PRINCIPLE OF ECONOMICS (MACRO)

MODULE ONE THE FIELD OF MACROECONOMICS

Unit 1 Meaning of Macroeconomics
Unit 2 Differences between Microeconomics and Macroeconomics
Unit 3 Importance of Macroeconomics

MODULE TWO NATIONAL INCOME ACCOUNTING

Unit 1 Meaning of National Income Analysis
Unit 2 Consumption, Savings and Investment
Unit 3 Economic Welfare and National Income

MODULE THREE MONEY AND BANKING

Unit 1 Origins of Money
Unit 2 Financial Institution
Unit 3 Central Banking

MODULE FOUR COMPONENTS OF GROSS DOMESTIC PRODUCT

Unit 1 Personal Consumption Expenditure
Unit 2 Gross Private Domestic investment and Net Exports
Unit 3 Government Consumption and Gross investment.

MODULE 5 AGGREGATE DEMAND AND AGGREGATE SUPPLY

UNIT 1 Meaning and Nature of Aggregate Demand Curve
UNIT 2 Meaning and Nature of Aggregate Supply Curve
UNIT 3 Short-run and Long-run Aggregate Demand and Supply.

MODULE 6 GOVERNMENT AND THE ECONOMY

UNIT 1 Meaning of Government Spending
UNIT 2 Meaning of Government Revenue
UNIT 3 Budget analysis

MODULE 7 OPEN ECONOMY MACROECONOMICS

Unit 1 Analysis of International Trade
Unit 2 Gain from Trade
Unit 3 Net Export Function in the Open Economy.

MODULE ONE THE FIELD OF MACROECONOMICS

UNIT 1 Meaning of Macroeconomics

3.1 Definition of Macroeconomics
Let us start this lecture by first of all defining what Macroeconomics is. Can anyone
define macroeconomics? Macroeconomics studies the behavior of the whole (aggregate)
economy or economic systems rather than individual economic markets (which is the domain of
Microeconomics). Macroeconomics is concerned primarily with the forecasting of national
income, through the analysis of major economic factors that show predictable patterns and
trends, and of their influence on one another. These factors include level of
employment/unemployment, gross national product (GNP), balance of payments position, and
prices (deflation or inflation). Macroeconomics also covers role of fiscal and monetary
policies, economic growth, and determination of consumption and investment levels.

However, we can also define macroeconomics as the field of economics that studies the
1
 behavior of the aggregate economy. Macroeconomics examines economy-wide phenomena
such as changes in unemployment, national income, rate of growth of gross domestic product,
inflation and price levels. Alternatively macroeconomics is the branch of economics that studies
the behavior and performance of an economy as a whole.

Having defined macroeconomics in two several ways, it can be said that it is concrete that
macroeconomics is a study of "the big picture" in the economy. Rather than focusing on
individual households and firms, it examines conditions within the economy as a whole. This is
the most vital differences between micro and macroeconomics. In more technical terms,
macroeconomics looks at the factors that influence aggregate supply and demand. Although
macroeconomics has a much broader focus than microeconomics does, many
macroeconomic factors are essential to making predictions and conclusions at the
microeconomic level. For instance, knowing what the unemployment rate is at the national level
can help a macroeconomist to predict future layoffs in a specific industry.

3.2. Goal of Macroeconomics

(a) FULL EMPLOYMENT
Full employment has been ranked among the foremost objectives of macroeconomic goal. It is
an important goal not only because unemployment leads to wastage of potential output, but also
because of the loss of social standing and self-respect. Moreover, it breeds poverty.

According to Keynes, full employment means the absence of involuntary unemployment. In other
words, full employment is a situation in which everybody who wants to work gets work. Full
employment so define is consistent with frictional and voluntary unemployment. To achieve
full employment, Keynes advocated increase in effective demand to bring about reduction in
real wages. Thus the problem of full employment is one of maintaining adequate effective
demand. Keynes gave an alternative definition of full employment at another place in his General
Theory thus: “it is a situation in which aggregate employment is inelastic in response to an
increase in the effective demand for its output.” It means that the test of full employment is
when any further increase in effective demand is not accompanied by any increase in output.
Since 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 full
employment involves three conditions:
(i) Reduction in the real wage rate
(ii) Increase in effective demand
(iii) Inelastic supply of output at the level of full employment.

(b) PRICE STABILITY

One of the goals of macroeconomics policy is to stabilize the price level. Both economists and
laymen favour this policy because fluctuations in prices bring uncertainty and instability to the
economy. Rising and falling prices are both bad because they bring unnecessary loss to some
and undue advantage to others. Again, they are associated with business cycles. So a
policy of price stability keeps the value of money stable, eliminates cyclical fluctuations, brings
economic stability, helps in reducing inequalities of income and wealth, secure social justice and
promotes economic welfare.

However, there are certain difficulties in pursuing a policy of stable price level. The first
problem relates to the type of price level to be stabilized. Should the relative or general price level
be stabilized, the wholesale or retail, of consumer goods or producer goods? There is no specific
criterion with regard to the choice of a price level. Economists suggest, the compromise solution
would be to try to stabilize a price level which would include consumers’ goods prices as well as
wages. But this will necessitate increase in the quantity of money but not by as much as is
implied in the stabilization of consumer’s goods price.
Second, innovations may reduce the cost of production but a policy of stable prices may
bring larger profits to producers at the cost of consumers and wage earners. However, in an
open economy which imports raw materials and other intermediate products at high prices, the
2
cost of production of domestic goods will rise. But a policy of stable prices will reduce profits and
retard further investment. Under the circumstances, a policy of stable prices is not only
inequitable but also conflicts with economic progress.

(c) ECONOMIC GROWTH

One of the most important goals of macroeconomics objective in recent years has been the rapid
economic growth of an economy. Economic growth is defined as the process whereby the real
per capita income of a country increases over a long period of time. Economic growth is measured
by the increase in the amount of goods and services in each successive time period. Thus, growth
occurs when an economy’s productive capacity increases which, in turn, is used to produce more
goods and services. However, economic growth implies raising the standard of living of the people,
and reducing inequalities of income distribution. We all will agree that economic growth is a
desire goal for a country. But there is non agreement over the magic number viz, the annual
growth rate which an economy should attain.

Generally, economists believe in the possibility of continual growth. This belief is based on the
presumption that innovations tend to increase productive technologies of both capital and
labour over time. But there is very likelihood that an economy might not grow despite
technological innovations. Production might not increase further due to the lack of demand which
may retard the growth of the productive capacity of the economy. The economy may not grow
further if there is no improvement in the quality of labour in keeping with the new technologies.

However, policy makers do not take into consideration the costs of growth. Growth is not
limitless because resources are scarce in every economy. All factors have opportunity cost. To
produce more of one particular product will mean reduction in that of the other. New
technologies lead to the replacement of old machines which become useless. Workers are also
displaced because they cannot be fitted in the new technological set up immediately. Moreover,
rapid growth leads to urbanization and industrialization with their adverse effects on the pattern of
living and environment. People have a live in squalor and slums. The environment becomes
polluted. Social tensions develop.

(d) BALANCE OF PAYMENTS

Another goal of macroeconomic objectives has been to maintain equilibrium in the balance of
payments. The achievement of this goal has been necessitated by the phenomenal growth in the
world trade as against the growth of international liquidity. It is also recognized that deficit in
the balance of payment will retard the attainment of other goals. This is because a deficit in
the balance of payments leads to a sizeable outflow of gold. But it is not clear what
constitutes a satisfactory balance of payments position. Clearly a country with a net debt must
be at a surplus to repay the debt over a reasonably short period of time. Once any debt has been
repaid and an adequate reserve attained, a zero balance maintained over time would meet the
policy objective. But how is this satisfactory balance to be achieved on the trading account or on
the capital account? The capital account must be looked upon as fulfilling merely a short-term
emergency role in times of crises.

UNIT 2 THE DISTINCTION BETWEEN MICROECONOMICS AND MACROECONOMICS.

3.1 Difference between Microeconomics and Macroeconomics

Microeconomics is the study of individual economic units of an economy whereas
macroeconomics is the study of aggregates of an economy as a whole. For example,
when we study an individual sugar mill manufacturing firm, our study is micro analysis but if
we study the entire sugar manufacturing sector of the economy, our study is macro
analysis.

3
Also please note if we study the problem of production of a firm, our analysis is micro study
but if we study the problems of production of the whole economy, our analysis is macro study.
Both Microeconomics and Macroeconomics are inter- dependent and complementary.

The main difference between the Microeconomics and Macroeconomics are as follows:

MICROECONOMICS MACROECONOMICS
1. It is the study of individual It is the study of economy as a whole and
economic units of an economy its aggregates.

2. It deals with individual income, It deals with aggregates like national

individual prices and individual output, income, general price level and national output,
etc. etc.

3. Its Central problem is price Its central problem is determination of

determination and allocation of level of income and employment.
resources.

4. Its main tools are demand and Its main tools are aggregate demand and
supply of a particular aggregate supply of economy as a whole.
commodity/factor.

5. It helps to solve the central It helps to solve the central problem of full
problem of what, how and for whom employment of resources in the economy.
to produce in the economy

6. It discusses how equilibrium of a It is concerned with the determination of

consumer, a producer or an equilibrium level of income and
industry is attained. employment of the economy.

7. Price is the main determinant of Income is the major determinant of

microeconomic problems. macroeconomic problems.

3.2 Transition from Microeconomics to Macroeconomics

In this section, we will discuss the transition of from microeconomics to macroeconomics
analysis.
However, both microeconomics and macroeconomics were used by both the classical and
the neo-classical economists in their analysis. Marshall was the one that developed and perfected
microeconomics as a method of economic analysis. More so, Keynes was the one that developed
macroeconomics as a distinct method in economic theory. Therefore, the actual process of
transition from microeconomics to macroeconomics started with the publication of keynes’s
general theory.

Microeconomics is the study of economic actions of individuals and small groups of individuals. It
includes particular households, particular firms, particular industries, particular commodities,
individual prices, wages and incomes. Thus microeconomics studies how resources are allocated
to the production of particular goods and services and how efficiently they are distributed. But
microeconomics studied in itself, and does not study the problem of allocation of resources to the
economy as a whole. It is concerned with the study of parts and neglects the whole, for
example according to the economists “Description of a large and complex universe of facts
like the economic system is impossible in terms of individual items’. Thus the study of

4
microeconomics presents an imprecise picture of the economy. However, the orthodox
economist, like Pigou, tried to apply microeconomic analysis to the problems of an economy.
Keynes thought otherwise and advocated macroeconomics which is the study of aggregates
covering the entire economy such as total employment, total income, total output, total
investment, total consumption, total savings, aggregate supply, aggregate demand, and general
price level, wage level and cost structure. For understanding the problems facing the economy,
Keynes adopted the macro approach which brought about the transition from micro to macro.
Microeconomics also assumes the total volume of employment as given and studies how it
is allocated among individual sectors of the economy. But Keynes rejected the assumption of
full employment of resources, especially of labour. From the macro angle, he regarded full
employment as a special case. The general situation is one of under-employment. The existence of
involuntary unemployment of labour in capitalist economies proves that underemployment
equilibrium is a normal situation and full employment is abnormal and accidental.

UNIT 3 IMPORTANCE OF MACROECONOMICS AS A SEPARATE FIELD OF STUDY

3.1 Importance of Macroeconomics

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.

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.

The Keynesian theory of employment suggested that. Increasing total investment, total output,
total income and total consumption should raise unemployment caused by deficiency of
effective demand. Thus, macroeconomics has special significance in studying the causes,
effects and remedies of general unemployment.

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.

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.'

We may conclude that macroeconomics enriches out knowledge of the functioning of an economy
by studying the behavior of national income, output investment, saving and consumption.
Moreover, it throws much light in solving the problems of unemployment, inflation, economic
instability and economic growth.

MODULE TWO NATIONAL INCOME ACCOUNTING

UNIT 1 NATIONAL INCOME ANALYSIS

3.1. Concept of National Income

National income has several concepts that are interrelated, they includes; National income
concepts include Gross Domestic Product (GDP), Gross National Income (GNP), Net National
5
Product (NNP), Net National Income (NNI), Disposable Income (DI), Real Income (RI), GDP at factor
cost, and GDP at market price, etc

3.1.1 Gross Domestic Product (GDP)

The gross domestic product is the summation of all the values of goods and services produced in
a country by the nationals and non-nationals. It does not include incomes and property earnings
of the nationals abroad neither does it exclude the incomes and property earnings of the non-
nationals in the country.

Gross domestic product is the market value of all the final goods and services that are produced
in a country during a given period of time, usually in a year by all factors of production located
within a country. Moreover, let us try to explain the points in the definition. The key words are
“market value”, “final goods and services”, “produced within a country during a given period of
time.”

1. Market Value
Gross Domestic Product or National Income is an aggregation of the market values of all
the goods and services produced in the economy in a given period. You should note that goods
and services that are not sold in the markets such as unpaid house works are not counted in GDP.
Important exceptions in this regard are goods and services provided by the government (they
do not have market value) which are included in GDP as the government’s cost of providing them.

i. Final Goods and Services

In this case, we should note that not all goods and services that have a market value are
counted in GDP. GDP includes only those goods and services that are the end product of the
production process which are called final goods and services.

Many goods are used in the production process. For example, in order for a producer to produce a
yam flower, yam must be planted and harvested, the yam must thereafter be pilled, dried to have a
dried yam and then grinded to become a yam flower. Out of the process as mentioned earlier,
that are used in the production of the yam flower, it is only the yam flour that is used by
the consumers, since the production of the yam flour is the ultimate aim of the process,
and the yam flour is therefore called a final good.

It can therefore be seen that a final good or service is the end product of the production process,
or the product or service that consumers actually use. The goods and services produced in the
process of making the final product (in our example, the yam and the dried yam) are called
intermediate goods and services.

Since we are only interested in measuring items that are of direct economic value, only final goods
and services are therefore included in the calculation of GDP. Intermediate goods and services
which are used up in the production of final goods and services are not counted.

To illustrate the distinction between final goods and intermediate goods, let us consider the
following examples:
Illustration 1:
Suppose that a bag of grain has a market value of N25 (twenty naira, the price the milling
company paid for the grain). If the grain then is milled into flour, which has a market value of
N50.00 (the price the baker paid for the flour). The flour is then made into a loaf of bread worth
N150.00 in the market.
In calculating the contribution of these activities to GDP, we cannot add together all the values of
the grain, flour and bread, this is because the grain and flour are only intermediate goods used in
the production of bread. So, the total contribution to GDP is N150.00 which is the market
value of the loaf of bread, the final product.
‘Illustration 2:

6
A tailor charges N1000.00 for each cloth that she makes. The tailor pays her shop apprentice
N100.00 per cloth made in return for sweeping the floor and other chores. For each clothe sown,
what is the total contribution of the tailor and her apprentice to GDP?
Answer:
The answer to this question is simply 1000.00 which is the market value of each cloth sown. This
service is counted in GDP because it is the final service, the one that actually has value to the final
user. The services the apprentice provided are intermediate services and have value only because
the services contributed to the production of the making of the cloth; thus, they are not counted in
GDP.
As earlier pointed out, intermediate goods are not counted in GDP to avoid double counting.
Double counting can also be avoided by counting only the value added to a product by each firm
in the production process.
iii. Produced within a Country during a given Period
The word ‘domestic’ used in the definition of gross domestic product tell us that GDP is a
measure of economic activities within a given country. Therefore, only goods and services
produced with the country’s borders are counted. For example, the GDP of Nigeria includes the
market value of all goods and services produced within the Nigerian borders even if they are
made in foreign-owned industries or are produced by foreigners. Also, goods and services
produced in Ghana by a Nigerian based company like Globacom, etc. are not counted. In addition,
only goods and services produced during the current year, or the portion of the value produced
during the current year, are counted as part of the current year’s GDP.
In sum, the output produced by Nigerians abroad for example, Nigerian citizens working for a
foreign company is not counted in Nigeria’s GDP because the output is not produced within
Nigeria. In the same vein, profits earned abroad by Nigerian companies are not counted in
Nigeria’s GDP. However, the output produced by foreigners working in Nigeria is counted in
Nigeria’s GDP because the output is produced within Nigeria. Also, profits earned in Nigeria by
foreign- owned companies are counted in Nigeria’s GDP. For example, while the output of
foreigners working in Shell, Exxon, Mobil, etc are counted as part of GDP, output produced by
Nigerians abroad are not counted.

Illustration 4:
Suppose a 10 year old house is sold to Mr. Olusanya Samuel for N5 million and Mr. abdulrahoof
bello pays the real estate agent in charge of the sales a commission of one per cent which
is N50,000 (1/100 x N5 million). The contribution of this economic activity to GDP is only
N50, 000. Generally, purchases and sales of existing assets such as old houses or used cars, do
not contribute to the current year’s GDP.
Since the house was not produced during the current year, its value (N5, million) is not counted
in this year’s GDP. This is so because the value of the house has already been included in the
GDP 10 years ago which was the year the house was built. However, the N50, 000 will be included
in GDP because the N50, 000 fee paid to the real estate agent represents the market value of
the agent’s services in helping Mr. Olusanya Samuel to find and purchase the house. Since these
services were provided during the current year the agent’s fee is counted in the current year’s GDP.

In summary, the followings are not included in the calculation of GDP:

a. Goods and services that have no market value are not included in GDP because it would be
impossible to have a correct estimate of their market prices. Such goods and services that have
no market value include those rendered free of charge. Examples include the bringing up of a child
by the mother, songs recited to friends by a musician etc.
b. Intermediate goods and services are not included in GDP. This is because many of the
intermediate goods pass through a number of production stages or processes before they are
finally purchased or consumed. If these products are now counted at every production stage,
they would be included many times in GDP leading to the problem of double counting, and as
a result, the GDP would increase or be overstated. Therefore, to avoid double counting, only
the market value of the final products and not the intermediate products should be included in GDP.
c. The transactions that do not arise from current year product or which do not contribute in any
7
form to production are excluded in GDP. Thus, the sale and purchase of old goods, fairly used
goods, and of shares, bonds and assets of existing companies are all excluded in GDP because
they do not make any addition to national product, and the goods are simply transferred.
d. Likewise, transferred payments (monies that you do not work for) such as payments received
under social security e.g., unemployment insurance allowance, scholarship, bursary, gifts and
bequests, old age pension, and disability pension are also not included in GNP because the
recipients do not provide any service for them.
e. The profits earned or losses incurred on account of changes in capital assets as a result of the
fluctuations in market prices are not included in GDP if and only if they are not responsible for
the current year’s production or current year’s economic activity. For example if the price of
a house increases due to inflation, the profit earned by selling such a house will not be part of
GDP, but if a portion of the house is constructed anew during the current year, the increase in the
value of the house (after deduction of the cost of the newly constructed portion) will be included in
GDP.
Similarly, variations in the value of assets which can be ascertained beforehand and that are
therefore insured against uncertainties such as flood, fire, etc, are not include in GDP. Note
however that the depreciation of machines, plants and other capital goods is not deducted from
GDP.
f. Income earned through illegal activities such as smuggling, drug trafficking,
children trafficking, prostitution etc are not included in GDP. Also, goods sold in the black market,
are excluded although they are priced (they have market value) and fulfil the needs of the people
but from the social point of view, they are not useful, and thus, the income received from their sales
and purchases is always not included in GDP.

3.1.1.1 Problem of Computation of GDP

1. Problem of double counting or multiple counting: This problem arises when applying the
output-expenditure method to estimating national income. If we add the market value of the
output of all firms we would obtain a total that is greatly in excess of the value of output actually
available to consumers (households). To avoid this difficulty, National income accountant use
the value of the firm’s output less the value of the inputs purchased from other firms Therefore,
a firm’s output is defined as the value-added. The summation of all the value added would give
the value, of all the goods and services produced in the economy. This allow us to differentiate
between intermediate product and final product. Intermediate products are goods used as
inputs in a further stage of production while final products are the outputs of the economy
after eliminating double counting.
2. The problem of definition of conceptual variables That is, the problem, of deciding what
to include in the national income accounting and what not to include. For example, the
exclusion of the services of full housewives in shopping and performing other domestic
works and the recognition given to it when performed by a paid house maid in national
income accounting.
3. The problem of owner-occupier properties: This is somehow related to the second
problem highlighted above in the sense that it bothers on what to include or not to
include in the national income estimate. The practice is to input a value representing the
normal rent which the owner could have paid had the property been let.
4. The distinction between receipts and payments of income and transfer payments.
5. Statistical problems - the problem of information or data collection, collation and
analysis. Often inadequate information would lead to errors in national income accounts.
6. Problems of treating depreciation. The way depreciation is recognized and treated vary
from one firm to other, because there are many methods of calculating this depreciation
and all them give different values.

3.1.2. Gross National Product (GNP)

Gross national product is the market value of all goods and services produce by all the nationals
(citizens) of a given country, irrespective of whether they reside within the domestic country or
abroad. It includes the output or income of only the citizens of country resident in the domestic

8
country, as well as the output or income of the citizens of a country who are abroad. The
income of citizens of a country living abroad is termed factor income from the rest of the world.
Unlike GDP, it excludes the output foreigners residing in the domestic country. Thus, it subtracts
the income of the foreigners living in the domestic country that is called payments of factor
income to the rest of the world.
GNP therefore takes account of three components which are the income or output of citizens of a
country residing in the country (GDP), the income or output of citizens residing abroad (factor
income from the rest of the world) and excludes the income or output of foreigners residing in the
domestic country (factor income to the rest of the world)

3.1.3. Net National Product (NNP)

It can be recalled that GNP includes the value of the total output of a country. In the production
of these output or goods, capital goods such as machineries, equipments etc are used. Some of
these equipments wear out, their component are damaged or destroyed, and others become
obsolete (out of fashion) through technological improvement. All these are termed depreciation or
capital consumption allowance. In essence, fixed capital is subject to depreciation.
To calculate NNP, we subtract depreciation from GNP because the word ‘net’ refers to the
exclusion of the part of total output that has depreciated. Thus, net national product is gross
national product minus depreciation, that is, NNP = GNP – D

3.1.4. Domestic Income

This is similar to GDP but is particular about income earned on the output produced.
Domestic income is the income earned or generated by all the factors of production (land, labour,
capital, entrepreneurship) within a given country from its own resources. Domestic income
includes: (i) wages and Salaries earned by labour; (ii) rent, including imputed house rents
earned by land; (iii) interest on capital; (iv) dividends,; (v) undistributed corporate profits including
the surpluses of public sector undertakings; (vi) other incomes consisting of profits of
unincorporated firms, partnerships, self-employed, and (vii) direct taxes.
3.1.5. Personal Income
This is the total income received by the individuals of a country from all sources in one year
before it is subjected to direct taxes.

Per Capita Income /GDP Per Capita

Per capita income is defined as the ratio of a country’s income to its population, while GDP per
capita is defined as the ratio of a country’s GDP to the population of the country. Per capita GDP
or per capita income gives the value of the average income per person in the country. If the value is
high, it shows that the standard of living of an average person is high, and if the value is low, it
indicates that the standard of living per head is low.

Per capita income = National Income

Total Population

Per capita GDP = GDP

Total Population

3.1.6. Disposable Income (DI)

Disposable income or personal disposable income is the actual income which an individual spent
on consumption. It is the income that remains after direct taxes have been deducted from one’s
personal income. Thus, Disposable Income = Personal Income – Direct Taxes.

3.1.7 Nominal versus Real GDP

To make justice to these two terms, gross domestic product of a country may rise or fall due to
an increase or decrease in prices. The rise or fall of the gross domestic product may,
9
however, not be real. That is, gross domestic product might not increase or fall in the real sense.
To guide against erring on this account, real gross domestic product has to be calculated.
Real gross domestic product is calculated using the prices of goods and services that
prevailed in a base year rather than in the current year. Real gross domestic product is nominal
gross domestic product that has been adjusted for inflation. In other words, inflation has been
removed or taken care of in real gross domestic product. Thus, comparisons of economic
activities at different times should be done using real gross domestic product and not nominal
gross domestic product because using nominal gross domestic product to compare economic
activities at two or more different points in time may give a misleading answer.

Nominal GDP is the GDP measured in the current market prices of the goods and services. In
other words, it is calculated using current year prices. It can increase or decrease, but it does not
tell us if the increase or decrease is as a result of rise or fall in inflation or price level. It is also
called GDP at market or current prices. On the other hand, real GDP is called GDP at constant
prices.

Illustration 5:
Let us assume that Nigeria produces only two commodities: Rice and Yam. The prices and
quantities of these two goods in 1990 and 1991 are presented in Table
3.1.

Table 3.1: Prices, Quantities and GDP in 1990 and 1991

Quantity of Prices of Quantity of Price of Yam

Rice Yam (N) Yam (N)
Year
1990 20 5 30 4
1991 40 10 60 5
a. Calculating Nominal GDP
If we calculate GDP in each of the two years as the market value of production, then,
GDP for 1990 = (20 bags of rice x 5) + (30 bags of yam x 4)
= N220
GDP for 1991 = (40 bags of rice x 10) + (60 bags of yam x 5)
= N700
These values (N220 and N700) are referred to by the economists as GDP valued at current year
prices or nominal GDP. If we compare GDP for 1990 with GDP for 1991, we might conclude
that the GDP in 1991 is 3.3 times greater than 1990 GDP, that is (700 > 220).
As shown from the example, if we want to use GDP in comparing economic activity at different
point in time, there is need to exclude the effects of price changes that is, we need to adjust for
inflation.

To adjust for inflation, economists usually use a common set of prices to value quantities
produced in different years. A particular year when prices are normal or stable is called the base
year is usually selected, and the price from that year is then used in calculating the market
value of output. Thus, real GDP is calculated using the prices from a base year; rather than the
current year’s prices.

b. Calculating Real GDP

Still using the data contained in Table 3.1, and assuming 1990 as the base year, the real GDP for
years 1990 and 1991 can be calculated. Here, with real GDP, we are interested in knowing by how
much real output grew between 1990 and 1991.
1
Solution:
To calculate real GDP for 1991, the quantities produced in 1991 must be valued using the prices in
the base year (1990) 1991 Real GDP = (1991 quantity of rice x 1990 price of rice + ((1991 quantity
of yam x 1990 price of yam)
= (40 x 5) + (60 x 4)
= N440

However, the real GDP for 1990 equals year 1990 quantities valued at base year prices. Since the
base year is year 1990, therefore the real GDP for 1990 equals (year 1990 quantities valued at
year 1990 prices which is the same as nominal GDP for 1990. Moreover, in the base year, real
GDP and Nominal GDP are the same.
Furthermore, having known how to determine the real GDP, we can now determine how
much real production has actually grown over the two years period. Since real GDP was 220
in 1990 and 440 in 1991, we can clearly see that the physical volume of production doubled
between 1990 and 1991. This conclusion makes good sense as we can see in Table 3.1 that
the production of both rice and yam exactly doubled over the two years period. In sum, using real
GDP, we have eliminated the effects of price changes and have gotten a reasonable
measure of the actual change in physical production over the two years period.

3.1.7 GDP at Factor Cost

We can find terms like GDP at factor cost in National Income accounting. GDP at factor cost is the
sum of the monetary value of all goods and services produced by the factors of production or
the income accruing to the various factors of production in one year in a country.

3.2. Importance of National Income Accounting

1. National income is used to records the transactions that take place in the economy
as whole, and information can be derived about the annual income of that country,
how it generated, distributed and expended, how the wealth of the nation is being built
up, etc.
2. The information obtained in a national income account provides a basis for national
economic policies. It also helps the government in an attempt to maintain economic
stability and prosperity and ensure an efficient distribution of economic resources as well
as balanced growth.
3. The working of an economy depends on the availability of data about aggregate
transactions recorded in the national income acounts. National income accounts are
designed to reveal the significant relationship between the aggregates of transactions,
which play important roles in the theory of the determination of the level of economic
activity such as consumption investment, general price level, etc.
4. It is useful in the study of business fluctuations and economic policies generally.
5. The analysis of a well prepared national income account will help in understanding
the complex system in the economy like changes in the structure of assets and
commodity prices.
6. National Income account provides an insight into how and why an economy
functions the way it does. This is considered important because it provides us with a
greater insight into the interdependency of different sectors of the economy.
7. It is a good instrument for the policy makers both in the domestic and international
sectors because decisions are usually based on past records.
8. Comparisons of the changes in the components of the economy over time and across
the frontiers are made possible only by the estimates in the national income accounts.
9. It is used to forecasts about the future of an events and it can also be used to analyse
what changes are likely to occur in the economy either as a consignment of or
independently of economic and political policies.

3.3. Measuring GDP

There are three basic approaches to the measurement of GDP. These are: the value- added
1
approach, the income approach and the expenditure approach.

3.3.1. The Value-Added Approach

Value added method is used when the value of final good and services produced in the economy
are added together, of particular period usually a year. On the other hand, it can be measured by
estimating only the net values of output (value-added) at every stage of production in the economy
during the course of the year.

The value added by any given firm equals the market value of its product or services minus the
cost of the inputs the firm purchased from other firms. The summing-up of the value added by all
firms (including the producers for both intermediate and final goods and services) gives the same
result as simply adding together the value of all final goods and service. The major advantage of
the value added approach is that it eliminates the problem of dividing the value of a final good or
services between two periods and thus, prevents the double counting problems.

3.3.2. The Income Approach

The income approach to the calculation of GDP measures GDP in terms of who receives it as
income.
According to this approach, national income is the sum of eight income items which are
compensation of Employees, proprietors’ Income, rental Income, corporate Profits, Net Interest,
indirect Taxes minus Subsidies, net Business Transfer Payments, surplus of Government
Enterprises.

Table 3.3
Illustration of National Income
National Income (NI) Million Naira (N’m)
Compensation of Employees xxx
+ Proprietors’ Income xxx
+ Rental Income xxx
+ Corporate Profits xxx
+ Net Interest xxx
+ Indirect Taxes minus Subsidies xxx
+ Net Business Transfer Payments xxx
+ Surplus of Government Enterprises xxx
= National Income xxxx

However, it should be noted that NI is the total income of the country but it is not quite GDP. The
NI is GDP less net factor income from abroad (which is equal to GNP) less depreciation (which is
equal to NNP) less statistical discrepancy. This is illustrated in table below

3.3.3. The Expenditure Approach

It should be noted that the expenditure approach measures the total value of all, expenditures on
goods and services by individual private businesses and public sector (governments) in a
particular period of time. In order to avoid double counting, all expenditures on intermediate
products should not be included in the measurement.
This can be symbolically stated thus: Y = C +
I + G + (X – M)
OR
Y = C + I + G + Xn
Where
Y = The value of national income

1
 C = Aggregate consumption expenditure
I = Private investment expenditure
G = Government expenditure
X = Exports expenditure
M = Imports expenditure
X= Net exports (Xn > 0)
<
Alternatively, national income may be computed using the output - expenditure method.

The output - expenditure method calculates the total expenditure required to purchase the
nation's output. In a spend thrift economy (an economy where all income is spent on goods and
services for current consumption and all current output is consumed) national income may
be calculated via the output - expenditure approach by measuring the actual expenditure of
households on currently produced goods and services.

The expenditure approach considers GDP in terms of expenses incurred on purchases of goods
and services produced by a country. The expenditure approach sums the expenditure from the
four main economic agents in the country which are the households, the firms, the government
and the rest of the world. More so, these are four main categories of expenditure and these
are Personal Consumption Expenditure, Gross Private

Domestic Investment, Government Consumption and Government Gross investment

consumption, Net Exports (X – M).

3.4. National Income Measurement Problems

There are several problems that are encountered in the computation of NI, some of these
problems are:
1. Problem of double counting: the greatest difficulty in measuring national income is that of
double counting, which arises from the improper distinction between final and an intermediate
product. There is always the possibility of a good or a service being included more than once.
2. There is also the difficulty of defining “nation” in national income. Although every nation
has its political boundaries, the income earned by nationals of a country in a foreign country
beyond the territorial boundaries of that country is also included in national income.
3. The problem of measuring non-market or domestic activities: national income is always
measured in monetary value, but there are a number of goods and services that are difficult to
measure or assess in terms of money and are therefore excluded. Such activities include house
works, child care, driving one’s car etc., they are excluded in GDP even though, they amount to real
production. However, if one decides to send his/her children to the day-care, or hire a cleaner or a
chauffeur to drive his/her car, GDP will increase because the salaries of day-care staff, cleaners
and chauffeurs would be counted in GDP whereas, the time spent by individuals in doing the
same activities is not counted. Excluding all such activities will make national income to be less
than what it should actually be.
4. Income earned through illegal activities also makes national income to be less, because
they are excluded from GDP.
5. Measuring national income in monetary terms leads to the underestimation of real national
income. This is because national income measured in monetary value does not include the
leisure forgone in the process of production of a commodity. For instance, if two individuals earn
the same amount as income but if one of them works for longer hours than the other, it would
be right to state that the real income of this individual has been understated.
6. Some public services cannot be estimated correctly. For example, how should police and
military services be estimated? In days of war, the forces are active but during peace, they rest in
their cantonment. Also, measuring the contribution of profits earned on certain projects such as
power project and irrigation to national income in terms of money is a difficult task.

1
UNIT 2 CONSUMPTION, SAVINGS AND INVESTMENT ANALYSIS

3.1 Consumption
Consumption is the use of goods and services by households. Consumption is distinct from
consumption expenditure, which is the purchase of goods and services for use by
households. Consumption differs from consumption expenditure primarily because durable
goods, such as automobiles, generate an expenditure mainly in the period when they are
purchased, but they generate “consumption services” (for example, an automobile provides
transportation services) until they are replaced or scrapped. More so, it is the final purchase of
goods and services by individuals constitutes consumption and it is also the aggregate of
all economic activity that does not entail the design, production and marketing of goods and
services (e.g. the selection, adoption, use, disposal and recycling of goods and services).

3.1.2. Consumption function

It is a single mathematical function used to express consumer spending. It was developed by
John Maynard Keynes and detailed most famously in his book The General Theory of
Employment, Interest, and Money. The function is used to calculate the amount of total
consumption in an economy. It is made up of autonomous consumption that is not influenced
by current income and induced consumption that is influenced by the economy's income level.
This function can be written in a variety of ways, an example being .
This is probably the most simplistic form of the consumption function.

The simple consumption function is shown as the affine function

where
C = total consumption,
c0 = autonomous consumption (c0 > 0),
c1 is the marginal propensity to consume (i.e. the induced consumption) (0
< c1 < 1), and
Yd = disposable income (income after government intervention – benefits, taxes and
transfer payments – or Y + (G – T)).

Autonomous consumption represents consumption when income is zero. In estimation, this is

usually assumed to be positive. The marginal propensity to consume (MPC), on the other hand
measures the rate at which consumption is changing when income is changing. In a geometric
fashion, the MPC is actually the slope of the consumption function.

The MPC is assumed to be positive. Thus, as income increases, consumption increases.

However, Keynes mentioned that the increases (for income and consumption) are not equal.
According to him, "as income increases, consumption increases but not by as much as the
increase in income
However, the aggregate consumption and can be determined by subtracting aggregate savings
from national income. The aggregate consumption any economy depends on a number of factors.
These include:

1. Government fiscal policy: A reduction in tax rate will increase disposable income and
consequently the consumption of the people.
2. Expected future change in income: If the income level is expected be higher in
future relative to the present income level, then people will tend to consume more out of
their present income.
3. Credit facilities: This is the act of enjoying a particular commodity which are not out
rightly or fully paid for but whose full payment can be made at a, future time. The more
readily available these facilities a higher will be the, consumption level of the household.

1
4. Inherited wealth: The higher the environmentally inherited wealth by the community or
society the wealthier it becomes and the higher will be their level of consumption all
things being equal.
5. Population distribution with respect to age: The aged and the infants are prone to
consuming more than the active and productive age of theMpopulation. Hence, the
higher the population of the aged and the infants anyMsociety the higher will be their
propensity to consume from their income.
6. Societal attitudes towards current savings: The more favourable disposed the
society is towards present savings and investment, the lower will be the consumption
level.

From the above stated factors determining consumption, it implies that consumption is
dependent on disposable income and has a positive correlation with income levels (that is the
higher the disposable income the higher will be the consumption level all things being equal).
Thus, consumption is the dependent variable, and disposable income is independent variable.

Figure 2
A GRAPH SHOWING CONSUMPTION FUNCTION
C C = bo + b1Y

b0

0 Income

The graph above shows the relationship between consumption and income. The graph cut the
consumption axis at point bo and the equation is given as follows C = bo + b1Y where bo is
the autonomous consumption, b1 is the marginal propensity to consume. However, it should
be noted that the graph can also start from the origin.

Fig 3 consumer spending

C = Yd

1
 bo
Real disposable income Yd
0

sFigure three above also shows the relationship between consumption and income. The
Keynesian Consumption function expresses the level of consumer spending depending on three
items
Yd – disposable income
a – autonomous consumption (consumption when income is 0. (e.g. even with no
income, you may borrow to be able to buy food))
c – Marginal propensity to consume (the % of extra income that is spent) Also known
as induced consumption.

Consumption Function formula

C = a + c Yd

This suggests Consumption is primarily determined by the level of disposable income (Yd).
Higher Yd, leads to higher consumer spending.

This model suggests that as income rises, consumer spending will rise. However, spending will
increase at a lower rate than income.

At low incomes, people will spend a high proportion of their income. The average
propensity to consume could be one or greater than one. This means people spend
everything they have. When you have low income, you don’t have the luxury of being able
to save. You need to spend everything you have on essentials.
However, as incomes rise, people can afford the luxury of saving a higher proportion of
their income. Therefore, as income rise, spending increases at a lower rate than
disposable income. People with high incomes have a
lower average propensity to spend.

3.1.3. Average Propensity to Consume (APC)

The average propensity to consume (APC) refers to the percentage of income that
is spent on goods and services rather than on savings. One can determine the percentage of
income spent by dividing the average household consumption (what
is spent) by the average household income (what is earned). The inverse of the average
propensity to consume is the average propensity to save (APS).

That is,

APC = CY

O < APC < I (provided 0 < C < 1) APC = I

(as C = Y),

APC< 1 (as C> Y) – dis-saving

3.1.4. Marginal Propensity to Consume (MPC)

Marginal propensity to consume is defined as the ratio of the change in consumption to

1
the change in income that necessitated it. That is,
MPC = ΔC =

ΔY

Where
ΔC= Change in consumption

ΔY= Change in income

0 < MPC < 1 (Marginal Propensity to consume ranges between zero and unitary)

3.2 Savings
This is income not spent on goods and services for current consumption. It is the act of
abstaining from consumption. Savings can be done by the keeping your money income in the
bank (financial investment). Aggregate savings can be defined as the summation of
households savings (S h) and firms savings (Sf) or undistributed profits of the firms (πu)
Symbolically written as:
S = Sh + Sf or
S = Sh + πu

3.2.1. Determination of Savings function

Given national income as Y = C + S ……………………………………. (1) Therefore S = Y-

C ……………………………………………………….(2) Where Y is the national income, C is the
consumption and S is the savings and Consumption function as C = b0 + b1 Y
Then Substitute for C in equation 2; So the
equation becomes;
Therefore S = Y- (b0 - blY)
S = Y – b0 + b1 Y
S = -b0 + (1 – b1) Y S =
- b0 + BY
Where S is the savings –bo is the autonomous savings and B marginal propensity to save.

1
 Figure 3
A GRAPH SHOWING THE SAVINGS FUNCTION Saving
S

S = -b0 + BY

Income (Y)

- b0

The graph above shows the relationship between savings and income. The graph cut the savings
axis at second quadrate at –bo and the curve give rise to the equation S = -bo + BY.

3.2.2. Determinants of Savings

1. Income level: The higher the levels of income the higher will be the amount of
savings all things being equal.
2. Interest rate: the higher the interest rate the more people will be willing and attracted
to save.
3. Government fiscal policy: The fiscal policy of the government of the affect the
disposable income of the people. If, for example, there, is an increase in taxation, it will lead to a
decrease in people’s disposable income and consequently leads to a reduction in the level of
savings (people will .be constrained from saving because of the smaller income at their disposal)
4. Habits and environmental factors: Some people save out of habit cultivated in
saving towards certain ceremonies or occurrence like burial ceremonies or children's
school fees. The efficiency of the banking institutions can equally encourage
savings. Savings and income are positively correlated, that is S = - a + b Y (where b > 0).

3.2.3 Average propensity to save (APS)

The average propensity to save (APS) is an economic term that refers to the proportion of income
that is saved rather than spent on goods and services. Also known as the savings ratio, it is
usually expressed as a percentage of total household disposable income (income minus
taxes). The inverse of average propensity to save is the average propensity to consumer (APC).
That is,

APS = SY

0 < APS < I (provided 0 < S < Y) APS = I

(as S=Y)
APS = 0 (as S = 0) - zero savings

3.2.4 Marginal propensity Save

Marginal propensity to save is the ratio of the change in savings change in income that
necessitated it. It is the fraction of an increase income that is saved. .

1
 MPS = ΔS
ΔY

Where

ΔS = Change in savings

ΔY = Change in income

0 < MPS < (MPS ranges between zero and unitary) MPS +
MPC = 1
MPS = I - MPC

3.3. Investment
Investment in economics can be defined as the act of producing capital goods which are not for
immediate consumption. It may be defined as net additions to capital stocks.

3.3.1. Component of investment

1. Autonomous investment: This is an exogenously determined investment, that is I = 10, is
the investment that yield profit and interest rate levels in an economy, and which is not
related to the economy's growth.
2. Induced investment: This is an endogenously, determined investment, that is
I = 10 + vY defining investment as a function of income
3. Net investment: Defined as the gross investment that occurs in an economy less capital
consumption allowance (depreciation).

3.3.2 Determinants of Investment

1. Level of national income: Income and investment are positively related, therefore the
Equilibrium level of national income will be when the total demand for all the types of goods.
2. Cost of funds (lending rate or interest rate): The higher the cost of funds
(interest rate) the lower the volume of investment in an economy
3. Technical progress (technological changes): The high the rate of technological
progress the more profitable it becomes to undertake more investment in order to
produce new types of goods by using new and more economical production techniques.
4. Government fiscal policies in respect of minimum wages and salaries, and taxes: The
volume of new investment undertaken in an economy will be determined by the policy of
the government regardless of the costs.
5. Business climate: In the view of the business investors, if the climates perceived
hostile no matter how low the lending rate (cost of funds) investment level may not
appreciated.

UNIT 3 ECONOMIC WELFARE AND NATIONAL INCOME

3.1 Economic Welfare and National Income

Let us start this lecture by asking ourselves what is economic welfare? You may be thinking
what can we called economic welfare and how can we say economic welfare has been attained
by different individuals. Economic welfare is a state of the mind which reflects human happiness
and satisfaction. In actuality, welfare is a happy state of human mind. According to one of the
great welfare economists A.C. Pigou regards individual welfare as the sum total of all
satisfactions experienced by an individual; and social welfare as the sum total of individual
welfare. He divides welfare into economic welfare and non-economic welfare. Economic welfare
is that part of social welfare which can directly or indirectly be measured in money. Pigou
attaches great importance to economic welfare because welfare is a very wide term. However, the
1
range of our analysis will be restricted to the part that discusses social (general) welfare that can
be brought directly or indirectly into relation with the measuring rod of money. But it should be note
that non-economic welfare is that part of social welfare which cannot be measured in money, for
example moral welfare.

More so, caution should be taken when differentiating between economic and non- economic
welfare on the basis of money and even an economist Pigou also accepts this stand. However,
according to pigou, non-economic welfare can be improved upon in two ways.

First, by the income-earning method, that is longer hours of working and unfavourable conditions
will affect economic welfare adversely. Second, by the income-spending method. In economic
welfare it is assumed that expenditure incurred on different consumption good which provide the
same amount of satisfaction, but in actuality it is not so, because when the utility of purchased
goods starts diminishing the non-economic welfare declines which results in reducing the
total welfare. However, Piguo is of the view that it is not possible to calculate such effects,
because non-economic welfare cannot be measured in terms of money. Hence, Piguo arrives at
the conclusion that the increase in economic welfare results in increase of total welfare and vice
versa.

It should be noted that it is not possible always, because the causes that lead to an increase in
economic welfare may also reduce the non-economic welfare. The increase in total welfare may,
therefore, be less than anticipated. For instance, with the increase in income, both the economic
welfare and total welfare increase and vice versa. But economic welfare depends not only on the
amount of income but also on the methods of earning and spending it. When the workers earn
more by working in factories but reside in slums and vitiated atmosphere, the total welfare
cannot be said to have increased, even though the economic welfare might have increased.
Similarly, as a result of increase in their expenditure proportionately to income, the total welfare
cannot be presumed to have increased, if they spend their increased income on harmful
commodities like wine, cigarettes etc. Finally you should note that economic welfare is not an
indicator of total welfare.

3.2. Relationship between Economic Welfare and National Income

Let us now look at the relationship between Economic Welfare and National Income. According an
economists A.C Piguo, assert that there is a close relationship between economic welfare and
national income, because both of them are measured in terms of money. When national income
increases, total welfare also increases and vice versa. The effect of national income on economic
welfare can be studied in two ways:
(a) By change in the size of national income and,
(b) By change in the distribution of national income.

(a) The change in the size of national income may be positive or negative. The positive change in
the national income increases its volume, as a result people consume more of goods and services,
which leads to increase in the economic welfare. Whereas the negative change in national income
results in reduction of its volume. People get lesser goods and services for consumption which
leads to decrease in economic welfare. But this relationship depends on a number of
factors.
Moreover, let us ask ourselves a question: is the change in national income real or monetary? If the
change in national income were due to change in prices, it would be difficult to measure the real
change in economic welfare. For example, when the national income increases as a result of
increase in prices, the increase in economic welfare is not possible because it is probable that
the output of goods and services may not have increased. It is more likely that the economic
welfare would decline as a result of increase in prices. It is only the real increase in
national income that increases welfare.

Second, it depends on the manner in which the increase in national income comes about. The
economic welfare cannot be said to have increased, if the increase in national income is due to
exploitation of labour, for example, to increase in production by workers working for longer
hours, by paying them lesser wages than the minimum. Thus forcing them to put their women
and children to work, by not providing them with facilities of transport to and from the factories
and of residence, and their residing in slums.

Third, national income cannot be a reliable index of economic welfare, if per capita income is
not borne in mind. It is possible that with the increase in national income, the population may
increase at the same pace and thus the per capita income may not increase at all. In such a
situation, the increase in national income will not result in increase in economic welfare. But from
this, it should not be concluded that the increase in per capita income results in increase in
economic welfare and vice versa.
Furthermore, it is possible that as a result of increase in national income, the per capita income
might have risen. But if the national income has increased due to the production of capital
goods and there is shortage of consumption goods on account of decrease in their output, the
economic welfare will not increase even if the national income and per capita income rise. This is
because the economic welfare of people depends not on capital goods but on consumption goods
used by them. Similarly, when during war time the national income and the per capita income rise
sharply, the economic welfare does not increase because during war days the entire production
capacity of the country is engaged in producing war material and there is shortage of
consumption goods. As a result, the standard of living of the people falls and the economic
welfare decreases.

More so, even with the increase in national income and per capita income the economic welfare
decreases. This is the case when as a result of the increase in national income, income of the
richer sections of the society increases and the poor do not gain at all from it. In other words,
the rich become richer and the poor become poorer. Thus when the economic welfare of the rich
increases, that of the poor decreases, because the poor are more than the rich, the total
economic welfare decreases.

Last, the influence of increase in national income on economic welfare depends also on the
method of spending adopted by the people. If with the increase in income, people spend on such
necessities and facilities such as milk, eggs, gari, etc, which increase efficiency, the economic
welfare will increase. But on the contrary, the expenditure on drinking, gambling etc. will result in
decrease in economic welfare as a result of increase in national income depend on changes in
taste of people. If the change in fashions and tastes takes place in the direction of the
consumption of better goods, the economic welfare increases, otherwise the consumption of bad
goods decreases it.

So it is clear from the above analysis that though the national income and economic
welfare are closely inter-related, yet it cannot be said with certainty that the economic welfare
would increase with the increase in national income and per capita income. The increase or
decrease in economic welfare as a result of increase in national income depend on a number of
factors such as the rate of growth of population, the methods of earning income, the conditions
of working, the method of spending, the fashions and tastes, etc.

(ii) The changes in the distribution of national income take place in two ways. First, by transfer of
wealth from the poor to the rich, and second, from the rich to the poor. When as a result of
increase in national income, the transfer of wealth takes place in the former manner, the
economic welfare decreases. This happens when the government gives more privileges to the
richer sections and imposes regressive taxes on the poor.

However, the actual relationship between the distribution of national income and economic
welfare concerns the latter form of transfer when wealth flows from the rich to the poor. The
redistribution of wealth in favour of the poor is brought about by reducing the wealth of the rich
and increasing the income of the poor. The income of the richer sections can be reduced by
adopting a number of measures, e.g., by progressive taxation on income, property etc., by
imposing checks on monopoly, by nationalizing social services, by levying duties on costly and
foreign goods which are used by the rich and so on. On the other hand, the income of the poor can
also be raised in a number of ways, e.g., by fixing a minimum wage rate, by increasing the
production of goods used by the poor, and by fixing the prices of such goods, by granting financial
assistance to the producers of these goods, by the distribution of goods through co-operative
stores, and by providing free education, social security and low rent accommodation to the poor.
When through these methods the distribution of income takes place in the favour of the poor, the
economic welfare increases. According to Piguo “any cause which increases the absolute share
of real income in the hands of the poor, provided that it does not lead to a contraction in the
size of national dividend from any point of view will, in general, increase economic welfare.”

But it is not essential that the equal distribution of national income would lead to lead to increase
in economic welfare. On the contrary, there is a greater possibility of the economic welfare
decreasing if the policy towards the rich is not rational. Heavy taxation and progressive taxes at
high rates affect adversely the productive capacity, investment and capital formation, thereby
decreasing the national income. More so, when through the efforts of the Government the
income of the poor increases but if they spend that income on bad goods like drinking, gambling
etc. or if their population increases, the economic welfare will decrease. But both these situations
are not real and only express the fears, because the government, while imposing different kinds of
progressive taxes on the rich, keeps particularly in view that taxation should not affect the
production and investment adversely. On the other hand, when the income of a poor man
increases he tries to provide better education to his children and to improve his standard of
living. Therefore we can then conclude that as a result of the increase in national income, the
economic welfare will increase provided that the income of the poor increases instead of
decreasing and they improve their standard of living and that the income of the rich decreases in
such a way that their productive capacity, investment and capital accumulate do not decline.

MODULE THREE MONEY AND BANKING

3.1 What is Money?

At first sight the answer to this question seems obvious; the man or woman in the street would
agree on coins and banknotes, but would they accept them from any country? What about
cheques? They would probably be less willing to accept them than their own country's coins
and notes but bank money (i.e. anything for which you can write a cheque) actually accounts for
by far the greatest proportion by value of the total supply of money. What about I.O.U.s (I owe
you), credit cards and gold? The gold standard belongs to history but even today in many rich
people in different parts of the world would rather keep some of their wealth in form of gold than
in official, inflation-prone currencies. The attractiveness of gold, from an aesthetic point of view,
and its resistance to corrosion are two of the properties which led to its use for monetary
transactions for thousands of years.

In primitive societies, goods and services were exchanged for other, a man who has tubers of
yam but needs eggs must look for another who has eggs and also needs eggs must look for
another who has eggs and also needs tubers of yam for exchange to take place. This system is
known as the ‘Barter System’ that is exchanging good for goods and services for services. Let us
consider this advertisement- ‘Man with twenty (20) tubers of yam needs a quarter bag of rice in
exchange’. The difficulties in such an advert are obvious. These difficulties include:

(a). Double Coincidence of Want: There must be an agreement as to the type of products and
quantity of product to be exchange. The man in the advert must not only look for another who
has rice (first coincidence), but for one who has rice and also needs to exchange his rice (a
quarter bag) for tubers of yam (second coincidence).

(b). Divisibility: The goods offered in barter faces the problem of divisibility. How will a
shepherd, who needs small quantities of yam, eggs, ‘tomatoes, divide his sheep or goat as
exchange?
 (c). Storability: The absence of storage facilities makes barter system unattractive as most
goods used in exchange for each other are perishable ones. How do you store the fresh portion
of meats for further transactions?

(d). Cumbersomeness: The goods used in barter system could not be carried from one place to
another for exchange. Goods such as cow, camels, sheep, yam, etc are too cumbersome to be
carried from one place to another.

In modern economy, barter or direct-exchange is comparatively rare. A high degree of

specialization now operates in the world today. Exchange must take place smoothly and
quickly. Money serves to eliminate the problems of barter as significantly make smooth exchange
possible in modern economy.

3.2 History of Money

The use of barter-like methods may date back to at least 100,000 years ago, though there is no
evidence of a society or economy that relied primarily on barter. Instead, non-monetary
societies operated largely along the principles of gift economics and debt. When barter did in fact
occur, it was usually between either complete strangers or potential enemies.

Many cultures around the world eventually developed the use of commodity money. The
shekel was originally a unit of weight, and referred to a specific weight of barley, which was
used as currency. The first usage of the term came from Mesopotamia circa 3000 BC. Societies in
the Americas, Asia, Africa and Australia used shell money – often, the shells of the money cowry.
According to Herodotus, the Lydians were the first people to introduce the use of gold and silver
coins. It is thought by modern scholars that these first stamped coins were minted around
650–600 BC.

The system of commodity money eventually evolved into a system of representative money. This
occurred because gold and silver merchants or banks would issue receipts to their depositors –
redeemable for the commodity money deposited. Eventually, these receipts became generally
accepted as a means of payment and were used as money. Paper money or banknotes were first
used in China during the Song Dynasty. These banknotes, known as "jiaozi", evolved from
promissory notes that had been used since the 7th century. However, they did not displace
commodity money, and were used alongside coins. In the 13th century, paper money became
known in Europe through the accounts of travelers, such as Marco Polo and William of
Rubruck. The gold standard, a monetary system where the medium of exchange are paper
notes that are convertible into pre-set, fixed quantities of gold, replaced the use of gold coins as
currency in the 17th-19th centuries in Europe. The use of barter-like methods may date back to at
least 100,000 years ago, though there is no evidence of a society or economy that relied primarily
on barter. Instead, non-monetary societies operated largely along the principles of gift economics
and debt. When barter did in fact occur, it was usually between either complete strangers or
potential enemies.

After World War II, at the Bretton Woods Conference, most countries adopted fiat currencies that
were fixed to the US dollar. The US dollar was in turn fixed to gold. In 1971 the US government
suspended the convertibility of the US dollar to gold. After this many countries de-pegged their
currencies from the US dollar, and most of the world's currencies became unbacked by anything
except the governments' fiat of legal tender and the ability to convert the money into goods via
payment.

3.3. Characteristics of Money

Anything which serves as money must possess some characteristics, these include:

1. Acceptability: This is the most important characteristics of money. It must be accepted

immediately and without question in exchange for goods and services. It must have full
legal backing and citizens must accept them for exchange.
2. Homogeneity: The commodity that is acceptable within a community or areas as money
 must be the same. There should not be any variations in size, shape or colour. It must
be capable of being identified immediately it
is tendered for exchange.
3. Stable in Value: Money must be relatively stable overtime to command respect and
acceptability, to serve as a means of deferred payment and store of value. If money
depreciates overtime or is devalued overtime, it creates loss of confidence in it. If it
persist it loses its value and people tends to look for other commodity for exchange
4. Divisibility: Money must be divisible into convenient units as transactions can be of
varying sizes that is either in smaller quantities or bigger quantities. However, divisibility
must be possible without any damage, to the money material.
5. Portability: The more the ease with which money can be carried about the better. As
transactions take place daily, the material used as money must be light enough to be
carried around for transactions.
6. Relative Scarcity: The substance or commodity used as money must be relatively scare
so as to retain its value. Hence Government all over the world regulates the supply of
money in circulation.

3.4 Functions of Money

1. Medium of exchange: This is the most important functions of money.
Modern economy aged on specialization and money serves as the oil which allows the
machinery of exchange that is buying and selling to run smoothly. Money therefore
renders obsolete the practice of double coincidence of wants. The cassava farmer who
needs clothes do not need to look for a cloth seller who needs cassava before he can
make exchange, all he needs is money.
Money removes this problem created by barter as it is acceptable on its own merit
unquestionably for buying and selling of goods and services. The use of money therefore
has increased tremendously the volume of trade in the world.

2. Store of Value: Money serves as the most convenient way of keeping surplus incomes
and wealth of the person. In a stable economy where prices are relatively stable, money
could be stored over time without the fear of risk of loss of value. It is the only asset
which can be turned into other goods immediately and without incurring any cost. This
liquidity is what Keynes considered to be money’s most distinctive function because it
has both asset and exchange functions.
3. Unit of Account: Money makes possible the operation of the price system.
It is used to measure the prices of goods and services and provides the basis for keeping
accounts, expressing the performance of businesses in terms of calculating of profit
and loss and balance sheets, etc. It also assists international economy in
expressing the currency of one country in terms of another.
4. Standard of Deferred Payments: Money makes it possible for lending and borrowing
of money to take place. Goods and services can be bought now and paid for in the future.
Loans could be obtained now paid for later, future contracts can be entered into. Money
makes dealing in debts possible and such institutions like banks, building societies,
insurance companies, etc.

3.5. Types of Money

1. Legal Tender: A country legislates on a commodity and gives it full legal backing. This
commodity becomes money which is generally acceptable to the inhabitants in
transactions and in payment of debt. This is conferring acceptability by law, but people
must have confidence in it.
2. Notes and Coins: This possesses the essential characteristics of money that is general
acceptability. They are the currency we make use of everyday for transactions naira and
kobo.
3. Demand Deposits: These are deposits in a current account lodged in a bank. It
operates with the use of a cheque which are redeemed on presentation to the bank. It
serves as a means of payment together with
 notes and coins, they constitute the money supply.
4. Commodity Money: This has a commodity value in addition to its own value as money.
Precious metals such as gold, silver, diamond, etc, fall under commodity money.
5. Token Money: This type of money derives its value from being used as money. It has no
commodity value that is a note has no commodity value; hence it is worthless unless
used as money.

3.6 Motive of Holding Money

Motive of holding money is classified into three ways:
1. Transactionary Motive
2. Precautionary Motive
3. Speculative Motive

3.6.1. Transactionary Motive

Day–to-day transactions are done by individuals as well as firms. An individual person has to buy
so many things during a day. For this purpose people want to keep some cash money with
them. This type of demand for liquidity is for carrying on day to day transactions is called
demand for liquidity for transaction motive. So we can say that money needed by consumers,
businessmen and others in order to complete economic transactions is known as the demand for
money for transactions motive.

3.6.2. PRECAUTIONARY MOTIVE

Every man wants to save something or wants to keep some liquid money with him to meet some
unforeseen emergencies, contingencies and accidents. Similarly business firms also want to
keep some cash money with them to safeguard their future. This type of demand for liquidity
is called demand for precautionary motive.

3.6.3. SPECULATIVE MOTIVE

People want to keep cash with them to take advantage of the changes in the prices of bond and
securities. In advanced countries, people like to hold cash for the purchase of bond and securities
when they think it profitable. If the prices of the bond and securities are expected to rise
speculators will like to purchase them. In this situation they will not like to keep cash with them.
On the other hand if prices of the bonds and securities are expected to fall people will like to keep
cash with them. They will buy the bonds and securities with the cash only when their prices would
fall.

UNIT 2 FINANCIAL INSTITUTIONS

3.1. The History of the Nigeria Banking System

In 1892 Nigeria's first bank, the African Banking Corporation, was established. No banking
legislation existed until 1952, at which point Nigeria had three foreign banks (the Bank of British
West Africa, Barclays Bank, and the British and French Bank) and two indigenous banks (the
National Bank of Nigeria and the African Continental Bank) with a collective total of forty
branches. A 1952 ordinance set standards, required reserve funds, established bank examinations.
Yet for decades after 1952, the growth of demand deposits was slowed by the Nigerian to prefer
cash to cheque for debt settlements.

British colonial officials established the West African Currency Board in 1912 to help finance the
export trade of foreign firms in West Africa and to issue a West African currency convertible to
British pounds sterling. But colonial policies barred local investment of reserves, discouraged
deposit expansion, precluded discretion for monetary management, and did nothing to train
Africans in developing indigenous financial institutions.

In 1952 several Nigerian members of the Federal House of Assembly called for the
establishment of a central bank to facilitate economic development. Although the motion was
defeated, the colonial administration appointed a Bank of England official to study the issue. He
advised against a central bank, questioning such a bank's effectiveness in an undeveloped capital
market. In 1957 the Colonial Office sponsored another study that resulted in the establishment of
a Nigerian central bank and the introduction of a Nigerian currency. The Nigerian pound (see
Glossary), on a par with the pound sterling until the British currency's devaluation in 1967, was
converted in 1973 to a decimal currency, the naira (N), equivalent to two old Nigerian pounds.

However, the smallest unit of the new currency was the kobo, 100 of which equaled 1 naira.
The naira, which exchanged for US$1.52 in January 1973 and again in March 1982 (or N0.67 =
US$1), despite the floating exchange rate, depreciated relative to the United States dollar in the
1980s. The average exchange rate in 1990 was N8.004 = US$1. Depreciation accelerated after the
creation of a second-tier foreign exchange market under World Bank structural adjustment in
September 1986.

The Central Bank of Nigeria, which was statutorily independent of the federal government until
1968, began operations on July 1, 1959. Following a decade of struggle over the relationship
between the government and the Central Bank, a 1968 military decree granted authority over
banking and monetary policy to the Federal Executive Council. The role of the Central Bank,
similar to that of central banks in North America and Western Europe, was to establish the
Nigerian currency, control and regulate the banking system, serve as banker to other banks in
Nigeria, and carry out the government's economic policy in the monetary field. This policy
included control of bank credit growth, credit distribution by sector, cash reserve requirements for
commercial banks, discount rates--interest rates the Central Bank charged commercial and
merchant banks--and the ratio of banks' long-term assets to deposits. Changes in Central Bank
restrictions on credit and monetary expansion affected total demand and income. For example, in
1988, as inflation accelerated, the Central Bank tried to restrain monetary growth.

During the civil war, the government limited and later suspended repatriation of dividends and
profits, reduced foreign travel allowances for Nigerian citizens, limited the size of allowances to
overseas public offices, required official permission for all foreign payments, and, in January 1968,
issued new currency notes to replace those in circulation. Although in 1970 the Central Bank
advised against dismantling of import and financial constraints too soon after the war, the oil
boom soon permitted Nigeria to relax restrictions.

The three largest commercial banks held about one-third of total bank deposits. In 1973 the
federal government undertook to acquire a 40-percent equity ownership of the three largest
foreign banks. In 1976, under the second Nigerian Enterprises Promotion Decree requiring 60-
percent indigenous holdings, the federal government acquired an additional 20-percent holding in
the three largest foreign banks and 60-percent ownership in the other foreign banks. Yet
indigenization did not change the management, control, and lending orientation toward
international trade, particularly of foreign companies and their Nigerian subsidiaries of foreign
banks.

At the end of 1988, the banking system consisted of the Central Bank of Nigeria, forty-two
commercial banks, and twenty four merchant banks, a substantial increase since 1986. Merchant
banks were allowed to open checking accounts for corporations only and could not accept
deposits below N50,000. Commercial and merchant banks together had 1,500 branches in 1988,
up from 1,000 in 1984. In 1988 commercial banks had assets of N52.2 billion compared to N12.6
billion for merchant banks in early 1988. In FY 1990 the government put N503 million into
establishing community banks to encourage community development associations, cooperative
societies, farmers' groups, patriotic unions, trade groups, and other local organizations, especially
in rural areas.

Other financial institutions included government-owned specialized development banks: the

Nigerian Industrial Development Bank, the Nigerian Bank for Commerce and Industry, and the
Nigerian Agricultural Bank, as well as the Federal Savings Banks and the Federal Mortgage
Bank. Also active in Nigeria were numerous insurance companies, pension funds, and
finance and leasing companies. Nigeria also had a stock exchange (established in Lagos in 1961)
and a number of stockbrokerage firms. The Securities and Exchange Commission (SEC) Decree of
1988 gave the Nigerian SEC powers to regulate and supervise the capital market. These
powers included the right to revoke stockbroker registrations and approve or disapprove any new
stock exchange. Established in 1988, the Nigerian Deposit Insurance Corporation increased
confidence in the banks by protecting depositors against bank failures in licensed banks up to
N50,000 in return for an annual bank premium of nearly 1 percent of total deposit liabilities.

Finance and insurance services represented more than 3 percent of Nigeria's GDP in 1988.
Economists agree that services, consisting disproportionately of nonessential items, tend to
expand as a share of national income as a national economy grows. However, Nigeria, lacked
comparable statistics over an extended period, preventing generalizations about the service
sector. Statistics indicate, nevertheless, that services went from 28.9 percent of GDP in 1981 to
31.1 percent in 1988, a period of no economic growth. In 1988 services comprised the
following percentages of GDP: wholesale and retail trade, 17.1 percent; hotels and restaurants, less
than 1 percent; housing, 2.0 percent; government services, 6. percent; real estate and business
services, less than 1 percent; and other services, less than 1 percent.

3.2. Commercial Bank and its Functions

An institution which accepts deposits, makes business loans, and offers related services.
Commercial banks also allow for a variety of deposit accounts, such as checking, savings, and
time deposit. These institutions are run to make a profit and owned by a group of individuals,
yet some may be members of the Federal Reserve System. While commercial banks offer
services to individuals, they are primarily concerned with receiving deposits and lending to
businesses.

A banking company is one which transacts the business of banking which means the accepting
for the purpose of lending all investments, of deposits of money form the public, repayable on
demand or otherwise and withdraw able by cheque, draft or otherwise. There are two essential
functions that a financial institution must perform to become a bank. These are accepting depo
sit a n d l e a d i n g t o t h e p u b l i c .

These functions are:

1. It accepts deposits from the public. These deposits can be withdrawn by cheque and are
repayable on demand.
2. A commercial bank uses the deposited money for lending and for investment in securities.
3. It is a commercial institution, whose aim is to earn profit
4. It is a unique financial institution that creates demand deposits which serves as the medium of
exchange.
5. Money created by commercial banks is known as deposit money.

3.2.1 Functions of commercial Banks

Various functions of commercial banks can be divided into three main groups;
i. Primary Functions ii
Agency Functions
iii.General utility functions

a. PRIMARY FUNCTIONS - There are two main primary functions of the commercial banks which
are discussed below:
1. Accepting deposits
The primary function of commercial bank is to accept deposits from every class and from
every source. To attract savings the bank accepts mainly three types of deposits. They are
namely demand deposits, saving deposits, fixed deposit.

(a). Demand deposit

It also known as current deposit and those deposits which can be withdrawn by the
depositor at any time by means of cheque. No interest is paid on such deposits. Rather, the
 depositor has to pay something to the bank for the services rendered by the businessmen and
industrialists. It is also called current account.

(b). Saving deposits – These are those deposits on the withdrawal of which bank places certain
restrictions. Cheque facility are provided to the depositors. Saving deposits accounts are
generally held by households who have idle or surplus money for short period.

(c). Fixed deposit – These are those deposit which can be withdrawn only after the expiry of
the certain fixed time period. These deposits carry high rate of interest. The longer the period,
higher will be the rate of interest.

3.2.2. Differences between demand deposit and fixed deposit

1. Demand deposit can be withdrawn by the depositor at anytime

without notice while these deposits can be withdrawn only after
the expiry of the certain fixed time period.
2 . They are chequable i.e., demand deposits are withdraw through
cheques while they are not chequable.
3 . No interest is paid on these deposits. Rather depositors have to
pay something to the bank for its services while these deposits
carry high rate of interest

2. Advancing of loans
Commercial banks give loans and advances to businessmen, farmers, consumers
and employers against approved securities. Approved securities refer to gold, silver, bullion,
govt. Securities, easily savable stock and shares and marketable goods. The bank advances
following types of loans-

(a). Cash credit – Under this the borrower is allowed to withdraw up to a certain amount
on a given security which comprise mainly stocks of goods, but interest is charged on the
amount actually withdrawn.

(b). Overdraft – It is a most common wa y of lending. Unde r it, the borrower is

allowed to overdraw his current account balance. Overdraft is a temporary facility.

(c). Sh ort ter m l oa ns – Un der it loa ns of a f ixed a mo un t are sanctioned. The

sanctioned amount is credited in the debtors a/c. Bank charges interest on the whole amount
from the day it was sanctioned.

The difference between a loan and an overdraft is that, while in case of loan, the borrower pays
us interest on the amount outstanding against his account. But in the case of an overdraft, the
customer pays interest on the deal balance standing against his account further. Loans are given
against security, while overdraft made without securities. From the borrowers’ point of view,
overdraft is preferable thorough a loan because, in case of loan, he will have to pay interest on the
full amount of loan sanctioned whether he uses it fully or not. But in the case of overdraft, he has
the facility of borrowing only as much as he requires.
4. Discounting of the bill of exchange
This is another popular type of lending by the commercial banks. Through this method, the holder
of the bills of exchange (written during trade transactions) can get it discounted by the banks.
The banks after demanding the commission pays the value of the bills to the holder. When the
bills of exchange mature, the bank gets its payment from the party which had accepted the bill
5 . M oneyat ca ll
Such loans are very short period loans and can be called back by the bank at a very short notice of
say one day to14 days. These loans are generally made by one bank to another bank or financial
institutions.

3.3. The Growth and Development of Commercial Bank in Nigeria

The banking system in Nigeria has been since independence undergone radical changes. Banking
in Nigeria developed from an industry, which at the time of independence in 1960 was essentially
dominated by a small number of foreign banks into one in which the public sector ownership of
banks predominated in the 1970s and a980s; and in which the Nigeria private investors have
played an increasingly important role since the mid 1980s. The banking industry also went
through phases of regulation and deregulation. In the 1960s, extensive government intervention
characterized the financial sector. This was intensified in the 1970s.

The objective was to influence the efficiency of resource allocation and promote indigenization.
Since the adoption of structural Adjustment Program (SAP) in 1986, the financial sector has
been liberalized and measures have been put in place to enhance prudential guidelines and tackle
bank distress.

The different licensed banks in Nigeria fall into different generations. These “generations” of
banks fall into four phases of banking licensing.

1. First Generation bank: These were banks that were licensed before
Nigeria’s independence in 1960
2. Second Generation: These were banks licensed between 1960 and
1980.
3. Third Generation bank: These were banks licensed between 1980 and 1991.
4. Fourth Generation: These were banks licensed from 1998 to the present time.

3.4. Merchant Bank

Merchant banks are set up primarily to cater for the needs of corporate and institutional
customers. They collect large amounts as deposits from their customers. They collect large
amounts as deposits from their customers; hence they are referred to as wholesale banker. The
first merchant banks in Nigeria are Phillip Hill (Nigeria) Limited and the Nigeria acceptances
Limited (NAL) in 1960. They however, merged in 1969. It becomes the sole merchant merchant
bank till 1973 before other banks came. Their role principally in the economy is to provide medium
to long-term finance, therefore engage in activities such as loan syndication, equipment leasing,
debt factoring, project financing.etc

The merchant banks perform the major role of financial intermediation in the economy and
facilitate the payment system of the modern exchange economy. They were governed under the
1952 Banking Ordinances, Banking Act 1969 (as amended) and now under the Banks and other
Financial institution Decree (BOFID) No. 25 of 1991.

3.4.1. Functions of Merchant banks

1. They provide medium and long term finance to corporate bodies and institutions
2. They advise companies on new share’s and place these firms, shares for subscription.
3. They float government loan stocks
4. They engage in equipment leasing and project financing.

UNIT 3 CENTRAL BANKING

3.1 EVOLUTION OF CENTRAL BANK IN THE WORLD

The history of Central Banks dates back to the time the Bank of England was established. It is
known to be one of the oldest central banks in the world. The birth of central banking in the
modern sense began with the creation of the Central Bank of England. However, it took mainly the
complex financial problems that wars and economic crises produced to accord it distinctive roles
that should be given to it both in practice and theory of finance (Ajayi, 1995). The various
economic, political and social changes, which occurred between the two world wars, gave it the
principles and operations, which brought it into the center stage.

The older central banks (including those of England), Sweden and France had their origin as a
role in their ability to serve their respective governments financially. When the Bank of England
was incorporated in 1694, it granted a loan of 1.2 million pounds, the amount of the bank’s entire
capital, to the government of William III to finance the war of the Grand Alliance against
France (1689-1697). In exchange for the generous offer, government permitted the Bank of
England to carry on general banking business including the right to buy and sell coin and bullion, to
deal in bills of exchange, to issue its own notes and to make loans. The subsequent extensions
of the government. Thus, the bank of England has from the beginning served as the
government’s banker. Commercial banks soon found it convenient to keep deposits with the Bank
of England since the later was the principal issuer of notes. Supplies of notes by these commercial
banks and joint stock companies could be obtained in times of need by drawing on their deposits.

By the middle of the nineteen century, the bank of England had become a become a banker’s bank.
The legislation passed in 1833 granted its notes legal power while that prerogative was denied to
other banks. The Bank Act 1844 (Peel’s Act) provided that no new bank in the United Kingdom
could since notes and placed restrictions on existing note-issuing bank in England and Wales.

During the nineteenth century, however, the bank was beset by one crisis after another. Excessive
lending by the banks brought on the crisis 1825 and 1837, when many banks failed. It was not
until 1837, that the Bank of England started to show concern by acting as a lender of last resort to
banks. The banking crisis led to a demand for parliamentary intervention to regulate banking and
more particularly to control the issue of notes. The crisis generated a debate amongst two
popular schools of thought (that is the Currency vs the Banking Schools). The Currency School
viewed that the only way to prevent an over-issue of notes was to insist that the note issue be fully
backed by gold, or at least by fiduciary issue. The Banking School, however, believed that the note
issue should be rigidly restricted, but that it should be made variable to suit the particular needs of
business. The Currency School tended to overemphasize the dangers attendant on an excessive
issue of notes, while the opposing school was inclined to minimize them.

In the later part of the nineteenth century the Bank of England began to develop as a true central
bank and it was during this period that it learnt how to use the bank rate as an instrument of
monetary policy. The Bank of England fully accepted the responsibilities of a central bank and
became used to exercising its powers of control over the commercial banks.

3.2 Functions of Central Bank

Traditionally, a central bank performs three main functions:
Managing the nation’s monetary system, serving as a banker to commercial banks and acting as
a financial agent for the national government. To these must be added the unorthodox role
of a central bank as an engine of economic growth. This last function is a development of the
1930s and it is usually associated with central banking in developing countries.

The most important function of a central bank is its control over the monetary system. In
pursuance of this objective, the central bank regulates the supply, cost and availability of credit.
The ability of the central bank to control the monetary system is enhanced by the central bank’s
ability to create and destroy monetary reserves by its lending and investigating activities. The
central bank is the ultimate source of cash and its ability is the base on which the commercial
banks erect their credit-creating policy. Thus, the controlling function of the central bank is the
control of its own liability.

A central bank acts as banker to commercial banks by providing services to the banking system
similar to those which the commercial banking system performs for individuals and business
enterprise. Some of the services rendered by the central bank lend support to its role as the
manager of the monetary system. Such services include the holding of legal reserves and acting
as a lender of the last resort. It also provides services that promote the smooth working of the
monetary system. Among such services may be the clearing and collection of cheques,
distribution of coins and paper currency to commercial banks and supervising and regulating the
activities of commercial banks.

In its role as the financial agent, the central bank acts as the banker to the government. It
receives, holds, transfers and disburses the fund of the government. It provides technical services
related to the public debt and financial advice to government.

3.3 Central bank Relationship with the government

The working relations between the central bank and the government vary widely among different
countries and this variability reflects the different conditions under which central banks
develop. In some countries (e.g Britain), central banking started as a private institution; and as
the central banking function increased, governments in some cases either took them over
completely or enacted legislation that regulate their activities. The bank of England, for example,
was nationalized in 1946. In countries such as Nigeria, government control is exercised by
government subscription the entire capital of the central bank.

The relationship between the government and the central bank can take one of three possible
forms. One extreme kind of relationship is the case of complete and full independence of the
central bank. Under this arrangement, the bank pursues any kind of monetary policy that it deems
without interference from the central bank is just arm of the government. In the case of lack of
autonomy, the central bank takes directives from the government (usually through the Ministry of
Finance) and it rarely initiates a policy of its own. Neither of the two extremes is not effective for
the execution and implementation of monetary policy.

Full independence is not advisable, because monetary policy is part and parcel of overall
economic policy. A responsible government would want to be seen as being in full control of
its economic policy and would not want to relinquish monetary policy to an institution that is
not responsible to the people. As an elected representative of the people, the government
would want to be responsible for its action, be they good or bad. The other extreme case is
equally inadvisable. A central bank that was no more than another department of government
could not initiate and execute monetary policy effectively, as it would inevitably be subject to civil
service procedures and red tape. Moreover, the central bank is not only an organ of government
but also part of the financial system. It must therefore not be identified with politics if it is to have
prestige and command the confidence necessary to deal with the financial community both at
home and abroad.

Today, most observers recognize that the middle ground between the two extreme discussed
above is in fact the preferable one. Most subscribe to the idea of a central bank that is
relatively independent “which” government, with the latter holding ultimate responsibility for
economic policy. It may be put this way: the central bank has independence responsibility for
regulating money and credit and for advising government, but as last resort it must conform
to government’s overall economic policy. Most central banks the world over have tended to occupy
this middle ground.

One should also mention, in conclusion, that, apart from laws and regulations governing the
relationship between the central bank and government, the personality (or stature) of the governor
of the bank relative to that of the Minister of Finance can also influence the autonomy (or lack of it)
of the central bank.

Where, for example, the governor is a highly respected individual with a reputable track record of
professionalism, his views on economic problems will be both widely accepted and respected and
he will most probably maintain and sustain the independent nature of the central bank.

3.4. The birth of the Central Bank of Nigeria

As far back as 1948 (before the banking boom in Nigeria), Mr J. Mars drew attention to the
desirability of having a central bank in Nigeria (Mar, 1948). Following the failure of banks in the
950s, support for the establishment of the Central Bank of Nigeria grew. Many nationalists
advocated the establishment of central bank to put in place regulations for the operation of
banks and perform other functions related to central banking and the development of the
economy. The urge to set up a central bank was resisted for quite some time by the colonial
administrators on the ground that there was no developed and highly organized money market. In
1952 the government of Nigeria requested Mr. J.l. Fisher, an advisor to the Bank of England, to
report on the “desirability and practicability of establishing a central bank in Nigeria as an
instrument of economic development”. His report, which was published in 1953, contained the
following:

1. An elaborate description of Central Banking as it had developed in England.

2. A review of Nigeria’s financial system as it then existed; and
3. The possibility of making use of the orthodox principles of central banking as contained in (1).

The main feature of the report was that it would be inadvisable to contemplate the establishment
of a central bank at that time.

Besides, he found it hard to see how a central bank could be used to promote economic
development. Instead Fisher proposed:

1. The transfer of the West African Currency Board to Nigeria.

2. The establishment of a Nigerian currency Board; and
3. The establishment of a Nigerian Bank of Issue, which would gradually evolve into a bank.

The fishers Report can be critized on several grounds (Olakunpo, 1965, pp, 38-41). First it erred
too much on the side of conservatism by not recognizing the developmental role of a central bank.

Secondly, there was no time prefix attached to the commendation that a new bank of issue could
gradually evolve into a central bank. Besides, it is not sure that the slow but sluggish conversion of
a bank of issue into a central bank would meet the country’s monetary requirements.

Thirdly, in his orthodox approach to monetary problems, Fisher argued that it was better to build
the financial structure from the base upwards rather than to build it from the top downwards. The
question was “how developed must a financial structure be before establishment of a central bank?
Fisher did not have an answer to this. He did not recognize that a central bank could aid
and nurture the development of the financial structure.

In 1953, the World Bank Mission visited Nigeria, the mission came out in support of Fisher’s views,
but it felt that in view of the impending attainment of independence a state bank with limited
functions should be established. The functions of such a bank could gradually be broadened to
enable it to perform the functions of a central bank.

In 1954, soon after the Fisher report, Newlyn and Rowan’s views were published. Their verdict was
a qualified “yes” for the establishment of a central bank, for reasons opposite to Fisher’s. They
concluded that there was little that a central bank of a developing country could do by way of
stabilization. The only role for the central bank in such a situation was purely developmental.

Another adviser to the Bank of England, Mr Loynes in 1957 favoured the idea of establishing a
Central Bank in Nigeria. It was his views and recommendations that formed the basis of the draft
legislation for the establishment of the Central Bank in Nigeria which was presented to the House
of Representatives in March 1958. The Central Bank of Nigeria (hereafter referred to a CBN) came
into being on July 1st, 1959 with an initial capital of seventeen million pounds.

The core mandate of the CBN, as spelt out in the Central Bank Act (1958), and amendments (1991,
1998) include:
1. Issuance of legal tender currency notes and coins in Nigeria
2. Maintenance of Nigeria external reserve to safeguard the international values of the legal
currency.
3. Promotion and Maintenance of monetary stability and a sound and efficient financial system
in Nigeria.
4. Acting as banker and financial adviser to the Federal Government; and
5. Acting as lender of last resort

Given this mandate, the CBN is also charged with responsibility for administering the Banks and
other Financial institutions (BOF) Act (1991) as amended (1997 and 1998), with the sole aim of
ensuring high standard of making practice and financial stability through its surveillance activities
as well as the promotion of efficient payments and clearing system.

MODULE FOUR: COMPONENTS OF GROSS DOMESTIC PRODUCT

3.1 Meaning of Personal Consumption Expenditure

Personal consumption is the largest part of GDP and it is the spending of households on goods
and services such as food, clothing, entertainment etc. Consumption is usually denoted by ‘C’.
However, there are three main types of consumption expenditure: expenditures on durable goods,
non durable goods and services.
a. Consumer durable goods: these are goods that last for a relatively long period of time.
They include automobiles, furniture, household appliances, etc. It should be noted that
new houses are not treated as consumer durables, but as part of investment.
b. Consumer nondurable goods: these are goods of shorter-lives. They include goods such as
food, clothing, etc. They are usually used up fairly quickly.
c. Services: these are things that are bought by consumers but do not involve the
production of physical items. Examples include the services of lawyers, doctors, financial
and educational services, haircut, hairdo, etc.

Moreover, personal Consumption Expenditure is a measure of price changes in consumer goods

and services. Personal consumption expenditures consist of the actual and imputed expenditures
of households; the measure includes data pertaining to durables, non-durables and services. It is
essentially a measure of goods and services targeted toward individuals and consumed by
individuals.

3.1.1. Household Final Consumption Expenditure

Household final consumption expenditure (HFCE) is a transaction of the national account's use of
income account representing consumer spending. It consists of the expenditure incurred by
resident households on individual consumption goods and services, including those sold at prices
that are not economically significant. It also includes various kinds of imputed expenditure of
which the imputed rent for services of owner-occupied housing (imputed rents) is generally
the most important one. The household sector covers not only those living in traditional
households, but also those people living in communal establishments, such as retirement homes,
boarding houses and prisons.

More so, the definition of household Final Consumption Expenditure includes expenditure by
resident households on the domestic territory and expenditure by resident households abroad
(outbound tourists), but excludes any non-resident households' expenditure on the domestic
territory (inbound tourists). From this national definition of consumption expenditure may
be distinguished the household final consumption expenditure according to the domestic
concept which includes household expenditure made on the domestic territory by residents and
inbound tourists, but excludes residents' expenditure made abroad.

HFCE is measured at purchasers' prices which is the price the purchaser actually pays at the time
of the purchase. It includes non-deductible value added tax and other taxes on products,
transport and marketing costs and tips paid over and above stated prices

UNIT 2 GROSS PRIVATE DOMESTIC INVESTMENT AND NET EXPORTS

3.1 Meaning of Gross Private Domestic Investment

Gross private domestic investment measures the investment used to calculate GDP in economic
measurement of nation. It is an important component of GDP because it provides an indicator of
the future productive capacity of the economy. However, it includes replacement purchases
plus net additions to capital assets plus investments in inventories. We can also define Gross
private domestic investment as the expenditures on capital goods to be used for productive
activities in the domestic economy that are undertaken by the business sector during a given time
period.

Based on the definition above, Gross private domestic investment includes 3 types of investment
which we will look at briefly by defining them.

1. Non residential investment: This is expenditures made by firms on capital such as tools,
machinery, and factories.
2. Residential Investment: This is expenditures on residential structures and residential
equipment that is owned by landlords and rented to tenants.
3. Change in inventories: This is the change of firm inventories in a given period, and
inventory is the goods that are produced by firms but kept to be sold later.

3.1.1. Specific Measure of Gross Private Domestic Investment

Gross private domestic investment is a relatively specific measure of investment, it is a gross
(versus net) measure of private (versus public) domestic (versus foreign) investment.
1. Gross: The Gross private domestic investment includes the production of all capital
goods, including those used to replace depreciated capital. Subtracting capital
depreciation (officially known as the capital consumption adjustment) from gross private
domestic investment results in net private domestic investment.
2. Private: However, gross private domestic investment measures investment expenditures
made by the private sector. Any capital goods purchased by the public, or government, is
included in government consumption expenditures and gross investment.
3. Domestic: Finally, gross private domestic investment is expenditures on capital goods
used in the domestic economy. The alternative is investment expenditures on capital
goods used by the foreign sector.

3.1.2. Calculation of Gross Private Domestic Investment

The calculation of Gross Private Domestic Investment can be a little tricky on its surface, infact
the calculation is not difficult to calculate. Gross private domestic investment, or GDP, equals
consumer spending plus investment plus government spending plus exports minus imports.
However, this formula is the government standard for determining GDP. It is used by the federal
bureau of statistics and many other organizations in order to determine consistent estimates. It is
also useful to business analysts and other professionals.

3.1.2.1. Steps on how to calculate the Gross Private Domestic Investment.

Step 1:
Now let us look at the first step on how to calculate the Gross Private Domestic investment.
The first thing is to calculate the amount by which businesses in the country have increased or
decreased the value of their inventory compared to the previous year. Moreover, inventory refers
to the stock of goods businesses have to sell. For example, the inventory of a food manufacturer
would be the finished, packaged food products ready for sale. Depending on economic conditions,
this figure may be positive or negative.
Step 2:
Since we have known the techniques on how calculate the first step, we will further
proceed to the second step of calculating Gross Private Domestic investment. We will then
determine the value of new real estate construction in the country. However, this includes all
types of buildings, such as single-family homes, multi-family apartments and office buildings.
Step 3:
In this step, we will need to add up the value of all the capital items businesses purchase to
generate value. These items include office equipment, manufacturing machinery, software and
tools.
Step 4:
Step 4 is the final step where we will find the total of the three figures that represent all the new
capital in which businesses invest throughout the year. The resulting figure is the country's gross
private domestic investment.

3.2. Meaning of Net Export

Net exports equals exports minus imports. The value of net exports gives the difference between
exports and imports.
a. Exports (X): exports are domestically produced final goods and services that are sold
abroad. In other words, it is the sale of domestically produced goods and services to
foreigners.
b. Imports (M): imports are purchases by domestic buyers of goods and services that were
produced abroad. For instance, Nigeria’s purchases of goods and services from abroad.
The difference between imports and exports (net exports) gives the net amount of spending on
domestically produced goods and services. Net exports reflect the net demand by the rest of
the world for a country’s goods and services.

Net exports can be defined as the value of a country's total exports minus the value of its total
imports. It is used to calculate a country's aggregate expenditures, or GDP, in an open economy. We
can also define it as the difference between a country's total value of exports and total value of
imports. Depending on whether a country imports more goods or exports more goods, net exports
can be a positive or negative value.

In other words, net exports is the amount by which foreign spending on a home country's goods
and services exceeds the home country's spending on foreign goods and services. For
example, if foreigners buy N300 billion worth of Nigerian exports and Nigeria buy N250 billion
worth of foreign imports in a given year, net exports would be positive N50 billion. Factors
affecting net exports include prosperity abroad, tariffs and exchange rates.

3.2.1. Measurement of Net Exports

Net exports are measured by comparing the value of the goods imported over a specific time
period to the value of similar goods exported during that period. The formula for net exports is:

Net Exports = Value of Exports - Value of Imports

For example, let's suppose Nigeria purchased N3 billion of gasoline from other countries last
year, but it also sold N7 billion of gasoline to other countries last year. Using the formula
above, Nigeria's net gasoline exports are:

Net Exports = N7 billion - N3 billion = N4 billion

Net exports are an important variable used in the calculation of a country's GDP. When the value
of goods exported is higher than the value of goods imported, the country is said to have a
positive balance of trade for the period. When taken as a whole, this in turn can be an indicator of
a country's savings rate, future exchange rates, and to some degree its self-sufficiency,
although some economists constantly debate the idea.

Finally, net exports are negative when there is a decrease in the equilibrium GDP. This means that
a country is importing more than what the country exports. There is no balance of trade in this
situation.

UNIT 3 GOVERNMENT CONSUMPTION AND GROSS INVESTMENT

3.1 Meaning of Government Consumption Expenditure

Government Consumption Expenditure (GCE) is a transaction of the national account's use of
income account representing government expenditure on goods and services that are used for the
direct satisfaction of individual needs (individual consumption) or collective needs of members of
the community (collective consumption).

It consists of the value of the goods and services produced by the government itself other
than own-account capital formation and sales and of purchases by the government of goods and
services produced by market producers that are supplied to households - without any
transformation - as social transfers in kind (for more detail see for example

3.2. National Accounts Measurement of Government Spending

1. Government consumption expenditures and gross investment

This is a measure of government spending on goods and services that are included in GDP.
Consumption expenditures include what government spends on its work force and for goods
and services, such as fuel for military jets and rent for government buildings and other
structures. Gross investment includes what government spends on structures, equipment, and
software, such as new highways, schools, and computers.

2. Government current expenditures

Total spending by government is much larger than the spending included in GDP. Current
expenditures measures all spending by government on current- period activities, and consists not
only of government consumption expenditures, but also current transfer payments, interest
payments, and subsidies (and removes wage accruals less disbursements). Payments such as
transfer payments and interest payments are excluded from the calculation of GDP because
these payments do not represent purchases of goods and services, though income from transfer
and interest payments may fund consumption expenditures or investment in other sectors of the
economy.

3. Total government expenditures: In addition to the transactions that are included in

current expenditures, this measure includes gross investment (as defined earlier), and other
capital-type expenditures that affect future-period activities, such as capital transfer payments and
net purchases of non produced assets (for example, land). Total expenditures exclude
consumption of fixed capital (CFC), which is a noncash charge.

3.3. Gross Investment

Gross investment is the value of investment in buildings, machinery etc before taking away
depreciation (the fall in value of something over time). It can also be the amount a company
invests in business assets that does not account for any depreciation. The gross figure more
accurately reflects the company's actual financial commitment to an asset from which it can
derive a return on investment.
Investment has different meanings in finance and economics. In economics, investment is the
accumulation of newly produced physical entities, such as factories, machinery, houses, and
goods inventories. In finance, investment is putting money into an asset with the expectation of
capital appreciation, dividends, and/or interest earnings. This may or may not be backed by
research and analysis. Most or all forms of investment involve some form of risk, such as
investment in equities, property, and even fixed interest securities which are subject, among
other things, to inflation risk. It is indispensable for project investors to identify and manage the
risks related to the investment.

MODULE 5: AGGREGATE DEMAND AND AGGREGATE SUPPLY

.
UNIT 1: Meaning and Nature of Aggregate Demand Curve

3.1 Meaning of Aggregate Demand

In this unit we shall define what is aggregate demand and aggregate demand curve. So let
us start by defining aggregate demand. Aggregate demand is the total demand for goods and
services in the economy. Aggregate demand is usually equal to planned expenditure.
Aggregate demand is national income denoted as Y and planned expenditure is the addition of
consumption expenditure (C), investment (I) and government consumption expenditure (G). Y = C +
I+G

3.1.1. Aggregate Demand Curve

Having defined aggregate demand, let us take a look at how the aggregate demand curve looks
like. The aggregate demand curve shows the relationship between short-run equilibrium output, ‘Y’,
(which equals planned aggregate spending) and price level, ‘P’ or inflation. However, it should be
noted that the relationship is a negative one, implying that an increase in price level will lead to a
decrease in aggregate output and vice versa. More so, we can conclude that the name of the
curve reflects the fact that short-run equilibrium output is determined by total planned spending
or demand in the economy. We can then get the relationship between the short-run equilibrium
output and price level shown in figure 3.1 but the overall price level is on the vertical axis and the
aggregate output is on the horizontal axis.
Let us take a look at the graph of aggregate demand curve from figure 3.1 bellow. We can see
that the aggregate demand (AD) curve is downward-slopping; depicting a negative relationship
between output and price level (or inflation). Therefore we can say that an increase in the price
level will reduce short-run equilibrium output. But it should be noted that the AD curve can either
be straight or curving.
Figure 1: Diagram showing the Aggregate Demand Curve
Note that the AD curve is not the sum of all the market demand in the economy. It is not a market
demand curve. It is different from an ordinary demand curve in the sense that the logic behind the
ordinary demand curve is that when price of a commodity changes, ceteris paribus, the prices of
all other commodities will not change. However, in the case of aggregate demand curve this
logic does not follow, because when the general price level changes every other prices like wages
(price of labour), commodity prices and interest rates will change. Given this, the logic that
explains why a simple demand curve slopes downward fails to explain why the AD curve also has
a negative slope. Note that the AD curve shows a negative relationship between a short-run
equilibrium output and price level (inflation). Economists sometimes define the AD curve as
the relationship between aggregate demand and the price level rather than inflation.

3.2. Reasons for the downward sloping of the Aggregate Demand Curve
a. Monetary Authority Response: Let us consider the situation when inflation is high, the
monetary authority (Central Bank of Nigeria (CBN), in the case of Nigeria) responds by
raising the interest rate. The increase in interest rate reduces consumption and
investment spending (autonomous expenditure). The reduction in consumption and
investment spending in turn reduces short-run equilibrium output. The higher inflation
which led to a reduction in output makes aggregate demand curve to be downward
slopping.
b. Effectiveness of Money Supply and Demand on Interest Rate: Aggregate demand falls
when the price level increases because the higher price level causes the demand for
money (Md) to rise. With money supply constant, the interest rate will rise to re-
establish equilibrium in the money market. It is the higher interest rate that causes
aggregate output to fall. Thus, in the end, the increase in the price level will lead to a fall
in aggregate output, which gives a negative relationship between the two.
c. Consumption Expenditure: Consumption expenditure tends to rise when interest rate
falls and fall when interest rate rises, just as planned investment does. The
consumption link is another reason for the downward slopping shape of AD curve. An
increase in general price level increases the demand for money, which in turn leads to
an increase in the interest rate. A rise in interest rate causes a decrease in
consumption as well as planned investment, which consequently leads to a decrease in
output or income.
d. Analysis of Real Wealth Effect: Consumption depends on wealth (that is, holding of
money, shares, housing, stocks, etc) other things being equal, the more wealth
households have, the more they consume. If household wealth decreases, the result will
 be less consumption now and in the future. The price level has an effect on some kinds
of wealth. For example, an increase in the price level leads to decrease in
purchasing power and lowers the real value of some types of wealth such as stocks,
housing etc. however, the effect of a rise in general price level on wealth depends on
what happens to stock prices and housing prices when the overall price level rises. If
these two prices rise by the same percentage as the overall price level. The real value
of stocks and housing will remain unchanged and this will lead to a decrease in
consumption, which leads to a decrease in aggregate output. Thus, there is a
negative relationship between the price level and output through this real balance effect.
e. The uncertainty in the Economy: During period of inflation, aggregate demand falls
because in uncertain economic environment both households and firms may become
more cautious and reduce their spending.
f. Foreign Price of Domestic Goods: A final link between the price level and total spending
operates through the prices of domestic goods and services sold abroad. The foreign
price of domestic goods depends in part on the rate at which the domestic
currency exchanges for foreign currencies.

However, for constant exchange rate between currencies, a rise in domestic inflation causes the
prices of domestic goods in foreign markets to rise more quickly. As domestic goods become
relatively more expensive to prospective foreign purchasers, export sales decline. Since net
exports are part of aggregate expenditure, so we find that increased inflation tends to reduce
spending and cause the AD curve to slope downward.

UNIT 2: Meaning and Nature of Aggregate Supply Curve

3.1 Meaning of Aggregate Supply

Based on the above analysis of aggregate demand, we can then take a look at the meaning of
aggregate supply. So we can start by defining aggregate supply as the total supply of goods and
services in an economy. Although economists have little disagreement about the logic behind the
aggregate demand curve, there is a great deal of disagreement about the logic behind the
aggregate supply curve and its shape. However, in economics, aggregate supply can also be seen
as the total supply of goods and services that firm in a national economy plan on selling
during a specific time period. It is the total amount of goods and services that firms are
willing to sell at a given price level in an economy.

3.2 Aggregate Supply Curve

Now let us consider the aggregate supply curve, the way we have done for aggregate
demand. The aggregate supply (AS) curve shows the relationship between the aggregate quantity
of output supplied by all firms in an economy and the overall price level. The short-run aggregated
supply curve usually gives a positive relationship between aggregate supply and the overall price
level. This implies that an increase in price level will lead to an increase in aggregate supply and
vice versa.

However, the aggregate supply curve is not a market supply curve, and it is not the simple sum of
all the individual supply curves in the economy. One of the reasons for this is that most firms do
not simply respond to prices determined in the market but instead, they actually set prices (it is
only in perfectly competitive markets that firms simply react to prices determined by market
forces). In contrast, firms in imperfect competitive industries make both output and price
decisions based on their perceptions of demand and costs). Price setting firms (imperfect
competitive firms) do not have individual supply curves and this is because these firms are
choosing both output and price at the same time and if supply curves do not exist for these
imperfect markets, we certainly cannot add them together to get an aggregate supply curve

Based on the aforementioned, we can look at the aggregate supply curve as a “price-output
response” curve – that is, a curve that traces out the price and output decisions of all the
markets and firms in the economy under a given set of circumstances.

3.3 Aggregate Supply in the Short-Run

Although it is generally opined that the AS curve has a positive slope, the shape of the short-run AS
curve is a source of much controversy in macroeconomics. It is often argued that at very low
levels of aggregate output (for example, when the economy is in a recession, the aggregate
supply curve is fairly flat, and at high levels of output (for example, when the economy is
experiencing a boom), the curve is vertical or nearly vertical. Thus, we have the AS curve
sloping upward and becoming vertical when the economy reaches its capacity or maximum output.
Such a curve is shown below in figure 2.

3.4. Reasons for the Shape of the Short-Run AS Curve

Several reasons accounted for the shape of the short-run AS curve. Some of the reasons
associated with the shape of the AS curve are given below:

1. The Fairly Flat Shape

At low levels of output in the economy, firms are likely to be producing at levels of output which
are below their existing capacity constraints. That is, they are likely to be holding excess capital
and labour, and it is also likely that there will be cyclical unemployment in the economy as a whole
in periods of low output.

Suppose now that there is an increase in aggregate demand when the economy is operating at
low levels of output. The firms will respond to this increase in aggregate demand by
increasing output (much more than they increase price) with little or no increase in the overall
price level. This is because firms are already operating below capacity, so, the extra cost of
producing more output is likely to be small. This is because firms can hire more labour
from the ranks of the unemployed workers without much, if any, increase in wage rates. This
makes the aggregate supply curve to be fairly flat at low levels of aggregate output.

In figure 2, if the economy is operation at a low level of output such as at point A that is below full
capacity, and then, suppose now that there is an increase in aggregate demand from point A to
B, one can see from the curve that the movement from point A to B makes the curve to
become fairly flat as the increase in aggregate demand results in an increase in output with a
small increase in overall price level.

Thus, the aggregate supply curve is likely to be fairly flat at low levels of aggregate output.

ii. The Nearly Vertical/Vertical Shape

If aggregate output continues to expand, the firms and the economy as a whole will begin to
move closer and closer to full capacity. Firm’s response to the increase in aggregate output is
likely to change from mainly increasing output to increasing prices. This is so because as firms
continue to increase their output, they will begin to bump into their short-run capacity
constraint. In addition, unemployment will be falling as firms hire more workers to produce the
increased output so the economy will be approaching its full capacity.

As aggregate output rises, the prices of labour and capital will begin to rise more rapidly, leading
firms to increase their output prices. But at full capacity (when all sectors in the economy are
fully utilizing their existing factories and equipment and factors of production, where there is
little or no cyclical unemployment) when it is virtually impossible for firms to expand any further,
firms will respond to any further increase in demand only by raising prices, since they are unable
to expand output any further. At full capacity and with output remaining unchanged, the aggregate
supply curve becomes vertical.

In figure 2, moving from points C to D results in no increase in aggregate output but a large
increase in the price level, so, the economy is at full capacity at point C. It can be seen that a little
below point C, as the economy approaches point C or as the economy approaches full capacity,
the aggregate supply curve becomes nearly vertical but at full capacity which is at point C, the
curve assume a vertical shape.

3.5. The Long-Run Aggregate Supply Curve

It is interesting to know that whether or not the economy is producing at a level of output close to
full capacity, there must be a time lag between changes in input prices and changes in output
prices for the aggregate supply curve to slope upward. Therefore, if input prices change at
exactly the same rate as output prices, the AS curve will be vertical. For example, all output and
input prices increase by 10 per cent, no firm will find it advantageous to change its level of output
because the output level that maximized profits before the 10 per cent increase will be the same
as the level that maximizes profits after the 10 per cent increase. Thus, if input prices adjusted
immediately to output prices, the aggregate supply curve would be vertical.

It is precisely the above that leads to an important distinction between the AS curve in the
short-run and the AS curve in the long-run. As noted earlier, for the AS curve to be vertical, input
prices must change at exactly the same rate as output prices and for the AS curve not to be
vertical, some costs must lag behind increases in the overall price level. If all prices (both input
and output prices) change at the same rate, the level of aggregate output will not change.

In the long-run, however, which is a time sufficient for adjustments to be made such that costs
and price level change at the same rate, the AS curve is best modelled as a vertical curve. In other
words, in the short-run, if the wage rates and other costs adjust fully to changes in prices, and if all
prices (both input and output prices) change at the same rate and the level of aggregate output
does not change, thus, the long-run AS curve is vertical. The long-run AS curve is shown in figure
3.
Figure 3: The Long-Run Aggregate Supply Curve

P
Long run AS Curve

Short run AS Curve

0 Y
Aggregate Output (Income)

UNIT 3: AGGREGATE SUPPLY-AGGREGATE DEMAND MODEL

3.1 Aggregate Supply-Aggregate Demand Model.

The aggregate supply curve does not usually shift independently on its own unlike the aggregate
demand curve and this is because aggregate supply does not contain the term that are indirectly
related to the price level or output. The only thing that aggregate supply contains is derived from
the aggregate supply and aggregate demand model.
 Figure 4

Graph of the Aggregate Supply-Aggregate Demand Model

The graph above shows aggregate supply and aggregate demand model. However, the graph
shows the aggregate demand curve, short run aggregate supply curve and long run aggregate
supply curve. The vertical axis is the price level while the horizontal axis is the output or income.
However, the three curves cut one another at point P which is the equilibrium.

3.2. Shifts in Aggregate Demand in the Aggregate Supply-Aggregate Demand Model

The primary cause of shifts in the economy is aggregate demand. But it should be noted that
aggregate demand can be affected one way or the other by consumers both domestic foreign, and
the government. It should be noted that any expansionary policy will shifts the aggregate demand
curve to the right, while contractionary policy will shifts the aggregate demand curve to the left.
Moreover, in the long run, as we should note that long-term aggregate supply will be fixed by the
factors of production, short-term aggregate supply shifts to the left so that the only effect of a
change in aggregate demand is a change in the price level.

Figure 5

Graph of an expansionary shift in the Aggregate Supply-Aggregate Demand model.

From the graph above, at point A where short-run aggregate supply curves 1 meets the long-run
aggregate supply curve and aggregate demand curve 1. The short run equilibrium is where the
short-run aggregate supply curve and the aggregate demand curve meet and the long run
equilibrium is the point where the long-run aggregate supply curve and the aggregate demand
curve meet.
Let assume that during expansionary monetary policy, the aggregate demand curve shifts to
the right from aggregate demand curve 1 to aggregate demand curve 2. But the intersection
of short- run aggregate supply curve 1 and aggregate demand curve 2 will then shift to the upper
right from point A to point B because at this point, both the output and the price level have
increased and this gives rise to a new short run equilibrium.

But, as we move to the long run, the expected price level comes into line with the actual price level
as firms, producers, and workers adjust their expectations. When this occurs, the short-run
aggregate supply curve shifts along the aggregate demand curve until the long-run aggregate
supply curve, the short-run aggregate supply curve, and the aggregate demand curve all intersect.
This is represented by point C and is the new equilibrium where short-run aggregate supply
curve 2 equals the long-run aggregate supply curve and aggregate demand curve 2. Thus,
expansionary policy causes output and the price level to increase in the short run, but only the
price level to increase in the long run.

Figure 6
Graph of a Contractionary Shift in the Aggregate Supply-Aggregate Demand model.

The opposite case exists when the aggregate demand curve shifts left. For example, say the
Government pursues contractionary monetary policy. Let begin again at point A where short-run
aggregate supply curve 1 meets the long-run aggregate supply curve and aggregate demand
curve 1. We are in long-run equilibrium to begin.

However, if the Government pursues contractionary monetary policy, the aggregate demand
curve shifts to the left from aggregate demand curve 1 to aggregate demand curve 2. It should be
noted that at this junction that the intersection of short-run aggregate supply curve 1 and the
aggregate demand curve will then shift to the lower left from point A to point B. At point B, both
output and the price level have decreased, and this gives rise to a new short run equilibrium.

Let us consider the long-run analysis, we can see from the graph that as we move to the long run,
the expected price level comes into line with the actual price level as firms, producers, and
workers adjust their expectations. When this occurs, the short-run aggregate supply curve shifts
down along the aggregate demand curve until the long-run aggregate supply curve, the short-run
aggregate supply curve, and the aggregate demand curve all intersect. This is represented by point
C and is the new equilibrium where short-run aggregate supply curve 2 meets the long-run
aggregate supply curve and aggregate demand curve 2. Therefore, we can conclude that
contractionary policy causes output and the price level to decrease in the short run, but only the
price level to decrease in the long run.

Furthermore, this is the logic that is applied to all shifts in aggregate demand. The long-run
equilibrium is always dictated by the intersection of the vertical long-run aggregate supply curve
and the aggregate demand curve. The short-run equilibrium is always dictated by the
intersection of the short-run aggregate supply curve and the aggregate demand curve. When the
aggregate demand curve shifts, the economy always shifts from the long-run equilibrium to the
short-run equilibrium and then back to a new long-run equilibrium. By keeping these rules and the
examples above in mind it is possible to interpret the effects of any aggregate demand shift in
both the short run and in the long run.

3.3. Shifts in Aggregate Supply in the Aggregate Supply-Aggregate Demand Model.

The Shifts in the short-run aggregate supply curve are much rarer than shifts in the aggregate
demand curve. Usually, the short-run aggregate supply curve only shifts in response to the
aggregate demand curve. But, when a supply shock occurs, the short-run aggregate supply curve
shifts without prompting from the aggregate demand curve. Fortunately, the correction process is
exactly the same for a shift in the short-run aggregate supply curve as it is for a shift in the
aggregate demand curve. That is, when the short-run aggregate supply curve shifts, a short- run
equilibrium exists where the short-run aggregate supply curve intersects the aggregate demand
curve. Then the aggregate demand curve shifts along the short- run aggregate supply curve until
the aggregate demand curve intersects both the short-run and the long-run aggregate supply
curves. Once the economy reaches this new long-run equilibrium, the price level is changed but
output is not.

More so, let me remind us that there are two types of supply shocks. Adverse supply shocks
include things like increases in oil prices, a drought that destroys crops, and aggressive union
actions. In general, adverse supply shocks cause the price level for a given amount of output to
increase. This is represented by a shift of the short-run aggregate supply curve to the left.
Positive supply shocks include things like decreases in oil prices or an unexpected great crop
season. In general, positive supply shocks cause the price level for a given amount of output to
decrease. This is represented by a shift of the short-run aggregate supply curve to the right.

Figure 7

Graph of a positive supply shock in the Aggregate Supply-Aggregate Demand model.

Let us begin at point A where short-run aggregate supply curve 1 meets the long- run aggregate
supply curve and aggregate demand curve 1, at this junction, we are in the long-run equilibrium to
begin.

Let us assume that a positive supply shock occurs, which is a reduction in the price of oil. In
situation, the short-run aggregate supply curve shifts to the right from short-run aggregate supply
curve 1 to short-run aggregate supply curve 2. The intersection of short- run aggregate supply
curve 2 and aggregate demand curve 1 has now shifted to the lower right from point A to point B.
At point B, output has increased and the price level has decreased and this gives rise to a new
short-run equilibrium.

However, as we move to the long run, aggregate demand adjusts to the new price level and output
level. When this occurs, the aggregate demand curve shifts along the short-run aggregate supply
curve until the long-run aggregate supply curve, the short-run aggregate supply curve, and the
aggregate demand curve all intersect. This is represented by point C and is the new equilibrium
where short-run aggregate supply curve 2 equals the long-run aggregate supply curve and
aggregate demand curve 2. Thus, a positive supply shock causes output to increase and the price
level to decrease in the short run, but only the price level to decrease in the long run.

Figure 8
Graph of an adverse Supply Shock in the Aggregate Supply-Aggregate Demand model
We will start at this junction at point A where short-run aggregate supply curve 1 meets the long
run aggregate supply curve and aggregate demand curve , but we should note that we are in long-
run equilibrium.

Let assume that if an adverse supply shock occurs which is a terrifying increase in the price of oil.
In this case, the short-run aggregate supply curve shifts to the left from short-run aggregate
supply curve 1 to short-run aggregate supply curve 2. The intersection of short-run aggregate
supply curve 2 and aggregate demand curve 1 has now shifted to the upper left from point
A to point B. At point B, output has decreased and the price level has increased. This condition
is called stagflation. This is also the new short- run equilibrium.

However, as we move to the long run, aggregate demand adjusts to the new price level and output
level. When this occurs, the aggregate demand curve shifts along the short-run aggregate supply
curve until the long-run aggregate supply curve, the short-run aggregate supply curve, and the
aggregate demand curve all intersect. This is represented by point C and is the new equilibrium
where short-run aggregate supply curve 2 equals the long-run aggregate supply curve and
aggregate demand curve 2. Thus, an adverse supply shock causes output to decrease and the
price level to increase in the short run, but only the price level to increase in the long run.

This is the logic that is applied to all shifts in short-run aggregate supply. The long-run
equilibrium is always dictated by the intersection of the vertical long run aggregate supply curve
and the aggregate demand curve. The short-run equilibrium is always dictated by the
intersection of the short-run aggregate supply curve and the aggregate demand curve. When the
short-run aggregate supply curve shifts, the economy always shifts from the long-run equilibrium
to the short-run equilibrium and then back to a new long-run equilibrium. By keeping these rules
and the examples above in mind, it is possible to interpret the effects of any short- run aggregate
supply shift, or supply shock, in both the short run and in the long run.

MODULE 6: Government and the Economy

UNIT 1: Meaning and Nature of Aggregate Demand Curve

3.1 Meaning of Government Spending

Government spending is the spending activities carried out by the government of a country.
There are essential services that government provides. These include national defence, provision
of education, health, public roads, policing, internal and external securities, and possibly
provision of social securities – unemployment benefits, pension schemes and so on.

Government spending also means Government expenditure and is a term used to describe money
that a government spends. Spending occurs at every level of government, from local city councils
to federal organizations. There are several different types of government spending, including the
purchase and provision of goods and services, investments, and money transfers.

In a free market economy, not all basic needs are generally met by the private sector. Some
goods or services may not be produced at all, while others may be produced in enough quantity or
at an affordable rate for citizens. Much of government spending is involved in the creation and
implementations of these goods and services. This type of government spending is referred
to as government final consumption.

Some examples of government final consumption include the creation and maintenance of the
military, police, emergency, and firefighting organizations. These are funded by federal and
regional governments, in order to provide for both the safety of the country from attack, and the
safety of citizens from crime and disasters. Others examples include programs such as health
care, food stamps, and housing assistance for disabled or severely low-income citizens. Public
education and public transportation infrastructure are other main categories of this form of
government spending.
Since the beginning of the 70's, every category of Nigerian government spending has increased
more rapidly than envisaged. This, primarily, can be attributed to the discovery of crude oil and
the upsurge in the prices of crude petroleum that brought in more revenue to the government
that it has ever generated.

3.2. Reasons for Increase in Government Spending

The following reasons are the factors that lead to increase in government spending overtime.
(a). Defence: Over the years, expenditures on defense have been on the increase in most African
countries. The need for a strong and well-armed force necessitates the building of additional
barracks, purchase of military armaments and other military equipments. Wars and frictions in
most African countries have, made such governments to increase expenditures on defense.
(b). Population: Population in most African countries has been increasing. Nigeria's
population was 63 million in the 1963 census, but the 1991 census put the country at 88.5
million, while latest estimate put the country at over a 160 million people as population
increases more amenities would have to be provided, more schools have to be built, hospitals, etc.
(c). Development projects: After independence, most countries in West Africa embarked on
development projects. They began building airports, refineries, hospitals, etc. These involved
huge cost and consequently increase government expenditure.
(d). Depreciation and devaluation of currency: Over the years most West African countries
have either devalued their currencies or allowed it to depreciate. This act only result in high prices
of goods and services which in turn increases the expenditure of the government.
(e). Interest on debt: The public debts of most West African countries have been on the increase
over the years. Likewise the servicing of the debt have also been on the increase and have gone
to increase government expenditure.

3.3. How Government Spending is Financed

Government generates income through various means to finance its spending, Some of the
means are as follows: Rents, royalties and profits: These includes revenue from mining rights, rent
from the use of government properties, profits from all government businesses, etc.
(I).Taxation: Government get to finance its spending through various tax levied on its citizens
and corporate organization.
(II).Fines, Fees and Special Charges: These includes fines on defaulters, traffic offences, etc.,
income derived from fees such as motor vehicle licenses, water rate, toll gate, etc.
(III). Loans: This takes the form of:
a. Short-term loans: These are obtained through the sale of treasury bills and Certificate to
members of the public.
b. Medium and long-term loans: These include long term stocks sold also to the public.
c. Foreign loans: These are loans obtained from International Monetary Fund. World
Bank, Paris Club, etc.

UNIT 2: MEANING OF GOVERNMENT REVENUE

3.1 Meaning of Government Revenue

Government revenue is money received by a government. It is an important tool of the fiscal policy
of the government and is the opposite factor of government spending. Revenues earned by
the government are received from sources such as taxes levied on the incomes and wealth
accumulation of individuals and corporations and on the goods and services produced, exported
and imported from the country, non-taxable sources such as government-owned
corporations' incomes, central bank revenue and capital receipts in the form of external loans
and debts from international financial institutions.

3.2 Taxation
A tax is a compulsory levy imposed by the government on individuals and business firms
as it relates to the incomes, consumption, and production of goods and services. Such levies are
made on personal income, this consist of salaries (Pay-As You Earn), business profits interest
income on dividends, royalties; and also on company profits, petroleum profits, capital gains, etc.
However, the resultant benefit from such levies does not necessarily correspond in magnitude to
the amount of tax paid by the various sectors. It should be noted however that:
I. The payment of tax is a compulsory obligation which is enforced by law by the government
who ensures penalty is given to defaulters;
ii. The government alone can levy tax which it does through such agencies like
Customs and Exercise Department, Internal Revenue Department, Inland Revenue
Division, etc.

3.2.1 Reasons why government levy taxes

1. Revenue Generation: this is one of the main sources of government revenue Government
imposes taxes to raise money to finance its expenditure. Raising taxes is an unpopular decision
and government must be able to mould and feel the pulse of the citizenry or they may express
their displeasure at the next general election.
2. Re-distribute income: Taxes are levied to achieve greater equality in the distribution of
wealth and income. Where there are great disparities of income, aggregate demand falls, hence
government can introduce a progressive tax system which will take more money from the rich
than poor. The revenue generated will be used to further invest in projects that will be beneficial
to both the poor and rich alike.
3. Exercise Control of the Economy: Taxation can be used to regulate inflation and deflation in
an economy. A higher tax will reduce disposable income, hence aggregate demand, a lower
tax will increase disposable income thereby stimulating aggregate demand. It is used also
to achieve the objective of full employment.
4. Modifying the Influence of the Price System: By protecting infant industries developing vital
industries, increasing trade with regional trading partners lie ECOWA, etc and improving the
terms of trade.
5. To Discourage ‘Certain’ Consumption: There are some goods which are socially undesirable
as a result of the danger to health, such as alcohol and cigarettes, danger to environment,
that is, pollution emitting cars, etc. government can impose heavy taxes on sales and high import
duties on such cars to discourage their consumption. If the goods are fairly elastic, quantity
demanded will fall. To promote expert deduction in tax on exported goods (i.e. reducing export
duty) will serves as incentives to exporter to export more goods.
6. Promote Economic Growth and Development: Such as granting tax holidays, tax concessions
to some companies over a period of time. Taxed profits could be reinvested at lower rate and
generous investment allowance should be given.

To Promote Balance of Payment by imposing duties to restrict imports.

3.3 Types of Taxes

There are two types of taxes direct and indirect.

3.3.1. Direct taxes: This is a tax levied directly on the incomes or individuals and business firms.
The incidence of tax fall directly on the payer since it is not possible for the person who
pays the tax to .shift the burden to someone else, hence, each individual or business 'firm's
liability is assessed separately.
Under direct taxes, we have:

a. Income tax: This is a tax levied on individual’s incomes usually at a standard rate.
Personal allowances on family and other responsibilities are allowed before the tax is
levied on the remainder called taxable income. The incidence of taxation is certain as
the individual cannot shift the burden of taxation. It is based on the Pay As You Earn
(PAYE) system.
b. Corporation or company tax: This is a tax levied on the profit of the company after
all expenses have been deducted. The incidence of tax is uncertain because it is
possible for a company to shift the tax burden to the consumers. The ability to shift
or not depends on the elasticity of the products of the company.
 c. Property tax: This is a tax levied on the property of the individual. Such taxes include
tenement rates, etc.
d. Capital gains tax: This is a tax levied on capital gains (or appreciated value)
realized on all assets usually at a flat rate. Owner occupied houses, cars, goods and
chattels sold for excess of their original value (i.e. appreciated value) are taxed.
e. Poll tax: This is a flat rate levied on every individual in a country. This type of tax
ensures everybody pays tax in the country.
f. Estate duty: This is a tax payable on the estate of a deceased person. Rate charged are
progressive depending on the value of the building.
g. Other taxes: This includes motor vehicle duties, stamp duties, land tax and mineral-rights
duties, Petroleum income tax, capital transfer tax, etc.

(a). Forms of Direct Taxes

I. Progressive tax: This is a situation where tax rate increases as the size of
income increases, that is, the higher the tax base (taxable income). These types of tax
reduce income inequality and increases aggregate demand. It is
non-inflationary and yield more revenue to the government. A major
disadvantage is that it becomes a disincentive to work as the payer pays more as he
earns more income. Graphically, the tax behaves in this form.

Fig 1A
GRAPH SHOWING THE PROGRESSIVE TAXATION Tax
30 –
Progressive Tax

25 –

20 –

15 –

10 –

0 1000 2000 3000 4000 5000

Income (NY)

ii. Regressive tax: This is a situation where tax rate reduces as the size of income
increases. It is hardly used in real life as it tends to widen !be inequality of income
between the rich and the poor (which is not good for development) and it results in a fall
in aggregate demand and lower yield of revenue to the government. Though it has the
advantage of creating incentive to work as the more you earn, the lower will be the tax
deducted from your income. Diagrammatically, it is represented below:
 Fig 2
A GRAPH SHOWING THE REGRESSIVE TAXATION Tax
35 –

30 –

25 –
20 –

Regressive Tax
15 –

10 –

0 1000 2000 3000 4000 5000

Income (NY)

iii. Proportional (neutral) tax: This has a constant rate. The tax levied is proportional
to the tax base or income of the individual. It does not take into account the
economic situation of the tax payer either he is rich or poor. This tax is impartial but
it is insensitive to the economic situations of the payer. Proportional tax is represented
below?
 Fig 3
A GRAPH SHOWING THE PROPORTIONAL TAXATION

Tax
rate
(%)

10 –

Proportional Tax

Income (NY)

0 1000 2000 3000 4000 5000

3.3.1.1. Advantages of Direct Taxes

1. High Yield: A direct tax has the advantage of high yields at a low cost of collection. Employers
are required to deduct the tax each week or month from their salary. All increase in tax
guarantees higher revenue to the government.
2. Convenience: Tax deducted under the PAVE system enable the burden of tax to be spread
over the year instead of being paid lump-sum. The tax payer would have conditioned his mind to
giving out a determined amount each month rather than pay in lump-slim at the end of the year
which can become burdensome for him.

3. Certainty: The tax payer knows for certain how much will be deducted from his income as
tax and when he is to be paid. It enables him to plan on his income even before he receives it
Moreover, it is difficult to evade direct tax as it is deducted from source, that is PAYE (pay has
you earn), dividends.
4. Equity: Direct taxes ensure that the rich are made both the rich and poor to pay according to
their earnings. Allowances are usually given for family and other responsibilities which are
deducted from gross income to arrive at taxable income or tax base. Furthermore, a progressive
tax is added when income reaches a certain level.
5. Redistribution of Income: Direct taxes help redistribute income and wealth more equally. The
progressive nature of the tax enables the government to generate more revenue from the
rich which it can be used to finance investment beneficial to both the rich and the poor.

3.3.1.2. Disadvantages of Direct Taxes

1. Act as disincentive to work: High tax rate can cause disincentive to work. People may prefer
to go for leisure (which is not taxed) rather than go for work (which is taxed) they feel that they
are not getting enough from the extra work they arc putting in as it is heavily tax. Though this
is not always the general view, while some might not want to put in extra efforts because of the
interest they have on the job.
2. It encourages tax avoidance: Though PAYE system ensures that every employee pay taxes,
tax payer might be forced to falsify their family and other responsibility allowances to get lower
 tax base when tax is high.
3. It Encourages Efficiency: Individuals that have business firm tends to become less efficient
where there is high tax rate to be paid by them. A situation where firm pay 45 percent of profit
as tax and workers pay more in tax will result in the unwillingness of the firms to take further
role to expand and for the workers to perform effectively.
4. It Repels Foreign Capital: Investors come to invest in countries where they hope to enjoy
higher returns from capital. Consequently, any increase in tax payable on their return which
persists will discourage them and they might move their investment to a higher yield, lower tax
countries.
5. Reduce Plough back ProfitS: Most firms plough back certain percentage of their profits in
other to expand and venture into new areas. Where tax rate imposed on the firm is high, it reduces
the funds in the hands of the companies and ultimately hinders the firms desired growth.
6. Reduce savings: High tax rate may sometime reduce savings. Small companies or sole
proprietors and workers rely on a fat salary or profit to enable them save part of it for rainy day.
But where high tax rate is applied, there will be little or nothing to save after other expenses have
been taken care of.

3.3.2. Indirect Taxes

These are taxes levied on goods and services indirectly by the government which is collected
through the importers, manufacturers or other intermediary. The incidence of tax is, as far as
possible, .shifted on to the consumer by including the duty in the final selling price of the good.
When an importer pays tax (import tax) or a manufacturer pays tax (excise duty) on goods
imported or produced locally, depending on the elasticity of the good, the importer or
manufacturer adds the tax to the cost of the goods which it passes to the consumer who
ultimately pays the tax.

However, it is possible to avoid indirect taxes because it is payable only if a consumer buys the
good on which tax is levied. There arc two types of indirect tax. They are:
Specific: This is a fixed sum irrespective of the value of the good. For example, if a sum of N20.00
is fixed on a shirt, then the fixed tax of N20.00 is the specific tax. Advalorem: This is a given
percentage of the value of the good. For example, if a machine tool is N1,000,000 and an ad
valorem tax of 7 percent is imposed, then tax paid is N70.00.

Under indirect tax we have:

1. Custom duties: This refers to export and import duties.
Export duties: these are taxes imposed on all exports from the country. They constitute a
source of revenue of most African countries who rely much on income from their
primary products exported. They are easy to collect.
Import duties: These are taxes levied on all import into the country. They are usually
levied at the point of entry of the goods and constitute a source of revenue in most less
developed countries. The government uses it sometimes to discourage consumption of
certain products or to promote domestic production.
2. Excise duties: These are taxes on home-produced goods such as petrol, cigarettes, beer and
whisky, milo, etc. Higher tax rate on locally manufactured goods discourages domestic
production which may make the domestic goods costlier than imported goods.
3. Purchase tax: This is an ad valorem tax imposed on goods at various percentages and which
is generally collected at the wholesale point. It is imposed on a wide range of products that is,
confectionery, clothing, household equipment etc.

3.3.2.1 Advantages of Indirect Taxes

1. Convenience: The consumer is able to spread the payment of the tax burden as and when he
actually make purchases since the tax is payable only at the wholesale stage. Most buyers
of the goods are not aware that they are even paying taxes on goods purchased. This helps to
reduce the resentment they may have on the tax.
2. Reduces Imposition of High Direct Taxes: Since taxes are one of the main sources of
government revenue, the high yield of indirect taxes have made the government not to
excessively increase direct taxes to source for funds.
3. Certain and Immediate Yield: Yields from indirect taxes especially on fairly demand are
 certain since the consumer has little alternative to the product. Any increase in tax produces
extra income with little time-lag as far as the elasticity of the product remains inelastic.
4. It Does not Disturb Initiative and Enterprise: Unlike direct tax which is deducted from his
earnings directly, indirect taxes on the other hand fall on spending. It will not lead to
disincentive to work. In fact, it may lead to incentive to work as the worker may work more hours
to enable him maintain his lifestyle being eroded by increase in price.
5. It Can be Used to Discourage Consumption: If the governments want to discourage
consumption of certain goods, or to help promote home made goods, this is done by imposing
high tax rate on the products to make it expensive. This will reduce the purchase of these good
by the consumers.
6. It serves as automatic stabilizer of the economy: The government can heavily tax home-made
goods and imported luxuries with high income elasticity, such that as income increases,, the yield
from indirect taxes also increases. The increase in revenue from this tax helps to stabilize the
economy in periods of inflation.

3.3.2.2. Disadvantages of Indirect Taxes

1. Double Taxation: To an individual, he is made to pay income tax known rates and he also
pays indirect taxes through purchases he made at rates unknown to him likewise, producers
pay income tax as individuals and also pay company tax and as applicable import or export
duties. This double taxation may discourage production. It is regressive: If the rich and the poor
buy the same goods, then they are liable to pay the same amount of tax levied on goods. This is
regressive and it does some of the redistributive effects of direct taxation. However, imposing ad
valorem tax instead of specific tax may lessen the effect on the poor.
2. Discourages Domestic Production: High excise duties make domestic manufactured goods
more expensive than imported goods. Moreover, when import duties on such goods are low, it will
encourage importation of such goods rather than promote growth in domestic production.
3. It can create inefficient industries: Import duties and subsides arc intended to give special
assistance to an industry. But if prolonged over a period of time, government may be protecting
inefficient industry. Moreover, the government might find strong opposition if it wants to remove
the protection e.g. the fertilizer subsidy in Nigeria.
4. It may have inflationary influence: When indirect taxes are imposed, it is reflected in high
prices on the goods. Where this increase is general on all goods, a strong labour might agitate for
higher wages which may put the government into difficulties of controlling inflation.

3.4. Differences between Direct and Indirect Taxes

i. Some direct taxes, that is, on petty traders, self-employed, professionals, etc. are
difficult to compute and collect because it is difficult to know their income, but indirect
taxes are paid once you consume the goods.
ii. The incidence of tax can be shifted more readily under an indirect tax hence people are
more willing to pay, but it cannot be shifted in a direct tax which
makes the payer wants to dodge paying taxes. Thus it is common to see people
evade and avoid taxes under direct tax than indirect tax.
iii. People are more sensitive to increases in direct taxes as they are to indirect tax. Direct
tax has direct effects on their disposable income which reduces
their purchasing power. But they rarely notice the increase in indirect tax except when
the prices of goods are very high.
iv. As a fiscal tool, indirect taxes are more effective than direct taxes.
However, objective being pursued by the government and the responsiveness of quantity
demanded to price changes also play an important role.
v. Indirect taxes involve little administrative costs than direct fees.

3.5 Attributes or Principles of a Good Tax System

1. Economic Principle: A good tax system must ensure it does not make the economic situation
of the tax payer worse off. The government must see the payer as an investor, consumer and
saver and should ensure it does not adversely affect the payers’ contributions.
 2. Production of Revenue: The cost of collection should at least be less than the yield from the
tax. It is unwise and uneconomical to spend too collection of tax.
3. Certainty: The tax must be certain and the payer must know exactly when and where he has to
pay his tax. He should find it difficult to evade payment
4. Equity: Tax implementation must not be arbitrary or vindictive. Persons of the same tax base
should be made to pay the same amount as tax. For example if Mr. OIusanya and Mr. Adedeji
earn the same income., the same family size and other things equal, then they must pay the same
amount as tax.
5. Convenience: Tax payment should relate to how people receive and spend their incomes. It will
be out of place to ask for tax from a farmer whose produce one yield to be harvested. But a
PAYE system is convenient to salary earner while import duties imposed at the port is convenient
to the payer.
6. Neutral: A good tax system should not dislocate or distort the relative prices in an economy.
7. Adjustable or Flexible: It should be flexible enough as an economic tool of control, to change
in policy. Import duties aimed to protect infant industry always becomes difficult to remove or
lower when the infant becomes dependent on of the protection.
8. It Should Not be Harmful to Enterprise and Initiative: When tax rate is high up to a point, it
becomes less exciting to work. This can induce the tax payer seek for leisure instead of striving
harder for promotion or overtime.
9. It Must be Consistent with Government Policy: Individual taxes must be constantly reviewed
to see how they could be used to promote government policy or to prevent their working out of
harmony with it.
10. Acceptability: In a democracy, people respond to bad government policies through general
elections, government must ensure that its tax system is politically acceptable to the people who
will pay it or they might respond unfavourably to it at be next general elections.

3.6. Terms in Taxation

1. Tax Evasion
This is a deliberate attempt by a tax payer not to pay tax. It is a criminal act, such people are Petty
traders, self-employed, etc. always try to evade payment of tax.

2. Tax Avoidance
This is an intentional or deliberate act of exploiting the loopholes in the tax regulations to
manipulate his economic situation in other to pay lower tax. Example is when a tax payer
claims he has children or aged parents to get tax relief when actually he has none.

3. Tax Incidence
This refers to the bearer of the burden of the tax.
As disclosed above, there are two types of taxes - direct and indirect taxes. Direct taxes, as said,
are progressive. They fall heavily on the rich than on the poor, while indirect taxes are regressive
as the poor pays more tax than the rich. But this is only the formal incidence of tax. The
economist is concerned with the effective incidence, that is, how the real burden of a tax is
distributed between be producers and the ultimate consumers; and to show the non effects of such
taxation on output and price.

The regressive nature of indirect taxes is based on the decreasing marginal propensity to
consume as income rises. Second, “consumption tax (or commodity tax) does 'not reduce the
rate of return on savings and therefore avoids the substitution effect of the income tax, which
is averse to saving.” That is why it is generally suggested that the developing countries should
adopt commodity' taxation for mobilizing resources for rapid economic growth.

UNIT 3: BUDGET ANALYSIS

3.1 The Budget

This is a financial statement of the sources and uses (i.e. Revenue and expenditure) of the
government. It as “a financial plan of the projected expenditures and revenues of a unit of
government to ensure fiscal period”. It is “basically a tool for selecting a particular mix of public
and private goods and services.”

Budget is needed to perform some allocative function just as the price mechanism performs in
the private sector Management use budget as a tool direction and control of work programme. In
Nigeria, the budget is initiated by the executive through the Ministry of Finance. It is presented
to the Senate and House of Representatives for debate and adoption.

There are four characteristics of budget. They are:

i. Equilibrium: there must be a balance between the revenue and expenditures;
ii. Comprehensiveness: It must take care of all facets of the economy;
iii. Unity: All fiscal operations are spelt out in the budget; and
iv. Periodicity: The Nigerian budget is usually read at the beginning of every year.

The budget is an important economic document of a country. It reveals the state of the economy
and what future trends the country will follow. The budget is always presented like a balance
sheet in a tentative form after all ministries have submitted their inputs. It is then sent to the
congress, that is, Senate and House of Representatives to be adopted as a final budget. The
legislative body will scrutinize, adjust or delete or ask the executive to modify some portion of the
budget. Once the budget is passed by the house it becomes operational. In a democracy, no
government can spend money without the approval of the parliament. Hence, the executive can
only make use of the budget after it has been adopted by the house. The executive can either
operate a surplus budget, that is, when the revenue to be generated is forecasted to .be greater
than expenditure, or it can operate a deficit budget where expenditure is greater than
revenue. A balanced budget is where the government intends to spend the actual money it
received. That is, the revenue equals expenditure. At the end of the accounting year, the
executive including its various ministries and parastatals must account to the whole country how
money was realized and spent.

3.2 Budget Concepts

1. Recurrent expenditure: These are costs known as running cost, which the government
undertakes in its day-to-day activities. These costs include wages -and salaries, national debt
interest, etc.
2. Recurrent revenue: These are receipts of monies from fines, taxes, fees, etc. by the
government.
3. Capital expenditure: These are expenditures on capital projects. Such projects include,
provision of hospitals, roads, defence, social and community services, etc.
4. Capital receipts: These are loans, aids, grants, etc. made to the government by foreign
governments or international organizations. Other arms of government can extend such facilities.

3.3. Types of Budget

3.3.1. Budget Surplus
A situation in which income exceeds expenditures. The term "budget surplus" is most commonly
used to refer to the financial situations of governments; individuals speak of "savings" rather
than a "budget surplus." A surplus is considered a sign that government is being run efficiently. A
budget surplus might be used to pay off debt, save for the future, or to make a desired purchase
that has been delayed. A city government that had a surplus might use the money to make
improvements to a run-down park, for example.

When spending exceeds income, the result is a budget deficit, which must be financed by
borrowing money and paying interest on the borrowed funds, much like an individual spending
more than it can afford and carrying a balance on a credit card. A balanced budget occurs when
spending equals income.

3.3.2. Budget Deficit

Budget deficit is a status of financial health in which expenditures exceed revenue. The term
"budget deficit" is most commonly used to refer to government spending rather than business or
individual spending. When referring to accrued federal government deficits, the term
"national debt” is used

In the early 20th century, few industrialized countries had large fiscal deficits. This changed during
the First World War, a time in which governments borrowed heavily and depleted financial
reserves. Industrialized countries reduced these deficits until the 1960s and 1970s despite years of
steady economic growth.

Budget deficits as a percentage of GDP may decrease in times of economic prosperity, as

increased tax revenue, lower unemployment and economic growth reduce the need for
government programs such as unemployment insurance. If investors expect higher inflation
rates, which would reduce the real value of debt, they are likely to require higher interest rates on
future loans to governments. Countries can counter budget deficits by promoting economic
growth, reducing government spending and increasing taxes. By reducing onerous regulations
and simplifying tax regimes, a country can improve business confidence, thereby prompting
improved economic conditions while increasing treasury inflows from taxes. Reducing
government expenditures, including on social programs and defense, and reforming
entitlement programs, such as state pensions, can result in less borrowing.

3.3.3. Balanced Budget

A situation in financial planning or the budgeting process where total revenues are equal to or
greater than total expenses. A budget can be considered balanced in hindsight, after a full year's
worth of revenues and expenses have been incurred and recorded; a company's operating budget
for an upcoming year can also be called balanced based on predictions or estimates.

It is commonly used in reference to official government budgets. For example, governments may
issue a press release stating that they have a balanced budget for the upcoming fiscal year, or
politicians may campaign on a promise to balance the budget once in office.
It is important to understand that the phrase "balanced budget" can refer to either a situation where
revenues equal expenses or where revenues exceed expenses, but not where expenses exceed
revenues.

MODULE 7: OPEN ECONOMY MACROECONOMICS

UNIT 1 ANALYSIS OF INTERNATIONAL TRADE

3.1 Meaning of International trade

As a starting point, we can conceive of international economics as being partly micro-economics
and partly macro-economics. It is partly micro-economics because it addresses how the basic
question of which products will be produced; by which methods; and with which technology; and
how the products will be shared among people. All these questions are resolved and influenced in
every nation of the world. It is also partly macro-economic issue because in determining total
spending in an economic system such components as consumption expenditure, investment
expenditures, government expenditures, as well as foreign spending are added.

Spending by foreigners therefore is a component of total spending because if foreigners spend

more for our goods and services, total spending gross up and that leads to economic growth.
Therefore, international economics is concerns with economic relationships within and among
nations.

3.2. Reasons for International Trade

International trade could therefore be safely defined as trade relation between a country and the
rest of the world.

The reasons for trade between countries are not in any way different from reasons individuals
trade within a country. What we call international trade is not more than trade relation
between individuals who live in different countries. International trade is hence important as
it is a channel of meeting the wants of individuals who are residents in different countries of the
world. The importance of international trade is as follows:

a. Imports Serve Domestic Industry: Domestic industries would have pretty difficult time if
basic raw materials, machinery and other needs are not met. Some domestic industrial
needs are only met import.
b. Imports Serve Domestic Consumers: International trade enlarges the range of
consumers’ choices of goods and services, without international trade consumers will
have fewer choices.
c. Exports are Vital to Many Domestic Producers: The market for nation’s export is very
important. For example, without international trade the market for the Nigerian
crude oil, columbine, cocoa, rubber, etc. would have been limited to domestic economy.
d. Exports Serve as a Foreign Exchange Earner: Exports of goods and services act as
foreign exchange earner to the domestic economy. Foreign exchange availability is an
essential requirement for the survival of any national economy.
e. Exports Act as Agent of Growth: Other countries' demands for goods and services
produced within a domestic economy act as a catalyst to the growth of the total
spending and hence growth in the Gross National Product of such an economy.

3.3. THE THEORY OF INTERNATIONAL TRADE

a. The Theory of Absolute Advantage
The classical economist Adam Smith said that the basis of international trade falls along the
divide of Absolute Advantage which may be defined as the good or service in which a country is
more efficient or can produce more than the other country or can produce the same amount with
other country using fewer resources.

b. The Theory of Comparative Cost Advantage

David Ricardo was the proponent of the theory of Comparative Advantage. He propounded that
the basis of international trade should be premised on the concept of comparative advantage.
His reasoning emanated from a rational economic consideration in which a country that is
capable of producing a good or a service may carefully elect to buy it from elsewhere where
opportunity cost of production is lower. Comparative advantage theory states that a country
should specialize in the production of a commodity or service in which it has a lower opportunity-
cost. comparative disadvantage on the other hand is that situation where a country has higher
opportunity cost of-producing the good or service. For example suppose that you are the most
highly paid petroleum consultant in town and charge a consultancy fee of Income (NY) N15,
000.00 per hour. Suppose further that you are the world's best computer operator earning N4,
000.00 per hour. Should you do your typing by yourself, if you have enough consultancy work to
keep you busy full time. This is so because every hour you spend typing incurs an opportunity
cost of N15, 000.00 in forgone consultancy fees. This makes typing very costly. The rational
thing you might do is employ eight 50-words-per-minute operators and perhaps pay them each
N500.00 per hour. This amount pays N4, 000.00 per hour to type 400 words per hour. The
opportunity cost of consultancy (and earning NI5, 000.00 per hour) is programming (earning N4,
000.00 per hour) the best and most rational thing to do is spend your" time to do what you do at
the lower opportunity cost.

The consultant who can do everything more efficiently than every other person is synonymous
with the country that can produce everything more efficiently than any other country in the
world. But because resources are not infinitely abundant; resources should be of used to
produce and export goods and services (consultancy) that can be produced at the lower
opportunity cost. Goods or services that incur higher opportunity cost of production (typing)
should be imported.
It is on the basis of the above that David Ricardo illustrated the principles of comparative
advantage by the famous example of England and Portugal each capable of producing both wine
and cloth, the only difference lies on the labor cost of producing each good fey each country.

Table 1: Comparative Advantage Matrix

Wine per man hour Cloth per man hour
England 2 units 6 units
Portugal 4 units 8 units

Table 1 indicates that amount of wine (W) and cloth (C) that can be produced with one man hour in
Portugal and England respectively. It should be noted that more wine and cloth could be produced
per man hour in Portugal than in England as one man would work for one hour to produce 6 units of
wine 4units and 8units of cloth in Portugal compared to a man working for one hour to produce
2units of wine and 4units of cloth in England respectively. This shows that Portugal has absolute
disadvantage in production of the two.

One could be tempted to think that Portugal should not trade since she has absolute
advantage in the production of the two goods. This should not be the case as it is comparative
advantage rather than absolute advantage that forms basis of trade as propounded by David
Ricardo. Countries should produce and export those goods in which they have comparative
advantage i.e. where their opportunity cost is lower while they should import those goods in which
they have comparative disadvantage i.e. where their opportunity cost is higher.

However, comparative advantage is obtained by computing the relative opportunity cost

of production, as given in table 1 each hour of labor can produce 6 units of wine and 8 units of
cloth in Portugal. This can be summarized as follows:
In Portugal 6w=8c

If we are interested in relating one unit of wine to cloth, or 1 of cloth to wine; we divide both sides
by 6 and 8 respectively, i.e. 1 unit of wine relative to doth
6w:8c
6/6w = 8/6c
1w = 1.33
Or
1 unit of cloth relative to wine
6w = 8c
:. 6/8w = 8/8c
1cc = 0.75w

Therefore in Portugal
1w = 1.33c or lc = 0.75w

Where wine
C = cloth
The above indicates that the opportunity cost of unit of wine is 1.33c in Portugal. Similarly, the
opportunity cost of producing unit of cloth is 0.75 unit of wine.

While in England, the opportunity cost of production is not the same with Portugal for the following
obvious reasons:
2w = 4c and,
The relative opportunity cost of production can be obtained also from table 9.1 by getting one unit
of wine in relative to cloth and one unit of cloth relative to wine respectively. This is done by
dividing both sides by 4 if we are to get one unit of cloth relative to cloth in the following manner:
In England

1 unit of cloth relative to wine

2w = 4c
 2w/2w = 4/2c
1w = 2c
Or
1 unit of cloth relative to wine
2w/4 = 4/4c
0.5w = 1c

This follows that the opportunity cost of 1 unit of wine is 2units of cloth in England while
the opportunity cost of unit of cloth is 0.5 unit of wine. From the forgoing, it can be seen that the
opportunity cost of producing wine in Portugal is 1.33 units of cloth which is lower than it is
in England i.e. 2 units. While in England, the opportunity cost of producing a unit of cloth is
0.5'unit of wine which is lower than it is in Portugal i.e. -0.75 unit of wine. It can therefore be
concluded that Portugal has relative comparative advantage in the production of cloth. Whereas
England has relative advantage in the production of cloth while it has relative comparative
disadvantage in the production of wine.

It is apparent therefore that Portugal should specialize in the production and export of wine, while
England should specialize in the production and export of cloth in exchange for Portugal wine, at
the opportunity cost ratio 0.5, 1.33.

UNIT 2: Gain from Trade

3.1 Gain from trade analysis

Arising from the law of comparative advantage as stated earlier, countries will benefit from trade
with a rise in world output without additional factor inputs when countries specialize in the
production of those goods in which their opportunity cost is lower.
For example, let us assume that:
a. England and Portugal are the only two countries in the world.
b. Wine and cloth are also the only two good in the world.
c. Transport cost is nonexistent. :
d. Each of England and Portugal has equal workers of say 100 each. e.
Survival need deserves that each worker has two units of cloth.

From the foregoing, it means that England must commit 50 workers to cloth production i.e.
50x4 = 200 And Portugal 25 workers i.e25x8-200

By extension 50 workers will be left for the production of wine in England i.e. 50.2.. 100 and in
Portugal 75 workers will be left also for the production of wine i.e. 75 x 6- 450. This is given in
table 9.2

Table 2
Cloth Wine
England 50 x 4 = 200 50 x 2 = 100
Portugal 25 x 8 = 200 75 x 6 = 450
World 400 550

If we again assume that each country should now-specialise, England on cloth and Portugal on wine:
world output will increase as in shown in table 3

Table 3
Cloth Wine
 England 100 x 4 = 400 0=0
Portugal 0=0 100 x 6 = 600
World 400 600

Therefore the following benefits will follow specialization.

(a) Increase in the world output of wine from 550 to 600 though output of cloth still remains
at 400.
(b) Increase in specialization and skills.

3.2. The Terms of Trade

Though the gains from international trade brings about increase output, except of Course Portugal
is able to trade some wine for cloth. Workers in Portugal will not get much work done, the same
applies to England.

Without trade workers in England will not get much work done. But how much cloth must, England
give in exchange for Portugal wine is a question that is very much decided by countries terms
of trade. In other words terms of trade is basically expressed as a relationship between a unit
price of a country's export to a unit price of the country's import. In the case of England and
Portugal: terms of trade is how much unit of cloth England must give in exchange for each unit of
wine and vice versa.

Before trade, each unit of wine has an opportunity cost of 1.33 units of cloth in Portugal and 2.00
units of cloth in England. This] means that Portugal will be willing to import cloth by having more 1
than 1.33 units of cloth per unit of wine, and England will be willing to export cloth by giving less
than 2.00 units per cloth per unit of wine. This incidentally gives an associated terms of trade
inequality to be 1.33 < I w < 2,0c. This means that terms of trade inequality = l,33c < I w <
2.0c, The terms of trade will therefore-lie within the inequality bracket as may be agreed upon by
the two countries.

Unit 3 Net Export Function in the Open Economy

3.1 Export
Exports depend on spending decisions made by foreign consumers or overseas firms that
purchase domestic goods and services. The spending decisions are guided by the level of
income, price level, taste and fashion of the foreign consumers. We will therefore assume that
exports are determined by factors outside the control of the home economy. This allows
us to treat it as an exogenous variable.

Imports on one hand depend on the spending decisions of domestic consumers and on the other
hand domestic firms using foreign raw materials, capital goods and intermediate goods. The
latter is treated to be exogenous because in most cases firms know the amount of intermediate
goods or capital goods they will need for their production. In fact, we can say that this set of
goods is basic for production to take place. We will then assume that this aspect of import is also
exogenous.

Another aspect of import demand is the one that changes as income changes. When income
rises, this aspect of import demand rises as well and when income falls, it falls. Therefore, we
have two components of import demand, the one that is fixed, and the one that varies with income.

Because export is exogenous while a part of import is an increasing function of income, net
exports are negatively related to national income/national output. Let X0 represent planned
export demand, Mo represents imported basic investment good, while M1 represents an aspect
of import that changes with income, that is, marginal propensity to import. Finally let M represent
total import demand so that M equals M0 plus M1Y, where Y is national income. Therefore, net
export function can be written algebraically as follows:
 X0 – M
X0 – (M0 + M1Y)
X0 – M0 – M1Y
Consider a set of income level say Y = 1000, 1500, 2000, 2500, and 3000. Let planned export
demand equals 800 and let marginal propensity to import equals
0.2. Finally, let exogenous import equals 250. We can construct net export table as follows:

Table 1: Net Export Schedule

GDP (Y) Export M0 = M1 = M = M0 Net

(X0) 250 0.2Y + M1 Export

1000 800 250 200 450 350

1500 800 250 300 550 250
2000 800 250 400 650 150
2500 800 250 500 750 50
3000 800 250 600 850 -50

The table shows that export demand was higher than import demand (net export being positive)
up to the point when income was 2500. If we graph import function, you will find out that import
is an increasing function of income. As income rises, import demand also rises. Lastly, note that
as income is increasing, with fixed export demand, net export is falling. This implies that net
export is inversely related to income.

3.2. Prices for International Transaction

Exports and imports are both affected by international prices. When imported goods and
services are purchased from abroad, though we pay in local currency in the local market,
importers actually purchase those imported goods with the currency of the foreign country
from which such goods are purchased.

For simplicity, let us assume that a unit of good worth $2 is to be imported to Nigeria from the
United States. Importer will need to pay the US producers in dollars before such goods could be
purchased. This means that some naira has to be exchanged for dollars. The rate at which the
naira is exchanged for the dollar is called exchange rate. In particular, exchange rate is the
quantity of domestic currency that can be exchanged for a unit of foreign currency in order to
allow international transactions to take place. Let the unit price of Nigeria currency be
N (naira), while that of the US is $, then exchange rate of naira to dollar will be:

ER = naira/dollar or N /$
To compute the amount of naira needed when we want to buy $10 worth of US products given
that ER is N50, we proceed thus: ER = naira/dollar
50 = N /10 = 50 x 10
after simplifying, we see that the amount of naira needed is N500.00.
Let us assume that exchange rate now falls to 25, and then the amount needed to purchase a $10
US product is N250.00.
What this implies is that as exchange rate falls, import demand becomes cheaper and as it rises,
import demand becomes more expensive. A fall in exchange rate (when domestic currency falls
relative to foreign currency) is called exchange rate appreciation. A rise in exchange rate (when
domestic currency rises relative to foreign currency), is called exchange rate depreciation.
What is the implication of exchange rate on export demand? Consider a US consumer that
intends to buy Nigeria products worth N1000.00, how much dollars does he need for the
transaction? Given that exchange rate is 50, we proceed thus:

50 = 1000/$
$ = 1000/50 = $20.

This means that the consumer needs $20. Now let the exchange rate be 25
25 = 1000/$ = $40
That is, the foreign consumer need $40 (an extra $20) to purchase the same basket of good.
What this implies is that all other things being equal, appreciation of domestic currency relative
to foreign currency makes export expensive and makes import cheaper. Conversely, if other
things remain the same, depreciation makes export cheaper and makes import expensive. Hence,
any factor that changes exchange rate will cause net export to change. If exchange rate
appreciates, export falls, import rises and net export function shifts downwards and to the left,
such that aggregate demand falls. If exchange rate depreciates, export rises, import falls and net
export function shifts upwards and to the right such that aggregate demand rises.

Another factor that can affect trade flows is the changes in domestic price level relative to foreign
price level. Consider first a rise in domestic price. On the one hand, foreigners will now see
domestic-produced goods as more expensive relative to both goods produced in their country
and to goods imported from other countries. On the other hand, domestic residents will see
imports from foreign countries become cheaper relative to the prices of home-produced goods.
As a result, they will buy more foreign goods, and imports will rise. Both of these responses will
cause the net export function to shift downwards. As it shifts downward, aggregate demand
falls. Thus, increase in domestic price will cause net export to fall.

Consider a situation whereby domestic price level falls relative to foreign price level. Domestic
good exported will look cheaper in foreign country relatively to home-produced goods, and to
goods imported from say other countries. As a result, home country exports will rise. On the
other hand, the same change in relative prices – home-made goods become cheaper relative
to foreign-made goods – will cause domestic country’s import to fall. Thus, the net export
function will shift upwards in exactly the opposite way to the previous situation.

Thus far, we have established the fact that changes in foreign GDP, changes in exchange rate, and
international differences in inflation rates cause net export function to shift. What is the
implication of these factors on the equilibrium aggregate output/aggregate income? This is the
question we provide answer to in the next section.

3.3. Equilibrium in the Open Economy

The aggregate demand will now include net export (X-M) component. However, equilibrium output
is still the level of output at which desired aggregate demand equals national output/income.

To establish equilibrium in an open economy, let us rewrite our aggregate demand function and
incorporate net export component. To put the matter very simple, let us assume that planned
aggregate demand is given by:
AD = C + I + G + NX
Let C = 610 + 0.8Y; I = 220; and G = 300; NX = 10 and T = 250
Note that planned private consumption has fallen by 10-unit but this has been taken care of
by NX which is 10. Equilibrium output can be achieved as follows:
AD = 610 + 0.8 (Y – 250) + 220 + 300 + 10
= 610 + 0.8Y – 200 + 220 + 300 + 10
 = 940 + 0.8Y at equilibrium, AD = Y hence, Y = 940/0.2 = 4700.
This implies that the equilibrium has been restored but in this case through net export surplus.

From this simple example above, it is clear that positive net export (current account
surplus) can be used to recover the economy from recession, while negative net export
(current account deficit) can also plunge the economy into recession. In particular, exchange rate
policy, domestic inflation and foreign inflation have implication on the output performance of the
domestic economy. A rise in domestic inflation can plunge the economy into recession through a
fall in net export. While a fall in domestic inflation will help economy recover from recession
through increase in net export. Specifically, this analysis implies that an economy that is in
recession can recover by reducing import demand and increasing export supply which can be
achieved through exchange rate manipulation or reduction in domestic price level.