MACROECONOMIC PRINCIPLES

(EC107)

National Income Accounting

Economic theory is conventionally divided into 2 groups which are:

Microeconomics Macroeconomics

Microeconomics focuses on individual markets, that is, it looks at the behavior of individual consumers, households and firms as they interact in the market. It studies the individual demand for and the supply of goods and services. It examines, for example, the choices that people make between goods and services, and what determines their relative prices and the relative quantities produced.

Macroeconomics examines the behavior of the economy as a whole. It looks at the aggregate demand and the aggregate supply in the economy. It examines national output and its rate of growth, national employment (and unemployment), and the general level of prices and their rate of increase (i.e. rate of inflation).

Macroeconomic theory studies the causes of and interrelationships between aggregate economic phenomena such as inflation, the growth rate of income and the rate of unemployment.

Main macroeconomic indicators are:

Output – economic growth Prices – inflation Employment or unemployment International trade – balance of payments and exchange rate

Government Macroeconomic Policy Objectives

The typical macroeconomic policy objectives that governments pursue are:

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

The framework of Economic Policy

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The first task of economic policy is to determine the objectives. Then the target has to be selected. Targets are the variables through which the government attempts to achieve its objectives. Targets of policy could be high living standards, high employment and low unemployment, avoidance of recessions and inflation.

The next task is to choose the instruments to be used in pursuit of the objectives and these instruments are based upon some available range of measures. The main instruments of policy are fiscal (government spending and taxes) and monetary (interest rates and money supply) policies.

The main macroeconomic policy problem is to come up with the right instrument that will bring about the right outcome.

Main Macroeconomic policies

There are a number of different forms of government macroeconomic policies which are:

1. Fiscal policy The deliberate manipulation of government income (T) and expenditure (G) so as

to achieve desired economic and social objectives. One major aim of such budget policies is to control swings in the business cycle

originating in the private economy. Fiscal policy concerns general budget policies i.e., government taxation and

expenditure policies. Government may attempt to affect aggregate demand in the economy by a

combination of tax cuts and government spending programs that would increase national employment and output.

During a recession or lagging economic growth, government may run a budget deficit (G>T). During periods of inflation, the fiscal remedy may be to increase taxes in combination with reductions in government spending.

A budget surplus, with tax revenue greater than government expenditures, would then reduce aggregate spending and choke off both private and public demands.

2. Monetary policy Refers to attempts to manipulate either the rate of interest (r) or money supply (Ms) so as

to bring about the desired changes in the economy. It consists of the manipulation of bank reserves through alterations in the discount rate,

open market sales and purchases of securities and changes in reserve requirements. Financial system reserve changes affect the money stock and interest rates, which can

change private consumption and investment expenditures (aggregate demand) and thus employment, output and prices.

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

3) Supply Side Policies

Conflicts in Government Policy

It is important to realize that the objectives may be incompatible. In order to achieve one goal governments have often been obliged to sacrifice another.

Policies designed to bring about full employment have sometimes generated unacceptable levels of inflation while policies aimed at eradicating a BOP deficit have restricted the rate of economic growth and so on.

Policy makers therefore are obliged to establish some scale of priorities.

Government Failure

Government failure occurs when government intervention fails to improve economic efficiency (welfare) or even reduces it. Government failure occurs because of the following reasons:

1. It is difficult for the government to achieve all its objectives simultaneously.2. Time lags – this is the time taken to recognize that there is a problem, the time taken to

formulate policy measures, the time taken to introduce policies and the time for people and firms to react to policies. From the time the problem is identified to the time the policy is implemented, economic circumstances may have changed.

3. Policy constraints – there are also practical problems and international constraints. It is difficult to change much of government expenditure, particularly capital expenditure, taxation and legislation quickly.

4. Political influences – governments tend to introduce harsh measures just after an election and more popular ones near an election. Economic advisors may recommend a rise in taxation but if this is just before a general election a government may choose to ignore the advice.

5. Complexity – the real world is a complex and a constantly changing place e.g. with increasing mobility of money around the world, it is becoming more difficult to measure and control money supply.

6. Civil servants and politicians self interest- civil servants and politicians may promote the growth of their own development to pursue their own advancement.

Instruments of Macroeconomic Policies

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These are tools used by the government in order to achieve macroeconomic objectives.

Taxation – compulsory transfer of money (or occasionally of goods and services) form private individuals, institutions, or groups to the government.

Devaluation of exchange rate – deliberate reduction of the official rate at which one currency is exchanged for another by the monetary authorities (central bank) e.g. a movement of the exchange rate from $1 = £0.6 to $1 = £0.50 represents a devaluation of the dollar.

Revaluation of the exchange rate – deliberate action by monetary authorities (central bank) to move exchange values of their currencies to higher parities e.g. a movement from $1 = £0.6 to $1 = £0.80 represents a revaluation of the dollar.

Subsidies – subsidies may be regarded as negative taxes. They normally take the form of payments by the governments to producers and are particularly important in the case of agricultural products (e.g. wheat, milk, meat etc). The effect of a subsidy is to reduce the cost of supplying the good.

Interest rate – price of borrowed money or the cost of money / the reward of capital. Government expenditure- is largely expenditure on infrastructural development eg on

roads and communications infrastructure, public works on schools and hospitals etc.

National Income Accounts

Macroeconomics is concerned with the overall economic performance of a national economy. National income accounting was developed to measure that performance over a given period of time.

National income statistics are important because they can be used to plot the previous course of the economy, to make forecasts about the future direction of the economy, to assist economists in testing various macro models, and to provide parliament and other administrative agencies with a basis for policy making.

A practical knowledge of these accounts is essential to explaining or predicting important economic phenomena.

National Income Accounting Variables

Gross National Product (GNP)

GNP is the total market value of final goods and services produced in an economy during a given period of time.

The word “gross” indicates that no deduction has been made for that part of total output which is needed to maintain the nation’s stock of capital assets. The value of the output

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required to replace obsolete and worn out capital is known as depreciation or capital consumption.

Total market value means that all of the final goods and services have been valued at market prices.

We cannot sum the physical amounts of the goods and services produced in an economy over a period of time. Thus GNP is the value of the goods and services sold in the market. It is expressed in money terms.

Problems with GNP

There are, however, some goods and services which are produced but not sold in the market; for example, there are those who grow and consume their own vegetables or who perform their own housework, such as cooking, sewing, or baby-sitting. These types of activities are not counted as part of GNP.

Also not counted in measuring GNP are certain goods and services which are sold in the market but have been declared by society to be illegal. Marijuana and prostitution are good examples. These activities have been declared illegal by law and since they are not officially reported measurement is a problem. For this reason, illegal goods or services are excluded from GNP calculations.

GNP only measures newly produced goods, that is, we do not count used goods. There are certain types of business and government expenditures which are excluded

from GNP but are added to the household’s personal income. These expenditures are referred to as transfer payments. Transfer payments are excluded for they are received for no work done during the current production period.

Since GNP tends to understate the actual output of the final goods and services produced in the economy, the national income accountants try to partially offset this by imputing values to some goods and services not sold in the market. For example, they estimate a value for owner occupied housing, for food and fuel produced and consumed on a farm, and for work performed by government employees.

Not counted in GNP are intermediate goods: goods purchased for resale or included in other products. If intermediate goods were included in estimating GNP, there would be double counting. To avoid the problem of double counting, national income accountants only count the value added at each stage of producing the final product.

The value added is the difference between the price of the goods at that stage and the cost of the goods purchased from the supplier in the previous stage (see notes on output approach).

GNP is a standard international index of output and should not be thought of as measure of the economic (social) welfare or “well-being” of any particular economy. It was never intended to be an aggregate welfare index.

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GNP or even GNP per capita does not give us any information as to how the total output is distributed among the households in the economy. Real GNP may be growing, and at the same time the distribution of income may be becoming more uneven.

GNP does also not indicate what has happened to the quality of goods over time. An important measure of welfare is also leisure time. There has been a growth of leisure

time with a reduction in the hours of work, and this result is not reflected in calculating GNP

Along with an increasing GNP, there are associated social costs which are not measured in GNP. For example, a rising GNP may be associated with higher levels of both air and water pollution.

Gross Domestic Product

GNP includes the output of every factor of production owned and supplied by residents of a country regardless of where that factor happened to be located.

GDP is a measure of the final output of goods and services produced during a given period of time with factors of production located within a country.

To determine GDP, we subtract from GNP the net inflow of income earned on labor and property owned by domestic residents in foreign countries. Some of the country’s resources might be overseas and thus earn income for the home country i.e. inflow of funds

Foreign assets may also exist in the domestic market and their incomes are remitted i.e. outflow of funds

The net difference between these flows i.e. inflow of funds and outflow of funds gives the net property income from abroad.

Thus GNP- net property income from abroad = GDP

Methods of Measuring National Income

There are 3 possible approaches to measuring national income.

1. National income may be viewed as the total output from domestically owned resources during the course of one year (the Output Approach/ Product Approach)

2. National income may be viewed in terms of the incomes earned by the factors of production engaged in producing the national output. Since the total output/product is valued at factor cost, it must be exactly the same as the total value of all incomes (wages,

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interest, profit, rent). National income, then, may be measured by totaling these incomes (the Income Approach).

3. National income may be looked at from the point of view of its disposal. The national output must either be bought for use or added to stocks. If we assume that net additions to stocks amount to “expenditure” by the firm on its own output, we can measure national income by the total amount of money spent on purchasing the national output (the Expenditure Approach).

Thus National Output/ National Product ≡ National Income ≡ National Expenditure

The Circular Flow of National Income

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

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

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

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return, there is a matched flow of expenditures on final goods and services from the household sector to the business sector. The market value of the final output of goods and services is determined by the household sector’s demand for the business sector’s supply of the final product.

The upper loop shows the business sector hiring the services of the factors of production from the household sector. In return there is a flow of earnings or income to the household sector which matches the flow of factor services to the business sector. The market value of each factor is determined by the business sector’s demand for and the household sector’s supply of the factors of production.

In all, the flow of expenditures going to the business sector from the household sector (lower loop) must be numerically identical to the flow of income going from the business sector back to the household sector (upper loop).

The flow of expenditures approach to gross national product

In national income accounting, the economy is broken down into four sectors. These four sectors are: (1) household, (2) business, (3) government and (4) foreign.

In the flow of expenditures approach, GNP is determined by adding up the total amount spent on final goods and services by each sector.

National Income = Personal Consumption (C) + Investment (firms expenditure) + Government Expenditure (G) + Net Exports (Exports – Imports) that is Y = C + I + G + (X – M)

All expenditure on intermediate goods and services must be excluded. This method is complicated by indirect taxes e.g. sales tax and subsidies on welfare goods

like food. Thus the value of expenditure is often measured at cost. National income at factor cost = national income at market prices – indirect prices + subsidies

Illustrated Example: the expenditure approach

1. Personal consumption expenditures------------------------------------------1670.1Durable goods-------------------------------------------210.2Non-durable goods-------------------------------------674.4Services--------------------------------------------------785.5

2. Gross private domestic investment-------------------------------------------395.1Fixed investment----------------------------------------399.0Non-residential------------------------------------------295.0Residential-----------------------------------------------104.0Change in business inventories------------------------3.9

3. Government expenditures------------------------------------------------------534.8

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Federal-----------------------------------------------------198.9State and local---------------------------------------------335.9

4. Net exports of goods and services--------------------------------------------27.5Exports------------------------------------------------------341.2Imports------------------------------------------------------313.6

5. Total expenditures in GNP----------------------------------------------------

Source: extracted from DeLorme and Ekelund 1983.

The flow of earnings or income approach to Gross National Product

In this approach, national income is determined by adding up the income earned by the factors of production (land, labor, capital, entrepreneurial ability) which were employed in producing the final output of goods and services during a given time period.

All factor incomes are added i.e. rent, wages and salaries, interests, profits and undistributed surpluses (i.e. income generated in the production process that does not find its way into personal incomes e.g. ploughed back profits or retained profits and also national reserves)

Transfer incomes / transfer payments / transfer earnings are payments made without corresponding contribution to current output e.g. unemployment benefits, retirement pensions / schemers, distributed grants etc must be excluded.

Net factor income from abroad must be added. Finally the stock appreciation adjustment must be made in order to eliminate

the element of windfall gain in the profits received.

Example:

1. Compensation of employees------------------------------------------------------1596.5Wages and salaries-----------------------------------1343.6Supplements of wages and salaries-----------------252.9

2. Proprietor’s income-----------------------------------------------------------------130.63. Rental income of persons-------------------------------------------------------------31.94. Corporate profits---------------------------------------------------------------------181.7

Profits before taxes--------------------------------------------241.2

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Inventory valuation adjustment-------------------------- -42.0Capital consumption adjustment------------------------- -17.5

5. Net interest -------------------------------------------------------------------------

National income (NI)-------------------------------------------------------------2120.56. Indirect business taxes---------------------------------------------------------------211.77. Business transfer payments-----------------------------------------------------------10.58. Less: subsidies minus current surplus of govt enterprises------------------------ -4.79. Statistical discrepancy------------------------------------------------------------------1.6

Net National Product (NNP)--------------------------------------------------

10. Capital consumption allowances (depreciation)-------------------------- -----

Total Gross National Product (GNP)----------------------------------------2627.4

Source: extracted from DeLorme and Ekelund 1983.

The Output Approach

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

When using this method double counting or multiple counting should be avoided.

To avoid double counting only the final output or the value added at each stage of production should be added.

Example

Value of Output Cost of Intermediate Goods

Value Added

Farmers 10 0 5Millers 15 10 10Bakers 25 15 5Retailers 30 25

Total 30

Total value added should be used or alternatively the value of the final product is used which is $30.

To this GDP must be added net property income from abroad. If the general level of prices has been changing during the course of the year,

it is necessary to make an adjustment for the purely monetary changes in the value of stocks.

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A rise in prices increases the value of existing stocks even when there is no change in their volume.

In order to obtain an estimate of the real changes in stocks it is necessary to make a deduction equal to the ‘inflationary’ increase in value.

This deduction is described as Stock Appreciation (this would be added when prices had been falling in official tables.

The relationship of GNP, NNP and National Income

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

GNP less Depreciation = Net National Product (NNP) Depreciation (capital consumption) is the reduction in the value of an asset through wear

and tear over time. This has to be taken into account when calculating national income NNP is the true national income. However it is difficult to accurately estimate the value

of depreciation as a result National Income is often given as GNP. The total output of capital goods is described as Gross Investment and net additions to the

stock of capital is known as Net Investment. Gross Investment – Depreciation = Net Investment GNP – Depreciation = NNP GDP – Depreciation = Net Domestic Product NNP consists of all the goods and services becoming available for consumption together

with the net additions to the nation’s stock of capital. This is the total which is generally known as National Income.

However it is extremely difficult to obtain an accurate estimate of the annual depreciation and economists often use the figures for GNP for purposes of analysis.

Uses of National Income Accounts

1. Planning Purposes: Statistics of national income accounts are worthwhile for planning purposes.

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2. Economic Growth Assessment: National income statistics are often used to provide some indication of changes in the economic welfare of citizens to see if the economy has grown year after year.

A simple example should make clear the manner in which the national income of one year may be compared in real terms with that of another year .e.g.

Year 1 Year 2National Income (£m) 10 000 12 000 Index of Prices 100 105

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

x = £11 428,5m

The example shows that although the national income in monetary terms had increased by 20%, in real terms the increase was only 14.3%.

3. Policy formulation and assessment: The government uses national income data in formulating and assessing economic policy.

4. For making international comparisons: National Income statistics are used for comparing changes in living standards over time and internationally.

Shortcomings / Problems of national income statistics as a proxy for measuring living standards

1. The first problem which arises is that of valuation. Total output consists of a vast range of different goods and services whose quantities can’t be added together in physical units e.g. kilograms of wheat, meters of cloth, tonnes of coal, bales of cotton, litres of cooking oil. All these commodities have to be converted to money values for compilation.

2. Self provided commodities e.g. a farmer consuming part of his output. Figures of such are normally not included in national accounts.

3. Statistics of information about what is produced in rural areas and also in remote areas e.g. in LDCs is hard to come by.

4. Activities of housewives who also contribute to national income are not included in national income figures.

5. Informal activities are not included e.g. black market activities, prostitution, thieves, robbers, foreign currency dealers behind the back door, anti-social devials / practices etc.

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6. Payment in kind e.g. a worker getting his salary plus 5 litres cooking oil, a bag of mealie-meal, salt, kapenta etc. Figures of payment in kind not included.

7. Double counting / multiple counting.8. Inflation i.e. the rise in the general price level of goods and services over a period of

time makes national income figures to be misleading. Real figures must be computed.9. Composition of output not reflected in GNP figures

Problems encountered when making international comparisons

1. Inflation – different countries have different rates of inflation making comparison difficult.

2. Account should be taken on how the income is spent e.g. GDP for country A = GDP for country B. If the bulk of income of country A is spent on defense while that of B is spent on consumer goods then Country B’s standard of living is better than that of Country A.

3. Different people have different tastes so it is difficult to compare and measure satisfaction.

4. Population growth has to be taken into account when making international comparisons. Income per head / capita has to be used.

GDP per capita =

The problem of using income per head is that it ignores the distribution of income i.e. most of the income will be in the hands of a few people.

5. To compare incomes of different countries effectively we have to also look at the welfare of citizens e.g. look at things like health standards, leisure, educational standards, life expectancy, infant mortality rate, birth rate, death rate, literacy rate, number of people per doctor, number of pupils per teacher, access to clean water etc

6. Externalities i.e. both positive and negative externalities are not accounted for in the calculations of the national income. Pollution, noise, congestion and mental strain may be the by-products of a rapidly increasing national income.

7. Use of different currencies makes comparisons between countries difficult. The problem is compounded / worsened by floating exchange rates on a daily basis. International comparisons also have to be undertaken in a common unit of measurement. For some time the most widely used unit has been the US Dollar (US$).

8. Composition of output9. Different accounting methods

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Alternative measures of living standards The use of national income figures for the purpose of comparing standards of

living over time and between countries needs to be supplemented by various social indicators such as : 1. Number of hospital beds2. Doctors per head of the population3. Numbers in further education4. The nature and quality of the different welfare measures.5. Measurable economic welfare (MEW). This is an interesting approach which

seeks to cover more of the aspects which affect economic welfare although it does encounter the difficulty of having to attach a monetary value to non – marketed goods. The aspects of economic welfare included include leisure, unpaid housework, non – marketed goods etc

6. Human Development Index (HDI) The idea is that human development depends on the quantity of resources available to people in a country, their ability to use the goods and services and the time they have to use these goods.HDI also seeks to give a wider measure of economic welfare. It was introduced by the United Nations in 1990.The index is based on 3 sets of indicators i.e. real GDP, adult literacy and mean years of schooling, life expectancy.

Nominal GDP vs. Real GDP

Using a monetary system of measurement gives rise to certain problems. Difficulties arise when we wish to compare the national income of one year with that of another because the value of the money itself may change.

When the general level of prices is changing, the value of money is changing and the standard of measurement becomes variable.

If the general price level has been changing during the period under consideration, the figures recorded for the different years will have to be adjusted to take account of the price changes.

What is needed is a measure of what the national income would have been in the latter year, had prices remained constant (in real terms) e.g.

Year 1 Year 2National Income (£m) 10 000 12 000Index of Prices 100 105

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

= £ 11 428,5m This example shows that, although the national income in monetary terms had increased

by 20%, in real terms the increase was only about 14.3%. Nominal GDP is GDP measured at current prices. Nominal GDP is also called money

GDP. It measures GDP in the prices ruling at the time and thus take no account of inflation.

Real GDP is GDP after allowing for inflation i.e. GDP measured in constant prices i.e. in terms of the prices ruling in some base year.

Real GDP for Year 2 = x

GDP Deflator

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

GDP Deflator = x 100%

= x 100%

= x 100%

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

1987 Nominal GDP 1993 Nominal GDP 1993 Real GDPBananas 15 at $0.20 $3.00 20 at $0.30 $6.00 20 at $0.20 $4.00Oranges 50 at $0.22 $11.00 60 at $0.25 $15.00 60 at $0.22 $13.20Total $14.00 $21.00 $17.20

The GDP deflator measures the change in prices that has occurred between the base year and the current year.

We can get the measure of inflation between 1987 and 1993 by comparing the value of 1993 GDP in 1993 prices and 1987 prices.

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The ratio of nominal to real GDP in 1993 is 1.22 (= ). In other words output is

22% higher in 1993 when it is valued using the higher prices of 1993 than valued in the lower prices of 1987.

We ascribe the 22% increase to price increases of inflation over the period 1987 to 1993. Since the GDP deflator is based on a calculation involving all goods produced in the

economy, it is a widely based index that is frequently used to measure inflation.

The Circular Flow of Income

According to Keynes, the most important determinant of national income is the level of aggregate demand.

The higher the level of demand, the higher the level of output and employment.

National Income Determination

The Two Sector Economy

Assumptions of the Model

There are only 2 sectors in the economy: the business sector/firms (B/B) and the public or household (H/H) sector.

There is no government intervention in this economy i.e. no government expenditure or taxes.

The economy is closed i.e. no international trade H/H spend all their income on consumption and they do not save. Firms pay all their incomes to H/H and there is no investment. From these simplifying assumptions, the national income identity can be written as

Y≡C+I where Y= national income (real output), C= household consumption expenditures and I = business investment or Y≡C+S where S= household savings

Subtracting C from both identities we have Y-C≡I≡S Thus we have I≡S When we introduce real life economy with injections (investment) and withdrawals

(savings). Withdrawals are a leakage from the circular flow of income paid out by firms which is

not returned to them through the spending of H/H. Withdrawals cause national income to contract. Injections are expenditures by firms

which add to the circular flow of income. Injections cause output income to expand.

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

National Income in a Three Sector Model

Implications More leakage in the form of taxes. Another injection in the form of government expenditure (G) G should equal T to maintain equilibrium. If G>T – it leads to expansionary effect in the economy. If G<T – there is contractionary effect on the economy. Y = C+S+T – withdrawals E = C+I+G – injections The national income identity can be written as Y=C+I+G where Y is GNP, I is

gross investment, G is government expenditures on goods and services. Or from the income side, Y≡C+S+T where Y is GNP, C is consumption

expenditures, S is private saving (the sum of household and business saving), and T is net tax revenues.

Subtracting C from both sides Y-C≡I+G≡S+T or I+G≡S+T

National Income in a Four Sector Model (open economy)

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A closed economy ignores foreign trade. Open economy include dealings with the outside market – foreign trade is introduced in

the form of exports and imports. Exports are local goods sold in the foreign market. Imports are foreign goods bought / brought to the home market.

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

Implications

More leakages introduced in the form of imports (M) (i.e. money earned in the domestic market is spent on goods produced outside the country – there is an outflow of funds) capital.

Additional injections in the form of exports (X) i.e. goods and services produced in the country are sold to foreigners living outside the country – there is an inflow of funds / capital inflow – to maintain equilibrium M = XIf M > X it leads to a contractionary effect on the economy.If M < X it leads to an expansionary effect on the economy.

Open Economy

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The national income identity for the flow of expenditures on final product is written as:

Y ≡ C+I+G+(X-M) where X-M is net exports. Or Y≡C+S+T or I+G+X≡S+T+M

A basic model of aggregate demand: the Keynesian Macro model

The 2 sector model

Assumptions: Money wages and prices are exogenous. The price level and the money wage are held

rigid. The interest rate is fixed since the monetary side of the economy is excluded. There is no government sector. There is no foreign sector Businesses and households are considered in the model. Businesses however do not save,

but pass all of their earnings over to the households

Defining Variables

Y= national income in real terms

C= real consumption expenditures by households

I= real investment expenditures by businesses

The Equilibrium Level of National Income

1) Expenditure = Output

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The national output or national income will be in equilibrium when total planned expenditure = output that is actually produced.

Total expenditure consists of several elements i.e C + I + G + (X-M) The value of national output is in equal to national income, hence the economy will be in

equilibrium when Y = C + I + G + (X-M)

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

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

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

2) Leakages = Injections

From the circular flow of income, national income will only be stable when total planned leakages are equal to planned injections i.e

Total planned injections = total planned leakages

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I + G + X = S + T + M

The Consumption Function

Consumption is the amounts of money households spend on goods and services to satisfy their current wants.

The four basic determinants of aggregate demand (or expenditure) areI. Consumption (H/H)

II. Investment (B/B)III. Government Expenditure (G)IV. Net Exports (X – M)

Any change in the above results in changes in the level of income e.g. if C increases – Y also increases.

Consumption is the largest component of aggregate demand. It consists of 2 main categories namely:

I. Consumption on durables e.g. furniture, cars etc. these are consumed over a long period of time.

II. Consumption on non-durables e.g. food, cigarettes, clothes etc i.e. immediate consumption.

When looking at the consumption function, you are looking at consumption as a function of disposable income i.e. income after tax has been deducted.

Consumption increases with rising income and therefore has a positive slope that is sloping upwards from left to right.NoteAs income continues to rise, the percentage spent on basics e.g. food, shelter, clothing etc tends to fall although more may be spent in monetary terms.

Autonomous Consumption

Autonomous consumption is consumption of goods and services independent of the level of income i.e. even if income is $0 the consumer my borrow or use past savings to consume i.e. dissaving

Tabulated Consumption Function

Based on the assumption of no government and no foreign trade. Y = C + S

S = Y – C

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C = Y – S

National Income (Y) Consumption (C) Savings (S)0 30 -3040 60 -2080 90 -10120 120 0160 150 10200 180 20

Diagrammatically

d = dissaving (c > y)s = saving (c < y)B = breakeven (c = y)

The 45° line connects all points where expenditure is equal to income.

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The Savings Function

Average Propensity to Consume (APC)

APC is the proportion of disposable income which is consumed.

APC =

Referring to the diagrams above

At B1 C = Y

= 1 – APC is unity

At lower levels of income (lower than B)

C > Y - > 1

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i.e. APC > 1 At higher levels of income (above B)

C < Y - < 1 – APC < 1

Average Propensity to Save (APS)

It is the proportion of disposable income which is saved.

APS =

CheckY = C + S ǁ÷y

= +

I = APC + APS

Marginal Propensity to Consume (MPC)

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

MPC =

MPC =

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

Marginal Propensity to Save (MPS)

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

MPS = =

Check

Y = C + S

But a change in income leads to changes in both consumption and savings.

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∆Y = ∆C + ∆S ǁ÷y

= +

I = MPC + MPS

Illustration

Assume constant MPC and MPS (but it’s unrealistic)

Disposable Income (Y)

Consumption (C)

Savings (S)

APC APS MPC MPS

$10 000 11 000 -1000 1.1 -0.1 0.8 0.2$12 000 12 600 -600 1.05 -0.05 0.8 0.2$14 000 13 200 800 0.94 0.06 0.8 0.2$16 000 14 800 1200 0.93 0.07 0.8 0.2$18 000 16 400 1600 0.91 0.09 0.8 0.2

The Relationship between the Consumption function, MPS and MPC

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

At P, APC =

At Q, APC =

= MPC

The slope of the consumption function gives the MPC.

The consumption function can also be expressed algebraically as

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C = a + bY

Where C = consumptiona = autonomous consumption (not dependent on Y)b = MPC (slope of the consumption functionY = disposable incomeIn this model, there is no government intervention Yd = Y (disposable income)

The relationship between APC and MPC

c = a + by ǁ÷y

= +

(APC) = + b (MPC)

If a = 0

APC = MPC

If a > 0 (positive)

APC > MPC

If a < 0 (negative)

APC < MPC

Relationship between APS and MPS

S = -a + sY ǁ÷y

= +

(APS) = + s(MPS)

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APS = - + MPS

If a = 0, MPS = APS

If a > 0, MPS > APS

If a < 0, APS > MPS

Determinants / Factors affecting consumption

1. The level of income2. Availability and cost of credit – the easier and cheaper it is to borrow, the more are the

people likely to spend. When people spend more money than they earn, they are dissaving.

3. The distribution of income – a less even distribution of income may reduce spending i.e. an uneven distribution of Y reduces spending because Y will be in the hands of a few people who spend less i.e. the MPC of rich people is low.

4. Age structure – middle aged people and old people tend to spend a lower proportion of their income than young people.

5. Inflation – the effects are uncertain. If people expect prices to keep increasing in the future, they are tempted to bring forward their purchases of cars, furniture, imperishable etc.

6. Indirect taxes – a rise in indirect taxes is likely to reduce consumption.7. Range of goods and services – the greater the range of goods and services and the higher

their quality, the more people are likely to spend.8. Wealth and savings – these can help cushion people to maintain their current

consumption in the case of falling incomes.9. Changes in fashion10. Adverting11. Consumer tastes

NB

I. An increase in income leads to a movement along the consumption function.II. A change in any of the above factors will lead to a total shift of the consumption function.

Savings

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Savings is income which is not spent but set aside – S = Y – C As income increases both the total amount saved and the proportion saved tend to

increase.

Determinants of Savings

1. Level of income – as income increases, so does the ability to save.2. Social attitudes – savings are generally low in communities which place a higher value on

leisure and consumption.3. The financial framework – advanced financial systems stimulate savings.4. The rate of interest – higher interest rates attracts savings.5. Inflation - inflation causes people to reduce their savings in banks. Why hanging onto

money while / when its purchasing power is losing value by the day? The saver will likely decide to spend money immediately and enjoy its present purchasing power.

6. Much saving is habitual.7. A larger part of savings is contractional8. Many people save in order to achieve a definite objective.9. A large part of total savings is carried out by companies.10. A part of total saving is made up of government saving.11. Government policies e.g. government putting policies in place to encourage savings.12. Speculative motive i.e. people saving in order to make profits out of it.13. Precautionary motive – people save so as to safeguard against / cushion themselves

against unforeseen contingencies or emergencies e.g. sickness, death, unexpected visitors.

Keynesian Consumption Function

This is the first theory of consumption which was developed by John Maynard Keynes.

The Keynesian Theory of consumption is also known as Absolute Income Hypothesis.

The basic hypothesis of Keynesian Theory of Consumption is that current consumption expenditure is a function of current real income.

The total volume of private expenditure in an economy depends according to Keynes on the total current disposable income of the people and the proportion of income which they decide to spend on the consumer goods and services.

This relationship between aggregate consumption demand and aggregate disposable income is expressed through a consumption function expressed as C = a + bY

Where C = aggregate consumption expenditure, Y = total disposable income, a is a constant term, b = consumption coefficient ( i.e. the proportion of income spent on consumption)

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According to Keynes, the consumption function stems from a fundamental

psychological law. The law states that propensity to consume ( i.e. MPC

decreases with the increase in income in the SR Period. The law implies that total consumption increases but not by an equal amount of increase in income.

The absolute income hypothesis makes the following propositions:1. Consumption increases as disposable income increases, but not by the amount of

absolute increase in income.2. As the absolute level of disposable income tends to rise, the proportion of income

spent on consumption tends to decrease i.e. MPC decreases as the absolute level of income rises.

3. Up to a certain level of Y, C > Y.4. Consumption is a fairly stable function of income.

The Keynesian Consumption Function

Criticism of the Absolute Income Hypothesis

1. The theory is based more on “introspection” than observed facts.2. Kuznet’s study on disposable income and savings for the period 1869 – 1929 discovered

that the LR MPC had remained constant and hence equal to APC which contradicted the 3rd property of Keynesian Consumption Function.

3. It is also claimed that the Keynesian Consumption Function applied to pre-war data, predicted on a consumption level much higher than the aggregate income, which was seen as an impossibility.

4. Economists have found empirically that the Keynesian Consumption Function may be applicable to individual consumption behavior but not for the aggregate consumption expenditure. It is now a convention to use a linear consumption function at the aggregate level as opposed to a non-linear consumption function proposed by Keynes.

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INVESTMENT

Some Basic Concepts

Capital and Investment

Capital means accumulated stock of productive assets. It induces all man-made resources that can be used in the process of production.

Three main categories of capital are :a) Machinery and equipmentb) Land and buildingsc) Inventories i.e. stocks or stores of raw materials, components, work in progress or

finished goods. An expanded definition of capital would include educated and skilled manpower,

consumer durables, research and development. From a nation’s point of view, public constructions like roads, railways, airports, dams, barrages, bridges, canals, schools and hospitals.

Investment is net addition to the stock of capital. While capital is a “stock” concept, investment is a “flow” concept.

Investment is measured per unit of time. Investment is made in various forms of capital. Investment is expenditure on real capital goods. It is also taken to mean purchase of any asset or indeed the undertaking of any commitment, which involves an initial sacrifice followed by subsequent benefits. In theory of income determination, investment means strictly expenditure on capital goods. In this sense, investment is the amount by which the stock of capital of a firm or economy changes, once we have allowed for replacement of capital which is scrapped.

Gross Investment and Net Investment

Gross Investment is the total investment on capital goods per period of time, adjusted for depreciation. Gross Investment consists of investment:a) Plant, building, machinery and equipmentsb) Inventories

The investment category a) is called gross fixed investment and b) is non-fixed investment.

Gross investment may be positive or zero. It is zero when capital goods are not being purchased and worn out capital is not being replaced.

A firm intending to reduce its stock of capital makes zero gross investment. But a firm intending to maintain its capital stock intact makes gross investment at a rate of depreciation (i.e. wear and tear of capital stock over a period of time) of machines.

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Finally, a firm intending to increase its sock of capital undertakes gross investment at a rate higher than the rate of depreciation, the rate of capital consumption.

Net investment (IN) is the difference between gross investment (IG) minus depreciation (D)

IN = IG – D

Autonomous and Induced Investment

Autonomous investment is one that takes place due to exogenous factors i.e. factors that are outside the preview of the investment function.

Technically exogenous factors are those which are generally not included in the investment function. Such factors may include innovations in the productive technique, inventions of new production processes, new resources, new products, new markets, population growth, research and development, expansion plans of business firms etc

Autonomous public investment include expenditure of public buildings, establishment of public undertakings, construction of roads, railways, dams, bridges, canals and such overheads as educational institutions, hospitals, parks, tourist resorts etc

Induced investment is one that is induce or affected by endogenous variables i.e. factors that are included in the investment function e.g. investment may be induced by increase in income and employment or decrease in the rate of interest.

While induced investment is positively related to income (or output), it is negatively related to interest rates.

The distinction between autonomous and induced investment can be clarified with the help of the investment function. A general form of investment function is given as follows :

I = f ( Y,i ) Where Y = national income

i = interest rate The variables Y and I included in the investment function are endogenous variables Investment caused by endogenous variables ( Y and i ) are called induced investment. On the other hand, investment caused by variables or factors other than Y and i is

autonomous investment.

Investment Decisions

A business firm’s motive behind investment is to make profit. Profitability of an investment depends on:a) Cost of investment i.e. price of the investment goods.b) Expected income flow from the investmentc) Market rate of interest

- Given the investment opportunities and necessary information, investors have to decide whether or not to invest.

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- The following are methods used to decide whether or not to invest.a) Net Profit Value (NPV) methodb) Marginal Efficiency of Capital (MEC) method

Net Profit Value (NPV) Method

The NPV method suggests that an investment project is worth undertaking if its NPV is considerably greater than its cost of capital.

The NPV is the discounted value of the expected returns from the investment. Money is now worth more than money in the future, because it could be invested now to

produce a greater sum in the future. The present value of money in the future is calculated by discounting it at a rate of interest equivalent to the rate at which it could be invested.

The net present value of an investment is the difference between the capital cost of an investment and the present value of the future cash flows to which the investment will give rise.

NPV = + + …. + - Co

Where R1, R2, …. , Rn are gross profits arising in years 1, 2, …. ,n, Co is the present value of capital expenditure, and r is the annual interest rate (assumed constant throughout the period).

If the total expected return (i.e. the total PV) from a capital investment exceeds its total cost, the capital good is worth buying.

Marginal Efficiency of Capital Method

Keynes defined MEC as “that rate of discount which would make the present value of a series of annuities given by the returns expected from the capital asset during the life just equal to the cost of capital good.

In simple words, MEC is the rate of discount which makes the discounted present value of expected stream of income equal to the cost of capital good.

MEC is also known as Internal Rate of Return (IRR) in contrast to the external rate of return which is the same as market rate of interest. E.g. if the cost of capital having a life

of one year is C and it yield s an income R after one year. And if = C

Then r in the above equation is equivalent to the MEC. The value r can be worked out as

follows : r = - 1

Using MEC the investment decision rule may be set as follows :a) If MEC (r) > i, then investment project is worth its cost.

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b) If MEC = I, the contemplated investment yields a profit just equal to the market rate of interest. The project may be or may not be undertaken.

c) If MEC < i, the investment project is unprofitable, net worth its cost. The project has to be rejected.

The Acceleration Principle

The relationship between investment expenditure and change in output is explained by the principle of acceleration.

The origin of the principle can be traced back in the writings of Aftalion (1909), Bickerdike (1914) and Howtrey (1913). The best known formulation of this principle was however made by J.M. Clark (1917)

The acceleration principle describes the technical relationship between the change in capital stock and the change in level of output.

Note – acceleration principle is a theory of the size of the desired or optimum capital stock rather than a theory of (net) investment.

The Acceleration Coefficient

To explain the principle of acceleration and the acceleration coefficient, let us first take the note of the usual simplifying assumptions:I. A production function of Cobb – Douglas type is given for all firms.II. Factors of production are homogenous and perfectly divisible.III. Factor prices are given.IV. Firms produce at least cost combination of inputs.V. There is no excess production capacity.VI. Firm’s estimates of future demand for their products are fairly accurate.VII. There is no financial constraint – funds are easily available.

Suppose the demand for firms product in period t is given by Yt and firms use Kt amount of capital to produce Yt output. Assuming a give capital – output ratio, k, the relationship between capital stock, Kt, and the output Yt can be expressed as

Kt = kYt Now let the demand for the product increase in period t+1 to Yt+1 i.e. the demand for output

increases by ∆Yt+1 = Yt+1 - Yt. Given the assumptions (iv) and (v) above, the firms will be required to increase their stock of capital in period t + 1, to produce additional quantity demanded.

Suppose firms increase their capital stock form Kt to Kt+1 in period t + 1, then Kt+1 = KYt+1

The relationship between change in capital stock (∆K) and the change in output (∆Y) may be expressed as Kt+1 – Kt = k(Yt+1 – Yt) ∆Kt+1 = k∆Yt+1

From the equation above, the capital output ratio (k) is accelerator r acceleration coefficient.

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We know that ∆K = In where subscript “n” denotes net.Thus in period t+1 ∆Kt+1 = In = k∆Yt+1

Gross investment (Ig) that equals net investment (In) plus replacement capital ® in period t+1 may be expressed as Igt+1 = k(Yt+1 – Yt) + Rt+1

It must be noted that the size of k, the accelerator, dpends not only on the capacity of the capital goods to produce a commodity but also on the period over which capital goods are acquired and output is measured.

Significance of Acceleration Principle

The acceleration principle has significant implications in :a) Theories of investmentb) Employmentc) Trade cycles

Factors affecting Investment

1. Rate of interest2. Changes in technology3. Changes in cost of capital4. Expectations of entrepreneurs5. Corporate Tax / Corporation Tax6. Government Policies / Government Incentives7. Profit Levels8. Rate of change of income

Aggregate Demand (AD) and Aggregate Supply (AS)

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

Aggregate demand relates to the demand side and aggregate supply to the supply side. At any given point in time, AD will be equal to the actual output of the economy (real

GDP) and is given by : AD = C + I + G + ( X-M ) = Real GDP The aggregate demand curve shows the quantity demanded of real GDP at different

price levels, holding all other factors constant.

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The AD curve is downward sloping as a result of 2 separate effects :1. Real money balance effect (i.e. at lower price levels the real purchasing power of

money balances i.e. currency and bank deposits rise).2. Substitution effects i.e. a rise in the price level will normally lead to a rise in

interest rates ceteris paribus. This is because given higher prices h/h and firms have less real purchasing power and therefore they will tend to lend less and wish to borrow more.

Changes in AD

AD curve shifts due to :1. Government macroeconomic policy2. Expectations of firms and households3. Global trends

Aggregate Supply

As is the total of goods and services produced in the economy at any given time. The AS available will depend upon the factor of production utilized. These factors are

labour (N), capital (K) and land (L). also important is the state of technology (T) including the technical know – how available in the economy.

The AS relationship can be represented in terms of an aggregate production function that relates output (Y) to inputs (N, K, L, T) – aggregate production function Y (N, K, L, T)

The aggregate production function states that the greater the volume of factor inputs, the greater the economy’s output.

Aggregate Supply in the LR period

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The LRAS curve shows the relationship between the price level and real GDP in the LR. The LRAS curve is shown as vertical at the economy’s full employment GDP. The

LRAS is unaffected by price changes.

AS in the SR period

In the SR period, real GDP may be at r below the potential real GDP at full employment. A higher AD at a time when AS is below its potential level can be expected to lead more

output produced. This is illustrated below by an upward sloping SRAS curve.

Macroeconomic equilibrium exists when AD = AS

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

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The Multiplier

The multiplier is a measure of the effect on total national income of a unit change in some component of AD.

The multiplier is the ratio of the resultant change in national income w.r.t the initial change in injections or leakages.

Multiplier =

=

There are as many multipliers as there are components of aggregate demand i.e.1. Consumption expenditure multiplier2. Investment multiplier3. Government expenditure multiplier4. Export multiplier

Deviation of the multiplier (Investment Multiplier)

Y = C + I reap MPC =

∆Y = ∆C + ∆I ∆C = MPC∆Y

∆Y = MPC∆Y + ∆I

-∆I = MPC∆Y + ∆Y

∆I = ∆Y - MPC∆Y

∆I = ∆Y ( 1 – MPC)

= ∆Y ǁ÷ ( 1 – MPC)

= =

Reap

MPC + MPS = 1

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MPS = 1 – MPC

Substituting MPS for ( 1 – MPC )

The multiplier = =

The Working of the Multiplier

The multiplier is based on the principle that one person’s expenditure is someone else’s income. So there is a circular flow of income and expenditure. The multiplier assumes that MPC ≠ 0

If MPC = 0, then there would be no multiplier effect since there is no expenditure (no income).

The multiplier effect will continue until equilibrium is reached / regained i.e. injections (investment) is equal to withdrawals (savings).

Example

If a firm decides to construct a new bridge costing $1000 then the income of the builders and suppliers of raw materials will rise by $1000.

However, the process does not stop there. If we assume that the recipients of the $1000

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

income for another group of people.

If we assume that they also have an MPC of , they will spend $444.44 of the $666.67

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

of the previous round. Thus a long chain of extra income, extra consumption and extra saving is set up.

Increase in income ∆Y

Increase in consumption ∆C

Increase in savings ∆S

1st Recipients 1000 666.67 333.332nd Recipients 666.67 444.44 222.233rd Recipients 444.44 296.30 148.144th Recipients 296.30 197.53 98.775th Recipients 197.53 131.69 65.84Total ∆Y = $3000 ∆C = $2000 ∆S = $1000

This process will come to a halt when the additions to savings total $1000. This is because the change in savings (∆S) is now equal to the original change in investment (∆I)

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and therefore the economy is returned to equilibrium because S = I once again i.e. withdrawals = injections.

At this point the additions to income total $3000. Thus $1000 extra investment has created $3000 rise in income. Therefore in this case the value of the multiplier = 3.

i.e. multiplier = =

= =

= =

= 3 ↔ 3

Note

1. If investment falls (or any of the components of aggregate demand), national income also falls by the magnitude or size of the multiplier times change in investment.

2. The greater the withdrawals, the less the multiplier effect i.e. multiplier =

If MPS (withdrawals) increase, the multiplier falls.

The multiplier in a more complex economy

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

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

In fact 1 – MPC is equal to that proportion of any increase in income which leaks out of the circular flow.

As a fraction of additional income, this leakage is equal to MPS + MPM + MPT where: MPM is marginal propensity to import. MPT = marginal rate of taxation

The multiplier = = =

Balanced Budget Multiplier

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The multiplier effect on national income of an increase in government expenditure exactly matched by an increase in taxation, so that the governments’ budget remains unchanged.

It might be thought that an increase in government expenditure say $100 million, would have no net effect on aggregate demand in the economy and that national income would remain unchanged.

This is not in general the case, however there will usually be an expansionary effect. At its simplest, the reason for this is that only part of the increase in taxation results in lower aggregate demand while all the increased expenditure results in increased aggregate demand so that there is a net injection of demand in the economy, which then has a multiplier effect.

The balanced budget multiplier results when government expenditure increases or decreases by exactly the same magnitude of increases and decreases in T.i.e. ∆G = ∆T

The balanced budget multiplier is always = 1∆G = ∆T∆Y = ∆G

= 1

Inflationary & Deflationary Gaps

Full employment level of national income is the level of national income at which there is no deficiency of aggregate demand and hence no disequilibrium unemployment.

At full employment level all resources in the economy are fully employed or utilized. None is lying idle.

Rarely does equilibrium level of income correspond with full employment level. Full level of GDP can be thought of as measuring full capacity output, i.e. the largest

output of which the economy is capable when all resources are employed for their feasible limits.

Deflationary Gap

Represents a situation of deficiency in demand in the economy, indicating the amount by which aggregate demand must be increased and exists when the equilibrium level of national income is below full employment potential.

To increase aggregate demand to the level required to raise national income and therefore SRAS to the full employment level, the government could either raise government expenditure or reduce taxation levels.

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Either of these measures would produce a multiple rise in demand through the multiplier effect.

The shortfall of national expenditure below national income (and injections) below withdrawals at full employment level of national income.

With deflationary gap aggregate demand is lower than the desired level at full employment. There is thus unemployment of resources or underutilization of resources.

Aggregate expenditure is less than aggregate output so insufficient demand results.

Inflationary gap represents a situation of excess demand in the economy and reflects the amount by which aggregate demand must be reduced in order to achieve the full employment equilibrium level of output with stable prices.

To close this gap, the government could either reduce government expenditure to raise taxation levels. Again these measures would have the effect of reducing aggregate demand, this time through a negative multiplier effect.

For the deflationary gap an expansionary fiscal policy measures cause aggregate expenditure to rise from AE1 to AE2 leading to an increase in real GDP (national income) from Y1 to YFe.

For the inflationary gap the level of aggregate expenditure is reduced from AE3 to AE4 as a result of contractionary fiscal policy measures.

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The economy’s full potential output is YFe, any output to the right of this such as Y2

cannot be produced in the SR period.

The Paradox of Thrift

The classical economists argued that saving was a national virtue. More saving would lead to via lower interest rates to more investment and faster growth.

Keynes was at pains to show the opposite. Saving, far from being a national virtue, could be a national vice.

Just because something is good for an individual, it does not follow that it is good for society as a whole ( i.e. the fallacy of composition). This fallacy applies to saving.

If individuals save more, they will increase their consumption possibilities in the future. If the society saves more, however this may reduce its future income and consumption. As people save more, they will spend less. There will thus be a multiplied fall in income.

The phenomenon of higher saving leading to lower national income is known as “the paradox of thrift”.

But this is not all. Far from the extra saving encouraging more investment, the lower consumption will discourage firms from investing. If investment falls, the injections line / curve will shift downwards.

There will then be a further multiplied fall in national income. The paradox of thrift had in fact been recognized before Keynes, and Keynes himself

referred o various complaints about “under consumption” that had been made back in the 16th century and 17th century.

But despite these early recognitions of the danger under consumption, the belief that would increase the prosperity of the nation was central to classical economic thought.

Keynesian Cross Model

MONEY AND BANKING

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

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

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

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

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

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

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

Money helps to solve all these problems.

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

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

Functions of Money

1. A medium of exchange – one can use money to buy goods and services.

2. A measure of value

3. A store of value – wealth can be stored or held in the form of money. Storing wealth as wheat – wheat can decay vs. storing wealth as money – can be eroded by inflation.

4. A standard for deferred payments. Goods and services bought on credit can be paid for by money on a future date.

5. A unit of account – money should provide an agreed standard measure i.e. a unit of account by which the value of different goods and services can be compared. This of course is not the case in a barter economy in which the value of every good and service must be individually expressed in terms of all other goods and services.

Characteristics/Qualities/Attributes of Money

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

1. Acceptability – i.e. generally acceptable to all consumer and businesses.

2. Durability – must not deteriorate rapidly and lose value while in people’s possession.

3. Homogeneity – specific notes and coins must be identical in appearance and value.

4. Divisibility – capable of subdivision into smaller units without any loss of value.

5. Portability – manageable and easy to carry around and handle.

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6. Stability of value – must not be eroded or lose value due to inflation.

7. Difficult to counterfeit – minimum fraud or forging

8. Scarcity limited in supply.

9. Uniformly – specific notes and coins must look the same / identical.

10. Recognizable – money must distinguish itself easily from other goods.

Advantages of Money

1. It is universally acceptable as a means of payment.

2. It simplifies transactions.

Disadvantages of Money

1. Value of money can be eroded by inflation.

2. Money can attract attention of thieves.

3. Money is not suitable to be sent or posted to a payee unless if money orders, telegraphic transfers or registered mail is used and these methods of sending demand a payment fee – it ends up being expensive

The Demand for Money

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

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

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

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

Note

The quantity of money is a stock and that the demand for it is demand for stock: people wish to hold so much money in cash or deposits. This makes the demand for money to

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hold different from any commodity/good to consume. The demand for a consumption commodity is a flow demand and requires a time dimension to make it meaningful i.e. so many units per week, per month or per year.

Motives for demanding or holding money

1. The transactions demand for money (the transactions motive)

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

The transactions demand for money arises because of the non-synchronization of payments and receipts.

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

2. The precautionary demand for money

Households and firms may wish to hold additional balances called precautionary balances in response to the motive for holding money.

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

The precautionary motive arises, therefore out of stochastic disturbances in the flows of payments and receipts.

The protection provided by any given stock of precautionary balances depends on the degree to which payments and receipts are subject to haphazard fluctuations and on the value of the payments and receipts.

The precautionary demand for money is due to unforeseen contingencies for e.g. death, accident, illness, unexpected visitors etc

The precautionary demand for money is negatively related to the rate of interest as well as being positively related to the level of income.

3. The Speculative Demand for Money

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

Thus suppose an individual can hold his wealth either in bonds or in money. If he expects the price of the bonds to fall in the future, he will wish to switch from bonds to money i.e.

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he will sell his bonds. This is because a fall in the price of bonds involves him in loss of wealth.

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

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

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

Md = MT + MP +MSP

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

The 3 motives for holding money can be summarized by listing 3 hypotheses which are:

1. The demand for money is positively related to national income valued in current prices.

2. The demand for money is negatively related to the rate of interest.

3. The demand for money is positively related to wealth.

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

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

The real demand for money is given by:

MD = L(Y, r, W)

Where

MD = real demand for money L = liquidity preference which indicates a functional relation Y = real national income

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r = interest rate W = real purchasing power of wealth

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

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

The determinants of MD are Y, r and W.

-The study of the effect of money on the economy is called monetary theory. When economists mention supply, the word demand is sure to follow. The supply of money is an essential building block in understanding how monetary policy affects the economy because it suggests the factors that influence the quantity of money in the economy.

-The demand for money evolve through theories postulated by:-

The Classicals in the 20th century and pioneering economists were Irving Fischer, Alfred Marshall and A.C Pigou. They came up with the quantity theory of money.

The Keynesians under John Maynard Keynes. They came up with the Liquidity Preference Theory

The Monetarists under Milton Friedman came up with the Modern Quantity Theory of Money.

1) The Classicals Quantity Theory of Money

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

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

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

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

The concept that provides the link between M and P x Y is called velocity of money or velocity of circulation or simply velocity i.e the rate of turnover of money i.e the average number of times per year that a unit of currency is spent in buying the total

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amount of goods and services produced in the economy or the number of times a unit of currency changes hands in buying total goods and services produced in the economy over a given period of time which is usually a year.

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

V = P xY/M

Multiplying both sides by M, we obtain the equation of exchange which relates nominal income to the quantity of money and velocity

i.e M x V = P x Y

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

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

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

Quantity Theory of Money

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

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

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

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

For Classical economists, the quantity theory of money provided an explanation of movements in the price level. Therefore movements in the price level result solely from changes in the quantity of money.

The Quantity Theory of Money Demand

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

Dividing both sides of the equation of exchange by V

M = 1/V x PY

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

Md = k x PY

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

that people demand.

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

Keynes Liquidity Preference Theory

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

Keynes called his theory of the demand for money, the liquidity preference theory. He postulated that there are three motives for holding money i.e

1) The transactions motive

2) The precautionary motive ; and

3) The speculative motive

1) The transactionary motive

People hold money to finance their day to day needs (transactions). Keynes emphasised that this component of the demand for money is determined primarily by the level of people’s transactions. But he believed that these transactions were proportional to income, like the Classicals, he took the transactions component of the demand for money to be proportional to income.

2) The precautionary motive

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Keynes also said that people hold money as a cushion against an unexpected need, unforeseen contingencies or emergencies e.g unexpected bills, unexpected visitors, death, accident, hospitalization.

Keynes believed that the amount of precautionary money balances people want to hold is determined primarily by the level of transactions that they expect to make in the future and that these transactions are proportional to income. Therefore he postulated the demand for precautionary money balances is proportional to income.

3) The speculative motive

Keynes agreed with the Classical economists that money is a store of wealth and called this reason for holding money as the speculative motive. He believed that even though the wealth component of the demand for money is proportional to income, interest rates too have an important role to play in being a determinant of the speculative motive of the demand for money.

From Keynes reasoning, as interest rates rise, the demand for money falls and therefore money demand is negatively related to the level of interest rates.

Keynes wrote the following demand for money equation known as the liquidity preference function which says that the demand for real money balances Md/ P is a function of (is related to) i and Y

= f(i, Y)

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

Friedman’s Modern Quantity Theory of Money

In 1956, Milton Friedman developed a theory of the demand for money in a famous article “The quantity theory of money: A restatement”

Like his predecessors, Friedman pursued the question of why people choose to hold money. Instead of analyzing the specific motives for holding money as Keynes did, Friedman simply stated that the demand for money must be influenced by the same factors that influence the demand for any asset. Friedman then applied the theory of asset demand to money.

The theory of asset demand indicates that the demand for money should be a function of the resources available to individuals (their wealth) and the expected return on money.

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Friedman expressed his formulation of the demand for money as follows:

Md/ P = ( Yp, rb-rm, re-rm, Πe-rm)

+ - - -

Where Md/ P = demand for real money balances

Yp = Friedman’s measure of wealth known as the permanent income (technically the present discounted value of all expected future income, but more easily described as expected average long run income)

rm = expected return on money

rb = expected return on bonds

re = expected return on equity (common stocks)

Πe = expected inflation rate

The signs underneath the equation indicate whether the demand for money is positively (+) related or negatively (-) related to the terms that are immediately above them.

Equilibrium in the money market

It exists where the demand for money is equal to the supply of money. The supply of money is determined by the monetary authorities and can be taken as fixed in the short run period. It is identified as a vertical line (MM).

According to Keynes, the transactions and precautionary motives are added together and are described as active balances. The demand for such balances will not be influenced by changes in the rate of interest and so it appears as a vertical line La. The speculative demand for money is influenced by changes in the rate of interest. There is an inverse relationship between interest rate and the demand for money. Keynes referred to the relationship between the quantity of money demanded and the rate of interest as speculative balances. Speculative balances are often referred to as idle balances.

This analysis indicates that when the quantity of money demanded is related to the rate of interest, we obtain the demand curve of the normal shape.

At high rates of interest, very little money is demanded for speculative purposes. At low rates of interest, large amounts of money are demanded.

The speculative demand for money is represented by the curve Li in the diagram below.

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

The Li curve becomes horizontal at a positive rate of interest. This is because it is believed that some minimum reward for example 2% is required to persuade people to forgo the advantages of holding money. This is called the liquidity trap i.e the absorption of any additional money supply into idle balances (i.e speculative) at very low rate of interest leaving aggregate demand unchanged.

If the demand for active balances La is added to the demand for speculative balances L i

we obtain the total demand curve for money i.e LL as shown by the diagram above. This is the liquidity preference schedule which tells us how the quantity of money

demanded varies as the rate of interest varies.

Changes in the money market equilibrium are as a result of changes in the determinants of money demand or money supply.

Determinants of money demand

1) Real GDP2) The price level3) Expectations4) Transfer costs i.e transfers between non-money and money deposits. Therefore the

demand for money will increase as it becomes more expensive to transfer between money and non-money accounts. The demand for money will fall if transfer costs decline.

5) Preferences

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6) Expected rate of inflation7) Risk8) Liquidity of alternative assets9) Efficiency of payment technologies

Effects of changes in the money market

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

1) The effect of changes in money demand

An increase in liquidity preference or money demand brought about by an increase in income or an increase in prices will raise the liquidity preference curve from LL to L1 L1 in diagram a). This causes the rate of interest to rise from OR to OR1. What happens is that the increased preference for money balances leads to an increased desire to sell securities and an increased supply of securities in the market depresses their prices i.e the rate of interest rises. A fall in the liquidity preference, other things being equal will lower the rate of interest as the demand for securities increases.

2) The effect of a change in money supply This is illustrated in diagram b). When the supply of money increases from MM to M1M1

the rate of interest falls from OR to OR2. This is because an increase in the supply of money must leave some groups holding excess money balances (assuming no change in liquidity preference). People will be holding a greater proportion of their wealth in the form of money than they wish to hold at current rates of interest.

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A fall in the supply of money will leave the community with less money that it wishes to hold at current interest rates. People will try to increase their money balances by selling securities and in doing so, they will raise the rate of interest.

Factors affecting money supply

1) Changes in the reserve deposit ratio2) Changes in the currency reserve ratio3) Open market operation4) Changes in reserve requirement ratio5) Changes in discount window borrowing6) Changes in the bank rate/ discount rate

Measures of controlling money supply growth

Money supply growth must be controlled. The monetarists advocate that the rate of money supply growth must match the rate of growth of the economy.

If money supply grows faster than the rate of growth of the economy, the general price level of goods and services will increase i.e its inflationary.

The following are measures which can be used to control money supply growth. They are instruments of monetary policy:-

1) The rate of interest i.e the bank rate, repo rate, discount rate or minimum lending rate2) Open market operations3) Special deposits4) Funding5) Quantitative and qualitative controls6) Moral suasion7) Hire purchase controls

Forms of Money

Credit money

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

Coins

Bank notes (flat money)

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

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

The Supply of Money / Money Stock

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

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

Measures of Money Supply

Monetary Base

Notes and coins or cash in circulation outside the central bank.

Narrow Money

Reflects the medium of exchange function and thus refers to money balances that are readily available to finance current spending i.e. balances available for transaction purposes.

Broad Money

Not only includes money balances held for transaction purposes, but incorporates money held as a form of saving. It provides an indicator of the private sector’s holdings of relatively liquid assets – assets which can be converted with relative case and without capital loss into spending on goods.

There is no single “correct” measure of money supply; instead, there are several measures classified along a spectrum or continuum between narrow and broad monetary aggregates. Narrow measures include only the most liquid assets, the ones most easily used to spend (currency, checkable deposits). Broader measures add less liquid types of assets (certificates of deposits) etc.

The different types of money are typically classified as “M”s. the “M”s usually range from M0 (narrowest) to M3 (broadest) but which “M”s are actually used depends on the country’s central bank.

M0 – in some countries such as UK, M0 includes bank reserves, so M0 is referred to as the monetary base or narrow money.

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

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M1 is the narrowest measure of money supply. It consists of notes (bills of different denominations) and coins and checkable deposits. The checkable deposits are spilt into2 categories i.e. demand deposits and other checkable deposits (non demand checkable deposits). M1 also includes traveler’s checks.

M2 measure of money supply is made broader than the M1 monetary aggregate by adding additional items that fall under the near money category. M2 includes M1 + savings deposits, small denomination time deposits.

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

M3 measure of money supply further broadens the M2 monetary aggregate by adding additional assets that are less liquid than those included in M1 and M2.

M3 includes M1 and M2 plus large denomination time deposits. Large denomination certificates of deposits are usually negotiate certificates of deposits (CDs) that can be sold in the secondary market before they mature. Thus large denomination negotiable CDs serve as an alternative to investing in Treasury Bills for corporate treasurers who have idle funds to invest for a short time.

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

The Monetary System/ The Financial System / The Banking System

The financial system is made of various financial intermediaries which facilitate financial transactions and these are:

1) The Central Bank/ The Reserve Bank

Most countries of the world have a central bank which is at the helm of the banking system. The central bank is responsible for operating the banking and financial system of a country. Its functions are:-

a) Issuing bank notes and coins and reparing tattered ones.b) Keeping the government’s account and maintain itc) Servicing the national debtd) Lender of last resorte) Supervision of the banking system

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f) The banker’s bankg) Banker’s clearing househ) Special advisor to the governmenti) Management of the country’s foreign exchange reservesj) Formulation and implementation of monetary policyk) Handles the country’s gold outputl) Manages the country’s balance of paymentsm) Formulation and implementation of the country’s exchange rate policyn) Administers the issue of government loans and treasury billso) Manages the country’s domestic and external debt.

2) Commercial Banks/ Retail Banks

These are financial institutions set up to promote and facilitate financial transactions for example CBZ, Standard Chartered Bank, Barclays Bank, TN Bank, BancABC, Metropolitan Bank.The following are functions of commercial banks:-

a) Attracting customer depositsb) Foreign currency transactionsc) Business and investment advice to customersd) Provision of night safee) Protects customer durables and willsf) Giving short and long term loans to customersg) Provision of finance either in the form of loans or overdrafts to help customers finance

their transactionsh) Help business people receive payments for goods sold abroad or locallyi) Help business people make payments for supplies obtainedj) They accept and discount bills of lading and bills of exchangek) Buying and selling foreign currencyl) Provide limited assurance (bancassurance)m) Provide trade financingn) Sometimes they offer utility account payment services for their clients and act as

collectors of utility funds for utility companies e.g ZESA, ZINWA, Multichoiceo) Provision of telephone banking servicesp) Provision of internet banking services

3) Building Societies Building societies differ from commercial banks in that they do not operate any

current accounts or checking accounts. They are purely dealers on the domestic market and may not have any correspondent

banking arrangement in other countries. They usually have very low minimum balance requirements (the poor man’s bank)

Building societies typically serve small depositors i.e people in the low income group

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who may find commercial banks unattractive due to the requirements imposed by those banks.

A building society is a financial institution that accepts deposits upon which it pays interest and makes loans for house purchase secured by mortgages.

They insure mortgaged properties against fire and special risks through their own insurance companies.

Provide loans to members of the public who wish to purchase their own homes. Inspect and appraise properties.

4) Merchant Banks

These are financial institutions that deal mainly with international trade. The following are their functions:-

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

5) Discount Houses

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

The following are the functions of discount houses:-

Ensure the liquidity of the banking system by accepting short term deposits. Invest these funds in liquid liabilities of other financial institutions. Provision of short term loans. Buy and sell financial assets in order to create a stable and active market for financial

assets They act as market markers in treasury bills and other short term securities Assists the government with its borrowing requirements. They provide a vital link between the central bank and the rest of the banking system.

6) Insurance Companies

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7) They sell a number of financial products to their clients. They administer policies, pension funds and annuities for their clients. These funds are then invested in some safe investment that would make Development Banks

The main aim of development banks is to look at socio-economic inequalities of the past and improve the standards of living of people.

8) Post Office Savings Bank

It allows the small saver the chance to invest their monies and the money is invested in government bonds.

insurance companies not risk their clients’ money.

9) Pension Funds

The majority of big corporations run pension funds for the benefit of their employees. Normally the company contributes a certain % of the employees’ salary and these pension funds are invested in stocks, bonds and other securities and the companies make a lot of profits. The pensions will be paid to employees at a later stage in life for example when the employee retires or the pension is paid to beneficiaries when the employee dies.

10) Finance Houses

They obtain their funds from banks and other sources at concessional rates and then sell the funds to borrowers at premium rates

In this case, banks have surplus funds that they are willing to sell to finance houses at a lower interest rate. In turn, the finance houses would make the funds available to individuals and other businesses that are in a deficit.

The Banking Sector and the Money Creation Process/ The credit creation process

Banks perform 2 crucial functions which are:-

1) They receive funds from depositors and in turn provide these depositors with a checkable source of funds or with interest rate.

2) They use funds they receive from depositors to make loans to borrowers i.e they serve as intermediaries in the borrowing and lending process.

When banks receive deposits, they do not keep all these deposits on hand because they know that depositors will not demand all of the deposits at once. Instead banks keep only a fraction of the deposits that they receive. These deposits that banks keep on hand are called bank reserves.

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When depositors withdraw deposits, they are paid out of the bank reserves. The reserve requirement is a proportion/ fraction of deposits set aside for withdrawal purposes.

The reserve requirement is determined by the reserve bank or central bank of a country. Deposits that banks are not required to set aside as reserves can be lent to borrowers in the form of loans.

Banks earn profits by borrowing funds from depositors at zero or low interest rate and using these funds to make loans at higher interest rates.

A balance sheet for a typical bank is given in the table below. A balance sheet summarises the bank’s assets and liabilities. Assets are the valuable items that the bank owns and consist primarily of the bank’s reserves and loans. Liabilities are valuable items that the bank owes to others and consist primarily of the bank’s deposit liabilities to its depositors.

In the table below, the bank assets (reserves and loans) total $1 million. The banks liabilities (deposits) total $1 million. A banking firm’s assets must always equal liabilities.

The balance sheet for a typical bank:

Assets Liabilities

Reserves $100 000 Deposits $1 000 000

Loans $900 000

From the table, the reserve requirement is 10%.

If the bank receives a deposit of $100 000 from one of its depositors, assuming that the bank is required to by the reserve bank to set aside 10% of this deposit or $10 000. It then lends out its excess reserves i.e the remaining $90 000 (or 90%) of the initial deposit.

Suppose that all borrowers deposit their funds into the same bank, the bank will then receive $90 000 in new deposits of which it sets $90 000 aside as reserves and lends out all the excess reserves.

Suppose again that all borrowers redeposit their loans in the same bank, that bank sets aside a portion of these deposits and can lend out the remainder, which again is redeposited into the bank and the process continues on and on. The repeated chain of events is summarized in the table below:

Multiple Expansion of Credits

Round New Deposits New Reserves New Loans

1 $100 000 $10 000 $90 000

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2 $90 000 $9 000 $81 000

3 $81 000 $8 100 $72 900

4 $72 900 $7 290 $65 610

5 $65 610 $6 561 $59 049

6 - - -

- - - -

- - - -

- - - -

- 00 00 00

TOTAL $1 000 000 $100 000 $900 000

If one were to follow this multiple deposits expansion process to its completion, the end result would be that the bank’s deposits would increase by $1 million [i.e $100 000 x 10 (money multiplier)], loans would increase by $900 000 [i.e $90 000 x 10 (money multiplier)] and its reserves would increase by $100 000 [i.e $10 000x 10 (money mulitiplier)], all due to the initial deposit of $100 000.

Credit creation by banks is one of the most important and major source of generating income by banks. When the reserve requirement is increased by the central bank, it would directly affect credit creation by banks because then the lendable funds by banks decreases and vice versa.

Credit Creation by Banks (another example)

Suppose there are a number of Commercial Banks in the banking system i.e Bank 1, Bank 2, Bank 3 and so on.

Suppose an individual A makes a deposit of $100 in Bank1. Bank 1 is required to maintain a cash reserve requirement of 5% which is decided by the central bank’s monetary policy.

Bank 1 is required to maintain a cash reserve of $5 (5% of $100). The bank now has lendable funds of $95 ($100 - $5).

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Let Bank 1 lend $95 to a borrower, say B. The method of lending is the same i.e Bank 1 opens an account in the name of the borrower cheque for the loan amount. At the end of the process of deposits and lending, the balance sheet of the bank reads as given below:

Balance Sheet of Bank 1

Liabilities Amount Assts Amount

A’s deposit 100 Cash Reserve 5

Loan to B 95

Total 100 Total 100

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

Liabilities Amount Assts Amount

B’s deposit 95 Cash Reserve 4.75

Loan to C 90.5

Total 95 Total 95

The total amount advanced to D will return ultimately to the banking system, as described in case of B and the process of deposits and credit creation will continue until the reserves with the banks are reduced to zero.

The final picture that would emerge at the end of the process of deposit and credit creation by the banking system is presented in the consolidated balance sheet of all banks as shown below:-

The combined Balance Sheet of Banks

Bank Liabilities

Deposits

Assets

Credits

Reserves Total Assets

Bank 1 100 95 5 100

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Bank 2 95 90.5 4.75 95

Bank 3 90.5 85.98 4.52 90.5

- - - - -

- - - - -

Bank n 00 00 00 00

Total 2 000 1 900 100 2 000

- It can be seen from the combined balance sheet that a primary deposit of $100 in Bank 1 leads to the creation of the total deposit of $2 000.

- The combined balance sheet also shows that the banks have credited a total credit of $2 000 and maintained a total cash reserve of $100 which equals the primary deposits.

- The total deposits created by the commercial banks constitutes the money supply by the banks

The Deposit Multiplier = = 20

Total Liabilities Deposits = 20 x 100 = 2 000 Total Assets Credits = 95 x = 2000 Total Reserves = 5 x 20 = 100 Total Assets = 100 x 20 = 2000

The Money Multiplier

This is the amount by which bank deposits expand in response to an increase in excess reserves.

Money multiplier =

From the example in the table above, the reserve requirement is 10%,

The money multiplier = 1/ 10% = 10

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The excess reserves resulting from the initial deposit of $100 000 are $90 000, multiplying $90000 by the money multiplier 10 yields $900 000, which is the amount of additional deposits created by the banking system as a result of the initial $100 000 deposit.

In reality, loan recipients do not deposit all of their loans into a bank, they hold a fraction of their loan funds as currency. If some funds are held as currency, then there is a leakage of money out of the banking system. In this case the money multiplier will still be greater than 1, but it will be less than the inverse of the reserve requirement.

The Deposit Multiplier

This is the amount by which an increase in bank reserves is multiplied to calculate the increase in bank deposits i.e

Deposit Multiplier =

The deposit multiplier is linked to the desired reserve ratio by the following equation,

Deposit Multiplier =

Monetary Base and Bank Reserves

The monetary base is the sum of notes and coins and commercial banks reserves held at the central bank. The monetary base is held either by banks as reserves or outside the banks as currency held by the public.

When the monetary base increases, both the bank reserves and currency held by the public increase. But only the increase in bank reserves can be used by banks to make loans and create additional money.

An increase in currency held by the public is called currency drain. A currency drain reduces the amount of additional money that can be created from a given increase in the monetary base.

The money multiplier is the amount by which a change in the monetary base is multiplied to determine the resulting change in the quantity of money.

The money multiplier is equal to the change in the quantity of money divided by the change in the monetary base.

Money Multiplier =

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

or

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

The Money Multiplier

The size of the money multiplier depends on:-

1) The magnitudes of the required reserve ratio2) The ratio of currency to deposits.

Assuming R = desired reservesr = desired reserve ratioC = currencyc = ratio of currency to depositsD = depositsM = the quantity of moneyMB = monetary base

Recall the Money Multiplier =

Desired reserves R = Rd and

Currency C = Cd

The quantity of money M = C + D (substitute C)

M = cD + D

M = (1+c)D ………………………………….1)

The monetary base MB = R + C substitute R = rD and C = cD

MB = rD + cD

MB = (r + c)D………………………………2)

Divide equation 1) by equation 2)

Money Multiplier = =

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=

Or M = x MB

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INFLATION

Definition

Inflation is a situation in which the general price level of goods and services is persistently moving upwards.

Inflation is a dynamic process in which the general price level of goods and services moves upwards over a period of time.

Inflation is a steady increase in the supply of money. Inflation is a situation where demand persistently exceeds supply. A process of steadily rising prices resulting in diminishing purchasing power of a given

nominal sum of money.

Types of Inflation

1. Hyperinflation - It is an extreme form of inflation. It takes place when prices shoot up at more than 3 digit

rate per annum.- During the period of hyperinflation paper money becomes worthless and price increases

get out of hand e.g. Germany experienced hyperinflation in 1923 after the 1st World War.- Hyperinflation is also called galloping inflation or runaway inflation.- By the end of 1923 in Germany prices were one million million times greater than the

pre-war level.- Towards the end of 1923 paper money was losing half or more of its value in one hour

and wages were fixed and paid daily.- In a hyperinflation situation, you go for shopping pushing a wheelbarrow of money but

coming back home goods not enough to fit your pocket.- Hungary also experienced also experienced hyperinflation in 1945 – 1946. The rate of

inflation averaged 20 000 per cent per month for a year and in the last month prices sky rocketed 42 quadrillion percent.

- In recent times Argentina, Brazil and Peru had hyperinflation in 1989 and 1990 as shown below.

Country 1989 1990Argentina 3.079,8% 2314,0%Brazil 1287,0% 2937,8%Peru 3389,6% 7481,7%

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

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- Zimbabwe experienced the worst hyperinflation during the period 2006 to 2008. Inflation rate was averaging 56 billion per cent. People would only know the prices of goods and services at the till.

- Prices were no longer stuck on goods and prices were changing and increasing many times a day.

- Under conditions of hyperinflation people lose confidence in the currency’s ability to carry out its functions. It becomes unacceptable as a medium of exchange.

2. Suppressed Inflation- This refers to a situation where demand persistently exceeds supply but the effect on the

prices is minimised by the use of such devices as price controls or rationing or controlled distribution of goods through public distribution system or subsidisation of commodities with high inflation potentials.

- In spite of these control measures, prices do rise and inflation does take place but at a lower rate than the potential rate in the open system.

3. Creeping Inflation- Creeping inflation is also called moderate inflation. The annual rate of inflation will be a

single digit.- During the period of moderate inflation price increases but at a moderate rate.- The moderate rate may vary from country to country. However, the important feature of

moderate inflation is that it is “predictable” and people hold money as a store of value.- The inflation is insidious (unseen but deadly) and persistent e.g. India has had creeping

inflation during the post independence period, except for a few years.- Most developed countries e.g. the UK and USA also experience creeping inflation.- After introduction of multicurrency denomination (i.e. dollarization) of the Zimbabwean

economy in 2009 February, the country also experiences creeping inflation.

Basic Theories of Inflation

Types of Inflation / Causes of Inflation

1. Demand Pull Inflation2. Cost Push Inflation3. Structuralist Inflation

1. Demand Pull Inflation

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Demand Pull Inflation may be defined as a situation where aggregate demand persistently exceeds aggregate supply at current prices so that prices are being pulled upwards.

Demand Pull Inflation can be broken into:

a) Keynesian Theory (Real Theory of Inflation) This was postulated by John Meynard Keynes. The Keynesians say that aggregate demand is greater than aggregate

supply, so prices are being pulled upwards.

b) The Monetarist Theory It was postulated by Milton Friedman. They believe that inflation arises when there will be too much money

chasing too few goods and services. The monetarists believe in the quantity theory of money. The quantity

theory of money is based on the belief that the general level of prices depends on the supply of money: if the money supply increases without a corresponding increase in the quantity of goods and services produced, then prices tend to rise.

From the quantity equation of money MV = PT (postulated by Irvin Fisher) M = money supply, V = velocity of circulation, P = price level, T =

transactions

P =

Assuming that V is constant. This implies that the general level of prices P is related to M. All economists agree that once a nation’s resources are fully employed, an

increase in demand must lead to an upward movement of prices.

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

2. Cost Push Inflation This occurs when prices rise as a result of the costs of production increasing more

rapidly than output.a. An increase in the costs of imported raw materials (imported inflation)b. A rise in wages unmatched by a rise in outputc. An increase in profits to meet the demand of shareholders would each tend

to push up prices.d. An increase in indirect taxes cause the supply curve to shift to the left and

prices increase.

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

3. Structuralist Inflation / Supply Stock Inflation Structuralist inflation is caused by structural bottlenecks caused by

underdevelopment in developing countries. Supply shock is caused by unexpected decline in the supply of major consumer goods or key industrial inputs.

These could be due to :a. Foreign currency shortagesb. Transport bottlenecks/shortagesc. Urbanisationd. Housing bottlenecks

Food prices shoot up due to crop failure / drought Prices of inputs e.g. coal, steel, cement, oil etc go up due to strikes. Rise in price may be caused by supply bottlenecks in the domestic economy or

international events e.g. wars e.g. sudden rise in OPEC oil prices of 1970s due to Arab – Israel war or current Middle East Crisis.

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4. Expectations induced Inflation Expectations can play a very important part in the causes of inflation e.g. if

workers expect prices to rise they are likely to react in advance of actual inflation by demanding higher money wages to retain the real value of their wages.

Similarly if firms expect inflation they are likely to respond by building in inflationary expectations into their price planning.

Government may anticipate higher costs of running public services and raise taxes in advance.

Also consumers expecting goods to be more expensive in the future may buy now rather than delay their spending.

The overall consequences are that the expectation of inflation can induce inflationary pressures both on the supply and demand side of the economy.

The expectations effect is illustrated in the diagram above.

Anticipated Inflation

If inflation is fully anticipated or foreseen then all individuals and firms in the economy expect it / foresee it and thus are able to gain full compensation for any consequential effects.

In this situation, inflation will have no significant effect on the overall wealth of the economy or on the distribution of income between the various sectors of the economy.

Banks may compensate for anticipated inflation by adjusting nominal interest rates on savings to ensure that real government returns are not diminished.

Governments may adjust tax thresholds to ensure that there is no fiscal drag effect resulting from inflation. Fiscal drag refers to the extent to which tax revenues increase automatically due to a nominal rise in incomes.

Also government may raise level of transfer payments e.g. pensions and unemployment benefits to ensure that the recipients receive the same real level of income.

In the case of anticipated inflation there will be no inflation or money illusion on the part of workers and employers. In other words workers do not confuse nominal and real

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wages (the real purchasing power of wages), such that they demand full compensation in terms of higher nominal wages to offset any anticipated inflation.

Money Illusion - e.g. suppose that your money income and the prices of goods you could buy were simultaneously doubled. Because your money income has risen you feel richer and now buy more of luxury goods and less of necessities, you would be said to be suffering from money illusion, since you have not realised that your real income has remained the same.

Unanticipated Inflation

If the actual rate of inflation is not fully anticipated, then the real level of wages, interest rates, taxes and transfer payments may be affected.

There are mainly 2 consequences of unanticipated inflation namely redistribution effects and uncertainty.

Redistribution effects i.e. an arbitrary redistribution of income. There will be gainers and losers i.e.

a) From lenders to borrowers. With unanticipated inflation the value of debt falls, borrowers gain. Savers and lenders lose.

b) From those on fixed incomes to those whose income adjusts in line with inflation.c) From tax payers to government.

Uncertainty – unanticipated inflation makes business forward planning more difficult with respect to future prices, wages, profits etc thus creating uncertainty. Such uncertainty may in turn discourage investment expenditure by the private sector with negative consequences for output and long term economic growth.

Consequences of Inflation / Effects of Inflation

1. Effects on the distribution of incomeInflation leads to an arbitrary redistribution of income. Some groups of workers are able to negotiate larger pay increase because of a strong bargaining position. Others fall behind and their real income fall e.g. people receiving unemployment benefits and people receiving social security benefits. With inflation there will be some “gainers” and “losers”.

2. Effects on Production Demand pull inflation results in complacency and inefficiency in a firm. Since the

competitive pressures to improve both the product and performance are greatly weakened.

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With cost push inflation, some firms can no longer absorb some of the higher factor prices. Hence, firms will try to economise in their production methods and end up retrenching some workers resulting in an increase in unemployment.

3. Effects on Balance of Payments (BOP) For countries which are highly dependent upon a high level of imports or exports

inflation often leads to BOP difficulties. If other countries are not inflating to the same extent, home produced goods will become

less competitive in foreign markets and foreign goods will become more competitive in the home market. Exports will decrease and imports will increase. If this process continues, it leads to BOP deficit on the current account.

4. Effects on Savings Inflation can lead people to reduce their savings in banks. Why hanging onto money

when its purchasing power is losing value by the day e.g. suppose a savings account yields 6% interest rate. The 6% interest rate is money earned / nominal. But if inflation rate goes up to 8%, then the saver is actually losing 2% per year of purchasing power.

The saver is likely to decide to spend money immediately and enjoy its present purchasing power.

5. Net taxing people who previously did not pay tax

One of the effects of inflation is to net tax some people who previously did not pay income tax e.g. suppose your first $2000 of income is tax free and income tax is payable at a rate of 25%. If in Year 1 your income is $2000 you don’t pay any tax. By Year 2 prices have risen by 10% and your income which is now $2200. You now have to pay 25% tax on $200 which reduces your money income to $2150. $2150 will not purchase as much in Year 2 as $2000 did in Year 1. So your real income will have fallen.

6. Menu Costs These are costs associated with having to adjust price lists and labels. For firms, they would again be the relatively minor costs of having to change the price

labels, or prices in catalogues or on menus or just slot machines and automatic vending machines.

Terms to Note

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Deflation Deflation is a reduction in the general level of prices Antonym of inflation / opposite

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

will result in lower levels of national incomes, employment and imports as well as lower rates of increase of wages and prices.

It may be brought about by monetary policies such as increases in rates of interest and contraction of money supply, and/or by fiscal policies such as increases in taxation (direct and indirect) or decreases in government expenditure.

The aims of deflation may be to improve the BOP, partly by reducing aggregate demand and thus imports and partly by causing disinflation and improving exports.

Deflation is also the adjustment of an economic variable measured in money terms by a price index (index number) in order to give an estimate of the change of the variable in real terms.

Stagflation It is situation in which rapid inflation is accompanied by stagnating or declining output

and employment. It is characteristic of cost push inflation rather than demand pull inflation.

Companies experience increased costs of raw materials and/or of labour which reduces their profitability and forces them to raise their own prices and cut investment.

The government is then faced with the dilemma that measures to reduce the rate of inflation generated in this way may exacerbate unemployment.

Reflation Macroeconomic policy designed to expand aggregate demand in order to restore full

employment levels of national income. Typical reflationary measures include expansion the money supply with consequent

reductions in interest rates, increases in government expenditure and reduction in taxation.

Controlling Inflation / Fighting Inflation / Cures to Inflation

Fighting Demand Pull Inflation Excess demand is a source of demand pull inflation. Any policy aimed at fighting this

type of inflation must target excess demand. The Keynesians emphasize fiscal policy i.e. tax changes and government policies to

lower excess demand. Monetarists emphasize too much money supply as a source of inflation. Hence they

emphasize a “stabilised” money supply control.

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a) Using Fiscal Policy Aggregate Demand = C + I + G + (X- M) Any component of aggregate demand can be directly attacked in order to reduce

demand pull inflation. Consumption (C) can be reduced by raising indirect taxes. Higher indirect taxes

take money from consumers and reduce their demand or ability to purchase goods and services.

Investment (I) can be reduced by placing higher corporate taxes on business profits. This will reduce the amount of money available to businesses for investment purposes. Investment can also be reduced by increasing interest rates. This makes it expensive for businesses to borrow money for investment purposes.

Government Expenditure (G) can be reduced by reducing government expenditure on e.g. public goods, merit goods, highway construction, transfer payments etc.

Net export i.e Exports – Imports (X – M) can also be attacked by putting restrictions on international trade e.g. tariffs, quotas, subsidies, exchange controls etc. This will reduce imported inflation.

b) Using Monetary Policy Monetarists propose stabilising and controlling money supply growth rate so that

it matches the rate of growth of the economy – prices of goods and services will not increase.

Monetary policy advocates the use of the following instruments to control money supply growth:-i) Bank rate/ rediscount rateii) Reserve requirement ratio (RRR)iii) Special depositsiv) Open Market Operations (OMO)v) Moral suasionvi) Prime lending ratevii) Repo rateviii) Tight hire purchase facilities

Fighting Cost Push Inflation

a) Wage Price Guidelines When the government sets up wage price guidelines, it is asking the industry and

labour to stay within set limits in their price and wages policies. Since the goal is to keep wages and prices from rising too high, the government

will formulate % increases for both labour and businesses for example the

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government might determine that 5% increase is a reasonable limit for both wage and price increases.

Increases can be less than 5%. In order to enforce wage price guidelines, the government will have to move around and rally to negotiate the acceptable increases.

b) Wage Price Controls The government can implement wage price controls to prevent any wages and

prices rising. The strategy represents a drastic change in economic systems. When wage price controls are implemented, the market economy ceases to exist.

The economy becomes a command economy. Examples of wage price controls are maximum, minimum prices and buffer

stocks.

c) Tax Based Income Policies (TIP) TIP mean using tax as a penalty for raising wages too rapidly or as a reward for

raising wages less rapidly than some target level. In most cases TIP would affect the employer e.g. suppose its decided through

elected representatives that the acceptable rate of increase in wages and salaries should be 5%. If businesses give their employees more than 5% wage increase, corporate tax on their profits will be increased.

If an employer gives his employees less than 5% wage increase, corporate taxes will be reduced.

Fighting Structuralist Inflation The only cure for structural and other inflation caused by shortages is time. In the short

run period, people must simply adjust to current reality and new structure. Eventually the economy will re-gear itself to produce the product that is in short supply. One possible way of eliminating structuralist inflation is to stockpile raw materials like

oil, uranium, copper and even some agricultural products for reasons of national security during war / drought.

Indexation Economists argue that if controlling inflation is not advisable, its adverse effects on

different sections of society can be minimised by a method called indexation. They suggest that indexation of prices, wages and contractional obligations with a view

to compensating those who lose their real incomes due to inflation. Indexing is not a mechanism by which wages, prices and contracts are partially or

wholly compensated for changes in the general price level.

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Indexation is not a method of controlling inflation. It is a method of adjusting monetary incomes to as to minimise the undue gains and losses in real incomes of different sections of the society due to inflation.

The main objective of indexation is to manage social discontent. Its objective is to make inflation easier to live with.

Indexation of wages is the most important and common practise in many countries where wage contracts are long term and inflation continues to persist.

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UNEMPLOYMENTDefinition

Unemployment is a situation which exists when members of the labour force wish to work but cannot obtain a job (i.e. the able bodied people).

Unemployment is a situation where the economically active population fail to find jobs (i.e. 16-65 years).

Unemployment is the total workforce that is not working at any given time. Unemployment is the total number of those of working age who are without work, who

are available for work at current wage rates.

Labour force or workforce is the number of people employed plus the number unemployed.

Unemployment rate refers to the % f workforce that is unemployed at any given time.

Unemployment Rate = x 100

Measuring Unemployment

1. Claimant Count This includes as unemployed anyone between ages of 18 – 60 years receiving an

unemployment related benefit such as job-seekers allowance (main official measure in the UK).

Advantages

a) Relatively inexpensive to calculate.b) Available frequently (normally monthly).c) Available quickly.d) 100% count gives figures for small areas.

Disadvantages

a) Not internationally recognised.b) Coverage changes whenever administrative system changes, although

recalculation of consistent series allows meaningful comparisons over time.c) Coverage depends upon administrative rules, may not be suitable for other

purposes.d) Limited analysis of characteristics of unemployed people.

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2. Labour Force Survey This uses International Labour Organisation’s (ILO’s) definition of

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

Advantages

a) Internationally standardised.b) Usable for inter-country comparisons.c) Considerable potential for analysis of other labour market characteristics, or of

particular sub-groups.d) Articulated with data from the same source on employment and the economically

inactive.

Disadvantages

a) Relatively costly to compile.b) Normally less timely.c) Subject to sampling and response error.d) Not always suitable for small areas due to sampling limitations.

Types and Causes of Unemployment

1. Residual Unemployment Is made up of people who are virtually unemployable on a permanent basis. These are people who find it difficult or impossible to cope with the demands of

modern productions methods and the disciplines of organised work. This may be due to disability.

2. Frictional Unemployment This arises from immobilities in the labour force. Labour is not perfectly geographically or occupationally mobile, so people can

remain unemployed despite the fact that there are jobs available either in other parts of the country, or requiring skills they do not have.

3. Seasonal Unemployment This occurs in those industries which experience marketed seasonal patterns of

demand. Industries such as farming, building, tourism etc are affected in this way.

4. Structural Unemployment

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This is unemployment which arises from a permanent decline in demand for an industry’s product.

Much of the fall in demand is as a result of people buying goods from suppliers elsewhere.

The decline will result in workers employed in that industry being laid off / retrenched.

5. Technological Unemployment This arises from introduction of new technology / machinery. Manufacturers have endlessly found ways of substituting machinery for people in

their production methods and such workers are made redundant e.g. the introduction of harvesters, computers, industrial sewing machines have led to many workers being laid off because work will no longer be done manually.

People or workers are being replaced by machinery since machinery do not get tired i.e. can work 24 hours a day except when being serviced but people get tired.

6. Cyclical Unemployment (Demand Deficiency Unemployment) It arises due to inadequate demand for goods and services – firms will find no

reason to keep on employing workers and hence lay them off to the streets.

7. Search Unemployment This is a form of frictional unemployment. It occurs when people who are unemployed do not take the first job on offer but

search for better paid unemployment.

8. Casual Unemployment This is again a form of frictional unemployment. There are certain groups of people who are out of work between periods of

employment e.g. singers, actors, footballers etc

9. Disguised Unemployment A potential addition to the labour force which does not reveal itself unless

opportunities are actually available. Consequently it does not show up in unemployment statistics e.g. married women

who are full-time housewives.

10. Regional Unemployment This is linked to structural unemployment. It arises when declining industry is concentrated in one area. The region dependent upon the industry may suffer particularly heavy

unemployment because there will be a local multiplier effect arising from the

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decline in the income granted by the major industry e.g. the copper belt of Zambia.

11. International Unemployment This arises when workers lose their jobs due to a fall in demand for domestically

produced goods

Stocks and Flows of Unemployment

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

However this stock of people is influenced by the flow of people into the stock and the flow of people leaving the stock.

New people ordering the stock of unemployment will not only be those losing jobs but previous non-participants in the labour force who are now seeking employment e.g. students finishing degree courses who cannot find employment.

People who leave the stock may have given up looking for work, may have retired, may have joined a government scheme or may have entered a higher education.

Unemployment will rise if the number entering the stock exceeds the number of new jobs.

Equilibrium Unemployment Equilibrium unemployment is the unemployment which exists when aggregate demand

for labour (ADL) is equal to aggregate supply of labour (ASL) and vacancies match the number unemployed.

This is shown in the diagram below:

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ADL = aggregate demand for labourASL = aggregate supply of labourALK = total labour force

The labour market is in equilibrium at wage rate OW but there is unemployment LLX. Disequilibrium unemployment occurs when there is disequilibrium in the labour market.

This can be due to the fact that ASL > ADL or ADL >ASL. Reasons for disequilibrium unemployment are :

a) Trade union powerb) Government set minimum wage ratec) Growth in labour supply not matched by a rise in aggregate demand for labour.d) A fall in aggregate demand.

Effects / Consequences of Unemployment Unemployment has consequences for the unemployed themselves and for the society as a

whole.

Benefits of Unemployment1. Benefits to those unemployed

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

(frictional and search unemployment).

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

opportunities.

2. Benefits to the society

Unemployment creates greater flexibility. The economy will be able to expand

relatively quickly and easily if there is a pool of suitably qualified unemployed

workers.

Unemployment also reduces cost push inflation by lowering wage claims, makes

workers more willing to accept new methods of production and more reluctant to take

industrial action.

Note: But however, costs of unemployment exceed any possible benefits.

Costs of Unemployment

1. Costs to the unemployed

People may have more time to pursue leisure activities but they may be

constrained from doing so by lack of income.

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

stigma is still attached to being unemployed.

Unemployed people are more likely to experience divorce, nervous breakdowns,

bad health and are more likely to attempt suicide than the rest of the adult

population.

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

up becoming redundant / useless.

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

training in new methods.

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

they are likely to find or gain another job.

Unemployed people end up becoming redundant people.

2. Costs to the society

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Output is lost due to unemployment. Even if unemployment later falls, the loss of

output can never be regained.

People will enjoy fewer goods and services than they could have consumed with

higher employment. The country will be producing inside the ppf at point X as

shown below.

Unemployment depresses income and thereby deprives the government of both direct and indirect tax revenue. While government revenue will fall as unemployment rises, it will have to increase its spending on unemployment related benefits.

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In recent years, there has been evidence of a link between crime and unemployment particularly in the case of young unemployed men.

The burden of unemployment is not borne evenly by the society. The young people from ethnic minorities and those lacking skills are more likely to experience unemployment.

Unemployment also results in the emergence of corruption because the unemployed may end up paying bribes to secure employment.

Unemployment also results in sexual abuse/sexual harassment especially of women.

Anti-devial practices also emerge e.g. prostitution, robbery, murder etc because the unemployed will be trying to find a source of income for survival.

Emergence of black markets e.g. doing things at the back door.

Classical UnemploymentClassical economists believe that unemployment occurs when wage rates are too high for firms to offer sufficient employment to clear the labour market.

Voluntary UnemploymentIt is unemployment that results because people choose not to accept the jobs available.

Involuntary unemploymentIt occurs when people are actually seeking work but are unable to obtain it.

Solutions to Unemployment / Controlling/ Fighting Unemployment

The Classical Economists The classical economists believe that unemployment occurs when wage rates are too high

for firms to offer sufficient employment to clear the labour market. According to this view unemployment can most effectively be reduced by lowering wage

rates. However lowering wage rates is not easy especially if prices have risen. Those in

employment are unwilling to accept lower wages and many of the unemployed will not be prepared to take jobs at the lower rate.

The Keynesians The Keynesians believe that the way to reduce unemployment is to increase aggregate

demand. A government might do this either by reducing taxes and leaving people with more money to spend on goods and services for consumption, or by increasing government spending.

This is called demand side economics as it takes the view that the way to solve economic problems is by managing demand.

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New or Neo Classical Economists They argue that increasing demand will only be successful in reducing unemployment in

the short run period. In the long run period, it will cause inflation accompanied by a rise in unemployment. They believe that there is a natural level of unemployment, and barriers exist to prevent

unemployed people from accepting jobs at wage rates necessary to clear the labour market.

New classicals consider that unemployment should be tackled form the supply side of labour, rather than trying to manage demand.

The New Classicals advocated the following policies in order to reduce unemployment. Increase income thresholds, or reduce rates in the lowest tax band, increase the

level of the minimum wage. Reduce benefits to the unemployed (Job Seekers’ Allowance, National Insurance

credits), or ay top-up allowance to those unemployed who accept low paid jobs (Welfare to Work incentives).

Increase the skills of the unemployed by providing training opportunities both in full time work and education.

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ECONOMIC GROWTH AND ECONOMIC DEVELOPMENT

Definitions Economic growth occurs when an economy achieves an increase in income measured by

GNP in excess of its rate of population growth. This will lead to increase in GDP per capita.

Economic growth is the steady process of increasing productive capacity of the economy and hence of increasing national income.

Economic growth is any increase in the total output of the economy from one year to another.

Economic growth is the rate of increase in an economy’s potential real output (the volume of output) in the economy over time.

Economic growth can be illustrated by the movement outwards of the ppf. This results in the supply of more goods and services in the economy.

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

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

Causes of Economic Growth / Ways of Promoting Economic Growth

1. Increased skills and educationEducation and training are often described as “investment in people” and people play an important part in raising the productivity of the labour force. The lack of these facilities provides a serious barrier to more rapid economic progress in the developing countries.

2. Economies of ScaleLarge scale production can raise productivity. There is much more scope for growth through economies of scale in developing countries than in larger industrialised societies.

3. InvestmentFor economic growth to take place, there must be net investment i.e. the additions to the national stock of capital. Increasing the amount of capital per worker is known as “capital deepening” and this process should lead to increasing labour productivity. The investment must be channelled toward sectors such as manufacturing, commercial and agricultural for economic growth to take place.

4. New TechnologyNew technology includes such things as new inventions, new techniques of production, improvements in the design and performance of machinery, better organisation and management, more efficient factory layouts better training facilities and more efficient systems of transport and communication. New technology increase the industry’s productive potential leading to economic growth.

5. Reallocation of resources As economic development takes place, there is a tendency for labour to shift first

from primary production (agriculture, mining etc) to secondary production (manufacturing) and later to services industries.

Normally output per worker tends to grow rapidly in agriculture and manufacturing than in the service industry (ies) since it is more difficult for people such as doctors, teachers and civil servants to raise their productivity. It is also the case that productivity has tended to rise more rapidly in manufacturing than in agriculture.

Since the 2nd World War, there has been a substantial movement of labour from agriculture to manufacturing; there have also been some very high growth rates recorded.

In the USA and UK, the service sector has tended to grow much faster than other sectors.

6. Natural Resources

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An economy may benefit from the discovery and development of natural resources. Existence of natural resources offers are important source of economic growth e.g. discovery of diamonds in Zimbabwe.

Benefits and Costs of Economic GrowthThe Benefits

Generally the standard of living will rise. People will have more access to goods and services. Development should lead to more choice not simply in terms of more goods but in

opportunities. The country becomes independent; its destiny to a greater degree will be in its own

hands. The country ceases to seek for aid e.g. from the IMF, World Bank and other organisations and NGO’s.

With development / economic growth usually comes a whole set of statistics favourable to people’s well-being e.g. higher life expectancy, better literacy rates, lower child mortality or IMR, more doctors and nurses per head of population etc. Number of TVs per 1000 population, number of telephone per 1000 population, teacher/pupil ratio, doctor/patient ratio.

Economic growth makes it possible to devote more resources to social services without having to cut private consumption.

The Costs If economic growth is not planned carefully, then depletion of natural resources is likely

to follow. Economic growth gives rise to a variety of social costs. Rising incomes make it possible

for more people to own cars but this could lead to problems of pollution and traffic congestion.

Modern production methods destroy the natural beauty and the ecosystem e.g. modern methods of agriculture and the installation of oil refineries and generating stations of power e.g. electricity

The rapid pace of economic change e.g. technical progress makes machines and production methods obsolete and also make people redundant – there will be instability i.e. booms and slumps in economic activity.

Dual economies can exist within the same country, where one sector thrives whilst another stagnates due to neglect (e.g. rural vs. urban development).

There can also be social and cultural conflict. Should the country allow the development of a natural resource such as oil if this means the destruction of a way of life of particular ethnic groups living in that vicinity?

The benefits of economic growth may not be evenly spread. There are some losers and gainers.

Economic growth can result in depletion of the ozone layer resulting in global warming and melting of polar ice.

Preconditions for Economic Growth

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1. Human ResourcesThe quality of human resources can be increased by improvements in education training and health.

2. Capital ResourcesOutput per head will increase with capital deepening and with technology.

3. Natural ResourcesFertile land and favourable climate and good supply of minerals and fuels are obviously beneficial. However, a number of advanced countries e.g. Israel do not possess good supply of natural resources.

4. Allocation of ResourcesTo increase income per head, resources should be moved from low productivity industries to high productivity industries.

5. Innovation Economic growth will be stimulated by the adoption of new methods, improved technology, better communications and advanced management techniques.

6. International trade especially exporting of goods and services. International trade is considered as an engine for economic growth.

ECONOMIC GROWTH THEORIES

Stages of Economic GrowthThere are 5 stages of economic growth which all economies are considered as going through in their development from fairly poor agricultural societies to highly industrialized mass consumption economies. These 5 stages were analysed by W.W. Rostow in 1960.

Stage 1 – Traditional SocietyThe economy is dominated by subsistence activity where output is consumed by producers rather than traded. The trade is carried out by barter where goods are exchanged directly for other goods. Agriculture is the most important industry and production is labour intensive using only limited quantities of capital. Resource allocation is determined very much by traditional methods of production.

Stage 2 – Transitional Stage (the preconditions for Take Off)Increased specialization generates surpluses for trading. There is an emergency of a transport infrastructure to support trade. As incomes, savings and investment grow, entrepreneurs emerge. External trade also occurs concentrating on primary products.

Stage 3 – Take OffIndustrialization increases with workers switching from the agricultural sector to the manufacturing sector. Growth is concentrated in a few regions of the country and in one or two manufacturing industries. The level of investment reaches 10% of GNP. The economic

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transitions are accompanied by the evolution of new political and social institutions that support the industrialization. The growth is self sustaining as investment leads to increasing incomes in turn generating more savings to finance further investment.

Stage 4 – Drive to MaturityThe economy is diversifying into new areas. Technological innovation is providing a diverse range of investment opportunities. The economy is producing a wide range of goods and services and there is less reliance on imports.

Stage 5 – Era of High Mass ConsumptionThe economy is geared towards mass consumption. The consumer durable industries flourish. The services sector become increasingly dominant.

According to Rostow, development requires substantial investment in capital. For the economies of developing countries to grow, the right conditions for such, investment would have to be created. If aid is given or foreign direct investment occurs at stage 3 the economy needs to have reached stage 2. If stage 2 has been reached, then injections of investment may lead to rapid growth.

Limitations of Rostow’s Theory

Many development economists argue that Rostow’s model was developed with western cultures in mind and is not applicable to developing countries.

The generalized nature of the theory makes it somewhat limited. It does not set down the detailed nature of the preconditions for growth.

In reality policy makers are unable to clearly identify the stages as they merge together. Thus as a predictive model its not very helpful.

Perhaps the main use of the theory is to highlight the need for investment. Like many other growth models, it is essentially a growth model and does not address the

issue of development in the wider context.

THE HARROD DOMAR GROWTH MODEL

LEWIS’S DUAL SECTOR MODEL OF DEVELOPMENT (THE THEORY OF TRICKLE DOWN)

THE DEPENDENCE THEORY

THE CLASSICAL GROWTH THEORY

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ECONOMIC DEVELOPMENT

Economic growth occurs when an economy achieves an increase in income measured by GNP or GDP in excess of its rate of population growth. This will lead to an increase in GDP per capita.

Economic development In its World Development Report in 1991, the World Bank offered the following view of

development:-“The challenge of development …. is to improve the quality of life especially in the world’s poor countries, a better quality of life generally calls for higher incomes – but it involves much more. It encompasses as ends in themselves better education, higher standards of health and nutrition, less poverty, a cleaner environment, more quality of opportunity, greater individual freedom and a richer cultural life”

Although the statement acknowledges that economic growth is important, it makes clear that higher income in itself is not sufficient to ensure that there is a rise in the quality of life of citizens of a country.

There is a much broader view of development than the one confined to increases in GND. It is one that provides a focus for those responsible for development policy planning and moves away from measures designed purely to increase and maintain the economic growth target.

Todaro states that development must be seen as a multi-dimensional process:-“Development must represent the whole gamut/ range of change by which an entire social system, tuned to diverse basic needs and the desire of individuals and social groups within that system moves away from a condition of life widely perceived as unsatisfactory toward a situation or condition of life regarded as materially and spiritually better”.

According to Todaro and others, the movement to a better life can be analysed and measured against core values.1) Sustanance – the ability to meet basic needs.2) Self esteem – to be a person.3) Freedom of servitude – to be able to choose

Development is the growth and change in societies and countries. It usually involves some improvement of people’s lives so that they become better, happier and freer. However some changes have bad effects and make life worse.

Aspects of developmentThere are 4 aspects of development which are:-

1) Economic aspects – A country is developed economically when it produces more for each person and the society gets richer and there are more goods and services being produced. There is therefore economic growth.

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2) Social Aspects – A country is developed socially when people have a better standard of living and their basic needs are more fully met. The basic needs are:-a) Food to eatb) Clean water to drinkc) Shelter for protectiond) Clothes for warmthe) Basic health f) Basic education

3) Political aspects – a country is developed politically when there is freedom and justice. People have more control over their lives. They have freedom of movement, association, speech and people have the right to vote. There is no violation of human rights in terms of physical and sexual abuse. There are equal opportunities for all i.e people have political rights.

4) Environmental aspects A country is said to be developed environmentally if resources on the earth’s

surface are used and enjoyed by the current generations and also preserved for future generations.

The resources i.e wildlife, vegetation, minerals, air to breathe, soil etc must not become extinct in the future.

Future generations must not be jeopardised form seeing present resources eg what happened to dinosaurs, some wildlife and even vegetation which is now extinct.

The air we breathe must continue to be fresh air even for future generations. There is currently a lot of emissions of gases into the atmosphere (pollution). The ozone layer is being destroyed. Polar ice is melting and there are a lot of climatic changes eg floods etc. There is need to look at sustainable development.

Indicators of comparative developmentClassification according to levels of incomeEconomies are classified according to GNP per capitaThere are 3 ways of classifying countries according to GNP per capita which are:-

1) Low income – countries with per capita GDP of $755 or less per annum.2) Middle Income

a) $756 to $2 995 (lower middle)b) $2 996b to $9 265 (upper middle)

3. High income – $9 266 or above The income levels are above annual. The thresholds between the categories are updated each year for international rates of

inflation. As a result the thresholds are constant in real terms over time. Low and middle income countries are also classified as developing countries. High income countries are classified as developed countries or advanced countries or

highly industrialized countries.

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Classification according to the level of indebtedness Developing countries can also be classified according to the degree of their

indebtedness. These categories are:

1. Severely (or highly) indebted2. Moderately indebted 3. Less indebted

The categorization depends upon a number of measures of international indebtedness, the most important of which is devoted to servicing debt.

The fact that such categorization is used is a reflection of the extent to which international indebtedness is an obstacle to economic development.

Measures of Development1. IMF classification

a) Industrialized countriesb) Developing countriesc) Transitional economies

2. World Bank and UN Classificationa) High incomeb) Middle incomec) Low income

3. UN further classificationa) High human developmentb) Medium human developmentc) Low human development

Most of these categories are based on income per head measurement. The UN now sticks to the Human Development Index (HDI). In 1997, the UN started to publish a new measure i.e. the Human Poverty Index (HPI)

based on people in a country who don’t have / reach minimum standards e.g. % of people without health services adequate supplies of food, shelter and sufficient free time.

Economic StructureEconomic activity can be placed in the following sectors:

1. The Primary sector2. The Secondary Sector3. The Tertiary Sector Developing countries are dependent on the primary sector which account for e.g. 30 –

60% of GDP. The tertiary sector / services sector account for a greater % of GDP in developed /

industrialized countries.

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As the country develops it moves from primary sector to secondary sector to tertiary sector.

Characteristics of Developing Countries

1. High birth rates, relatively high death rates and a low life expectancy.2. Concentration or high dependency on the primary sector compared to the secondary and

tertiary sectors.3. A poor natural resource endowment.4. Underemployment of resources.5. Social, religious and cultural patterns which often act as a barrier to change and

development.6. Low levels of investment in human capital.7. A heavy dependency on a narrow range of export products (usually) primary products.8. An inadequate industrial and social infrastructure.9. Low literacy rate and school enrollment.10. High infant mortality rate.11. Low GNP per capita.12. Low energy use.13. High pupil/teacher ratio.14. High patient/doctor ratio.15. A totally inadequate industrial and social infrastructure.16. Low quality of labour.

Conditions for Development Human resources. Capital Resources. Natural Resources Allocation of Resources Innovation

Development Strategies Increasing primary production Industrializing through important substitution Promoting exported growth Borrowing from abroad Relying on foreign aid Population policy i.e. limiting the growth of the population

INTERNATIONAL TRADE

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Definition

International trade involves the exchange of goods and services across international boundaries.

International trade is the exchange of goods and services between one country and another.

Uniqueness of International Trade

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

There are many restrictions imposed by governments and international organizations on international trade as opposed to home trade.

Communication may be difficult during the trading process since different countries speak different languages.

Higher costs may be involved including the possibility of greater transport costs, the need to translate languages.

Firms may also face differences in technical and legal requirements in overseas markets. There are also extra costs involved in international trade including wars and families

abroad. Different units of measurement might be used e.g. kilograms versus pounds, kilometers

versus miles, °C versus °F etc. Different exchange rates are used and this is worsened by exchange rate fluctuations.

Why do countries specialise and trade?

Countries specialize and trade because of the benefits of international trade which are:-

1. To get goods that they cannot produce themselves.2. To get goods and services which they can produce themselves but can be produced more

cheaply elsewhere.3. To benefit from economies of scale by mass production because the market is big.4. To get rid of surplus.5. T o foster international relations.6. To earn foreign currency.7. To achieve economic growth and economic development.8. Consumers to have a variety of goods and services – more choice.

Definition of Terms

Exports

These are goods and services sold to other countries. An export is represented by a flow of money coming into the country (capital inflow).

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Imports

Imports are goods and services bought from other countries. An import is represented by a flow of money leaving the country and going abroad – capital outflow.

Visible trade

It involves trade in goods such as e.g. oil, machinery, groceries, food, chemicals etc. Trade in goods is called visible trade simply because imports and exports of goods may be seen, touched, weighed and measured as they pass through the borders or ports.

Balance of Visible Trade

When a country sells visible exports, it earns money. When it buys imports it pays money. Therefore the balance of visible trade measures how well a country does overally on visible trade.

Balance of Visible Trade = Value of visible exports – Value of visible imports

if positive – favourable

Negative- unfavourable

Invisible Trade

- Involves the exchange of services i.e. import and export of services such as WABTIC, tourism, entertainment etc which can’t be touched, seen, weighed/measured when they pass through borders or ports hence the name invisibles.

- If a person buys a foreign holiday he is paying for a foreign service which takes money out of the country and so is an invisible import.

- If a buys insurance, he is buying a service which brings money to the country and this is an invisible export.

- How well a country does in invisible trade is measured by the invisible balance.

- Invisibles include interests, profits and dividends. A country earns interest on money saved or loaned abroad, profits from firms owned abroad and dividends on shares held in foreign companies.

- On other hand, a country pays interests and dividends on savings, loans and investments made by foreigners.

- A number of transfers are also made between countries e.g. UK can give aid to developing countries and also pays contributions to the European Union (EU).

- If the Balance of Invisible Trade is positive then the country has a surplus or favourable BOT.

- If the balance is negative, then the country has deficit on the BOT. A deficit means that the country is losing each year to foreigners i.e. importing more than exporting.

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- This is said to be unfavourable BOT.

The Mercantilists

During the period 1500 – 1800, a group of writers appeared in Europe who were concerned with the process of nation building.

According to the mercantilists, the central question was how a nation could regulate the domestic and international affairs so as to promote its own interests.

The solution lay in a strong foreign-trade sector. If a country could achieve a favourable trade balance (a surplus of exports over imports),

it would realise net payments received from the rest of the world in the form of gold and silver.

Such revenues would contribute to increased spending and arise in domestic output and employment.

To promote a favourable trade balance, the mercantilist advocated government regulation of trade.

Tariffs, quotas and other commercial policing were proposed by mercantilists to minimise international trade.

The Gains from International Trade

- In the real world international trade is carried on by a large number of countries in a vast range of goods and services.

- This is a very complex situation but it is possible to gain an understanding of the principles which underlie this complicated economic structure by using a very simplified model.

Assumptions

a) There are two countries, Country A and Country B.b) Only 2 commodities are produced i.e. tractors and wool.c) There are no barriers to trade and no transport costs.d) Resources within each country are easily transferred from one industry to another.

Absolute Advantage Theory by Adam Smith

- This is the fairly realistic situation where each country is more efficient than the other in the production of one of the commodities.

- Absolute advantage means that given the same amount of resources, Country A can produce more output compared to Country B.

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- Country B, we will assume produces wool more efficiently than Country A while Country A has an absolute advantage in the production of tractors.

Tractors Wool (bales)With x resources Country A can produce (per annum)

20 100

With x resources Country B can produce (per annum)

10 50

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

Example

- Assume that UK and USA both produce 2 commodities i.e. wheat and music centres.

- Each country we assume will have 100 workers, half devoted to wheat production and half to the production of music centres- total output per year for both countries is:

Music Centres Wheat (tonnes)UK 50 30USA 40 35Total 90 65

- USA is better than UK at producing wheat. With the same number of workers USA can produce 5 tonnes more of wheat than UK – USA has an absolute advantage over UK in the production of wheat.

- UK has an absolute advantage also in the production of music centres.

- If each country specialises or concentrates in the production of one commodity, USA would concentrate on wheat production only and UK on music centres. The total output for both countries will rise.

After Specialisation

Music Centres produced by 100 workers (only in UK)

Wheat (tonnes) produced by workers (only)

UK 100 0USA 0 70Total 100 70

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- The example assumes that 100 workers can produce twice as much as workers i.e. there are no diminishing returns to labour.

- If UK agrees to trade music centres for 30 tonnes of wheat from USA, each country after trade is better off.

Music Centres Wheat (tonnes)UK 60 30USA 40 40Total 100 70

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

Comparative Advantage Theory by David Ricardo

- A country has a comparative advantage over another in the production of a good if it can produce it at a lower opportunity cost i.e. if it has to forgo less of other goods in order to produce it.

- The Law of Comparative Advantage says trade can benefit all countries if they specialise in the goods in which they have a comparative advantage.

- The principle of comparative advantage says that production of both products will be increased if each country specialises to some extent in the products in which they have a comparative cost advantage.

- It still benefits countries to specialise and trade even if one does not have an absolute advantage in the production of a commodity.

Cars TelevisionsJapan 100 400Germany 80 160Total 180 560

- Japan has an absolute advantage in the production of both goods. However in Japan, they will need to give up 4 televisions to produce one extra car.

- In Germany only 2 televisions will have to be given up to produce one extra car.

- So Germany has a comparative advantage in car manufacturing while Germany is less efficient than Japan in producing both goods. It is least efficient in car production.

- By specialising in car production, Germany can export cars and import televisions with their export earnings.

- Japan should concentrate n the production of televisions.

- Both countries can gain from specialisation and trade.

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Opportunity Cost of 1 car in Japan = 4 TVsOpportunity cost of 1 car in Germany = 2TVsTherefore Germany produces cars more effectively than Japan. Hence Germany has a comparative advantage in the production of cars.

Opportunity Cost of 1 TV in Japan = Cars

Opportunity cost of 1TV in Germany = Cars

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

- Japan and Germany now specialise, trade and mutually benefit from their comparative advantages.

- Assume that each country has 10x resources and in the absence of international trade

devotes its resources to each industry.

Cars TelevisionsJapan 500 2000Germany 300 800Total 800 2800

- If trading possibilities arise, each country will specialise in that industry in which it has a comparative advantage.

Cars TelevisionsJapan 200 3200Germany 0 1600Total 200 4800

- By partially specialising the more a efficient a country can have more of both commodities. Thus if Japan devotes 2x resources to cars and 8x resources to TVs while Germany specialises completely in the production of cars the above situation results.

- We now have greater total output of both commodities than that which was obtained when both countries were producing for only domestic consumption.

- The countries i.e. Japan and Germany can now trade and mutually benefit.

Barriers to Trade

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

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Types

1. Tariffs- A tariff is a tax on the price of imports.

- Tariffs are used to raise the price of imports and make them more expensive compared to home produced goods in order to stop people from buying them.

- Tariffs encourage retaliation by other countries.

- Tariffs can either be specific or advalorem.

- E.g. of a specific tariff - $100 per unit imported

- E.g. of an advalorem tariff – 10% per unit imported2. Subsidies- A subsidy is a grant given to an industry by the government so that the industry can lower

its prices.- Subsidies are used to stop consumers from buying foreign imports and making local

goods cheaper.- Subsidies can be applied to domestic goods to prevent foreign competition from

otherwise lower priced imports. - They can also be applied to exports in a process known as dumping.

- The goods are “dumped” at artificially low prices in the foreign market (This, of course is a means f artificially increasing exports rather than reducing imports).

3. Quotas- A quota is a physical limit on the number of imports allowed into the country per year. A

quota reduces the quantity of imports without changing prices.4. Embargo- An embargo is a complete ban on the imports of certain goods into a country e.g.

stopping imports of dangerous drugs like Heroin, Dagga or Marijuana.- An embargo is also imposed in order to punish a country for political reasons by refusing

to buy its goods and services – sanctions.5. Foreign Exchange Controls- These include limits on how much foreign exchange can be made available to importers

(financial quotas), or to citizens travelling abroad, or for investment.- Alternatively they may take the form of charges for the purchase of foreign currencies.6. Export Taxes- These can be used to increase the price of exports when the country has monopoly power

in their supply.7. Import Licensing- The imposition of exchange controls quotas often involves requiring importers to obtain

licenses. This makes it easier for government to enforce its restrictions.8. Administrative Barriers

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- Regulations may be designed to exclude imports e.g. in Germany all lagers not meeting certain purity standards could be banned.

- Taxes may be imposed that favour local products or ingredients.9. Procurement Policies- This is where governments favour domestic producers when producers when purchasing

equipment (e.g. defence equipment).

Reasons for Protection

1. To protect infant industries- Infant industries are newly established. Infant industries normally charge higher prices

than foreign firms.- They will be unable to sell their goods because they will be more expensive compared to

foreign goods.- Tariffs or other forms of protection are used to make foreign goods expensive and allow

infant industries to survive.2. The sterile industry argument- This is where industries with a potential comparative advantage have been allowed to run

down and can no longer complete effectively. - They may have considerable potential, but be simply unable to make enough profit to

afford the necessary investment without some temporary protection.- This is one of the most important and powerful arguments used to justify the use of

special protection for the automobile and steel industries in the USA.3. To prevent unemployment or to safeguard the interests of workers- Specialisation in producing a certain good or service can result in rising unemployment

for those industries which were producing goods and services but no longer being produced by the country.

- This is because the country has forgone production of some goods and services and is now producing those goods and services where it has a comparative advantage.

- Free trade will always hurt someone.4. To prevent dumping- Dumping is when a country sells goods to another country at a price below the average

costs of production.- This may out complete local producers of the country where the goods are being dumped.

- Industries will close down resulting in high unemployment.

- Dumping may also mean strictly the sale of a commodity on foreign market of a price below marginal cost.

- A country may dump in order to dispose of temporary surpluses in order to avoid a reduction in home prices and therefore producer’s income.

- Dumping is also practiced in order to dispose poor quality products.

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5. Because other countries are using barriers to trade – retaliation- Barriers to trade are used in retaliation to the fact that other countries are using them also.6. To prevent overspecialization- Free trade encourages countries to specialise in the production of goods and services in

which they have a comparative advantage.- Specialisation in one or two products can be very dangerous in the modern world as

demand for goods and services always fluctuate.- A fall in demand will result in a fall in export earnings and the country will experience

BOP deficit.7. To solve BOP problems- If a country imports more than it exports, this can result in a BOP deficit- restrictions on

trade are used to reduce imports – solving BOP problems.8. Self sufficiency -To promote a country to be self sufficient rather than to depend on other

countries for the supply of goods and services.9. Revenue Purposes- The use of tariffs/customs duties as a means of providing the state with revenue or

increasing foreign currency earnings.- This revenue will be used for development purposes – economic growth and economic

development.- Trade is seen as an engine for economic growth and economic development.10. Exchange rate management- To stabilize the exchange rate of the country and make it

stronger. Too much or more imports in a country result in a weaker exchange rate. Restrictions on international trade normally result in a reduction of imports and boost of exports – the exchange rate becomes stronger.

11. For Strategic Reasons- Some industries such as iron and steel, agriculture, chemicals and scientific instruments

are regarded as strategic industries which are absolutely essential to a nation at war.- It is regarded as most desirable that such industries should be maintained so as to reduce

a nation’s dependence on foreign suppliers on strategic materials.- Where they have not been competitive in world markets these industries have normally

been protected by means of tariffs or quotas.

BALANCE OF PAYMENTS (BOP)

Definition

- A country engaging in foreign trade will be making payments to foreign countries and receiving payments from them.

- Each nation keeps an account of its transactions with the rest of the world which it presents in the form of a balance sheet described as the balance of payments.

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- BOP is a tabulation of the credit and debit transactions of a country with foreign countries and international institutions drawn up and published in a similar form to the income and expenditure accounts of companies.

- BOP is a record of the country’s transactions with the rest of the world. It deposits in other countries (debits) and its receipts or deposits from other countries (credits). It also shows the balance between these debits and credits under various headings.

- In an open economy there will be a balance of payments account. This records all the flows of money between residents of that country and the rest of the world. Receipts of money from abroad are regarded as credits and are entered into the accounts with a positive sign.

- Outflows of money from the country are regarded as debits and are entered with a negative sign.

- There 3 main parts / components of the BOP:a) The current accountb) The capital accountc) The financial accountd) The balancing item or net errors and omissions

The Current Account

- Records payments for imports and exports of goods and services plus incomes flowing into and out of the country plus net transfers of money into and out of the country.

- It is normally divided into 4 subdivisions:a) The trade in goods account

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

- Exports result in an inflow of money and are therefore a credit item.

- Imports result in the outflow of money and are therefore a debit item.

- The balance of these is called the balance on trade in goods or balance of visible trade or merchandise balance.

- A surplus is when exports exceed imports.

- A deficit favourable balance of visible trade is when imports exceed exports and the balance of visible trade is said to be unfavourable.

b) Trade in services account - This records inputs and exports of services (such as WABTIC, tourism,

entertainment, shipping etc).- Thus the purchase of a foreign holiday would be a debit since it represents an

outflow of money whereas the purchase by an overseas resident of a UK insurance policy would be a credit to the UK services account. The balance is called the services balance.

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- The balance of both the goods and services accounts together is known as the balance of trade (BOT) in goods and services or simply balance of trade.

c) Income Flows- These consist of wages, interest and profits flowing into and out of the country

e.g. dividends earned by a foreign resident from shares in a UK company would be an outflow of money (a debit item).

d) Current Transfers of Money- These include government contributions to and receipts from the EU and

international organizations and international transfers of money by private individuals and firms.

- Transfers out of the country are debits. Transfers into the country (e.g. money sent from Greece to a Greek student studying in the UK) would be a credit item.

The Current Account Balance

- It is the overall balance of all the above subdivisions.

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

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

The Capital Account

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

The Financial Account

- The financial account records cross border changes in the holding of shares, property, bank deposits and loans, government securities etc.

- In other words unlike the current account which is concerned with money incomes, the financial account is concerned with the purchase and sale of assets. The financial account includes:a) Investment (Direct and Portfolio)

This account covers primarily long term investment. i. Direct Investment

If a foreign company invests money from abroad in one of its branches or associated companies in the UK, this represents an inflow of money when the investment is made and is thus a credit item (any subsequent profit from this investment that

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flows abroad will be recorded as an investment income flow on the current account).

Investment abroad by UK companies represents an outflow of money when the investment is made. It is thus a debit item.

Direct investment here represents the acquisition or sale of assets e.g. a factory or farm, not the imports or exports of equipment.

ii. Portfolio Investment This is changes in the holdings of paper assets such as

company shares. Thus if a UK resident buys shares in an overseas company, this

is an outflow of funds and is hence a debit item.iii. Other Financial Flows

These consist primarily of various types of short term monetary movement between the UK and the rest of the world.

Deposits by overseas residents in banks in the UK and loans to the UK form abroad are credit items since they represent an inflow of money.

Deposits by UK residents in overseas banks and loans by UK banks to overseas residents are debit items.

They represent an outflow of money.iv. Flows to and from the reserves

The UK like all other countries holds reserves of gold and foreign currencies.

Drawing on reserves represents a credit item in the BOP accounts.

Money drawn from the reserves represents a an inflow to the BOP (albeit an outflow from the reserves account).

The reserves can thus be used to support a deficit elsewhere in the BOP.

Conversely if there is a surplus elsewhere in the BOP, the Bank of England can use it to build up reserves.

Building up the reserves counts as a debit item in the BOP since it represents an outflow from it (to the reserves).

The Balancing Item / Net Errors and Omissions

- It is impossible to obtain a complete and accurate record of millions of individual transactions which go to make up the BOP account – total credits are not exactly equal to total debits.

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- There are numerous errors and omissions which are due to payments not being recorded and to delays in obtaining information.

- It is for this reason that, as more information becomes available, the BOP figures are subject to the revision in the months following the original publication.

- The balancing item represents the total of the errors and omissions. It is the amount which is required to bring the recorded BOP into balance.

- The inclusion of the balancing item makes the sum of the credit and debit items equal to zero.

- A positive balancing item means that there has been unrecorded net inflow of foreign currency.

Dealing with BOP deficit

Causes of deficits on the current account balance

- Whilst the overall BOP must balance, sections may be in deficit or in surplus.

- Most attention is usually paid to the current account position and particularly to current account deficits.

- A deficit on the current account may arise from high income levels in the home country. This is because when incomes are high people will usually buy more goods and services. Some of these will come from abroad, thereby increasing imports and some from domestic producers, thereby possibly reducing exports.

- In addition to increasing the imports of finished manufactured goods, high incomes may also increase expenditure on imported raw materials as domestic firms expand output to meet higher home demand.

- In contrast it is when income levels abroad are low that a deficit may arise. This is because overseas countries are likely to import less and to compete more vigorously in the export market.

- An overvalued exchange rate will also lead to problems with exports being relatively high in price and imports being relatively cheap.

- The country may be producing products of low quality, its costs of production may be higher and it may be producing products in low world demand.

Effects of deficits and surpluses on the current account balance

- The effects will depend on the size and cause and duration of the deficit or surplus.

- In the short term a deficit will increase living standards because the country will be consuming more goods and services than it was producing. If the deficit is not covered by an inflow of overseas investment, it will have to be financed by drawing on reserves or by borrowing. Reserves are not finite and it may be difficult to find willing lenders.

- In addition borrowing and attracting overseas investment will involve an outflow of interests, profits and dividends in the future thereby weakening the invisible balance.

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- A deficit on the current account balance will reduce the money supply if it is not offset by changes in monetary policy of net transactions in assets and liabilities. It will reduce inflationary pressure as it involves a net leakage on demand.

- In contrast a surplus involves a net injection of extra demand in the economy. It is often taken to be a sign of economic strength.

Equilibrium in the BOP- Although the BOP always balances, this does not mean that it is always in equilibrium.

- Common belief is that the BOP situation is satisfactory when it shows a surplus but world exports and world imports must be identically equal.

- If a nation is in surplus, there must be a corresponding deficit somewhere in the world because all nations cannot achieve surplus simultaneously.

Measures which the government can put in place to correct a BOP deficita) Trade restrictions e.g. tariffs, quotas, embargoes etc.b) Devaluation of the exchange rate.c) Export oriented industrialization i.e. promoting industries which produce for export

purposes.d) Import substitution industrialization. A strategy of restricting imports of manufactured

goods and using the foreign exchange saved to build up domestic substitute industries.e) Use of subsidies and interest rates.

Or simply speaking 4 major policies can be used:a) Monetary Policyb) Fiscal Policyc) Exchange Rate Policyd) Supply side policies i.e. government policy that attempts to alter the level of

aggregate supply directly.

EXCHANGE RATES

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

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

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- Currencies are exchanged on the foreign exchange market, but what determines the rate at which they exchange for one another? It is the forces of supplies and demand which determine the price of one currency in relation to the other currencies.

- The exchange rate is the price (rate) at which one currency is exchanged for another currency, for gold or special drawing rights (i.e. the instruments for financing international trade in the post war period were predominantly the reserve currencies such as $, £ and gold).

- The exchange rate is the relationship at which one currency can be exchanged for another currency. The rate is expressed as the amount of one currency that is necessary to purchase one unit of another currency (e.g. $1.60 = £1).

Reserve Currency / Reserves / Foreign Reserves- A currency which governments and international institutions are willing to hold in their

gold and foreign exchange reserves and which finances a significant proportion of international trade).

- Foreign reserves also refer to the sum, total or basket of foreign currencies held by the central bank of a country.

Types of Exchange Rates

1. Free, fluctuating or floating exchange rate- This means the existence of free or competitive foreign exchange market where the price

of one currency in terms of another is determined by the forces of demand and supply operating without any official interference.

- For example the value of the £ in terms of the $ would depend upon the demand for £s from holders of $s and the supply of £s from holders of the sterling who want to buy $s.

- British residents trying to buy goods and services will be supplying £s to the foreign exchange market (and demanding foreign currencies) while overseas residents wishing to buy goods and services will be demanding £s (and supplying foreign currencies)

- There will be some equilibrium price (i.e. the exchange rate) which equates the two forces of supply and demand.

- The price of £s will be expressed in terms of foreign currencies. These can also be referred to as free or floating or fluctuating exchange rates.

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

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

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

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

- Thus the foreign change value of a national currency will be closely related to that: Country’s balance between Xs and MS. Capital transactions between that country and the rest of world. Activities of speculators. Speculators buy and sell foreign currencies with a view

of making capital gain. They buy when the value of a currency is expected to fall e.g. if the exchange value of the £ is expected to rise and in fact does rise from say £1 = $1.5 to £1 = $2 then someone who transfers $15 000 into £s at a higher rate will make a profit of $5 000.

These transactions when carried out on a large scale can make a significant influence on exchange rates.

Advantages of Floating Exchange Rates

- Floating exchange rates provide kind of automatic mechanism for keeping the BOP in equilibrium. If a government if confident a floating exchange rate will ensure BOP equilibrium, it will not have to hold reserves of foreign currency.

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- A floating exchange rate stops the exchange rate being a target. The government will not have to introduce measures to protect the value of the currency at a fixed rate which might threaten other objectives.

- Automatic CorrectionThe government simply lets the exchange rate move freely to the equilibrium. In this way BOP disequilibria are automatically and instantaneously corrected without the need for specific government policies – policies that under other systems can be mishandled.

- No problem of international liquidity and reserves

Since there is no central bank intervention in the foreign exchange market, there is no need to hold reserves. A currency is automatically convertible at the current market exchange rate. International trade is thereby financed.

- Insulation from external economic eventsA country is not tied to possibly unacceptably high world inflation rate, as it is under fixed exchange rate. It is also to some extent protected against world economic fluctuations and shocks.

- Governments were free to chose their domestic policyUnder a floating rate, a government can choose whatever level of domestic demand it considers appropriate, and simply leave exchange rate movements to take care of any BOP effects. This is a major advantage especially when the effectiveness of deflation is reduced by downward wage and price rigidity, and when competitive deflation between countries may end up causing a world recession.

Disadvantages of free floating exchange rates

- Floating exchange rates add a further element of uncertainty on international trading. The world prices of commodities are far from stable and traders are obliged to accept a high degree of risk on this account. Costs of production of firms are also affected. Buyers have 2 prices to watch i.e. the foreign price of the commodity and the price of the foreign currency.

- There is a lot of uncertainty and instability associated with floating exchange rates. This acts as a major deterrent to the growth of world trade and in particular it discourages long term contracts.

- The external prices of home produced goods will be subject to constant change and this will lead to a very unstable pattern of demand. This makes production planning very difficult because economic resources are not sufficiently mobile to cope with this type of situation without imposing some hardship e.g. a much greater uncertainty about employment prospects.

- The depreciation of the currency in the foreign exchange market will make imports dearer and this could lead to cost push inflation.

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- A floating exchange rate cannot insulate or protect the home economy from external forces.

Managed Exchange Rates

- Although market forces are the main determinant of floating exchange rates, there are times when central banks try to influence the market rate.

- Governments do this by adjusting interest rates or by intervening directly in the foreign exchange market i.e. by reducing or increasing foreign exchange reserves.

- If the central bank does not intervene in the market, it is described as clean floating and if the central bank does not intervene, it is described as dirty floating.

- Government attempts to “manage” the exchange rate in order to smooth out fluctuations around what is believed to be the equilibrium rate of exchange rate.

- Since floating exchange rates can sometimes overshoot due to forces of supply and demand, they can create some imbalances which can result in exports being halved or doubled – some official intervention in the foreign exchange market may be designed to offset the overshooting to some extent.

- If the country decides to adopt a managed floating system, how could the central bank prevent the exchange rate from falling? There are two main methods:a) Using reserves on foreign loans to purchase domestic currency on the foreign

exchange market.b) Raising interest rates to attract short term financial inflows.

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- Above the equilibrium price, there is excess supply of £ - the central bank in UK will buy the excess of £.

- Below the equilibrium there is excess demand for £s – the central bank will supply £s to meet the excess demand.

- If a currency beings to move outside the managed floating band, the country is expected to take action to bring it into line for instance if the exchange rate is falling near to its lower limit a country would be expected to buy its currency and if this failed, to raise its domestic interest rate.

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

- The diagram above shows how an increase in the supply of the currency, arising for instance from an increase in demand for imports, would lower the price of the currency and place it outside the set band.

- To avoid this, the government of the country concerned, possibly with the support of other member governments steps in and buys the currency. This shifts the demand curve to D1D1 and keeps the value of the exchange rate within the set band.

Fixed Exchange Rates

- In a typical fixed exchange rate system, the countries must fix the values of their currencies in terms of common standards.

- In order to maintain currency at a fixed value, the monetary authorities of a country must stand ready to buy and sell the currency at a fixed price.

- This means that they must have large supplies of their own currency, gold and convertible currencies i.e. foreign reserves in order to remove any excess demand or supply at the fixed price.

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

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

- Initially the market is in equilibrium at this price. If imports increase and the supply curve shifts from SS to S1S1. In the absence of any intervention by the authorities the price would fall to £1 = US$1.5

- The authorities however enter the market and buy £s raising demand from DD to D1D1

and maintaining the exchange rate at £1 = $2.- When authorities are intervening to buy the domestic currency, they are of cause

spending the official reserves of foreign currency and gold.

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- Similarly when the demand for the currency exceeds it supply at the fixed price, the monetary authorities will be selling home currency on the foreign exchange market and hence replenishing the reserves of foreign currency.

-Advantages of Fixed Exchange Rate

- It removes the uncertainty associated with the floating exchange rates. The negotiation of long term contracts, the granting of long term credits, the undertaking of the long term investment overseas are less risky when there is confidence in the stability of the exchange rate.

- A fixed exchange rate imposes discipline on a country to avoid inflation. This is because it will not be able to rely on a fall in the exchange rate to regain competitiveness lost through inflation.

- Certainty- with fixed exchange rates, international trade and investment become less risky, since profits are not affected by movements in the exchange rate.

- Little or no speculation- provided the rate is absolutely fixed and people believe that it will remain so there is no point in speculating.

- Automatic correction of errors- if the central bank allows the money supply to expand too fast, the resulting extra demand and lower interest rates will lead to a BOP deficit. This will force the central bank to intervene to support the exchange rate. Either it must buy the domestic currency on the foreign exchange market, thereby causing money supplies to fall again (unless it sterilises the effect) or it must raise interest rates. Either way this will have the effect of correcting the error.

- Prevents governments from pursuing “irresponsible” macroeconomic policies- if a government deliberately and excessively expands aggregate demand – perhaps in an attempt to gain short term popularity with the electorate – the resulting balance of payments deficit will force it to constrain demand again (unless it resorts to import controls).

Disadvantages of Fixed Exchange Rate

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

- If say fiscal measures are used like tariffs and quotas to reduce demand for imports, these measures are likely to be inflationary as prices will go up.

- Higher interest rates may be used to attract short term capital from abroad. This will improve the BOP but it will also raise home costs and discourage investment.

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The New Classical Economists criticise fixed exchange rates on 2 grounds: Fixed exchange rates make monetary policy ineffective – interest rates are pegged

to world levels and thus money supply is infinitely elastic and depends purely on the demand for money. As a result the central bank cannot control inflation by attempts to control money supplies.

Fixed exchange rates contradict the objective of having free markets – why fix the exchange rate when a simple depreciation or appreciation can correct disequilibrium. The exchange rate must be left to adjust due to forces of supply and demand i.e. the invisible hand must be left to play its role.

The Keynesian View

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

Terms to note

Revaluation versus Devaluation- Revaluation involves deliberate action by monetary authorities to move the exchange

values of their currencies to higher parities. - Revaluation makes exports relatively dearer (in terms of foreign currencies) and imports

relatively cheap in term of the home currency.- Since BOP surplus is widely regarded as a sign of success, surplus countries are usually

reluctant to revalue, but if they do not, they are perpetuating the imbalance of world trade and in other countries in persistent deficit may be forced to resort to the use of trade restrictions.

- Devaluation involves deliberate action by monetary authorities to lower the exchange value of their currencies in terms of other currencies e.g. BWPI = ZAR1.50 to BWPI = ZAR1.20

- Devaluation makes exports relatively cheaper and imports expensive – devaluation discourages imports and corrects BOP deficits.

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Appreciation versus Depreciation of Exchange Rates- Appreciation is the gain in value of a currency due to forces of supply and demand

without any intervention by the government and monetary authorities of a country e.g. £1 = US$1.5 and after appreciation the exchange rate is £1 = US$2, then the pound (£) is said to have appreciated.

- Depreciation is the loss of value of a currency due to forces of supply and demand without any intervention by the government or any monetary authorities of a country e.g. before £1 = $1.50 and after depreciation the exchange rate is £1 = $1.2. The £ is said to have depreciated.

Effective Exchange Rates- For any given currency, there is large number of exchange rates. The external value of

the £ may be expressed in terms of $, €, ZAR, BWP etc.- Effective exchange rates are a way of measuring a currency’s external value in terms of

other currencies. E.g. £1 =? US$, £1 =? €, £1 =? ZAR, £1 =? BWP.

Purchasing Power Parity Theory- A theory which states that the exchange rate between one currency and another is in

equilibrium when their domestic purchasing power at that rate of exchange are equivalent e.g. the rate of exchange £1 = US$1.70 would be in equilibrium if £1 will buy that same goods in the UK as $1.70 will buy in the US. If this holds true, purchasing power parity exists.

- The basic mechanism implied by the theory is that, give complete freedom of action, if $1.70 buys more in the US than £1 does in the UK, it would pay to convert £s into $s and but from the US rather than in the UK. The switch in demand would raise prices in the US and lower them in the UK and at the same time lower the UK exchange rate until equilibrium and parity are re-established.

- Purchasing Power Parity (PPP) means equal value of money.

Factors underlying fluctuations in exchange rates

1) Demand and supply factors.2) Activities of speculators.3) The balance between exports and imports of a country.4) Capital transactions between that country and the rest of the world.5) Political shocks/influences6) Exogenous shocks e.g droughts, earthquakes, floods etc or simply natural disasters.

The Purchasing Power Parity (PPP)

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

Overvalued Exchange Rate versus Undervalued Exchange Rate

Overvalued Exchange Rate- It is a situation in which the exchange rate of a country exceeds what the open market is

willing to pay. For example, currency overvaluation may occur when central banks buy more of a currency that they ordinarily do when other trading is flat.

- Currency overvaluation makes a country’s exports more expensive and may thus be detrimental to international trade.

Currency Overvaluation- A currency is considered overvalued if private demand for the currency at the going

exchange rate is less than total private supply (i.e. central banks are buying up the difference, supporting the value of the currency through foreign exchange intervention).

- A currency is considered overvalued if the currency value exceeds the purchasing power parity.

Problems of Overvalued Exchange rate- An overvalued rate implies that a country’s currency is too high for the state of the

economy.- An overvalued exchange rate means that the country’s exports will be relatively

expensive and imports cheaper.- An overvalued exchange rate tends to depress domestic demand and encourage spending

on imports.- An overvalued exchange rate can also be measured by looking at the purchasing power

parity (PPP). An overvalued exchange rate will mean goods are relatively more expensive in that country (a more sophisticated form of PPP also takes into account difference in real GDP per capita).

- An overvalued exchange rate is particularly a problem during a period of sluggish growth. If the economy is booming, an overvalued exchange rate can help reduce inflationary pressure, but in a recession an overvalued exchange rate can cause deflationary pressures.

- Governments can deal with overvalued exchange rate in 3 ways.1. Devalue the currency2. The country should restrict international transactions3. The government can buy (or demand) its own currency to make the fundamental

value equal to the official rate.

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Undervalued Exchange Rate- This is when the official rate of the currency is below it fundamental value, the currency

is said to be undervalued.- The government has 3 choices for dealing with an undervalued currency:

1. The government could revalue the currency, increasing the official rate to the fundamental value.

2. The government could ease restrictions on international transactions.3. The government can continue to acquire official reserve assets.

Advantages of Undervalued Exchanged Rate- Exports would be cheaper for other countries to buy; they would want to buy from you,

increasing demand and increasing trade revenue.

Disadvantages of Undervalued Exchange Rate- Imports would become expensive to buy, the country would have to pay more than usual

for foreign goods, this would be discouraging and the country may look towards buying cheapest goods. So the quality of goods would suffer just to compensate for price.

E.g. of an undervalued exchange rate is the Chinese Yuan.

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MACROECONOMIC MANAGEMENT

Objectives of Macro-Economic Policy

The objectives of macro-economic policy are:1. A high level and rapid growth of output.2. Low unemployment.3. Stable prices or low inflation4. Balance of payments equilibrium5. Equitable distribution of income and wealth.6. Exchange rate stability

Output The ultimate objective of economic activity is to provide the goods and services that the

population desires. The most comprehensive measure of total output in an economy is the Gross Domestic

Product (GDP). GDP is the measure of market value of all final goods and services e.g. cars, donkey rides

and so on – produced in a country during a year. Potential GDP represents the maximum sustainable level of output that the economy can

produce. When and economy is operating at its potential, there are high levels of utilisation of the

labour force and capital stock. When output rises above potential output, price inflation tends to rise, while below

potential level of output leads to high unemployment. Potential output is determined by the economy’s productive capacity which depends upon

the inputs available (capital, labour, land etc) and the economy’s technological efficiency.

High Employment, Low Unemployment Of all the macroeconomic indicators, employment and unemployment are most directly

felt by individuals. People want to be able to get high paying jobs without searching or waiting too long and

they want to have job security and good benefits. In macroeconomic terms, there are the objectives of high unemployment which is

counterpart of low unemployment.

Unemployment Rate It is the percentage of the labour force that is unemployed.

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The labour force includes all employed persons and those unemployed individuals who are seeking jobs.

It excludes those without work who are not looking for jobs. The unemployment rate tends to reflect the state of the business cycle: when output is

falling, the demand for labour falls and the unemployment and the unemployment rate rises.

Price Stability The third macroeconomic policy objective is to maintain price stability. The term means that the overall price level is either unchanged or rising very slowly. To track prices government statisticians construct price indexes or measures of the

overall price level. An important example is the consumer price index (CPI) which measures the average

price of goods and services bought by consumers. Economists measure price stability by looking at the inflation rate of rate of inflation. The inflation rate is the percentage change in the overall level of prices from one year to

the next. A deflation occurs when prices decline (which means that the rate of inflation is

negative). Price stability is important because a smoothly functioning market system requires that

prices accurately and easily convey information about relative scarcities.

The Tools of Macroeconomic Policy A policy instrument is an economic variable under the control of the government that

can affect one or more of the macroeconomic policy are:1. Fiscal Policy2. Monetary Policy

Fiscal Policy Fiscal policy denotes the use of taxes and government expenditures. Government expenditures come in two distinct forms. First there government purchases. These compromise spending on goods and services – purchases of goods and

payments of salaries. In addition, there are government transfer payments, which boost the incomes of

targeted groups such as the elderly or the unemployed. The other part of fiscal policy, taxation, affects the overall economy in two ways. To begin with taxes affect people’s incomes. By leaving households with more or less disposable or spendable income, taxes tend

to affect the amount people spend on goods and services as well as the amount of private savings.

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Private consumption and saving have important effects on investment and output in the short run and long run.

In addition taxes affect the prices of goods and factors of production and thereby affect incentives and behavior.

There are three major functions of the fiscal policy:

1. Allocation function – The allocation function of the fiscal policy in related to ensuring that there is equitable resources distribution between the public sector and the private sector.

2. Stabilisation – The role of stabilisation as a function of fiscal policy aims at ensuring that there is stability in employment and price stability.

3. Distribution – The distribution role of the fiscal policy aims at ensuring equitable distribution. It involves transfer from those with plenty to those less privileged. This has to do with taxation in the manner that income is equitably distributed through various measures that may be adopted.

Monetary Policy The second major instrument of macroeconomic policy is monetary policy, which the

government (through its central bank) conducts through managing the nation’s money, credit and banking system.

Zimbabwe Macroeconomic History since 1980

Zimbabwe at independence in 1980 inherited a dual economy characterized by a well developed modern sector and a largely poor rural sector that employed about 80% of the labour force.

The new government maintained the variety controls used by Smith’s regime. These were done in context of command economy.

The country experienced very high growth rates of 10.7% and 9.7% in 1980 and 1981 respectively.

The government in the 1980s recorded very high achievements in the educational and health sectors. However these achievements in the social sector did not match with what was going on in the productive sector. The country was producing over 200 000 school leavers while the economy was creating less than 35 000 new jobs. There was a diminishing demand of Zimbabwean exports, a decline in investment and capital formation, severe shortages of foreign currency. Their combination brought in recession and the country had no option but to settle for International Monetary Fund (IMF) initiated Economic Structural Adjustment Programme (ESAP).

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

The program entailed the following:1. Economic Liberalisation – meant to move away from important substitution strategy

to an open market driven economy.2. Implementation of Monetary Policy Reform – market based interest rates and

liberalisation of the financial sector.3. Opening up of one stop investment centre.4. Commercialisation of the parastatals.5. Liberalisation of labour market.

ESAP failed miserably and led to a decline in job security in the public sector and working up of some industries.

The government failed to meet the domestic logic of the reforms. It failed to implement fiscal stabilisation as a result deficit increased to 8% against the target of 5%.

Zimbabwe Programme for Economic and Social Transformation (ZIMPREST) – (2000-2005)

The government abandoned ESAP and came up with its own program ZIMPREST.

It was short-lived due to its failure to have any impact because its donors shunned it.

ZIMPREST failed in the same way as ESAP due to government fiscal indiscipline as a result of not compromising macro-economic fundamentals leading to high inflation, depleted foreign currency reserves, disequilibrium in the Balance Of Payment (BOP) and declining economic growth.

Crisis Period Era (1997 – 2008)

The 14th of November 1997 is the day known as “Black Friday” when the domestic currency crashed caused by unplanned grant payments to ex-combatants. In addition Zimbabwe rendered a hand in 1998 by sending troops in DRC Congo which further increased budget deficit.

As a result GDP declined from 0% in 1998 to -7.4% in 2000 further declining to -10.4% in 2003. Real GDP growth averages -5.9% was achieved between the periods 2005 – 2007.

The period from 2000 saw decline in economic activity due to land reform programme when production decreased on farm and further effects due to sanctions imposed on the country. The effects spread to all the sectors.

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The period up to 2008 saw increasing quasi fiscal activities by the central bank which further fuelled the decline of the economy – high inflation low capacity utilisation.

In 2009 government adopted multi-currency regime when it abandoned the Zimbabwean dollar.

Short Term Emergency Recovery Programme (STERP) I

On the 15th of September 2008, 3 political parties signed a Global Political Agreement (GPA).

The inclusive government took office in the context of an economy that had many challenges – high inflation, negative GDP, massive devaluation of currency, low productivity, loss of jobs, food shortages, poverty, massive de-industrialization and general despondency.

As part of its obligation to address the economic crisis, government came with Short Term Emergency Recovery Programme (STERP) which covered period February to December 2009.

The objectives and key goals of STERP were:1. Stabilize the macro and micro-economy.2. Recover the levels of savings.3. Investment and growth.4. Lay the basis of a more transformative midterm to long term economic

programme that will turn Zimbabwe into a progressive development state

Key Priority Areas of STERP

a) Political and Governance Issuesi. Strengthening governance and accountability.ii. Promoting governance and rule of law.iii. Promoting equality and fairness.

b) Social Protectioni. Food and humanitarian assistance.ii. Education.iii. Health.iv. Strategically targeted vulnerable sectors.

c) Stabilisationi. Implementation of a growth oriented recovery programme.ii. Restoring the value of the local currency and guaranteeing its stability.iii. Increasing capacity utilisation in all sectors of the economy and hence

creation of jobs.iv. Ensuring adequate availability of essential commodities such as food, fuel and

electricity.

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v. Rehabilitation of collapsed social, health and education sectors.vi. Ensuring adequate water supply.

STERP was expected to create an economy with the following:a. Able to sustain itself through food self sufficiency.b. Weaned off the current price distortions.c. That creates jobs and employment opportunities.d. Confers equal opportunities and treatment to all its citizens.e. That accepts the equality and central role of women and mainstream gender in all

facets of the same.f. That takes cognizance of the environment and global environment changes.g. With functional infrastructure such as roads, water and telecommunications.h. That is people centered and inward looking.i. That guarantees freedom of expression and property rights.j. That generates confidence and inter-sectored synergies.k. That reduces poverty.l. That is free of any sanctions and measures and is totally integrated in the region.

Performance of STERP I Although there have been some achievements of STERP such stabilising the economy

through reduction of inflation and availability of products, the programme failed to achieve the targets.

The program has not been supported by the donor community hence lacked resources to implement various programs.

The program had a shortfall in that it was not clear how it was going to achieve its stated targets.

The fact that the inclusive government came up with another STERP II is itself an admission of the failure of the program otherwise they wouldn’t be STERP II if STERP I was successful.

Three Year Macroeconomic Policy and Budget Framework 2010 – 2012 STERP II

1. The Three Year Macroeconomic Policy and Budget Framework for the years 2010-2012 anchors the three year rolling budget formulation.

2. It will attend to the outstanding objective, agenda and commitment of STERP I, also embracing other growth-oriented stabilisation measures.

3. The Three Year Macro-Economic Policy and Budget Framework also draw from various sectoral and cluster development strategies.

4. The targets set for the three years and consolidated into comprehensive work programs over the priorities of government have all been linked to budget process.

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5. STERP II will carry out land audit, address the security of tenure, arresting further farm disruptions and putting in place market based funding arrangements for agriculture, targeted at achieving agricultural annual growth rates of above 20%.

6. Containing inflation within the single digit levels for the period 2010-2012.7. Government maintains in principle the use of multiple currencies form 2012-2012.8. Government will review tax holidays and other business tax incentives and implement an

appropriate corporate tax rate.9. The implementation of incentives for attracting financial resources outside the banking

system.10. The financial institutions will be required to inject fresh capital to meet minimum capital

requirement.11. The establishment of Securities Commission to work on rules and registration, licensing

corporate governance, insides trading mergers and acquisition.12. STERP II builds on STERP I efforts to restore the ability of mining houses to begin

realizing adequate revenues to cover production costs and allow for surpluses.13. Mining activity is therefore projected to grow by 40%, 17% and 15% in 2010, 2011 and

2012 respectively.14. Formulation of diamond policy to provide further guidelines for exploration.15. STERP II targets to increase capacity utilisation levels from current levels to 75% by

December 2010 and 100% by December 2011.16. Government shall enact national trade policy which will focus on exports promotion

integrated with the industrialization development strategy, who focus on attaining a higher industrial productivity and output.

17. STERP II will prioritise image building, marketing, product re-branding, improving access to tourist destinations, and investment in tourism infrastructure.

18. The government will enact the SME’s Bill and finalise the review of the SME’s Policy and strategy framework including the establishment of an SME Observatory Unit and conclusion of SME’s consensus.

19. Given resource constraints in government and at ZESA, involvement of private players with capacity t refurbish, lease and operationalise idle thermal power stations will be instituted.

20. Investment in transport, infrastructure and services across the main modes of transport – road, rail, air inland, water and pipeline will be made.

21. STERP II will focus on three critical health delivery areas relating to human resources, medicines and medical supplies as well as medical equipment and infrastructure.

Shortcomings of STERP II1. STERP II ahs shortcoming originating from the period it is to be implemented e.g. 3

years. This should be a period of Medium Term Plan not Short Term Plan.2. It has overlapping lists of targets with no specific plans and strategies to achieve them.

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3. It lacks resources just as STERP I was hence it is likely not to achieve its goals and targets.

MEDIUM TERM PLAN (MTP)- (2011-2015)

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