Economics IB

Macroeconomics
ECO10B
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 GENERAL INFORMATION

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 ASSIGNMENT
Semester 1 2024
Module name MACRO ECONOMICS
Module Code ECO10B
Due date 22 April 2024
Total Marks 75

This assignment is compulsory and must be submitted through CANVAS, inside

the corresponding Module Class Course on or before 22 April2024 by 24:00.

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LIST OF REFERENCES
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IMPORTANT: Ensure that you submit your assignment answers on or before the due
date and time.

©STADIO Assignment – 2024 Semester 1 MACRO ECONOMICS ECO10B

Page 1 of 4
 STEP 2: SUBMITTING YOUR ASSIGNMENT ON CANVAS
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©STADIO Assignment – 2024 Semester 1 MACRO ECONOMICS ECO10B

Page 2 of 4
Question 1 (25 marks)

1.1 Explain the 5 macro-economic objectives. (5)

1.2 Read the press statement ‘20 July Statement of the monetary policy committee’
and answer the questions. Addendum A or access the link.
https://www.resbank.co.za/en/home/publications/publication-detail-
pages/statements/monetary-policy-statements/2023/Statement-of-the-Monetary-Policy-
Committee-July-2023
1.2.1 Indicate how they measure the different macro-economic objectives and the
expected forecasts for some of the South Africa objectives. (8)
1.2.2 While South Africa’s economic conditions appear to have improved, the longer-
term outlook still mirrors some uncertainty. Why? (4)
1.3 Define monetary policy and indicate the aims of monetary policy. (2)
1.4 Distinguish between expansionary and contractionary fiscal policy. (3)
1.5 Define the budget deficit and explain how it is related to the public debt.
(3)

Question 2 25 marks)

2.1 Use a diagram to explain how a central bank can try (in principle) to stabilise
the external value of its currency (that is, explain managed floating).
Illustration (4)
Explanation (4)
2.2 Define the different measures of money in South Africa. How are they linked to
the functions of money? (6)
2.3

Source: South African Statistic, Key findings: P0211- Quarterly Labour Force
Survey (QLFS), 1ste Quarter 2023

©STADIO Assignment – 2024 Semester 1 MACRO ECONOMICS ECO10B

Page 3 of 4
With reference to the extract above, answer the following questions:
2.3.1 The controversy remains whether the strict or expanded definition of
unemployment should be used. Explain the difference between the strict
definition and the expanded definition of unemployment. (4)
2.3.2 Explain what you understand by “Discouraged work-seekers”. (1)
2.3.3 What is the current unemployment rate in South Africa? (1)
2.4
Consider the economy below and use the Keynesian model provided to answer the
questions that follow for Economy A.

𝐂𝐂̅ = R180 million

c = 0.75
𝐈𝐈 ̅ = R120 million
𝐆𝐆̅ = R200 million
t = 0.2
Yf = R2 700 million
T = tY
C = 𝐂𝐂̅ + c(1 – t)Y
Equilibrium income: Y = C + I + G
Disposable income: Yd = (1 – t)Y

NOTE: Round off answers to two decimals. Final values should be expressed in
millions of rand.

Answer the following questions for Economy A:

2.4.1 Calculate the value of the multiplier. (2)
2.4.2 Calculate the equilibrium level of income. (3)

Question 3 (25 marks)

3.1 If C = R40 million, Ī = R280 million, Ḡ = R180 million, c = 0,875, t = 0,143 and
Yf = R2 400 million, by approximately how much must government spending be
raised to achieve full employment? First calculate the equilibrium level of
income Y0 = αA. (7)
3.2 Explain cost-push inflation and indicate four possible sources of cost-push
inflation. (5)
3.3 The slope of the AS curve is clearly important What is the significance of the slope of
the AS curve? (7)
3.4 One of the main functions of the South African Reserve bank is to provide
services to the government, discuss this main function. (3)
3.5 Discuss the Role of the government. (3)

Assignment Total: 75 marks

©STADIO Assignment – 2024 Semester 1 MACRO ECONOMICS ECO10B

Page 4 of 4
 Table of Contents

Heading Page number

Welcome 1

Module Purpose and Outcomes 2

Topic 1 Measuring the Performance of the Economy 5

1.1 Introduction 5
1.2 Macroeconomic Objectives 5
1.3 Measuring the Level of Economic Activity: Gross Domestic Product
(GDP) 6
1.4 Other Measures of Production, Income and Expenditure 8
1.5 Measuring Employment and Unemployment 9
1.6 Measuring Prices: The Consumer Price Index 10
1.7 Measuring the Links with the Rest of the World: Balance of Payments 11
1.8 Measuring Inequality: Distribution of Income 11

Topic 2 The Monetary Sector 13

2.1 Introduction 13
2.2 Functions of Money 13
2.3 Different Kinds of Money 14
2.4 Money in South Africa 15
2.5 Financial Intermediaries 16
2.6 The South African Reserve Bank 17
2.7 The Demand for Money 18
2.8 The Stock of Money: How Is Money Created 19
2.9 Monetary Policy 20

Topic 3 The Public Sector 23

3.1 Introduction 23
3.2 Role of Government in the Economy: An Overview 23
3.3 How Does Government Intervene? 25
3.4 Government Failure 25
3.5 Nationalisation and Privatisation 26

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Macroeconomics ECO10B
3.6 Fiscal Policy and the Budget 27
3.7 Government Spending 28
3.8 Financing of Government Spending 29
3.9 Taxation 29

Topic 4 The Foreign Sector 33

4.1 Introduction 33
4.2 Why Countries Trade 33
4.3 Trade Policy 35
4.4 Exchange Rates 35
4.5 Terms of Trade 37

Topic 5 A Simple Keynesian Model of the Economy 39

5.1 Introduction 39
5.2 Production, Income and Spending 40
5.3 The Basic Assumptions of the Model 41
5.4 Consumption Spending 42
5.5 Investment Spending 44
5.6 The Simple Keynesian Model of a Closed Economy without a
Government 44
5.7 Algebraic Version of the Simple Keynesian Model 46
5.8 The Impact of a Change in Investment Spending: The Multiplier 47
5.9 The Simple Keynesian Model: A Brief Summary 48

Topic 6 Keynesian Models including the Government and the Foreign Sector 51
6.1 Introduction 51
6.2 Introducing the Government into Our Model 52
6.3 Introducing the Foreign Sector into the Model: The Open Economy 56
6.4 Impact of the Government and the Foreign Sector: A Brief Summary 59

Topic 7 More on Macroeconomic Theory and Policy 61

7.1 Introduction 61
7.2 The Aggregate Demand-Aggregate Supply Model 61
7.3 The Monetary Transmission Mechanism 63
7.4 Monetary and Fiscal Policy in the AD-AS Framework 64

Topic 8 Inflation 67
8.1 Introduction 67
8.2 Definition of Inflation 67
8.3 Measurement of Inflation 68
8.4 Effects of Inflation 69
8.5 The Causes of Inflation 71

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Macroeconomics ECO10B
Topic 9 Unemployment 73
9.1 Introduction 73
9.2 Unemployment 73
9.3 Unemployment and Inflation: The Phillips Curve 76

Topic 10 Economic Growth and Business Cycles 79

10.1 Introduction 79
10.2 The Definition and Measurement of Economic Growth 79
10.3 Sources of Economic Growth 82

References 83

Answers to Questions 85

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Macroeconomics ECO10B
 Welcome

Welcome to ECONOMICS IB (Macroeconomics) (ECO10B)! Economics is different

from most of the other subjects you have studied so far in the sense that you
have to practice it as you study. It is therefore advisable that you keep a pencil
as well as some highlighters available. When embarking on the exercises in the
learning manual and/or the prescribed textbook, it is suggested that you re-draw
the graphs and summarise the key aspects in the learning content to enhance
your learning. Economics come alive as your knowledge of the subject grows.
You will be able to recognise key elements and principles of economics as you
follow the news in the media. Economics is part of everyday life and it is only
natural that you will encounter many economic moments in every day of your
life.

The first section deals with what macroeconomy is and how we measure it. In
this section, we will introduce you to monetary-, fiscal policy and international
trade and exchange rates. The last topic in the first section explains how the
performance of the macroeconomy can be measured.

The second section deals with macroeconomic theory and policy. Here we will
introduce macroeconomic models and show you how economic policy makers use
the information from these models.

The last part refers to macroeconomic challenges. Here we will address upswings
and downswings in the economy, how to combat unemployment and inflation
and the ultimate macroeconomic challenge – improving economic development.

The questions or activities that appear throughout the study guide should be
attempted as you progress through the topics. It is a good idea to practice the
graphs and to do the calculations before you provide your final answer.

The study guide guides you through the prescribed textbook and to be successful
in your studies we strongly recommend that you purchase the prescribed
textbook. Study each section in the textbook before you attempt the activities.

We trust that you will enjoy the exciting issues and challenges you will be facing.
We look forward to accompany you on this meaningful and positive learning
journey.

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Macroeconomics ECO10B
1
 Module Purpose and Outcomes

After studying this study guide, you should be able to:

• Calculate the most important national figures for an economy and interpret
these figures to judge the performance of that economy.
• Analyse the demand and supply of money in the economy and to predict
how the main monetary policy measures implemented by the monetary
authorities will affect the macroeconomy and express an opinion on whether
certain measures will be suitable for certain economic conditions.
• Predict how changes in government’s fiscal policy may affect the economy.
• Discuss the country’s involvement in international trade and predict how
changes in the foreign sector may affect the domestic economy.
• Explain the use of economic models, to predict how changes in the
components of aggregate spending may influence the goods market,
employment, production and income and to illustrate the impact of these
changes by means of a graph.
• Use the AD-AS model to analyse the impact of fiscal and monetary policy
measures on the economy.
• Assess and evaluate the inflation, unemployment and economic growth in
an economy.

Note

Any reference to masculine gender may also imply the feminine. Singular may
also refer to plural and vice versa.

Prescribed Reading

The prescribed textbook for ECONOMICS IB (Macroeconomics) (ECO10B) is:

• Mohr, P. & Fourie, L. & Associates. 2020. Economics for South African
students. 6th ed. Pretoria: Van Schaik.
[ISBN: 978–0–627–03705–4]

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 Recommended Reading

Gans, J., King, S., Stonecash, R. & Mankiw, N.G. 2009. Principles of economics.
4th ed. Australia: Cengage Learning, Australia, Pty Ltd.

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 Topic 1
Measuring the Performance of the Economy

Prescribed Reading

Before continuing with this topic, please read the following:

• Mohr, P. & Fourie, L & Associates (2020:225–276)

1.1 Introduction

After you have worked through this topic, you should be able to:
• Explain the standard macroeconomic objectives.
• Define the most important national accounting concepts.
• Define the unemployment rate.
• Define and interpret the Consumer Price Index (CPI).
• Explain the balance of payments.
• Explain the Lorenz curve and the Gini-coefficient.

Every four years soccer teams from all over the world gather to determine the
best soccer team. Every nation wants to boast that their soccer team is the
winner of the World Cup, in other words, the best soccer team in the world. But
how does one compare the performances of the economies of the world? What
criteria should be used? In this topic, we are going to take a closer look at how
the performance of an economy can be measured.

1.2 Macroeconomic Objectives

Prescribed Reading

Study Section 13.1 of the prescribed book

Five macroeconomic objectives are discussed in this section. These objectives

serve as criteria for assessing the performance of the economy. Study the section
to ensure that you know what each objective or criterion means.

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 Activity 1.1

Note: Solutions to the questions marked with an asterisk (*) are provided at the
end of this study guide.

*Indicate whether the following statements are true (T) or false (F):
T F
a The five macroeconomic objectives serve as criteria for judging the
performance of the economy.
b One of the macroeconomic objectives is that no price in the
economy will increase.
c The objective of price stability means that the inflation rate should
be kept as low as possible.
Short Question

List the five macroeconomic objectives which serve as criteria for measuring the
performance of the economy and explain briefly what each objective means.
(10)

1.3 Measuring the Level of Economic Activity: Gross Domestic

Product (GDP)

Prescribed Reading

Study:
• Section 13.2 of the prescribed book
• Box 13–1 of the prescribed book
• Box 13–2 of the prescribed book

GDP, which serves as the basis for calculating economic growth, is one of the
central concepts in economics. Study the section, and pay particular attention to
the components of the GDP definition and the three methods for calculating GDP.
Also, make sure that you understand the difference between valuation at factor
cost, basic prices and market prices, and that you can distinguish between
current prices and constant prices (or nominal values and real values). Economic
growth is usually measured as the percentage change in GDP at constant prices
(that is, real GDP).

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 Activity 1.2

Note: Solutions to the questions marked with an asterisk (*) are provided at the
end of this study guide.

*Indicate whether the following statements are true (T) or false (F):
T F
a The basic information about the performance of the economy is
recorded in the national accounts.
b The central concept in the national accounts is the gross domestic
product (GDP).
c The owner of a hardware shop purchases 20 axes from a
wholesaler. The axes sold by the wholesaler are not classified as
final goods.
d Peter Modise purchases an axe from a hardware store to chop down
a tree in his garden. The axe sold by the hardware store is classified
as a final good.
e Anna Gumbu spends R10,00 on the ingredients required to bake a
chocolate cake. She bakes the cake and sells it for R20,00 at a
morning market. The value added in this example amounts to
R10,00.
f The flour used in a bakery to bake bread and the flour used by
Helen Rantho to bake bread for her family are both classified as
intermediate goods.
g The compilers of the national accounts can avoid double counting by
recording only every second transaction in the economy.
h To avoid double counting in the national accounts, only sales of final
goods and services (expenditure method) or the value added during
different stages of the production process (production method)
should be taken into account.
i According to the income method, GDP is estimated by adding up the
income earned by the various factors of production.
j The GDP in a particular country in a particular year is a stock
concept.
k The value of computers manufactured in South Africa by a Japanese
firm does not form part of the South African GDP.
l The wages earned by a citizen of Lesotho working at a South African
gold mine form part of the South African GDP.
m A farmer buys his neighbour’s tractor. The value of this transaction
is included in GDP
n GDP at factor cost includes value-added tax (VAT).
o As a result of VAT and other taxes on products being greater than
subsidies on products, GDP at market prices is greater than GDP at
basic prices in South Africa.

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p GDP at current prices is synonymous with real GDP.
q To measure real economic growth, GDP at current prices has to be
transformed into GDP at constant prices.
r During inflationary periods, the growth in real GDP is always higher
than the growth in nominal GDP.
Short Questions

1.* Define the gross domestic product (GDP) and explain the meaning of the
various elements of the definition. (6)
2. Explain how double counting can be avoided when GDP is estimated. (4)
3. Use examples to explain the difference between final goods and
intermediate goods. (4)
4. Name the three methods used to estimate GDP. (3)
5. Is GDP a stock or a flow? Explain. (3)
6. Explain the difference between measurement at market prices, basic prices
and factor cost. (4)
7. Explain the difference between measurement at current prices and
measurement at constant prices. (4)
8. Explain the difference between nominal GDP and real GDP. (2)
9.* The table below shows the GDP at current prices of country A for years 1
and 2.
Year GDP at Current Prices
1 100
2 110
Given the information in the table, explain why it is impossible to tell whether
the 10% increase in GDP from year 1 to year 2 represents economic growth.
(6)
10.* Use the information in the following table to calculate the increase in real
GDP between 2001 and 2003. (2)
Year Nominal GDP Real GDP
2001 280 280
2002 315 260
2003 305 300

1.4 Other Measures of Production, Income and Expenditure

Prescribed Reading

Study Section 13.3 of the prescribed book

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This section contains definitions and explanations for a number of other national
accounting concepts. You must be able to distinguish between gross national
income (GNI), GDP and gross domestic expenditure (GDE).

Activity 1.3

Note: Solutions to the questions marked with an asterisk (*) are provided at the
end of this study guide.

*Indicate whether the following statements are true (T) or false (F):
T F
a Income earned by Zimbabwean citizens working in South Africa
forms part of the South African GDP and the Zimbabwean GNP.
b In South Africa, GDP has always been smaller than GNI.
c Part of consumption spending (C) in South Africa is on imported
goods.
d Part of government spending (G) in South Africa is on imported
goods.
e Imports are included in GDE.
f Imports are included in GDP.
g Exports are not included in GDE.
Short Questions

1. Explain the difference between GDP and GNI. (3)

2. Explain the difference between gross product and net product. (2)
3. What is gross domestic expenditure (GDE) and how does it differ from
expenditure on GDP? (4)

1.5 Measuring Employment and Unemployment

Prescribed Reading

Study Section 13.4 of the prescribed book

This is a short section on the measurement of employment and unemployment.

Note that employment and unemployment are quite difficult to measure in
practice. We will revisit this section when we deal in greater deal with the various
aspects of employment and unemployment in Topic 9.

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 Activity 1.4

Short Question

Define the unemployment rate. (2)

1.6 Measuring Prices: The Consumer Price Index

Prescribed Reading

Study:
• Section 13.5 of the prescribed book
• Box 13–6 of the prescribed book

This section deals with the measurement of inflation. Inflation is usually

measured by calculating the rate of change in the consumer price index (CPI).
You must be able to define the CPI and to use it in order to calculate changes in
the purchasing power of money.

Activity 1.5

Note: Solutions to the questions marked with an asterisk (*) are provided at the
end of this study guide.

*Indicate whether the following statements are true (T) or false (F):
T F
a The consumer price index (CPI) and the inflation rate are the same.
b The CPI is an index of the cost of a representative basket of goods
and services and serves as a basis for calculating the inflation rate.
c The CPI is an index of the cost of living.
Short Questions

1. Differentiate between nominal and real values. (2)

2. Describe the CPI. (3)
3. What are the main elements of the CPI? (4)

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1.7 Measuring the Links with the Rest of the World: Balance of
Payments

Prescribed Reading

Study Section 13.6 of the prescribed book

This section deals with the balance of payments, which you will deal with in
Topic 4.

Activity 1.6

Short Questions

1. What is the balance of payments? (2)

2. Distinguish between the current account and the financial account of the
balance of payments. (4)

1.8 Measuring Inequality: Distribution of Income

Prescribed Reading

Study:
• Section 13.7 of the prescribed book
• Figure 13–1

This section deals with the measurement of inequality. Note the three measures
that are used to measure inequality.

Activity 1.7

Short Question

Name the three measures that are used to measure inequality. (3)

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 Topic 2
The Monetary Sector

Prescribed Reading

Before continuing with this topic, please read the following:

• Mohr, P. & Fourie, L. & Associates (2020:581–299)

2.1 Introduction

After you have worked through this topic, you should be able to
• Explain what money is and explain its functions.
• Define M1, M2 and M3.
• Discuss the functions of the SARB.
• Explain and illustrate with the aid of a diagram the interaction between the
interest rate and the demand for money.
• Discuss the instruments of monetary policy.

A rate cut? The repo rate? Monetary policy? Yes, the time has arrived to have a
closer look at the financial sector.

2.2 Functions of Money

Prescribed Reading

Study Section 14.1 of the prescribed book

We start our investigation of the monetary sector with a closer look at money.
Study the functions of money in detail.

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Macroeconomics ECO10B
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 Activity 2.1

Note: Solutions to the questions marked with an asterisk (*) are provided at the
end of this study guide.

*Indicate whether the following statements are true (T) or false (F):
T F
a An economy in which goods are traded for other goods is called a
barter economy.
b The use of money eliminates the need for a double coincidence of
wants associated with a barter economy.
c The essential function of money is that it serves as a medium of
exchange (or means of payment).
d When inflation is experienced, money loses some of its usefulness as
a store of value.
e Individuals can hold their wealth only in the form of money in other
words, money is the only possible store of value.
f Money is a financial asset.
g During inflation it is often more advantageous to keep certain assets
other than only money.
h Wealthy people generally keep most of their assets in the form of
money.
Short Questions

1. What is the difference between a monetary economy and a barter economy?

(2)
2. List the three basic functions of money and explain briefly what each one
means. (6)
3. Define money. (3)
4. Differentiate between money, income and wealth. (3)

2.3 Different Kinds of Money

Prescribed Reading

Study:
• Section 14.2 of the prescribed book
• Box 14–1 of the prescribed book

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This section deals with the different kinds of money. It is important to note that
originally the intrinsic value and exchange value of money were the same (for
example, a gold coin). At present, the intrinsic value of money is nothing (the
paper value of a note is worth nothing), but the exchange value is high (think
about a R200 note). In other words, its value is based on confidence.

Activity 2.2

Note: Solutions to the questions marked with an asterisk (*) are provided at the
end of this study guide.

*Indicate whether the following statements are true (T) or false (F):
T F
a The South African money supply is fully backed by the amount of
gold in the vaults of the SARB.
b Demand deposits can be withdrawn immediately by writing out a
cheque (which is generally accepted as payment) and therefore
demand (or cheque) deposits form part of the quantity of money.
Short Questions

1. List four properties a commodity must have in order to serve as money.

(4)
2. Why are credit cards not seen as money? (2)

2.4 Money in South Africa

Prescribed Reading

Study Section 14.3 of the prescribed book

The different measures for the quantity of money used by the SARB are
introduced in this section. You must be able to define M1, M2 and M3. Note that
demand deposits are greater than coins and banknotes in equation 14–1.

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 Activity 2.3

Note: Solutions to the questions marked with an asterisk (*) are provided at the
end of this study guide.

*Indicate whether the following statements are true (T) or false (F):
T F
a The quantity of money in South Africa consists largely of coins and
banknotes.
b In South Africa, there are at least three different measures for the
quantity of money: M1, M2 and M3.
c M1 is the narrowest measure of money and consists of coins, notes
and demand deposits.
d M1 relates to the function of money as a medium of exchange.
Short Question

What is the main difference between M1, M2 and M3? (2)

2.5 Financial Intermediaries

Prescribed Reading

Study:
• Section 14.4 of the prescribed book
• Box 14–3

The place of the financial sector in the economy, as introduced in section 3.7 of
the prescribed book, is revisited in this section. Take note of the main function
of financial intermediaries, which is to act as an intermediary between the surplus
units and deficit units in the economy.

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 Activity 2.4

Note: Solutions to the questions marked with an asterisk (*) are provided at the
end of this study guide.

*Indicate whether the following statements are true (T) or false (F):
T F
a The major function of a financial intermediary such as a bank is to
act as a link between the surplus units in the economy and the
deficit units.
b Interest is the amount that a borrower has to pay a lender for the
use of the funds concerned.
Short Questions

1. Distinguish between real and financial transactions. (2)

2. Explain the basic function of a financial intermediary. (3)

2.6 The South African Reserve Bank

Prescribed Reading

Study Section 14.7 of the prescribed book

The functions of the South African Reserve Bank (SARB) are explained in this
section. The central bank plays an important role in the South African economy
and you must know what its main functions are.

Activity 2.5

Short Questions

1. List four of the functions of the SARB. (4)

2. Explain what a clearing bank means. (2)
3. Explain the term “lender of last resort”. (3)

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2.7 The Demand for Money

Prescribed Reading

Study:
• Section 14.5 of the prescribed book
• Table 14–1 The demand for money (or liquidity preference): A summary

The various aspects of the demand for money are summarised in table 14–1 and
figure 14–1. Study this section in detail.

Activity 2.6

Note: Solutions to the questions marked with an asterisk (*) are provided at the
end of this study guide.

*Indicate whether the following statements are true (T) or false (F):
T F
a The opportunity cost of holding money is the interest that could
have been earned by holding interest-bearing assets (for example,
bonds) instead.
b The demand for money arises from the functions of money as a
medium of exchange and as a store of value.
c The quantity of money demanded for transaction purposes is related
to the function of money as a medium of exchange.
d The demand for money for speculative purposes arises from the
function of money as a store of value.
e There is a positive relationship between the quantity of money
demanded for speculative purposes and the level of income.
f Since money is the most liquid of all assets, the demand for it is also
called liquidity preference.
g The quantity of money demanded for transactions and precautionary
purposes is also called the demand for active balances and is related
to the level of income in the economy.
h If the interest rate is high, the quantity of money demanded for
speculative purposes will also be high.
i The demand for passive balances refers to the precautionary
demand for money.
j There is an inverse relationship between the interest rate and the
quantity of money demanded for speculative purposes.

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k The total quantity of money demanded depends on the level of
income and the interest rate.
l An increase in income will result in an increase in the quantity of
money demanded at each interest rate, which can be illustrated by a
rightward shift of the money demand curve.
Short Questions

1. What is the opportunity cost of holding money? (2)

2. Define the demand for money. (2)
3. Name the three motives for holding money according to John Maynard
Keynes. (3)
4. What is the main determinant of
a the quantity of money demanded for transaction purposes?
b the quantity of money demanded for precautionary purposes?
c the quantity of money demanded for speculative purposes? (3)
5. Distinguish between active balances and passive balances and name the
main determinant of the quantity demanded of each type. (5)
6.* Use diagrams to illustrate how the total demand for money (or liquidity
preference) in the economy is made up. (6)

2.8 The Stock of Money: How Is Money Created

Prescribed Reading

Study:
• Section 14.6 of the prescribed book
• Box 14–7

In section 14.7 we have said the South African Reserve bank uses three
definitions for money. These definitions are used to determine the quantity of
money. In section 14.5 we indicated that demand deposits constitute the main
component of the quantity of money. You must take note of how banks can
create money.

The South African Reserve Bank control the creation of money by commercial
banks using interest rates because creating money uncontrolled can contribute
towards higher inflation.

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Take note that there is no independent supply for money curve. The stock of
money is determined by the interaction of the demand for money and the interest
rate. The South African Reserve Bank determines the interest rate. This is
illustrated in Figure 14–2. The conclusion reached in this section, that the supply
of money in South Africa is essentially a function of the demand for money.

2.9 Monetary Policy

Prescribed Reading

Study Section 14.8 of the prescribed book

Monetary policy can be defined as the measure that monetary authorities take
to influence the quantity of money or the rate of interest with a view to achieving
stable prices, full employment and economic growth. In South Africa, the SARB
formulates and implements monetary policy.

You should be able to define monetary policy, distinguish between direct or non-
market oriented measures and market-oriented measures, and provide examples
of each type. Pay particular attention to accommodation policy and open-market
policy.

Activity 2.7

Note: Solutions to the questions marked with an asterisk (*) are provided at the
end of this study guide.

*Indicate whether the following statements are true (T) or false (F):
T F
a In South Africa, monetary policy is formulated and implemented by
the SARB, which is the country’s monetary authority.
b The use of open-market policy and accommodation policy are
classified as market-oriented monetary policy measures.
c An increase in the rate of value-added tax from 14 to 15 per cent
can be classified as a market-oriented monetary policy measure.
d The rate at which the SARB grants accommodation to the banks is
called the repo rate.
e Changes in the repo rate are part of the SARB’s accommodation
policy.

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f If the SARB wishes to apply a contractionary monetary policy, it can
raise the repo rate.
g When the price of bonds increases, the market rate of interest also
increases.
h There is an inverse relationship between the price of bonds and the
market interest rate.
i An increase in the supply of bonds will raise the price of bonds and
lower the interest rate.
Short Questions

1. Define monetary policy and name any three instruments of monetary policy.
(5)
2. List three market-oriented instruments of monetary policy in South Africa.
(3)
3. Identify two direct or non-market-oriented instruments of monetary policy.
(2)
4. Define the repo rate and explain how it can be used as an instrument of a
contractionary monetary policy. (6)
5. Define accommodation policy and explain how it should be applied if the
central bank wishes to stimulate economic activity. (6)
6. Explain what open-market policy means. (3)
7. Explain briefly how open-market policy can be used to stimulate economic
activity in the economy. (3)

Note

Section 14.9 of the prescribed book is not prescribed for this topic.

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 Topic 3
The Public Sector

Prescribed Reading

Before continuing with this topic, please read the following:

• Mohr, P. & Fourie, L. & Associates (2020:309–330)

3.1 Introduction

After you have worked through this topic, you should be able to:
• Explain briefly, why government is involved in economic activity.
• Explain how government intervenes in the economy.
• Discuss government failure.
• Discuss nationalisation and privatisation.
• Explain how government spending can be financed.
• Explain the criteria for a good tax.
• Discuss the various types of taxes.
• Define and explain fiscal policy.

Taxes. Yes, what a dreadful word. But we can hardly discuss the role of
government in the economy without raising the question of taxes. Why do we
have to pay taxes? Surely, government can find alternative ways to finance the
promised free education, housing and basic services? In this topic, we will
investigate the different aspects of the public sector or government’s role in the
economy, particularly the level and composition of government spending, the
financing of government spending, taxation and fiscal policy.

3.2 Role of Government in the Economy: An Overview

Prescribed Reading

Study Sections 15.1 and 15.2 of the prescribed book

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In chapter 2 of the prescribed book, it is suggested that nowadays all economies
can be classified as mixed economies in which the government, the private sector
and market forces all play an important role. The appropriate mix of market and
government intervention is investigated in this section.

The role of government in the economy can be summarised by distinguishing

between three broad functions of government:
• The allocative function refers to the role of government in correcting market
failure and achieves a more efficient allocation of resources.
• The distribution function refers to the steps government takes to achieve a
more equitable or socially acceptable distribution of income than that
generated by market forces.
• The stabilisation function refers to the measures government takes to
promote macroeconomic stability for example, full employment, price
stability and balance-of-payments stability.

Activity 3.1

Note: Solutions to the questions marked with an asterisk (*) are provided at the
end of this study guide.

*Indicate whether the following statements are true (T) or false (F):
T F
a General government consists of central, provincial and local
government.
b Adam Smith argued for extensive government intervention in the
economy because of market failure.
c The existence of externalities prevents the attainment of a socially
efficient allocation of resources in the economy.
d Market systems tend to generate unequal distributions of personal
income.
e The allocation function of government refers to actions by
government to promote an efficient allocation of resources in the
economy.
f The stabilisation function of government refers to measures taken to
promote political stability in the country.
Short Question

Give two reasons for government intervention in the economy. (2)

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 Note

Sections 15.3 and 15.4 of the prescribed book are not prescribed for this topic.

3.3 How Does Government Intervene?

Prescribed Reading

Study Section 15.5 of the prescribed book

Having had a look at the reasons for government intervention in the economy,
we now turn to the question of how government intervenes. You should be able
to discuss the different options available to government.

Activity 3.2

Short Question

Discuss the instruments available to government to achieve its objectives. (10)

3.4 Government Failure

Prescribed Reading

Study Section 15.6 of the prescribed book

Contrary to popular belief, government can also fail. In this section, we examine
some of the forms of government failure.

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 Activity 3.3

Note: Solutions to the questions marked with an asterisk (*) are provided at the
end of this study guide.

*Indicate whether the following statement is true (T) or false (F):

T F
a Government failure arises when politicians, bureaucrats and other
interest groups put their own interests before those of society as a
whole.
Short Question

Discuss the different forms of government failure. (8)

3.5 Nationalisation and Privatisation

Prescribed Reading

Study Section 15.7 of the prescribed book

In this section, the desirability of nationalisation compared to privatisation is

investigated. Ensure that you are familiar with the arguments for and against
each.

Activity 3.4

Note: Solutions to the questions marked with an asterisk (*) are provided at the
end of this study guide.

*Indicate whether the following statement is true (T) or false (F):

T F
a Privatisation could improve efficiency, but it might have an adverse
impact on employment.
Short Questions

1. Distinguish between nationalisation and privatisation, and give a practical

example of each. (4)

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2. Briefly discuss the arguments for and against nationalisation and
privatisation. (8)

3.6 Fiscal Policy and the Budget

Prescribed Reading

Study Section 15.8 of the prescribed book

This section introduces fiscal policy, one of the most important types of economic
policy, which is analysed in part IV of the prescribed book. You should be able to
define fiscal policy and distinguish between fiscal policy and monetary policy.
Note also the meaning of demand management, expansionary (or stimulatory)
policy and restrictive (or contractionary) policy.

Activity 3.5

Note: Solutions to the questions marked with an asterisk (*) are provided at the
end of this study guide.

*Indicate whether the following statements are true (T) or false (F):
T F
a The annual budget sets out the joint fiscal and monetary policy of
the government and the SARB for the coming financial year.
b Changes in taxes and government expenditure represent fiscal
policy decisions.
c Government could use the budget to try to influence variables such
as total production, income and employment and to redistribute
income in the economy.
d Government should implement restrictive fiscal policy measures
during a recession.
Short Questions

1. Define fiscal policy and list the major instruments of fiscal policy. (5)
2. Distinguish clearly between fiscal policy and monetary policy. (4)
3. Suppose the government wishes to stimulate economic activity by applying
expansionary monetary and fiscal policy. Name one monetary policy step
and one fiscal policy step, which can be taken. (2)

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3.7 Government Spending

Prescribed Reading

Study Section 15.9 of the prescribed book

Note how government spending has increased in South Africa. You should be
able to explain the causes of this trend. Also, note the changes in the composition
of government spending.

Activity 3.6

Note: Solutions to the questions marked with an asterisk (*) are provided at the
end of this study guide.

*Indicate whether the following statements are true (T) or false (F):
T F
a Government spending in South Africa consists largely of spending on
capital goods (that is, investment spending).
b Changes in the level and composition of government spending
sometimes reflect changes in social priorities but could also be the
result of the influence of powerful special interest groups.
c Political shocks and other major disturbances could exert strong
upward pressure on government spending.
d Excessive or unrealistic expectations about what government can
deliver (for example, in the form of improved education, health and
housing) could exert upward pressure on real government spending.
e Both a rapidly growing population and a high rate of urbanisation
tend to exert upward pressure on government spending.
Short Question

Give four reasons for the growth in government spending in South Africa since
1960. (4)

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3.8 Financing of Government Spending

Prescribed Reading

Study Section 15.10 of the prescribed book

Study the different ways in which government spending can be financed. Note
how public debt and the interest on public debt have increased. The latter to a
point where almost 20 cents out of each rand of tax revenue are used to finance
the interest payments.

Activity 3.7

Note: Solutions to the questions marked with an asterisk (*) are provided at the
end of this study guide.

*Indicate whether the following statements are true (T) or false (F):
T F
a The budget deficit (or surplus) is the difference between government
spending and current revenue (mainly taxes).
b The budget deficit is usually financed through taxation.
c If government finances part of its spending by borrowing from the
central bank, this is called inflationary financing.
d A budget surplus occurs when the government’s purchases of goods
and services exceed the tax revenue it has received.
Short Questions

1. Identify the three broad ways in which government spending can be

financed. (3)
2. Define the budget deficit. (2)

3.9 Taxation

Prescribed Reading

Study Section 15.11 of the prescribed book

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• Criteria for a Good Tax
Study the three criteria for a good tax.

• Different Types of Tax

You should be able to distinguish between direct taxes and indirect taxes
and give examples of each. You should also be able to distinguish between
progressive, proportional and regressive taxes and provide examples of
each.
You must be able to distinguish between marginal and average tax rates.
Note how the overall tax burden and the personal income tax burden have
increased in South Africa in recent decades.
Please note that the tables are provided to illustrate certain trends. You are
not expected to study the data (figures) in these tables!

Activity 3.8

Note: Solutions to the questions marked with an asterisk (*) are provided at the
end of this study guide.

*Indicate whether the following statements are true (T) or false (F):
T F
a Taxes that distort relative prices inhibit the functioning of the
market mechanism and are not neutral.
b Taxes should always be aimed at changing the economic behaviour
of taxpayers.
c An admission fee at a public swimming pool is an example of user
charging.
d Tax avoidance refers to the practice of using illegal ways of avoiding
taxes.
e Tax evasion is illegal.
f Direct taxes are levied directly on goods and services.
g A tax is progressive if lower income groups pay a smaller percentage
of their taxable income in the form of tax than higher income
groups.
h A tax is regressive if it takes a greater percentage of the taxable
income from lower-income groups than from higher-income groups.

Short Questions

1. List the three basic criteria for a good tax. (3)

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2. Explain the difference between direct taxes and indirect taxes and give an
example of each. (4)
3. Explain the difference between progressive and regressive taxes and give
an example of each. (4)
4. Explain the difference between a marginal tax rate and an average tax rate
in respect of personal income tax. (2)

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 Topic 4
The Foreign Sector

Prescribed Reading

Before continuing with this topic, please read the following:

• Mohr, P. & Fourie, L. & Associates (2020:333–354)

4.1 Introduction

After you have worked through this topic, you should be able to:
• Explain the concepts of “absolute advantage” and “relative advantage”.
• Identify possible trade barriers.
• Explain the exchange rate between the United States dollar and the South
African rand as well as any changes that might occur.
• Explain an appreciation or depreciation of the rand against the dollar and
vice versa.

In 2002, the Myburgh Commission was set up to investigate the reasons for the
sharp decline in the value of the rand. Needless to say, the Commission could
not pinpoint the reasons for the decline in the value of the rand. Recently, with
the strengthening of the rand, cries went up from various sectors of the economy
that the foreign exchange market should be stabilised. Do you have any
suggestions? In this topic, we will investigate the interaction between the foreign
sector and the domestic economy. We will focus on the reasons for international
trade, the main components of the balance of payments and the exchange rate.

4.2 Why Countries Trade

Prescribed Reading

Study Section 16.2 of the prescribed book

In this section, we will investigate the reasons for trade between countries.

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Study the three advantages of trade namely absolute advantage, comparative
advantage and equal advantage. Also, note the sources of comparative
advantage.

Activity 4.1

Note: Solutions to the questions marked with an asterisk (*) are provided at the
end of this study guide.

*Indicate whether the following statements are true (T) or false (F):
T F
a The more open a country’s economy is, the more vulnerable it is to
changes in the economic conditions of other countries.
b A country is said to have an open economy if a significant
percentage of GDP is exported and a significant part of domestic
spending is on imported goods and services.
c Adam Smith argued that countries should try to be as self-sufficient
as possible.
d One of the basic reasons for international trade is that not all
countries have the same factors of production for example, natural
resources.
e South African citizens would be better off economically if the country
did not engage in international trade at all.
f The law of relative (or comparative) advantage states that two
countries will benefit from trade if the opportunity costs of
production (or relative prices) differ between the two countries.
g Absolute advantage is a prerequisite for trade.
h Equal advantage is a prerequisite for trade.
i Comparative (or relative) advantage is a prerequisite for trade.
Statements (10) to (15) are based on the following information:
Susan can knit four jerseys or sew eight dresses per week, while
Jackie can knit three jerseys or sew four dresses per week.
j Susan has an absolute advantage in knitting jerseys.
k Susan has an absolute advantage in sewing dresses.
l Susan has a relative (or comparative) advantage in knitting jerseys.
m Susan has a relative (or comparative) advantage in sewing dresses.
n Jackie has a relative (or comparative) advantage in knitting jerseys.
o Jackie should specialise in knitting jerseys while Susan should
specialise in sewing dresses.
p If country A can produce 2 400 tractors or 3 million tons of maize
per year and country B can produce 1 500 tractors or 3 million tons
of maize per year, then A should specialise in producing tractors,
while B should specialise in producing maize.

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Short Questions

1. Use the following information to illustrate the law of comparative

advantage: (6)
Guns Roses
Country A 20 80
Country B 10 20

2. List the main sources of comparative advantage. (3)

4.3 Trade Policy

Prescribed Reading

Study Section 16.3 of the prescribed

This section deals with steps that governments introduce to protect domestic
industries against foreign competition. These measures include:
• Import tariffs
• Import quotas
• Subsidies
• Non-Tariff barriers
• Exchange control
• Exchange rate policy

4.4 Exchange Rates

Prescribed Reading

Study:
• Section 16.4 of the prescribed book
• Table 16–1 and 16–2

This section, which explains exchange rates, must be studied in detail. Note that
an exchange rate is a price – like the price of any other commodity – and that
the determination of exchange rates is simply an application of the
microeconomic theory of demand and supply, explained in chapters 4 and 5.

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You should be able to explain the exchange rate between the United States dollar
and the South African rand, as well as possible changes in this exchange rate.
You should also be able to distinguish between an appreciation and a depreciation
of the rand against the dollar. Note that the SARB’s ability to intervene in the
foreign exchange market depends on the availability of foreign exchange
reserves.

Activity 4.2

Note: Solutions to the questions marked with an asterisk (*) are provided at the
end of this study guide.

*Indicate whether the following statements are true (T) or false (F):

T F
a Exports create a supply of foreign exchange, while imports
constitute a demand for foreign exchange.
b An exchange rate is the price of one currency in terms of another
currency.
c An increase in South African imports from the United States will give
rise to an appreciation of the rand against the US dollar.
d A fall in the value of the rand against the Japanese yen is described
as a depreciation of the rand against the yen.
e One possible source of the demand for dollars in the South African
foreign exchange market is American investors wishing to invest in
South Africa.
f If American importers purchase more South African goods, the
supply of dollars in the South African foreign exchange market
increases.
g An increase in the supply of dollars in the South African foreign
exchange market will result in an appreciation of the rand against
the dollar.
h A depreciation of the rand against the US dollar will reduce the
competitiveness of American goods and services in South Africa.
i If the demand for US dollars in the South African foreign exchange
market falls, the rand will depreciate against the US dollar.
j If the rand appreciates against other currencies, South African
exports will become more competitive.
k A depreciation of the rand against other currencies can be useful in
the fight against inflation.
l A depreciation of the rand against other currencies will raise the
prices of imported capital goods.

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m If the SARB had the necessary foreign exchange reserves, it could
intervene in the foreign exchange market to prevent sharp
fluctuations in the exchange rates between the rand and other
currencies.
Short Questions

1.* Use a diagram to explain what would happen to the exchange rate between
the rand and the US dollar if South African exports to the United States
increased, ceteris paribus. (8)
2.* With the aid of a diagram, explain what will happen to the exchange rate
between the rand and the dollar when the demand for dollars increases.
(6)
3. Name two possible sources of
a the demand for dollars in South Africa.
b the supply of dollars in South Africa. (4)
4. Use a numerical example to distinguish between an appreciation and a
depreciation of the rand against the dollar. (4)
5. Explain the policy options available to stabilise a currency under a floating
exchange rate system. (6)

4.5 Terms of Trade

Prescribed Reading

Study Section 16.5 of the prescribed book

You should understand and be able to define what is meant by terms of trade.

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 Topic 5
A Simple Keynesian Model of the Economy

Prescribed Reading

Before continuing with this topic, please read the following:

• Mohr, P. & Fourie, L. & Associates (2020:355–377)

5.1 Introduction

After you have worked through this topic, you should be able to:
• Explain the relationship between the three central macroeconomic flows.
• List the basic assumptions of the Keynesian macroeconomic model.
• Explain (with or without the aid of a diagram) the three important
characteristics of the consumption function.
• Explain the relationship between consumption and saving.
• Explain, with the aid of a diagram, the equilibrium level of income.
• Read from a given diagram the level of autonomous spending, the marginal
propensity to consume and the equilibrium level of income.
• Calculate:
o Private consumption expenditure
o The level of autonomous spending
o The multiplier
o The equilibrium level of income

“But now comes the burden of having to decide what to do with some
discretionary income – spend it à la Keynes or save it à la the governor? “What
does this statement mean? The time has arrived for us to apply what we have
learnt so far.

In Topic 3 of ECO15A, we saw how the different role players in the economy are
related. In Topic 1 of ECO10B, the importance of economic growth and
unemployment was emphasised. But how can the different role players in the
economy work together to increase economic growth? In this topic, we will build
a model of the economy. In so doing, we will use the views of Keynes to explain
how the equilibrium level of income is determined in an economy without a
government and a foreign sector.

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The important role played by the multiplier, which indicates by how much the
equilibrium level of income, will change if investment-spending changes, will also
be examined.

5.2 Production, Income and Spending

Prescribed Reading

Study:
• Section 17.1 of the prescribed book
• Box 17–1 of the prescribed book

This section is concerned with the three central flows in the economy (production,
income and spending), which were introduced in Topic 3 of ECO15A. Note the
distinction between the national accounts, which are concerned with the
measurement of total production, income and spending in the economy and
macroeconomic theory, which is concerned with the explanation of these flows.
Pay particular attention to the equilibrium condition. Make sure that you
understand the three possible relationships between spending and production (or
income). Also, note the difference between the Keynesian approach, which
focuses on aggregate spending, and Say's law, according to which supply creates
its own demand.

Take note of the synonyms discussed in box 17–1 for total production and income
and total spending in the economy otherwise you may be confused when they
are used.

Activity 5.1

Note: Solutions to the questions marked with an asterisk (*) are provided at the
end of this study guide.

*Indicate whether the following statements are true (T) or false (F):
T F
a In macroeconomics, we use the symbol Y to denote total income and
production in the economy, while the symbol A denotes total
spending in the economy.

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b In macroeconomic theory, the symbol Y is the theoretical equivalent
of national accounts aggregates such as GDP and GNI.
c In macroeconomic theory, spending is always equal to production or
income.
d Macroeconomic theory uses the information of the national accounts,
hence production, income and spending must, as in the national
accounts, always be equal in macroeconomic theory as well.
e According to John Maynard Keynes, total production and income in
the economy is determined by total spending (or aggregate
demand).
f According to Say's law, goods and services will only be produced if
there is a demand for them.
g According to Say, aggregate (total) demand in the economy can
never be insufficient because supply creates its own demand.
h The full-employment level of production (or income) is the level of
production (or income) at which all the factors of production are
fully employed.
i In the Keynesian model there will always be an automatic tendency
towards full-employment if the economy is operating at a level of
production or income below the full-employment level.
Short Questions

1. Indicate how the relationships between the three main flows in the economy
in macro-economic theory differ from those in the national accounts. (7)
2. What is the basic difference between the national accounts and
macroeconomic theory? (4)
3. Contrast the views of Jean-Baptiste Say and John Maynard Keynes on the
relationship between total income and total spending in the economy. (4)

5.3 The Basic Assumptions of the Model

Prescribed Reading

Study:
• Section 17.2 of the prescribed book
• Box 17–2 of the prescribed book

The basic assumptions of the model are explained in this section. Study this
section, including box 17–2, carefully. We start with a simple model of an
economy which does not include a government sector or a foreign sector.

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This is done so we can focus on certain important concepts without being
confused by too much detail. Once the foundation has been laid, the simplifying
assumptions can be relaxed.

Activity 5.2

Note: Solutions to the questions marked with an asterisk (*) are provided at the
end of this study guide.

*Indicate whether the following statements are true (T) or false (F)
T F
a In the Keynesian macroeconomic model of this chapter, prices,
wages and interest rates are regarded as exogenous variables, in
other words assumed to be given.
b In macroeconomic theory the symbol I is used to indicate the total
flow of funds through the financial institutions.
c Macroeconomic theory deals with events that occurred in the past.
Short Question

Give the four basic assumptions of the Keynesian macroeconomic model of an

economy without a government and a foreign sector. (4)

5.4 Consumption Spending

Prescribed Reading

Study Section 17.3 and 17.4 of the prescribed book

Aggregate spending on goods and services A (or the aggregate demand for goods
and services) is the driving force in the Keynesian model. The largest component
of aggregate spending is consumption spending by households C, which is
introduced in this section. The important points to note are:
• the direct (or positive) relationship between consumption spending C and
income Y;
• the difference between autonomous consumption C and induced
consumption cY; and
• the meaning of the marginal propensity to consume c.

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Make sure that you can express the consumption function both graphically and
as an equation, and that you know what the different elements of the graph and
the equation signify. Section 17.4 introduces saving S and explains how S is
related to Y (and C).

Activity 5.3

Note: Solutions to the questions marked with an asterisk (*) are provided at the
end of this study guide.

*Indicate whether the following statements are true (T) or false (F)
T F
a The marginal propensity to consume is indicated by c and equals
∆C/∆Y which indicates the slope of the consumption function.
b Induced consumption refers to the fixed part of consumption
spending which does not change as the level of income changes.
c The intercept of the consumption function reflects the influence of
the non-income determinants of consumption spending.
d Consumption spending can exceed income because households can
use savings from a previous period to finance such spending.
e If the marginal propensity to consume is 3/4, then at an income
level (Y) of 100 the level of induced consumption is 75.
f If C = 80 and c = 4/5, then C = 880 at an income level of 1000.
g If C = 100 + 0,7Y, then S = −100 − 0,7Y.
Short Questions

1. Explain with the aid of a diagram, the economic significance of the intercept
and the slope of the consumption function. (3)
2. Explain with the aid of a diagram, the three important characteristics of the
consumption function. (6)
3. Explain with the aid of a diagram, the difference between autonomous
consumption and induced consumption. Also refer to the meaning of the
marginal propensity to consume. (6)
4. Use diagrams or equations to explain the relationship between consumption
and saving. (4)

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5.5 Investment Spending

Prescribed Reading

Study Section 17.5 of the prescribed book

This section introduces investment spending I, which is related to capital goods

(not to financial assets). Make sure that you know what investment (also called
capital formation) means. Note that investment is not related to changes in total
production or income Y, i.e. it is regarded as autonomous with respect to Y.

Activity 5.4

*Indicate whether the following statements are true (T) or false (F)
T F
a Investment is negatively (inversely) related to the interest rate.
b Investment spending is less volatile than consumption spending
because it takes a long time to implement investment projects.
c If investment is independent of the income level, it is regarded as
autonomous and illustrated graphically by a horizontal line.
d Income is the most important determinant of the level of
investment.
Short Question

*Use two diagrams to illustrate the relationship between:

a Investment spending and the interest rate.
b Investment and the level of income in the economy (Y). (4)

5.6 The Simple Keynesian Model of a Closed Economy without a

Government

Prescribed Reading

Study Section 17.6 of the prescribed book

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Consumption spending C and investment spending I are combined with the 45°
line to establish the equilibrium level of production and income in the economy.
Study the subsection on the 45° line and make sure that you understand why it
represents all the possible equilibrium points where aggregate spending A is
equal to total production or income Y. Also make sure that you understand why
any other combination of A and Y represents either excess demand or excess
supply. The essential elements of the model are explained in words, symbols (or
equations), numbers (or schedules) and graphs. Study this section carefully.

Activity 5.5

Note: Solutions to the questions marked with an asterisk (*) are provided at the
end of this study guide.

*Indicate whether the following statements are true (T) or false (F)
T F
a The 45° line shows all the possible equilibrium points in the
Keynesian model.
b At any level of income below the equilibrium level Y0 there is an
excess supply of goods and services in the economy.
c If income exceeds spending, firms' inventories will decrease.
d If firms' inventories increase, they will cut back on production.
e The slope of the consumption function is an important determinant
of the equilibrium level of income in Keynesian macroeconomic
models.
f In an economy without a government and a foreign sector, the slope
of the total spending (A) curve = slope of the consumption function
= ∆C/∆Y = c = marginal propensity to consume.
Short Questions

1. Explain, with the aid of a diagram, the significance of the 45° line in the
Keynesian macro-economic model. What do points above and below the 45°
line represent? (5)
2. Explain, with the aid of a diagram, the equilibrium level of income in a
Keynesian model without a government or a foreign sector. Clearly indicate
the equilibrium level of income as well as the areas of excess demand and
excess supply. (8)

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5.7 Algebraic Version of the Simple Keynesian Model

Prescribed Reading

Study:
• Section 17.7 of the prescribed book
• Box 17–4 of the prescribed book

This section contains a more detailed algebraic version of the model. You should
try to master it, but if you cannot follow the argument, then concentrate on the
results (i.e. equations 17–1 and 17–7a). You will not be required to derive the
results in the examination.

In box 17–4 is a numerical example of the determination of the equilibrium level

of income. Concentrate on the short method. You should be able to do the
calculations.

Activity 5.6

Note: Solutions to the questions marked with an asterisk (*) are provided at the
end of this study guide.

*Indicate whether the following statements are true (T) or false (F)
T F
a If C = R26 billion, the slope of the C curve = 4/5, and I = R10
billion, the equilibrium level of income (Y0 ) in a closed economy
without a government will be R180 billion.
b If C = R10 billion, I = R30 billion and c = 3/4, then the equilibrium
level of income (assuming that there is no government or foreign
sector) will be R160 billion.
c If C = 50, I = 100 and c = 6/7, then the equilibrium level of income
is 1050.
Short Question

*Calculate the equilibrium level of income in an economy without a government

and a foreign sector if:
a C = R100 million, c = 7/8 and I = R150 million (3)
b C = R10 million, c = 3/4 and I = R40 million (3)

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5.8 The Impact of a Change in Investment Spending: The Multiplier

Prescribed Reading

Study:
• Section 17.8 of the prescribed book
• Box 17–5

The multiplier, one of the central concepts in macroeconomics, is introduced in

this section. The fact that it is quite a long section does not mean that the
multiplier is a difficult concept. Because the multiplier is so important, it is
explained in a number of different ways, again using words, symbols, numbers
and graphs. You do not have to study all the derivations of the multiplier in detail
with a view to reproducing them in the examination. You should only make sure
that you understand the following:

• What the multiplier means.

• How it can be calculated from the formula.
• Why its size depends on the marginal propensity to consume.
• How it can be represented graphically.

Activity 5.7

Note: Solutions to the questions marked with an asterisk (*) are provided at the
end of this study guide.

*Indicate whether the following statements are true (T) or false (F)
T F
a The multiplier indicates how much a change in autonomous
spending will change the equilibrium level of income.
b If the marginal propensity to consume increases, the equilibrium
level of income will increase.
c In an economy without a government and a foreign sector, the size
of the multiplier is determined by the marginal propensity to
consume.
d In an economy without a government and a foreign sector, a
marginal propensity to consume of 4/5 will yield a multiplier of 5/4.
e If c = 4/5, then an increase of 200 in investment spending will
increase the equilibrium level of income by 1000.

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f The equilibrium level of income can be obtained by multiplying the
autonomous components of aggregate spending by the multiplier.
Short Questions

1. Define the multiplier (in words) and give the equation for the multiplier in
a Keynesian model of an economy without a government and a foreign
sector. (4)
2. Explain (in one sentence) the relationship between the equilibrium level of
income, total autonomous spending and the multiplier. (2)
3.* Draw a diagram to explain how a decrease in investment spending will affect
the equilibrium level of income in a Keynesian model of an economy without
a government and a foreign sector. Comment on the relationship between
the size of the change in investment spending and the size of the change in
the equilibrium level of income. (8)
4.* Calculate the multiplier in an economy without a government and a foreign
sector if the marginal propensity to consume is (i) 3/4, (ii) 8/10, (iii) 7/8,
(iv) 2/3, (v) ½, (vi) 6/7, (vii) 8/9. (2 marks each)
5.* Suppose that autonomous consumption expenditure is R200 million, the
marginal propensity to consume is 5/6 and autonomous investment
spending is R400 million. Calculate:
a The multiplier.
b The equilibrium level of income.
Show all your calculations. (4)
6.* Calculate the impact of an increase in investment spending of R100 million
in an economy without a government and a foreign sector if the marginal
propensity to consume is (i) 3/4, (ii) 2/3, (iii) 6/7. (3 marks each)

5.9 The Simple Keynesian Model: A Brief Summary

Prescribed Reading

Study:
• Section 17.9 of the prescribed book
• Box 17–6 of the prescribed book

The main elements of the simple Keynesian model introduced in this chapter are
summarised in this section.

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 Activity 5.8

Note: Solution to the question marked with an asterisk (*) is provided at the end
of this study guide.

Short Question

*Let autonomous consumption (C) = 10. At equilibrium, consumption spending

= 70 and investment spending = 20. Calculate:
a the slope of the aggregate spending curve
b the marginal propensity to consume
c the multiplier

Hint: Draw a diagram with the basic facts at your disposal. (10)

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 Topic 6
Keynesian Models including the Government
and the Foreign Sector

Prescribed Reading

Before continuing with this topic, please read the following:

• Mohr, P. & Fourie, L. & Associates (2020:379–400)

6.1 Introduction

After you have worked through this topic, you should be able to:
• Explain the impact of the introduction of government spending on aggregate
spending, the multiplier and the equilibrium level of income.
• Explain the difference between income and disposable income.
• Explain the impact of the introduction of a proportional income tax on:
o Private consumption expenditure
o Autonomous spending
o The multiplier
o The equilibrium level of income
• Explain, using a diagram, the impact of a change in government spending
or a change in the tax rate on the equilibrium level of income.
• Calculate:
o The level of autonomous spending
o The multiplier
o The equilibrium level of income
o The required change in government spending to reach full employment
• Explain the impact of changes in autonomous exports and induced imports
on the equilibrium level of income.

What do you think? Can the government do more to stimulate the economy? In
this topic, we will extend the model introduced in the previous topic. We will now
include the government and the foreign sector.

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In so doing we will examine the impact of government spending, taxes, exports
and imports on aggregate spending, the multiplier and the equilibrium level of
income. The inclusion of the government allows us to introduce fiscal policy.

6.2 Introducing the Government into Our Model

Prescribed Reading

Study:
• Section 18.1 of the prescribed book
• Boxes 18–1 to 18–4 of the prescribed book

• Government Spending

This section starts by introducing government spending (G). Make sure you
understand why G is regarded as autonomous, how it affects aggregate spending
and the equilibrium level of income, and why it does not affect the multiplier.

Activity 6.1

Note: Solutions to the questions marked with an asterisk (*) are provided at the
end of this study guide.

*Indicate whether the following statements are true (T) or false (F)
T F
a In the simple Keynesian model of an economy with a government
sector, prices, wages and interest rates are regarded as given.
b The introduction of the government into the Keynesian model makes
it possible to analyse the impact of monetary policy.
c Government spending increases as total income Y increases.
d Government spending is essentially a political issue and the level of
government spending is therefore not related systematically to any
economic variable.
e The introduction of government spending increases the size of the
multiplier.
f The introduction of government spending leaves the multiplier
unchanged.
g The introduction of government spending increases the level of
aggregate spending in the economy.

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h Increases in government spending could be used to raise the level
of total production and income in the economy.
i Government spending forms part of total autonomous spending A.
Short Questions

1. Why is government spending classified as part of autonomous spending in

the Keynesian model? (2)
2. How does government spending affect the following?
a Aggregate spending
b The multiplier in the Keynesian model (2)
3.* Use a diagram to illustrate the impact of an increase in government
spending in a Keynesian model of an economy without a foreign sector and
comment on the size of the change in the equilibrium level of income
relative to the change in government spending. (8)

• Taxes

The next variable included in the model is taxes. Make sure that you understand
what a proportional tax is (this was explained in chapter 15) and why we have
to distinguish between income and disposable income once taxes are included in
the model. Also, study the impact of taxes on aggregate spending, the multiplier
and the equilibrium level of income.

Activity 6.2

Note: Solutions to the questions marked with an asterisk (*) are provided at the
end of this study guide.

*Indicate whether the following statements are true (T) or false (F)
T F
a When taxes are introduced in the Keynesian model we have to
distinguish between total income and disposable income.
b The introduction of a proportional income tax in the Keynesian
model reduces the slope of both the consumption function and the
total spending curve; as a result the multiplier also becomes
smaller.
c Taxes form part of autonomous spending in the economy.
d If c = 6/7 and t = 1/8, the value of the multiplier is 8.
e If the marginal propensity to consume = 4/7 and the tax rate = 1/8,
then the multiplier will be 2.

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Short Questions

1. Explain the difference between income Y and disposable income Yd. (2)
2. Explain how a proportional income tax affects:
a autonomous spending
b aggregate spending
c the multiplier in the Keynesian model (5)
3.* Calculate the multiplier if:
a c = 5/6; t = 1/10
b c = 3/4; t = 1/9
c c = 5/8; t = 1/5 (2 marks each)

• The Equilibrium Level of Income in an Economy with a Government Sector

This subsection deals with the combined effect of government spending and
taxes on the equilibrium level of income. Study it and work through the numerical
example in box 18–3 to ensure that you can handle a Keynesian model that
includes the government sector.

Activity 6.3

Note: Solutions to the questions marked with an asterisk (*) are provided at the
end of this study guide.

*Indicate whether the following statement is true (T) or false (F)

T F
If autonomous consumption = 100, the marginal propensity to consume
= 5/6, investment = 200, government spending = 200 and the tax rate
= 1/5, then the equilibrium level of income in a Keynesian model of a
closed economy with a government = 1500.
Short Question

*Calculate the equilibrium level of income in an economy without a foreign sector

if:
a C = R100 million; I = R200 million; G = R280 million; c = 4/5; t = 1/6
b C = R50 million; I = R250 million; G = R300 million; c = 9/11; t = 1/12
c C = R30 million; I = R200 million; G = R400 million; c = 3/4; t = 1/9 (3)

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• Fiscal Policy

The introduction of government spending and taxation means that we can now
analyse the impact of fiscal policy (which was originally defined in chapter 16).

Boxes 18–1 to 18–3 contain numerical examples of the impact of government

spending and a proportional income tax on aggregate spending, the multiplier
and the equilibrium level of income. You should be able to do the type of
calculations illustrated in the examples.

The examination paper will usually include questions involving similar

calculations. Box 18–4 contains a numerical example of the impact of fiscal policy
on aggregate spending and the equilibrium level of income. You should be able
to do the type of calculations illustrated in the example.

Activity 6.4

Note: Solutions to the questions marked with an asterisk (*) are provided at the
end of this study guide.

*Indicate whether the following statements are true (T) or false (F):
T F
a The government can use fiscal policy (i.e. a change in government
spending and/or taxes) to change the equilibrium level of income.
b If the government wishes to reduce the equilibrium level of income,
it can reduce government spending or increase the tax rate.
c If the equilibrium level of income Y0 is below the full-employment
level of income Yf, government spending should be increased by the
required increase in income to close the gap.
d If the marginal propensity to consume = 2/3, the tax rate = 1/4 and
the equilibrium level of income = 2500, then government spending
must be increased by 500 to increase the equilibrium level of
income to 3000.
e If Yf = R240 billion, A = R60 billion, c = 3/4 and t = 1/9, then
government spending must increase by R20 billion to wipe out the
gap between the equilibrium level of income and the full-
employment level of income.
Short Questions

1.* Define fiscal policy and explain how the equilibrium level of income can be
raised through fiscal policy in a Keynesian model. (8)

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2.* Suppose that the marginal propensity to consume = 5/6 and the tax rate =
1/10. The government wants to increase the equilibrium level of income by
R40 billion. Calculate by how much government spending needs to be
increased to raise the equilibrium level of income by this amount. (4)
3.* If C = R40 million, I = R260 million, G = R200 million, c = 7/8, t = 1/7 and
Yf = R2400 million, by how much must government spending increase to
bring the economy to full employment? Show all your calculations. (6)
4.* Suppose the equilibrium level of income is below the full-employment level
of income and that the government wants to eliminate the gap. Explain,
with the aid of a diagram, how this can be achieved by changing the level
of government spending. In addition, comment on the size of the change in
government spending that is required relative to the desired change in the
level of income. (10)

6.3 Introducing the Foreign Sector into the Model: The Open
Economy

Prescribed Reading

Study:
• Section 18.2 of the prescribed book
• Box 18–7 of the prescribed book

The model is extended to include the foreign sector. South Africa is an open,
developing economy. It is important to take note of the impact of the foreign
sector on the level of production and income in the economy.

• Exports

Exports are seen as autonomous as there is no systematic relationship between

income and exports. It depends mainly on economic conditions in the rest of the
world, a country's international competitiveness and exchange rates. Exports are
just added to the other expenditure components and it does not affect the size
of the multiplier.

• Autonomous Imports

If we assume, to keep matters simple, that imports do not depend on income we

are able to treat autonomous imports like any autonomous expenditure

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component. The only difference is, seeing that imports are a leakage from the
circular flow of income and spending, it is subtracted from total expenditure. The
size of the multiplier is however not affected. The more realistic approach is to
recognise that a positive relationship between imports and income exist.

• Induced Imports

When the level of income in the domestic economy increases, it almost

automatically leads to an increase in imports. Though the algebraic treatment of
induced import looks complicated it is not the case. It is treated in the same way
as we treated private consumption function. Therefore it consists of an
autonomous component, Z, and an induced component, mY. The extent to which
imports increase for a given increase in income depends on the marginal
propensity to import, m. A smaller portion of any increase in income is spent
locally and the size of the multiplier is decreases as a result.

Box 18–2 shows a numerical example of the impact of the external sector on
aggregate spending, the multiplier and the equilibrium level of income. You
should be able to do the type of calculations illustrated in the example.

Note

Except if it is otherwise stated, we treat imports as a function of income in this

topic, that is, all questions in the assignments and examination refer to induced
imports, including the impact of the marginal propensity to import on the
multiplier.

Activity 6.5

Note: Solutions to the questions marked with an asterisk (*) are provided at the
end of this study guide.

*Indicate whether the following statements are true (T) or false (F)
T F
a Exports X represent a withdrawal from the circular flow of income
and spending in the domestic economy, since the goods concerned
flow out of the country.

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b Imports Z represent an injection into the circular flow of income and
spending in the domestic economy, since the goods flow into the
country.
c Exports depend mainly on economic conditions in the rest of the
world, a country's international competitiveness and exchange
rates.
d There is no systematic relationship between the level of exports X
and the level of domestic income Y; exports are therefore assumed
to be autonomous with respect to total income Y.
e Exports do not affect the size of the multiplier.
f Imports have a negative sign in the equation for aggregate
spending, because they represent leakages or withdrawals from the
circular flow of income and spending in the domestic economy.
g Imports, like taxes, are a leakage from the flow of income and
spending and therefore reduce the equilibrium level of income.
h Total production and income in the economy can be increased by
increasing imports and decreasing exports.
i If net exports are negative, aggregate spending A will be lower at
each level of income than before the introduction of the foreign
sector.
Short Questions

1. State three possible determinants for the demand of South African exports
and explain why exports are classified as part of autonomous spending in
the Keynesian model. (5)
2.* Use a diagram to illustrate the impact of an increase in exports on the
equilibrium level of income in a Keynesian model of an economy with a
government sector and a foreign sector and comment on the size of the
change in income relative to the size of the change in exports. (8)
3.* Calculate the multiplier if:
a c = 5/6; t = 1/10; m = 1/4
b c = 3/4; t = 1/9; m = 1/6
c c = 5/8; t = 1/5; m = 1/8 (2 marks each)
4.* Suppose that the marginal propensity to consume = 9/10, the tax rate =
1/6 and the marginal propensity to import = 1/12. Calculate the effect of a
reduction of R5 billion in autonomous net exports on the equilibrium level
of income in a Keynesian model of an economy with a foreign sector. (4)

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6.4 Impact of the Government and the Foreign Sector: A Brief
Summary

Prescribed Reading

Study Section 18.4 of the prescribed book

Study the summary about the impact of the government and the foreign sector
as provided in this section.

Activity 6.6

Note: Solution to the question marked with an asterisk (*) is provided at the end
of this study guide.

Indicate whether the following statement is true (T) or false (F)

T F
a In an economy with a government and a foreign sector, aggregate
spending A = C + I + G + X − Z. In the above equation, I, G, X and
Z are autonomous with relation to Y.
Short Question

Given the following information:

• Autonomous consumption = R100m
• Investment spending = R200m
• Government spending = R150m
• Autonomous net exports = R50m
• Marginal propensity to consume = 8/9
• Proportional tax rate = 1/4
• Marginal propensity to import = 1/6
• Full-employment level of income = R1 600m
Calculate:
a Autonomous spending.
b The multiplier.
c The equilibrium level of income.
d The change in government spending required to attain full employment.
Show all your calculations. (8)

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 Important Note

We would like to draw your attention to three variants of the simple Keynesian
model which are presented in chapters 17 and 18. The first is a model of a closed
economy without a government sector in which there are only households and
firms. The second is a model of a closed economy with a government. In this
model, there are households, firms and a government. The last is a model of an
open economy with a government. In other words, the foreign sector is also
included. The three variants may be summarised as follows:

1. The simple Keynesian model of a closed economy without a government:

A=C+I
(i.e. total spending consists of spending by households [C] and spending by
firms on capital goods [ I ])

The multiplier:
1
α=
1 − c

2. The simple Keynesian model of a closed economy with a government:

A=C+I+G
(i.e. total spending now also includes spending by government [G])

The multiplier:
1
α=
1 − c (1 − t )

3. The simple Keynesian model of an open economy with a government:

A = C + I + G + (X − Z)
(The addition of the foreign sector means that autonomous exports (X) and
induced imports (Z) must also be taken into account.)

The multiplier:
1
α=
1 − c (1 − t ) + m

Remember that a closed economy means that the foreign sector is excluded
(i.e. X and Z are excluded), while an open economy means that the foreign
sector is included.

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 Topic 7
More on Macroeconomic Theory and Policy

Prescribed Reading

Before continuing with this topic, please read the following:

• Mohr, P. & Fourie, L. & Associates (2020:403–421)

7.1 Introduction

After you have worked through this topic, you should be able to:
• Use aggregate demand (AD) and aggregate supply (AS) curves to analyse
monetary and fiscal policies and supply shocks.
• Explain the monetary transmission mechanism.
• Explain the policy dilemma in an open economy.

In chapter 14 of the prescribed book, we introduced monetary policy. However,

we did not examine whether monetary variables influence economic activity. In
this topic, we will show how aggregate demand and aggregate supply curves can
be used to analyse the linkage between the monetary and real sectors of the
economy.

7.2 The Aggregate Demand-Aggregate Supply Model

Prescribed Reading
Study:
• Section 19.1 of the prescribed book
• Box 19–1 of the prescribed book
• Table 19–1: Impact of key changes on the aggregate demand curve
• Table 19–2: Impact of key changes on the aggregate supply curve

This is an important section which shows how aggregate demand (AD) and
aggregate supply (AS) can be combined to analyse a variety of macroeconomic
issues.

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This section should be studied in detail. Take note of the definition of the AD
curve and the difference between the AD curve and a microeconomic demand
curve (that is, a demand curve for a specific good or service). Note the factors
that can cause a shift of the AD curve. The definition of the AS curve, the
difference between an AS curve and a microeconomic supply curve, and the
factors which can cause a shift of the AS curve are also important. The
subsections on shifts in aggregate demand and shifts in aggregate supply require
careful attention. You should be able to use the AD-AS model to explain the
impact on the price level and total production (or income) in the economy of (a)
expansionary and contractionary monetary and fiscal policies and (b) a change
in aggregate supply (for example, a supply shock).

Activity 7.1

Note: Solutions to the questions marked with an asterisk (*) are provided at the
end of this study guide.

*Indicate whether the following statements are true (T) or false (F):
T F
a The introduction of the AD-AS model means that the assumption of
a fixed price level (as in the simple Keynesian models) has been
dropped.
b The AD-AS model can be used to analyse changes in the price level.
c The AD curve illustrates the levels of total expenditure in the
economy at various price levels.
d When government spending increases, the aggregate demand curve
shifts to the right.
e If the interest rate increases, the aggregate demand curve will shift
to the left.
f The AS curve illustrates the levels of output in the economy, which
will be supplied at different price levels.
g An increase in the cost of production (for example, the cost of
labour) will result in an upward (or leftward) shift of the aggregate
supply curve.
h An unfavourable supply shock (for example, an increase in the price
of oil) will result in an increase in the domestic cost of production of
each level of output.
i An increase in aggregate demand is usually accompanied by a fall in
the equilibrium level of income.
j A contractionary fiscal policy will shift the aggregate demand curve
to the left.

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k An increase in aggregate supply and a fall in aggregate demand,
which happen simultaneously, will lead to a decrease in the price
level.
l Stagflation is a term used to describe high unemployment
accompanied by a high inflation rate.
m When the AS curve is very steep, an increase in aggregate demand
leads to an increase in production with little or no increase in the
price level.
n A decrease in aggregate supply, illustrated by a leftward or upward
shift of the AS curve, will have an adverse effect on both the price
level and the level of production in the economy.
Short Questions
1. Define stagflation. (2)
2.* Use aggregate demand (AD) and aggregate supply (AS) curves to analyse
the impact of an expansionary fiscal policy on prices and production in the
economy when income is below the full-employment level. (8)
3.* Use aggregate demand (AD) and aggregate supply (AS) curves to analyse
the impact of a supply shock on prices and production in the economy. (8)
4.* Explain, with the aid of a diagram, why policy makers cannot solve the
stagflation dilemma using only demand management (that is, monetary and
fiscal policies). (8)

7.3 The Monetary Transmission Mechanism

Prescribed Reading

Study Section 19.2 of the prescribed book – except for the subsection on other
links between interest rates and the rest of the economy

In the macroeconomic model developed in chapters 17 and 18, it was assumed

that the money supply and the interest rate are fixed. By assuming a fixed money
supply and a fixed interest rate, we have actually eliminated the impact of money
and monetary policy. In the AD-AS model introduced in the previous section, we
dropped these assumptions and allowed for the impact of a variable interest rate
on aggregate demand. We said that a fall in the interest rate would increase
aggregate demand (illustrated by a rightward shift of the AD curve) and that an
increase in the interest rate would reduce aggregate demand (illustrated by a
leftward shift of the AD curve). We now need to examine these links more closely,
and examine how changes in interest rates will affect total spending, production,
income and prices in the economy.

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The way in which changes in the monetary sector are transmitted to the rest of
the economy is called the monetary transmission mechanism. This section must
be studied in detail. Note that the subsection on other links between interest
rates and the rest of the economy is not prescribed for this topic.

Activity 7.2

Note: Solutions to the questions marked with an asterisk (*) are provided at the
end of this study guide.

*Indicate whether the following statements are true (T) or false (F):
T F
a The monetary transmission mechanism is the process through which
changes in the interest rate give rise to changes in variables such as
spending and production.
b The link between the interest rate and investment spending plays no
role in the monetary transmission mechanism.
Short Questions

1. Define a monetary transmission mechanism. (2)

2. Explain why the link between the interest rate and investment spending is
important in the monetary transmission mechanism. (2)
3.* Use the AD-AS model and explain, with the aid of diagrams, how an increase
in the interest rate will affect the level of prices, production and income in
the economy. (10)
4.* Summarise your explanation in (3) by using symbols. (5)
5.* The following statement is made in the prescribed book: “To summarise:
The smaller the interest elasticity of investment demand, and also the
steeper the AS curve, the less effective an expansionary monetary policy
will be as a means of stimulating the economy”. Do you agree? Use
diagrams to substantiate your answer. (10)

7.4 Monetary and Fiscal Policy in the AD-AS Framework

Prescribed Reading

Study Section 19.3 of the prescribed book

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In this section, we will summarise some of the earlier discussions and add a few
further topics with regard to monetary and fiscal policy. You should be able to
define and distinguish between fiscal and monetary policy. You must know the
meanings of demand management, expansionary (or stimulatory) policy and
restrictive (or contractionary) policy.

You must be able to define and discuss the different lags associated with fiscal
and monetary policy. Pay special attention to the subsection on the policy
dilemma in an open economy.

Activity 7.3

Note: Solutions to the questions marked with an asterisk (*) are provided at the
end of this study guide.

*Indicate whether the following statements are true (T) or false (F):
T F
a Restrictive monetary and fiscal policies are normally applied during
recessions.
b Monetary policy entails the manipulation of government spending
(G) and taxation (T).
c The recognition lag would be shortened if economic data were
available in good time.
d The impact lag could be reduced by tackling bureaucracy and
inefficiency in the government.
Short Questions
1. Distinguish between fiscal and monetary policy. (6)
2. Discuss the four lags associated with the implementation of fiscal and
monetary policy. (10)
3. Discuss, with the aid of a diagram, the policy dilemma in an open economy.
(10)

Note

Section 19.4 of the prescribed book is not prescribed for this topic.

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 Topic 8
Inflation

Prescribed Reading

Before continuing with this topic, please read the following:

• Mohr, P. & Fourie, L. & Associates (2020:425–445)

8.1 Introduction

After you have worked through this topic, you should be able to:
• Define inflation.
• Define the consumer price index (CPI).
• Use CPI data to calculate inflation rates.
• Explain the reasons for calculating the core inflation rate.
• Define the production price index (PPI).
• Discuss the differences between the CPI and PPI.
• Define the implicit GDP deflator.
• Compare the different measures of inflation.
• Explain why policy makers regard inflation as a problem.
• Explain the difference between demand-pull and cost-push inflation using
diagrams.

Inflation has often been described as “public enemy number one”. But what is
inflation? How is it measured? Why is it a problem? What causes inflation and
how can it be combated? In this topic, we take a closer look at inflation, focusing
on the definition, effects and different types of inflation.

8.2 Definition of Inflation

Prescribed Reading

Study Section 20.1 of the prescribed book

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Study the definition of inflation in detail noting the four aspects of the definition.

Activity 8.1

Note: Solutions to the questions marked with an asterisk (*) are provided at the
end of this study guide.

*Indicate whether the following statements are true (T) or false (F):
T F
a An increase in the price of vegetables is a good example of inflation.
b Inflation involves a continuous and considerable increase in the
general level of prices.
c A once-off increase in prices cannot be classified as inflation –
Inflation is a continuous process of increasing prices.
d If prices increase at a constant rate, there is no inflation.
Short Questions

1. Define inflation. (3)

2. List the main elements of the definition of inflation. (4)

8.3 Measurement of Inflation

Prescribed Reading

Study Section 20.2 of the prescribed book

This section picks up from our discussion of the CPI in Topic 1. It begins with an
explanation of how a set of CPI data can be used to calculate the inflation rate.
Note the purpose and meaning of the core inflation rate. Ignore the paragraph
on the CPIX because Statistics South Africa discontinued the calculation of the
CPIX during 2008. The production price index (PPI), a measure of the cost of
production, is introduced. You must be able to differentiate between the implicit
GDP deflator, the CPI and the PPI. Note how the implicit GDP deflator is used to
calculate the economic growth rate.

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 Activity 8.2

Note: Solutions to the questions marked with an asterisk (*) are provided at the
end of this study guide.

*Indicate whether the following statements are true (T) or false (F):
T F
a The CPI is an inflation rate.
b The rate of change in the CPI is one of the possible measures of
inflation.
c The CPI is an index of the cost of living.
d The calculation of a core inflation rate is an attempt to measure the
underlying inflationary pressures in the economy.
e The basket used to calculate the core inflation rate excludes fresh
and frozen meat, fish, vegetables and fruit.
f The prices used to calculate the core inflation rate exclude VAT.
g The consumer price index measures the cost of living, while the
production price index measures the cost of production.
h The PPI excludes the prices of imported goods.
i The PPI excludes the prices of services – only goods are included in
the PPI basket.
j The PPI includes the prices of capital goods.
k Consumers are generally more interested in the rate of change in
the implicit GDP deflator than in the rate of change in the CPI.
Short Questions

1. Describe the CPI. (3)

2. Distinguish between the CPI and core inflation. (3)
3. Describe the PPI. (3)
4. Differentiate between the CPI and the PPI. (4)

8.4 Effects of Inflation

Prescribed Reading

Study Section 20.3 of the prescribed book

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Study the distribution effects, economic effects, social and political effects of
inflation to understand why combating inflation is such a serious matter to policy
makers.

Activity 8.3

Note: Solutions to the questions marked with an asterisk (*) are provided at the
end of this study guide.

*Indicate whether the following statements are true (T) or false (F):
T F
a Inflation tends to benefit debtors at the expense of creditors.
b Inflation reduces the real value (or purchasing power) of money.
c Inflation tends to benefit government at the expense of the private
sector.
d Inflation tends to redistribute income and wealth of elderly people
with relatively fixed nominal incomes to younger people whose
nominal incomes are keeping pace with inflation.
e The fact that taxpayers are taxed on their nominal incomes,
irrespective of what happens to their real incomes, could give rise to
bracket creep (as in South Africa).
f High inflation tends to stimulate speculative activity at the expense
of productive activity.
g Real interest rate is the rate at which banks are prepared to lend
money, while the nominal interest rate is the rate that can be
earned on savings deposits at banks.
h Inflation can cause balance of payments problems, particularly when
a country’s inflation rate is consistently higher than the inflation
rates in the economies of its major trading partners and
international competitors.
Short Questions

1. *Explain why policy makers regard inflation as a problem. (10)

2. Distinguish three main types of costs of inflation, and give examples of
each. (9)

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8.5 The Causes of Inflation

Prescribed Reading

Study Section 20.4 of the prescribed book – only the subsection dealing with
demand-pull and cost-push inflation

The distinction between demand-pull inflation and cost-push inflation is one of

the most basic elements of the theory of inflation and must be studied in detail.
Note that the fight against demand-pull inflation results in a trade-off between
inflation and unemployment.

Activity 8.4

Note: Solutions to the questions marked with an asterisk (*) are provided at the
end of this study guide.

*Indicate whether the following statements are true (T) or false (F):
T F
a Demand-pull inflation can be illustrated by an outward or rightward
shift of the aggregate demand (AD) curve.
b Demand-pull inflation can be caused by an increase in any or a
combination of C, I, G and X.
c Demand-pull inflation raises the price level while it reduces the level
of production or income in the economy at the same time.
d Demand-pull inflation can be combated by applying expansionary
monetary and fiscal policies.
e Reduced government spending and increased interest rates are two
of the measures that can be used to combat demand-pull inflation.
f Cost-push inflation can be illustrated by an upward or leftward shift
of the AS curve.
g Increased profit margins, decreased productivity and increases in
the prices of imported capital goods are all potential causes of cost-
push inflation.
h During cost-push inflation, increases in the price level are
accompanied by reductions in the level of production or income.
That is why it can also be called stagflation.

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Short Questions

1. Use aggregate demand (AD) and aggregate supply (AS) curves to illustrate
the difference between cost-push inflation and demand-pull inflation and
list possible causes of each type of inflation. (10)
2. Explain, with the aid of diagrams, what policy measures can be used to
combat cost-push inflation and demand-pull inflation respectively and
comment on the possible side effects of these measures. (10)

Note

Section 20.5 of the prescribed book is not prescribed for this topic.

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 Topic 9
Unemployment

Prescribed Reading

Before continuing with this topic, please read the following:

• Mohr, P. & Fourie, L. & Associates (2020:447–459)

9.1 Introduction

After you have worked through this topic, you should be able to:
• Define the rate of unemployment.
• Identify the costs of unemployment.
• Distinguish between the different types of unemployment.
• Suggest policies to tackle the unemployment problem.
• Illustrate and explain the Phillips curve.

Most people see unemployment as the primary economic problem in South

Africa. Do you have any suggestions about how best to tackle the unemployment
problem? In this topic, we will take a closer look at unemployment. We will
consider the definition, the costs, and different types of unemployment. Once we
have done that, certain policy options in the fight against unemployment will be
highlighted.

9.2 Unemployment

Prescribed Reading

Study:
• Section 13.4 of the prescribed book
• Section 20.6 of the prescribed book
• Section 21.1 of the prescribed book
• Box 21–1 of the prescribed book

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The rate of unemployment in South Africa forces us to take a very close look at
this section of the work. The rate of unemployment is obtained by expressing the
number of unemployed persons as a percentage of the labour force.

• Measuring Unemployment

Note the different ways in which unemployment is defined in this subsection.

Activity 9.1

Note: Solutions to the questions marked with an asterisk (*) are provided at the
end of this study guide.

*Indicate whether the following statements are true (T) or false (F):
T F
a It is easy to define and measure unemployment.
b The unemployed include those people who are not willing to work.
c The rate of unemployment is obtained by expressing the number of
unemployed people as a percentage of the labour force.

• The Cost of Unemployment

You must be able to differentiate between the individual costs of unemployment

and the costs to society in general.

Activity 9.2

Note: Solutions to the questions marked with an asterisk (*) are provided at the
end of this study guide.

*Indicate whether the following statement is true (T) or false (F):

T F
a Unemployment involves significant costs both to individuals who are
unemployed and to society as a whole.
Short Questions

1. Describe the costs of unemployment to society in general. (4)

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2. Differentiate between the individual cost of unemployment and the cost to
society as a whole. (7)

• Types of Unemployment

The different types of unemployment must be studied in detail.

Activity 9.3

Note: Solutions to the questions marked with an asterisk (*) are provided at the
end of this study guide.

*Indicate whether the following statements are true (T) or false (F):
T F
a There will always be some frictional unemployment, and this type of
unemployment is not regarded as a serious problem.
b Cyclical unemployment occurs when there is a recession resulting
from a temporary lack of sufficient aggregate demand in the
economy.
c Cyclical unemployment is associated with recessions.
d Structural unemployment is a serious problem since it cannot be
remedied by simply increasing the aggregate demand for goods and
services.
e Workers who are replaced by labour-saving machines become
structurally (or technologically) unemployed.
f Structural unemployment is usually limited to specific industries,
sectors or categories of workers.
Short Question

Distinguish between frictional, seasonal, cyclical and structural unemployment

and give an example of each type. (8)

• Policies to Reduce Unemployment

Note that the unemployment problem must be tackled from both the supply and
the demand side.

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 Activity 9.4

Short Question

Discuss the policies that can be implemented to reduce unemployment. (10)

• Unemployment in the Keynesian and AD-AS Models

In this subsection, the Keynesian and AD-AS models are revisited. Note the
positive relationship between an increase in production and an increase in
employment.

Activity 9.5

Short Question

Discuss the following statement: “An increase in real production is a necessary

but not sufficient condition for reducing unemployment”. (5)

9.3 Unemployment and Inflation: The Phillips Curve

Prescribed Reading

Study Section 20.6 of the prescribed book

As far as the Phillips curve is concerned, you only need to study the introduction
and the subsection on the trade-off principle. The existence of the Phillips curve
is a controversial topic, but the term has become so established in economics
that you should know what it is. In particular, you should be able to explain the
implications of a Phillips curve for policy makers as well as the causes and
consequences of a rightward shift of the Phillips curve.

Figures 20–4 and 20–5 is important! Make sure that you are able to draw this
figure in the examination and explain it

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 Activity 9.6

Note: Solutions to the questions marked with an asterisk (*) are provided at the
end of this study guide.

*Indicate whether the following statements are true (T) or false (F):
T F
a The Phillips curve is an illustration of a possible trade-off between
inflation and unemployment.
b According to the Phillips curve, a lower inflation rate will give rise to
a lower unemployment rate.
c According to the Phillips curve, a lower inflation rate can be
“bought” at the expense of a higher unemployment rate.
Short Question

Illustrate and explain the Phillips curve, and discuss the policy implications of the
existence of such a curve. (6)

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 Topic 10
Economic Growth and Business Cycles

Prescribed Reading

Before continuing with this topic, please read the following:

• Mohr, P. & Fourie, L. & Associates (2020:462–468)

10.1 Introduction

After you have worked through this topic, you should be able to:
• Define economic growth.
• Explain how economic growth is measured.
• Define the business cycle.
• Identify sources of economic growth.

Economic growth is mentioned in each topic of this study guide. Various policy
measures are discussed and suggestions made on what can be done to enhance
economic growth. What do you think can be done to improve economic growth?

In this topic, we will examine the definition, measurement and causes of

economic growth.

10.2 The Definition and Measurement of Economic Growth

Prescribed Reading

Study:
• Section 22.1 of the prescribed book
• Section 22.2 of the prescribed book

The first section deals with the definition and measurement of economic growth.
Economic growth is usually defined as the annual rate of increase in real gross
domestic product (real GDP).

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Allowance should preferably also be made for population changes (that is, the
figures should be expressed on a per capita basis), but this is not always done.
There is no “perfect” measure of economic growth – even GDP is subject to a
number of shortcomings of which you should take note. As indicated in this
section, economic growth is not a smooth process, a feature of economic growth,
which is related to the business cycle.

The business cycle is the pattern of upswing (expansion) and downswing

(contraction) that can be identified in economic activity over a number of years.
One complete business cycle has four elements: a trough, an upswing or
expansion (also called a boom), a peak, and a downswing or contraction (also
called a recession). The different elements of the business cycle are illustrated
in the following diagram:

The figure shows a complete business cycle from one trough (point A) to the next
trough (point C). The cycle describes a pattern of fluctuation around the long-
term trend. After the trough, there is an upswing indicated by AB. The peak is
reached at point B, followed by a downswing from B to C.

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 Activity 10.1

Note: Solutions to the questions marked with an asterisk (*) are provided at the
end of this study guide.

*Indicate whether the following statements are true (T) or false (F):
T F
a GDP for 2004 expressed at 2000 prices is an example ofnominal
GDP.
b GDP for 2004 expressed at 2004 prices is an example ofnominal
GDP.
c GNI for 2004 expressed at 1995 prices is an example of realGNI.
d When measuring economic growth, changes in prices and inthe
population should be taken into account.
e One of the problems associated with GDP as a measure ofeconomic
activity is that not all goods and services are soldin markets, which
makes it difficult to value them in monetaryterms.
f GDP is an accurate indicator of economic welfare.
g GDP measures the impact of economic growth on pollutionand
environmental destruction.
h Once GDP has been estimated for a certain period, thefigure
obtained is never adjusted.
i Economic growth is a smooth process.
j The expansion phase of the business cycle ends at the peakof the
cycle.
k The expansion phases of the business cycle (upswings) always last
exactly as long as the recession phases (downswings).
Short Questions

1. Define economic growth. (2)

2. Explain why it is important to use real GDP (or GNI) per capita when
measuring economic growth. (2)
3. List four problems associated with GDP as a measure of total production in
the economy. (4)
4. Define the business cycle, and list the four elements of a complete cycle.
(6)

Note

Section 22.2 of the prescribed book is not prescribed for this topic.

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10.3 Sources of Economic Growth

Prescribed Reading

Study Section 22.3 of the prescribed textbook

This section deals with the sources of economic growth. You should be able to
identify the various supply factors and demand factors discussed in this section.
Note that the supply factors all relate to the four factors of production, while the
demand factors relate to the components of aggregate spending (or aggregate
demand) in the economy.

Activity 10.2

Note: Solutions to the questions marked with an asterisk (*) are provided at the
end of this study guide.

*Indicate whether the following statements are true (T) or false (F):
T F
a Sustained economic growth requires a sustained expansion of both
aggregate supply and aggregate demand.
b An increase in the quantity and/or quality of the various factors of
production is a prerequisite for sustained economic growth.
c An increase in the quantity and/or quality of the factors of
production is a necessary condition for economic growth, but is not
sufficient to ensure economic growth.
d Sustained economic growth requires an expansion in aggregate
demand for goods and services.
e Inward industrialisation is a strategy for economic growth, which
focuses on domestic demand (that is, the demand for housing and
electricity).
f Import substitution means that goods which were previously locally
produced, are now imported.
Short Question

What are the main sources of economic growth viewed from:

a The supply side?
b The demand side? (7)

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 References

Le Roux, W.J. 2010. Economics 1B study guide. Pretoria: Unisa.

Mohr, P. & Fourie, L. & Associates. 2015. Economics for South African students.
5th edition. Pretoria: van Schaik.

83
 Answers to Questions

Topic 1

Activity 1.1

True/False Statements

a T
b F
c T

Activity 1.2

True/False Statements

a T
b T
c T
d T
e T
f F
g F
h T
i T
j F
k F
l T
m F
n F
o T
p F
q T
r F

Short Questions
1. When we measure economic growth, we want to establish whether more
goods and services were produced. An increase in GDP at current prices
could be a result of increases in the general price, without any increase in
production, for example:

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 Year General Price Number of Goods Nominal GDP
Level Produced (P × Q)
1 10 10 100
2 11 10 110

Alternatively, an increase in GDP at current prices could be the result of an

increase in production:
Year General Price Number of Goods Nominal GDP
Level Produced (P × Q)
1 10 10 100
2 11 10 110

A combination of changes in the general price level and changes in the

production level can also lead to an increase in the GDP at current prices:
Year General Price Number of Goods Nominal GDP
Level Produced (P × Q)
1 10 10 100
2 22 5 110

300–280 100
10. %∆ in GDP = 280
× 1

20 100
= 280 × 1

=7,14%

Activity 1.3

True/False Statements

a T
b F
c T
d T
e T
f F
g T

Activity 1.5

True/False Statements

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a F
b T
c T

Topic 2

Activity 2.1

True/False Statements

a T
b T
c T
d T
e F
f T
g T
h F

Activity 2.2

True/False Statements

a F
b T

Activity 2.3

True/False Statements

a F
b T
c T
d T

Activity 2.4

True/False Statements

a T
b T

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Activity 2.6

True/False Statements

a T
b T
c T
d T
e F
f T
g T
h F
i F
j T
k T
l T

Short Questions

6. All that is required here is a reproduction of figure 14–1 in the prescribed

book accompanied by a short written explanation. You should mention that
the total demand for money consists of the demand for active balances,
which depends on the income level (not the interest rate), and the demand
for passive balances, which is inversely related to the interest rate. Proceed
by providing two fully annotated diagrams (as in figure 14–1).

Activity 2.7

True/False Statements

a T
b T
c F
d T
e T
f T
g F
h T
i F

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Topic 3

Activity 3.1

True/False Statements

a T
b F
c T
d T
e T
f F

Activity 3.3

True/False Statements

a T

Activity 3.4

True/False Statements

a T

Activity 3.5

True/False Statements

a F
b T
c T
d F

Activity 3.6

True/False Statements

a F
b T
c T

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d T
e T

Activity 3.7

True/False Statements

a T
b F
c T
d F

Activity 3.8

True/False Statements

a T
b F
c T
d F
e T
f F
g T
h T

Topic 4

Activity 4.1

True/False Statements

a T
b T
c F
d T
e F
f T
g F
h F
i T

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Statements 10 to 15:

Susan has an absolute advantage in the knitting of jerseys and in the sewing of
dresses. She can knit four jerseys per week compared to the three Jackie can
knit, or sew eight dresses compared to Jackie’s four. With absolute advantage,
the question to ask is simply “who can produce more?”

However, with relative advantage, one would want to establish the opportunity
cost of specialising in the production of a particular product. To knit one jersey
per week Susan has to sacrifice two dresses, whereas Jackie sacrifices 1¼
dresses in order to produce one jersey. Jackie can knit jerseys “cheaper” and will
specialise in the knitting of jerseys. Jackie has a relative advantage in the knitting
of jerseys. On the other hand, to sew one dress Susan has to sacrifice ½ a jersey,
while Jackie must sacrifice ¾ of a jersey. Susan can sew dresses “cheaper” and
will specialise in the sewing of dresses. Susan has a relative advantage in the
sewing of dresses.

j T
k T
l F
m T
n T
o T
p T To produce one unit of maize country A must sacrifice 800 (that is 2 400
÷ 3) tractors, while country B must sacrifice 500 (1 500 ÷ 3) tractors.
Country B can produce maize “cheaper” and will specialise in the production
of maize. Country B has a relative advantage in the production of maize
To produce one tractor, Country A has to sacrifice 3 2 400 (in other words
3 ÷ 2 400) units of maize whereas Country B must sacrifice 3 1 500 (that
is 3 ÷ 1 500) units of maize in order to produce a tractor. Country A can
produce tractors “cheaper” and will specialise in the production of tractors.
Country A has a relative advantage in the production of tractors.

Activity 4.2

True/False Statements

a T
b T
c F
d T

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e F
f T
g T
h T
i F
j F
k F
l T
m T

Short Questions

1. You must start with a diagram similar to the one in figure 16–4 in the
prescribed book. Make sure that you label the axes and curves correctly
and show the equilibrium exchange rate. An increase in South African
exports to the USA will result in an increase in the supply of dollars. This is
illustrated by a rightward shift of the supply curve in the diagram. Obtain a
new equilibrium exchange rate that will be at a lower dollar price than
before. This means that the dollar has depreciated against the rand or that
the rand has appreciated against the dollar. The marks will again be split
between the diagram and the accompanying explanation. In a question like
this, the important requirements are (i) a correct initial diagram with correct
labels, (ii) the correct shifting of the appropriate curve and (iii) correct
conclusions drawn from the analysis. Make sure that you can use diagrams
to get all the results summarised in table 16–1 and 16–2 in the prescribed
book.
2. This question is similar to the previous one but a little easier, since you are
informed that the demand for dollars has increased. This increase is
illustrated by a rightward shift of the demand curve. The equilibrium price
of the dollar increases, indicating an appreciation of the dollar against the
rand, or a depreciation of the rand against the dollar.

Topic 5

Activity 5.1

True/False Statements

a T
b T
c F

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d F
e T
f F
g T
h T
i F

Activity 5.2

True/False Statements

a T
b F
c F

Activity 5.3

True/False Statements

a T
b F
c T
d T
e T 3 100
x = 75
4 1
f T C = C + cY
= 80 + 4/5(1 000)
4 1000
= 80 + x
5 1
= 80 + 800
= 880
g F If C = C + cY
then S = - 100 + (1 - 0,7)Y
= -100 + 0,3Y

Activity 5.4

True/False Statements

a T
b F

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c T
d F

Short Question

a There is an inverse relation between the interest rate and the level of
investment.

b Investment spending is independent of the level of income.

Activity 5.5

True/False Statements

a T
b F

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c F
d T
e T
f T

Activity 5.6

True/False Statements

a T C is R26 billion and the slope of the C curve is 4/5, thus the consumption
function:
C = R26 billion + 4/5Y
(remember the marginal propensity to consume is represented by the slope
of the C curve)
I = R10 billion

At equilibrium:
Y=A
Y = C + I
 Y = 26 + 4 Y + 10
5

= 36 + 4 Y
5

Y − 4 Y = 36
5

 1 Y = 36
5
1 5 36 5
 Y = 
5 1 1 1
 Y = R180 billion

Alternatively you can use the following formula:

Equilibrium, or Y0 =  A
where  = the multiplier (see the next section)
and A = autonomous spending

Firstly calculate the value of the multiplier:

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 1
α= Where c is the marginal propensity to consume
1 − c
1 4
= substitute c with and subtract from1
4 5
1 −
5
1 1 5
= 1 =1x
1 5 1
5
= 5

Autonomous spending:
A = 36 (= C + I)

∴ Equilibrium Y0 = 5 x 36 = R180 billion

b T C = R10 billion + 3/4Y

I = R30 billion

At equilibrium:
Y=A
Y = C + I
 Y = 10 + 3 Y + 30
4

= 40 + 3 Y
4

Y − 3 Y = 40
4

 1 Y = 40
4
1 4 40 4
 Y = 
4 1 1 1
 Y = R160 billion
Alternatively you can use the following formula:

Equilibrium, or Y0 =  A
where  = the multiplier (see the next section)
and A = autonomous spending

Firstly calculate the value of the multiplier:

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 1
α= Where c is the m arg inal propensity to consume
1 − c
1 3
= substitute c with and subtract from 1
3 4
1 −
4
1 1 4
= 1 =1x
1 4 1
4
= 4

Autonomous spending:
A = 40 (= C + I)

∴ Equilibrium Y0 = 4 x 40 = R160 billion

c T C = 50 + 6/7
I = 100

At equilibrium:
Y=A
Y = C + I
 Y = 50 + 6 Y + 100
7
= 150 + 6 Y
7
 Y − 6 Y = 150
7
 1 Y = 150
7
1 7 150 7
 Y = 
7 1 1 1
 Y = 1 050

Alternatively you can use the following formula:

Equilibrium, or Y0 =  A
where  = the multiplier (see the next section)
and A = autonomous spending

Firstly calculate the value of the multiplier:

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 1
α= Where c is the m arg inal propensity to consume
1 − c
1 6
= substitute c with and subtract from 1
6 7
1 −
7
1 1 7
= 1 =1x
1 7 1
7
= 7

Autonomous spending:
A = 150 (= C + I)

∴ Equilibrium Y0 = 7 x 150 = 1 050

Short Questions

a C = R100 million + 7/8Y

I = R150 million

At equilibrium:
Y=A
Y = C + I
 Y = 100 + 7 Y + 150
8
= 250 + 7 Y
8
 Y − 7 Y = 250
8
 1 Y = 250
8
1 8 250 8
 Y = 
8 1 1 1
 Y = R 2 000m

Alternatively you can use the following formula:

Equilibrium, or Y0 =  A
where  = the multiplier (see the next section)
and A = autonomous spending

Firstly calculate the value of the multiplier:

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 1
α= Where c is the m arg inal propensity to consume
1 − c
1 7
= substitute c with and subtract from 1
7 8
1 −
8
1 1 8
= 1 =1x
1 8 1
8
= 8

Autonomous spending:
A = R250 million (= C + I)

∴ Equilibrium Y0 = 8 x R250 million = R2 000 million

b C = R10 million + 3/4Y

I =R40 million

At equilibrium:
Y=A
Y = C + I
 Y = 10 + 3 Y + 40
4
= 50 + 3 Y
4
 Y − 3 Y = 50
4
 1 Y = 50
4
1 4 50 4
 Y = 
4 1 1 1
 Y = R 200m

or

Y0 =  A

The multiplier:

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 1
α= Where c is the m arg inal propensity to consume
1 − c
1 3
= substitute c with and subtract from 1
3 4
1 −
4
1 1 4
= 1 =1x
1 4 1
4
= 4

Autonomous spending:

A = R50 million (= C + I)

∴ Equilibrium Y0 = 4 x R50 million = R200 million

Activity 5.7

True/False Statements

a T
b T
c T
d F 1
α=
1 − c
1 4
= substitute c with and subtract from 1
4 5
1 −
5
1 1 5
= 1 =1x
1 5 1
5
= 5
e T The change in income will be equal to the multiplier 5 (calculated above)
times the change in investment spending 200, that is 5 x 200 = 1 000
f T

Short Questions

3. Here you must provide a diagram which will look similar to Figure 17–10,
but in which the order of things is reversed.

Start off with a basic equilibrium diagram like the one below:

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With a decrease in investment spending the level of aggregate demand will fall
at each level of income. This will be illustrated by a parallel downward shift of
the aggregate demand curve (e.g. a shift from A2 to A1 in figure 17–10). The
result is a fall in the equilibrium level of income. Why? Because, with aggregate
spending (A) at a lower level at each level of income (Y) than before, it stands
to reason that point E in the diagram will no longer be an equilibrium point. There
will now be excess supply at point E. Firms will experience an unplanned increase
in inventories and will cut back on production. Therefore, the equilibrium level of
income will fall. Moreover, the decrease in income will be greater than the
decrease in investment spending as a result of the multiplier effect (which works
in reverse in this case).

4. In each case the formula for the simple multiplier has to be applied:
a 1
α=
1 − c
1 3
= substitute c with and subtract from 1
3 4
1 −
4
1 1 4
= 1 =1x
1 4 1
4
= 4

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 b 1
α=
1 − c
1 8
= substitute c with and subtract from 1
8 10
1 −
10
1 2 10
= 1 =1x
2 10 2
10
= 5

In the same way the following answers can be obtained:

c 8; d 3; e 2; f 7; g 9.

Note how the size of the multiplier is directly related to the size of the
marginal propensity to consume.

5. C = R200m + 5/6Y
I = R400m

The multiplier (  )
1
α=
1− c
1
=
5
1−
6
1
=
1
6
=6

Autonomous spending (A) = R200m + R400m = R600m

Thus Y0 =  A = 6 x R600m = R3 600m

Alternatively you could have started by stating that there is equilibrium

where:

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 Y=A
Y = C + I
 Y = 200 + 5 Y + 400
6
= 600 + 5 Y
6
Y − 5 Y = 600
6
 1 Y = 600
6
1 6 600 6
 Y = 
6 1 1 1
 Y = R 3 600 m

6. To calculate the impact of a change in investment spending on total

production or income in the economy, the change in I must be multiplied
by the multiplier. Using the formula for the multiplier, as explained in the
solution to question (4), the following multipliers are obtained: (i) 4; (ii) 3;
(iii) 7. Multiplying each of these multipliers by the increase in I of R100
million yields the following increases in total production or income in the
economy: (i) R400 million; (ii) R300 million; (iii) R700 million.

Activity 5.8

As indicated in the question, it is useful to draw a diagram containing the basic

information provided.

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With C and I both given, the intercept of the aggregate spending curve (A) can
be calculated as 30 (= C + I = 10 + 20). We can calculate the equilibrium level
of income:
Y=A
=C+I
= 70 + 20
= 90

a The problem is to calculate the slope of the aggregate spending curve (i.e.
the marginal propensity to consume). If Y = 0, then A = 30; If Y = 90, then
A = 90. Thus, if Y changes by 90, then A changes by 60. The slope of the A
curve (i.e. c) is thus:
A 90 − 30 60 2
= = =
Y 90 − 0 90 3

b In this case, the marginal propensity to consume is, of course, the same as
the slope of the aggregate spending curve = 2/3.

c 1
α=
1− c
1
=
2
1−
3
1
=
1
3
=3

Topic 6

Activity 6.1

True/False Statements

a T
b F
c F
d T
e F
f T
g T

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h T
i T

Short Questions

3. What is required here is a fully annotated diagram like figure 18–6, along
with a written explanation. The increase in income will be greater than the
increase in government spending as a result of the multiplier effect. Note
that you are required to present a model of a closed economy, which means
that there are no exports or imports. In this case, you will be penalised by
a mark or two if you include exports and imports in your diagram.

Activity 6.2

True/False Statements

a T
b T
c F
d F
e T

Short Questions

3. The multiplier can be calculated by substituting the given values into the
equation:

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a 1
α=
1 − c (1 − t )
1 5 1
= substitute c with and t with
5 1 6 10
1 − 1 − 
6  10 
1  1 9
= first calculate the impact of the tax 1 −  =  
5 9   10   10 
1−  
6  10 
1 5 9 3  45 3 
= x =  60 = 4 
1−
3 6 10 4  
4
1 1 4
= 1 =1x
1 4 1
4
4
=
1
=4

b 1
α=
1 − c (1 − t )
1 3 1
= substitute c with and t with
3  1 4 9
1 − 1 − 
4  9
1  1 8
= first calculate the impact of the tax 1 −  =  
3 8  9 9
1−  
4 9
1 3 8 2  24 2 
= x =  36 = 3 
1−
2 4 9 3  
3
1 1 3
= 1 =1x
1 3 1
3
3
=
1
=3

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c 1
α=
1 − c (1 − t )
1 5 1
= substitute c with and t with
5 1 8 5
1 − 1 − 
8 5
1  1 4
= first calculate the impact of the tax  1 −  =  
5 4  5 5
1−  
8 5
1 5 4 1  20 1 
= x =  40 = 2 
1−
1 8 5 2  
2
1 1 2
= 1 =1 x
1 2 1
2
2
=
1
=2

Activity 6.3

True/False Statements

a T Y0 =  A

The multiplier:
1
α=
1 − c (1 − t )
1
=
5  1
1 − 1 − 
6  5
1
=
5 4
1−  
6 5
1
=
2
1−
3
1
=
1
3
3
=
1
=3

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 Autonomous spending:

A = C + I + G = R(100 + 200 + 200) million

= R500 million

Equilibrium level of income:

Y0 =  A
= 3 x R500 million
= R1 500 million

Short Questions

a Y0 =  A

The multiplier:
1
α=
1 − c (1 − t )
1
=
4  1
1 − 1 − 
5 6
1
=
4 5
1−  
5 6
1
=
2
1−
3
1
=
1
3
3
=
1
=3

Autonomous spending:

A=C+I+G
= R(100 + 200 + 280) million
= R580 million

Equilibrium level of income:

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 Y0 =  A
= 3 x R580 million
= R1 740 million

b Y0 =  A

The multiplier:
1
α=
1 − c (1 − t )
1
=
9  1
1 − 1 − 
11  12 
1
=
9  11 
1−  
11  12 
1
=
3
1−
4
1
=
1
4
4
=
1
=4

Autonomous spending:

A=C+I+G
= R(50 + 250 + 300) million
= R600 million

Equilibrium level of income:

Y0 =  A
= 4 x R600 million
= R2 400 million

c Y0 =  A

The multiplier:

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 1
α=
1 − c (1 − t )
1
=
3 1
1 − 1 − 
4 9
1
=
3 8
1−  
4 9
1
=
2
1−
3
1
=
1
3
3
=
1
=3

Autonomous spending:

A=C+I+G
= R(30 + 200 + 400) million
= R630 million

Equilibrium level of income:

Y0 =  A
= 3 x R630 million
= R1 890 million

Activity 6.4

True/False Statements

a T
b T
c F
d F Equilibrium income must increase from 2 500 to 3 000, that is, with 500.
We know an increase in government spending puts the multiplier process
in motion. This means that the required increase in government spending
is less than 500. To determine the amount by which government spending

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 has to increase, the 500 has to be divided by the multiplier. Therefore, you
first have to calculate the multiplier.

The multiplier:

1
α=
1 − c (1 − t )
1
=
2  1
1 − 1 − 
3 4
1
=
2 3
1−  
3 4
1
=
1
1−
2
1
=
1
2
2
=
1
=2

The required change in government spending is:

Y
G =

3000 − 2500
=
2
500
=
2
= 250

e T This statement differs from the previous one in that we first have to
calculate the equilibrium level of income..

The equilibrium level of income:

Y0 =  A

The multiplier:

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 1
α=
1 − c (1 − t )
1
=
3  1
1 − 1 − 
4  9
1
=
3 8
1−  
4 9
1
=
2
1−
3
1
=
1
3
3
=
1
=3

Autonomous spending:

A = R60 billion (given)

Thus, equilibrium is

Y0 =  A
= 3 x R60 billion
= R180 billion

The required change in government spending is therefore:

Y
G =

240 − 180
=
3
60
=
3
= R 20 billion

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Short Questions

1. Fiscal policy refers to the use of variables such as government spending (G)
and taxes (T) to influence important macroeconomic variables such as total
production or income in the economy. The rest of the question can be
answered in words only or with the aid of diagrams. If possible, it is always
useful to use diagrams. In this case, figure 18–6 is again appropriate since
an increase in government spending is one of the instruments of fiscal policy
which can be used to raise the equilibrium level of income. Another
possibility is to lower the tax rate. This will increase the level of disposable
income at each level of income and therefore raise consumption spending
at each level of income. A lower tax rate implies a larger multiplier. This
can be illustrated by an increase in the slope of the aggregate spending
curve:

Y0 = original equilibrium level of income

Y1 = new equilibrium level of income after the lowering of the tax rate

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2. 1
α=
1 − c (1 − t )
1
=
5 1
1 − 1 − 
6  10 
1
=
5 9 
1−  
6  10 
1
=
3
1−
4
1
=
1
4
4
=
1
=4

The income gap to be filled is R40 billion. To obtain the required increase in
government spending, this gap has to be divided by the multiplier. The
answer is thus R40 billion รท 4 = R10 billion.

3. First you have to calculate the equilibrium level of income:

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 1
α=
1 − c (1 − t )
1
=
7  1
1 − 1 − 
8  7
1
=
7 6
1−  
8 7
1
=
3
1−
4
1
=
1
4
4
=
1
=4

A = R(40 + 260 + 200) million = R500 million

Y0 =  A = 4 x R500 million = R2 000 million

With the full-employment level of income (Yf) at R2 400 million, it means

that a gap of R400 million has to be filled. To determine the amount by
which government spending has to increase to close this gap the R400
million has to be divided by the multiplier (i.e. 4).

The required increase in government spending is therefore R100 million.

You can always check your answer by using the new level of G (i.e. R200
million + R100 million) to calculate the new equilibrium level of income. The
increase in government spending means that total autonomous spending A
now becomes R600 million. Multiplying A by the multiplier (4) yields R2 400
million, which is equal to the full-employment level of income.

4. To answer this question you have to provide a diagram such as figure 19–
6 along with a written explanation. As explained in the solution to
question (3), the required increase in government spending will be equal to
the gap between the equilibrium level of income (Y0) and the full-
employment level of income (Yf) divided by the multiplier.

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Activity 6.5

True/False Statements

a F
b F
c T
d T
e T
f T
g T
h F
i T

Short Questions

1. The answer to this question is similar to the answer for activity 6.1(3). The
only difference is that aggregate spending (A) now includes net exports (X
_ Z). You can use a figure similar to figure 18–6, but A0 will now be C + I
+ G + (X _ Z)0 and A1 will be C + I + G + (X _ Z)1, to indicate that the
increase in aggregate spending (illustrated by an upward shift of the
aggregate spending curve) is the result of an increase in exports (X _ Z).
Again, the resultant increase in the equilibrium level of income will be equal
to the increase in exports multiplied by the multiplier.

Topic 7

Activity 7.1

True/False Statements

a T
b T
c T
d T
e T
f T
g T
h T
i F
j T

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k T
l T
m F
n T

Short Questions

2. Here, you have to start by providing a diagram of the AD-AS model showing
the equilibrium price level (P) and the equilibrium level of production or
income (Y). Also, indicate clearly that the full-employment level of income
is greater than the equilibrium level of income.
An expansionary fiscal policy can take the form of an increase in
government spending and/or a lowering of tax rates. In both cases, the
aggregate demand for goods and services will increase, illustrated by a
rightward shift of the AD curve. This will result in an increase in total
production (Y), but will occur at the expense of an increase in the price
level. See figure 19–4.
3. To answer this question you have to provide a diagram similar to the one
in figure 19–5 as well as an accompanying explanation. The essential
elements of the answer are a decrease in supply (illustrated by a leftward
(upward) shift of the AS curve), an increase in the price level and a decrease
in the level of production, (which implies an increase in unemployment).
4. Start with a diagram illustrating a supply shock resulting in an increase in
both unemployment and the price level [that is, the same diagram as for
question (3)]. Both monetary policy and fiscal policy impact on the
aggregate demand in the economy (illustrated by the AD curve). That is
why the use of monetary and fiscal policies is called demand management.
The increase in the price level can be counteracted by contractionary
monetary and fiscal policies. For example, an increase in the interest rate,
an increase in tax rates or a decrease in government spending, but this
would result in a further reduction in production, income and employment.
This can be illustrated by a leftward (downward) shift of the AD curve.
Alternatively, the decrease in production, income and employment can be
counteracted by applying expansionary monetary and fiscal policies. For
example, a decrease in the interest rate, an increase in government
spending or a decrease in tax rates, which would, however, result in a
further increase in the price level. This can be illustrated by a rightward
(upward) shift of the aggregate demand curve. Demand management can
thus be used to combat either the stagnation element or the inflation
element of stagflation, but not both at the same time.

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Activity 7.2

True/False Statements

a T
b F

Short Questions

3. Start by drawing diagrams similar to those in figure 19–7(a) and figure 19–
7(c). An increase in the interest rate will lead to a decrease in investment.
Spending decreases, leading to a decrease in aggregate demand (the AD
curve shifts to the left), while prices, production and income will also
decrease.
4. ↑i → ↓I → ↓A → ↓AD → ↓P and ↓Y
5. Though we are going to use diagrams similar to those in figure 19–7(a) and
figure 19–7(c), we need to draw
a a steeper investment demand curve (reflecting a smaller interest
elasticity of investment demand)
b a steeper AS curve

A decrease in the interest rate will result in a small increase in investment

spending. Spending and aggregate demand in the economy will increase by
a small margin. The shift to the right of the AD curve will thus be small and
the effect on income will be minimal.

Activity 7.3

True/False Statements

a F
b F
c T
d F

Topic 8

Activity 8.1

True/False Statements

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a F
b T
c T
d F

Activity 8.2

True/False Statements

a F
b T
c T
d T
e T
f T
g T
h F
i T
j T
k F

Activity 8.3

True/False Statements

a T
b T
c T
d T
e T
f T
g F
h T

Short Questions

1. To answer this question you have to summarise the different costs of

inflation. Use the three categories (distribution effects, economic effects
and social and political effects) to organise your answer and list some of the
most important costs in each category. Of course, you are also free to add
other observations, provided they make economic sense.

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Activity 8.4

True/False Statements

a T
b T
c F
d F
e T
f T
g T
h T

Short Questions

1. You could have used diagrams similar to those in figure 20–1 and figure
20–2 to answer this question. Demand-pull inflation is illustrated by a
rightward (upward) shift of the AD curve. Such inflation is accompanied by
an increase in total production and income (up to the full-employment
level). Once full employment has been achieved, any further increase in
aggregate demand will raise only the price level.
Note that inflation pertains to the economy as a whole and that we are
therefore dealing with the general price level and total production or
income. Not with the prices or production of individual goods and services,
as in microeconomics.
Cost-push inflation is illustrated by a leftward (upward) shift of the AS
curve. This results in an increase in the price level, accompanied by a
decrease in production, income or employment (that is, an increase in
unemployment). That is why cost-push inflation is also sometimes referred
to as stagflation. All that remains is to name the possible causes of each
type of inflation.
2. Start by drawing diagrams of demand-pull inflation (figure 20–1) and cost-
push inflation (figure 20–2). To combat demand-pull inflation, aggregate
demand has to be reduced. This can be achieved by applying contractionary
monetary and fiscal policies, illustrated by a leftward (downward) shift of
the AD curve. However, such policies have the undesirable side effect of
reducing total production, income or employment in the economy. In other
words, the result is greater unemployment (except if the economy is still at
the full-employment level after the implementation of the policies) if the
movement is from AD4 to AD3 (figure 20–1).

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 In the case of cost-push inflation, a contractionary monetary or fiscal policy
will succeed in lowering the general price level but it will increase
unemployment even further. In principle, the appropriate policy strategy
would be to raise aggregate supply (illustrated by a rightward or downward
shift of the AS curve).

Topic 9

Activity 9.1

True/False Statements

a F
b F
c T

Activity 9.2

True/False Statements

a T

Activity 9.3

True/False Statements

a T
b T
c T
d T
e T
f T

Activity 9.6

True/False Statements

a T
b F
c T

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Topic 10

Activity 10.1

True/False Statements

a F
b T
c T
d T
e T
f F
g F
h F
i F
j T
k F

Activity 10.2

True/False Statements

a T
b T
c T
d T
e T
f F

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