer to Table 8.3 for the explanation of these two types of short-term capital accounts.

Table 8.3: Types of Short-term Capital Account

Types of Capital Account

Explanation

Official short-term capital

The movement of official short-term capital is the payment of interest rate on loans taken from other countries or international financial institutions. For example, payment of interest by the Malaysian government on loans taken from the World Bank.

Private short-term capital

The movement of private short-term capital includes bank loans, trade credits and such for a short period. For instance, the short-term investments made by foreign investors in the country to get profits in the short-run.

(c) Mistakes and omissions Mistakes and omissions are movements of short-term capital that cannot be

determined and classified as either official or private. Besides this, it is also the capital flow which cannot be traced or recorded.

8.5.3 Official Settlement Account

Official settlement account records the net change of foreign currency reserve and gold reserve in a country. This change is due to an imbalance in the balance of payments. When there is an excess balance of payments, foreign currency and gold will increase. Instead, if there is a deficit balance of payments, the foreign currency and gold reserves will decrease as well. This clearly shows that surplus or deficit balance of payments will be balanced by changes in the official settlement account.

Current balance + Long-term capital account = BASIC BALANCE


When the basic balance (Current balance + Long-term capital account) is added to short-term capital account and the official settlement account, the total obtained is called the balance of payment.

CURRENT BALANCE + CAPITAL ACCOUNT + OFFICIAL SETTLEMENT ACCOUNT = BALANCE OF PAYMENT

SELF-CHECK 8.1

Please mark “ in the suitable place. You can check your answers based on the topics you have studied.

No. Statement True False

1. A capital account records all transactions on exports and imports of goods and services plus net international transfers (public or private gifts or donations).

2. Current account records the flow of public and private capital/international investments flowing in and out of a country.

3. A current account is classified into three smaller accounts, namely trade account, services account and transfer of payments account.

4. All forms of capital inflow and outflow in a country which have maturity date of more than a year are known as short-term capital account.

5. All forms of capital inflow and outflow in a country which have a maturity date of less than a year are known as long-term capital account.

6. A current balance added with a long-term capital account is known as current balance.

7. Trade account added with services account and services payment account is known as a current balance.

8. Three types of long-term capital account are official long-term capital, private long-term capital and government long-term capital.

9. Short-term capital account consists of two types, namely official short-term capital and private short-term capital.


182

• This topic had started its discussion on foreign exchange rates. The foreign exchange determinant process is based on the power of supply and demand.

• Factors such as prices of goods, inflation levels, interest rates, and peopleÊs income influences the foreign exchange rate. This topic ended with discussion on the balance of payment.

• Three main components of a balance of payment account are the current account, the capital account and the official settlement account.

Balance of payment Capital account Credit transaction

Foreign exchange rate Interest rate Trade account

ACTIVITY 8.4

In the website mentioned below, you will find articles on balance of payments and the accounts that you have studied in this topic.

Surf the website to strengthen your knowledge and understanding of what you had studied. Get the important key words form the article to be used when answering your question paper later.

http: //www.statistics.gov.my/Melayu/frameset_keluaran.php

TOPIC 1: INTRODUCTION TO MACROECONOMICS

Exercise 1.1

Inflation is an increase in the general price level. Before the Asian financial crisis in 1997-1998, the inflation rate in Malaysia was low, about 3%. The inflation rate increased following the crisis, to about 5% in the years between 1997 to 1998.

Exercise 1.2

Business cycle refers to short-term movements (economic growth and recession) of economic activities. The rate of unemployment will increase when there is a recession and it will decrease when there is economic growth. The rate of unemployment will not become zero even when there is economic growth because there will be some unemployment when there is a change of jobs, or while workers wait for better job opportunities.

Exercise 1.3

Macroeconomists are involved in forecasting, macroeconomic analysis, macroeconomic research, developing and testing an economic theory and collecting data. Macroeconomic research is beneficial in testing models to increase the precision of their forecast. It can provide information on how economic research can help in the macroeconomic analysis and also on the types of data that need to be collected.

Exercise 1.4

The classical view states that wages and prices will change rapidly whereas Keynesian view states that wages and prices change rather slowly when the economy is imbalanced. The classical theory shows that the rate of unemployment will not last long and the change in wages and prices will help the economy achieve market equilibrium. However, if the Keynesian theory is true, then the slow change in wages and prices would mean unemployment rate will remain for a longer period of time unless there is government intervention.

Answers

ANSWERS 184

TOPIC 2: NATIONAL PRODUCTION

Exercise 2.1

True (T) or False (F) statement

1. T 2. F 3. F 4. T 5. T

Exercise 2.2

1. The difference between GDP and GNP is the net income from overseas. GNP = GDP + Net foreign factor income.

2. The goods are included in the calculations for 2002 because GDP measures

the output value of goods produced and not sold. 3. For developing countries, the value of GDP is usually higher than the value

of GNP. This is because the foreign investment in the country is higher than the investments made by the locals in foreign countries.

Exercise 2.3

1. Methods of calculating GDP: (a) Expenditure approach; (b) Production approach; and (c) Income approach.

2. The value of factor cost is adjusted to market prices using the formula

below:

Market prices = Factor cost + Indirect Taxes Subsidies

Exercise 2.4

1. Activities that are not included are: (a) Traditional farming activities; (b) Illegal activities; (c) Unpaid productive activities; and (d) Non-cash reward.

2. Real GDP is calculated based on fixed yearly prices. Basically, the GDP

value does not have any element of price change in its calculations. Only the quantity of the goods produced changes. Meanwhile, nominal GDP is measured using the current prices for the year.

ANSWERS 185

Exercise 2.5

1. National production data usage are as follows: (a) To measure economic performance; (b) To facilitate policy-makers to plan; (c) To show or indicate the success or failure of government policies; (d) To measure the peopleÊs standard of living; and (e) To evaluate the contributions of economic sectors toward the

countryÊs economy. 2. There are two kinds of factors that affect the national income level, namely,

internal factors and external factors.

(a) Internal Factors One of the internal factors that affects the level of national production is natural resource such as petroleum or gas. Countries that are rich with natural resources are bound to have a higher national production level compared to countries that have no natural resources at all.

The energy or labour factor plays an important role in contributing towards national production. Countries that have hardworking and capable employees like Japan will definitely increase the national production level compared to nations with lazy and unproductive labourers. Total capital owned by a country also affects the level of national production. Countries that have less capital cannot afford to produce large outputs compared to countries that have a more capital.

Besides these, the level of technology too determines the national production level. Countries that have the knowledge and technological advancement are able to produce goods and services using a fast and efficient method.

(b) External Factors

Foreign investment is an external factor. It plays an important part in increasing national income and economic growth of a country. Foreign investment, whether directly or indirectly, contributes towards a countryÊs economic growth and income level.

Terms of trade also affects the income of a country. Terms of trade are the ratio of the price a country receives for its export commodity to the price it pays for its import commodity.

The terms of trade are good if it shows that a country is receiving more import quantity compared to its export quantity.

ANSWERS 186

Receiving assistance from other countries can also improve the recipient countryÊs standard of living. For example, assistance provided by international organizations and developed nations can help reduce the rate of poverty in poor countries. National production of developing countries can be improved with the help of other countries.

Exercise 2.6

1. Problems in calculating national production:

(a) Gathering of Information Gathering of information or data is difficult as there are some parties such as small-time businessmen and farmers who do not keep detailed records about their economic activities. The production value obtained from them is usually an estimated figure. Mistakes happen when classifying this information, which could cause some confusion in the calculating process.

(b) The Problem of Counting Twice/Double Counting The difficulty in identifying final goods and intermediate goods might lead to the problems of double counting. A product can be classified as either a final or an intermediate good depends on its usage. For example, flour purchased by a housewife is considered a final product. However, flour purchased by a baker is considered an intermediate product.

(c) Determining the Price of Goods Usually, prices of goods differ from area to area. In addition to that, prices of certain goods are always changing such as the price of palm oil which changes everyday. Thus, the difficulty arises in determining the price that should be taken into account in calculating national production.

(d) Measuring Devaluation It is difficult to calculate devaluation because there are no detailed records about devaluation for some economic activities. Besides this, there are many different methods of calculating devaluation and each method gives a different figure.

ANSWERS 187

2. The business cycle refers to the periodic fluctuation in the rate of economic activity, as measured by levels of employment, prices and production.

There are five phases in a business cycle, namely, peaks, troughs, recovery, growth (expansion) and recession (contraction). The points between the stages are indicated by peaks and troughs. The most important phases in a business cycle are growth (expansion) and recession (contraction). An economy is said to have achieved a full cycle when the economy has gone through the five stages. For example, a business cycle that starts at the peak is complete when it ends at the next peak.

Recession starts at the peak and ends at the trough. Recession occurs when the value of real national production drops for two quarters of a year continuously. The main characteristics of a recession include a decrease in demand for labour and a reduction in spending by the consumer. Recession is also reflected in the drop in firmsÊ profits. Since consumer spending decreases during recession, all the firmsÊ unsold products increase and this will raise the firmsÊ inventories.

Expansion on the other hand begins at the trough and ends at the peak. The early stage of expansion is called recovery. This happens when national production actually increases for six months continuously. A growth in the economy reflects the increase in business sector confidence, hike in investment and a demand for labour. As income increases, the peoplesÊ spending power increases too. FirmsÊ profits go up and inventories reduce.

TOPIC 3: DETERMINANT OF EQUILIBRIUM INCOME THEORY

Exercise 3.1

1. Disposable income = Consumption + Savings 2. Multiplier is a ratio between changes in national income and changes in

aggregate expenditure multiplier value = 1/MPS 3. If C = 100 + 0.8Y and I = 50, At equilibrium level, Y = C + I Y = 100 + 0.8Y + 50 0.2Y = 150 Y = 750

ANSWERS 188

4. Because MPC + MPC = 1, then MPS = 0.25 5. Above 6. Marginal propensity to consume (MPC) 7. Leakage is bigger than injection, therefore national income level decreases.

It also creates deflation.

Exercise 3.2

1. Please refer to discussion on taxes and government expenditure for the answer.

2. Savings + Taxes = Investment + Government Expenditure 3. Government expenditure multiplier = 1/MPS = 1/0.4 = 2.5 4. If MPC = 0.4, then the government expenditure multiplier = 1/0.6 = 1.67

Therefore, if government increases its expenditure by RM2 million, then the equilibrium income level will increase by RM2 × 1.67 = RM3.33 million.

Exercise 3.3

1. Players in the four-sector economy: (a) Households (b) Firms (c) Government (d) Foreign country

Two additional concepts for four sector economy are import and export 2. Equilibrium condition: Y = C + I +G +(X M) or S + T + M = I + G + X 3. increases, decreases 4. Export multiplier = 1/MPS = 1/0.1 = 10 Change in income = 10 change in export Change in export = 200/10 = 20 Therefore export will have to be increased by 20.

ANSWERS 189

Exercise 3.4

1. Fiscal policy is a government policy that is used to achieve government objectives or economic goals such as higher employment rate, stable inflation rate, and encouraging economic growth. The fiscal policy consists of two main tools, namely government expenditure and taxes.

2. Discretionary fiscal policy refers to a situation when government makes

some changes in taxes and government expenditure to overcome economic problems that cannot be handled through automatic fiscal policy.

3. Similarity: It happens when the aggregate supply differs from the aggregate

demand

Difference: Inflationary gap happens when the aggregate demand is more than the aggregate supply. Deflationary gap happens when the aggregate demand is less than the aggregate supply.

TOPIC 4: MONEY AND BANKING SYSTEM

Exercise 4.1

1. Money can be defined as something that is universally accepted as a mode of exchange. Features of money:

• Legal Tender;

• Durability;

• Divisibility;

• Portability;

• Homogeneity; and

• Acceptability. 2. Four functions of money:

(a) Medium of Exchange Money is very important to purchase goods and services. With money, the buying and selling of goods and services becomes easy as a price system can be formed. Retailers can do business with wholesalers of sugar, rice, flour, tinned food, cooking oil and such with great ease because of the existence of money. Similarly, with money, consumers can purchase what they need easily from businessmen. This situation is completely different from the barter system because in a barter system, you have to be sure that the other

ANSWERS 190

party wants what you have to offer. For example, if someone has flour and wants rice, he has to find someone else who has rice and wants the flour. This makes it difficult to do business.

(b) Unit of Account

Money is being used as the common benchmark to designate the prices of goods throughout the economy. Unit of account, or measure of value, means money is functioning as the measuring unit for prices. In other words, prices of goods are stated in terms of the monetary unit. Just as weight is measured in kilogrammes, and distance in kilometers, we can use Ringgit Malaysia (RM) to measure the value of goods and services. This makes the accounting system much simpler. The measurement of goods, services and wealth can be done using the same measuring unit, which is money.

(c) Store of Value

As money is an easily exchangeable asset, it is perfect to be stored and used in future. Thus, economic sectors, such as households, firms, government and overseas segments are willing to save and borrow.

(d) Standard of Deferred Payment Money is used as a standard benchmark for specifying future payments for current purchases, that is, buying now and paying later. Similarly, loans from financial institutions can be quantified with the rate of money.

Exercise 4.2

1. BNM has to ensure that the banking system is operating properly and smoothly because it is a necessity for a good economic growth. Therefore, BNM has to control the activities of financial institutions so that it is in line with the government is objectives.

2. Three deposits that are received by commercial banks:

(i) Savings deposit Does not have cheque facility and savings get paid interest as returns.

(ii) Fixed deposit Savings for a fixed time period and interest is paid. No cheque facility.

(iii) Current deposit Interest is not paid but depositors are given cheque facility.

ANSWERS 191

Exercise 4.3

(a) Deposit multiplier = 1/RR = 1/0.25 = 4

(b) Total money supply = Multiplier value × Deposit = 4 × RM2,000 = RM8,000

Exercise 4.4

1. Money creation does not refer to the activity of printing money. It refers to the multiplier process that happens each time credit is given to the customer because giving of new credit will add the total money supply (M1,M2 and M3) in the market. This process of adding money supply is called money creation or credit creation.

2. Industries based on agriculture can be expanded and developed through

financial policies by imposing low interest rates on farmers. This will encourage and increase activities in the agricultural sector and eventually help in boosting production from this sector.

Exercise 4.5

1. Money demand for precautionary purposes refers to money demand needed to face unforeseen events like accidents, death and such. In life, we usually face unforeseen events. These unexpected events usually make it difficult for us to plan our expenses. An example is when you are retrenched because the company suffered losses due to recession. While looking for a new job, you will probably have to use up your savings for your daily expenditure. Therefore, you should keep aside a portion of your income/salary for unforeseen expenditures.

2. The main factor influencing this is the level of income. The higher the

income, the more money will be saved for this purpose.

Exercise 4.6

1. Current deposit refers to savings in bank that are not paid any interest but the depositor is provided with the facility to withdraw money by issuing a cheque.

ANSWERS 192

2. When money supply exceeds money demand, there will be excess money in the market. To use up the excess money, people will buy bonds. This continuous process will cause the price of bonds to rise, whereas interest rate will drop until it reaches the equilibrium level.

3. (a) Money demand reduces from Md to Md

1 and interest rate drops as well to R1.

(b) In order to maintain the interest rate, the central bank will have to cut down the money supply in the market.

(c) Reducing the money supply in the market is a contractionary financial

policy.

TOPIC 5: AGGREGATE DEMAND AND SUPPLY

Exercise 5.1

1. Aggregate demand curve slopes negatively to show the negative relationship between price and production level, assuming that all other factors are fixed.

2. Four factors that change the aggregate demand curve:

(a) Consumption Expenditures (C) Consumption expenditures are usually connected to households. Among the factors that influence consumption and cause the AD curve to shift either to the left or right are the consumersÊ wealth, consumer expectations, household debts and taxes.

(b) Investment Expenditures (I)

Investment expenditures are usually incurred by firms. The changes in purchasing capital goods and other investments will cause the AD

ANSWERS 193

curve to move either to the left or to the right. The change in investment can be caused by interest rates, expected returns from investment projects, business taxes, the level of excess capacity and technology.

(c) Government Purchases (G)

If the government increases its expenses in providing infrastructure through an expansionary budget policy, the AD curve will shift to the right. Instead, if government practices a contractionary budget policy, then the AD curve will move to the left.

(d) Net Exports (X M)

The changes in exports connected to the movements of the AD curve are influenced by factors other than price, namely:

(i) Foreign income When the income of foreigners is high, their demand is relatively high as well, whether it be for domestic or foreign goods. The demand for foreign goods will increase the exports of the exporter country (assuming that exporter country imports less). The increase in net exports is shown in the shift of the AD curve to the right. If the income in foreign countries is low, then the net exports will decrease and the AD curve will move to the left.

(ii) Foreign currency exchange rate The change in foreign currency exchange rate also influences net exports and aggregate demand (AD). For example, the exchange rate between Ringgit Malaysia and American Dollar (exchange rate E = RM/Dollar). If the value of Ringgit deteriorates, then the rate of exchange has increased. Americans can get more Ringgit. Whereas, Malaysians will get fewer Dollars. The deterioration in the value of Ringgit will make Malaysian goods relatively cheaper compared to American goods. Therefore, MalaysiaÊs net exports will increase (assuming that our imports are less than the exports). This phenomenon will move the AD curve to the right. The reverse situation will make the curve move the other way.

3. Macroeconomic equilibrium in the short-run refers to a situation where the

firms and resource suppliers are unaware of the full market conditions. It does not happen at full employment level.

4. Changes in government expenditure is a fiscal budget policy because

government expenditure is a tool that is usually used by the government to carry out its budget policies.

ANSWERS 194

5. The long-run aggregate supply curve is vertical because the produced output is the potential output. The costs and prices increase together.

TOPIC 6: UNEMPLOYMENT AND INFLATION

Exercise 6.1

1. Unemployment refers to the labour force that does not work. They are a working age group above 16 years old who do not work but who are actively looking for jobs.

2. Unemployment rate of 4% means 4% of the labour force in the country is

not working.

Exercise 6.2

1. Both unemployed persons and discouraged workers do not have jobs. The difference between these two are: an unemployed person is actively looking for a job while a discouraged worker does not show any interest or make easy attempt to a job.

2. Full-time workers are those who work 35 hours or more in a week. Part-

time workers only work less than 35 hours a week.

Exercise 6.3

1. Types of unemployment: (a) Frictional

Frictional unemployment or normal unemployment exists only for a short period. It happens when individuals are moving between jobs, careers and locations.

Sometimes, people are willing to be unemployed while waiting to get another job and not because they are unable to look for a job.

Usually, frictional unemployment will continue to exist all the time, especially when the economy is having a continuous rapid growth. This unemployment will exist even when the economy is at full employment.

However, as this unemployment is short-termed, it is not a serious problem.

ANSWERS 195

(b) Structural Structural unemployment happens because workers do not have the expertise and the ability to work in a new sector. It usually exists for a longer period of time and a government policy has to be implemented to overcome this problem.

Economic growth of a country will usually be followed by structural changes and changes in economic activities. For example, in Malaysia, beginning in the early 1980s, the industrial sector became more prominent compared to the agricultural sector. This caused some workers to be laid off because skills possessed by farmers could not be used in the industrial sector.

(c) Cyclical Cyclical unemployment is caused by economic conditions that go up and down. It occurs when the unemployment rate moves in the opposite direction as the GDP growth rate. So when GDP growth is small (or negative) unemployment is high. When there is recession, demand for goods and services drop. This will force firms to reduce their production and thus, cut down on their labour.

2. The natural unemployment rate equals to the structural unemployment rate plus frictional unemployment rate. It exists when the cyclical unemployment rate is zero.

3. Jobs for all that want them. Full employment means that everyone who

wants work and is willing to work at the market wage is in work. In a larger context, it refers to a situation whereby production resources are used fully without any wastage. It can also be defined as production level where the real unemployment rate equals natural unemployment rate.

Exercise 6.4

1. Source of unemployment: (a) Job Losers

A job loser is someone who has been involuntarily terminated or laid off from a job, whether temporarily or permanently. There are many reasons for this, example, failure of the worker to fulfil his work requirements/conditions or the firmÊs failure to fulfil its employeeÊs needs. Those who have lost their jobs have two choices either to look for a new job or leave the labour force. Those who leave the labour force are not considered unemployed.

ANSWERS 196

(b) Job Leavers There are some who voluntarily leave their jobs and not necessarily because they were laid off. If they were leaving one job because they were accepting another offer, then this would not contribute towards the increase in the unemployment rate. Unemployment rates will only increase if these job leavers were still looking for a new job.

(c) New Entrants and Re-entrants New entrants are those who have just completed their studies and are ready to join the work force. They have never before been employed and are actively seeking employment for the first time. However, while looking for a suitable job, they have to be unemployed. Re-entrants are those who had previously been classified as employed, but have been out of the labour force for a period of time before actively seeking employment once again. Usually, they will have to be unemployed while trying for a new job.

2. The negative effects of unemployment towards the economy:


Unemployment does not encourage economic growth

High unemployment rates will ruin the economic growth and performance. There will also be excess capacity from the industrial machines. This will indirectly cause a drop in investment levels.

Drop in Government Revenue

When people are unemployed, the tax collection is also reduced. Government then has to reduce its expenditure to boost economic growth.

Wastage of production resources

High rates of unemployment forces the economy to operate at a level below maximum. The wastage of resources bring about output production far lower than the potential output.

Exercise 6.5

1. A continued increase in general price levels is known as inflation. 2. The main component of the consumer basket for Malaysian CPI is the

expenses for food which represents 34% of the total expenditure.

ANSWERS 197

Exercise 6.6

1. There are three main steps in the calculation of CPI, namely: (a) Calculate the cost of CPI consumer basket at base year price. (b) Calculate the cost of CPI consumer basket at current year price. (c) Calculate the CPI for base year and current year.

2. Inflation Rate = −

×( )

100.Old CPI

New CPI Old CPI

TOPIC 7: INTERNATIONAL TRADE

Exercise 7.1

1. International trade is the process of exchanging or sale and purchase of goods and services between two or more countries.

2. Main factors that encourage international trade:

(a) Possession of Different Production Factors Each country has its own factors of production, different in type, quality and quantity. This difference is the main factor why countries conduct trade with one another. Different factors of production makes each country focus on different types of production.

(b) Different Climate Differences in climate makes every country concentrate on producing different types of product. For instance, hot and wet climates in most Southeast Asian countries, makes countries like Malaysia, Indonesia and Thailand focus on rubber plantation. The cold climates of Australia and New Zealand allows both these countries to focus on the production of fruits like apples and oranges. So, different climates cause the production of different goods. The differences in agriculture produce encourage countries to trade with one another.

(c) Different Labour Skills Every country has its own level of labour skills. For instance, countries like Japan, United States of America and Singapore have skilled labour force in the industrial sector. Therefore, these countries focus on production of industrial goods. Other countries like New Zealand, Australia, China and Malaysia have a skilled labour force in the agricultural sector. The difference in labour skills causes the production of different types of goods and this encourages international trade.

ANSWERS 198

(d) Different Consumption Pattern Normally, different societies have different tastes, preferences and spending patterns. This situation causes the production of goods in accordance with the societyÊs needs and preferences. Therefore, each country will produce different type of goods. The different types of goods produced encourage international trade.

Exercise 7.2

1. Absolute advantage is defined as a countryÊs ability to produce more of the product than another country can, with the same amount of resources. Comparative advantage refers to a countryÊs ability to produce a product with lower relative cost compared with other countries.

2. Absolute advantage looks at the efficiency of the absolute production,

taking into account the output quantity that can be produced using total input. Comparative advantage looks at relative efficiency, taking into account the production with the lowest opportunity costs.

Exercise 7.3

1. Four benefits of international trade:

The Benefits of International Trade Description

Acquire Goods that Cannot Be Produced Locally

People in every country need a variety of goods. However, every country is unable to produce all the goods wanted and needed. Therefore, trade between countries is carried out to acquire goods that cannot be produced locally.

For instance, Malaysia specialises in the production of palm oil, rubber and other plantation products to be exported to other countries. Instead, Malaysia obtains goods that cannot be produced in the country such as aeroplanes, apples and oranges.

ANSWERS 199

Widen the Market for Local products

A countryÊs production can be marketed widely through international trade. Goods that are locally made can be exported to other countries. Higher production quantity will help to efficiently utilise factors of production.

This will reduce the cost of production and the price. It will increase the welfare and living conditions of the people.

Increase Efficiency in Usage of Production Factors

International trade encourages specialisation. Specialisation means each country specialises in producing a particular product which it can do efficiently. This will ensure efficiency in usage of production factors.

Acquire Modern Technology

International trade allows modern technology to be imported from developed countries to developing nations. Modern technology will enable developing countries to increase their production capabilities. International trade also allows developing countries to enjoy the usage of high technology products like computers, digital cameras and such.

2. Methods to restrict free trade:

(a) Tariffs Tariff is a tax on foreign goods upon importation. Tariffs can be divided into two types: (i) Ad-valorem tariff Is import tax that is calculated based on the

percentage of the value of the imported goods. (ii) Specific tariff A fixed tax figure that does not depend on the

value of the imported goods.

(b) Quotas A quota is the maximum limit set on the quantity of a good that can be imported into a country in a given period of time. Implementation of quotas will not influence government revenue. In fact, quotas provide protection for local firms. There is no more competition from foreign firms once the quota is fulfilled. The main effect of a quota is that it increases the prices of the imported goods. But because of the limited quantity of goods, consumers are willing to spend a lot of money to get these products.

ANSWERS 200

(c) Foreign Currency Exchange Control Besides tariff and quota, government can also control the foreign currency used for import. A government can impose various forms of controls to influence international trade activities such as import. Among the methods used to control the quantity of goods imported is by controlling the total foreign currency that is usually used to import these goods. Another alternative is by selling the foreign currency at a higher rate compared with the market rate.

(d) Other Restrictions Governments can also use other methods to reduce usage of imported goods. For example, the government can direct all government departments to use only locally made products such as using the national car Proton. The government can also direct financial institutions such as banks to reduce the giving of loans to support the purchase of imported goods.

Exercise 7.4

1. Terms of trade can be defined as the ratio of price or quantity of an export commodity to price or quantity of an import commodity.

2. Protectionism is needed to:

(a) Protect New Industries Each country has a new industry to promote. A new industry is not ready to compete with foreign firms and needs government assistance and support to continue its operations. Without government help, it could face strong competition and may even have to be shut down if it fails to survive the competition.

(b) National Security Certain goods produced have to be done by the country itself. The country cannot depend on another country to produce such goods. This is for security reasons. For instance, if Malaysia depends on Thailand fully to get its supply of rice, and if a war takes place between Malaysia and Thailand, then this could possibly affect national security as Thailand could restrict the supply of rice to Malaysia.

ANSWERS 201

(c) Diversify Economic Activities Trade restrictions are also necessary to diversify a countryÊs economic activities, which will contribute towards national income through foreign exchange. If a country depends a lot on specific export industry, it can cause a decrease in national income if the industry deteriorates.

(d) Protect Resources Protectionism can also be used to protect local industries and its resources. When consumers start depending on imported goods, it will not encourage domestic economic activities. This will affect the demand for local sources of production including the labour force. This will cause unemployment rates to go up. Other related social problems will appear such as robberies, thefts and political instability.

(e) Anti-dumping Anti-dumping refers to the activities of foreign firms that have excess production and sells it to other countries for a much lower price compared with the price sold in its own country. This situation will encourage imports. If this continues, it will seriously affect the local industry. Therefore, protection policies are needed to look after the welfare of the local industries because they contribute towards a countryÊs economy.

TOPIC 8: INTERNATIONAL FINANCE

Exercise 8.1

1. Foreign exchange rate refers to the rate at which one currency may be converted into another.

2. Foreign exchange rate is determined based on interaction between money

demand and supply. Equilibrium is achieved when demand and supply for a currency is the same. When factors that influence the demand or supply, change, the equilibrium foreign exchange rate also changes.

Exercise 8.2

Factors that influence foreign exchange rate: (a) The Price of Traded Goods

The price of traded goods is the main determining factor for demand and supply. If local goods can be sold cheaper than goods from other countries,

ANSWERS 202

it will increase exports and eventually, cause a hike in the demand for local currency. This means the value of local currency will increase compared with other currencies. Instead, if the price of imported goods are cheaper, it will encourage demand for foreign currency through increase in imports. This will make the value of foreign currency to go up and the value of local currency to drop.

(b) Inflation Level

There are two reasons why the value of currency can drop. Firstly, high inflation level will make the local products more expensive compared with imported goods. The difference in price will encourage consumers to purchase imported goods, which will directly increase the value and demand for foreign currency. Secondly, inflation not only affects the price of goods sold domestically, but also the price of goods exported. Exported goods will become more expensive and this will cause a decline in the demand for local currency. Eventually, the value of local currency will deteriorate.

(c) Interest Rate

Among the important factors that influence the movement of capital is interest rate. Interest rate reflects the rate of returns on investments made. High interest rates show profitable investment returns and this increases capital inflow. Increase in capital inflow will cause an increase in demand for local currency and this will eventually increase the value of local currency compared with foreign currency. Instead, low interest rates compared with other countries will encourage capital outflow. This will reduce demand and subsequently, the value of local currency. Demand for foreign currency will increase because investors will invest in countries that offer a high interest rate.

(d) Income of the People in a Country

The average income of people in a country influences their expenditure pattern. For those who have high incomes, they prefer to import goods from overseas because they have a higher purchasing power. This will increase the demand for foreign currency. Instead, low income encourages them to buy only locally produced goods.

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