CONCEPTS OF MACRO ECONOMICS :

Definitions, Importance, Limitations of macroeconomics, Macro-Economic Variables. Circular Flow

of Income in Two, Three, Four Sector Economy, Relation between Leakages and Injections in
Circular Flow.

NATIONAL INCOME DETERMINATION

National Income: Concepts, Definition, Methods of Measurement, National Income, Problems in
Measurement of National Income & Precautions in Estimation of National Income.

MACRO ECONOMIC FRAMEWORK:

Theory of Full Employment and Income: Classical, Modern (Keynesian) Approach, Consumption
Function, Relationship between Saving and Consumption. Investment function, Concept of Marginal
Efficiency of Capital and Marginal Efficiency of Investment; National Income Determination in
Two, Three and Four Sector Models; Multiplier in Two, Three and Four Sector Model.

ANALYSIS OF MONEY SUPPLY AND INFLATION:

Functions and Forms of Money, Demand for Money- Classical, Keynesian and Friedmanian
Approach, Measures of Money Supply, Quantity Theory of Money, Inflation- Types, Causes, Impact
and Remedies.

EQUILIBRIUM OF PRODUCT AND MONEY MARKET:

Introduction to IS-LM Model, Equilibrium- Product Market and Money Market, Monetary Policy,
Fiscal Policy

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CONCEPT OF MACRO ECONOMICS

Macroeconomics is a branch of economics that studies how the overall economy behaves. it deals
with the output, (total volume of goods and services produced) levels of employment and
unemployment, average prices of goods and services. It also deals with the economic growth of
the country, trade relationship with other countries and the exchange values of the currency in
the international market.
The major factors influencing these outcomes are international market forces like population
growth, consumption behavior of the country, external forces like, natural calamities, political
instability and policy related changes such as tax policy, government expenditure (budget)
money supply and various other economic policies of the country. Therefore it is essential to
know the aggregate demand and aggregate supply of the country.
Features and Nature of Macroeconomics
The characteristics or features of macroeconomics are encompassed in its summative or
aggregative impact on variables that concern the entire geographical boundary called nation or
country. The study of macroeconomics generally involves the study of a number of variables that
affect the whole elephant economy. Such variables include, among others, the rate of inflation
i.e. changes in general price level, population and other demographic issues, public finance,
national income accounting and determination, employment and wage determination,
international trade and balance of payment issues, foreign exchange and domestic currency value
stabilization, economic planning issues and economic growth and development, to mention but a
few.
The nature, like feature, is the general outlook of macroeconomic conditions which encompasses
the characterization of the entire system. In a nut shell, the nature of macroeconomics includes
the macroeconomics variables and policy objectives.
Macroeconomic Goals/Objectives
The macroeconomic policy are framed by the government to:
(i) Achieve National level of full employment.
The Performance of any government is judged in terms of goals of achieving full
employment and price stability. These two may be called the key indicators of health of an
economy. Unemployment refers to involuntary idleness of mainly labour force and other
productive resources. Keynes said that the goal of full employment may be a desirable one
but impossible to achieve. Full employment, thus, does not mean that nobody will be
unemployed. If 4 or 5 percent of the total population remain unemployed, the country is said
to be fully employed. Full employment, though theoretically conceivable, is difficult to
attain in a market-driven economy.
(ii) Achieve Price stability:
By price stability we must not mean an unchanging price level over time. Price increase is
welcome but must be restricted within a reasonable limit. Sustained increase in price level as
well as a falling price level produce destabilising effects on the economy. Therefore.One of
the objectives of macroeconomic policy is to stabilize price fluctuations or ensure (relative)
price level stability in the market. This goal prevents not only economic fluctuations but also
helps in the attainment of a steady growth of an economy.
(iii) Achieve Economic growth:

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 Economic growth in a market economy is never steady. These economies experience ups
and downs in their performance. Such ups and downs in the economic performance are
refers to as trade cycle/business cycle. In the short run such fluctuations may exhibit
depressions or prosperity (boom). One of the important benchmarks to measure the
performance of an economy is the rate of increase in output over a period of time. There are
three major ‘sources of economic growth, viz. (i) the growth of the labour force, (ii)
capital formation, and (iii) technological progress. A country seeks to achieve higher
economic growth over a long period so that the standards of living or the quality of life of
people, on an average, improve.
(iv) Achieve Balance of payments equilibrium and exchange rate stability:
From a macro- economic point of view, an international transaction differs from domestic
transaction in terms of (foreign) currency exchange. Over a period of time, all countries aim
at balanced flow of goods, services and assets into and out of the country. Whenever this
happens, total international monetary reserves are viewed as stable. If a country‘s exports
exceed imports, it then experiences a balance of payments surplus or accumulation of
reserves, like gold and foreign currency. When the country loses reserves, it experiences
balance of payments deficit (or imports exceed exports). However, depletion of reserves
reflects the unhealthy performance of an economy and thus creates various problems. That is
why every country aims at building substantial volume of foreign exchange reserves.
However, the accumulation of foreign exchange reserves is largely conditioned by the
exchange rate. The foreign exchange rate should be stable as far as possible. This is what
one may call it external stability in price. External instability in prices hampers the smooth
flow of goods and services between nations. It also erodes the confidence of currency.
(v) Income redistribution:
Macroeconomic policy is also used to attain some social ends or social welfare. This means
that income distribution needs to be more fair and equitable. In a capitalist market-based
society some people get more than others. In order to ensure social justice, policymakers use
macroeconomic policy instruments.
(vi) Control monopoly market structure

Differentiation between Macroeconomics and Microeconomics

Macroeconomics and microeconomics are the two vantage points from which the
economy is observed.
Macroeconomics looks at the total output of a nation and the way the nation allocates its
limited resources of land, labour, and capital in an attempt to maximize production levels
and promote trade and growth for future generations. After observing the society as a
whole, Adam Smith noted that there was an "invisible hand" turning the wheels of the
economy, a market force that keeps the economy functioning.
Microeconomics looks into similar issues but on the level of the individual people and
firms within the economy. It tends to be more scientific in its approach, and studies the
parts that make up the whole economy. Analyzing certain aspects of human behaviour,
microeconomics shows us how individuals and firms respond to changes in price and
why they demand what they do at particular price levels.
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Macroeconomics is concerned with the aggregate, or overall, economy. It’s deals with
economic factors such as total national output and income, unemployment, balance of
payments, and the rate of inflation. It is distinct from microeconomics, which is the study
of the composition of output such as the supply and demand for individual goods and
services, the way they are traded in markets, and the pattern of their relative prices.

IMPORTANCE OF MACROECONOMICS

1. The study of macroeconomics is indispensable for understanding the workings of the

economy. Our main economic problems are related to the bahaviour of total income, output,
employment and the general price level in the economy. The variables are statistically
measurable thereby facilitating the possibilities of analyzing the effects on the functioning of
the economy. It gives a bird eye view of the economic world.
2. For the formulation of useful economic policies for the nation, macro-analysis is of the
utmost significance; economic policies cannot be obviously based on the fortunes of a single
firm or even industry or the price of individual commodity.
3. macroeconomics has special significance in studying the causes, effects and remedies of
general unemployment.
4. The study of macroeconomics is very important for the evaluation of overall performance of
the economy in terms of national income. National income data helps in forecasting the
levels of economic activity and to understand the distribution of income among different
groups of people in the economy.
5. It is in terms of macroeconomics that monetary problems can be analyzed and understood
properly. Frequent change in the value of money, inflation or deflation, affect the economy
adversely. Adopted monetary, fiscal and direct control measures for the economy as a whole
can counteract them.
6. Macroeconomics has special significance in studying the causes, effects and antidotes of general
redundancy.
7. The study of macroeconomics is very significant for evaluating the overall performance of the
economy in terms of national income.
8. Helpful in understanding the functioning of an Economy
Modern economy has become a very complex affair. Several economic factors which are
interdependent operate in it. To have an understanding of its organization and functioning one cannot
depend on individual unit alone. Study of an economy as a whole, has therefore, become very
essential.
9. Balance of Payment
It explains factors which determine balance of payment. At the same time, it identifies causes of
deficit in balance of payment and suggests remedial measures.

Limitations of Macro Economics

1. Danger of excessive thinking in terms of aggregates: There is danger of executive thinking in
terms of aggregates which are not homogeneous. For example, 2apples +3apples=5 apples is the
meaning full aggregate, similarly 2 apples +3 oranges is meaningful to some extent.
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2. Aggregate tendency may not affect all sectors equally: For example, the general increase in
price affects different sections of the community or the different sectors of the economy differently.
The increase in general level of price benefits the producers, but hurts the consumers.
3. Indicates no change has occurred: The study of aggregates make us believe that no change has
occurred even if there is a change. It indicates that there is no need of new policy. For example, a 5
percent fall in agricultural price and 5 percent rise in industrial prices does not affect the price level.
4. Difficulty in the measurement of aggregates: There are at times, difficulties in the measurement
of aggregates. It is difficult to measure the big aggregates. This problem has now been more or less
erased by the use of calculators and the things which are not homogeneous.
5. The fallacy of composition: The aggregate economic behavior is the sum of individual behavior.
This is called fallacies of composition. What is true in case of an individual may not be true in the
case of economy as whole. For example, individual saving is a virtue, whereas the public saving is
vice. According to K.E. Boulding "These difficulties are aggregative paradoxes which are true when
used to one person, but false when used to the economy as a whole.
6. It ignores the contribution of Individual Units: Macro economic analysis throws light only onm
the functioning of the aggregates. However, in real life, the economic activities and decision taken by
individual units on private- level have their effects on the economy as a whole. Such effects are not
known by the study of macro economics.
7. Limited Application: Another limitation of macro economics is that most of the models relating
to it have only theoretical significance. They have very little use in practical life. Moreover it is very
difficult to measure various aggregates of macro economics.

Macro Economic Variables:

Macroeconomic variable are generally classified as:
Endogenous Variables: These are those whose value is value is determined within the model.
Some typical endogenous variables used in macroeconomic models are national income,
consumption, savings, investment, market interest rate, price level and employment.
Exogenous Variables: These are those that are determined outside the models, e.g. money
supply, tax rates, government expenditures, exchange rates, etc. However depending on the
objective of analysis, endogenous variables are converted into exogenous variables, and
exogenous variables can be endogenised.

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 NATIONAL INCOME
National income is the total market value of all final goods and services produced by a country's
economy over a specific period, usually one year. In other words, it is the total amount of income
accruing to a country from economic activities in a year year. It measures the economic performance and
productivity of a nation and includes incomes earned by residents and businesses, including wages, rents,
interest, and profits. National income is an essential indicator used in economics to assess the overall
health of an economy, and it helps guide policy decisions regarding taxation, inflation, and economic
growth.

National Income Concept:

The major concepts used in national income calculation are Gross Domestic Product
(GDP), Gross National Product (GNP), Net National Product (NNP), personal income and
Disposable income.

Gross Domestic Product:

GDP can be calculated at both market prices (GDPMP) and factor cost (GDPFC).

GDP at Market Price: is the total market value of all final goods and services currently
produced within the domestic territory of a country in a year. It measures the market value of
annual output of goods and services currently produced and counted only once to avoid double
counting. It includes only final goods and services. It includes the value of goods and services
produced within the domestic territory of a country by nationals and non-nationals.
GDP at factor cost: GDP at factor cost is a measure of a country's gross domestic product (GDP) that
considers only the costs of production (income earned by factors of production or payment made to labor
capital, and other inputs in production), excluding any indirect taxes and including subsidies provided by
the government within an economy.
Net Domestic Product: NDP is an economic measure that represents the total value of goods and
services produced within a country over a specific time period, after accounting for the depreciation of
capital assets. Some of the countrys capital equipment wears out or becomes obsolute each year during
the production process. The value of this captal consumption is some percentage of gross investment
which is deducted from GDP. Tus, NDP is derived from the Gross Domestic Product (GDP) by
subtracting depreciation (also known as capital consumption allowance).
For example, if a country's GDP is N 500 billion and the depreciation on its capital assets is N50
billion, then its NDP would be N450 billion. This figure reflects the net output, adjusting for the
wear on resources used in production.
Gross National Product: GNP is a measure of the total economic output produced by a country’s
residents, both domestically and abroad, over a specific period (typically a year). It includes all goods and
services produced by the labor and property supplied by the country’s residents, regardless of where the
production occurs. It does not include the production of foreign residents or companies operating
domestically.
Net factor income from abroad (NFIA): Factor income earned by our residents from abroad-Factor
income earned by non-residents within our country.
Final Goods: Final goods are those goods which have crossed the boundary line of production,
and are ready for use by their final users. Final users may be consumers and any firm. Final
goods as used by the producers are called capital goods.
Intermediate Goods: These are those goods which are not out of the boundary line of
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production and are yet not ready for use by their final users. These used are largely used as raw
material.
Depreciation: A reduction in the value of an asset with the passage of time, due in particular to
wear and tear. Depreciation is a non-cash expense that reduces the value of an asset over time.
Assets depreciate for two reasons: Wear and tear
Transfer Payment: A payment made or income received in which no goods or services are
being paid for, such as a benefit payment or subsidy.
A no compensatory government payment to individuals, as for welfare or social security benefits
is transfer payment. People sometimes get income without any productive activity. Ex:
Unemployment benefits, old age pensions etc. produced annually in a country plus net factor income
from abroad.
Personal Income (PI): Personal Income is the total money income received by individuals and
households of a country from all possible sources before direct taxes. Therefore, personal income
can be expressed as follows: PI = NI - Corporate Income Taxes - Undistributed Corporate Profits
- Social Security Contribution + Transfer Payments
Disposable Income (DI) :
Disposable Income (DI): is an individual take home pay, what is left in an individual’s
pocket after the deduction of personal income tax. DI=PI-Direct Taxes
Per Capita Income (PCI): Per Capita Income of a country is derived by dividing the national
income of the country by the total population of a country. Thus, PCI=Total National Income/Total
National Population
Method of calculating National income
Basically, there are three major approaches to calculation of national income accounting,
The use of these methods depends on the availability of data and the purpose they
include income approach, expenditure approach and product or output approach.
THE INCOME METHOD
This method values GDP as the sum of final incomes earned by factors of production
located in a country for the production of goods and services for a defined accounting
period.
The first stage under the income method is to determine and sum up factor incomes. We
account for only factor incomes generated through the production of good and services.
Some of these incomes are wages, salaries, commissions, etc. before taxes, social security
and pension deductions which accrue to labour, rent, royalties, etc. which accrue to land;
interest and dividends which are earned by capital and profits of private and public
business which accrue to enterprise. We therefore, exclude from the accounts transfer
payments e.g. state pension, private transfer of money from one individual to another.
THE EXPENDITURE METHOD
Under the expenditure method GDP is the sum of the final expenditure on goods and
services produced in a country measured at market prices. There are four main spending
sectors: Household (C), Firms (I), Government (G) and Foreign sector (X-M).
Symbolically, GDP = C+ I + G + (X – M)
THE VALUE- ADDED (OUTPUT) METHOD

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National income can also be measured by adding all values of final goods and services
produced in the economy during the period and excluding the values of intermediate
products to avoid double counting. On the other hand, it can be measured by estimating
only the net values of output at every stage of production in the economy during the
course of the year.

Numerical Example:
Given the following data of the national income accounts

S/No. Item N (Million)

1 Consumption expenditure 1221
2 Gross private investment 310
3 Wages and salaries 953
4 Income of self employed 105
5 National insurance and security trust fund 85
6 Government subsidies 253
7 National housing fund 65
8 Rents 48
9 Exports 85
10 Imports 160
11 Personal income tax 195
12 Company income tax 76
13 Government expenditure on goods and services 348
14 Capital consumption allowance 183
15 Net income from abroad 48
16 Undistributed profits 87
17 Indirect business taxes 165
18 Dividends 95

Determine
i) GDP using expenditure method
ii) GDP using the income method
iii) Gross National Profit (GNP)
iv) Net National Profit (NNP)
v) National Income (NI)
vi) Personal Income (PI)
vii) Disposal Income (D.I)

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Solution
I) Using the expenditure approach (method) for GDP
Consumption expenditure 1221
Gross private investment 310
Export 85
Good Expenditure 348
Less imports (160)
GDP N1804m
Ii) Using the factor income method
Wages & Salaries 953
Income of self-employed 105
N.I.S.T.F 85
N.H.F 65
Rents 48
Personal Income tax 195
Company income tax 76
Undistributed profit 87
Indirect business taxes 165
Dividends 95
Capital consumption allowance 183
Less government subsidies (253)
GDP N1804m
iii) Gross National product
GDP + Net income from abroad
1804 + 48 = N1852m
iv) Net National Product
GNP - Depreciation
1852 – 183 = N1669m

v) National Income (N.I)

NNP – Indirect business taxes
1669 – 165 = N1504m
Alternatively it can be obtained directly from GNP by subtracting depreciation and
indirect business taxes components from the value of GNP i.e
NI = GNP – (D + IBT)
= 1852 – (183 + 165)
= 1804 – 348
= N1504m
vi) Personal Income (PI)

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 PI = NI + government subsides – (NISTF + NHF + undistributed profits +
company income tax)
PI = 1504 + 253 – (85 + 65 + 87 + 76)
= 1504 + 253 – 313
PI = N1444m
vii) Disposable income
Personal income – personal income tax
= 1444 – 195
DI = N1249m
viii) Per capital income (PCI) = GNP/Population
PCI = 1852/15
= N123.47m

USES OF NATIONAL INCOME ACCOUNTING.

i. It clearly revealed the contribution of the difference sector of the nation to National
income. Through it one can easily know the contribution of each sector to the economy
and this may influence planning in the future, for example, for allocation of resources.
ii. It makes us to know the structure of production, level of consumption, savings and
investment.
iii. Through national income one can measure a country economy growth and it also
gives an idea of the standard of living of a country, for example, the greater the standard
of living vis-à-vis the citizens of the economy.
iv. It also gives an idea of the economy strength of the country. It provides assistant to
foreign investors who may have to decide whether or not to invest in a country.
V. It is useful in the study of business functions and economic policies generally.
vi. It helps in the forecasts of any future events. It can be used to analyze what changes
are likely to occur in the economy both in economic or political policies.
Vii National income accounting is also use for comparative analysis of two or more
countries. The purchasing power parity (PPP) of countries could be established through
the per capital income of individual nations from which the standard of living of a
country is recognized.

PROBLEM OF MEASURING NATIONAL INCOME

The following problems arise in the calculation (estimating) of national income:
i. Double Counting: This has to do with intermediate goods, intermediate expenditure
and transfer payments. There is the likelihood of valuing, for example, cassava and gari,
counting expenditure on suiting material as well as the suit and counting incomes earned
not for productive activities (transfer payments). If this happens, the value of total output
will be grossly exaggerated. This problem is avoided to a very large degree by taking
note of only the value added or final expenditure and excluding transfer payments.

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ii. Marketability of Goods: National income is the money value of goods and services
produced in a given period. A problem arises in connection with goods and services that
are not exchanged through the market. This problem is solved to some extent by
including goods and services that do not enter the market. Conventionally, items that do
not enter the market are included. (a) Rent is imputed to owner occupied houses. (b)
Value is also imputed to food produced and consumed on the farm. (c) Housewives
income is not also included in National income but estimation of these could temporary
reduce the problem.

Output approach provides detailed information on the contributions of the various

sectors and sub-sectors of the economy. Data provided by the expenditure approach gives
an idea about the proportion of income invested, consumed or transferred. Finally, data
provided by the income approach provides information on functional distributions of
income which is useful for income tax policies.
iii. Income earned through illegal activities such as gambling or extraction of wine etc. is
not included in national income, such goods and services do have value and meet the
needs of the consumers, but by leaving them out, the national income works out to be less
than the actual.
iv. There arises the difficulty of including transfer payments in the national income.
Individual get pension, unemployment allowance and interest on public loans but whether
these should be included in national income is a difficult problem. On the other hand,
these earning are a part of individual income and on the other hand they are government
expenditure.
v. Another difficulty in calculating national income is that of price changes which fail to
keep stable the measuring rod of money for national income. When the price level in the
country rises, the national income also shows an increase even though the
production might have fallen. On the contrary, with a fall in price level, the national
income shows a decline even though the production might have gone up.
vi. Problem of treating depreciation. There is problem of estimating the current
depreciated value of a piece of capital whose expected life is fifty years is very difficult.
Also, how depreciation is calculated between firms are different and these will give
different value.

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 CIRCULAR FLOW OF INCOME
The circular flow of income and expenditure refers to the process whereby the national
income and expenditure flow in a circular manner continuously through time that is the
circular flow of income shows the movement of real resources as well as flow of fund
within the economy. We shall explain this flow in a two sectors economy, three sectors
economy and the one that emphasized the movement of all economic resources within the
country (four sector economies).

Circular Flow of Income in a two sectors model

Assumptions:
The following are the assumptions that are considered for explaining circular flow of income
in two-sector model simple economy.
1. The economy is closed economy. That is, there is no foreign sector;
2. Households do not produce but provide factors of production;
3. Firms or business sector is the only producing sector;
4. Whatever is produced by firms is sold and there is no accumulation of inventories;
5. Consumers or household sector do not save their income but spend all their income;
6. There is absence of taxes, government expenditure on goods and services etc.
7. The economy has two sectors – household sector and business sector
8. The role of savings and investment is not captured.
9. The government and the foreign sectors are also not represented.

In a two sector economy, households are basically consumer units and they own factors of production.
Firms produce goods while households provide services of the factors of production to these firms.
Factors of production receive incomes for rendering their services. The sales value of net production must
equal the sum total of payments made by the firms to the factors of production in the form of wages,
rents, interest and profits. These incomes are spent on various goods and services by households. Thus
income flows from firms to households in exchange of productive services while products flow in return
when expenditure by households takes place.

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The diagram shows Real Flow (goods and services) and Monetary Flow (income and
expenditure).
The bottom pair arrows depict the goods market. In this market, households exchange
money for the goods and services produced by the firms. The total value of these goods
and services estimates nationalincome from the product/output side. The other arrow
shows the expenditure approach. The summation of these expenditures represents the
expenditure approach.
The top pair of arrows represents the factor market in which the firms exchange money
for the services provided by the household, that is, wages-payments for labour services,
interest for incomes earned by factors of production for producing the economy‟s goods
and services.

The circular flow diagram shows that national income may be measured by final output
expenditure (Expenditure Method). The diagram gives us the basic national income
identity: National Income = National Product = National Expenditure. This identity
means that actual incomes received in the economy are identical to both actual
expenditure and actual output or product produced in the economy.

Circular flow with savings and investment.

This approach shows the circular flow of income that emphasis impact of savings and
investment

From the diagram above the outer loop represent the flow of real resources which start
from the movement of factors from household to factor markets and from factor market
to the firm ( after being employed). This factor inputs were made to produce goods and
services by the firm and in turn this output is taken to the product market for final
consumption by the same household. On the other hand, the inner loop represents the
flow of financial resources, which begins from the firm (who pays the employed factors)
to the household, the household in turn could either save or consume the earned income.
Fraction of the income earned by the household, if consumed will be taken to the product
market for final consumption of goods and services, while in turn, the money realise form
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the product market be taken to the firm for further production, however, if saved in the
financial market, such saving would be converted to loan to the firm for investment and
in turn, the firm pays the loan given to them with interest to the financial market who also
pay back part of the interest with capital to the household on demand.
Therefore, we can say that the savings by households and firms are leakages and
borrowings by the firms act as injections into the circular flow of income.

Circular Flow of income in a three sectors model

For the three sectors model we introduce the government sector so as to make it a three
sector closed model of income and expenditure. For this we add taxation and government
purchases. Taxation is a leakage from the circular flow and government purchases are
injections into the circular flow. Here we take the household, business firms and
government sectors together to show their inflows and outflows in the circular flow.
Taxation tends to reduce consumption and saving of the household sector. Reduced
consumption, in turn reduces the sales and income of firms. Also taxes on business firms
tend to reduce their investment and production. The government offsets these leakages by
making purchases from the business sector and buying services of household sector equal
to the amount of taxes. The diagram shows that taxes flow out of household and business
sectors and go to the government. The government makes investment and purchases
goods from firms and also factors of production from households. Thus government
purchases of goods and services are injection in the circular flow of income and taxes are
leakages.

Circular Flow of Income in a Four Sector Model

In a four sector model, an economy moves from being a closed economy to an open
economy. In an open economy imports and exports are made. You must understand that
one country’s exports are other country's imports. In case of a country imports, money
flows to the rest of the world and in case of exports, money flows in from the rest of the
world. An economy experiences a trade surplus if its exports exceed its imports. On the
14
other hand, there is a trade deficit if imports exceed exports. Imports act as leakages and
exports as injection into the circular flow of income in an economy. The figure shows the
four sector model in an economy

In a 4 sector model, we have,

Y = C + I + G + (X-M)
Where,
Y = Income or Output
C = Household consumption expenditure
I = Investment expenditure
G = Government expenditure
X-M = Exports minus Imports

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THEORY OF FULL EMPLOYMENT AND INCOME

Meaning of Full Employment

From the classical to the modern economists, there is no unanimity of views on the
meaning of full employment. Therefore, it is worth-while to analysing the various views
of economists on full employment.

The Classical View of Full Employment

They believed in the existence of full employment at all times in the economy, to them
full employment is a normal situation in the economy. According to Pigou, the tendency
of the economic system is to provide full employment in the labour market. There is
unemployment when there is wage rigidity and interference in the working of free market
system in the form of trade union legislation, minimum wage legislation, etc. Full
employment exists when everybody who at the present wages wishes to be employed. For
the Pigovain view those who are not prepared to work at the existing wage are not
unemployed but they are voluntary unemployed. Also, with perfectly free competition
there will always be a strong tendency for wage rates to be so related to demand that
everybody is employed. This view on full employment is consistent with frictional,
voluntary, seasonal or structural unemployment.

The Keynesian View of Full Employment

According to Keynes, full employment means the absence of involuntary unemployment
that is full employment is a situation in which everybody who wants to work gets work.
Full employment is consistent with frictional and voluntary unemployment. He assumes
that with a given organisation, equipment and technique, real wages and the volume of
output are co-related, so that, an increase in employment can only occur to the if the wage
rate decline. To achieve full employment, Keynes advocates increase in effective demand
to bring about reduction in real wages. According to him when effective demand is
deficient, there is underemployment of labour in that people unemployed will be willing
to work at less than existing real wage. But if effective demand increases, employment
increases, though at a real wage equal to, or less than, the existing one, until a point
comes, at which there is no surplus of labour available at the existing real wage.
Keynes also gives another definition of full employment in his “General theory”: ‘It is a
situation in which aggregate employment is inelastic in response to an increase in the
effective demand for its output.’if the supply of output becomes inelastic at the full
employment level, any further increase in effective demand will lead to inflation in the
economy. Thus the Keynesian concept of employment involves three conditions: (i)
reduction in the real wage rate, (ii) increase in effective demand and (iii) inelastic supply
of output at the level of full employment.

Other Views on Full Employment

16
Lord Beveridge in his book “Full Employment in a Free Society” defined it as a situation
where there were more vacant jobs than employed men so that normal lag between losing
one job and finding another will be very short.” By full employment he does not mean
zero employment which means that full employment is not always full. That is, there is
always a certain amount of frictional unemployment in the economy even when there is
full employment.
According to the American Economic Association Committee, “Full employment means
that qualified people who seek jobs at prevailing rates can find them in productive
activities without considerable delay. It means full time jobs for people who want to work
full time. It does not mean people like house-wives and students are under pressure to
take jobs when they do not want jobs or that workers are under pressure to put in
undesired overtime. It does not mean unemployment is zero.”Therefore, both Beveridge
and the Committee considered full employment to be consistent with some amount of
unemployment.
Measures to Achieve and Maintain Full Employment
Since underemployment is caused by deficiency in effective demand, full employment
can be achieved by increasing effective demand either by stimulating investment or
consumption, or both. Full employment is thus sought to be achieved and maintained
by monetary, fiscal and direct measures.
Monetary Policy
Monetary policy in an underdeveloped country plays an important role in increasing
the growth rate of the economy by influencing the cost and availability of credit, by
controlling inflation and maintaining equilibrium in the balance of payments. So the
principal objectives of monetary policy in such a country are to control credit for
controlling inflation and to stabilize the price level, to stabilize the exchange rate, to
achieve equilibrium in the balance of payments and to promote economic
development.
An expansionary monetary policy is used to overcome a recession or depression or a
deflationary gap. When there is a fall in demand for consumer goods and services, and
in business demand for investment goods, a deflationary gap emerges. The central
bank starts an expansionary monetary policy that eases the credit market conditions
and leads to an upward shift in aggregate demand. For this purpose, the Central Bank
purchases government securities in the open market, lowers the reserve requirements
of member banks, lowers the discount rate and encourages consumer and business
credit through selective credit measures. By such measures, it decreases the cost and
availability of credit in the money market, and improves the economy.

A monetary policy designed to curtail aggregate demand is rceasllteridc ti ve

monetary policy. It is used to overcome an inflationary gap. The economy experiences
17
inflationary pressures due to rising consumers’ demand for goods and services and
there is also boom in business investment. The central bank starts a restrictive
monetary policy in order to lower aggregate consumption and investment by incr
easing the cost and availability of bank credit. It might do so by selling government
securities in the open market, by raising requirements of member banks, by raising the
discount rate, and controlling consumer and business credit through selective
measures. By such measures, the Central Bank increases the cost and availability of
credit in the money market and thereby controls inflationary pressures.

Fiscal Policy
Fiscal policy is a powerful instrument of stabilization. “By fiscal policy we refer to
government actions affecting its receipts and expenditures which are ordinarily taken
as measured by the government’s net receipts, its surplus or deficit.” The government
may offset undesirable variations in private consumption and investment by anti-
cyclical variations of public expenditures and taxes. Fiscal policy as can be seen as a
policy under which the government uses its expenditure and revenue programmes to
produce desirable effects and avoid undesirable effects on national income,
production and employment. Though the ultimate aim of fiscal policy is the long-rum
stabilization of the economy, yet it can only be achieved by moderating short-run
economic fluctuations. In this context fiscal policy can be described as changes in
Taxes and expenditures which aim at short-run goals of full employment and price-
level stability.

In a developing country, where monetary policy alone is ineffective, due to the

existence of undeveloped money and capital markets, fiscal policy can be used as an
important adjunct to monetary policy in accelerating the rate of capital formation.
Fiscal policy plays a significant role in the development plans of developing
countries. Under planning, balance has to be achieved both in real and money terms.
In other words, a physical plan has to be matched by a financial plan. The
implementation of the financial plan and the achievement of balances of real and
money terms obviously will have to rely largely on fiscal measures.

UNEMPLOYMENT AND UNDEREMPLOYMENT

18
Underemployment refer to situation when an individual or group of person is contributing
less than their productive capacity, it can also be said to be a situation where an
individual is employ to a cadre below his statue. For instance, a graduate selling recharge
cards.
On the other hand, unemployment refers to a situation where people who are willing and
able to work do not find jobs at the existing wage rate. For a person to be referred to as
unemployed he or she must be qualified for a job, willing to work at the current wage rate
and unable to find a job.
The unemployment rate is expressed as a percentage of the total number of persons
available for employment at any time. Unemployment is a problem that each society
faces, and each society must find a way to beat it. Unemployment is one of the
developmental problems that face every developing economy in the 21st century.

Types of Unemployment.
The main types of employment are:
1. Frictional unemployment:-it refers to unemployment caused by changes in individual
labour markets. This is the type of unemployment resulting from people who have left
jobs that did not work out and are searching for new employment or people who are
either entering or re-entering the labour force to search for a job.
2. Structural unemployment:- This is unemployment resulting from changes in the
pattern of demand for goods and services or changes in technology. These changes may
in turn alter the structure of the total demand for labour rendering some particular skill
less in demand or may become obsolete. The demand for other skill however may
expand. Unemployment in this case is the result of the composition of the labour force
which does not respond quickly to new structures of job opportunities.

3. Cyclical unemployment:- This type of unemployment (also known as Keynesian

unemployment or the demand deficient unemployment) is due to the operation of the
business cycle. This arises at a time when the aggregate effective demand of the
community becomes deficient in relation to the productive capacity of the country. In
other words, when the aggregate demand falls below the full employment level, it is not
sufficient to purchase the full employment level of output. Less production needs to be
carried out which ultimately leads to retrenchment of workers. Cyclical or Keynesian
unemployment is characterized by an economy wide shortage of jobs and last as long as
the cyclical depression last

4. Seasonal unemployment:- This is due to seasonal variations in the activities of

particular industries caused by climatic changes, changes in fashions or by the inherent
nature of such industries. The ice factories are closed down in winter throwing the
workers out of their jobs because there is no demand for ice during winter. Likewise, the

19
sugar industry is seasonal in the sense that the crushing of sugar-cane is done only in a
particular season. Such seasonal industries are bound to give rise to seasonal
unemployment.

5. Disguised unemployment: This type of unemployment is to be found in the backward

and the underdeveloped countries of Asia and Africa. The term „disguised
unemployment‟ refers to the mass unemployment and underemployment which prevail in
the agricultural sector of an underdeveloped and overpopulated country. For example, if
there are four persons trying to cultivate an area of land that could be cultivated as well
by three persons, then only three of these persons are really fully employed and the
remaining fourth person represents disguised unemployment. The people in
underdeveloped countries are outwardly employed but actually they are unemployed, the
reason being that agricultural production would suffer no reduction if a certain number of
them are actually withdrawn from agriculture. This can also be seen when the growth of
the labour force exceeds the amount of investment made. The lack of investment is due to
shortages in real factors such as shortage of skilled labour, managers, right type of
entrepreneurs, etc. As a result, there is over supply of labour available and these excess
labours are „employed” (to be exact, underemployed) in jobs when there are already
enough workers. Therefore, the marginal productivity of such labour is low. This type of
disguised unemployment is caused by the chronic shortage of capital resources in relation
to the rapidly growing population.

6. Technological unemployment: The purpose of growth causes this and it results

from the installation of labour saving machinery. Technological changes may eliminate
many unskilled and semi-skilled workers while creating jobs for specialised trained
persons. This is why many rural urban immigrants cannot even get factory work because
of lack of needed skills.

Causes of Unemployment
i) Recessions
When the economy is not growing, then jobs aren't being created and unemployment
rises. Combating recessions is done through a prudent fiscal policy that includes
incentives to invest and to spend money, including lower taxation and interest rates.
Recessions are a reason why Conservatives want sustainable growth with a prudent fiscal
policy. Recklessness in public finances means that a recession strikes harder and does a
lot more damage.
ii) Over-Regulation

Over-regulation is an important cause for unemployment. Too much burden on a business

shoulders and that business cannot afford to expand and, with its expansion, to create

20
more jobs. Because of this, if you are unemployed, it will be almost impossible for you to
find work, and this will be especially critical for students and for anyone who finds him
or herself out of work when they are middle aged. There is too much paperwork involved
to do anything; there are too many regulations that stifle job creation efforts. This leads to
a two-tier system, usually, with those who are already employed having a job for life, and
those who do not have a job are unable to find anything, and are forced to live on welfare.
There are too few job offers for the demand, a shortage that leads to poverty and chronic
unemployment. This means that adding burdens to the economy will not create new jobs.
It will, in fact, make the amount of new jobs being created decrease.
iii) Skills
To be able to handle a certain job, a person needs a set number of skills. If the person
does not have the skills for a job, then he or she either gets training or he or she is unable
to get that job. When the types of jobs in a certain area change, then people without the
right skills are either able to move to a different area or they are unable to find work. In
the meantime, these new jobs are filled up with new people, who do have the skills these
require. A technology shift can lead to this sort of unemployment, which is structural in
nature. The wrong approach to this problem would be to keep the old jobs going forever,
because that situation is unsustainable. A lot of money will be spent and the people get to
keep their jobs, but they are not given the possibility to improve their situation. The way
to solve this issue is through training.
iv) Lack of Information
A source of unemployment that cannot be overlooked is the lack of information about
available jobs. If people don‟t know that jobs are there, then they will not take them. It is
also important that, when people do know about possible employment opportunities for
them, they are able to take them. Dissemination of information is fundamental in any
market, and in the job market it is fundamental as well. The obvious solution for this
problem is to be able to bring information to the people who need it.
v) Wide gaps between rural and urban incomes. In the urban cities, white collar jobs are
available for few lucky ones who are generally better paid than their counterparts in the
rural areas. This causes the drift from the rural to the urban centres.

Effect of Unemployment
Unemployment always has the following effects on the economy of a country:
(i) Valuable human resources would be wasted
(ii) Valuable material resources would be lying idle
(iii) Potential goods and services would not be produced in large quantities and therefore
leading to goods and services scarcity
(iv) It makes life to become miserable for unemployed people and the overall effect is
that there will be a setback for the whole nation in general.

21
Solution to Unemployment
There are various solutions that an economy can apply to solve the problem of
unemployment and among are the following:
1. Infrastructural development in the country; If a nation developed its basic
infrastructure such as road network, electricity, pipe borne water and other social
overhead. This will encourage producers to established business at lower cost and
promote employment opportunity.

2. Human capital development: Development of human resources is a back bone of

every economy. A nation that developed its resources would expand its productive
capacity by doing the right thing in the right way and encouraging further production.

3. Foreign direct investment; There is a linkage between infrastructural development

and foreign direct investment. Foreign direct investment implies in domestic economy by
multinational, this will generate employment opportunities and increase in local
productivity.

4. Training and retraining of employees; incentives for both companies to retrain and
employees to take part in training to
result of structural unemployment are very high. This will boost productivity and give
opportunities to expand production capacity, thereby creating employment opportunity.

5. Research and Development; Research and development enable a country to expand

knowledge base and production capacity thereby creating employment opportunity.

6. Political Stability: A stable polity with sound macroeconomic environment

encourages both domestic and foreign entrepreneur to established business and thus
create employment opportunity.

7. Absence of corruption, nepotism, favouritism, etc; A nation that is free of all these
social ailments would have a stable polity and will grow faster than those that did not.
The presence of corruption and other social disease are responsible for backwardness of
developing nations. If a country is free of these cankerworms, there would be judicious
utilisation of public funds which will enhance expansion of productivity capacity in the
Ministries Department and Agencies (MDAs) of government and thereby create
employment opportunities.

8. People should try to be self employed rather than look for white collar jobs that could
not be found in abundance.

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9. Government should try to develop the rural sector so as to reduce the problem of
“rural-urban migration”.

10. To a certain extent, government should try to control population as well as making
adequate plan in seeing that the graduates are well absorbed into the employment

INFLATION AND PRICE LEVEL

Inflation describes a persistent and an appreciable increase in the general price level. The
Inflation rate is measured as a percentage change in a price index, such as the consumer
price index. Inflation can also be refers to a high and persistent rise in the general prices
of goods and services which is due mainly to large volume of money in circulation
relative to goods and services produced. From these definitions, it means that inflation
can occur if:
- There is an increase in the supply of money not matched with a corresponding increase
in goods and services.
- There is a lower increase in production of goods and services than money supply.
- There is a greater increase in demand for goods and services than physical production of
goods and services.

Types of Inflation
a) Demand Pull Inflation: it describes a sustained increase in general price level that is
caused by a permanent increase in nominal aggregate demand. Simply, is can be viewed
as an inflation that occurs as a result of increase in aggregate demand. When aggregate
demand exceeds aggregate supply at current prices, prices are pulled upwards to
equilibrate aggregate supply and demand.

b) Cost Push or Supply Inflation: it is a situation where the process of increasing price
level is caused by increasing costs of production which push up prices.

Cost push inflation is also referred to as supply inflation. Price level in this case increases
due to an increase in business costs. These increases in prices occur in the face of high
unemployment and slacken resource utilization. The increase in cost of production causes
supply of final goods and services to fall. This creates excess aggregate demand and a
new equilibrium is attained at a higher price level.
c) Creeping Inflation: when the rise in prices is very slow like that of a snail, it is called
creeping inflation or a sustained rise in prices of annual increase of less than 3% per
annum is characterised as creeping inflation and it essential for economic growth.

d) Hyper Inflation: This is the extreme form of inflation in which the value of money
loses its purchasing power. Money thereby loses its function as a store of value. The
23
increase in the economy‟s output is impossible because of the breakdown in monetary
mechanism. It is associated by an increase in the supply of money. It is usually
experienced during war when labour and other resources are channeled towards the
persecution of war.

Causes of Inflation
1. Excessive growth in wages relative to productivity can cause inflationary pressures.
This causes aggregate demand to increase relative to aggregate supply and pulls up prices
level.
2. Government sector causes. Changes such as an increase in government expenditure can
produce an increase in the price level in the economy via increased aggregate demand.
3. Price stocks. These are substantial increases in the prices of some items, for example,
due to drought, floods, or massive oil price hike. These increases in the prices of these
items may feed into cost of production. Aggregate output may fall and given the
aggregate demand the price level is pushed up.
4. Excessive growth in money supply relative to the level of production in the economy.
This causes the level of aggregate demand in the economy to increase relative to
aggregate output, shortages occur and the price level rises.
5. Changes in exchange rate. If the external value of the domestic currency falls relative
to other nations currencies this may be inflationary. Under this circumstance important
goods become more expensive and this may add o domestic cost and price structure on
the economy fuelling inflation.

Effects of Inflation
1. On income Earners: Those on fixed income or assets (fixed in nominal terms) lose,
however, those on incomes, which are directly related to the price level; real incomes
may remain relatively unchanged or may even increase.
2. On profits: Generally, profits increases when the inflation is the demand pull type and
decline when the inflation is the cost push type. During demand pull inflation the prices
of final goods and services tend to be more flexible in an upward direction than many
other prices.
3. On lenders and borrowers: inflation tends to encourage borrowing and discourage
lending. This is so because what is borrowed today which could have been used to
purchase, say a bowl of garri today, would not enable the creditor to purchase the same
bowl of garri when the loan is paid back. This is true only when nominal interest rate is
fixed or rises at a slower pace than inflation.

24
4. On production: Demand pull inflation may lead to inefficiency in production since
competitive pressures to improve both product and performance will be greatly reduced
cost – push inflation however, puts a premium on efficiency.
5. On foreign Trade: Rising domestic prices can hurt exports. If domestic prices are rising
faster than the rest of the world prices, exports will fall and imports will tend to increase
and this will invariably affect our net exports and may have devastating balance of
payment implications.

Control of Inflation
How inflation is controlled in an economy depends on the causes and the type of inflation
the economy is experiencing
1. Use of Fiscal Policy

Fiscal policy is one of the two main macroeconomic policies used to control aggregate
demand and thereby achieve economic stability. Fiscal measures relate to taxation.
Government expenditure and public debt management, which seek to influence the level
of aggregate demand in an economy.
There are three main tools of fiscal policy viz. government spending (G), the income tax
rate (t) and government transfer payments (Tr). In times of demand pull inflation these
tools are used to reduce aggregate demand. An increase in tax rate, decrease in
government expenditure and decline in government transfer payment will reduce
aggregate expenditure in the economy.

2. Use of Monetary Policy

Monetary policy is that part of macroeconomic policy which regulates the changes in
money supply in order to maintain price stability.
Tools of monetary policy are changing discount rate (d); changing required ratio (rr) and
open market operations (OMO). Increased required reserve ratio (rr) reduces the extent to
which commercial banks create credit hence reduces money supply. When the discount
rate is increased short term interest rates increased and this discourages borrowing to
finance investment spending. This invariably reduces aggregate demand. Central bank
selling of its own government securities to the general public reduces money supply
which reduces aggregate demand.
We employ Figure 5.3.1 to illustrate how monetary and fiscal policies shift the aggregate
demand curve.
Figure 4.3.1: Effects of Monetary and Fiscal Policy On Aggregate Demand.

25
In the mainstream macroeconomics, monetary policy shifts the aggregate demand curve
of an economy. In figure 4.3.1, the equilibrium price level is P 0 and the equilibrium
aggregate output is Y0. If the central bank increases the discount rate (d) or engages in
open market sales or increases the required reserve ratio the AD – curve shifts to the left
(aggregate demand falls) from AD0 to AD1 and the price level declines to P1. This is
known as restrictive monetary policy. The central bank in an attempt to fight inflation
may embark on restrictive monetary policy.
Contractionary fiscal policy via reduction in government expenditure (G), decrease in
transfer payments (Tr) and increase in the income tax rate (t), would also cause the AD 0
to shift to AD1.

3. Control measures
These measures may take the form of wage freeze, linking wage increases to increase in
productivity. Price controls may also be used. Maximum prices are used in this case.
These prices are the highest possible legal prices for scarce goods. However, these prices
may lead to queues rationing and black marketing in scarce products.
4. Supply Side Policies.
In addition to the demand management policies, supply side policies could also be used
in controlling inflation. This however is a long – term measure. The following may
increase aggregate supply: increasing productivity in all sectors of the economy.
Increases in productivity may increase output, which will subsequently increase supply.
This may be achieved by the retraining labour, improving technology, removing all
structural rigidities e.g. land tenure system, poor road infrastructure etc.

Relationship between Inflation and Unemployment

Inflation is described as persistent and appreciable increase in the general price level. The
Inflation Rate is measured as a percentage change in a price index, such as the consumer
price index. Inflation can also be defined as persistent increase in general price level due
to too much money chasing few goods and services. Unemployment refers to a situation
where people who are willing and able to work do not find jobs at the existing wage rate.
For a person to be referred to as unemployed he or she must be qualified for a job, willing
to work at the current wage rate and unable to find a job. J. m Keynes defined full

26
employment which is the opposite of unemployment as the absence of involuntary
unemployment, therefore unemployment Keynes and Pigou sense is the presence of
“involuntary unemployment” that is a situation in which people are willing to work at
prevailing market wage but could not find work to do.
However, several authors have established different relationships between inflation and
unemployment but the most popular one is that of Professor Philips that said that inverse
relationship exist between unemployment and inflation and that trade off exist between
them, that an appeal to solve unemployment problem will generate inflation and vice
versa

The Philip’s Curve Analysis

Phillips curve theory indicates that changes in inflation are influenced by the state of the
economy relative to its productive capacity, as well as to other factors. This pro-ductive
capacity can be measured by potential GDP, which is a function of the natural rate of
unemployment, the rate of unemployment consistent with full employment. The Philips
curve is the graphical tool that professor Philips uses in illustrating the trade of that
existed between unemployment and inflation when he carried out his research in the
United States of America. In that research he discovered that there is negative or inverse
relationship between inflation and unemployment and any macroeconomic policy mix
use in curbing one will generate the other. He demonstrated this by using a downward
sloping curve to illustrate his point the curve has since then been named Philip‟s curve.
The curve has on its vertical axis inflation or price level while the horizontal axis is
represented by unemployment level.

The Stagflation Phenomenon

The word stagflation is formed by combining two words: stagnation and inflation. An
economy is said to experience stagflation when it has both inflation and unemployment at
the same time. One of the principal causes of stagflation has been restriction on the
aggregate supply. When aggregate supply is reduced, there is a fall in output and
employment and the price level rises that is a reduction in aggregate supply, may be

27
caused by a rise in money wages on account of strong unions or by a rise in the legal
minimum wage rate, or by increased tax rates which reduce work effort of the workers.
When wage rise, firms are forced to reduce production and employment, consequently,
there is fall in real income and consumer expenditure. Since the decline in consumption
will be less than fall in the real income, there will be excess demand in the commodity
market which will push up the price level. The rise in the price level will reduce output
and employment in the following three ways:
(a) It reduces the real quantity of money, raises interest rates and brings a fall in
investment expenditure.
(b) The rise in the price level reduces the real value of cash balances with the government
and the private sector via the Pigou effect which reduces their consumption expenditure.
(c) The rise in prices of domestic goods makes exports dearer for foreigners and makes
foreign goods relatively more attractive to domestic consumers, thereby adversely
affecting domestic output and employment.

Another cause of restriction in aggregate supply is the increase in indirect taxes. When
government increases taxes, it leads to the transfer of real purchasing power from the
people to the government. As a result, aggregate demand falls, and output and
employment are affected. But, if government increases its expenditure equal to the
increase in tax revenue, it would raise the price level further due to increase in additional
demand.
Stagflation can be controlled by either restrictive or expansionary measures, tax-based
income policies, introduction of income policies i.e. income policies should be linked
with increase in money wage or increase in productivity and reduction in personal and
business taxes.

Taylors Rule and Nairu Proposition

Federal Reserve (CBN in Nigeria) and most other central banks currently conduct
monetary policy by setting a target for short-term interest rates like the federal funds rate.
But how should this target be chosen?
John Taylor of Stanford University has come up with an answer, called the Taylor rule.
The Taylor rule indicates that the federal (fed) funds rate should be set equal to the
inflation rate plus an "equilibrium" real fed funds rate (the real fed funds rate that is
consistent with full employment in the long run) plus a weighted average of two gaps: (1)
an inflation gap, current inflation minus a target rate, and (2) an output gap, the
percentage deviation of real GDP from an estimate of its potential full employment level.'
This rule can be written as follows: Federal funds rate target = inflation rate +
equilibrium real fed funds rate + 1/2 (inflation gap) + 1/2 (output gap)
Taylor has assumed that the equilibrium real fed funds rate is 2% and that an appro-
priate target for inflation would also be 2%, with equal weights of 1/2 on the inflation and
28
output gaps. For an example of the Taylor rule in practice, suppose that the infla-tion rate
were at 3%, leading to a positive inflation gap of 1% (= 3% - 2%), and real GDP was 1%
above its potential, resulting in a positive output gap of 1%. Then the Taylor rule
suggests that the federal funds rate should be set at 6% (= 3% inflation + 2% equilibrium
real fed funds rate +1/2( 1% inflation gap) + 1/2 (1% output gap)1%.
The presence of both an inflation gap and an output gap in the Taylor rule might indicate
that the Fed should care not only about keeping inflation under control, but also about
minimizing business-cycle fluctuations of output around its potential. Car-ing about both
inflation and output fluctuations is consistent with many statements by Federal Reserve
officials that controlling inflation and stabilizing real output are impor-tant concerns of
the Fed (CBN).
An alternative interpretation of the presence of the output gap in the Taylor rule is that
the output gap is an indicator of future inflation as stipulated in Phillips curve theory.
Phillips curve theory indicates that changes in inflation are influenced by the state of the
economy relative to its productive capacity, as well as to other factors. This pro-ductive
capacity can be measured by potential GDP, which is a function of the natural rate of
unemployment, the rate of unemployment consistent with full employment.
A related concept is the NAIRU, the non-accelerating inflation rate of unemployment,
the rate of unemployment at which there is no tendency for inflation to change.' Simply
put, the theory states that when the unemployment rate is above NAIRU with output
below potential, inflation will come down, but if it is below NAIRU with output above
potential, inflation will rise. Prior to 1995, the NAIRU was thought to reside around 6%.
However, with the decline in unemployment to around the 4% level in the late 1990s,
with no increase in inflation and even a slight decrease, some critics have questioned the
value of Phillips curve theory. Either they claim that it just doesn't work anymore or,
alternatively, they believe that there is great uncertainty about the value of NAIRU,
which may have fallen to below 5% for reasons that are not absolutely clear.

The Okun’s Law

In its most basic form, Okun‟s law investigates the statistical relationship between a
country unemployment rate and the growth rate of its economy. Okun‟s intended to tell
us how much of a country‟s gross domestic product (GDP) may lost when the
unemployment rate is above its natural rate. it also explained, that output depend on the
amount of labour use in the production process, so there is a positive relationship
between output and employment. Total employment equal the labour force minus the
unemployed, so there is a negative relationship between output and unemployment.
Okun‟s is, in essence, a rule of thumb to explain and analysis the relationship jobs and
growth.
A onetime chairman of federal reserve of the united state of American, Ben Bernanke
once summaries Okun‟s law basic concept as : “that rule of thumb describes the observed

29
relationship between changes in the unemployment rate and the growth rate of real output
(GDP). Okun noted that, because of ongoing increases in the size of the labour force and
in the level of productivity, real GDP growth close to the rate of growth of its potential is
normally required, just to hold the unemployment rate steady. To reduce the
unemployment rate, therefore, the economy must grow at a pace above it potential.
More specifically, according to currently accepted versions of Okun‟s law to achieve a 1
percentage point decline in the unemployment rate in the cause of a year real GDP must
grow approximately 2 percentages point faster than the rate of growth of potential GDP
over that period. So, for illustration if the potential rate of GDP is 2%, Okun‟s law said
that GDP must grow at about a 4% rate for one year to achieve a 1 percentage point
reduction in the rate of unemployment.

DEFLATION
The opposite of inflation is deflation. It is a state in which the value of money is raising
i.e. prices is falling. Deflation is caused when prices are falling more than proportionately
to the output of goods and services in the economy as a result of decrease in money
supply.
Comparison between Inflation and Deflation
Inflation brings about rising prices and redistribution of income in favour of the better-off
classes. On the other hand, deflation leads to fall in output, employment and income.
According to Keynes, inflation is unjust while deflation is inexpedient; inflation is unjust
because it widens the gap between the rich and poor that is the poor and low income
classes suffer because their wages and salaries do not rise to the extent of price rise. It
becomes difficult for them to make ends meet with rising prices of consumer goods. On
the other hand, businessmen, traders, industrialists, real estate holders, etc. gain because
their profit and incomes increase much more than the rise in prices. So they are not
affected by the fall in purchasing power when price is rising.
Again inflation is unjust because persons who save are losers in the long run, when prices
are rising, the value of money is falling therefore, the savings in the banks reduced
automatically in real terms as inflationary pressures increase.
Inflation is also unjust because it is socially harmful. People amass wealth by
unscrupulous means, they resort to hoarding, black marketing adulteration, manufacture
of sub-standard commodities, speculation, etc. corruption also spreads in every walk of
life and all this reduces the efficiency of the economy.
Deflation on the other hand is inexpedient because it reduces national income, output and
employment. While inflation takes away half the bread of the poor, deflation
impoverished them by taking away the whole of the bread.
Deflation leads to mass unemployment because fall in production, prices and profits force
producers and businessmen to close down their enterprises. It is also inexpedient because

30
falling prices lead to depression, all economic activities are stagnant, and factories are
locked out, trade and business are at a standstill. According, to Keynes he prefer inflation
to deflation because inflation increases national output, employment and income, whereas
deflation reduces national income and brings the economy backward to a state of
depression. Again inflation is a lesser evil than deflation because it redistributes income
and wealth in favour of the rich but, deflation is a greater evil even though it redistributes
income in favour of the low income groups, yet it fails to benefit them because they are
unemployed and have little income during deflation. It also easier to control inflation than
deflation through appropriate monetary, fiscal and direct control measures. Moreover, as
long as inflation is mild, it helps the economy to grow. It is only when inflation is
hyperinflation that is dangerous, still its effects on the economy may not be so injurious
as under deflation.

Effects of Deflation
Deflation affects different groups differently;
i) Persons with fixed incomes such as white collar salaried workers, pensioners, etc. gain
because the value of money rises with falling prices. On the other hand, equity holders
also lose. Thus deflation affects adversely the distribution of income and wealth. When
prices are falling the purchasing power is increasing, the lower, middle, and other classes
with low incomes gain. On the other hand, businessmen, industrialists, traders, real estate
holders and other with variable incomes are hit hard and their profits decline with
deflation.
ii) Deflation also affects production adversely. With falling prices, production falls
because income and employment are also declining and the aggregate demand is on the
decline. Commodities start accumulating. Profits will fall which will make small firms to
close down making unemployment to spread. This vicious circle of fall in demand,
production, employment, income and aggregate demand leads to a depression.
iii) The government also suffer under deflation because revenues from direct and indirect
decline. The real burden of public debt increases, development of the economy suffers
because the government is unable to increase public expenditure.

Control of Deflation

Deflation can be controlled by adopting monetary and fiscal measures in just the opposite
manner to control inflation and this is discussed briefly.
1) Monetary Policy: To control deflation, the central bank can increase the reserves of
commercial bank through monetary policy. They can buy securities and reduce interest
rate. As a result the commercial bank ability to extend credit facilities to borrowers
increases. The success of monetary policy in controlling deflation is limited because
when business activity is almost at a standstill, businessmen do not have any inclination
31
to borrow to build up inventories even when the rate of interest is very low but, rather
they want to reduce their inventories by repaying loans already drawn from the banks.
Also, the consumers who are faced with unemployment and reduced incomes do not like
to purchase any durable goods through bank loan. Thus all that the banks can do is to
make credit available but they cannot force businessmen and consumers to accept it. So
the low interest rates and the unused reserves with the banks will not have any significant
impact on the economy.

2) Fiscal Policy: This through increase in public expenditure and reduction in taxes tends
to raise national income, employment, output, and prices. An increase in public
expenditure during deflation increases the aggregate demand for goods and services and
leads to a large increase in income via the multiplier process, while a reduction in taxes
has the effect of raising disposable income thereby increasing consumption and
investment expenditures of the people. The government should increase its expenditure
through deficit budgeting and reduction in taxes.

Deflation and Unemployment

Deflation is the continuous and consistence fall in general price level due to low volume
of money income in circulation which lead to deficiency in demand. A chronic demand
deficit (deficit demand) always results to deflation.
However, low money income which resulted to low or deficient demand will equally
leads to low productivity and low productivity will results to laying off of workers
(unemployment). This cycle will continue until a policy measure described earlier is put
forth to arrest the situation.
Unemployment refers to a situation where there is presence of involuntary unemployment
in Keynesian term. Unemployment can also be seen as a situation where people who are
willing and able to work at the going market wage rate could not get a job or a means of
livelihood. The first definition implies absence of voluntary unemployment which is a
situation where a number of people might not be willing to work at the market
established wage rate for some certain reasons.
Causation between Deflation and Unemployment
The definition of deflation above could infers that deflation generates unemployment for
the fact that low income leads to low demand and low demand leads to low productivity
while low productivity leads to unemployment.

32
It should however, be noted that deflation causes unemployment, it can also be viewed
that the low money income is as a result of chronic unemployment and then conclude that
there is a bi-directional relationship between deflation and unemployment and that a
solution to one is also solution to the other.

INTERNATIONAL TRADE
refers to the exchange of goods and services between countries. Good sold to other
countries are referred to as exports and goods bought from them are dubbed as imports.
International trade also involves movement of capital between countries.

Basic reasons for international trade.

i) From the supply side, differences in factor endowment countries are endowed
differently e.g. differences in climate and soil, differences in availability of natural
resources, differences in capital endowment and differences in labour skills. These
33
differences translate into differences in the abilities of countries because of their factor
endowment can produce certain goods cheaper than other countries, e.g. Nigeria is
endowed with crude oil and natural gas. These can be produced cheaper in Nigeria than
in Ghana, Ghana therefore imports them from Nigeria.
ii) From the demand side, the needs to satisfy certain wants: Countries are faced with
demand for goods and services that their factor endowment cannot produce. In order to
satisfy these wants they are sourced from foreign countries as imports. Nigeria imports
capital equipment for its oil sector from the nest of the world. The rest of the world
imports crude oil from Nigeria.
iii) It serves as a foreign exchange earner and act as agent of growth: exports acts as
foreign exchange earner to the domestic economy because foreign exchange availability
is an essential requirements for the survival of any national economy. Also international
trade act as a catalyst to the growth of the total spending and hence growth in the Gross
national product of such an economy

Differentiation between Internal and International Trade

The following features differentiate domestic trade from international trade:
i) Factor immobility: The factors of production are perfectly mobile within each nation
and perfectly immobile between countries entering into international trade.

ii) Different markets: International trade are separated by difference in language, habit,
taste etc. even the systems of weights and measures and pattern and styles of machinery
and equipment differ from country to country. Thus goods which may be traded within a
country may not be sold in other countries. That
is why in so many cases products to be sold in foreign countries are especially designed
to conform to the national characteristics of that country.
iii) Large scale production: A big firm may be producing and selling a number of
products in different countries, but it may not be able to standardize its product and
realize the economies of large scale production. On the other hand a firm which
specializes in the production of only one type of product for the domestic markets may
enjoy the economies of large scale production.

iv) Different currencies: The principal difference between domestic and international
trade lies in the use of different currencies which value may be different in foreign trade
but the same currency in domestic trade.

The Theory of Absolute Advantage

Adam Smith postulated that each country should specialize in those commodities it can
produce at the lower absolute cost than other countries. He made this assertion when he

34
was writing about division of labour and specialization in international trade in his
“Wealth of Nations” in 1776.
Adam Smith argued for free trade by comparing nations to households. Since every
household finds it prudent to produce only some of its needs and to buy others with
products it can sell, the same should apply to nations.
Adam Smith assumes a two (2) goods and a two (2) country in the world, he concluded
that trade is mutually beneficial if one nation has an absolute advantage in the production
of one good and the other nation has absolute advantage in the production of the second
good.

Assumptions Underlying The Theory

Some of the assumptions underlying the theory of absolute advantage are:
1. Factors of production are perfectly mobile within each nation and theycan be instantly
switched between industries, however, factors are immobile between countries, though
final goods and services can be traded.
2. There are constant returns to scale and constant average costs of production in both
industries in both countries.
3. The limited resources and factors of production in each nation are fully employed.
4. There are no transport costs between the two countries.
5. The theory assumes value in real magnitude entirely different from monetary
phenomenon i.e. in units of crude oil and cocoa.

Advantages of international trade

1. It leads to increased total world production of goods and services. International trade
based on comparative cost advantage allows countries to specialise in what they can do
best. This allows for increase in output and invariably increases in the volume of total
world output.
2. It leads to efficiency in use of world resources: international trade is based on
specialisation in what you can do best. This means each country involved in
international trade uses the resources available to her in the most efficient way and
hence world resources are efficiently used.
3.It leads to availability of variety of goods and services. International trade makes
citizens of nations to consume goods and services their resources cannot be used to
produce.
International trade leads to economies of scale. International trade leads to increased
output and firms involved in producing for exports may enjoy cost reducing advantages
that go with increased output.

35
5. International trade brings about interdependence. This politically may help a nation to
be conscious of the existence of other nations. The interdependence of nations helps to
promote good neighbourliness.

Disadvantages
1 It may lead to collapse of infant firms. These young firms not enjoying economies of
scale and producing at a high unit cost, if international trade is allowed cheap imports
are brought in and these may lead to the collapse of infant firms.
2 International trade may lead to excessive interdependence. This may have negative
effects on the country in times of crisis, if, for example there is a political crisis between
Ghana and Nigeria, Nigeria may halt its exports of crude oil to Ghana.
3 It may lead to unemployment. If through international trade infant firms collapsed in a
country their employees will be laid off and it will create unemployment.

4. It may lead to dumping. Dumping occurs when goods are sold in foreign countries
below their cost of production at home. This will under-cut competition in the foreign
country and destroy local firms

BALANCE OF PAYMENT AND BALANCE OF TRADE

Concept of Importation and Exportation

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Importation is the buying of goods and services from abroad or another country to
domestic economy. It involves foreign exchange and largely depends on domestic level
of income. For instance if a Nigerian buys goods from America that goods is estimated as
part of Nigerian importation at that period in time.

Terms of trade
The terms of trade are defined as the quantity of domestic goods that must be given up to
get a unit of imported goods. It is the rate at which a country‟s exports are exchanged for
its imports for a given period of time. Thus the terms of trade are nothing more than the
opportunity cost of obtaining goods through international trade rather than producing
them directly. Both countries will gain from trade as long as the terms of trade lie
between the domestic opportunity cost ratios of the two countries.
In other words, it is the ratio of the price index of the nation‟s exports (Px) to the price
index of imports (Pm) multiplied by 100.
T.O.T = Price index of Exports X 100
Price index of Imports
If this measure rise says from 1 to 2, it means that a given amount of exports will
purchase twice as many imports as before. Rises and falls in the measure are refer to as
favourable and unfavourable terms of trade.

3.3 Reasons for protecting trade and method used

The reasons for protecting international trade in spite of the benefits from free trade are:
1. The protection of infant industries: the absence of economies of scale to them makes
their unit cost of production higher than older and efficient firms in other countries.
Protection may be justified during the early growth of an infant firm. As the infant firms
grow, skill and productivity, as well as economies of scale will grow, so increasing the
firms‟ relative competitive advantage.
2. To protect labour against cheap foreign labour: the theory of comparative cost
advantage assumes that factors of production are both fully employed and mobile within
countries. It large scale unemployment exists within a country, protection may be used to
increase employment.
3. Protection against Dumping: it could be looked at as the export of commodities priced
below cost of production. Dumping is generally looked upon as an unfair

Tools used as Trade Barrier

The tools used as instrument for trade barrier are:

37
1. Tariffs: these are taxes imposed on traded commodities as they cross national borders.
There are two main types of tariffs. An import tariff is a duty on an imported commodity
while export tariff is a duty on an exported commodity.

Tariffs may be specific, ad valorem or compound ( a combination of ad valorem and

specific tariff). The effect of a tariff on import depends on its size and the elasticity of
demand for the imported commodity. If demand is elastic, a tariff imposed will reduce
imports by switching demand towards the domestically produced substitutes. Conversely,
if demand for imports is price inelastic, the main effect of the tariff will be on import
prices rather on the quantity of imports.
2. Domestic Subsidies: These may be provided in many forms to avoid dumping. They
are subsidies provided to certain domestic industries as a means of protecting them from
lower priced foreign goods. These subsidies reduce the prices of the domestic products
and make them more prices competitive.
3. Quotas: They are quantitative restrictions (non tariff restrictions) on the imports and
exports. They restrict the amount of commodities allowed to be imported or exported.

Other forms of non tariff barrie are voluntary export restraint (VER), technical
administrative and other regulations (these include safety regulation, health regulation,
packaging, labelling requirement etc.)

Balance of payment and Balance of Trade

Balance of payment is an account that summarizes a country‟s total payments and total
receipts from international economic transactions within a specific period usually one
year. Each transaction is entered on the credit and debit side of the balance sheet. The
main reason for compiling the balance of payments is to inform the government
authorities in a particular country of the international position of the country. It also helps
policy makers in taking decisions on monetary and fiscal policy one hand, trade and
payment policies on the other.
Balance of trade on the other hand is the difference between the values of goods and
services exported and imported. It contains the first two main items of the balance of
payment account on the credit and the debit side.
 Component of balance of payment/balance of trade

i. Current Account: This made up of the total receipts and payments on both visible and
invisible goods and services. It could also be subdivided into three main items,
merchandise imports and exports, services imports and exports and unilateral transfers.
Merchandise imports and exports are also referred to as visible trade and services imports
and exports. Visible goods are for example, crude oil, timber, cars, etc. the difference
between merchandise exports and imports is termed as the balance of trade. Unilateral
38
transfers or service accounts dubbed invisible trade, this records the services of shipping
and civil aviation, insurance, dividends, profits, remittances, government services, travel
and tourism, banking services, etc. this section also includes unilateral transfers (gifts),
that is, money transferred to and fro without rendering any services. Transactions on the
current account except unilateral transfers are referred to as autonomous meaning they
are undertaken because of profit motive.

The difference between invisible exports and invisible imports is called the balance of
services. This is classified as favourable or unfavourable. When invisible exports exceed
invisible imports we have favourable balance of services, otherwise we have
unfavourable balance of services.
ii) Capital Account: The capital account of a country consists of its transaction in
financial assets in the form of short-term and long-term lending and borrowings, and
private and official investments. In other words, the capital account shows international
flow of loans and investments and represents a change in the country‟s foreign assets and
liabilities. Long-term capital transactions relate to international capital movements with
maturity of one year or more and include direct investments like building of a foreign
plant, portfolio investment like purchase of foreign bonds and stocks and international
loans. On the other hand, short-term international capital transactions are for a period
ranging between three months and less than one year.
There are two types of transactions in the capital account – private and government.
Private transactions include all types of investment: direct, portfolio and short-term.
Government transactions consist of loans to and from foreign official agencies. In the
capital account, borrowings from foreign countries and direct investment by foreign
countries represent capital inflows. They are positive items or credits because these are
receipts from foreigners. On the other hand, lending to foreign countries and direct
investments in foreign countries represent capital outflow. They are negative items or
debits because they are payments to foreigners. The net value of the balances of short-
term and long-term direct and portfolio investments is the balance on capital account.

iii) Official Settlement Account: This part of the balance of payments informs us about
how the balance of both current and capital accounts taken together is settled. They are
accommodating transaction because the funds are moved to make the balance of payment
balance. When the net balance of the current and capital accounts is in deficit, the deficit
must be settled with an equal net credit in the official reserve account. If on the other
hand, a country has a surplus, the surplus must be used up to balance the balance of
payments.
Balance of Payment Deficit and Surplus

Basically, there are two outcomes from balance of payment account namely;

39
 Surplus Balance of Payment-: surpluses arise as a result of excess earnings from
external account i.e. positive external balance. It occur when receipt from export of goods
and services is greater than payment for import of goods and services. This conserves and
preserves foreign exchange. In other words, a surplus on the balance of payments may be
used in the following ways:

a) To augment a country‟s foreign reserves

b) As loans to other countries

c) Buying assets abroad

d) To invest in businesses in other countries

Balance of payment deficit:- This occurs when receipts from exportation of goods and
services is less than payment for importation of goods and services. It may be defined as
a situation which occurs when the combined receipts on the current and long term capital
accounts of a country are less than the corresponding payments. In other words balance
of payments deficit occurs when a country‟s expenditure flows are more than the
country‟s income flow.

Concept of equilibrium balance of payment

This occurs when the receipts from export of goods and services is equal payment for
importation of goods and services. Also balance of payment equilibrium means that the
algebraic sum of the net credit and debit balances of current account, capital account and
official settlements account are equal to zero. Balance of payment can be written as
B = Rf - Pf
Where, B represents balance of payments,
Rf is receipts from foreigners
Pf is payments made to foreigners.
When B = Rf – Pf = 0, the balance of payments is in equilibrium. When R f – Pf > 0, it
implies receipts from foreigners exceed payments made to foreigners and there is surplus
in the balance of payments. On the other hand, when R f - Pf < 0 or Rf < Pf there is deficit
in the balance of payments as the payments made to foreigners exceed receipts from
foreigners. If net foreign lending and investment abroad are taken, a flexible exchange
rate creates an excess of exports over imports. The domestic currency depreciates in
terms of other currencies. Exports becomes cheaper relative to imports that is
X + B = M + If
Where;
X is exports, M imports, If foreign investment, and B is foreign borrowing
Or X – M = If – B
40
The equation shows the balance of payments in equilibrium. Any positive balance in the
current account is offset by negative balance on its capital account and vice versa.

Causes of balance of payment disequilibrium

There are many factors that can lead to BOP disequilibrium:
1. Temporary Changes: there may be a temporary disequilibrium caused by random
variations in trade, seasonal fluctuations, the effect of weather on agricultural production,
etc. disequilibrium arising from such temporary causes are expected to correct themselves
within a short time.

2. Fundamental Disequilibrium: this refers to persistent and long run BOP disequilibrium
of a country. It is a chronic BOP deficit and it is caused by factors like: (i) changes in
consumer tastes within the country or abroad which reduce the country‟s exports and
increase its imports. (ii) Continuous fall in the country‟s foreign exchange reserves due to
supply inelasticities of exports and excessive demand for foreign goods and services. (iii)
Excessive capital outflow due to massive imports of capital goods, raw materials,
essential consumer goods, technology and external indebtedness.(iv) low competitive
strength in world markets which adversely affects exports.

3. Structural Changes: it brings about disequilibrium in BOP over the long run. They may
result from the following factors: (a) technological changes in methods of production of
products in domestic industries or in the industries of other countries. They lead to
changes in costs, prices and quality of products. (b) Import restrictions of all kinds bring
about disequilibrium in BOP. (c) deficit in BOP also arises when country suffers from
deficiency of resources which it is required to import from other countries. (d) it may also
be caused by changes in the supply or direction of long term capital flows.

4. Changes in Exchange Rates: changes in foreign exchange rate in the form of

overvaluation or undervaluation of foreign currency lead to BOP disequilibrium. When
the value of currency is higher in relation too other currencies, it is based to be
overvalued. Opposite is the case of an undervalued currency. Overvaluation of the
domestic currency makes foreign goods cheaper and exports dearer in foreign countries.
As a result, the country import more and exports less goods. There is also outflow of the
capital. This leads to unfavourable BOP. On the contrary, undervalued of the currency
makes BOP favourable for the country by encouraging exports and inflow of capital and
reducing imports.
5. Cyclical Fluctuations (or Disequilibrium). Cyclical fluctuations in business activity
also lead to BOP disequilibrium, when there is depression in a country, volumes of both
export and imports fall drastically in relation to other countries. But the fall in exports

41
maybe more than that of imports due to decline in domestic production. Therefore, there
is an adverse BOP situation. On the other hand, when there is boom in a country in
relation to other countries, both exports and imports may increase. But there can be a
surplus or deficit in BOP situation depending upon whether the country‟s export more
than import or imports more than exports. In both cases, there will be disequilibrium in
BOP.
6. Changes in National Income. Another cause is the change in the country‟s national
income. If the national income of a country increases it will lead to an increase in imports
thereby creating a deficit in its balance of payments, other things remain the same? If the
country is already at full employment level, an increase in income will lead to
inflationary rise in prices which may increase its imports and thus bring disequilibrium in
the balance of payment.
7. Price Changes. Inflation or deflation is another cause of disequilibrium in the balance
of payment. If there is inflation in the country, prices of exports increase. As a result,
export fall at the same time, the demand for import increase. Thus increase in export
price leading to decline in exports and rise in imports result in adverse balance of
payments.
8. Stage of Economic Development. A country‟s balance of payment also depend on its
stage of development. If a country is developing it will have a deficit in its balance of
payment because it import raw materials, machinery, capital equipment, and services
associated with the development process and exports primary products. The country has
to pay more for costly imports and gets less for its cheap exports. This leads to
equilibrium in its balance of payments.
9. Capital Movement. Borrowings and lending or movements of capitals by countries also
result in disequilibrium in BOP. A country which gives loan and grants on a large scale to
other countries has a deficit in its BOP on capital account. If it is also importing more, as
is the case with the USA, it will have chronic deficit. On the other hand, a developing
country borrowing large funds from other countries and international institutions may
have a favourable BOP. But such a possibility is remote because those countries usually
import huge quantities of food, raw materials, capital goods, etc. and export primary
products. Such borrowings simply help in reducing BOP deficit.
10. Political Conditions. Political condition of a country is another cause of
disequilibrium in BOP. Political instability in a country creates uncertainty among
foreign investors which leads to the outflow of capital and retards its inflows. This causes
disequilibrium in BOP of the country. Disequilibrium` in BOP also occurs in the event of
war or fear of war with some other country.

Solution To Disequilibrium In Balance Of Payment

A number of policy mix can be employed to combat balance of payment disequilibrium

42
i) Foreign exchange control: It involves the rationing of foreign exchange in order to
reduce balance of payment deficit.

ii) Fiscal control: This involves the raising of tariffs (i.e. increase in import duties) in
order to reduce the deficit.
iii) Devaluation: Devaluation cheapens exports and make imports expensive, thus
improving the balance of payments .
iv) Reduction of imports: The governments can restrict imports by the use of tariffs,
quotas and outright embargo on imports.
v) Promotion of import substitution industries: This is done to replace the commodities
that were previously brought from foreign countries.
vi) Grants, aids, borrowing: Grants and aid can be obtained from richer or friendly
nations to offset the deficit that occurs in the balance of payment. A country can also
borrow money from IMF or other richer nations in order to correct the deficit.
vii) Increase in production: With a spectacular rise in production, domestic prices of
goods would be brought down and export of goods stimulated. Demand for imported
goods will reduce.

Uses of balance of payment

The balance of payments is useful in view of the following considerations:
a) The current account of the balance of payment which is the sum of merchandise and
service exports and imports shows how competitive a nation exports are over time and
across space.
b) It is a matter of great interest and concern to economic policy makers especially when
the balance of trade is in deficit.
c) When capital account is presented in greater detail, it portrays significantly how much
capital is transferred abroad and the form in which they are transferred.
Foreign Exchange Rate
The foreign exchange rate or exchange rate is the rate at which one currency is exchange
for another. It is the price at which one country's currency is exchanged for another or it
is the price of one currency in terms of another currency. It is customary to define the
exchange rate as the price of one unit of foreign currency in term of the domestic
currency. The exchange rate between the Ghana cedi and the Nigeria naira from the
standing point of Ghana is expressed as C2.50=N1. The Nigeria would express it as the
number of naira requires to get one cedi, and the above exchange rate would be shown as
N0.40 = C1.00
The exchange rate of the C2.50 =N1 or N0.40 = C1.00 will be maintained in the world
foreign exchange market by arbitrage. Arbitrage refers to the purchase of a foreign
currency in a market where its price is low and to sell it in some other market where price
is high. The effect of arbitrage is to remove difference in the foreign exchange rate of
43
currencies so that there is a single exchange rate in the world foreign exchange market. If
the exchange rate is C2.48 in the Nigerian exchange market and C2.50 in the Ghana
exchange rate market, foreign exchange speculator, known as arbitrageurs, will buy naira
in Nigeria and sell them in Ghana, thereby making a profit of 2 kobo on each Naira. As a
result, the price of naira in terms of cedi rises in the Nigeria market and falls in the Ghana
market. Ultimately it will be equal in both markets and arbitrage comes to an end. If the
exchange rate between the cedi and naira rises to C2.60 = N1.00, the Cedi is said to
depreciate with respect to the naira, because now more cedi are needed to buy one naira.
When the rate of exchange between the cedi and the naira fall to C2.40 = N1.00, the
value of cedi is said to appreciate because now less cedi are required to purchase one
naira. The depreciation of the cedi against the naira is the same thing as the appreciation
of the naira against the cedi, and vice visa.

Determination of Equilibrium Foreign Exchange Rate

The exchange rate in a free market is determined by the demand for and the supply for
foreign exchange. The equilibrium exchange rate is the rate at which the demand for
foreign exchange equals to the supply of foreign exchange. Ragner Nurkse defines the
equilibrium exchange rate as “that rate which over a certain period of time, keeps the
balance of payments in equilibrium”. There are two ways of determining the equilibrium
exchange rate. The rate of exchange between Nigerian naira and Ghana cedi can be
determined either by the demand and supply of naira with the price of naira in cedi, or by
the demand and supply of cedi with the price of cedi in naira. Whatever method is
adopted, it yields the same result.

The Demand for Foreign Exchange

The demand for foreign exchange is derived demand from Naira. It arises from import of
Nigerian goods and services into Ghana and from capital movements from the Ghana to
Nigeria. In fact, the demand for Naira implies a supply of cedi. When the Ghana
businessmen buy Nigerian goods and services and make capital transfer to Nigeria, they
create demand for Nigerian naira in exchange for Ghana cedi because they cannot make
payments to Nigeria in their currency, the Ghana cedi.
The demand curve for naira DD is downward sloping from left to right. it implies that the
lower the exchange rate on naira, the larger will be the quantity of naira demanded in the
foreign exchange (Ghana) market, and vice versa. This is because lower exchange rates
on naira make Nigerian exports of goods and services cheaper in terms of cedi. The
opposite happens if the exchange rate on naira is higher. It will make Nigerian good and
services dearer in terms of cedi, and the demand for naira will fall in the foreign exchange
(Ghana) market. This is because, it is the demand for Nigerian tradeables (goods and
services) that calls for demand for Nigerian naira.
But the shape of the demand curve for foreign exchange will depend on the elasticity of
demand for imports. “if a country import necessities and raw materials we may expect the

44
elasticity of demand for imports to be inelastic and the quantity imported to be insensitive
to price changes. If, on the other hand, the country imported luxury and goods for which
appropriate substitutes exist, demand elasticity‟s for imports might be elastic and
response to price changes is high. If the country has a number of well developed import
competing industries, the elasticity of demand for imports most certainly is high, in the
short run; elasticity of demand for imports may not be very high. In the long run,
however, it is much more probable that the production pattern will alter according to
price changes, and the demand for imports, therefore, will be more elastics”. In
conclusion, value of a country currency is largely dependent on their demand for other
countries' tradeable (i.e. importation of goods and services that are sold and bought across
borders (import))
The Supply of Foreign Exchange
The supply of foreign exchange in Nigeria case is the supply of naira. It arises from
Ghana exports of goods and services and from capital movements from the Ghana to
Nigeria. Naira is offered in exchange for cedi because Nigerian holders of naira wish to
make payments in cedi. Thus the supply of foreign exchange reflects the quantities of
naira that would be supplied in the foreign exchange market at various cedi

price of Naira. The supply curve for naira SS is an upward sloping curve, as shown in
Figure 6.1a. It is a Positive function of the exchange rate on naira. As the exchange rate
on naira increases, the greater is the quantity of naira supplied in the foreign exchange
market. This is because with increase in the cedi price of naira (lower naira price of
cedi), cedi goods, services and capital fund become better bargains to holders of naira.
Therefore the holders of naira will offer large quantities of naira with the increase in the
exchange rate. But the shape of supply curve of foreign exchange will be determined by
45
the elasticity of supply curve. As the value of the country‟s currency increases, imports
become cheaper and export becomes dearer.

Analysis of Equilibrium Foreign Exchange Rate

Given the demand and supply curves of foreign exchange, the equilibrium exchange rate
is determined where DD, the demand curve for Naira intersects SS, the supply curve of
Naira. They meet each other at point E in figure 6.1a. The equilibrium rate is OR and OQ
of foreign exchange is demanded and supplied. At OR exchange rate the Ghana demand
for naira equals the Nigeria supply of naira, and the foreign exchange market is cleared.
At any higher rate than this, the supply of naira would be larger than the demand for naira
so that some people who wish to convert naira into cedi will be unable to do so. Then in
reaction to this, price of naira will fall, less naira will be supplied and more will be
demanded. Ultimately, the equilibrium rate of exchange will be re-established.
In Figure 6.1a when the exchange rate increase to QR, the supply of naira R 2B > R2A the
demand for naira. With the fall in the price of naira, the equilibrium exchange rate OR is
re-established at point E. where the two curves DD and SS intersect. Suppose there is a
shift upwards in the Ghana demand for naira, as shown by the upward shifting of the DD
curve to D1D1 in Figure 6.1bi. This may be due to increase in the Ghana tastes for Nigeria
goods, an increase in the Ghana national income, etc. which increases the demand for
imported foods in the Ghana. With the shifting up of the demand curve D 1D1. The Ghana
cedi depreciates and the Nigeria naira appreciates which re-establish the new equilibrium
exchange rate OR1 at point E1 in Figure 6.1bii where the S1S1 curve intersects the DD
curve. At the new equilibrium exchange rate OR1, OQ1 of foreign exchange is demanded
and supplied. The supply of naira may increase due to the increase in the tastes of
Nigerian for the Ghana goods, the increase in the national income of Nigeria, etc.

46
Causes of Movement (Changes) in the Exchange Rate
The exchange rate between countries change due to changes in demand or supply in the
foreign exchange market. The factors which cause changes in demand and supply are
discussed as under:
1. Change in Prices: It is changes in the relative price levels that cause changes in the
exchange rate. Suppose the price level in Nigeria rises relative to the Ghana price level.
This will lead to the rise in the prices of Nigeria goods in terms of Naira. Nigeria goods
will become dearer in the Ghana. This will lead to reduction in Nigeria exports to the
Ghana. So the supply of Cedi to Nigeria will diminish. On the other hand, the Ghanaian
goods become cheaper in Nigeria and their imports into Nigeria increase. The supply
curve for dollars will shift to the left so that the exchange rate is established at a higher
level from the point of view of the Ghana. It implies appreciation of value of the Cedi and
depreciation of the value of the Naira.
2. Change in Interest Rate. Changes in Interest rates also lead to changes in the
exchange rate. If interest rates rise in the home country, there is a large inflow of capital
from foreign countries. As a result the exchange rate of the domestic currency will
appreciate, relative to the foreign currency. The opposite will be the case, if interest rates
fall in the home country.
3. Changes in Export and Imports. The demand and supply of foreign exchange is also
influenced by changes in exports and imports. If exports of the country are more than
imports, the demand of its currency increases so that the rate of exchange moves in its
favour. On the contrary, if imports are more than exports, the demand for the foreign
currency increases and the rate of exchange will move against the country.
4. Capital Movements. Short – term or long-term capital movements also influence the
exchange rate. Capital-flows tend to appreciate the value of the currency of the capital
importing country and depreciate the value of the currency of the capital-exporting
country. The exchange rate will move in favour of the capital-importing country the
demand for currency of the capital importing country will rise and its demand curve will
shift upwards to the right and the exchange rate will be determined at a higher level,
given the supply curve of foreign exchange.
5. Influence of Banks. Banks also affect the exchange rate through their operation. They
include the purchase and sale of bank drafts, letters of credit, arbitrage, dealing in bills of
exchange, etc. These banking operations influence the demand for and supply of foreign
exchange. If the commercial banks issue a large number of drafts and letter of credit on
foreign banks, the demand for foreign currency rises
6. Influence of Speculation. The growth of speculative activities also influences the
exchange rate. Speculation causes short-run fluctuations in the exchange rate. Uncertainty
in the international money market encourages speculation in foreign exchange. If the
speculators expect a fall in the value of currency in the near future, they will sell that
currency and start buying the other currency they expect to appreciate in value.
Consequently, the supply of the former currency will increase and its exchanges rate will
fall. While the demand for the other currency will rise and its exchange rate will go up.
7. Stock Exchange Influences. Stock exchange operations in foreign securities,
debentures, stocks and shares, etc. put forth significant influence on the exchange rate. If
the stock exchanges help in the sale of securities, debentures, shares etc. to foreigners, the

47
demand for the domestic currency will rise on the part of the foreigners and the exchange
rate also tends to rise. The opposite will be the case if the foreigners purchase securities,
debentures, shares, etc. through the domestic stock exchanges.
8. Structural Influences. Structural changes are another important factor which
influences the exchange rate of a country. Structural changes are those which bring
changes in the consumer demand for commodities. They include technological changes,
innovations, etc. which also affect the cost structure along with the demand for products.
Such structural changes tend to increase the foreign demand for domestic products. It
implies increase in exports, greater demand for domestic currency, appreciation for its
value and rise in the exchanges rate.
9. Political Conditions. Stable political and industrial conditions and peace and security
in the country have a significant influence on the exchange rate. If there is political
stability ,strong and efficient, foreign investors will have tendency to invest their funds
into the country. With the inflow of capital, the demand for domestic currency will rise
and the exchange rate will move in favour of the country. On the contrary, if the
government is weak, inefficient and dishonest and there is no safety to life and property,
capital will flow out of the country and the exchange rate will move against the country.
10. Policies of Exchange Control and Protection. Policies of exchange control and
protection discourage imports and lead to fall in the demand for foreign currency. As a
result, the exchange rate f the home country appreciates in relation to the foreign country.
11. Type of Economy. If a country is developing, it needs to import large quantities of
raw materials, and capital goods for its development along with capital. But its capacity
to export is low. Therefore, its demand for foreign exchange is more which leads to the
depreciation of its exchange rate vis-a-vis a developed country whose exchange rate
appreciates.

Theories of Foreign Exchange Rate

The Mint Parity Theory

This theory is associated with the working of international gold standard. Under this
system, the currency is use was made of gold or was convertible into gold at a fixed rate.
The value of the currency unit was defined in terms of certain weight of gold, that is, so
many grains of gold to the naira, the cedi, rupee, the dollar, the pound etc. The Central
Bank of the country was always ready to buy and sell gold at the specified price. The rate
at which the standard money of the country was convertible into gold was called the mint
price of gold. If the official naira price of gold was N6.00 per ounce and the Ghana price
of gold C36 per ounce, they were the mint prices of gold in the respective countries. The
exchange rate between the cedi and the naira would be fixed at C36/N6. This rate was
called the mint parity or mint par of exchange because it was based on the mint price of
gold. Thus under the gold standard, the normal or basic rate of exchange was equal to the
ratio of their mint per values (R = C/N).
But the actual rate of exchange could vary above and below the mint parity by the cost of
shipping gold between the two countries. To illustrate this, suppose the Ghana has a
deficit in its balance of payments with Nigeria. The difference between the value of
imports and exports will have to be paid in gold by Ghana importers because the demand
48
for naira exceeds the supply of naira But the transhipment of gold involves transportation
cost and other handling charges, insurance, etc. Suppose the shipping cost of gold from
Ghana to Nigeria is 3 pasewa. So the Ghana importers will have to spend C6.03 (C6 +
0.3p) for getting N1.00. This could be the exchange rate which is the Ghana gold export
point or upper specie point. No Ghana importer would pay more than C6.03 to obtain one
naira because he can buy C6 worth of gold from the Ghana treasury and ship it to Nigeria
at a cost of 3pasewa per ounce. Similarly, the exchange rate of the naira cannot fall below
C5.97 to a naira is the Ghana gold import point or lower specie point.
Assumptions:
This theory is based on the following assumptions:
1. The price of gold is fixed by a country in terms of its currency.
2. It buys and sells gold in any amount at that price.
3. Its supply of money consists of gold or paper currency which is backed by gold.
4. Its price level varies directly with its money supply.
5. There is movement of gold between countries.
6. Capital is mobile within countries.
7. The adjustment mechanism is automatic.

Explanation
Given these assumption, the exchange rate under the gold standard is determined by the
forces of demand and supply between the gold point and is prevented from moving
outside the gold point by shipments of Gold.

Figure: 6.2a Equilibrium in Mint Parity theory of Exchange rate

Figure 6.2a shows the determination of the exchange rate under the gold standard the
exchange rate OR is set up at point E where the demand and supply curves DD 1 and SS1
intersect. The exchange rate need not be at the mint parity. It can be anywhere between
the gold points depending on the shape of the demand and supply curves. The mint parity

49
is simply meant to define the Ghana gold export point (C 6.03) and the Ghana gold
import point (C5.97). Since the Ghana treasury is prepared to sell any quantity of gold at
a price of C 36 per ounce, no Ghanaian would pay more than C6.03 per naira, because he
can get any quantity of naira, at that price by exporting gold. That is why, the Ghana
supply curve of naira becomes perfectly elastic or horizontal at the Ghana gold export
point. This is shown by the horizontal portion S 1 of the SS1 supply curve. Similarly, as the
Ghana treasury is prepared to buy any quantity of naira at the price by gold imports. Thus
the Ghana demand curve for naira becomes perfectly elastic at the Ghana gold import
point. This is shown by the horizontal portion D1 of the demand curve DD1.
Criticisms: The mint parity theory has been criticised on the following grounds:

1. The international gold standard does not exist now ever since it broke down after the
Depression of the 1930s.
2. The theory is based on the assumption of free buying and selling of gold and its
movement between countries. But government does not allow such sales, purchases and
movements.
3. The theory falls to explain the determination of exchange rates as most countries arte
on inconvertible paper standard.
4. This theory assumes flexibility of internal prices. But modern government follows
independent domestic price policy unrelated to fluctuation in exchange rate

The Purchasing Power Parity Theory

The purchasing power parity (PPP) theory was developed by Gustav Cassel in 1920 to
determine the exchange rate between countries on inconvertible paper currencies. The
theory states that equilibrium exchange rate between two inconvertible paper currencies
is determined by the equality of the relative change in relative prices in the two countries.
In other words, the rate of exchange between two countries is determined by their relative
price levels.
There are two versions of the PPP theory: the absolute and the relative. The absolute
version states that the exchange rate between two currencies should be equal to the ratio
of the price indexes in the two countries. The formula is R AB = PA/PB where RAB is the
exchange rate between two countries A and B and P refers to the price index. This
version is not used because it ignores transportation costs and other factors which hinder
trade, non-traded goods, capital flows and real purchasing power. Economists, therefore,
use the relative version which we discuss below:
The theory will be explained with the help of an example.
Suppose Nigeria and England are on inconvertible paper standard and by spending N60,
the same bundle of goods can be purchased in Nigeria as can be bought by spending £1 in
England.
Thus according to the purchasing power parity theory, the rate of exchange will be N60 =
£ 1.
If the price levels in the two countries remain the same but the exchange rate of N50 = £1
in England. It is a case of overvaluation of the exchange rate. This will encourage imports
and discourage exports by Nigeria. As a result, the demand for pounds will increase and
that of naira will fall. This process will ultimately restore the normal exchange rate of
N60 = £1. In the converse case, if the exchange moves to N70 = £1, the Nigerian
50
currency becomes undervalued. As a result, exports are encouraged and imports are
discouraged. The demand for naira will raise and that for pounds will fall so that the
normal exchange rate of N60 = £1 will be restored.
According to the theory, the exchange rate between two countries is determined as a
point which expresses the equality between the respective purchasing powers of the two
currencies. This is the purchasing power parity which is a moving par and fixed par (as
under the gold standard). Thus with every change in price level, the exchange rate also
changes. To calculate the equilibrium exchanges rate, the following formula is used:
or r = Ro x
Where 0 = base period, 1 = period 1, A and B countries, P = Price index and R o =
exchange rate in base period.
According to Cassel, the purchasing power Parity is “determined by the quotients of the
purchasing powers of the different currencies. This is what the formula does. Let us
explain it in terms of our above example. Before the change in the price level, the
exchange rate was N60 = £1. Suppose the domestic (Nigerian) price index rises to 300
and the foreign (England) price index rises to 200, thus the new equilibrium exchange
rate will be
R = £1 x = £1.5
Or N 60 = £1.5
This will be purchasing power parity between the two countries. In reality, the parity will
be modified by the cost of transporting goods including duties, insurance, banking and
other charges. These costs of transporting goods from one country to another are, in fact,
the limits within the exchange rate can fluctuate depending upon the demand and the
supply of a country‟s currency. There is the upper limit, called the commodity export
point; and the lower limit, known as the commodity import point. (These limits are not as
definite as the gold points under the mint par theory).

51
The PPP theory is illustrated in Figure 6.2b where DD is the demand curve for foreign
currency (pound in our example) and SS is the supply curve of currency. OR is the rate to
exchange of naira per £, which is determined by their intersection at point E so that the
demand for the supply of foreign exchange equals OQ quantity. Suppose the price level
rises in Nigeria and remains constant in England. This makes Nigerian exports costly in
England and Import from England relatively cheaper in Nigeria. As a result, the demand
for pounds increases the supply of pounds decreases. Now the DD curve shifts upwards
to the right to D1D1 and the SS curve to the left S1S1. The new equilibrium exchange rate
is set at OR1 naira per pound, which represents the new purchasing power parity. The
exchange rate rises by the same percentage as the Nigerian price level. The purchasing
power curve shows that with relative change in the price levels, the exchange rate tends
to fluctuate along this curve above or below the normal exchange rate. But there is a
limit up to which the purchasing power parity curve can move up and down. The upper
and lower limits are set by the commodity export point and the commodity import point
respectively.
Criticisms: Cassel‟s PPP theory became very popular among economist during 1914-24
and was widely accepted as a realistic explanation of the determination of foreign
exchange rate under inconvertible paper currencies. But it has severely criticised for its
weak theoretical base. Some of the criticisms are discussed as under:
1. Defects in Calculating Price level: One of the serious defects of the theory is that of
calculating the price levels in the two countries. The use of index number in calculations
presents many difficulties such as the base year. Coverage and method of calculation.
These may not be the same in both countries. The two countries may not include the
same types of commodities in calculating the index numbers. Such difficulties make the
index numbers only a rough guide for measuring the price levels and thus fail to give the
correct purchasing power parity between the two countries.
2. Comparison of General Price Level a Difficult Problem. According to the theory,
the purchasing power parity between two countries id determined by comparing their
general price levels. But the price level may be made of internally traded plus
internationally traded goods, or of the internationally traded goods. If the price level is
calculated in terms of the internally traded goods, then the prices tend to equality in both
countries, even allowing for the cost of transportation, tariffs, etc. Thus, according to
Keynes, “confined to internationally traded commodities, the purchasing power parity
becomes an empty truism”.

On the other hand, if the price level includes both internally and internationally traded
goods, then price of internally traded goods may move in the opposite direction of
internationally traded goods, at least in the short period. Thus the real exchange rate may
not conform to the parties.
Further, if the price level includes both types of goods, there is technical difficulty of
people spending their money differently in the two countries, so that the basis for
complete and accurate comparisons of price level is lacking.

52
3. Not applicable to Capital Account. Another weakness of the purchasing power parity
theory is that it applies to countries whose balance of payments is determined by the
merchandise trade Account. It is, therefore, not applicable to such countries whose
exchange rate is influenced more by capital account.
4. Difficult to Find Base year. The theory assumes the balance of payments to be in
equilibrium in the base period for the determination of the new equilibrium exchange
rate. This is a serious defect, because it is difficult to find the base year when the
exchange rate was initially in equilibrium.
5. Structural changes in Factors. The theory is also based on the assumption that there
have been no structural changes in the factors underlying the equilibrium in the base
period. Such factors are changes in technology, resources, tastes, etc. this assumption is
highly unrealistic because changes are
bound to take place in these factors which, in turn, are likely to affect exchange rate.
6. Capital is Mobile. The theory is based on the assumption of zero-capital movements.
There are many items in the balance of payments such as insurance, shipping, and
banking transactions, capital movements, etc. Which are not affected by changes in the
general price level. But these items affect the exchange rate by influencing the demand
for and supply of foreign currencies. The theory is thus weak for it neglects the influence
of these factors in determining the exchange rate.
7. Changes in Exchange Rates affect Price Level. The theory further assumes that a
change in the price level brings about changes in exchange rates. But changes in
exchanges rate do affect the price level. For instance, if the external value of naira falls,
imports will become dearer. As a result the costs and prices of goods using imported
materials will rise. On the other hand, exports will become cheaper with fall in the
external value of the naira. Consequently, their demand will increase which will raise the
demand for factors used for producing exports, and their prices will also rise. Thus
changes in exchange rate do influence the price level.
8. Barter Terms of trade Change. The theory assumes that the barter terms of trade do
not change between the two trading countries. This assumption is unrealistic because the
barter terms of trade constantly change due to changes in the demand for foreign goods,
in the volume of external loans, in the supply of exported goods, in the transport costs,
etc.
9. No Free Trade. The theory is based on the assumption of free trade and laissez – faire
policy. But governments do not follow these policies these days. Rather, they impose a
number of restrictions on the movement of goods between countries. Such trade
restrictions are tariff, import quotas, customs duties and various exchange control devices
which tend to reduce the volume of imports. These, I turn, cause wide deviations between
the actual exchange rate and the exchange rate set by the purchasing power parity.
10. Only Purchasing Power Parity does not Determine Exchange Rate. The
equilibrium exchange rate may not be determined by the purchasing power parity
between the two countries. Rather, a sudden increase in the demand for goods of one
country may raise the demand of its currency on the part of the other country. This will
lead to rise in the exchange rate.

53
11. Neglect of Elasticity’s of Reciprocal Demand. According to Keynes, one of the
serious defects of this theory is that it fails to consider the elasticity‟s or reciprocal
demand between the two trading countries.
12. It is One-Sided. Ragner Nurske points out that the theory is one sided in that it is
based exclusively on changes in relative prices and neglects all factors that influence the
demand for foreign exchange. The theory treats demand as a function of price but
neglects the influence of aggregate income and
expenditure on the volume and value of foreign trade, these are important factors which
affect the exchange rate of a country.
13. No Direct Relation between Exchange rate and Purchasing Power. The theory
assumes direct relation between exchange rate and purchasing powers of two currencies.
In reality, there is no such relation between the two.
14. Static Theory. This is a static theory because it assumes no changes in tastes,
incomes, technology, tariffs, etc. These make the theory unrealistic.
15. Long Run Theory. This Theory is applicable in the long run and falls to determine
exchange rate in the short run.
16. Relevant for Bilateral Trade. The theory is relevant only for bilateral exchange rate
determination and fails to determine exchange rate in the present multilateral trade
relation.
17. Not Possible to Compute Equilibrium Exchange Rate. According to Halm
“Purchasing Power parities cannot be used to Compute Equilibrium exchange rates or to
gauge with precision deviations from International payments equilibrium”.

The Balance of Payment Theory

According to this theory, under free exchange rates, the exchange rate of currency
depends upon its balance of payments. A favourable balance of payments raises the
exchange rate; while an unfavourable balance of payments reduces the exchange rate.
Thus the theory implies that the exchange rate is determined by the demand for the
supply of foreign exchange.
The demand for foreign exchange arises from the debit side of the balance of payments. It
is equal to the value of payments made to the foreign country for goods and services
purchased from it plus loans and investments made abroad. The supply of foreign
exchanges arises from the credit side of the balance of payments. It equals all payments
made by the foreign country to our country for goods and services purchased from us
plus loans disbursed and investments made in this country. The balance of payments if
debits and credits are equal. If debits exceed credits, the balance of payments is
unfavourable. On the contrary, if credits debit is favourable. When the balance of
payments is unfavourable. It means that the demand for foreign currency is more than its
supply. This causes the external value of the domestic currency to fall in relation to the
foreign currency. Consequently, the exchange rate falls. On the other hand, in case the
balance of payments is favourable, the demand for foreign currency is less than its supply
at a given exchange rate. This causes the external forces value of the domestic currency
to rise in relation to the foreign currency. Consequently, the exchange rises.
When the exchange rate falls below the equilibrium exchange rate in a situation of
adverse balance of payments, exports increase and the adverse balance of payments is

54
eliminated, and the equilibrium exchange rate is re-established. On the other hand,
when under a favourable balance of payment situation, the exchange rate rises above
the Equilibrium exchange rate, export decline, the favourable balance of payments
disappears and the equilibrium exchange rate is re-established. Thus at any point of
time, the rate of exchange is determined by the demand for the supply of foreign
exchanges as represented by the debit and credit side of the balance of payments. “Any
change in the conditions of demand or of supply reflects itself in a change in the
exchange rate, and at the ruling rate the balance of payments balances from day today
or from moment to moment.”

The determination of exchange rate under the balance of payments theory is illustrated
in Figure 6.2c DD is the Demand curve for foreign currency. It slopes downward to the
left because when the rate of exchange rises, the demand for foreign exchange which
slopes upwards from left to right. This is because when the exchange rate falls, the
amount of foreign currency offered for sale will be less, and vice versa. The two curves
intersect at E where OR equilibrium exchange rate is determined. At this rate, the
quantity of foreign exchange demanded and supplied equals OQ. E is also the point
where the balance of payments.
Suppose the exchange rate rises to OR1. The demand for foreign exchange R1A is less
than its supply R1B. It means that there is a favourable balance of payments. When the
exchange rate is more than equilibrium rate, exports decline and import increase.
Consequently, the demand for foreign exchange will rise and the supply will fall.
Ultimately, the equilibrium rate OR will be restored where demand and supply of foreign
exchange equals at point E. in the opposite case, when the exchange rate falls below the
equilibrium rate to OR2, the demand for foreign exchange rate falls below the equilibrium
rate to OR2, the demand for foreign exchange R 2H is greater than its supply R 2G (R2H >
R2G). it implies an unfavourable balance of payments. But fall in the exchange rate lead
to increase in exports and decline in imports. As a result, the demand for foreign currency
55
starts falling and the supply starts rising till the equilibrium exchange rate OR is re-
established with the equity of demand and supply of foreign exchange at point E.
However, it is the shape of the demand and supply curves of foreign exchange rate. For
this purpose, four elastic ties are relevant: (i) the foreign elasticity or demand for exports.
(ii) The domestic elasticity of supply for exports, (ii) the domestic equilibrium exchange
rate tends to be stable if the demand elasticises are high and the supply elasticises are
low.
However, according to this theory, the demand- and supply of foreign exchange are
determined by factors that are independent of changes in the exchange rate. Such factors
are interest on foreign loans, reparation payments, etc. Further, the demand for many
items that enter into import trade is perfectly inelastic so that exchange rate changes do
not affect them at all. Raw materials come in this category which is required to be
imported from certain countries whatever their prices.
Criticisms
The balance of payment theory has been criticised by economists on the following
counts:
1. Balance of Payments Independent of Exchange Rate: The main defect of the theory
is that the balance of payments is independent of the exchange rate. In order words, the
theory states that the balance of payments determines the exchange rate. This is not
wholly true because it is changes in the exchange rate that bring about equilibrium in the
balance of payments.
2. Neglects the Role of Price Level. The theory neglects the role of the price level in
influencing the balance of payments of a country and hence it‟s exchange rate. But the
fact is that price changes do affect the balance of payments and exchange rates between
countries.
3. No Free Trade and Perfect Competition. The theory is based on assumption of free
trade and perfect competition. This is unrealistic because free trade is
4. not practised these days. Government impose a number of restrictions to reduce
imports and adopt measures to encourage exports. This is how they try to correct
disequilibrium in the balance of payment.
5. Truism. This theory presupposes that there is an equilibrium exchange rate where
balance of payments equilibrium. In fact, exchange rates between countries continue to
prevail under conditions of surplus or deficit in the balance of payments and there is no
tendency for the balance of payments to be in equilibrium over the long run.
6. Demand for imported Raw Materials not Inelastic. The theory has been criticised
for the assumption that the demand for imported raw materials is inelastic. There are no
raw materials in the world the demand for which is perfectly inelastic.

EXCHANGE RATE SYSTEM

Under fixed or pegged exchange rates all exchange transactions take place at an
exchange rate that is determined by the monetary authority. It may fix the exchange
rate by legislation of intervention in currency markets. It may buy or sell currencies
according to the needs of the country in currency markets. It may buy or sell currencies
56
according to the needs of the country or may take policy decision to appreciate or
depreciate the national currency. The monetary authority (central bank) holds foreign
currency reserves in order to intervene in the foreign exchange market, when the
demand and supply of foreign exchange (say pounds) are not equal at the fixed rate.

Merits for Fixed Exchange Rates

Fixed exchange rates have the following advantages:
1. Based on Common Currency: The case of fixed exchange rate between different
countries is based on the case for a common currency within a country. A country having
a common currency with a fixed value of its currency in relation to other countries. Thus
fixed exchange rates encourage international trade by making prices of goods involved in
trade more predictable. They promote economic integration. As pointed out by Johnson,
“The case for fixed rates if part of a more general argument for national economic
policies conducive to international economic integration.”
2. Encourage Long Term Capital Flows. The second argument for a system of fixed
exchange rates is that it encourages long-term capital flows in an orderly and smooth
manner; there is no uncertainty and risk resulting from a regime of fixed exchange rates.
3. No fear of Currency Fluctuations. There is no fear of currency depreciation, or
appreciation under a system of fixed exchange rates. For instance, it removes fear that
holding large quantities of foreign currency might lead to losses, if a currency‟s value
drops. Thus it creates confidence in the strength of the domestic currency.
4. No Adverse Effect of Speculation. There is no fear of any adverse effect of
peculation on the exchange rate, as speculative activities are controlled and prevented by
the monetary authorities under a regime of fixed exchange rates.
5. Disciplinary. Another advantage claimed by a system of fixed exchange rates is that it
serves as an „anchor‟ and imposes a discipline on monetary authorities to follow
responsible financial policies with countries. “Inflation will cause balance of payments
deficits and reserve loss. Hence the authorities will have to take counter-measures to stop
inflation. Fixed exchange rates should, therefore impose „discipline on government and
stop them from pursuing inflationary policies which are out of tune with the rest of the
world.”
6. Best for Small Countries. Johnson favours fixed exchange rates in the „banana
republics‟ where foreign trade plays a dominant role. Flexible exchange rates in them
lead to inflation and depreciation when the exchange rate falls.
7. Less Inflationary. It leads to greater monetary discipline and so less inflationary
pressure.
8. Certainty. Fixed exchange rate create certainty about foreign payments among
exporters and importers if goods because they know what they have to receive or pay in
foreign exchange.
9. Suitable for Common Currency Areas: This system is suitable for common currency
areas such as Euro, Dollar, etc. Where fixed exchange rates promote growth of world
trade.
10. Promotes Money and Capital Markets. It promotes the development of
international money and capital markets and helps the flow of capital among nations.

57
11. Multilateral Trade. This system encourages multilateral trade globally among
countries because countries have no fear of wide fluctuations in exchange rates.
12. International Monetary Co-operation. The system of fixed exchange rates
promotes international monetary co-operation and so helps in the smooth working of the
international monetary system under such institutions as IMF, World Bank, Euro-Market.

Disadvantages of Fixed Exchange Rates

The following arguments are advanced against a system of fixed exchange rates
1. Sacrifice of Objectives. The Principle defect in the operation of a system of fixed
exchange rate is the sacrifice of the objectives of full employment and stable prices at the
alter of stable exchange rates. For example, balance of payments adjustment under fixed
exchange rates of a surplus country can take place through a rise in prices. This is bound
to impose large social costs within the country.
2. Unexpected Disturbances. Under this system, the effect unexpected disturbances in
the domestic economy are transmuted abroad. “While a country may be protected by
fixed exchange rate from the full consequences of domestic disturbances and policy
mistakes, it has to bear a share of the burden of the disturbances and mistakes of others.
For to the extent that excess demand „leaks out‟ of the country where it was originally
created. It „leaks in‟ (via a balance of payments surplus) to that country‟s trading
partners.
3. Heavy Burden. Under it, large reserves of foreign currencies are required to be
maintained. Countries with balance of payments deficits must have large reserves if they
must hold authorities for managing foreign exchange reserves.
4. Mal-allocation of Resources. This system requires complicated exchange control
measures which lead to mal-allocation of the economy‟s resources.
5. Complex System. This system is very complex because it requires high skilled
administrators to operate it. It is also time consuming and may lead to uncertain result.
There is always the possibility of mistakes in policy formulation and implementation.
6. Comparative Advantage Unclear. Under this system, the comparative advantage of a
country is not clear. For Instance, the exchange rate may be so low that a product may
seem very cheap to the other country. Consequently, the country may export that
commodity in which it has no comparative advantage. On the contrary with a very high
exchange rate, the country may possess comparative advantage in a product.
7. Fixed Exchange Rate not Always Possible. Another Problem relates to the stability
of the exchange rate. The exchange rate of a country vis-à-vis another country cannot
remain fixed for sufficiently long period. Balance of payments problems and fluctuations
in international commodity prices often compel countries to bring changes in exchange
rates. That it is not possible to have rigidly fixed exchange rates
8. Balance of Payment Disequilibrium Persists. This system fails to solve the problem
of balance of payments of disequilibrium. It can be tackled only temporarily because its
permanent solution lies in monetary, fiscal and other measures.
9. Dependence on International Institutions. Under this system, a country mostly
depends upon international institutions for borrowing and lending foreign currencies.

58
10. Problems of International Liquidity. To expand it trade, a country must have
adequate international liquidity. To maintain a fixed exchange rate, the country must have
sufficient reserves of foreign currencies to avoid balance of payments disequilibrium. On
the other hand. Excessive international liquidity is also not good for the country because
the resulting extra demand may lead to international inflation.

Floating or Flexible Exchange Rate System

Flexible, floating or fluctuating exchange rates are determined by market forces. The
monetary authority does not intervene for the purpose of influencing the exchange rate.
Under a regime of freely fluctuating exchange rates. If there is an excess supply of a
currency, the value of that currency in foreign exchange markets will fall. It will lead to
depreciation of the exchange rate. Consequently, equilibrium will be restored in the
exchange market. On the other hand, shortage of a currency will lead to appreciation of
exchange rate thereby leading to restoration of equilibrium in the exchange market. These
market forces operate automatically without any intervention on the part of monetary
authority.
Merits for Flexible Exchange rates
The following advantages are claimed for a system of flexible exchange rates:
1. Simple Operation. A system of flexible exchange rates is simple in the operative
mechanism. The exchange rate moves automatically and freely to equate supply and
demand, thereby clearing the foreign exchange market. It does not allow a deficit or
surplus to build up and eliminates the problem of scarcity or surplus of any one currency.
It also avoids the need to induce changes in prices and incomes to maintain or restore
equilibrium in the balance of payments.
2.Smoother Adjustments. Under it, the adjustment is continual. The adjustments in the
balance of payments are smoother and painless as compared with the fixed exchange rate
adjustments. In fact, flexible exchange rates avoid the aggravation of pressures on the
balance of payments and the periodic crises that follow disequilibrium in the balance of
payments under a system of fixed exchange rates. There is an escape from the various
corrective measures that are adopted by the government whenever the exchange rate
depreciates or appreciates.
3. Autonomy of Economic Policies. Under this system, autonomy of the domestic
economic policies is preserved. Modern governments are committed to maintain full
employment and promote stability with growth. They are not required to sacrifice these
objectives of full employment and economic growth in order to remove balance of
payments disequilibrium under a regime of flexible exchange rates.

4. Disequilibrium in the Balance of Payments Automatically Corrected. Since under

a system of flexible exchange rates disequilibrium in the balance of payments is
automatically corrected, there is no need to accommodate gold movements and capital
flows in and out of the countries.
5. No Need of Foreign Exchange Reserves. There is no need for foreign exchange
reserves where exchange rates are moving freely. A deficit country will simply allow its
currency to Depreciate in relation to foreign currency instead of intervening by supplying
foreign exchange reserves to the other country to maintain a stable exchange rate.
59
6. Removes problems of International Liquidity. A system of flexible exchange rates
removes the problem of international liquidity. The shortage of international liquidity is
the result of pegged exchange rate and intervention by monetary authorities to prevent
fluctuations beyond narrow limits. When exchange rates are flexible, speculators will
supply foreign exchange to satisfy private liquidity needs. Individuals, traders, bankers,
governments and others would, of course, continue to hold liquid asset in form of gold or
foreign exchange, but these holdings would be working reserve for purpose other than the
maintenance of a fixed external value of the country‟s currency.
7.No Need of Borrowing and lending Short- term Funds. As a corollary to the above,
when foreign exchange rate move freely, there is no need to have international
institutional arrangement like the IMF for borrowing the lending short- term fund to
remove disequilibrium in the balance of payments.
8. Effective Monetary Policy. The system of flexible exchange rates re- enforces the
effectiveness of monetary policy. If a country wants to increase output, it will lower
interest rate under a regime of flexible exchange rate, the lowering of interest rates will
result in an overflow of capital, a rise in thy spot rate for the currency which will, in turn,
cause exports to rise and import to fall. The increased exports will tend to raise domestic
prices, or income or both. Thus a favourable trade balance will reinforce the
expansionary effects of lower interest rate on domestic spending, thereby making
monetary policy more effective. The above process will be reversed if the country wants
to fight inflation by raising interest rates. Thus a country uses monetary policy to achieve
domestic objectives rather than external balance.
9.Mistakes Avoided. As a corollary, with automatic adjustments of balance of payments
there is no possibility of making monetary, fiscal and administrative policy mistakes.
10. Does not Require Complicated Trade Restrictions. A system of flexible exchange
rates does not require the introduction of complicated and expensive trade restrictions and
exchange controls. Thus the cost of foreign exchange restrictions is removed.
11. No Need of Forming Custom Union and Currency Areas. Under this system, the
world can get rid of competitive exchange rate depreciation and tariff warfare among
nations and there shall be no need forming custom unions and currency areas which are
the concomitant result of the system of fixed exchange rates.
12. Economical. This system is very economical because it does not require idle holding
of foreign currencies. Rather a country can use its foreign reserve to meet us immediate
requirement

13.Promote International Trade. This system promotes international trade because it

maintains the exchange rates at their natural level through continuous market
adjustments. Thus there is no danger of over- valuation or under- valuation of a country‟s
currency.
14.Insulation from International Economic Events. Under this system, a country is
protected against international economic fluctuations and shocks by making adjustments
in its exchange rates.
15. Comparative advantage. Under this system, the exchange rates are always in
equilibrium. It is, therefore, possible to assess the comparative advantage of a country in
a particular commodity.
Merits against Flexible Exchange Rates
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The following arguments are against a system of flexibility exchange rates.
1. Mal allocation of Resources. Critics of flexible exchange rates point out that market
mechanism may fail to bring about an appropriate exchange rate. The equilibrium
exchange rate in the foreign market at a point of time may not give correct signal to
concerned parties in the country. This may lead to wrong decisions and malallocation of
resources with the country.
2. Official Intervention. It is difficult to define a freely flexible exchange rate. It is not
possible to have an exchange rate where there is absolutely no official intervention.
Government may not intervene directly in the foreign exchange market, but domestic
monetary and fiscal measures do influence foreign exchange rate. For instance, if
domestic saving domestic investment, it means that the country is a net investment
abroad. The outflow of capital will bring down the exchange rate. All this may be due to
the indirect impact of government policies. Further, in the absence of any undertaking
among governments about exchange rate manipulation, the system of flexible exchange
might lapse into anarchy, for every company would like to establish favourable exchange
rates with other countries. This may lead to retaliation among nations and result in war of
exchange rates with disruptive effects on trade and capital movements. Thus some sort of
understanding or agreement concerning exchange rates is implied in regime of flexible
exchange rates.
3. No justification. As a corollary, there is no justification for a government to leave the
determination of exchange rates to international market forces when prices, rent, wages,
interest rates, etc, are often controlled by the government.
4. Exchange risks and uncertainty. Another disadvantage of this system is that frequent
variation in exchange rates, create exchange risks, breed uncertainty and impede
international trade and capital movements. For instance, an Indian who imports from
Japan and promises to pay back in yen runs the risk that the rupee price of yen will rise
above expected levels. And the Japanese exporter who sells for rupees runs the risks that
the yen price of rupees will fall below expected levels. Similarly, exchange risks may be
even more serious for long-term capital movements. This is because under a system of
flexible exchange rates borrowers and lenders will be discouraged to enter into long-term
contacts and the possibility of varying burden for servicing and repayment may be
prohibitive. But Sodersten has shown how flexible exchange rates increase uncertainty
for traders and have a dampening effect on the volume of foreign trade. Assume that a
country is under a regime of flexible exchange rates, the general price level is stable and
the balance of trade is in equilibrium. Suppose the demand for the country‟s export
decreases, this leads depreciation of the country‟s exports decreases, this leads to
depreciation of the country‟s currency which, in turn, raises import prices and brings a
fall in imports. Consequently, importers will be adversely affected. At the same time,
exporters will gain with the increase in the prices of export goods. But the volume of
exports will decline whereby they will also be losers. Opposite will be the consequences
when consequences when currency appreciates. Suppose there is an abnormal inflow of
short-term capital to country A‟s in terms of foreign currencies, thereby lowering the
levels of output, employment and income in its export industries. The rise of exchange
rates will also lower the costs of imports, thus discouraging output and employment in
A‟s import competing industries. Thus importers and exporters will be at a disadvantage
and the volume of trade will decline.
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5. Adverse Effect of Speculation. Under this system, speculation adversely influences
fluctuations in supply and demand for foreign exchange. Critics argue on basis on
empirical evidence that speculation is destabilising which means it aggravates fluctuation
in exchange rate. ``it is often said that speculation see a decline in the exchange rate as a
signal for further decline, and that their actions will cause the movement in the exchange
rate to be larger than it would be in absence of speculation. In such a case, speculation is
destabilising. Sodersten points out that the limited experience from the 1920s seems to
show that speculation at that time was destabilising. Since floating rates became common
in 1973, fluctuations in exchange rate have been large. It seems that some of the
excessive fluctuations have been caused by destabilising speculation”. Such fluctuations
increase uncertainties in trade and reduce volume of foreign trade further.
6. Encouragement to Inflation. This system has inflationary bias. Critics argue that
under a system of flexible exchange rates, a depreciation of exchange rates leads to a
vicious circle of inflation. Depreciation leads to a rise in import prices thereby making
import goods more expensive. This leads to cost-push inflation. At the same time, exports
prices rise in the cost of living, money wages rise which, in turn, intensify inflation. But
an appreciation of currency is unlikely to lead to a reduction in wages and prices when
imports prices fall. This is because wages and prices are sticky downwards. This leads to
an asymmetry which produces that Triffin calls ratchet effect that imparts an inflationary
bias to the economy.
7. Breaks The World Market. This systems break up the world market. There is no one
money which serves as a medium of exchange, unit of account, store of value and a
standard of deferred payment. Under it, the world market for goods and capital would be
divided. Resources allocation would be vastly sub-optimal.in fact, such a system clearly
would not last long, according to kindle Berger.

8. Failure to solve balance of payments deficit of LDCs. LDCs are faced with the
perpetual problem of deficit in their balance of payments because they import raw
materials, machinery, capital equipment, etc for their development. But their exports are
limited to primary and other products which fetch low prices in world markets. Their
balance of payment deficit can be removed in a system of flexible exchange rates if there
is continuous deprecation of the counter‟s currency.
This is illustrated in Fig.4 where D is country‟s demand curve for foreign exchange and S
is the supply curve for foreign exchange. To begin P is the point where OE exchange rate
is determined. Suppose disequilibrium develops in the balance of payments of the LDC in
relation to the pound currency area. This is shown by the shift in the demand curve form
D to D1 and the deficit equals PP. This means an increase in the demand for pounds and
depreciation of the currency (say Rupee) of the LDC. Now the exchange rate of Rs.-£
rises to OE1. This process of depreciation of the LDC currency continues with the rise in
the exchange rate to OE2 and so on. Such a policy of continuous depreciation adversely
affects trade and development process in LDCs.

Multiple Exchange Rate system

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It is a system under which a country adopts different rate of exchange for import and
export of different commodities. A country may adopt controlled rate of exchange with
some countries and free exchange rate with others. The exchange rate does not fluctuate
but several fixed exchange rate and their categories that may exist. Completely free and
floating exchange rate may also be possible for certain transaction with some countries.
The objectives of multiple exchange rates are to obtain the maximum foreign exchange
by maximizing export and minimizing import to correct the balance of payments deficit.
Merits
The main merits of multiple exchange rates system are as follows:
1. Promotion of Exports: Even though devaluation may also be used for promotion
export but it makes imports costly and export cheaper. But under the multiple exchange
rates system, the best exchange rate can be obtained for different exports and imports.
The country can obtain full advantages of elasticises of demand and supply which are
favourable to it. Thus this system is more effective than devaluation.
2. Import Profitable: A developing country has little to export but it has to import
capital goods, raw-materials, technical know- how and even consumption goods on a
large scale. Its imports have an inelastic demand. So it wants to enlarge the import of
above goods and restricts that of luxury and other consumer goods to raise its
development potential.

3. Correcting Balance of Payment Deficit: The above discussion makes it obvious that
under the multiple exchange rates system maximum foreign exchange may be earned
from export and minimum possible payments can be made for import. Thus the balance
of payments deficit can be corrected.
4. For Particular Country. Specially in a situation where a country has a balance of
payments surplus but deficit with a particular country, the deficit can be controlled by
lowering the exchange rate of the of commodity exported to imported from that particular
country. Thus the problem of deficit or surplus in balance of payments can be solved
through multiple exchange rates system.
5. Capital Formation. Capital goods and necessary inputs can be imported at cheaper
rates through the system of multiple rates. On the other hand, high earnings may also be
utilised for capital formation.
6. Capital Flows. Multiple exchange rates may be very helpful to achieve a higher
capital inflow from one country and to restrict capital outflow to another country. In such
case, a higher rate of exchange would be applicable to the former and a lower exchange
to the latter. It may also be used for channelizing foreign capital into favourable lines of
production.
7. Helpful for Weak Industries. Weak or declining industries can be lifted with the help
of multiple exchange rates system. They may get protection or export subsidies and
import capital goods, raw materials and technical know-how at some preferential and
favourable rate of exchange under this system.
8. Diversifying the Economy. The system encourages the diversification of industries
through favourable exchange rates. It provides protection to weak industries from foreign
competition. It can help in developing new export goods industries, processing and
defence industries. Commodities of mass consumption can also be produced. Thus is can
diversify the economy and raise output, employment and income in the economy.
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9. Maximising Revenues. The multiple exchange rates system enable the government to
earn more revenues. Since this system encourages the expansion and diversification of
industries, and increases output, employment and income, the government earns larger
revenues from excise duties, sales tax, corporation tax, personal taxes, etc.
10. Favourable Terms of Trade. A country may secure more favourable terms of trade
under this system. That is why it can be used for keeping prices of export goods at a
higher level and prices of import article at a lower level.
11. Improvement of Standard of Living. Since the import of capital goods, raw
materials, etc. Can be obtained at low price under this system, their cost of production is
low. Similarly, essential consumer goods for mass consumption are imported cheap.
These tend to reduce the cost of living and raise the standard of living of the people.

Demerits
The multiple exchange rates system has the following demerits:
1. Administrative Difficulties. In this system, large number of different exchange rate
exist for large variety of goods and for different countries. To administer them requires
large administrative machinery. This involves a complex exchange control system which
leads to administrative inefficiencies, red-tapism and corruption.
2. Discriminatory. This systemis discriminatory because it discriminates between
commodities, industries, sectors, region and countries. The same commodity may be
exported to a country at a different rate than to another country. This is likely to lead to
retaliation by the other country and so adversely affect their trade and political relations.
3. Harmful for Domestic Industries. A country may import commodities at cheap rates
from abroad which may harm the domestic industries as they cannot face foreign
competition.
4. Not Helpful for Export. If the demand for export is elastic or if export have inelastic
supply in the domestic market or if foreign importers form a monopsony or oligopoly,
multiple exchange rate will be of no help to the country in increasing its exports.
5. Black Marketing. This system leads to black marketing of foreign exchange.
Importers buy foreign exchange at lower rates because the exchange rate for essential
imports is low. But they sell foreign exchange at high rate in the foreign exchange
market.
6. Limits to Different Rates. It is not possible for the monetary authority to fix different
exchange rates for large number of exportable and importable commodities. So they are
classified in small categories or groups. Their classification may be arbitrary and lead to
corruption for every exporter or importer would like to have his commodity in the
favourable exchange rate category.
7. Less Effective in BOP. The multiple exchange rate system is less than quantitative
restrictions like export and import licences, exchange controls, etc. In reducing BOP
deficit.
8. Accumulation of Inventories. This system leads to accumulation of inventories.
When exporters do not export their goods in anticipating of more favourable exchange
rates being announced by the monetary authority, it leads to stock-piling of goods in
godowns. This adversely affect production and leads to losses.

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9. Not a Sufficient System. The multiple exchange rates system is not sufficient for
economic development of LDCs. In such countries, the demand for essential imports is
inelastic so the exchange rate for their imports cannot be lowered. On the other hand,
their capacity to export is limited. So they cannot increase the exchange rates for their
exports. That is why such countries suffer from shortage of foreign exchange.

65
Excercise:
1. What do you mean by full employment? Explain measures to achieve full
employment.

2. What action policy should the government undertake to eradicate unemployment in

the country? (answer: solution to unemployment)

3. Differentiate between Demand Pull inflation and Cost Push inflation

4. Explain the economic effects of inflation on different people

5. “Inflation has been a contributory factor to the decline in the Nigeria economy”.
Discuss.
- What is inflation and what effect does inflation have on the economy?
- Suggest possible measures to the government to cushion the effects of inflation.
-Discuss the various types of inflation you know..
-What types of relationship exist between inflation and unemployment?
6. Is inflation more preferable to you than deflation

7. What relationship exists between deflation and unemployment?

. Distinguish between inflation and deflation, what are the major features of these
economic ailments.
. “Inflation is unjust and deflation is inexpedient.” Discuss.
8. Explain the phenomenon of stagflation. Suggest measures to control it.

9. Is there any relationship between Taylors rule and Nairu‟s proposition.

10. How does Arthur Okun explain the relationship between inflation and
unemployment?
11. Why do countries involved in trade among themselves?

12.What are the difference between internal trade and international trade?

13. Does the advantages of international trade supersedes its disadvantages. Discuss.

14 How is the demand and supply of foreign exchange rate determined?

15. Enumerate and explain major factor(s) that affect the value of a country currency.

16 Critically examine the mint parity theory of exchange rate.

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1. Product Method or Value added Method
2. Income Method
3. Expenditure Method
Product Method/ Value added Method
Product method is that method, which measures domestic money by estimating the contribution
of each enterprise to production in the domestic territory of the country in an accounting year.
Product method or Value added method is also known as Industrial Origin Method or Net output

Method or Inventory Method or Commodity Service method.

Value added is the difference between value of output of an enterprise and the value of its
intermediate consumption.
Value added= Value of Output- Value of Intermediate consumption
Value of Output= Sales (if entire output of the year is sold during the year)
Value of output= Sales + Change in Stock
Value added=GDP mp
To calculate the national income by this method, we need to identify and classify productive
enterprises in three categories:
1. Primary Sector
2. Secondary Sector
3. Tertiary Sector
Primary Sector includes agriculture and allied activities such as animal husbandry fisheries,
forestry, and mining etc. The Secondary Sector includes manufacturing sector which converts the
raw materials into finished products. The Tertiary Sector is the service sector which includes
services such as banking, insurance, transport, communication and trade etc.
After classification, net value added in each sector is calculated in an accounting year. Gross
value added is found by deducting the intermediate consumption from the value of production
generated.
Precautions used in production or value added method
1. The sale and purchase of old goods and included but the commission charges by agents in
their transaction is a part of national income.
2. Imputed value of production for self-consumption is taken into account. Because, these
goods are like those produced for the market.
3. Imputed rent on the owner occupied house is included. Because all houses have rental
value, no matter these are self occupied or rented out.
4. Value of intermediate goods is not included into the estimation of national income.
5. Services for Self-consumption are not considered while estimating value added. Because it is
difficult to estimate their market value like services of housewives.
6. Income from illegal activities is not included in national income.
Income Method
This method is also known as factor cost method. Under this method, national income is
obtained by adding the incomes such as rent, wages, interest and profit received by all persons in
67
the country during a year. In practice, the income figures are obtainable mostly from income tax
returns, books of accounts and published accounts. To this, net income from foreign trade and
net investment from abroad should be added.
According to income method, the net income payments received by all citizens of a country in a
particular year are added up. The net incomes earned by the factors of production in the form of
rent, wage, interest and profit aggregated but incomes in the form of transfer payments are not
included in the national income.
NDPFC= Compensation of Employees + Operating Surplus + Mixed Income
Components of Income Method
Compensation of Employees: It includes Wages and salaries in cash, Employers contribution to
social security scheme, Pension on retirement, Bonus, Allowances etc.
Operating Surplus: It includes rent and royalty, interest, profit (dividend +corporation tax+
undistributed profits).
Mixed Income: It is the income of the self employed persons such as farmers, shopkeepers,
doctors etc. They generate goods and services with the help of their own land, capital and labour
and thus earn mixed income in the form of interest, profit rent and wages. This income is
included in national income.
In India, this method is used for adding up the net income arising from trade, transport, public
administration, professional and domestic services. Due to lack of popularity of personal
accounting practices, this method cannot be fully used or practiced. This method is used only for
some minor sectors. None of these methods alone will give a more correct figure.
Precautions:
1. All transfer income which does not represent earnings from productive services such as
pension, scholarship, unemployment doles, lottery prize, etc. are not to be included as they are
not earned by participating in the current production.
2. All unpaid services like services of a housewife are to be excluded.
3. All capital gains or loss (buying an old house, or resale of property) should be excluded.
4. Direct tax, revenue to the government should be subtracted from the total income as it is only
transfer of income.
5. Undistributed profits of companies, income from government etc. should be added.
6. Subsidies given by the government should be deducted from profits of the subsidized industry.
7. Income from sale of second hand goods is not included in national income.
8. Income from sales and purchase of old shares is not included in national income.
Expenditure Method
Expenditure method is the method which measures final expenditure on gross domestic product
at market price during an accounting year. Final expenditure is equal to the gross domestic
product at market price. This is also called “Income Disposal Method”, Consumption and
Investment Method”.
According to the expenditure method, the total expenditure incurred by the society in a particular
year is added together. According to these methods total expenditure equals the national income.
Following items are included in it:
1. Private Final Consumption expenditure
2. Govt. final consumption expenditure
3. Gross domestic capital formation
4. Change in stock
5. Net exports.
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1. Private Final Consumption Expenditure
It consists of expenditure on durable goods (e.g., furniture, cars, etc), non-durable goods (e.g.,
food items and toiletries) and services (e.g., hotels, educational institutions, hospitals, public
transport, etc.,) by the household consumers.
The figures of private consumption expenditure may be collected from retail trade activities
during an accounting period.
But the purchases made by non-residents and foreign visitors should be deducted from the final
consumption expenditure in the domestic market whereas direct purchases made by resident
households abroad during foreign travel should be included in consumption expenditure.
2. Government Final Consumption Expenditure
The government final consumption expenditure refers to the final consumption expenditure by
the general government and it can be arrived at by summing up (a) value of net purchases in the
domestic market, (b) net purchases abroad.
3. Gross Fixed Capital Formation
If consists of (a) Business fixed Investment, (b) Govt. Fixed Investment, (c) Investment on
residential construction.
4. Change in Stock as Inventory Investment
Change in stock is the difference between the opening stock and closing stock. All enterprises
and trading companies incur expenditure on stock of raw materials; semi finished goods or
finished goods.
5. Net Exports of Goods and Services
It is the difference between the value of exports and imports of a country during an accounting
period. What the foreigners spend on a country’s exports is the part of expenditure on the Gross
domestic product.
Precautions used in Expenditure method
1. Only expenditure on current final goods should be included so expenditure on second hand
goods must not be added in aggregate expenditure.
2. The intermediate expenditure also must not be included as it leads to double counting.
3. Expenditure on transfer payments should not be taken account of.
4. Gross domestic capital formation already has in it the replacement of machines therefore these
two items should not be separately included in aggregate expenditure.
5. Expenditure on financial transactions, e.g., shares and bonds should not be included because
these transactions do not add to the flow of goods and services but only change the ownership of
financial assets.
6. Only expenditure on final goods and services should be included in aggregate expenditure.
7. The aggregate expenditure got by adding up various components includes in itself the cost of
depreciation. Thus, we have the concept of so as to arrive at the Net Domestic Product at market
price; depreciation should be deducted from it.

Problems in measurement of National Income

There are many difficulties in measuring national income of a country accurately. The
difficulties involved in national income accounting are both conceptual and statistical in nature.
Some of these difficulties involved in the measurement of national income are discussed below:
1. Non Monetary Transactions
The first problem in National Income accounting relates to the treatment of non-monetary
transactions such as the services of housewives to the members of the families. For example, if a
69
man employees a maid servant for household work, payment to her will appear as a positive item
in the national income. But, if the man were to marry to the maid servant, she would perform the
same job as before but without any extra payments. In this case, the national income will
decrease as her services performed remains the same as before.
2. Problem of Double Counting
Only final goods and services should be included in the national income accounting. But, it is
very difficult to distinguish between final goods and intermediate goods and services. An
intermediate goods and service used for final consumption. The difference between final goods
and services and intermediate goods and services depends on the use of those goods and services
so there are possibilities of double counting.
3. The Underground Economy
The underground economy consists of illegal and unclear transactions where the goods and
services are themselves illegal such as drugs, gambling, smuggling, and prostitution. Since, these
incomes are not included in the national income; the national income seems to be less than the
actual amount as they are not included in the accounting.
4. Petty Production
There are large numbers of petty producers and it is difficult to include their production in
national income because they do not maintain any account.
5. Public Services
Another problem is whether the public services like general administration, police, army
services, should be included in national income or not. It is very difficult to evaluate such
services.
6. Transfer Payments
Individual get pension, unemployment allowance and interest on public loans, but these
payments creates difficulty in the measurement of national income. These earnings are a part of
individual income and they are also a part of government expenditures.
7. Capital Gains or Loss
When the market prices of capital assets change the owners make capital gains or loss such gains
or losses are not included in national income.
8. Price Changes
National income is the money value of goods and services. Money value depends on market
price, which often changes. The problem of changing prices is one of the major problems of
national income accounting. Due to price rises the value of national income for particular year
appends to increase even when the production is decreasing.
9. Wages and Salaries paid in Kind
Additional payments made in kind may not be included in national income. But, the facilities
given in kind are calculated as the supplements of wages and salaries on the income side.
10. Illiteracy and Ignorance
The main problem is whether to include the income generated within the country or even
generated abroad in national income and which method should be used in the measurement of
national income.
11. Second hand transactions
12. Inadequate and unrealistic statistics
National Income Precautions:
1. Only expenditure on current final goods should be included so expenditure on second hand
goods must not be added in aggregate expenditure.
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2. The intermediate expenditure also must not be included as it leads to double counting.
3. Expenditure on transfer payments should not be taken account of.
4. Gross domestic capital formation already has in it the replacement of machines therefore these
two items should not be separately included in aggregate expenditure.
5. Expenditure on financial transactions, e.g., shares and bonds should not be included because
these transactions do not add to the flow of goods and services but only change the ownership of
financial assets.
6. Only expenditure on final goods and services should be included in aggregate expenditure.
7. The aggregate expenditure got by adding up various components includes in itself the cost of
depreciation. Thus, we have the concept of so as to arrive at the Net Domestic Product at market
price; depreciation should be deducted from it.

MACRO ECONOMIC FRAMEWORK CLASSICAL MODEL

Classical theory:
Classical economics is widely regarded as the first modern school of economic thought. Its major
developers include Adam Smith, Jean-Baptiste Say, David Ricardo, Thomas Malthus and John
Stuart Mill.
Classical economists claimed that free markets regulate themselves, when free of any
intervention. Adam Smith referred to a so-called invisible hand, which will move markets
towards their natural equilibrium, without requiring any outside intervention.
Assumptions of Classical Approach
1. There is existence of full employment without inflation
2. There is a laissez faire capitalist economy without government interference
3. It is a closed economy without foreign trade
4. There is a perfect competition in labour and product markets
5. Total Output of the economy is divided between consumption and investment expenditure
6. The quantity of money is given and money is only the medium of exchange
7. Wages and Prices are perfectly flexible
8. Constant Technology
9. Equality between saving and investment
Say’s Law of Market: According to Say’s Law “Supply creates its own demand”, i.e., the very
act of producing goods and services generates an amount of income equal to the value of the
goods produced. Say’s Law can be easily understood under barter system where people produced
(supply) goods to demand other equivalent goods. So, demand must be the same as supply. Say’s
Law is equally applicable in a modern economy. The circular flow of income model suggests this
sort of relationship. For instance, the income created from producing goods would be just
sufficient to demand the goods produced.
Relation between Saving-Investment: There is a serious omission in Say’s Law. If the
recipients of income in this simple model save a portion of their income, consumption
expenditure will fall short of total output and supply would no longer create its own demand.
Consequently there would be unsold goods, falling prices, reduction of production,
unemployment and falling incomes.
However, the classical economists ruled out this possibility because they believed that whatever
is saved by households will be invested by firms. That is, investment would occur to fill any
consumption gap caused by savings leakage. Thus, Say’s Law will hold and the level of national
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income and employment will remain unaffected.
Wage Flexibility: The classical economists also believed that a decline in product demand
would lead to a fall in the demand for labour resulting in unemployment. However, the wage rate
would also fall and competition among unemployed workers would force them to accept lower
wages rather than remain unemployed. The process will continue until the wage rate falls enough
to clear the labour market. So a new lower equilibrium wage rate will be established. Thus,
involuntary unemployment was logical impossibility in the classical model.
Keyne’s Criticism of Classical Theory:
J.M. Keynes criticized the classical theory on the following grounds:
1. According to Keynes saving is a function of national income and is not affected by changes in
the rate of interest. Thus, saving-investment equality through adjustment in interest rate is ruled
out. So Say’s Law will no longer hold.
2. The labor market is far from perfect because of the existence of trade unions and government
intervention in imposing minimum wages laws. Thus, wages are unlikely to be flexible. Wages
are more inflexible downward than upward. So a fall in demand (when S exceeds I) will lead to a
fall in production as well as a fall in employment.
3. Keynes also argued that even if wages and prices were flexible a free enterprise economy
would not always be able to achieve automatic full employment.
Keynesian theory of Employment
Assumptions
1. The theory is applicable in advanced capitalistic Economy
2. Assumption of short period
3. Assumption of Perfect competition
4. Closed economy
5. It ignores the role of Government as a spender and Taxer
6. No time lag
7. Money also act as a store of value
8. Labor is the only variable factor of production
9. Under Employment Equilibrium
Saving depends upon income and Investment depends upon Rate of Interest
Keynes has strongly criticized the classical theory in his book ‘General Theory of Employment,
Interest and Money’. His theory of employment is widely accepted by modern economists.
Keynesian economics is also known as ‘new economics’ and ‘economic revolution’. Keynes had
invented new tools and techniques of economic analysis such as consumption function,
multiplier, marginal efficiency of capital, liquidity preference, effective demand, etc. In the short
run, it is assumed by Keynes that capital equipment, population, technical knowledge, and labour
efficiency remain constant. That is why, according to Keynesian theory, volume of employment
depends on the level of national income and output. Increase in national income would mean
increase in employment. The larger the national income the larger the employment level and vice
versa. That is why, the theory of Keynes is known as ‘theory of employment’ and ‘theory of
income’.
Theory of Effective Demand:
According to Keynes, the level of employment in the short run depends on aggregate effective
demand for goods in the country. Greater the aggregate effective demand, the greater will be the
volume of employment and vice versa. According to Keynes, the unemployment is the result of
deficiency of effective demand. Effective demand represents the total money spent on
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consumption and investment. The equation is:
Effective demand = National Income (Y) = National Output (O)
The deficiency of effective demand is due to the gap between income and consumption. The gap
can be filled up by increasing investment and hence effective demand, in order to maintain
employment at a high level. According to Keynes, the level of employment in effective demand
depends on two factors:
(a)Aggregate supply function, and
(b)Aggregate demand function.
(a) Aggregate supply function:
According to Dillard, the minimum price or proceeds which will induce employment on a given
scale, is called the ‘aggregate supply price’ of that amount of employment. If the output does not
fetch sufficient price so as to cover the cost, the entrepreneurs will employ less number of
workers. Therefore, different numbers of workers will be employed at different supply prices.
Thus, the aggregate supply price is a schedule of the minimum amount of proceeds required to
induce varying quantities of employment.
We can have a corresponding aggregate supply price curve or aggregate supply function, which
slopes upward to right.
(b)Aggregate demand function:
The essence of aggregate demand function is that the greater the number of workers employed,
the larger the output. That is, the aggregate demand price increases as the amount of employment
increases, and vice versa. The aggregate demand is different from the demand for a product. The
aggregate demand price represents the expected receipts when a given volume of employment is
offered to workers. The aggregate demand curve or aggregate demand function represents a
schedule of the proceeds of the output produced by different methods of employment.
Difference between Classical and Keynes Model
Classical
1. Economy is in full employment
2. The wages and prices are very flexible
3. There is no need of fiscal or monetary policy
4. The Aggregate supply curve is Vertical according to classical so any rise in aggregate demand
will increase prices not production
5. There is a direct relationship between the money supply and the price level
6. Saving-investment equality is brought about by the rate of interest mechanism.
7. Supply creates its own demand
8. Laissez Faire or Capitalistic economy
9. Automatic adjustment works
10. Long run concept
11. Saving is good
Keynesian theory:
1. Economy may not be in full employment in short run
2. Wage are rigid and prices are sticky (menu cost etc)
3. Fiscal as well as monitory policy may be needed to correct the disequilibrium or improve the
efficiency of economy
4. Aggregate supply is upward sloping in the short run so a rise in aggregate demand may rise
the production as well
5. No such direct relationship exists between the money supply and price level. The relation is
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only indirect.
6. The equality between saving and investment is brought about by the income level.
7. Demand creates its own supply
8. No is no adjustments
9. No laissez Faire
10. Short run
11. Saving is bad
Consumption Function
It is a functional relationship between two aggregates i.e., total consumption and National
income. Consumption is an increasing function of income. It was developed by John Maynard
Keynes
Symbolically, C= f (Y)
Consumption expenditure increases with increase in income.
But increase in consumption is less than increase in income. It is known as Fundamental
Psychological Law”.
Consumption Schedule It is the tabular representation of various amounts of consumption
expenditure corresponding to different levels of income.
Consumption is basically of two types:
Autonomous Consumption: This is the level of consumption which does not depend on
income. The argument is that even with zero income you still need to buy enough food to eat,
through borrowing or running down savings.
Induced Consumption: This is that level of consumption which depends on income and varies
at different level of income. When income increases, induced consumption also increases.
This function can be written as C= Ca + bY
Where
C= Total consumption
Ca= Autonomous Consumption
By=Induced Consumption (b= Marginal Propensity to consume and Y= income)
Ca+bY
Induced
Consumption
©
Consumption
Autonomous
Consumption
Income (Y)
Propensity to Consume
Propensity to consume is of two kinds:
Average Propensity to Consume
Marginal Propensity to Consume
Average Propensity to consume: APC is the ratio of total consumption to total income. It is
found by dividing the total consumption with total income.
APC= C/Y
Marginal Propensity to consume: MPC is defined as the ratio of change in consumption to
change in change in income. It is found by dividing the change in consumption expenditure with
the change in income.
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MPC = C/ Y
Characteristics of MPC
1.It is always positive
2.It is greater than zero and less than utility
3.MPC of the poor class is higher
4.Constant MPC in the long period
5.Falling MPC in the short period
6.MPC can be greater than 1 in abnormal conditions
Saving Function
Saving function may be defined as a schedule showing amounts that will be saved at different
level of income.
S=f(Y)
Saving increases with increase in income and decreases with decrease in income, i.e., saving is
income elastic.
Propensity to Save
Average Propensity to Save: APS is the ratio between total saving (S) and total income (Y) at a
given level of income and employment in the economy.
APS= S/Y
Marginal Propensity to Save: MPS is defined as the ratio of change in consumption to change
in income. It is found by dividing the change in consumption expenditure with the change in
income.
MPS= S/ Y
Relationship between Consumption and Saving Function
1. When consumption is more than income than saving is negative or when consumption graph is
above to income graph than saving is negative.
C>Y, than S becomes -S
2. When consumption becomes equals to income or consumption graph meet to income graph at
that time saving is zero.
C=Y, than S=0
3. When consumption is less than income or consumption graph is below to income than saving
increases and becomes positive.
C<Y, than S becomes +S
Relationship between APC and APS
We know that APC = C/Y and APS = S/Y
Y=C+S
Divide both side by Y Y/Y = C/Y + S/Y
1 = C/Y + S/Y
1 = APC + APS
1 - APC = APS
Relationship between MPC and MPS
We know that MPC = dC/dY and MPS = dS/dY
Y=C+S
And, dY= dC+dS Divide both side by dY dY/dY = dC/dY + dS/dY 1 = dC/dY + dS/dY
1 = MPC + MPS
1 - MPC = MPS
Investment Function
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An investment function is a concept or strategy within economics that helps to identify the
connection between shifts in the national income and the investment patterns that take place
within that particular national economy. In this type of situation, a function would be any
variable within the framework of the economy that would motivate investors to change their
typical buying and selling habits as a means of either taking advantage of the economic shift in a
bid to increase their returns or to minimize the amount of loss incurred as a result of that shift. In
weighing variables, the investor will consider the current level of gross domestic product (GDP)
as well as the average interest rates that currently apply within the economy.
The investment function is a summary of the variables that influence the levels of aggregate
investments. It can be formalized as follows:
I=f(r, Y,q)
Types of Investment
Different types or kinds of investment are discussed in the following points.
1. Autonomous Investment
Investment which does not change with the changes in income level, is called as Autonomous or
Government Investment. Autonomous Investment remains constant irrespective of income level.
Which means even if the income is low, the autonomous, Investment remains the same. It refers
to the investment made on houses, roads, public buildings and other parts of Infrastructure. The
Government normally makes such a type of investment.
2. Induced Investment
Investment which changes with the changes in the income level is called as Induced Investment.
Induced Investment is positively related to the income level. That is, at high levels of income
entrepreneurs are induced to invest more and vice-versa. At a high level of income, Consumption
expenditure increases this leads to an increase in investment of capital goods, in order to produce
more consumer goods.
3. Financial Investment
Investment made in buying financial instruments such as new shares, bonds, securities, etc. is
considered as a Financial Investment.
However, the money used for purchasing existing financial instruments such as old bonds, old
shares, etc., cannot be considered as financial investment. It is a mere transfer of a financial asset
from one individual to another. In financial investment, money invested for buying of new shares
and bonds as well as debentures have a positive impact on employment level, production and
economic growth.
4. Real Investment
Investment made in new plant and equipment, construction of public utilities like schools, roads
and railways, etc., is considered as Real Investment.
Real investment in new machine tools, plant and equipments purchased factory buildings, etc.
increases employment, production and economic growth of the nation. Thus real investment has
a direct impact on employment generation, economic growth, etc.
5. Planned Investment
Investment made with a plan in several sectors of the economy with specific objectives is called
as Planned or Intended Investment. Planned Investment can also be called as Intended
Investment because an investor while making investment, make a concrete plan of his
investment.
6. Unplanned Investment
Investment done without any planning is called as an Unplanned or Unintended Investment.
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In unplanned type of investment, investors make investment randomly without making any
concrete plans. Hence it can also be called as Unintended Investment. Under this type of
investment, the investor may not consider the specific objectives while making an investment
decision.
7. Gross Investment
Gross Investment means the total amount of money spent for creation of new capital assets like
Plant and Machinery, Factory Building, etc.It is the total expenditure made on new capital assets
in a period.
8. Net Investment
Net Investment is Gross Investment less (minus) Capital Consumption (Depreciation) during a
period of time, usually a year. It must be noted that a part of the investment is meant for
depreciation of the capital asset or for replacing a worn-out capital asset. Hence it must be
deducted to arrive at net investment. Marginal Efficiency of Capital MEC. The Marginal
efficiency of capital displays the expected rate of return from investment, in a particular given
time. The marginal efficiency of capital is compared to the rate of interest. Keynes described the
marginal efficiency of capital as:
"The marginal efficiency of capital is equal to that rate of discount which would make the
present value of the series of annuities given by the returns expected from the capital asset during
its life just equal to its supply price." - J.M.Keynes, General Theory.
This theory suggests investment will be influenced by:
1.The marginal efficiency of capital
2.The interest rates
Generally, a lower interest rate makes investment relatively more attractive.If interest rates, were
3%, then firms would need an expected rate of return of at least 3% from their investment
tojustify investment. If the marginal efficiency of capital was lower than the interest rate, the
firm would be better off not investing, but saving the money. Why are interest rates important for
determining the Marginal efficiency of capital? To finance investment, firms will either borrow
or reduce savings. If interest rates are lower, it's cheaper to borrow or their savings give a lower
return making investment relatively more attractive.
Marginal Efficiency of Capital - A cut in interest rates from R1 to R2 will increase investment
to I2. The alternative to investing is saving money in a bank, this is the opportunity cost of
investment. If the rate of interest is 5% then only projects with a rate of return of greater than 5%
will be profitable.
Factors which shift the Marginal Efficiency of Capital
1. The cost of capital. If capital is cheaper, then investment becomes more attractive. For
example, the development of steel rails made railways cheaper and encouraged more investment.
2.Technological change. If there is an improvement in technology, it can make investment more
worthwhile.
3.Expectations and business confidence. If people are optimistic about the future, they will be
willing to invest because they expect higher profits. In a recession, people may become very
pessimistic, so even lower interest rates don't encourage investment. (e.g. during recession 2008-
12, interest rates were zero, but investment low)
4.Supply of finance. If banks are more willing to lend money investment will be easier.
5.Demand for goods. Higher demand will increase profitability of capital investment.
6.Rate of Taxes. Higher taxes will discourage investment. Sometimes, governments offer tax
breaks to encourage investment.
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Determinants of Marginal efficiency Capital
Marginal efficiency of Capital is governed by the expected yield of a capital asset and its supply
price. In technical term the same are called:
Prospective yield:
It is the aggregate net return expected from it during its whole life. In order to determine
prospective yield, annual return of the capital is worked out. Aggregate of annual return expected
from a capital asset over its life-time is called total prospective yield. The remainder, after
deducting cost of production from total revenue earned by the sale of output produced with the
help of capital asset, is called prospective yield. With rise in prices, prospective yield increases
and with the fall in prices, it decreases. Prices are likely to change in the be expressed in terms of
the following equations: Py = Q1 + Q2 + Q3 + Q4 +«««+ Qn (Here Py= Prospective Yield; Q1,
Q2, Q3, Q4 and Qn = net revenue received in the first, second, third, fourth and nth year)
Supply Price :
The other factor influencing M.E.C. of a capital asset is its supply price. The supply price of a
capital asset is the cost of producing a new asset of that kind, not the supply price of an existing
asset. Hence, the supply price of a capital asset is also called Replacement Cost. It remains fixed
in the short period.
Marginal Efficiency of Investment
Marginal efficiency of investment, in economics, expected rates of return on investment as
additional units of investment are made under specified conditions and over a stated period of
time. A comparison of these rates with the going rate of interest may be used to indicate the
profitability of investment. The rate of return is computed as the rate at which the expected
stream of future earnings from an investment project must be discounted to make their present
value equal to the cost of the project.
As the quantity of investment increases, the rates of return from it may be expected to decrease
because the most profitable projects are undertaken first. Additions to investment will consist of
projects with progressively lower rates of return. Logically, investment would be undertaken as
long as the marginal efficiency of each additional investment exceeded the interest rate. If the
interest rate were higher, investment would be unprofitable because the cost of borrowing the
necessary funds would exceed the returns on the investment. Even if it were unnecessary to
borrow funds for the investment, more profit could be made by lending out the available funds at
the going rate of interest.
The MEI curve represents the interest elasticity of demand for investment (or capital goods), or
in other words, how responsive investment is to a change in interest rates. Interest rates represent
the cost of borrowing. Theoretically, the lower the rate of interest, the cheaper it is for firms to
finance investment, and the more profitable the investment will be. Hence, the level of
investment will rise. Keynes, however, suggested that investment is in fact relatively
unresponsive to changes in interest rates, particularly at the extreme ends of the Trade Cycle.
During a recession, businessmen are generally pessimistic about the future outlook and there is
also likely to be excessive unused productive capacity, which prevents a fall in interest rates
from stimulating I. On the other hand, during a boom, their optimism may cause them to
disregard high interest rates. Hence, MEI is more likely to look like the relatively inelastic MEI1
than the relatively elastic MEI2.

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