DISTANCE LEARNING INSTITUTE

UNIVERSITY OF LAGOS

DLI
COURSE MODULE

ECN141

PRINCIPLES OF
MACROECONOMICS
 DISTANCE LEARNING INSTITUTE
UNIVERSITY OF LAGOS

DLI
COURSE MODULE

ECN141
PRINCIPLES OF MACROECONOMICS
 © Distance Learning Institute
University of Lagos 2022
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COURSE DEVELOPMENT TEAM

Authors:
DR. ISAAC CHII NWAOGWUGWU
PROF. W.A. ISHOLA
DR. W.A. AYADI
DR. B.W. ADEOYE
MR. J. BALOUGA
MR. FOLUSO AKINSOLA
DR. ANTHONY OSOBASE
DR. TUNDE BAKARE-AREMU

Content Editor:
Prof. Riscat Dauda

Language Editor:
Prof. Funke Lawal

Instructional Designer:
Dr. Lukman Oyelami

ODL Expert:
Dr. Peter O. Olayiwola

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Table of Contents
1.0. Introduction .................................................................................................................................................... 7
2.0 MODULE OUTLINE .............................................................................................................................................. 7
Self L-earning Material (SLM) or Module ....................................................................................................................... 7
3.0 MODULE DELIVERY SCHEDULE ........................................................................................................................... 9
Delivery Schedule ........................................................................................................................................................... 9
4.0 ASSESSMENT DETAILS ....................................................................................................................................... 10
5.0. Grading................................................................................................................................................................... 10
6.0. LIST OF ICONS AND THEIR MEANINGS ................................................................................................................... 11
STUDY SESSION 1: ......................................................................................................................................................... 12
INTRODUCTION TO MACROECONOMICS ..................................................................................................................... 12
Introduction ................................................................................................................................................................ 12
Learning Outcomes for Study Session 1..................................................................................................................... 12
1.1 Meaning of Macroeconomics ................................................................................................................................. 12
1.2 Macroeconomics Goals and Variables .................................................................................................................... 13
Summary of Study Session 1 ......................................................................................................................................... 21
Self-Assessment Questions for Study Session 1 ........................................................................................................... 21
Links to OERs ................................................................................................................................................................. 23
Reference/Suggestions for Further Readings ............................................................................................................... 23
STUDY SESSION 2: ......................................................................................................................................................... 25
NATIONAL INCOME AND CIRCULAR FLOW OF INCOME ............................................................................................... 25
Introduction .................................................................................................................................................................. 25
Learning Outcomes for Study Session 2 ...................................................................................................................... 25
2.1National Income....................................................................................................................................................... 25
2.2Basic Concept in National Income Accounting ........................................................................................................ 26
2.3Measurement of National Income........................................................................................................................... 28
2.4 Problems of National Income Accounting .............................................................................................................. 29
Summary of Study Session 2 ......................................................................................................................................... 32
Self-Assessment Questions for Study Session 1 ........................................................................................................... 33
Links to OERs ................................................................................................................................................................. 34
Reference/Suggestions for Further Readings ............................................................................................................... 35
STUDY SESSION 3: ......................................................................................................................................................... 36
OVERVIEW OF THE KEYNESIAN THEORY ....................................................................................................................... 36
Introduction .................................................................................................................................................................. 36
Learning Outcomes for Study Session 3 ....................................................................................................................... 36
3.1 The Classical Economists and the Laissez-faire Economic Policy............................................................................ 36
Summary of Study Session 3 ......................................................................................................................................... 41
Self-Assessment Questions for Study Session 3 ........................................................................................................... 41
Links to OERs ................................................................................................................................................................. 43
Reference/Suggestions for Further Readings ............................................................................................................... 43
STUDY SECTION 4:......................................................................................................................................................... 44
CONSUMPTION, SAVINGS, AND INVESTMENT FUNCTIONS ......................................................................................... 44
Introduction ................................................................................................................................................................ 44
Learning Outcomes for Study Session 4 ....................................................................................................................... 44
4.1The Consumption Function...................................................................................................................................... 44
4.2The Saving Function ................................................................................................................................................. 45
4.3Factors affecting consumption and savings............................................................................................................. 48
4.4Investments ............................................................................................................................................................. 49
4.5The determinants of investment decisions are: ...................................................................................................... 49
4.6 Marginal efficiency of investment .......................................................................................................................... 49
Summary of Study Session 4 ......................................................................................................................................... 51
Links to OERs ................................................................................................................................................................. 52

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Reference/Suggestions for Further Readings ............................................................................................................... 52
STUDY SESSION 5: ......................................................................................................................................................... 54
MONETARY POLICY AND FISCAL POLICY ....................................................................................................................... 54
Introduction .................................................................................................................................................................. 54
Learning Outcomes for Study Session 5 ....................................................................................................................... 54
5.1Monetary Policy ....................................................................................................................................................... 54
5.2 Fiscal Policy ............................................................................................................................................................. 58
5.3 Discretionary fiscal policy ....................................................................................................................................... 59
Summary of Study Session 5 ......................................................................................................................................... 61
Self-Assessment Question for Study Session ................................................................................................................ 61
Links to OERs ................................................................................................................................................................. 63
Reference/Suggestions for Further Readings ............................................................................................................... 63
STUDY SESSION 6: ......................................................................................................................................................... 64
ELEMENTS OF TRADE .................................................................................................................................................... 64
Introduction .................................................................................................................................................................. 64
Learning outcomes of Study Session 6 ......................................................................................................................... 64
6.1 The Concept of Trade ............................................................................................................................................. 64
6.2 The differences between Domestic and Foreign Trade .......................................................................................... 69
6.3 Reasons why countries involve in international trade. .......................................................................................... 70
6.4 Theories of International Trade .............................................................................................................................. 71
6.5 The Merits and Demerits of International Trade .................................................................................................... 73
6.6 International Trade Policies and Regulations ......................................................................................................... 74
6.8 The Concept of Free Trade or Trade Liberalization ................................................................................................ 76
6.8.2 Disadvantages of free trade ................................................................................................................................. 76
Summary of Study Sesson 6 .......................................................................................................................................... 77
Self-Assessment Questions (SAQs) for Study Session 6................................................................................................ 77
Links to OERs ................................................................................................................................................................. 79
Reference/Suggestions for Further Readings ............................................................................................................... 79
STUDY SESSION 7: ......................................................................................................................................................... 82
TERMS OF TRADE AND BALANCE OF PAYMENTS ......................................................................................................... 82
Introduction .................................................................................................................................................................. 82
Learning outcomes of Study Session 7 ......................................................................................................................... 82
7.1The Concept of terms of Trade ................................................................................................................................ 82
7.2.Analysis of Balance of Trade (BoT) ......................................................................................................................... 85
7.3 The Balance of Payments (BOPs) Account .............................................................................................................. 87
7.4 Reasons why Nations need Balance of Payments (BOPs)....................................................................................... 92
7.5 Problems in computing Balance Of Payments (BOPs) Accounting ......................................................................... 92
7.6 Nigeria - Balance Of Payments (BOPs) .................................................................................................................... 92
Summary of Study Session 7 ......................................................................................................................................... 95
Links to OERs ................................................................................................................................................................. 98
Reference/Suggestions for Further Readings ............................................................................................................... 98
STUDY SESSION 8: ....................................................................................................................................................... 100
INFLATION AND UNEMPLOYMENT ............................................................................................................................. 100
Introduction ................................................................................................................................................................ 100
Learning Outcomes for Study Session 8 ................................................................................................................... 100
8.1Inflation .................................................................................................................................................................. 101
8.2Unemployment ...................................................................................................................................................... 113
Summary of Study Session 8 ....................................................................................................................................... 113
Self-Assessment Questions (SAQs) for Study Session 8.............................................................................................. 115
Links to OERs ............................................................................................................................................................... 116
References/Suggestions for Further Readings ........................................................................................................... 117
STUDY SESSION 9: ....................................................................................................................................................... 118
ECONOMIC GROWTH AND DEVELOPMENT ................................................................................................................ 118
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Introduction ................................................................................................................................................................ 118
Learning Outcomes for Study Session 9.................................................................................................................... 118
9.1 The Concept of Economic Growth and Development ........................................................................................ 119
9.2 Reasons Why Economic Growth May Not Promote Economic Development ..................................................... 120
9.3 The Development Objectives ................................................................................................................................ 121
9.4Common Characteristics of Developing Nations ................................................................................................... 122
9.5Measurement of Economic Growth ...................................................................................................................... 124
9.6.Economic Growth, Business Cycles, Unemployment, and Inflation ..................................................................... 126
9.7. Business Cycles .................................................................................................................................................... 130
9.8. The Phases of the Business Cycle ........................................................................................................................ 131
9.9 Leading Indicators ................................................................................................................................................. 132
Self-Assessment Questions (SAQs) for Study Session 9.............................................................................................. 133
Links to OERs ............................................................................................................................................................... 135
References/Suggestions for Further Readings ........................................................................................................... 135
STUDY SESSION 10: ..................................................................................................................................................... 136
MACROECONOMICS OF DEVELOPING AND TRANSITIONAL ECONOMIES .................................................................. 136
Introduction ................................................................................................................................................................ 136
Learning Outcomes for Study Session 10 ................................................................................................................... 136
10.1 The Concept of Transitional Economies ............................................................................................................. 136
10.2Macroeconomics of Developing and Transitional Economies ............................................................................. 137
10.3The Transition Indicators ..................................................................................................................................... 138
10.4Differing Goals of Developed and Developing Countries .................................................................................... 140
10.5 Economic Growth as an Appropriate Goal for Developing Countries ................................................................ 140
Self-Assessment Questions (SAQs) for Study Session 10............................................................................................ 142
Links to OERs ............................................................................................................................................................... 144
References/Suggestions for Further Readings ........................................................................................................... 144
APPENDIX II: GLOSARRY OF KEY TERMS ..................................................................................................................... 159
Classical economists: .................................................................................................................................................. 159
Macroeconomics: It is the........................................................................................................................................... 159

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COURSE GUIDE FOR ECN 141 PRINCIPLES OF MACROECONOMICS
Welcome Message
Good day to you and we are delighted to welcome you to this study guide on the Course ECN 141: Principles
of Macroeconomics. As your instructor/facilitator for this course, we are looking forward to working
together with you and helping you to get the best head start in this course. We want, once again, to welcome
you warmly and wish you well.
This Self-Learning Material (SLM) for the course has been specifically designed to help you acquire a
significant aspect of the skills you need to succeed in your dream to acquire a degree of the University of
Lagos. We hope also that you will maximize the opportunities provided through the material in this direction.
and complete this course leading to your degree programme. Read through the course outline carefully to
learn what is expected of you.
We wish you the best.

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1.0. Introduction
You are welcome to Basic Principles of Company Law (ECN141) module. Generally, this course
fundamentally aims to introduce you to principles of Macroeconomics. The module is specifically designed
to introduce you to macroeconomics variables. It is a guide for you to expand your knowledge of principles
of macroeconomic, the analysis of macroeconomics framework and the management of the national and
international economic related matters. At the end of each module, there are self-assessment questions for
you to practice with; to test your understanding of what you have read in each module.
a. Course Description
The goal of this course is to make you understand the fundamentals of macroeconomic concepts as a field
of study. The contents of this course and reading references provided broad knowledge of the course.
Assigned readings will cover all areas of the course; while your facilitators, group discussions and teamwork
are expected to complete the bulk of knowledge you must acquire through the course.
b. Background to the Course
This module is specifically designed to equip you with relevant academic skills that are supportive of your
excellent class performance. The module is divided into ten study sessions. It is an introductory course in
economics introducing learners to the basic terms in macroeconomics issues.
c. Module Aim
The main aim of this module is to develop the relevant key study skills in you. Note that your tutors are just
a click of the button away from you to give you the support you require.
This course will seek to:
• develop students in broad range areas.
• develop students specifically in: -
- Critical thinking and problem-solving skills.
- Accessing and analyzing information skills.
- Effective communication skills

2.0 MODULE OUTLINE

Self L-earning Material (SLM) or Module
a Learning Objectives
Define the concept of Macroeconomics
Discuss National Income and Circular Flow of Income
Explain an overview of the Keynesian Theory
Illustrate Consumption, Savings, and Investment Functions
Differentiate between Monetary policy and Fiscal policy
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List Elements of Trade
Discuss Terms of Trade and Balance of Payments
Analyse Inflation and Unemployment
Discuss Economic Growth and Development
Compare Macroeconomics of Developing and Transitional Economies
a. Study Sessions
Study Session 1: Introduction to the Study of Macroeconomics
Study Session 2: National Income and Circular Flow of Income
Study Session 3: Overview of the Keynesian Theory
Study Section 4: Consumption, Savings, and Investment Functions
Study Session 5: Monetary policy and Fiscal policy
Study Session 6: Elements of Trade
Study Session 7: Terms of Trade and Balance of Payments
Study Session 8: Inflation and Unemployment
Study Session 9: Economic Growth and Development
Study Session 10: Macroeconomics of Developing and Transitional Economies
b. Learning Supports
This study guide and the Self Learning Material (SLM) are the key materials for studying the relevant study
sessions. Each topic provides you with a 'road map' to guide you through the SLM. The textbook readings
will be supplemented by lecture notes. You are also expected to attempt the online activities on the Learning
Management System (LMS) as they will deepen your understanding of the individual topics. Online
discussions and collaborations are additional vital parts of the learning support tools. They give you the
opportunity to express your understanding and application of the topics under discussion in practice.
Furthermore, you benefit from the experiences and insights of your peers challenging their own perspectives
and actions.
There is availability of other useful sources such as numerous websites which are appropriate for this
course. The following list is by no means exhaustive but should be explored:
http://www.skills4study.com
http://www.ucd.ie/adulted/currentstudents/studyskillsguide/
http://www.mindmapping.com/
c. Self Learning Material (SLM) Evaluation
At the end of the study sessions, you will be asked to provide feedback on this SLM through an online
evaluation that will be sent to your email account. The gathering of such feedback is an important part of our
quality assurance and accreditation processes, and I would encourage you to complete these evaluations.

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 3.0 MODULE DELIVERY SCHEDULE
Delivery Schedule
a. Session Arrangements
The module delivery relies on your ability to engage in prior preparation, to seek confirmation and
clarification as appropriate and to be actively engaged during the session. You are expected to study and be
prepared for all sessions. The study sessions are divided into weekly format as will be seen on the LMS.
b. Preparation Required in Advance of Sessions
In addition to the SLM assignments, you are expected to have read the study sessions in advance of online
facilitations. ECN141 is a two-unit course, and the workload reflects that fact. It is essential to set out your
study schedule so that you can plan your learning activities for the academic year ahead with the aim of
balancing study, work, and family demands. You are expected to be fully familiar with the contents of the
module.
c. Student Engagement
During the sessions, you are expected to be able to discuss issues arising from the study. Session participation
is a vital element in the design of this Self Learning Material. Therefore, you are expected to engage in class
discussion and online collaborations to facilitate the formation of your critical judgments. To support your
learning, Power-Point slides will be available which (on certain occasions) may need to be upgraded /
modified during or following the sessions depending on the issues raised.
d. Preparatory Questions.
This Self Learning Material (SLM) includes two types of Assessments. These are In-Text Questions (ITQ)
and Self-Assessment Questions (SAQs). In-Text Answers (ITAs) follow directly after the ITQs. It affords
you to check your learning by answering correctly. Incorrect answers alert you about what to study again.
Correct answers say what a good student could really write, based on material in current or previous study
sessions.
The ITQ is meant to:
▪ engage you in active thinking.
▪ give you a brief mental ‘break’ from passive reading.
▪ focus your attention on a key point in the study session.
▪ remind you of a key point from a previous session.
▪ break up large blocks of text that may look intimidating to you.
SAQs appear at the end of the study session. The model answers are ‘hidden’ but they appear at the end of
the Module. Answering SAQs enable you to check your own progress in achieving the Learning Outcomes.

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 4.0 ASSESSMENT DETAILS
Assessment is undertaken to establish the extent of your learning on completing the Self Learning Material
(SLM). The module has three assessment components with specific weightings and marks awarded totaling
100. In the following pages, further details of each assessment component are presented along with
expectations in relation to prior preparation and completion.
You are required to submit THREE assignments for this module. You are advised to read the relevant section
of the study session before attempting each assignment.
The weighting for each assignment is outlined below:
Assignment 1 10%

Assignment 2 10%
Assignment 3 10%

You will be exposed to other forms of assessments in form of Computer Marked Assessments (CMA) and
Tutor Marked Assessments (TMA).
Please submit the assignments via the relevant assignment upload link on the LMS which can be located
under the ‘Assignments’ section of the course page. You are expected to complete all assignments ensuring
that they are submitted by the specified date. All submissions must be typed and must be well laid out. Please
ensure that all submissions are entirely your own work as plagiarism attracts penalties. The penalty may
include a deduction of marks, failure in the course, and/or referral to the Open Distance Learning Disciplinary
Committee.
5.0. Grading
Your programme is designed with courses which are weighted and classified into various levels. Courses are
assigned units depending on the volume of work required to complete the course. This section is designed to
acquaint you with the alphabets representing your final grade in this course. It is necessary to first recognize
and be thoroughly familiar with certain ranges that are commonly used in arriving at your grade. These are
defined as follows:
A (70-100%) 5 points
B (60-69%) 4 points
C (50-59%) 3 points
D (45-49%) 2 points
E (40-44%) 1 point
F (0-39%) 0 point

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6.0. LIST OF ICONS AND THEIR MEANINGS
S/No Icon Meaning
1.
Activity

2.
Calculations

3.
Charts and Tables

4.
Experiments

5. Group Activity
6.
IAG Information

7.
In-Text Questions

8.
In-Text Answers

9.
Introduction

10.
Learning Outcomes for Study
Session
11.
Summary

12.
E-Tutor

13.
Figure

14.
Key Terms

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 STUDY SESSION 1:
INTRODUCTION TO MACROECONOMICS

Introduction
This session deals with introductory topics in the study of Macroeconomics. Some of the issues examined
here include the meaning of Macroeconomics, Stocks and Flow and the Methodology of Macroeconomic
analysis. This session also highlights the key macroeconomic variables whose behaviours are crucial in
Macroeconomic Management.

Learning Outcomes for Study Session 1

At the end of this study session, you should be able to:
1.1 Define Macroeconomics
1.2 Explain some basic concepts in Macroeconomics
1.3 Explain the relationship between various macroeconomic variables
1.4 Evaluate the meaning of Stocks and Flows
1.5 Discuss the Methodology of Macroeconomics
Key Terms: Macroeconomics, Stocks and flows, Output, Inflation,
Economic stability, Money supply, Interest rates, Total investment,
Macrostatics

1.1 Meaning of Macroeconomics

Economic theory is divided into two broad categories – Microeconomics and Macroeconomics.
Microeconomics is the branch of Economic Science which studies the economic behavior of individuals;
that is individual units – a person, a particular household, or a particular firm. It is a study of a particular unit
rather than all the units combined.
As against the above, Macroeconomics may be defined as that branch of economic analysis which studies
the behaviour of all the units, combined. In other words, Macroeconomics studies the aggregates, such as
the aggregate level of economic activity including output, employment, general price level and money.

What does Macroeconomics Deal with?

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 Macroeconomics deals with aggregates.

1.2 Macroeconomics Goals and Variables

The issues examined under Macroeconomics studies are essentially overall averages and aggregates of the
system and the relationship among them. These define the scope of the subject while setting its goals. Hence,
the following goals and variables are identified as the primary fields of Macroeconomics. They are output,
employment, inflation, economic growth and stability, money, interest, rates, consumption, savings,
investment, and exchange rate adjustments.
These are examined below:
a. Output: Macroeconomic output is usually measured by Gross Domestic Product (GDP) or one of
the other national accounts. Macroeconomists interested in long-run increases in output study
economic growth. Advances in technology, accumulation of machinery and other capital, and better
education and human capital all lead to increased economic output over time. However, output does
not always increase consistently. Business cycles can cause short-term drops in output
called recessions. Economists look for macroeconomic policies that prevent economies from
slipping into recessions and that lead to faster long-term growth.
A variety of measures of national income and output are used in economics to estimate total
economic activity in a country or region, including gross domestic product (GDP), gross national
product (GNP), net national income (NNI), and adjusted national income (NNI* adjusted for
natural resource depletion). All are specially concerned with counting the total amount of goods
and services produced.
Three strategies have been used to obtain the market values of all the goods and services produced
in a country: the product (or output) method, the expenditure method, and the income method. The
product method looks at the economy on an industry-by-industry basis. The total output of the
economy is the sum of the outputs of every industry. However, since an output of one industry may
be used by another industry and become part of the output of that second industry, to avoid counting
the item twice we use not the value output by each industry, but the value-added; that is, the
difference between the value of what it puts out and what it takes in. The total value produced by
the economy is the sum of the values-added by every industry.
The expenditure method is based on the idea that all products are bought by somebody or some
organisation. Therefore, we sum up the total amount of money people and organisations spend in
buying things. This amount must equal the value of everything produced. Usually expenditures by
private individuals, expenditures by businesses, and expenditures by government are calculated
13
 separately and then summed to give the total expenditure. Also, a correction term must be
introduced to account for imports and exports outside the boundary.
The income method works by summing the incomes of all producers within the boundary. Since
what they are paid is just the market value of their product, their total income must be the total
value of the product. Wages, proprietor's incomes, and corporate profits are the major subdivisions
of income.
b. Unemployment/Full Employment: Full employment, in macroeconomics, is the level of
employment rates where there is no cyclical or deficient-demand unemployment. It is defined by the
majority of mainstream economists as being an acceptable level of unemployment somewhere above
0%. The discrepancy from 0% arises due to non-cyclical types of unemployment. Unemployment
above 0% is seen as necessary to control inflation in capitalist economies, to keep inflation from
accelerating, i.e., from rising from year to year. This view is based on a theory centering on the
concept of the Non-

Figure 1.1: Circular Flow of Income showing Full Employment

Accelerating Inflation Rate of Unemployment (NAIRU); in the current era, most mainstream
economists mean NAIRU when speaking of "full" employment. The NAIRU has also been

14
 described by Milton Friedman, among others, as the "natural" rate of unemployment. Having many
names, it has also been called the structural unemployment rate.
Shown below is the diagram of macroeconomic circulation. LS ≤ LD is the full employment
situation, one in which the rate of unemployment is zero or negative (corresponding to a labor
shortfall).
Unemployment (or joblessness) occurs when people are without work and actively seeking work.
The unemployment rate is a measure of the prevalence of unemployment and it is calculated as a
percentage by dividing the number of unemployed individuals by all individuals currently in
the labor force. During periods of recession, an economy usually experiences a relatively high
unemployment rate.
c. Inflation and General Price Stability: inflation is a sustained increase in the general price level of
goods and services in an economy over a period of time. When the general price level rises, each unit
of currency buys fewer goods and services. Consequently, inflation reflects a reduction in
the purchasing power per unit of money – a loss of real value in the medium of exchange and unit of
account within the economy. A chief measure of price inflation is the inflation rate, the annualized
percentage change in a general price index (normally the consumer price index) over time.
Inflation affects an economy in various ways, both positive and negative. Negative effects of inflation
include an increase in the opportunity cost of holding money, uncertainty over future inflation which
may discourage investment and savings, and if inflation were rapid enough, shortages of goods as
consumers begin hoarding out of concern that prices will increase in the future. Positive effects
include ensuring that central banks can adjust real interest rates (to mitigate recessions), and
encouraging investment in non-monetary capital projects.
Governments and central banks primarily use monetary policy to control inflation. The objective of
price stability refers to the general level of prices in the economy. It implies avoiding both prolonged
inflation and deflation. Price stability contributes to achieving high levels of economic activity and
employment by
• improving the transparency of the price mechanism. Under price stability people can
recognise changes in relative prices (i.e. prices between different goods), without being
confused by changes in the overall price level. This allows them to make well-informed
consumption and investment decisions and to allocate resources more efficiently;
• reducing inflation risk premia in interest rates (i.e. compensation creditors ask for the risks
associated with holding nominal assets). This reduces real interest rates and increases
incentives to invest;
• avoiding unproductive activities to hedge against the negative impact of inflation or deflation;

15
 • reducing distortions of inflation or deflation, which can exacerbate the distortionary impact
on economic behaviour of tax and social security systems;
• preventing an arbitrary redistribution of wealth and income as a result of unexpected inflation
or deflation;
• and contributing to financial stability.
d. Economic Growth and Stability: Economic stability refers to an economy that experiences constant
growth and low inflation. Advantages of having a stable economy include increased productivity,
improved efficiencies, and low unemployment. Common signs of an instability are extended time in
a recession or crisis, rising inflation, and volatility in currency exchange rates. An unstable economy
causes a decline in consumer confidence, stunted economic growth, and reduced international
investments.
Promoting economic stability is partly a matter of avoiding economic and financial crises, large
swings in economic activity, high inflation, and excessive volatility in exchange rates and financial
markets. Instability can increase uncertainty, discourage investment, impede economic growth, and
hurt living standards. A dynamic market economy necessarily involves some degree of instability, as
well as gradual structural change. The challenge for policymakers is to minimize instability in their
own country and abroad without reducing the economy’s ability to improve living standards through
rising productivity and employment.
The commitment to sound and sustainable public finances is a commitment to ensuring economic
growth and employment over the longer term. It also helps ensure that both today's and tomorrow's
citizens are provided for fairly – for example, through adequate healthcare provision and pensions.
As with consumers and companies, governments and their electorates – their citizens – also benefit
greatly from economic stability. Low inflation in a strong, well-managed euro area makes
government borrowing less expensive. This means that interest repayments on national debt, which
can be substantial, are reduced. This releases large amounts of taxpayers’ money, previously used to
repay the interest, for other purposes depending on national priorities; for example, for tax cuts, new
public infrastructure, or welfare systems. In addition, economic stability allows governments to plan
national finances, expenditure and revenues with more certainty.
Economic stability benefits society, in particular social cohesion and the less well-off. Volatile
changes in inflation and interest rates increase the gap between the richer and poorer groups and
regions, as those with more wealth have more opportunities to protect themselves. With stable
inflation and interest rates, the less well-off are better protected against the erosion of their wealth,
their savings and their purchasing power.

16
e. Money Supply: In modern economics, money has been considered as the most dynamic element in
the economy as well as a link between the present and the future. It influences not only the level of
prices but also the cyclical behavior of consumption, savings, investment and employment. In the
modern approach towards money the stability of money is no longer taken for granted, yet the
stabilization of the value of money is brought into direct relation with the stabilization of the levels
of income and employment. A well-conceived and well-executed monetary policy is, therefore,
considered as an essential pre-requisite for the stable and efficient working of the national economy.
Money is the fuel of the economy at three levels: the Federal Reserve and the government, business
firms, and individuals. At each of these levels, money plays a different yet equally important role and
each spend money with different goals in mind. These three levels also provide natural checks and
balances against each other by virtue of their interconnected nature.
At all three levels, money must be in circulation to maintain a healthy economy. Money circulates in
the government by receiving it through taxation and investment and spending it through programs
like the military and education. With business firms, money must circulate by receiving it through
the profit on the sale of goods and services and spending it on things like wages and research and
development. Individuals receive money through wages and interest on savings and spend it on goods
and services.
f. Interest Rates: An interest rate is the rate at which interest is paid by borrowers (debtors) for the use
of money that they borrow from lenders (creditors). Specifically, the interest rate is
a percentage of principal paid a certain number of times per period for all periods during the total
term of the loan or credit. Interest rates are normally expressed as a percentage of the principal for a
period of one year, sometimes they are expressed for different periods like for a month or a day.
Different interest rates exist parallelly for the same or comparable time periods, depending on the
default probability of the borrower, the residual term, the payback currency, and many more
determinants of a loan or credit. For example, a company borrows capital from a bank to buy new
assets for its business, and in return the lender receives rights on the new assets as collateral and
interest at a predetermined interest rate for deferring the use of funds and instead lending it to the
borrower. A commercial bank can usually borrow at much lower interest rates from the central bank
that companies can borrow from the commercial bank.
Interest-rate targets are a vital tool of monetary policy and are taken into account when dealing with
variables like investment, inflation, and unemployment. The central banks of countries generally
tend to reduce interest rates when they wish to increase investment and consumption in the country's
economy. However, a low interest rate as a macro-economic policy can be risky and may lead to the
creation of an economic bubble, in which large amounts of investments are poured into the real-estate

17
 market and stock market. In developed economies, interest-rate adjustments are thus made to keep
inflation within a target range for the health of economic activities or cap the interest rate
concurrently with economic growth to safeguard economic momentum.
g. Total Consumption: The study of consumption behaviour plays a central role in macroeconomics.
Macroeconomists are interested in aggregate consumption for two distinct reasons. First, aggregate
consumption determines aggregate saving, because saving is defined as the portion of income that is
not consumed. Because aggregate saving feeds through the financial system to create the national
supply of capital, it follows that aggregate consumption and saving behaviour has a powerful
influence on an economy’s long-term productive capacity. Second, since consumption expenditure
accounts for most of national output, understanding the dynamics of aggregate consumption
expenditure is essential to understanding macroeconomic fluctuations and the business cycle.
Consumption is normally the largest GDP component. Many persons judge the economic
performance of their country mainly in terms of consumption level and dynamics. The Keynesian
Theory of consumption is that current real disposable income is the most important determinant of
consumption in the short run. Real Income is money income adjusted for inflation. It is a measure of
the quantity of goods and services that consumers have buy with their income (or budget).
h. Aggregate Saving: saving offers something of a puzzle. From some viewpoints, savings are a
leakage from the circular flow of income, reducing multiplier effects. And if we all saved - in a
determined effort to repay our debts (which sounds like a great idea) – the level of aggregate demand
(AD) and economic activity would take a serious hit. This is the famous paradox of thrift. Yet
economies do need saving as a fund for business investment. The Harrod-Domar model is used in
development economics to explain an economy's growth rate in terms of the level of saving and
productivity of capital (see above). But many economies have a savings gap.
Aggregate saving occurs when the nation acquires real domestic asset. Such as new housing new
machinery, new factories and offices, additions to a firm's inventory of goods or new claim on asset
overseas. Saving is closely related to investment. By not using income to buy consumer goods &
services, it is possible for resources to be invested by being used to produce fixed capital, such as
factory & machinery. Saving can therefore be vital to increase the amount of fixed capital available
which contributes to economic growth.
However increased saving doesn't always refers to increased investment. If saving is not deposited
in a financial intermediary like bank or stashed for any reason there is no chance for those savings to
be recycled as investment by business.
This means saving may increase without increasing investment possibly causing a short fall of
demand rather than to economic growth. It may happen during recession period. In the short term, if

18
 saving falls below investment, it can lead to a growth of aggregate demand and an economic boom.
In the long term, if saving falls below investment it eventually reduces investment and detracts from
future growth is made possible by foregoing present consumption to increase investment.
i. Total Investment: Investment is spending on capital goods by firms and government, which will
allow increased production of consumer goods and services in future time periods. Be careful not to
confuse the economists’ definition of investment with another interpretation - that investment
involves putting funds into financial assets such as stocks and shares.
Investment is one kind of catalyst's for growth in aggregate wealth. Without increasing aggregate
saving we cannot increase investment. Investment is the accumulation of newly produced physical
entities, such as factories, machinery, houses, and goods inventories.
Investment is often modeled as a function of income and interest rates, given by the relation I = f (Y,
r). An increase in income encourages higher investment, whereas a higher interest rate may
discourage investment as it becomes more costly to borrow money. Even if a firm chooses to use its
own funds in an investment, the interest rate represents an opportunity cost of investing those funds
rather than lending out that amount of money for interest.
j. Exchange Rate Adjustment: An exchange rate is the price of one currency in terms of another – in
other words, the purchasing power of one currency against another. Exchange rates are an important
instrument of monetary policy.
Each country, through varying mechanisms, manages the value of its currency. As part of this
function, it determines the exchange rate regime that will apply to its currency. For example, the
currency may be free-floating, pegged or fixed, or a hybrid.
If a currency is free-floating, its exchange rate is allowed to vary against that of other currencies and
is determined by the market forces of supply and demand. Exchange rates for such currencies are
likely to change almost constantly as quoted on financial markets, mainly by banks, around the world.
A movable or adjustable peg system is a system of fixed exchange rates, but with a provision for the
revaluation (usually devaluation) of a currency. Still, some governments strive to keep their currency
within a narrow range. As a result, currencies become over-valued or under-valued, leading to
excessive trade deficits or surpluses.
A country may gain an advantage in international trade if it controls the market for its currency to
keep its value low, typically by the national central bank engaging in open market operations. Nigeria
has been acting this way over a long period of time.
Other nations, including Iceland, Japan, Brazil, and so on also devalue their currencies in the hopes
of reducing the cost of exports and thus bolstering their economies. A lower exchange rate lowers

19
 the price of a country's goods for consumers in other countries, but raises the price of imported goods
and services, for consumers in the low value currency country.
In general, a country that exported goods and services will prefer a lower value on their currencies,
while a country that imported goods and services will prefer a higher value on their currencies.

Mention any five macroeconomic variables.

The following are five macroeconomic variables.

Inflation, money supply, savings, foreign exchange, and total Investment

Macroeconomics may be defined as that branch of economic analysis which studies the
behaviour of all the units, combined.

1.3 Types of Macroeconomic Analyses

There are three methods of Macroeconomics analysis, viz:
(1) Macrotstatics
(2) Comparative macrostatics and
(3) Macrodynamics
Macrostatics: This is the method, which is used to explain certain aggregative relations in a
stationary state. It does not show the process by which the national economy reaches the final
equilibrium. It deals with the final equilibrium of the economy at a particular point in time. This
method presents a “stand still” picture of the economy as a whole at a particular point of time. This
can be illustrated with the simple Keynesian equation.
Y = C+I

Where: Y = Total Income

C = Total Household Consumption, and
I = Total Investment
This equation merely tells us that Y is equal to the aggregate of C and I. But it throws no light on the
process bye which this equality between Y on the one side and C + I o the other side has been reached.
In other words, the process of adjustment, which led to the final equilibrium, does not come into
limelight at all under macrostatics.
Comparative Macrostatics: The various macro-variables in an economy such as total consumption,

20
 total investment, total income etc. keep changing with time. As a result, the economy keeps on
reaching different levels of equilibrium. The method of comparative macrostatics involves a
comparable study of the different equilibria attained by the economy. But the method does not
analyze the process of adjustment through which the economy moves form one equilibrium to
another.
Macrodynamics: This method is the most realistic method of Macroeconomics analysis. In this
method, we study how the equilibrium in the economy is reached consequent upon changes in the
Macroeconomics variables and aggregates. This involves a detailed analysis of how the economy
moves from one equilibrium position to another – including all the factors that may disturb the
equilibrium positions. In essence, under macrodynamic analysis, nothing of consequence is omitted

Macrostatics: This is the method, which is used to explain certain aggregative relations in a
stationary state.

Summary of Study Session 1

This session briefly explained the meaning of Macroeconomics as a branch of Economics that deals with the
aggregative study unlike Microeconomics that deals with Individual analysis. You have also been taught that
does not only study the structure and trend of Macroeconomic Variables but pays adequate attention to the
relationship between these variables.
Self-Assessment Questions for Study Session 1
S.A.Q 1.1 What is Macroeconomics?
S.A.Q 1.2 Why is it important to study Macroeconomic variables individually and collectively?
S.A.Q 1.3 Explain Macrostatics, Comparative Macrostatics and Macrodynamics?
Multiple Choice Questions
1. Macroeconomics aim at ……..?
A. The study of macroeconomic policy of the governments
B. An understanding of the macroeconomy, macroeconomic variables and the
relationship between them.
C. An understanding of macroeconomic issues that derive from the microeconomic
analysis.
D. All of the above
2. Strike out the odd property from the following
21
A. Urban price level
B. Unemployment
C. Aggregate Investment
D. Output
3. One of the following is not part of the methodology of Macroeconomic analysis.
Identify that option
A. Macrostatics
B. Macrodynamics
C. Comparative Macrostatics
D. Comparative Macrodynamics
4. Macroeconomics focuses on the following units in an aggregative manner ….?
A. Individual Consumer-Household-Government
B. Government-Household-Firm-Individual Consumer
C. Household-Firm-Government
D. Individual Consumer-Household-Firm-Manufacturing Sector
5. Isolate the odd one from the following
A Exchange Rate
B. Inflation Rate
C. Public Expenditure
D. None of the above
6. A Flow variable is a variable that is defined ……?
A. over a period of time
B. at a particular point in time
C. in a particular year
D. between two periods
7. Which of the variables below does not belong to the group?
A. Income
B. wealth
C. fiscal deficit
D. saving
8. Which of the following is not a Stock variable?
A. savings
B. wealth
C. saving

22
 D. public debt
9. Macroeconomics deals with …….?
A. over all averages of the National economy
B. aggregates in the study of macroeconomic units
C. relationship with the various macroeconomic variables
D. all the above
10. Macroeconomic goals include all but one of the following.
A. price stability
B. firm output and capacity growth
C. full employment
D. economic growth
Links to OERs
https://socialsci.libretexts.org/Bookshelves/Economics/Book%3A_Economics_(Boundless)/18%3A_Introducti
on_to_Macroeconomics/18.1%3A_Key_Topics_in_Macroeconomics
https://socialsci.libretexts.org/Under_Construction/Purgatory/Workshops/4CD_OER_Hackathon/delmar/1%
3A_Welcome_to_Economics/1.3%3A_Microeconomics_and_Macroeconomics
https://socialsci.libretexts.org/Bookshelves/Economics/Book%3A_Principles_of_Economics/01%3A_Economi
cs%3A_The_Study_of_Choice/1.2%3A_The_Field_of_Economics
https://socialsci.libretexts.org/Bookshelves/Economics/Book%3A_Economics_(Boundless)/1%3A_Principles_
of_Economics/1.6%3A_Differences_Between_Macroeconomics_and_Microeconomics
Reference/Suggestions for Further Readings
Amacher, R.C. and Ulbrich, H.H. (1986) Principles of Macroeconomics, South-Western
Publishing Co.
Anyanwu, J.C. and Oaikhenan, H.E. (1995) Modern Macroeconomics: Theory and Applications
in Nigeria, Joance Educational Publishers.
Shapiro, E. (1996) Macroeconomics Analysis, Golgotia Publications (P) Ltd, New Delhi.
Olofin S. (2000) An Introduction to Macroeconomics, Malthouse Press Ltd, Ibadan.
William H. Branson (1972) Macroeconomic Theory and Policy, Harper and Row Publishers,
New York, London.
Ekpo A.H. (2000) Fiscal and Monetary Policy During Structural Adjustment in Nigeria, Nigerian
Economic Society, Ibadan.

Should you require more explanation on this study session, please do not hesitate to contact your e-
tutor via the LMS.

23
Are you in need of General Help as regards your studies? Do not hesitate to contact the DLI IAG
Center by e-mail or phone on:

[email protected] 08033366677

24
 STUDY SESSION 2:
NATIONAL INCOME AND CIRCULAR FLOW OF INCOME

Introduction
The keeping of financial records is a common phenomenon in the business world. Just as an individual
entrepreneur keeps an account of the monetary values of his production and consumption expenditures by
which the progress of his business is ascertained and evaluated, likewise, a nation keeps an account of the
aggregate values of its production, consumption and other economic activities. Such a record is otherwise
referred as ‘National Income. The complexity of such an account is the focus of this study session.

Learning Outcomes for Study Session 2

At the end of this study session, you should be able to:
2.1 Define national income.
2.2 Explain some basic concepts in national income accounting.
2.3 Explain the three methods of estimating national income.
2.4 Discuss the problems of computing national income.
Key Terms: National income, Personal income, GDP, GNP, Disposable
income, Per capita income, NNP, Income Approach, Output approach,
Expenditure Approach
2.1 National Income
National income is the basic concept in macroeconomics. It refers to the monetary value of all the goods
and services produced in a country during an accounting period, usually a year. The circular flow of income
is usually employed to throw more light on the methods of computing national income. As shown figure
2.1, two sectors are normally assumed, that is, the firm/business sector and the household. The household is
the owner of the factors of production: land, labour, capital, and entrepreneur. Firms or businesses employ
the factors of production to produce goods and services. For their contribution, the households are rewarded
in form of rent (land), interest (capital) wages and salary (labour) and profit/loss (entrepreneur). The
summation of the rewards of the factor of production constitutes the national income through the factor
income approach.
The summation of the goods and services produced by the firms is referred to as the national output, while
the expenditure of the household on the goods and services produced by the firms is otherwise referred to as
the national expenditure. This chain of activities is what we regard as circular flow of income. By definition,
circular flow of income is a model that indicates the movement of money throughout an economy, for
25
instance, between businesses and individuals. Investors spend their income by consuming goods and services
from businesses, paying taxes and investing in the stock market. Businesses use the money spent by
individuals while consuming together with the money raised from selling stock to pay for capital to run their
business, purchase material to manufacture products and to pay employees. Hence all the expenditure of the
businesses becomes the income of the individuals and vice versa

Figure 2.1: Interactions between firms and individuals in a circular form

Market for goods

and services

Firms Households

market for factors

of
production(labour)

2.1 What is circular flow of income?

2.1 By circular flow of income, we mean the flow of real resources and financial payments
between firms and households.

National income is the basic concept in macroeconomics. It refers to the monetary value of all the
goods and services produced in a country during an accounting period, usually a year.

2.2 Basic Concept in National Income Accounting

If the definition of national income is made elastic enough to include variables like the taxation, depreciation,
the nationality of the people involved in producing the goods and service among other factors, various

26
concepts of national income will emerge as discussed.
a. Personal Income
This is all earnings of an individual for taking part in the production process i.e production of goods
and services by self or owned properties. It includes wages to labour, interest received by the capital
owner, rent paid to the owner of land and profits received by entrepreneurs.
b. Disposable Income
This is part of the income which is left after personal income tax has been deducted.
Yd = Yp - Tax
c. Gross domestic product (GDP)
This is the total monetary value of all the final goods and services produced by the people living in a
country irrespective of their nationality within a given period of time, usually a year. GDP is also
called the local monetary value of all economic activity.
d. Gross national product (GNP)
This is the total monetary value of all goods and services produced by the nationals of a country
whether currently living in the country or abroad. GNP equals GDP plus net income from abroad.
Thus GNP = GDP + net-FIFA
e. Nominal and Real GNP
Nominal GNP measures GNP at the prices prevailing when income was earned. Real GNP, or GNP
at constant prices, adjusts for inflation by measuring GNP in different years at the prices prevailing
at some particular date known as base year.
f. Net national product
This is the gross national product less depreciation or capital consumption.
NNP = GNP – depreciation
National income measures the cost of the economic resources which have gone into the production
of output within a given period of time.
g. Per capita income
This is the national income divided by total population.
3.3.1 Flow not a stock
The GDP is not a measure of an economy’s wealth. It measures the flow of current output rather than
the resources available for the production of output. It includes the output of new cars during the
production period but not the stock of cars existing at a particular point in time. GDP includes, as
investment, the construction of new factories and new houses, but not the value of existing factories
and houses.

27
 Personal Income is all earnings of an individual for taking part in the production process i.e
production of goods and services by self or owned properties.

2.3 Measurement of National Income

Basically, there are three approaches or methods of national income accounting. They are considered below:
1. The income approach
2. The output approach
3. The expenditure approach
2.3.1 Income Approach
National income accounting by income approach sums all the income received by factors of
production-land earns rent, labour earns wages, capital earns interests and entrepreneur earns profit.
Aggregation of all income gives the national income which is calculated at factor cost.
2.3.2 Output Approach
National income is arrived at by adding together the value of net contribution of various sectors or
enterprises in the country. Value added simply means value of output less the cost of input. To get
value added, we take the firm’s output then deduct the cost of the input goods used up to make that
output. Closely related is the distinction between final goods and intermediate goods. For clarity,
final goods are purchased by the ultimate user, either households buying consumer goods or firms
buying capital goods such as machinery. Intermediate goods are partly-finished goods that form
inputs to a subsequent production process that then uses them up.
2.3.3 Expenditure Approach
This method measures the total expenditure of goods and services produced by individuals, firms and
government in a country. Basically, it is cumulating consumption by the household (C), investment
by the business (I), government spending or expenditure (G) and the net export(X-M) as economic
activities that constitute external sector. This is how we calculate Gross Domestic Product. The
mathematical equation is written thus:
GDP = C + I + G + (X-M)
Determinants of National Income
i. Stock of productive input available in terms of quality as well as quantity.
ii. State of technical knowledge.
iii. Extent of political and social stability.
iv. Level of infrastructure.
v. Level of economic stability which entails stable banking and financial systems.

28
2.3.5 Reasons for Measuring National Income
i. National income is used for economic planning.
ii. National income is used to measure economic progress.
iii. National income is used to measure the standard of living of the people.
iv. National income is used for international comparison.
v. National income can be used to attract foreign aids and technical assistance.
vi. National income influences foreign investment.

2.4 Problems of National Income Accounting

Measurement of national income poses several difficulties, which include both conceptual and statistical
ones. They are briefly described below.
1. Inappropriate prices: National income consists of not one but numerous goods, services, and
they have to be somehow added up to arrive at a measure of national income. The real difficulty
arises from the fact that dissimilar things cannot be added up. They have to be converted into some
common denominator before doing so and the only practical way of doing so is to take their market
prices. Now, it is widely recognized that market prices do not represent the true social valuation of
the goods and services. In the case of officially determined prices, they reflect only what the
authorities decide them to be and in the case of market determined prices, all kinds of market
imperfections distort them.
2. Addition difficulty: The problems of addition increase when we consider the question of
estimating national income in real terms. All the problems faced in the compilation of price index
numbers are encountered herein.
3. Imperfect or distorted information: There are problems regarding the reliability of information
to be used in estimating national income. These may arise owing to a number of factors as itemized
below:
(a) Several pieces of information are available with undue delay and it is not possible to use
them at appropriate time for formulation of effective policy measures. At the most, this
information may be used to revise the past estimates.
(b) A modern economy is so complex that it is next to impossible to gather complete
information needed for estimates of national income. A number of intelligent guesses have to
be made and used for this purpose. These omissions can be quite serious, particularly in the
case of developing countries where adequate records are not maintained. Moreover, in the
absence of records, most individuals and households are not able to provide correct

29
 information of their consumption and investment values.
(c) In some cases, relevant information may not be available to the authorities because the
households and business units required to provide the information may have reasons to hide
the information. In still other cases, they may not have the exact information.
4. Counting problem: National income estimates are faulty in terms of their conceptual approach as
well. The problem is that there is a lack of consistency even in this.
(a) The household services performed by the members of the household are left out of
estimates of income generation. But if the same services are performed by others and are paid
for in money terms, they are included in national income estimates. The logical inconsistency
of this stand comes to the fore when we compare two situations. In situation one, two
households perform various household services for themselves and no payment is involved.
In situation two, the two households perform same domestic services for each other and pay
each other in money terms. Clearly, there is no difference in real national income when we
move from one situation to the other. But in national income estimates, this is not so.
(b) Take the case of houses, factory buildings and other structures. When they are
constructed, there is a corresponding addition to national production. However, they are also
taken to add to the national income in later years when they are used for residential purposes
or as production centres. Moreover, this methodology is given up when we consider certain
other structures like roads. While the construction of roads is taken to contribute to national
income in the year of construction and the repairs are taken to add to national income later,
the use of roads is not taken to add to national income. However, if there is a road, which is
owned privately and can be used only on payment, the income received by the road owner is
again counted as a part of national income. There are similar contradictions in the case of
several other durable goods also. Thus, the manufacture of cars is counted as part of national
product during the year of manufacture but they are also taken to add to national income in
later years if they are hired out on payment instead of being used by the owners themselves.
In reality, however, the consumption service provided in both cases is the same.
(c) While consumption of fixed capital is considered when arriving at net output of the
economy, loss of other productive assets is ignored. Production activities not only lead to a
permanent loss of several mineral deposits, but also lead to degradation of many reproducible
resources. Examples include degradation of land fertility, forest resources, pollution of water,
discharge of harmful chemicals in the air and soil and so on. Some of these activities also lead
to a loss of human health. However, all such forms of losses to the economy are ignored while
estimating net value produced by the economy.

30
 (d) Even if the national income estimates ignore the loss of other productive resources and
confine itself only to the consumption of fixed capital, certain questions are not answered
satisfactorily. It can be debated as to whether depreciation should be estimated on the basis
of the cost of acquisition and technical life of the capital assets, or it should be estimated on
the basis of replacement cost.
5. Exclusion of illegal activities: The national income estimates do not cover illegal activities even
though they may be adding to national product. They include smuggling, inland trade activities,
production and income generation concealed from the authorities for avoiding tax obligations and
prosecution etc.
6. Inability to measure accurate economic contribution: National income estimates include profit
businesses. However, the profit of a business does not reflect the productive contribution of the
entrepreneur. Instead, it varies in relation to several factors like the overall expected or prevailing
rate of profit in the economy. This rate itself tends to vary from economy to economy, region-to-
region, industry to industry and with the passage of time.
In this context, mention may also be made of the fact that a large number of public sector undertakings
are not run with the motive of earning a profit, while private parastatals may fail to earn profit during
period of economic recession. As a result, national income estimates can vary simply because of
shifts in rate of profit without any, corresponding change in real output.
WORKED EXAMPLE
Given the following data about the economy
Table 2.1:
ITEM AMOUNT (N)
PERSONAL CONSUMPTION 700
INVESTMENT 500
CORPORATE INCOME TAX 215
PROPRIETOR’S INCOME 250
GOVERNMENT PURCHASES 300
PROFITS 250
WAGES 700
NET EXPORT 275
RENT 25
DEPRECIATION 25
INDIRECT BUSINESS TAX 100
UNDISTRIBUTED CORPORATE PROFIT 60
NET FOREIGN INFLOW -3
INTEREST 150

31
 SOCIAL SECURITY CONTRIBUTION 0
TRANFER PAYMENT 0
PERSONAL TAXES 165

Calculate the Gross Domestic Product (GDP) using income and expenditure approaches.

1. Income approach: Profits +Wages + Proprietor’s Income + Interest

GDP = 250 + 700 + 250 + 150 = N1350.
2. Expenditure approach: Consumption + Investment + Government Purchases + Net Export

GDP = 700 + 500 + 300 + 275 = N1775.

2.2 Why use final goods in Gross Domestic Product (GDP) computation?

2.2 Final goods are the commodities demanded by the ultimate user, either households which
purchase consumer goods such as bread, tomato; or firms buying capital goods like tools, plants
and machinery.

Summary of Study Session 2

National Income Accounting is the monetary value of the goods and services produced in a country during
an accounting period, usually a year. In making the definition of national income more elastic, we include
variables such as the nationality of the people involved in the production, depreciation of plant and machinery
used in the production, and inflation.
Circular Flow of Income has been discussed with a view to explaining the various methods of computing
national income
Gross domestic product (GDP) is the most widely used measure of a nation’s economic performance. Gdp
is the market value of all final goods and services produced in Nigeria during a period of time not minding
who owns factors of production.
National income measurement by income approach adds the major income components of GDP which
consist of rewards for factors of production.
Calculating national income by Expenditure approach sums the four major spending components of GDP:
consumption, investment, government net exports

32
Self-Assessment Questions for Study Session 1
SAQ 2.1 Explain why a washing machine sold to a dry cleaner is a final good though it is fixed investment
(capital) used to produce other goods. Is there a double –counting problem if this sale is added to GDP?
SAQ 2.2 Using the expenditure approach, net exports are total exports minus total imports. If the expenditure
by foreigners for Nigeria products exceeds the expenditures by Nigeria citizens for foreign products, net
exports will be a positive contribution to Gdp. Explain how net exports affect Nigeria economy. Describe
both positive and negative impacts on Gdp. Why do we use net export to calculate gdp rather than just add
exports to other expenditure components of gdp?

MCQs
1. National income can be defined as
a. the market value of goods and services produced in a state
b. the monetary value of all the goods and services produced in a country during an accounting
period, usually a year
c. the company value of all goods and services
d. the value of goods and services produced globally
2. Circular flow of income as a model
a. shows the movement of resources among states
b. shows the movement of fund
c. indicates the flow of human capital
d. shows the movement of resources between firms and households
3. Gross domestic product (GDP) refers to
a. total monetary value of all the final goods and services produced by the people living in a
country irrespective of their nationality within a given period of time, usually a year
b. monetary value of all final goods and services produced by the nationals of a country whether
currently living in the country or abroad
c. earnings of an individual for taking part in the production process
d. income which is left after personal income tax has been deducted
4. Depreciation also refers to
a. capital formation
b. capital destruction
c. net national product
d. capital consumption
5. By ‘stock’ variable, we mean

33
 a. total amount of existing output at a particular point in time
b. the amount of current output
c. value of output produced in a given year
d. excess capacity

6. National income computation by income approach

a. sum the value of households expenditure
b. sum all income received by factors of production
c. sum the value added to input
d. takes account of government intervention
7. One of the determinants of national income is
a. the number of political parties
b. the method of data gathering
c. business law
d. the state of technology
8. We measure national income so as to
a. criticise government programme and policies
b. make future economic forecast
c. develop an economic model
d. identify individual problems
9. One of the major problems encountered during national income accounting is
a. adjustment problem
b. valuation problem
c. counting problem
d. communication problem
10. By excluding illegal or underground activities from national income accounting
a. the exact economic contribution is overestimated
b. the true economic contribution is taken
c. the correct economic contribution of each sector is underestimated
d. we can rely totally on the figures
Links to OERs
https://socialsci.libretexts.org/Bookshelves/Economics/Book%3A_Economics_-
_Theory_Through_Applications/31%3A_Toolkit/31.28%3A_The_Circular_Flow_of_Income
https://socialsci.libretexts.org/Bookshelves/Economics/Book%3A_Principles_of_Economics/21%3A_

34
Measuring_Total_Output_and_Income/21.1%3A_Measuring_Total_Output
Reference/Suggestions for Further Readings
Amacher, R.C. and Ulbrich, H.H. (1986) Principles of Macroeconomics, South-Western Publishing Co.
Anyanwu, J.C. and Oaikhenan, H.E. (1995) Modern Macroeconomics: Theory and Applications in Ngeria,
Joance Educational Publishers.
Shapiro, E. (1996) Macroeconomics Analysis, Golgotia Publications (P) Ltd, New Delhi.
Olofin S. (2000) An Introduction to Macroeconomics, Malthouse Press Ltd, Ibadan.
William H. Branson (1972) Macroeconomic Theory and Policy, Harper & Row Publishers, New York,
London.

Should you require more explanation on this study session, please do not hesitate to contact your e-
tutor via the LMS.

Are you in need of General Help as regards your studies? Do not hesitate to contact the DLI IAG
Center by e-mail or phone on:

[email protected] 08033366677

35
 STUDY SESSION 3:
OVERVIEW OF THE KEYNESIAN THEORY

Introduction

The great depression of the 1930s that gave rise to massive unemployment provided the springboard for the
Keynessian approach to economic policy. John Maynard Keynes concluded that a market-driven economy
could fall into a recessionary trap and not get out. He therefore provided a set of concepts that posit a correct
theoretical basis to deal with the contemporary problem of mass unemployment. In this module therefore,
we focus on the demand side of the Macroeconomy. Specifically, we set out the analytical tools of Keynesian
employment theory.

Learning Outcomes for Study Session 3

At the end of this study session, you should be able to:
3.1 The Classical Economists and the Laissez-faire Economic Policy
3.2 The Postulates of the John Maynard Keynes

Key Terms: Classical economists, Laissez-faire economics policy

3.1 The Classical Economists and the Laissez-faire Economic Policy

For almost 150 years, economic theory relied on the classical economists that believed that governments
could be their own worst enemies when it comes to the economy. Classicalists averred that with laissez-faire
(hands-off government policies), the economy would better achieve the goals of price stability, full
employment, and economic growth.
However, the Classical Economic Theory did not stand the test of time as the Great Depression of 1930s
overwhelmed the developed economies and there was high unemployment rate and fall in real GDP in
different countries. Something had to be done and classical economic theory at that time offered no solutions.
The classical economists believed that prices, wages, and interest rates would adjust "as if led by an invisible
hand" to return the economy to full employment and economic growth.
The tide turned when John Maynard Keynes led a revolution in macroeconomic thought that began with his

36
book, General Theory of Employment, Interest, and Money, which was published in 1936. Prices, wages,
and interest rates were not declining as needed to stimulate demand and the economy. Keynes presented a
new macroeconomic theory that asked what government could do when prices, wages, and interest rates
were fixed, or "sticky". The solution he suggested is active government fiscal policy. Tax cuts or increased
government spending were needed for the economy to recover. This was a major departure from classical
economists of laissez-faire policy.
3.2 The Postulates of the John Maynard Keynes
Explicitly, prior to the depression of 1930s, economists (classicalists) believe that any idle resources caused
by a recession in the form of unemployed workers, empty factories and idle bank reserves creates what is
called the disequilibrium condition. In addition, this disequilibrium condition would correct itself. For
example, wages would decline until it was attractive enough for businesspeople to live more workers and fix
them up. Interest rates on its own would drop up to the level where it would be attractive enough to
businesspeople to borrow for the acquisition of machinery and inventory.
The great depression of 1930s therefore created the enabling ground for Keynes to launch his theory since
the idle resources would not find their own way back to work. He criticized the classical and observed that
it is possible to achieve equilibrium condition in the marketplace at a production level in which quantity
demanded at a price clears the market and the same time, in the short run, to have a part of the labour market
that are cut out of the market without any employment opportunity.
Keynes explained further that when there is a decline in consumer demand, businesspeople also react to this
by curtailing their investment Inventory and machinery. This action causes further reduction in consumer
demand and this sparks off idle capacity in factories and consequently resulting to layoffs. Due to economic
uncertainty, workers in anticipation of being laid off curtail their debt obligations and put up a savings
behavior to take care of “rainy days”.
We saw earlier that savings flows to investment. The classical economists believe that the interest rate will
fall under this circumstance to a level which make borrowing ant investment attractive to businesspeople. In
addition, they are of the opinion that low interest rate will discourage workers from savings.
Keynes’ opposition to the classical proposition is that when factories are empty of inventories and demand
is slackens, there is no rate of interest so low that makes borrowing and investment attractive to
businesspeople. In addition, when a worker is disengaged or foresees layoffs, there is no rate of interest so
low as to discourage savings.
Keynes argued further that as workers are laid off, it is true that they would be willing to accept jobs for less
pay, but because demand is declining and inventories are already higher than what the market demands, they
will not employ workers even if the workers are willing to take lower wages.
On the long run it might be possible for businesspeople to modify or change their production methods, and

37
employ more people, but in the short run, they cannot modify or change their machineries. Therefore, the
businesspeople can produce to meet up with the reduced level of demand without the need to utilize the idle
resources. The only way out of this depression according to Keynes is to stimulate demand.
Demand in an economy is a function of many things including disposable income. Keynes suggested
stabilization policy for business cycles. He proposed that government should reduce tax (so as to boost
disposable income) and run a deficit when demand shrinks and idle reserves exist. These measures will
stimulate demand and increase income level, employment and avert a recession.
The Keynessian theory can be presented alternatively as follows. The foundation of Keynesian
macroeconomic theory is that prices, wages, and interest rates are fixed. Prices and wages are directly related
because firms could not lower product prices if wages were not lowered. Classical economic theory suggests
that high unemployment rates would lead to lower wage rates, which would lead to lower prices, which
would lead to higher demand because of the increased purchasing power of existing wealth. But Keynes
observed that wages were not falling (actually there was a decline in the average price level during the early
1930s but evidently not enough). Keynes could not apply economic theory to explain why those out of work
were unwilling to accept a lower wage in order to get a job. He simply accepted it as an unexplained
socioeconomic fact of life and built a theory around the assumption that prices and wages were rigid.
Interest rates are a different story. Classical theory suggests that during a recession or depression, interest
rates should fall, which would stimulate consumption and investment spending. Keynes observed that if
interest rates were already near zero, they cannot go any lower. Moreover, even if interest rates could decline
further why would that lead to an increase in investment? With factories running well below capacity because
of the Depression, why build new production plants?
The assumption that prices and interest rates are fixed implies the aggregate supply curve is flat as shown in
Figure 3-1. Consequently, any change in aggregate supply (i.e., a rightward or leftward shift) will have no
effect on the economy. Aggregate demand is the driving force in Figure 1-1. On the supply side, firms simply
increase or reduce production at the constant market price to meet the level of demand.

Aggregat
e Price
Level

A
S
A
A D1
Real Output D0
Figure 3.1; Keynesian Aggregate Supply and Aggregate Demand

38
Here, we start with an accounting definition of aggregate expenditures because this is the foundation of the
Keynesian model. Also, there is need to convert the accounting identity for aggregate expenditures into a
model by first proposing an equilibrium condition in which aggregate output equals aggregate expenditures.
Thereafter, we will propose a behavioral equation for consumption in which people vary their consumption
spending based on their level of income. By doing this we convert consumption from the level of actual
spending in the accounting equation to the desired level of spending in our model. We can then build a simple
model that will reveal perhaps the most important feature of the Keynesian theory - spending multipliers.
Here, we begin by looking at the aggregate expenditures.

What is full employment?

Full employment is a certain politically acceptable rate of unemployment. This is a high level of
employment in which only a ‘politically acceptable’ percentage of unemployment is permitted. The
permitted rate of unemployment in full employment in US and Britain respectively are 3 – 4 and 21/2%.
3.2.1. Aggregate Expenditures
Herein, total spending on goods and services in the economy is the sum of four components:
consumption, investment, government spending, and net exports. Equation (1) is an accounting
identity that corresponds to the calculation of a country's GDP. We call this aggregate expenditure
rather than aggregate demand because prices are assumed to be fixed. Somewhere and sometime, it
became the convention in economics to use the term aggregate demand only in a graph of price versus
quantity, in which prices are variable.

AE = C + I + G + NX (1)

Where;
AE= aggregate expenditures
C = consumption
I = investment
G = Government spending
NX = net exports (exports - imports)
39
 Since prices are assumed constant in the Keynesian model there is no need to distinguish between
nominal and real expenditure or income.
To attain equilibrium, there is a need to convert the accounting identity for aggregate expenditures
into a macroeconomic model, and then we can propose an equilibrium condition. The economy is in
equilibrium when aggregate output is equal to aggregate expenditures. That is, firms are selling as
much as they produce and households are buying the amount they want to purchase.
Y = AE (2)
Where;
Y = aggregate output, or income
In the above equation, it is simply assumed that income is the same as aggregate output.
In the traditional classical macroeconomic theory, equilibrium always occurs at full employment
output. The economy may be below its potential or full employment level at a point in time but since
that does not represent equilibrium it cannot stay there. From a disequilibrium condition, the economy
will return to full employment equilibrium through adjustment of prices, wages, and interest rates.
In the Keynesian model with fixed prices, we can have equilibrium when the economy is operating
below its potential of full employment. The implication during the Great Depression was that the
economic depression could continue since it represents a possible equilibrium. The government must
step in to force the economy to a new equilibrium at full employment.
When the economy is not in equilibrium, aggregate output does not equal aggregate expenditures.
Firms are producing more or fewer goods than households are buying. What we will see in a
disequilibrium condition is that inventories are either building (output exceeds expenditures) or
declining (output is less than expenditures). In the classical model when there is undesired inventory
build or draw, firms will lower or raise prices to eliminate the imbalance. In the Keynesian model
with fixed prices firms will simply reduce or increase production without changing prices.

What is an aggregate supply curve?

This is a short-run schedule which shows the amount of output supplied at any price level, given a
fixed expected price level.

40
 Summary of Study Session 3

In this study session, you have learnt about:

• The laissez-faire economy of the Classicalists
• The depression of the 1930s and the failure of Classical theory to propose a solution.
• The emergence of the Keynes’ theory (later developed as Keynessian Economists).
• Keynes’ proposal and mode of intervention.

Self-Assessment Questions for Study Session 3

SAQ 3.1: What do you understand by laissez-faire?
SAQ 3.2: Explain explicitly Keynes theory and his criticisms of the Classicalists
Multiple-choice Questions
1) Aggregate expenditure in an open economy is represented by one of the following (C=
consumption, I =investment, G=government expenditure, NX=net export, M=import and N=
export)
(a) C+I+G
(b) C+I+G+XN
(c) C+I+G+NX
(d) C+I+G-M
2) One of the following is a net export9 where x =export and M is the import
(a) X+M
(b) G-M
(c) X/(X+M)
(d) X – M
3) Keynessian model of income determination was given impetus by
a) The need to propound a theory
b) The inability of the classicalists’ proposition to solve the depression of 1930s
c) The need to counter the existing theory
d) All of the above
4) One of these theories postulates that during a recession, interest rate should fall and this would
stimulate consumption and investment spending
a) Classical theory

41
 b) Neo classical theory
c) Keynes theory
d) Keynessian theory
5) Keynes concluded that a laissez-faire economy could fall into which of the following?
a) Unemployment
b) Inflation
c) Recessional trap
d) None of the above
6) The classicals believe that a market-driven economy would better achieve which of the following
goals?
a) Full employment
b) Price stability
c) Economic growth
d) All of the above
7) Which of the following led to the criticism of the classical economics?
a) Keynessian economists
b) The great depression of 1930s
c) The monetarist
d) The Neoclassicals
8) Which of the following describes the common usage of the term recession?
a) A fall in real GDP for the 2 quarters in recession
b) The slump in the supply of machinery
c) The low demand for goods and services for a quarter
d) The lack of industrial goods
9) Which of the following is the earliest economist to recommend the laissez-faire economy?
a) David Ricardo
b) John Maynard Keynes
c) Adam Smith
d) A.C Pigou
10) The branch of economic theory, and the doctrines, associated with Keynes is called
a) Keynes economics
b) Cambridge economics
c) Keynessian economics
d) Classical economics

42
 Links to OERs
https://socialsci.libretexts.org/Bookshelves/Economics/Book%3A_Principles_of_Macroeconomics/17
%3A_A_Brief_History_of_Macroeconomic_Thought_and_Policy/17.2%3A_Keynesian_Economics_i
n_the_1960s_and_1970s
https://socialsci.libretexts.org/Courses/Lumen_Learning/Book%3A_Macroeconomics_(Lumen)/12%
3A_10%3A_Keynesian_and_Neoclassical_Economics/12.1%3A_Why_It_Matters%3A_Keynesian_a
nd_Neoclassical_Economics
https://socialsci.libretexts.org/Bookshelves/Economics/Book%3A_Macroeconomics_(OpenStax)/12%
3A_The_Keynesian_Perspective/0Introduction_to_the_Keynesian_Perspective
Reference/Suggestions for Further Readings
Amacher, R.C. and Ulbrich, H.H. (1986) Principles of Macroeconomics, South-Western
Publishing Co.
Anyanwu, J.C. and Oaikhenan, H.E. (1995) Modern Macroeconomics: Theory and Applications
in Nigeria, Joance Educational Publishers.
Shapiro, E. (1996) Macroeconomics Analysis, Golgotia Publications (P) Ltd, New Delhi.
Olofin S. (2000) An Introduction to Macroeconomics, Malthouse Press Ltd, Ibadan.
William H. Branson (1972) Macroeconomic Theory and Policy, Harper & Row Publishers, New
York, London.
Ekpo A.H. (2000) Fiscal & Monetary Policy During Structural Adjustment in Nigeria, Nigerian
Economic Society, Ibadan.
Pearson Graham and Diran, Bodewhorn (1980) Managerial economics. Addison- Wesley
publishing company. Sydney.

Should you require more explanation on this study session, please do not hesitate to contact your e-
tutor via the LMS.

Are you in need of General Help as regards your studies? Do not hesitate to contact the DLI IAG
Center by e-mail or phone on:

[email protected] 08033366677

43
 STUDY SECTION 4:
CONSUMPTION, SAVINGS, AND INVESTMENT FUNCTIONS

Introduction
In any economy according to Keynes’ theory, equilibrium income level and output varies with the economy’s
aggregate demand for output. If there is a shortfall in the level of output that requires employment of all
available workers in its production, this leads to unemployment. In the same vein, this results into production
of goods and services below its potential. On the other hand, if aggregate demand is just enough, full
employment is created, and production is at its potential. If however aggregate demand is in excess, this
leads to inflation and full employment is attained and production is at its full potential.
Based on the Keynesian approach, aggregate demand is central in the discourse of unemployment and
equilibrium. Aggregate demand may be treated as the sum of consumption demand and private investment
demand. To accomplish the Keynesian analysis therefore, we must first break down the determinants of
aggregate demand into its components which include consumption, saving and private investment which is
the concern of this section.

Learning Outcomes for Study Session 4

At the end of this study session, you should be able to understand:

4.1 Define Consumption Function
4.2 Explain Saving Function
4.3 Discuss factors affecting consumption and savings
4.4 Define Investments
4.5 The determinants of investment decisions
4.6 Marginal efficiency of investment

Key Terms: Consumption, Consumption function, Saving, Saving function, Disposable

income, Investment, Autonomous investment, Induced investment

4.1 The Consumption Function

Consumption is simply total expenditure by consumers on final goods and services. It refers to expenditures

44
 by households (consumers) on final goods and services. The consumption function, just like the saving
function, depicts the relationship between income and spending. According to Keynes, we could learn a lot
about consumption simply by focusing on the relationship between income and spending. Accordingly, if
we know how much income consumers have, we should be able to predict how much they will spend on
consumption. Thus, is shown in figure 3.2.
Disposable income is however central here. Disposable income is the amount of income consumers take
home. This is the share of total income remaining in the hands of households after all taxes have been paid,
transfers (e.g. social security benefits) have been received, and depreciation charges and retained earnings
have been subtracted.

Consumption

Consumption
function

45o
Income

Figure 4.1: The consumption function

Consumption function therefore provides a precise basis for predicting how changes in income (YD) will
affect consumer spending (C).
4.2 The Saving Function
Saving is that part of disposable income not spent on current consumption (i.e. disposable income less
consumption). Disposable income (YD) represents the amount of income consumers can choose to spend or
not spend (save) in each period.
The saving function shows the relationship between saving and income. Savings generally varies directly
with income thus making their relationship a positive one. The following are the important points to note
about the saving functions:
(i) The saving function is expected to be positively related to income.
(ii) From zero to N100 income level, saving is negative and there is a negative intercept below the
origin (you will see this in the fig 3.3below).
(iii) Positive saving starts after the income level of N100m.

45
 Saving
(Nm) S

Saving

100 Income
(Nm)

Fig 4.2: The Saving Function

What is autonomous spending?

Categories of spending that is invariant of income in a simple model. This includes a portion of
consumption (autonomous consumption) and all private investment
The proportion of total disposable income spent on consumers’ goods and services in any given period is
referred to as average propensity to consume (APC). Simply put, APC is total consumption divided by total
disposable income.

APC = Total consumption (C)

Total disposal income (YD)
You will see that if total consumption for 2005 is N5,067 billion and total disposable income for the same
period is N5,307 billion, then;
APC = N5067 billion
N5307 billion = 0.9547
In other words, consumers spent, on average, about 95 kobo out of every Naira received. The remaining 5
kobo of every Naira was saved.
You must know however that the fact that APC was 0.9547 in 2006 does not imply that every consumer
46
spent exactly 95 kobo out of every Naira received. In other words, APC just summarizes the behavior of
millions of consumers with different incomes; consumers might have spent more or less out of each Naira.
It is necessary to observe how the choice between consumption and saving is influenced by changes in
income. The marginal propensity to consume (MPC) tells us how much consumer expenditure will change
in response to changes in disposable income.
MPC = Change in consumption =∆C
Change in disposable income ∆YD

MPC measures the fraction of income consumed as a result of a change in income. In order for you to
compute MPC, we could ask how consumer spending in 2005 was affected by the last Naira of disposable
income.

: If Ade’s disposable income increases from N4000 to N5000, and his consumption increases
from N3500 to N4000, find his MPC.
: MPC = ∆C = 4000 – 3500 = 500
∆YD 5000 – 4000 1000 = 0.5
That suggests that Ade spends half of his extra disposable income on consumption.
Once we have ascertained how much of their income consumers will spend, we also need to know the ratio
of savings to income. The average propensity to save (APS) measures the ratio of savings to disposable
income.

APS = Savings (S)

Income (YD)
The ratio of a change in saving to a change in disposable income is known as the marginal propensity to save
(MPS).
MPS = Change in saving S
Change in disposable income YD

MPS therefore measures the fraction of a change in disposable income which is saved.
You must note the following facts about MPC and MPS.
(i) Geometrically, MPC is the slope of the consumption function while MPS is the slope of the saving
function.

47
 (ii) MPC + MPS = 1 since every additional naira is either spent (consumed) or not spent (saved).
Alternatively, MPS equal one minus MPC and vice versa
(iii) Since disposable income is the sum of consumption and savings, it follows that APC + APS = 1

Consumption is simply total expenditure by consumers on final goods and services. It refers to
expenditures by households (consumers) on final goods and services.

4.3 Factors affecting consumption and savings

(i) Expectations: People who expect a pay rise often start spending more even before the extra income
is received and converse is the case when they anticipate being laid off.
(ii) Wealth: The amount of wealth an individual owns will affect the person’s ability and willingness to
consume. Wealth changes can also affect spending pattern.
(iii) Expectations of rising prices: This too can affect one’s consumption and saving behavior. For
instance, an anticipation of future rise in prices can lead to more consumption now.
(iv) Price levels or real-balance effect: Rising price levels reduce the real value of money balances and
cause people to reduce spending.
(v) Taxes: The major link between total and disposable income is tax. A change therefore in tax policy
may affect spending pattern.
(vi) Credit: The availability of credit encourages people to spend above their current income. On the
other hand, the need to meet up with past debt repayments places a limit on current consumption.
(vii) Changes in patterns of income distribution: You will recollect that households in any economy
have different MPCs; and MPC varies based on household income level. However, consumption of
poorer households will increase if incomes of those households are raised. Note that Udoji arrears
increased consumption substantially in Nigeria in the 1970s.
(viii) Some cultural factors: Consumption and savings are greatly influenced by people’s cultural beliefs.
In Nigeria for instance, some extravagant burial rites lead to excessive consumption and depression
of savings.

Briefly state 2 of the Keynes postulations about consumption function.

●Real consumption is stable function of real disposable income

48
 ● The MPC is positive but less than one
● The MPC < APC which implies that APC declines with rising income
● MPC declines with income rise.

4.4 Investments
Investment generally refers to the creation of new capital stock. Investment can be broken down into two
main categories (fixed investment and inventory investment). When business firms purchase new plant and
equipment for the purpose of expanding or improving their output capabilities, such purchases are called
fixed investment. Firms also acquire inventories of goods that can be used to satisfy consumers’ demands.
Such expenditures are called inventory investment.
4.5 The determinants of investment decisions are:
(i) Expectation: The desire to invest is influenced by, the expectations of future income and sales.
No firm would want to purchase a new plant and equipment neither unless his managers are
convinced that people would later buy the extra product of the plant and equipment nor would
producers want to accumulate larger inventories of goods if they thought sales were going to fall.
The favourable expectations of future sales therefore are a necessary condition for investment
spending.
(ii) Technology and innovation: Changes in technology and innovation increase the level of
investment. More recently, technological advances and cost reductions have stimulated an
investment spree in laptop computers, cellular phones, video conferencing, fiber-optic networks,
and anything associated with the internet.
(iii) Rate of interest: The major determinant of desired investment spending is the rate of interest.
Business firms often borrow money in order to purchase plant and equipment. The higher the rate
of interest, the costlier it is to invest. We would expect a lower rate of investment spending at
higher interest rates and more investment at lower rates (ceteris paribus).
4.6 Marginal efficiency of investment
Considerations of the relationship between the rate of interest and the investment decision prompted us to
the conclusion that investment is inversely related to the rate of interest.

49
 Rate of
interest
(%)
18 A

10 B
MEI

20 70 Investment (N million)
Fig 4.3: investment demand

In figure 5.3 above, if the rate of interest falls to 10%, N70 million worth of investment will be
made. If however, the rate of interest increases to 18%, investment volume will decline to N20 million. A
curve that joins possible points of investment decisions such as A and B in the graph above is called the
marginal efficiency of investment (MEI) function. This is based on the premise that investment should be
undertaken up to where the expected rate of profit is equal to the rate of interest.
Autonomous and induced investment
Keynes concludes that the demand for investment goods is heavily dependent on expectations, interest rates,
technology, and innovation. This explains why businesses often continue to purchase new plant and
equipment even in economic downturns. To the extent that investment is not affected by short-run changes
in national income, we may regard investment spending as autonomous (that is not dependent on income).
Induced investment is the investment that depends on income. This investment varies directly with income.
Investment is a function of income for two reasons. First, profits and profit expectations encourage
businesses to invest in direct proportion to their income increase. Secondly, investment is positively related
to GDP and the higher the growth of GDP, the greater the growth in investments.

Investment
Induced investment

Autonomous investment

Fig. 4.4: The induced and autonomous investment

0
Income (Y)

50
 Summary of Study Session 4

In this module, you have learnt about:

• Consumption, savings, and investments
• Consumption and savings functions.
• Concepts such as average propensity to save, average propensity to consume, marginal propensity
to save and marginal propensity to consume.
• Factors affecting consumption and savings
• Determinants of investment decisions.
• Marginal efficiency of investment, autonomous and induced investments.
Self-Assessment Questions of Study Session4
SAQ 4.1 What is the factors affecting consumption and savings
SAQ 4.2 What are the major determinants of investment decisions?
Multiple-choice Questions
(1) If total income for the year 2010 is ₦21,010 billion Naira, total transfer to the economy is ₦5,000 billion
while depreciation charges for the economy is ₦2,500 billion and, consumption expenditure for the period
is ₦15,000 billion. Disposable income and consumption expenditure for 2011 are ₦31,500 billion and
₦20,050 billion respectively. Total disposable income [in billion naira] for 2010 in the economy is?
(a) ₦21,010 (b) ₦5000 (c) ₦7,500 (d) ₦23,510 (e) ₦28,510.
(2) If total income for the year 2010 is ₦21,010 billion Naira, total transfer to the economy is ₦5,000 billion
while depreciation charges for the economy is ₦2,500 billion and, consumption expenditure for the period
is ₦15,000 billion. Disposable income and consumption expenditure for 2011 are ₦31,500 billion and
₦20,050 billion respectively. Average propensity to save for 2010 is?
(a) 0.286 (b) 0.362 (c) 0.7000 (d) 0.4739 (e) 0.421
(3) If total income for the year 2010 is ₦21,010 billion Naira, total transfer to the economy is ₦5,000 billion
while depreciation charges for the economy is ₦2,500 billion and, consumption expenditure for the period
is ₦15,000 billion. Disposable income and consumption expenditure for 2011 are ₦31,500 billion and
₦20,050 billion respectively. Marginal propensity to consume for 2011 is?
(a) 0.632 (b) 0.240 (c) 0.1771 (d) 0.523 (e) 0.731
(4) If total income for the year 2010 is ₦21,010 billion Naira, total transfer to the economy is ₦5,000 billion
while depreciation charges for the economy is ₦2,500 billion and, consumption expenditure for the period
is ₦15,000 billion. Disposable income and consumption expenditure for 2011 are ₦31,500 billion and
₦20,050 billion respectively. Marginal propensity to save for 2011 is?

51
(a) 0.269 (b) 0.477 (c) 0.823 (d) 0.760 (e) 0.368
(5) Expenditures on goods acquisition to meet consumers demand is called
(a) Investment (b) Inventory investment (c) Current investment (d) Fixed investment (e) Social investment
(6) One of the following is a determinant of consumption
(a) Total Income (b) Investment (c ) Expectations (d) Mood (e) Family size
(7) One of the following is a determinant of savings
(a) Real balance effect (b) Investment drive (c ) Availability of banks (d) Family size (e) Total Income
(8) A major determinant of Investment is?
(a) Consumption (b) Saving (c ) Rate of Interest (d) Cultural Factors (e) Total Income
(9) Which of the following is true of Investment?
(a) Investment is directly related to the rate of Investment (b) Investment is inversely related to the rate of
interest( c) Investment is difficult where consumption is low (d) Investment is a determinant of rate of interest
(e) None of the above
(10) Relationship between the rate of interest and Investment decisions is best captured by
(a) Autonomous Investment (b) Induced Investment (c) Fixed Investment(d) Inventory Investment (e)
Marginal Efficiency of investment [MEI] function
Links to OERs
https://socialsci.libretexts.org/Bookshelves/Economics/Book%3A_Macroeconomics_(OpenStax)/10%
3A_The_International_Trade_and_Capital_Flows/10.4%3A_The_National_Saving_and_Investment
_Identity
https://socialsci.libretexts.org/Bookshelves/Economics/Book%3A_Principles_of_Economics/29%3A_
Investment_and_Economic_Activity/29.1%3A_The_Role_and_Nature_of_Investment
https://socialsci.libretexts.org/Bookshelves/Economics/Book%3A_Principles_of_Economics/29%3A_
Investment_and_Economic_Activity/29.2%3A_Determinants_of_Investment
https://socialsci.libretexts.org/Bookshelves/Economics/Book%3A_Economics_-
_Theory_Through_Applications/05%3A_Life_Decisions/5.02%3A_Consumption_and_Saving
https://socialsci.libretexts.org/Bookshelves/Economics/Book%3A_Economics_-
_Theory_Through_Applications/27%3A_Income_Taxes/27.04%3A_Income_Taxes_and_Saving
Reference/Suggestions for Further Readings
Amacher, R.C. and Ulbrich, H.H. (1986) Principles of Macroeconomics, South-Western
Publishing Co.
Anyanwu, J.C. and Oaikhenan, H.E. (1995) Modern Macroeconomics: Theory and Applications
in Nigeria, Joance Educational Publishers.
Shapiro, E. (1996) Macroeconomics Analysis, Golgotia Publications (P) Ltd, New Delhi.
52
Olofin S. (2000) An Introduction to Macroeconomics, Malthouse Press Ltd, Ibadan.
William H. Branson (1972) Macroeconomic Theory and Policy, Harper & Row Publishers, New
York, London.
Ekpo A.H. (2000) Fiscal & Monetary Policy During Structural Adjustment in Nigeria, Nigerian
Economic Society, Ibadan.
Pearson Graham and Diran, Bodewhorn (1980) Managerial economics. Addison- Wesley
publishing company. Sydney.

Should you require more explanation on this study session, please do not hesitate to contact your e-
tutor via the LMS.

Are you in need of General Help as regards your studies? Do not hesitate to contact the DLI IAG
Center by e-mail or phone on:

[email protected] 08033366677

53
 STUDY SESSION 5:
MONETARY POLICY AND FISCAL POLICY

Introduction
This session deals with monetary policy and fiscal policy in detail and the special roles of the central bank
and the capital market. At the end of this session, you should be able to discuss the roles of the central bank,
meaning of monetary policy, types of monetary policy and fiscal policy.

Learning Outcomes for Study Session 5

At the end of this study session, you should be able to:
5.1 Define and explain Monetary and Fiscal Policies.
5.2 Explain the roles of central bank and ministry of Finance.

Key Terms: Monetary policy, Fiscal policy, Expansionary monetary policy, Restrictive or
contractionary monetary policy, Money market, Capital market, Balanced budget, Budget deficit,
Budget surplus

5.1 Monetary Policy

Monetary Policy is a policy of influencing the economy through changes in the banking system reserves
that influence the money supply and credit availability in the economy. Unlike the fiscal policy, which is
controlled by the government directly, monetary policy is controlled by the Central Bank of Nigeria (CBN).
For now, let us discuss the objectives of any monetary policy before we discuss the specific tools through
which monetary policy is conducted.
The objectives of any monetary policy are:
• To achieve full employment.
• To maintain minimum rate of inflation or to have price stability.
• To promote economic growth and development.
• To maintain balance of payment equilibrium.
• To have equitable distribution of income and wealth.
Students should also note that there are other functions of the monetary policy and these policies are different
for different countries. For example:

54
The CBN Act of 2007 of the Federal Republic of Nigeria charges the Bank with the overall control and
administration of the monetary and financial sector policies of the Federal Government.
The objects of the CBN are as follows:
1. ensure monetary and price stability.
2. issue legal tender currency in Nigeria.
3. maintain external reserves to safeguard the international value of the legal tender currency.
4. promote a sound financial system in Nigeria.
5. act as Banker and provide economic and financial advice to the Federal Government.
Consequently, the Bank is charged with the responsibility of administering the Banks and Other Financial
Institutions (BOFI) Act (1991) as amended, with the sole aim of ensuring high standards of banking practice
and financial stability through its surveillance activities, as well as the promotion of an efficient payment
system
In addition to its core functions, CBN has over the years performed some major developmental functions,
focused on all the key sectors of the Nigerian economy (financial, agricultural and industrial sectors).
Overall, these mandates are carried out by the Bank through its various departments.
The Central Bank of Nigeria (CBN) can influence the amount of money in the economy and the activities of
banks. The actual tools of monetary policy will affect the amount of reserve in the system. In turn, the amount
of reserve in the system will affect the interest rate. In order to facilitate the attainment of monetary policy
and to support the economic policy of the Federal Government, there shall be a Committee of the Bank
known as the Monetary Policy Committee (MPC).
The MPC shall consist of -
1. the Governor of the Bank who shall be the Chairman
2. the four Deputy Governors of the Bank
3. two members of the Board of Directors of the Bank
4. three members appointed by the President: and
5. two members appointed by the Governor
It should also be noted that monetary policy objectives can be achieved through the following instruments:
• Legal Reserve Ratio
• Interest Rate
• Open Market Operations
• Special Deposit
• Bank Rate
• Selective Credit Control
• Moral Suasion
55
 • Liquidity Ration
• Sales of Stabilization Securities
• Tools of monetary policy
The tools (instruments) of monetary policy differ with economic environments. Some countries like he USA
rely on a limited number of tools since the monetary environment is sophisticated enough to bring about the
required response. Both the methods of influencing economic life through monetary policy and the objectives
of such policies differ from country to country, reflecting differences in economic structure and instructional
development. The tools of monetary policy include open market operations, reserve requirements the
discount or bank rate, special deposits selective credit controls, interest rate. Exchange control and moral
suasion. Central Bank controls the supply of money through expansionary monetary policy and
contractionary or restrictive monetary policy.

Expansionary Monetary Policy: This is the shift in the monetary policy designed to stimulate aggregate
demand. For example, the central bank may reduce interest bank, bank rate and legal reserve ratio so as to
increase the growth rate of the money supply. Expansionary monetary policy will stimulate an economy in
recession toward full employment. If the economy is at full employment, expansionary policy will be
inflationary.
Restrictive or Contractionary Monetary Policy: This is a shift of monetary policy to reduce aggregate
demand and place downward pressure on the general level of prices. For example, reduction in the level of
money supply through increased interest rate, bank rate and legal reserve ratio.

ITQ 5.1 What is Monetary Policy?

ITA5.1 Monetary Policy is a policy of influencing the economy through changes in the banking system
reserves that influence the money supply and credit availability in the economy.
5.2 Money and Capital Markets
5.2.1 Money Market
Like any other commodity, money is bought and sold in money market. Those who have money to
sell go to this market to sell it and those who want to buy money to this market to buy it. The buying
and selling is done at a price called the rate of interest.
There are two main types of money market. One is the money market and the other is the capital
market. The money market proper deals with short-term funds while the capital market deals with
long-term funds. By short-term funds we mean that are required for any period up to about three
56
 years. Funds that are required for longer periods can be regarded as long-term funds.
The money market in West Africa is made-up of a number of markets in different financial
institutions. These include treasury bills, the call money fund and treasury reserve certificates.
Treasury bills were first issued in Nigeria and Ghana in 1960. They were initially issued monthly,
later they were issued every two weeks and now they are issued every week. The Treasury bill market
is a market in funds for ninety-one days. Those who need funds for such a period and those who have
funds to lend for such a period operate in this market. The call money market meets the requirements
of those who wish to borrow or lend money on an overnight basis or for a few days. In Nigeria, it
was established in July 1962 when a Special Fund was created at the central bank which was charged
with the responsibility of administering it. At the end of every day, participating institutions who
have surplus money put it in the fund on an overnight basis and those who need money to balance
their books borrow from it. Under this arrangement, the funds deposited are withdrawn able on
demand and interest is paid or charged at a rate determined by the central bank.
Another popular instrument in Nigeria money market is the treasury reserve certificate. This provides
a market for borrowers and lenders for periods longer than those provided by the call money scheme
or treasury bill at shorter than the long-term government security which matures after one or two
years and is intended to bridge the gap between treasury bills and development loan stocks.
There are other instruments in Nigeria’s money market like commercial papers. Treasury certificates,
pension funds, bankers acceptances, bankers unit funds etc. the various institutions that serve as
money markets in Nigeria are the CBN commercial and merchant banks, insurance companies,
discount houses and other financial institutions. The following are functions of Money Markets;
1. It allocates savings into investment and tends to obtain equilibrium between the
demand for and supply of loanable funds thereby promoting rational allocation of
resources.
2. A money market promotes liquidity and safely of financial assets and thereby it
encourages savings and investment.
3. A money market promotes financial mobility by enabling the transfer of funds from
one sector to the other.
A well-developed money market is essential for the successful implementation of the monetary policy
of the bank.
5.2.2 The Capital Market
The capital market is a market for mobilizing long-term securities. These securities are primarily of
two types: debt and equity
i. Debt Instrument are financial claims with an obligation by the insurer to pay interest at stated

57
 intervals and to redeem the issue at a future date. The types available on the Nigerian stock market
are divided into two groups.
ii. ndustrial Loans, Preference Stocks and Bonds which are issued by companies, government
parastatals and state governments. The FDSA are issued annually to raise long-term loans with
maturity ranging between six to twenty-five years. On the other hand, industrial loans, preference
stocks and bonds are corporate loan stocks that are standard forms for financing long-term capital
requirements.
iii. Equity capital refers to the capital of the owners of the firms i.e. ordinary shares/.the ordinary
shareholders are entitled to any surplus of income in the company after the prior right of creditors
have been satisfied. The Nigerian capital market is categorized into two: the Primary and Secondary
market. The primary is a market for the assurance of new securities. The mode of offer for the
securities traded in the market includes offers for subjection, rights issues, and debentures. Stock
preference shares State bonds and unit trusts. The unit trust scheme is a mechanism for mobilizing
the financial resources of small and big savers and managing such funds to achieve relatively high
returns with minimum risks through efficient portfolio diversification. The primary market is
administered by the Securities and Exchange Commission. The primary market is administered by
the Securities and Exchange Commission (SEC), the apex regulatory body of the entire Nigeria
capital market. On the other hand, the secondary market is a market for the sale and purchase of
existing securities. The ,market is organized and managed by the Nigerian stock exchange (NSE),
which brings holders of existing quoted securities wishing to sell such securities in contact with
individuals and institutions who are interested in buying them.
The main functionaries on the capital market in Nigeria are the CBN, commercial and merchant banks,
development banks, insurance companies and stock broking firms.

ITQ 5.2 What is Capital Market

ITA 5.2 Capital market is a market for mobilizing long-term securities. These securities are
primarily of two types: debt and equity
5.2 Fiscal Policy
We assume that the money supply (MS) is fixed, monetary policy is held constant so we can isolate and
focus on fiscal policy only. The Fiscal Policy is reflected through the government’s spending, taxing and
borrowing policies. It is one of the vital tools to help promote the macroeconomic goals of full employment,
price stability and rapid economic growth. Fiscal policy relates to government economic policy which relates
to the raising of revenue through taxation and the means and deciding on the level and pattern of expenditure
58
for the purpose of controlling and influencing economic activities for the attainment of some desirable
economic policy objectivities.
Fiscal policy refers to the manipulation of expenditure resources and taxation powers by the government for
the purpose of managing the economy. In advanced capitalist countries, fiscal have been mainly directed at
achieving price stabilization and full employment. The two essential elements of fiscal for this purpose
include:
(a) Discretionary fiscal policy
(b) Non-discretionary fiscal policy, otherwise called automatic stabilizers.
5.3 Discretionary fiscal policy
This refers to the deliberate use of fiscal actions for achieving certain macro-economic objectives.
Traditionally these policies are applied to the problem of recession and inflation.
Solving a recession problem:
An expansionary fiscal action must be applied for solving the problem of recession. This implies that
aggregate demand must be boosted by: -
a. Increase in government spending and or operating a budget deficit for expansionary effect if the
federal budget is clearly in balance
b. Decrease in taxes
c. A combination of a and b
The application of the above policies will invariably generate multiplier effects which will pull the economy
out of the recession through increased employment, output and income.
Solving Inflation Problems
In this case, the discretionary fiscal package used aim at producing a contracting effect on the economy. This
means that the fiscal actions must reduce aggregate demand which in turn will reduce pressure on the general
price level. The specific set of fiscal policies for solving inflation problems therefore include
(a) Reduction in government expenditure and or operating a budget surplus for deflationary
effects if the federal budget is balanced
(b) Increase in taxes
(c) A combination of a) and b
In general the above ultimate actions will reduce aggregate demand and set up a reverse multiplier process
whose ultimate will reduce the general price level.
5.3b. Non-discretionary fiscal policies or automatic stabilizers.
These are built in features in the fiscal system which generates stabilizing effects on the economy without
the deliberate action of policy makers. During a recession, automatic features will boost aggregate demand
to exert an expansionary influence on the macro system. During inflation, the automatic features will reduce
59
aggregate demand to exert a concretionary impact on the economy. Traditional examples of automatic
stabilizers include
(a) the tax system, especially a progressive one
(b) Unemployment compensation benefits
(c) Transfer payments
(d) Agricultural subsidies
(e) Dividend policies

Fiscal policy = Tax policy (T) and government spending (G) by the President and government with the
intention to affect the economy - promote growth, achieve low unemployment, etc.
Budget Deficits and Surpluses - Since fiscal policy involves a) setting tax policy to generate tax revenue (T),
and b) federal spending (G), we start by discussing Budget Surpluses and Deficits.
Balanced budget = Govt. Revenue (taxes, tariffs, fees) = Govt. Spending, (T = G)
Budget Deficit = Govt. Spending (G) > Govt. Tax Revenue (T)
Budget Surplus = Govt. Revenue (T) > Govt. Spending (G)
The federal budget is the primary tool of fiscal policy - attempt at stabilization and fine-tuning. Budget
deficits can change for two reasons:
1. Passive budget deficits - without a change in fiscal policy, deficits can reflect the current state of the
economy. Examples: deficit increases during recession. Tax receipts (T) are down during recession
and govt. spending (G) increases. During an expansion, T goes up and G goes down due to the strong
economy, leading to a smaller deficit, or a budget surplus.
2. Active Budget deficits - result from deliberate, discretionary fiscal policy where policy makers
plan the federal budget with the intention to spend more than they plan to take in (G > T, leading to
a deficit)
Nigeria’s budget deficits are mostly from discretionary fiscal policy, and when we talk about a "change in
fiscal policy," we are referring to a change in discretionary fiscal policy that affects the deficit or surplus.
Budget influences AD two ways:
1. Government spending on goods and services affects AD (G in C + I + G) such as National defense,
highways, education, etc. Increases in federal spending increases G in GDP, cuts in federal spending
decreases G.
2. Tax policy (T) influences AD. A tax cut increases disposable income, increases Consumption (C goes
up in GDP). Business tax cut increases business investment on equipment (I), etc. Tax decreases will
increase C and I, tax increases will decrease C and I.
Stabilize the economy through fiscal policy. If an economy is in recession, the government should engage in
Expansionary Fiscal Policy - increase government. spending and/or reduce taxes, increase budget deficit.

60
G > T (spending is greater than tax revenue), so the government. has to borrow money from individuals,
businesses or foreigners. Expansionary fiscal policy (active budget deficit) would involve some
combination of: i) cuts in personal income taxes, ii) cuts in corporate taxes, and iii) increased government
spending, and a possible budget deficit.
The Government can also pursue Restrictive Fiscal Policy to reduce aggregate demand (AD) by raising
taxes or cutting government. spending, running a smaller budget deficit or a budget surplus. Restrictive fiscal
policy in response to an expansionary "overheating" will also combat inflation.

ITQ 5.3 What is Fiscal Policy?

ITA 5.3 Fiscal policy relates to government economic policy which relates to the raising of revenue
through taxation and the means and deciding on the level and pattern of expenditure for the purpose of
controlling and influencing economic activities for the attainment of some desirable economic policy
objectivities.

Summary of Study Session 5

We have discussed in detail the roles of the central bank, the meaning of monetary and fiscal policies and
the main role of the money market and capital market.
Self-Assessment Question for Study Session
SAQ 5.1 Examine what you understand by Money Market.
S.A.Q 5.2 Discuss and differentiate between discretionary fiscal policy and expansionary monetary
policy
Multiple Choice Questions
1. Which of the following pairs best fit with fiscal policy?
A. Taxes and government spending.
B. Open market operations and reserve requirement
C. Taxes and open market operation
D. Open market operations and government spending
2. What is the primary purpose of taxation?
A. To annoy the public
B. To save money
C. To support the government
D. To help the Fed

61
3. Which of the following does not involve government spending?
A. Tayo purchases a new car.
B. Segun receives unemployment benefits.
C. Foluso is in the navy.
D. Lekan works for a defense contractor.
4. Which of the following is the key to taxation?
A. Government does not affect the public's money.
B. the government takes money from the public
C. The government gives money to the public.
D. None of the above.
5. Which of the following is the key to government spending?
A. The government does not affect the public's money.
B. The government takes money from the public.
C. The government gives money to the public.
D. None of the above
6. What does expansionary fiscal policy do to the production of cassava in Nigeria?
A. Does not affect it
B. Increases it
C. Decreases it
D. It depends
7. What does contractionary fiscal policy do to output?
A. Does not affect it
B. Increases it
C. Decreases it
D. It depends
8. What is the effect of expansionary fiscal policy on the money supply?
A. It depends
B. Does not affect it
C. Decreases it
D. Increases it
9. What is the effect of fiscal policy on the money supply?
A.It depends
B. Does not affect it
C. Decreases it

62
D. Increases it
10. What is the effect of stable fiscal policies on the money supply?
A. It depends
B. Does not affect it
C. Decreases it
D. Increases it

Links to OERs
https://socialsci.libretexts.org/Bookshelves/Economics/Book%3A_Principles_of_Macroeconomics_(C
urtis_and_Irvine)/12%3A_Exchange_rates_monetary_policy_and_fiscal_policy
https://socialsci.libretexts.org/Bookshelves/Economics/Book%3A_Principles_of_Macroeconomics_(C
urtis_and_Irvine)/11%3A_Inflation_real_GDP_monetary_policy_and_fiscal_policy
https://socialsci.libretexts.org/Bookshelves/Economics/Book%3A_Macroeconomics_(OpenStax)/17%
3A_Government_Budgets_and_Fiscal_Policy/17.4%3A_Using_Fiscal_Policy_to_Fight_Recession_U
nemployment_and_Inflation
Reference/Suggestions for Further Readings
Amacher, R.C. and Ulbrich, H.H. (1986) Principles of Macroeconomics, South-Western Publishing Co.
Anyanwu, J.C. and Oaikhenan, H.E. (1995) Modern Macroeconomics: Theory and Applications in Nigeria,
Joance Educational Publishers.
Shapiro, E. (1996) Macroeconomics Analysis, Golgotia Publications (P) Ltd, New Delhi.
Olofin S. (2000) An Introduction to Macroeconomics, Malthouse Press Ltd, Ibadan.
William H. Branson (1972) Macroeconomic Theory and Policy, Harper and Row Publishers, New York,
London.
Ekpo A.H. (2000) Fiscal and Monetary Policy During Structural Adjustment in Nigeria, Nigerian Economic
Society, Ibadan.

Should you require more explanation on this study session, please do not hesitate to contact your e-tutor via
the LMS.

Are you in need of General Help as regards your studies? Do not hesitate to contact the DLI IAG Center
by e-mail or phone on:

[email protected] 08033366677

63
 STUDY SESSION 6:
ELEMENTS OF TRADE

Introduction
This study session examines the concept of trade which is a key determinant of the growth and development
of any nation in the globe. Precisely, no nation stays in isolation by consuming what they produce, rather
they involve themselves in one trading activities or the other, to consume what they cannot produce and
export what they can produce for them to earn revenue. Therefore, it becomes pertinent for learners in the
field of economics to understand the basic elements of trade, and its vital roles in nation building. Also,
explained in this section are the earliest theories of trade, the pro, and cons of international trade as well as
trade policies and regulations.

Learning outcomes of Study Session 6

At the end of this study session, you should be able to:

6.1. Define and use correctly the key words printed in bold:
6.2. Explain the term trade
6.3 Describes the barter system of trade, the demerits, and merits
6.4. Identify the sub-division of trade
6.5 Distinguish between internal and external trade
6.6 Explain the motives why Countries involves in international trade
6.7. Discuss the elementary trade theory
6.8 Highlight the merit and demerit of international trade
6.9 Discuss international trade policies and regulations
6.10 Explain the reasons for trade regulation

Key Terms: Trade, Trade by barter, Internal trade, External trade, Tariff, Import
control, Quota, Subsidies
6.1 The Concept of Trade
The term trade in its simplest form means exchange of goods, services, or both. In a boarder term, it can be
defined as the activity or process of buying, selling, or exchanging of goods and services among two or more
persons or countries which is backed by means of payment in each period. Trade is likewise called commerce
and is essentially for satisfaction of human wants. It is conducted not only for the sake of earning profit; it

64
also provides service to the consumers. It is an important social activity because the economy needs
uninterrupted supply of goods always increasing and ever changing but never ending human wants. Trade
has taken birth with the beginning of human life and shall continue as long as human life exists on the earth.
It enhances the standard of living of consumers. Thus we can say that trade is a very important socioeconomic
activity of human life.
The actual face of trade was barter, which was the direct exchange of goods and services. That is, it is an
act of trading whereby goods and services are exchanged between two or more parties without the use of
money. An example of a barter arrangement would be if Mr. Osobase built a ranch fence for a cow for Mr.
Anthony in exchange for food. Rather than Mr. Anthony paying Mr. Osobase the builder, say, N10,000.00
for the fence, he would give the builder (Mr. Osobase) a similar value in beef. Virtually any good or service
can be bartered. However, trade by barter system had some difficulties which are discussed as follows:
i. Double coincidence of wants:
Under trade by barter system, a double coincidence of wants is a serious issue for exchange to take
place. That is, the needs of the two individuals who desire to exchange goods must coincide. For
instance, if Mr. Osa wants to acquire yams in exchange for garri, then he must find another person
who wants garri for yams. Such a double coincidence of wants involves great difficulty and wastage
of time in a modern society, it rarely occurs. In the absence of a double coincidence of wants, the
individuals under barter system are compelled either to hold their goods for long periods of time, or
to make numerous intermediary exchanges to get finally the goods of their choice.
ii. Absence of common measure of value:
Let assume that it is possible to have the double coincidence of wants, the absence of a common
measure of value creates great problem because a lot of time is wasted to strike a bargain. Because
there is no common measure in terms of which the value of a good and service can be expressed, the
problem arises how much yams should be exchanged for how many plastics or bags of garri.
iii. Lack of divisibility:
Another problem of the barter arrangement relates to the fact that all goods cannot be divided and
subdivided. In the absence of a common medium of exchange, a problem arises, when a big
indivisible commodity is to be exchanged for a smaller commodity. For example, if the price of a
cow is equivalent to five goats, then a person having one goat cannot exchange it for the cow because
it is not possible to divide the cow in small pieces without destroying its utility.
iv. Difficulty in making deferred Payments:
The trade by barter arrangement does not afford a reasonable unit in terms of which the contracts
about the deferred (future) payments are to be written. In an exchange economy, many contracts
relate to future activities and future payments. Under barter system, future payments are written in

65
terms of specific goods. It creates many problems. Such problems include:
(i) It may create controversy regarding the quality of goods or services to be repaid in future,
(ii) The two parties may be unable to agree on the specific good to be used for repayment.
(iii) Both parties run the risk that the goods to be repaid may increase or decrease in value
over the period of contract.
v. The problem of storing wealth:
In the trade by barter economy system, there is absence of appropriate and convenient means of
storing wealth or value, (a) As opposed to storing of generalized purchasing power (in the form of
money) in a monetary economy, the individuals have to store specific purchasing power (in the form
of horses, shoes, wheat etc.) under the barter system which may decrease in value in the due course
of time due to physical deterioration or a change in tastes, (b) It is very expensive to store specific
goods for a long time, (c) Again the wealth stored in the form of specific goods may create jealousy
and enmity among the neighbors or relatives.
vi. The difficulty in transporting goods and services:
Another challenge of barter system is that goods and services cannot be transported easily from one
place to another. For example, it is not easy and without risk for an individual to take herd of cows
from Edo state market to exchange them for other goods in Lagos state market. With the use of
money, the inconveniences or risks of transportation are removed. In spite of the demerits of
the barter system, it has some merits which are depicted as:
i. Under the barter system of trade, there is no problem of concentration of economic power
into the hands of a few rich persons since there is no possibility of storing the commodities.
ii. The trade by barter arrangement is a simple system devoid of the complex problems of the
modern monetary system.
iii. In the barter economy system, personal and natural resources are ideally utilized to meet
the needs of the society without involving any wastage.
iv. Under the barter trade arrangement, there is no question of over or under-production (or
of unemployment or underemployment) as goods and services are produced just to meet the
needs of the society.
v. The barter system also earns the benefits of division of labour since it represents a great
step forward from a state of self- sufficiency in which every individual has to be a jack of all
trades and master of none.
vi. The difficulties of international trade, such as, adverse balance of payments, foreign
exchange crisis, do not exist under barter system.
Having highlighted the benefits of barter system, learners ought to know that, today traders generally

66
 negotiate through a medium of exchange, like money, which then makes buying separate from
selling, or earning. The invention of money has made trade simpler. Thus, making trade exists for
many reasons. It can be due to specialization and division of labor. It exists between regions because
different regions have a comparative advantage in the production of some tradable commodity, or
because different regions' size helps getting benefits of mass production. Having stated the reason for
trade, there is the need to examine the sub-division of trade.

List three advantages and three disadvantages of trade by barter system

Under the barter arrangement, there is no question of over or under-production (or of unemployment or
underemployment) as goods and services are produced just to meet the needs of the society.
ii. In barter system, personal and natural resources are ideally utilized to meet the needs of the society
without involving any wastage.
iii. There is no problem of concentration of economic power into the hands of a few rich persons since
there is no possibility of storing the commodities.
Disadvantages
i. The problems of double coincidence of wants.
ii. Absence of common measure of value.
iii. Difficulty in making deferred Payments

6.1.1 Different forms/types of trade

The term trade has been viewed in different forms. We have the bilateral trade which involves the
trading activities between two individuals or countries and the multilateral trade which encompasses
trading activities between more than two individuals and countries. Within this context, we have to
divide trade into two types, namely:
i. Home, internal or domestic trade.
ii. Foreign, external, or international trade. These two types of trades are further discussed below:
i. home trade home trade is also known as internal trade. It is conducted within the
geographical and political boundaries of a country. It can be at local level, regional level, or
national level. Hence trade undertaken among traders of Lagos, Ogun, and Aba etc. is called
home trade.
Home /Internal trade can further be sub-divided into two groups, viz.
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 a.) Wholesale Trade: This involves individuals/firms buying larger quantities from
the manufacturers or producers and selling in lots to retailers for resale to consumers.
The wholesaler is a link between manufacturer and retailer. A wholesaler occupies
prominent position since manufacturers as well as retailers both are dependent upon
him. The wholesalers act as a middleman / intermediary between producers and
retailers.
b.) Retail Trade: It involves buying in smaller units from the wholesalers and selling
in very small quantities to the final consumers for personal use. The retailer is the last
link in the chain of distribution. He establishes a link between wholesalers and
consumers. There are different types of retailers small as well as large. Small scale
retailers include hawkers, pedlars, general shops, etc. See figure 7.1 for the different
types of trade.

Figure 6.1: Different types of trade

Trade

Home/Domestic/internal trade International/external trade

Wholesale Retail Import trade Export trade Entreport trade

ii. External Trade

ii. External Trade

External trade or international trade is also called foreign trade. It refers to buying and selling
between two or more countries. For instance, If Mr. Kutor who is a trader from Nigeria sells
his goods to Mr. Nwagwugwu another trader from Canada, then this is an example of foreign
trade. External trade can be further sub-divided into three groups, viz:
a) Export Trade: When a trader from home country sells his goods to a trader located
in another country, it is called export trade. For e.g. a trader from Tejosho in Nigeria
sells his goods to a trader located in Florida, USA.
b) Import Trade: When a trader in home country obtains or purchase goods from a

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 trader located in another country, it is called import trade. For instance, a trader from
Idumota market in Nigeria buys goods from Mr. Jackie another trader located in
Beijing, China.
c) Entrepot Trade: When goods are imported from one country and then re-exported
after doing some processing, it is called entrepot trade. In brief, it can be also called
as re-export of processed imported goods. Let take this example, suppose Mrs.
Abiodun a Canadian trader (from Canada) purchase some barrels of crude oil from
Mrs. Esther a Nigerian trader (from Nigeria), then she processed it into finished
products (Petrol, Kerosene, diesels etc.) and then re-export to Mrs. Osobase an
American trader (in U.S.A), we say entrepot trade have occurred.

What is the difference between entreport trade and export trade?

Entrepot trade is a form of trade whereby goods are export from one country to another and after value
added on the goods in the importing nation, it is re-exported to other countries. Likewise, export trade is a
form of trade whereby a trader dwelling in a country sells his goods to another trader in another country.

6.2 The differences between Domestic and Foreign Trade

i.) Domestic trade involves trading activities within the geographical region of a country. However,
when trade crosses the four boundaries of a country and trade takes place with other countries of the
world, it is known as external or foreign trade.
ii.) In internal trade, the value of goods and services are determined with the help of- currency of that
country while in foreign or international trade, the value of goods and services are determined with
the help of exchange rate between the currencies of the two countries.
iii.) Within the environment of domestic trade, the factors of production such as labour, land, capital
and entrepreneurs are mobile, to get higher income in any part of a country. But this is not easy in
the case of external/foreign trade. Capital and Labourers of a nation cannot move easily from one
society to another society. So in foreign trade, there is less mobility of factors but it is more in
internal/domestic trade.
iv.) In domestic trade, there is much scope for the operation of the forces of demand and supply. But,
in external trade, there is not much scope for the full operation of the forces of demand and supply.

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 v.) Basically, internal trade is subjected to laws and regulations of only one country, whereas external
trade is subjected to laws and regulations of two or more countries. Also, internal trade is, generally,
free from trade restriction, whereas foreign trade is subjected to a number of trade restrictions.
vi.) Although both internal/home trade and foreign trade are based on the principle of specialization
or division of labour, regional specialization within a nation leads to domestic trade or inter-regional
trade, whereas nation wise specialization leads to foreign trade.
vii.) About transportation of goods and services, there is lower cost of transporting goods and services
in domestic trade than in foreign trade. Also, there is greater risk in transporting goods in foreign
trade than in domestic trade. In foreign trade, there are language differences in business transaction
but this is not peculiar in home trade. Although, there are a lot of differences between internal and
international trade, but this section decided to identify the keys points for learner’s sound
understanding.
6.3 Reasons why countries involve in international trade.
i. Differences in factor endowments – Different nations are endowed with different natural resources.
Some economies are rich in natural resources (Nigeria has mineral resources) while others have
relatively little (Switzerland has few natural resources). Trade enables economies to specialize in the
export of some resources and earn revenue to pay for imports of other goods.
ii. Differences in Technological development- Another reason why economies involve in trading is
because of difference in technology that cut across different nations. Thus, trade benefit can occur
between countries if the countries differ in their technological abilities to produce goods and services.
Technology refers to the techniques used to turn resources (labor, capital, land) into outputs (goods
and services).
iii. Increased welfare – specialization (where countries have a comparative advantage in the
production of a good at a respective lower cost) and trade allow countries to gain a higher level of
consumption than they would do domestically and this leads to increased welfare and higher living
standards.
iv. Dissimilarities in Demand- trade gain can occur between countries if demands or preferences
differ between countries. Individuals in different countries may have different preferences or
demands for various products. For example, the Chinese are likely to demand more rice than
Americans, even if consumers face the same price. Nigeria can demand more champagnes than
Ghana would, even if they all faced the same prices.
v. Diversity of choice – Trading activities enables people to access goods and services that they may
not be able to produce ourselves. For instance, Nigeria import luxury cars (Range Rover Sports,
Toyota Camry, Fords etc.) they cannot produce.

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 vi. To gain economies of scale – With specialization and production on a larger scale than may be
possible domestically, an economy may be able to gain more economies of scale. This will lead to
lower average costs and benefit consumers through lower prices.
vii. Increased competition – Increased global competition may aid to spur domestic productivity
improvements and give domestic firms a better incentive to innovate and improve their products.
This will benefit consumers.
viii. Political / historical reasons – some trade takes place for political and other reasons relating to
history and tradition, though this is generally diminishing in importance.
Finally, trading activities might serve as an ‘engine for growth’ – increasing trading transactions may
help to spur greater domestic economic growth and drive further improvements in the standard of
living of the citizenry.
6.4 Theories of International Trade
There are numerous theories propounded by various authors to explain the concept of international trade but
we will streamline this work to three earliest theories, these include the mercantilist’s theory of trade,
absolute advantage and comparative advantage theories.
i) Mercantilism
This stress theory states that nations should accumulate financial wealth, usually in the form of gold,
by encouraging exports and discouraging imports. According to this theory other measures of
countries' wellbeing, such as living standards or human development, are irrelevant. Mainly Great
Britain, France, the Netherlands, Portugal and Spain used mercantilism during the 1500s to the late
1700s. Mercantilistic countries practised the so-called zero-sum game, which meant that world
wealth was limited and that countries only could increase their share at expense of their neighbours.
However, economic development was prevented when the mercantilistic countries paid their colonies
little for export and charged them high price for import. The main problem with mercantilism is that
all countries engaged in export but was restricted from import, prevention from development of
international trade.
ii) Absolute Advantage
The Scottish economist Adam Smith developed the trade theory of absolute advantage in 1776. The
theorist proposes that, a country that has an absolute advantage produces greater output of a good or
service than other countries using the same amount of resources. Simply because some countries
have natural advantage of cheap labour, skilled labour, mineral resources, fertile land etc. these
countries are able to produce some specific type of commodities at cheaper prices as compared to
others. So, each country specializes in the production of a particular commodity. Suppose, we have
two Countries, Nigeria and USA and both Nations produce petrol and car as seen in the table below.

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Here, Nigeria produces more of petrol (120,000 barrel per day as against USA’s 80,000 barrel per
day) and USA produces more of Cars than Nigeria. Thus, Nigeria has absolute advantage in the
production of petrol while USA has absolute advantage in Car production. Smith believes that it is
only in this kind of scenario that trade can take place between Countries and no country would then
need to produce all the goods it consumed. In addition, he opined that; trade should not take place
when a Nation has absolute advantage in the production of both commodities.

Table 6.4: Output of two Nations involves in international trade

Maximum Production
Nations Commodity Commodity
Petrol (Barrel per day in ‘000) Cars (per day)
Nigeria 120 160
USA 80 200

Also, Smith is of the notion that tariffs and quotas should not restrict international trade; it should be
allowed to flow according to market forces. His theory of absolute advantage destroys the
mercantilistic idea that international trade is a zero-sum game. According to the absolute advantage
theory, international trade is a positive-sum game, because there are gains for both countries for an
exchange. Unlike mercantilism this theory measures the nation's wealth by the living standards of the
people of a nation and not by gold and silver.
But this theory is not able to justify all aspects of international trade. This theory leaves no scope of
international trade for those countries that are having absolute advantage in all fields or for those
countries that are having no absolute advantage in any field.
There is a potential problem with absolute advantage. If there is one country that does not have an
absolute advantage in the production of any product, will there still be benefit to trade, and will trade
even occur? The answer may be found in the extension of absolute advantage, the theory of
comparative advantage.
iii) Comparative advantage
After 40 years of absolute advantage theory, in order to provide the full justification of international
trade arrangement, David Richardo presented the Richardian model—comparative cost theory in
1817. The theory states that a country should specialize in producing and exporting those products,
in which it has a comparative, or relative cost advantage compared with other countries and should
import those goods in which it has a comparative disadvantage. Out of such specialisation, it will
accrue greater benefit for all
If USA could produce 25 bottles of wine and 50 pounds of beef by using all of its production
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 resources and France could yield 150 bottles of wine and 60 pounds of beef by using the same
resources, then according to absolute advantage theory France finds clear advantage over USA in the
production of both beef and wine. So, there should not be any business activity between the two
countries. But this is not the case according to the comparative cost theory.

Table 6.5: Output of two Nations involves in international trade

Maximum Production
Nations Commodity Commodity
Wine Beef
USA 25 50
France 150 60

Comparative cost theory suggests relative comparing of the beef and wine production. In relative
comparing we can find that France sacrifices 2.5 bottles of wine for producing each pound of beef
(150/60) and USA sacrifices 0.5 bottles of wine for producing each pound of beef (25/50). So, we
can see that production of beef is more expensive in France as compared to USA. Comparative cost
theory suggests USA to import wine from France instead of producing it and in similar manner theory
suggests France to import beef from USA instead of producing it.
In this way, comparative cost theory well explains the driving forces behind international business.
In this theory there are several assumptions that limit the real-world application. The assumption that
countries are driven only by the maximisation of production and consumption and not by issues out
of concern for workers or consumers is a mistake.
6.5 The Merits and Demerits of International Trade
Merits of international trade
i) When nations indulge in trading with each other, there are monetary benefits accruing to the
respective country involves in such activity.
ii) Foreign trade makes more variety of goods available for consumer’s usage
iii) There are better qualities of goods when nations trade with one another.
iv) External trade brings about competition both at the international level as well as local level.
v) It brings about closer ties between nations.
Demerits of international trade
i.) Often times, foreign trade causes local production in a country to suffer.
ii.) When nations indulges in international trade, there is the tendency that local industries may be

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 overshadowed by their international competitors
iii.) Rich countries may influence political matters in other countries and gain control over weaker
nations.
iv.) Ideological differences may emerge between nations with regard to the procedures in trade
practices.
v.) Foreign trade is beneficial to the world economy. It adds to the money coffers of the world at
large.
6.6 International Trade Policies and Regulations
Trade policies and regulations are intended to maintain the equilibrium of economic objectives and gains.
Though, not all of these policies are compatible with all countries. Some of these policies are discussed
below:
i) Tariff: A tariff is a form of tax imposed on imported goods. It can be used to control import of
certain goods, to raise revenue, to protect infant industries as well to achieve macroeconomic goals.
A tariff or tax is added to the price of the imported good. Suppose, for example, that the price of an
imported good is N10,000. A tariff of N100 would then force importers to sell each good for N10100.
Domestic producers are usually thrilled with a tariff because the higher price of imports is bound to
reduce the quantity of imports sold. This means more domestic production is likely to be purchased.
Moreover, domestic producers can also raise the price they charge for their goods.
ii) Import control: This is an action taken by a government in order to limit the number of goods
that can be brought into a country from abroad to sell. It is another form of international trade policy
whereby the demand for imported goods are high as a result of high price and there is need for the
government to control import of goods into the Country.
iii.) Quota: This is a government-imposed trade restriction that limits the number, or in certain cases
the value, of goods and services that can be imported or exported during a particular time period.
Quotas are used in foreign trade to help regulate the volume of trade between countries. They are
sometimes imposed on specific goods and services to reduce imports, thereby increasing domestic
production. In theory, this helps protect domestic production by restricting foreign competition.

iv.) Prohibition and Embargo (Ban): Sometime the government can prohibit certain goods from
unfriendly Countries in order to protect her Citizenry. The government can banned some goods if
they feel it is harmful to the health of the people or it has bad influence on them.
v.) Subsidies: Another policy is for the domestic government to subsidize domestic industry facing
competition from imports. That is, the government pays domestic producers for each good produced.
Subsidies are simply payments from the government to individuals or businesses without any

74
 expectations of receiving any production in exchange. Domestic producers usually promote the use
of government subsidies as a way to be "competitive" with "lower cost" foreign imports. A subsidy
gives domestic producers the ability to produce more goods at a lower price and presumably reduce
the number of imports into the country. In sum, government may give subsidy to local entrepreneurs
to offset part of the costs of production.
vi.) Some antidumping legislation. Government can make laws to prevent a country from being
turned into a dumping ground for foreign goods.
vii.) Economic integration: This can take different forms. It can be in the form of custom unions, a
situation whereby two or more nations try to eliminate common tariff on their exports and have a
kind of common tariffs in their trade relations with each other. Examples are: European Economic
Community, Economic Community of West Africa States (ECOWAS), Economic Community of
East African States, European Economic Community (EEC), and General Agreement on trade and
Tariff (GATT) etc.
6.7 Arguments for Trade Regulation
While the benefits to domestic producers go a long way in explaining government trade policies, a number
of other reasons are also offered. Let's consider these arguments for trade regulation:
i.) Infant Industry: One common argument is to protect an infant industry; an industry is in its early
stages of development that is presumably unable to compete with more mature foreign industries.
However, trade protection might actually create a "crutch" that prevents the domestic industry from
maturing and improving efficiency.
ii) Low Foreign Wages: Another argument for trade restriction is to combat the low levels of wages
paid to foreign workers. Export subsidies or import tariffs would then allow domestic producers to
compete. However, low foreign wages are really just an indication that the foreign producers have a
comparative advantage.
iii.) Domestic Employment: A primary argument is to promote or protect domestic employment. If
fewer goods are imported, then more goods are produced domestically and more domestic citizens
have jobs. However, while imports could be, in principle, produced by domestic workers, eliminating
imports is no guarantee that the domestic industry will pick up the employment slack.
iv.) National Security: Furthermore, imports might need to be restricted to ensure a strong national
defence and to keep the country secure. Relying on foreign imports for a critical product might make
the country vulnerable. However, while a number of key national defence and security goods
(military aircraft, energy supplies, weapons, etc.) are justifiably protected to ensure that a country
can protect itself, other goods fall beyond the boundaries of this argument.
v.) Unfair Trade: Lastly, foreign competitors also might be benefitting from unfair trade practices,

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 especially selling imports below production cost, including subsidies from their governments. As
such, domestic producers need comparable assistance to remain competitive. However, this foreign
government/producer package can be considered as a part of the overall comparative advantage that
enables foreign trade.

6.8 The Concept of Free Trade or Trade Liberalization

When trade barriers, such as tariffs and subsidies are put in place, they protect domestic producers from
international competition and redirect, rather than create trade flows. However, when these trade policies
and regulation are absent or reduce in international trade, it is called free trade or trade liberalization. Thus,
we say Free trade occurs when there are no artificial barriers put in place by governments to limit the flow
of goods and services between trading countries. There are a lot of advantages when nations involves in free
trade, some are discussed below.
6.8.1 Advantages of free trade
i. Economic growth
The nations involved in free trade experience rising living standards, increased real incomes
and higher rates of economic growth. This is created by more competitive industries,
increased productivity, efficiency and production levels.
ii. Production efficiencies
Free trade improves the efficiency of resource allocation. The more efficient use of resources
leads to higher productivity and increasing total domestic output of goods and services.
iii. Benefits to consumers
Consumers benefit in the domestic economy as they can now obtain a greater variety of goods
and services. The increased competitions ensure goods and services, as well as inputs, are
supplied at the lowest prices.
iv. Increased production
Free trade enables countries to specialize in the production of those commodities in which
they have a comparative advantage. With specialization countries are able to take advantage
of efficiencies generated from economies of scale and increased output.
v. Employment opportunities
Trade liberalization creates losers and winners as resources move to more productive areas of
the economy. Employment will increase in exporting industries and workers will be displaced
as import competing industries fold (close down) in the competitive environment.
6.8.2 Disadvantages of free trade
Despite the benefits obtained from free trade, there are a number of arguments put forward by authors
and theorists against free trade and trade liberalization. These include:
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 i. Increased domestic economic instability from international trade cycles, as economies
become dependent on global markets. This means that investors, businesses, employees and
consumers are more vulnerable to downturns in the economies of the trading partners, eg.
Recession in the USA leads to decreased demand for Nigeria exports, leading to falling export
incomes, lower GDP, lower incomes, lower domestic demand and rising unemployment.
ii. With the removal of trade barriers, structural unemployment may occur in the short term.
This can impact upon large numbers of workers, their families and local economies. Often it
can be difficult for these workers to find employment in growth industries and government
assistance is necessary.
iii. International markets are not a level playing field as countries with surplus products may
dump them on world markets at below cost. Some efficient industries may find it difficult to
compete for long periods under such conditions. For instance, countries such as Nigeria whose
economies are largely agricultural face unfavourable terms of trade (ratio of export prices to
import prices) whereby their export income is much smaller than the import payments they
make for high value added imports, subsequently experience large foreign debt levels.
iv. Developing or new industries may find it difficult to become established in a competitive
environment with no short-term protection policies by governments, according to the infant
industries argument. It is difficult to develop economies of scale in the face of competition
from large foreign Transnational Corporations. This can be applied to infant industries or
infant economies (developing economies
v. Free trade can lead to pollution and other environmental problems as companies fail to
include these costs in the price of goods in trying to compete with companies operating under
weaker environmental legislation in some countries.

Summary of Study Sesson 6

This study session has thrown more light on the concept of trade. Within the context of trade, you have learnt
about the concepts of barter trade, the ‘pros’ and ‘cons’ of barter arrangement, some early theories utilized
to explain international trade. Also, the issues of trade regulation and why it is imposed was explicitly
discussed. Thereafter, the concept of free trade was explained to the understanding of learners. Furthermore,
the study session comes to an end with the discussion of the merits and demerits of free trade.
Self-Assessment Questions (SAQs) for Study Session 6
SAQ 6.1 Explain the term trade by barter?
SAQ 6.2 Explain three reasons why nations embark on international trade?
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Multiple choice Questions
Section A. Select the most appropriate letter (A, B, C, D) that best answers each of the following questions:
i.) Which one of these theories is associated with the words ‘Zero – Sum Game’……..
(a) Comparative advantage
(b) Mercantilism
(c) Absolute advantage
(d) Product life cycle
ii.) If goods are imported into Nigeria from Canada, then the imposition of a tariff in Nigeria
(a) Raises the price of the good in both countries ("the "Law of One Price").
(b) Raises the price in Nigeria and cannot affect its price Canada.
(c) Lowers the price of the good in Nigeria and could raise it in Canada.
(d) Raises the price of the good in Nigeria and lowers it in Canada.
iii.) Mercantilism held that..
(a) Silver alone was the mainstay of national wealth.
(b) Gold alone was the mainstay of national wealth.
(c) Silver and gold were the mainstays of national wealth.
(d) Silver and gold are not important for the national wealth of a country.
iv.) Which one of these theories is associated with the words ‘Positive – sum game’……..
(a) Comparative advantage
(b) Mercantilism
(c) Absolute advantage
(d) Product life cycle
v.) In the Mercantilist view of international trade (in a two-country world),
(a) Both countries could gain from trade at the same time, but the distribution of the gains
depended upon the terms of trade.
(b) Both countries could gain from trade at the same time, and the terms of trade were of no sequence for the
distribution of the gains.
(c) Neither country could ever gain from trade.
(d) One country's gain from trade was associated with a loss for the other country.
vi.) One of these, is not an advantage of nations involves in international trade.
(a) When nations indulge in trading with each other, there are monetary benefits accruing to the respective
country involves in such activity.
(b) Foreign trade makes more variety of goods available for consumer’s usage
(c) There are better qualities of goods when nations trade with one another.

78
(d) Foreign trade is beneficial to the world economy, thus it adds to the money coffers of the world at
large.
vii.) Which of these Nations was not involved in mercantilism trade in the 1500 to the late 1700s century?
(a) Netherlands
(b) Great Britain
(c) Portugal
(d) Ukraine
viii.) All of the following are problems encountered in barter trade except:
(a) Double coincidence of wants
(b) Absence of Common Measure of Value
(c) Lack of Divisibility
(d) The barter system is a simple system devoid of the complex problems of the modern monetary system.
ix.) When crude oil is imported from Shell Nigeria by a Brazilian oil company and this is processed into
petroleum, diesel and kerosene and later re-exported to chevron Kenya, this is called ……….
(a) Export trade
(b) Import trade
(c) Wholesale trade
(d) None of the above
x.) The theory of comparative advantage is associated with …..
(a) Adam Smith.
(b) David Ricardo.
(c) Ohlin-Hecker.
(d) John Stuart Smith.
Links to OERs
https://socialsci.libretexts.org/Bookshelves/Economics/Book%3A_International_Trade_-
_Theory_and_Policy/09%3A_Trade_Policies_with_Market_Imperfections_and_Distortions/9.10%3
A_Economic_Integration_Free_Trade_Areas%2C_Trade_Creation%2C_and_Trade_Diversion
https://socialsci.libretexts.org/Bookshelves/Economics/Book%3A_Economics_(Boundless)/31%3A_I
nternational_Trade/31.2%3A_Gains_from_Trade
https://socialsci.libretexts.org/Bookshelves/Economics/Book%3A_Economics_-
_Theory_Through_Applications/12%3A_Barriers_to_Trade_and_the_Underground_Economy/12.0
3%3A_Limits_on_Trade_across_Borders
Reference/Suggestions for Further Readings
Adebayo, A. (1999) ‘Economics, A simplified approach’ Volume 2, African International
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 publication Limited. ISBN 978-2837-24-5.
Afolabi, L. (1998) ‘Monetary Economics, Book published by PERRY BARR LTD. ISBN: 978-
2079-00-6.
Colorado Technical University Online. (2006) Global Managerial Economics Phase 3 Course Material.
Retrieved on August 8, 2007 from Council for Foreign Relations. (2007)
Mexico's Drug War. Retrieved on August 4, 2007 from
Frankel, J., A. (1990) ‘International Nominal Targeting’: A Proposal for Overcoming Obstacles to
Policy Coordination. Retrieved August 9, 2007 from
Rosenberg, M. (2007) ‘The Number of Countries in the World’. Retrieved on August 9, 2007 from
Sawyer, W. & Sprinkle, R. (2006) International Economics. (2nd ed.) Upper Saddle
River, NJ: Prentice Hall.
Tanzi, V. & Davoodi, H. (1998) ‘International Monetary Fund’. Roads to Nowhere: How Corruption in
Public Investment Hurts Growth. Retrieved August 9, 2007 from The Chief Engineer. (2007) Is
NAFTA to Blame? Retrieved on August 9, 2007
http://www.cfr.org/publication/13689/#2
https://campus.ctuonline.edu/MainFrame.aspx?ContentFrame=/Classroom/course.as x? Class
http://www.chiefengineer.org/content/content_display.cfm/seqnumber_content/3063.htm
http://geography.about.com/cs/countries/a/numbercountries.htm
http://ksghome.harvard.edu/~jfrankel/MONTDUMM.R51.PDF
http://oten.capex.com/oten_what_is_barter.htm
http://www.siilats.com/docs/keskkoolECON/ESAYINTR.htm
http://www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=international+trade
http://www.streetdirectory.com/travel_guide/141653/trading/history_of_trade.html
http://www.barternewyork.net/history-of-bartering.html
http://kalyan-city.blogspot.com/2011/03/what-is-trade-meaning-and-nature.html
http://www.investopedia.com/terms/b/barter.asp
http://www.preservearticles.com/201012271793/barter-system.html
http://www.bms.co.in/difference-between-internal-trade-and-international-trade/
http://www.economicsdiscussion.net/international-trade/difference-between-international-trade-and-
internal-trade/1914
http://www.investopedia.com/terms/q/quota.asp
http://markets.ft.com/research/Lexicon/Term?term=import-control

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Should you require more explanation on this study session, please do not hesitate to contact your e-tutor
via the LMS.

Are you in need of General Help as regards your studies? Do not hesitate to contact the DLI IAG
Center by e-mail or phone on:
[email protected] 08033366677

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 STUDY SESSION 7:
TERMS OF TRADE AND BALANCE OF PAYMENTS

Introduction

The previous study session examines the element of trade, which we define trade as a means of exchanging
goods, services, or both. This session will take a step further to give the learners a better understanding of
the concepts of terms of trade, balance of trade and Balance of Payments (BOPs) accounting. We all know
that every nation needs a favorable balance of trade records and surplus balance of payment receipts to boost
their economic growth, this shows how significant this topic is. Also, to give the learners a wider scope of
the subject matter, this session will identify the keys components of BOPs.

Learning outcomes of Study Session 7

At the end of this study session, you should be able to:

7.1 Define and use correctly the key words printed in bold:
7.2 Explain the concept of terms of trade
7.3 Identify the determinants of terms of trade
7.4 Discuss the term balance of trade
7.5 Explain the concept and components of balance of payments
7.6 Highlight the reasons why nations need balance of payment accounts
7.7 Discuss the problems in computing balance of payments accounting
7.8 Highlight the causes of Balance Of Payments (BOPs) deficits in Nigeria
7.9 Describe the measures to correct balance of payment deficit in Nigeria.
Key Terms: Terms of trade, Balance of trade, Balance of payment, Economic growth,
Devalution of currency, Inflation, Reciprocal demand, Export promotion, Import
Substitute, Exchange control

7.1 The Concept of terms of Trade

Terms of Trade (TOT) is a measure showing the price index of a nation’s exports in terms of its imports. In
other word, terms of trade show the relationship between the prices at which a country sells its exports and
the prices paid for its imports. Specifically, TOT represents the relationship between the price a country
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receives for its exported goods and the price it pays for imported items. For trade to be mutually beneficial
to all parties, the term of trade must make each nation better – off. That is, if the prices of a country’s exports
rise relative to the prices of its imports, one says that its terms of trade have moved in a favourable direction,
because, in effect, it now receives more imports for each unit of goods exported. The terms of trade, which
depend on the world supply of and demand for the goods involved, indicate how the gains from international
trade will be distributed among trading nations. For example, suppose the Nigeria economy is exporting
crude oil and importing petrol only, then the terms of trade, is solely the price of crude oil over the price of
petrol. In other words, how many litres of petrol can the Nigeria economy get for a barrel of crude oil. Since
many nations usually import and export variety of goods, measuring the TOT requires defining the price
indices for imported and exported goods and comparing the two. Based on the premises, the TOT is express
by dividing the value of exports by the value of imports, then multiplying the result by 100. This is expressed
as TOT:
Index of export prices X 100………………………………….equation 8.1
Index of import prices

Suppose the estimated value in equation 8.1, is less than 100 percent, thus, we deduce that, there is more
capital going out (to buy imports) of the country than capital coming in. However, if the result is greater than
100 perecnt, this implies that, the country is experiencing capital accumulation (more money is coming in
from exports). That is, when a country's terms of trade improve, it means that for every unit of exports sold
it can buy more units of imported goods. So potentially, a rise in the terms of trade creates a benefit in terms
of how many goods need to be exported to buy a given number of imports. Also, an increase in TOT can
mean the overall welfare of the country has improved, but not always. This often depends on the reason for
the change in prices. The TOT ratio can change based on several internal and external factors affecting a
particular country. These may include supply and demand for the products that are imported and exported,
as well as local and international economic health. A sudden TOT change can trigger balance of payment
problems if the country depends on export receipts to pay for its imports.
Historically, developing Nations are considered to be at a disadvantage regarding terms of trade. This is
because exports are more often raw goods or commodities with lower prices than the manufactured goods
imported from more developed counties. This analysis has come under scrutiny as more study is completed
on how TOT is affected by other factors, including a country's labour pool and foreign investments.

Suppose in 1998 Nigeria export price index rose from 150 to 220 in 2008 and her import price
index rose from 150 to 160 in the same years. Calculate the Nigeria TOT..

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 TOT1998 = 150 X 100 = 100 and TOT2008= 220 = X 100 = 137.5

150 160

The index figures indicated that Nigeria is better –off in 2008 as compared with the export and import price
index in 1998. This is because a given percentage of Nigeria export would buy about.

Terms of trade show the relationship between the prices at which a country sells its exports and
the prices paid for its imports.

7.1.1: Major factors that affect the terms of trade

i. Economic Growth: Economic growth is one major factor which affects the terms of trade. The
raising of a country’s national product or income over time is called economic growth. Given the
tastes and technology in a country, an increase in its productive capacity may affect favourably or
adversely its terms of trade.
ii. Reciprocal Demand: The terms of trade of a country depend upon reciprocal demand, that is,
“the strength and elasticity of each country’s demand for the other country’s product”. Suppose there
are two countries, Nigeria and USA, which produce zobo and cloth respectively. If Nigerian demand
for USA cloth becomes more intense (inelastic), as the price of cloth rises more than the price of
zobo, the commodity terms of trade will move against Nigeria and in favour of USA. On the other
hand, if USA demand for Nigeria zobo becomes more intense, the price of zobo will rise more than
the price of cloth, and the commodity terms of trade will move in favour of Nigeria and against USA
iii. Changes in Tastes: Changes in tastes of the people of a nation also influence its terms of trade
with another country. Suppose USA’s tastes shift from Nigeria’s zobo to its own cloth. In this
situation, USA would export less cloth to Nigeria and its demand for Nigeria zobo would also fall.
Thus, USA terms of trade would improve. On the contrary, a change in USA taste for Nigeria’s zobo
would increase its demand and hence the terms of trade would deteriorate for USA.
iv. Changes in Factor Endowments: Changes in factor endowments or natural resources of a nation
affect its terms of trade. Changes in factor endowments may increase exports or reduce them. With
tastes remaining unchanged, they may lead to changes in the terms of trade.
v. Tariff: An import tariff improves the terms of trade of the imposing country. Suppose a tariff is
imposed on Nigeria zobo by USA. These changes the terms of trade as it favours USA. Since the
quantity of exports reduced because of tariff by USA is greater than the quantity of imports reduced

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 by Nigeria, the terms of trade have definitely moved in favour of USA.
vi. Devaluation of currency: Devaluation raises the domestic price of imports and reduces the
foreign price of exports of a country devaluing its currency in relation to the currency of another
country. The effects of devaluation on the terms of trade have been much debated among economists.
It is stated that, devaluation is supposed to improve the balance of trade. Thus, a reduction in the
physical volume of imports in relation to the physical volume of exports constitutes an adverse
change in the gross barter terms of trade.
7.2. Analysis of Balance of Trade (BoT)

The Balance of Trade (BoT) is the difference between a nation’s exports and its imports. That is, BoT is the
difference between the value of goods and services exported out of a country and the value of goods and
services imported into the country. The balance of trade is the official term for net exports that makes up the
balance of payments. A crucial point to note is that both goods and services are counted for exports and
imports, because of which a nation has a balance of trade for goods (also known as the “merchandise trade
balance”) and a balance of trade for services. Thus, the official balance of trade is separated into the balance
of merchandise trade for tangible goods and the balance of services. The net or overall figure forms the
balance of trade or “trade balance” a major contributor to a country's economic well-being. The balance of
trade can be "favorable" that is surplus (exports exceed imports) or an "unfavorable" that is deficit (imports
exceed exports). A balance of trade surplus is most favorable to domestic producers responsible for the
exports. However, this is also likely to be unfavorable to domestic consumers of the exports who pay higher
prices. Alternatively, a balance of trade deficit is most unfavorable to domestic producers in competition
with the imports, but it can also be favorable to domestic consumers of the exports who pay lower prices.
Table 7.1 shows the Nigeria balance of trade statement for 14 years spanning from 2000 -2013.

7.1: Nigeria Balance of Trade (BOT) Account.

YEARS EXPORT IMPORT BALANCE OF TRADE
2000 1945723.3 985022.4 960700.9
2001 1867953.9 1358180 509773.6
2002 1744177.7 1512695 231482.4
2003 3087886.4 2080235 1007651.1
2004 4602781.5 1987045 2615736.2
2005 6372052.4 2800856 3571196.1
2006 5752744.7 3412177 2340568.1
2007 8126000.5 4381930 3744070.5

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 2008 9774510.9 5921450 3853061.2
2009 8356432 4583432 3773000
2010 11035823 8005411 3030412
2011 142314523 9485100 132829423
2012 187860350.3 15240943 172619407.3
2013 254839395.8 33415553 221423842.8
Source: CBN Statistical Bulletin various issues.

The Nigeria BoT from table 7.1 is obtained by subtracting import from her export. The Nigeria BoT
estimated in table 7.1 revealed that, there is trade surplus from 2001 to 2013. Here, the Nation’s export in
naira term is greater than her import. Precisely, exports of commodities (oil and natural gas) are the main
factor behind Nigeria's growth and its accounts for more than 95% of total exports. Nigeria's main exports
partners are: USA (30% of total in 2009), Equatorial Guinea (8%), Brazil (6.6%), France (6%) and India
(6%). Nigeria imports mainly: industrial supplies (32% of total), transport equipment and parts (23%), capital
goods (24%), food and beverage (11%) and consumer goods. Main import partners are: China (17% of total),
Albania (11.3%), United States (7.5%), France and Belgium.

The Balance of Trade (BoT) is the difference between a nation’s exports and its imports.

7.2.1: Some selected factors that affect balance of trade

There are several factors that affect a nation’s balance of trade. But for the learners understanding
few will be explain herein. These include:
i. Inflation: If inflation rate is running quickly in a country, the price to produce a unit of a product
may be higher than the price in a lower-inflation country. This would affect exports, as well as
affecting the trade balance.
ii. Trade policies: Nations that are insular and have restrictive trade policies such as high import
duties and tariffs may have larger trade deficits than countries that have open trade policies, since
they may be shut out of export markets because of these impediments to free trade.
iii. Exchange rates: A domestic currency that has appreciated significantly may pose a challenge to
the cost-competitiveness of exporters, who may find themselves priced out of export markets. This
may put pressure on a nation’s trade balance.
iv. Foreign currency reserves: To compete effectively in extremely competitive international
markets, a country has to have access to imported machinery that enhances productivity, which may
be difficult if foreign reserves are inadequate.

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 Highlight 3 factors each that affect terms of trade and balance of trade?

There are numerous factors that affect the terms of trade, three out of these are:
Reciprocal demand, change in taste and change in factor endowment
7.3 The Balance of Payments (BOPs) Account
The Balance of Payments (BOP) is the method countries use to monitor all international monetary
transactions over a specific period. It is a system of recording all a country's economic transactions with the
rest of the world over a period of one. A record of all transactions made between one country and all other
countries during a specified period. BOP compares the dollar difference of the number of exports and
imports, including all financial exports and imports. Usually, the BOP is calculated every quarter and every
calendar year. All trades conducted by both the private and public sectors are accounted for in the BOP to
determine how much money is going in and out of a country. If a country has received money, this is known
as a credit, and, if a country has paid or given money, the transaction is counted as a debit. Theoretically, the
BOP should be zero, meaning that assets (credits) and liabilities (debits) should balance. But in practice, this
is rarely the case and, thus, the BOP can tell the observer if a country has a deficit or a surplus and from
which part of the economy the discrepancies are stemming.
Nations keep record of their balance of payments over the course of a one-year period; Nigeria and some
other nations also keep such a record on a quarterly basis. An international transaction is an exchange of
goods, services, or assets between residents of one country and those of another. Residents include
businesses, individuals, and government agencies that make the country in question their legal domicile.
Although a corporation is considered to be a resident of the country in which it is incorporated, its overseas
branch or subsidiary is not. Military personnel, government diplomats, tourists, and workers who emigrate
temporarily are considered residents of the country in which they hold citizenship. The arrangement of
international transactions into a balance-of-payments account requires that each transaction be entered as a
credit or a debit. A credit transaction is one that results in a receipt of a payment from foreigners. A debit
transaction is one that leads to a payment to foreigners. This distinction is clarified when we assume that
transactions take place between Nigeria’s residents and foreigners and that all payments are financed in
dollars. From the Nigerian perspective, the following transactions are credits (+ ), leading to the receipt of
Naira from foreigners:
• Merchandise exports
• Transportation and travel receipts
• Income received from investments abroad
• Aid received from foreign governments
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 • Investments in Nigeria by overseas residents.
Conversely, the following transactions are debits (–), from the Nigeria’s viewpoint because they involve
payments to foreigners:
• Merchandise imports
• Transportation and travel expenditures
• Income paid on investments of foreigners
• Gifts to foreign residents
• Aid given by the Nigeria government
• Overseas investment by Nigerian residents
Although we speak in terms of credit transactions and debit transactions, every international transaction
involves an exchange of assets and so have both a credit and a debit side. Each credit entry is balanced by a
debit entry, and vice versa, so that the recording of any international transaction leads to two offsetting
entries. In other words, the balance-of-payments accounts utilize a double-entry accounting procedure.
7.3.1 Division of Balance of Payments
The BOP is divided into three main categories: the current account, the capital account and the
financial account. Within these three categories are sub-divisions, each of which accounts for a
different type of international monetary transaction.
i. The Current Account. The current account of the balance of payments refers to the
monetary value of international flows associated with transactions in goods, services, income
flows, and unilateral transfers. Each of these flows will be described in turn. Merchandise
trade includes all of the goods that Nigeria exports or imports: agricultural products,
machinery, automobiles, petroleum, electronics, textiles, and the like. The Naira value of
merchandise exports is recorded as a plus (credit), and the Naira value of merchandise imports
is recorded as a minus (debit). Combining the exports and imports of goods gives the
merchandise trade balance. When this balance is negative, the result is a merchandise trade
deficit; a positive balance implies a merchandise trade surplus. Exports and imports of
services include a variety of items. When Nigeria’s ships carry foreign products or foreign
tourists spend Nigeria’s money at restaurants and motels, valuable services are being provided
by Nigeria’s residents, who must be compensated. Such services are considered exports and
are recorded as credit items on the goods and services account. Conversely, when foreign
ships carry Nigeria’s products or when Nigeria’s tourists spend money at hotels and
restaurants abroad, then foreign residents are providing services that require compensation.
Because Nigeria’s residents are, in effect, importing these services, the services are recorded
as debit items. Insurance and banking services are explained in the same way. Services also

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include items such as transfers of goods under military programs, construction services, legal
services, technical services, and the like. To get a broader understanding of the international
transactions of a country, we must add services to the merchandise trade account. This total
gives the goods and services balance. When this balance is positive, the result is a surplus
on goods and services transactions; a negative balance implies a deficit. Just what does a
surplus or deficit balance appearing on Nigeria’s goods and services account mean? If the
goods and services account shows a surplus, Nigeria has transferred more resources (goods
and services) to foreigners than it has received from them over the period of one year. Besides
measuring the value of the net transfer of resources, the goods and services balance also
furnishes information about the status of a nation’s gross domestic product (GDP). This is
because the balance on the goods and services account is defined essentially the same way as
the net export of goods and services, which is part of a nation’s GDP. Within the current
account are credits and debits on the trade of merchandise, which includes goods such as raw
materials and manufactured goods that are bought, sold or given away (possibly in the form
of aid). Services refer to receipts from tourism, transportation (like the levy that must be paid
in Egypt when a ship passes through the Suez Canal), engineering, business service fees (from
lawyers or management consulting, for example), and royalties from patents and copyrights.
When combined, goods and services together make up a country's balance of trade (BOT).

The BOT is typically the biggest bulk of a country's balance of payments as it makes up total
imports and exports. If a country has a balance of trade deficit, it imports more than it exports,
and if it has a balance of trade surplus, it exports more than it imports. Receipts from income-
generating assets such as stocks (in the form of dividends) are also recorded in the current
account. The last component of the current account is unilateral transfers. These are credits
that are mostly worker's remittances, which are salaries sent back into the home country of a
national working abroad, as well as foreign aid that is directly received.
ii. The Capital Account: Capital and financial transactions in the balance of payments
include all international purchases or sales of assets. The term assets is broadly defined to
include items such as titles to real estate, corporate stocks and bonds, government securities,
and ordinary commercial bank deposits. The capital and financial account include both
private-sector and official (central bank) transactions. Capital transactions consist of capital
transfers and the acquisition and disposal of certain non-financial assets. The major types of
capital transfers are debt forgiveness and migrants’ goods and financial assets accompanying
them as they leave or enter the country. The acquisition and disposal of certain non-financial

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 assets include the sales and purchases of rights to natural resources, patents, copyrights,
trademarks, franchises, and leases. Though conceptually important, capital transactions are
generally very small in accounts and thus will not be emphasized in this session. The capital
account is where all international capital transfers are recorded. This refers to the acquisition
or disposal of non-financial assets (for example, a physical asset such as land) and non-
produced assets, which are needed for production but have not been produced, like a mine
used for the extraction of diamonds. The capital account is broken down into the monetary
flows branching from debt forgiveness, the transfer of goods, and financial assets by migrants
leaving or entering a country, the transfer of ownership on fixed assets (assets such as
equipment used in the production process to generate income), the transfer of funds received
to the sale for acquisition of fixed assets, gift and inheritance taxes, death levies, and, finally,
uninsured damage to fixed assets.
iii. The Financial Account: In the financial account, international monetary flows related to
investment in business, real estate, bonds and stocks are documented. Also included are
government-owned assets such as foreign reserves, gold, special drawing rights (SDRs) held
with the International Monetary Fund, private assets held abroad, and direct foreign
investment. Assets owned by foreigners, private and official, are also recorded in the financial
account.
7.3.2 Balancing Act
The current account should be balanced against the combined-capital and financial accounts.
However, as mentioned above, this rarely happens. We should also note that, with fluctuating
exchange rates, the change in the value of money can add to BOP discrepancies. When there is a
deficit in the current account, which is a balance of trade deficit, the difference can be borrowed or
funded by the capital account. If a country has a fixed asset abroad, this borrowed amount is marked
as a capital account outflow. However, the sale of that fixed asset would be considered a current
account inflow (earnings from investments). The current account deficit would thus be funded.
When a country has a current account deficit that is financed by the capital account, the
country is actually foregoing capital assets for more goods and services. If a country is borrowing
money to fund its current account deficit, this would appear as an inflow of foreign capital in the
BOP.
7.3.3 Liberalizing the Accounts:
The rise of global financial transactions and trade in the late 20th century spurred BOP and
macroeconomic liberalization in many developing nations. With the advent of the emerging market
economic boom - in which capital flows into these markets tripled from USD 50 million to USD 150

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million from the late 1980s until the Asian crisis - developing countries were urged to lift restrictions
on capital and financial-account transactions in order to take advantage of these capital inflows. Many
of these countries had restrictive macroeconomic policies, by which regulations prevented foreign
ownership of financial and non-financial assets. The regulations also limited the transfer of funds
abroad. But with capital and financial account liberalization, capital markets began to grow, not only
allowing a more transparent and sophisticated market for investors, but also giving rise to foreign
direct investment. For example, investments in the form of a new power station would bring a country
greater exposure to new technologies and efficiency, eventually increasing the nation's overall Gross
Domestic Product (GDP) by allowing for greater volumes of production. Liberalization can also
facilitate less risk by allowing greater diversification in various markets.
Concerning the balance of payments, the current account and the capital and financial account are
not unrelated; they are essentially reflections of one another. Total debits will always equal total
credits because the balance of payments is a double-entry accounting system. It follows that if the
current account registers a deficit (debits outweigh credits), the capital and financial account must
register a surplus, or net capital/financial inflow (credits outweigh debits). Conversely, if the current
account registers a surplus, the capital and financial account must register a deficit, or net
capital/financial outflow. To better understand this notion, assume that in a particular year your
spending is greater than your income. How will you finance your ‘‘deficit’’? The answer is by
borrowing or by selling some of your assets. You might liquidate some real assets (for example, sell
your personal computer) or perhaps some financial assets (sell a Nigeria government security that
you own). In like manner, when a nation experiences a current account deficit, its expenditures for
foreign goods and services are greater than the income received from the international sales of its
own goods and services, after making allowances for investment income flows and gifts to and from
foreigners. The nation must somehow finance its current account deficit. But how? The answer lies
in selling assets and borrowing. In other words, a nation’s current account deficit (debits outweigh
credits) is financed essentially by a net financial inflow (credits outweigh debits) in its capital and
financial account.
The net borrowing of an economy can be expressed as the sum of the net borrowing by each of its
sectors: government and the private sector, including businesses and households. Net borrowing by
government equals its budget deficit: the excess of outlays (G) over taxes (T). Private-sector net
borrowing equals the excess of private investment (I) over private saving (S). The net borrowing of
the nation is given by the following identity:
(G – T) + (I – S) = Current Account Deficit (Net Borrowing)
Govt Deficit Private Investment An important aspect of this identity is that the current account

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 deficit is a macroeconomic phenomenon. It reflects imbalances between government outlays and
taxes as well as imbalances between private investment and saving. Any effective policy to decrease
the current account deficit must ultimately reduce these discrepancies. Reducing the current account
deficit requires either decreases in the government’s budget deficit or increases in private saving
relative to investment, or both. However, these options are difficult to achieve.
7.4 Reasons why Nations need Balance of Payments (BOPs)
i) A country needs Balance of payments because it shows account of export and import of a country
and this act as a signal for the government to adjust her domestic policies when import is greater than
export.
ii) It provides historical data on export and import over a period of time, and this can be utilized for
planning purposes. As well, it helps to provide data for net foreign investment component of the
Country income
iii) It serves as an indicator of economic and political stability. For example, if a country has a
consistently positive BOP, this could mean that there is significant foreign investment within that
country. It may also mean that the country does not export much of its currency.
iv.) It serves as medium for nations to compare their trade relation among themselves.
v.) it show us the extent a country rely on some commodities for foreign exchange earnings.

7.5 Problems in computing Balance Of Payments (BOPs) Accounting

i) One major problem of computing BOPs is the activities of smugglers which have made export and
import figures stated in the report to be incorrect estimate of a Country’s trading activities.
ii) The problem created by illegal transfer of currencies also makes computation difficult.
iii) The activities of multinational companies cut across many countries and these multinational
companies can make invisible transactions which might not be recorded in BOPs account.
iv.) The problem of over stated invoices for illegal export of foreign exchange and the understated of
invoices to take advantage of low custom duties will not reflect the true monetary values of the actual
transaction in the BOPs account.
v.) There is the difficulty of currency linkage by means of currency unions and trade associations
among nations (Afolabi, 1998).
7.6 Nigeria - Balance Of Payments (BOPs)
The Nigeria Balance of payment reports for 2007 and 2008 is presented in table 8.2. Despite the negative
report of Balance of service (net) and balance of income (net) in 2007 and 2008, the current account increases
from N2703753.6 million in 2007 to N4150489 million in 2008. On the capital account, the table reveals
that there were net inflows of N759380.4 million in 2007 and N802615.7 million in 2008 for direct
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investment. This happened because investment coming to Nigeria by foreigners is greater than investment by
Nigerian abroad

Table 7.2 Summary of Nigeria Balance of payment (BOPs) accounting for 2007-2008 (N million)
Category 2007 2008
Current 2703753.6 4150489
Balance on goods 4134264.4 4162763
Balance on services (net) -1588963.3 -1574758
Balance on income (net) -2089260.9 -2460951
Current transfers (net) 2,247,713.60 4023436

Capital and Financial Account -324689.1 -668213

Direct Investment Abroad -58387.7 -114484
Direct investment in Nigeria 759380.4 802615.7
Portfolio Investment Assets -17269.3 -81514.2
Portfolio Investment Liabilities 1,642,491.60 1158098
Other Investment Asset -764311 -1433944
Other Investment Liabilities 179433.6 4562.9
Net Errors and Omissions -2379064.7 -3482276
Reserve Assets -1127212.8 -196368
Source: CBN Statistical Bulletin (2008)
The Net Errors and Omissions have a negative value of N2379064.7 million and N3482276 million in 2007
and 2008 respectively. Finally, the reserves assets recorded negative values in 2007 and 2008.

7.6.1. Causes of Balance Of Payments (Bops) deficits in Nigeria

Some of the factors that lead to balance of payments deficits in Nigeria are briefly discussed.
However, some of these factors are applicable to other developing Nations.
(i) Poor performance of the non – oil sector. Over the years the contributions of the
manufacturing and agricultural sectors have been very low and below 15 percent on the
average. Most of the producers in this subsector cannot compete with other producers in the
World market because of high production cost and the uses of crude methods and techniques
of production. Also, the neglect of the agricultural sector for white collar has really reduced
the performance of the sector.
(ii) Government monetary and fiscal policies: The expenditure capacity of the three tiers
level of government is very high and has led to so much cash in the hands of private
individuals and businesses who demand for imported goods at a very high price. Also, the
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 government deficit finance is carried out by the Central Bank of Nigeria and this post serious
problem to balance of payments.
iii) Technological progress by developed Nations. New techniques and methods of
production by developed Nations have reduced the demand for developing Nations primary
products.
iv.) High servicing of debt. The high interest rate paid for external and internal loan incurred
by the Nigeria government causes deficits in Nigeria balance of payments accounts.
v.) Import substitution strategies. This involves the production of imported goods locally.
This process required the importation of machinery, raw materials and other goods and
service that will fast tract industrialization and this will impact negatively on balance of
payments account.
7.6.2. Measures to Correct Balance Of Payment Deficit in Nigeria.
One of the strategies for correcting balance of payment deficit lies in earning more foreign exchange
through additional exports or reducing imports. Quantitative changes in exports and imports require
policy changes. Such policy measures are in the form of monetary, fiscal and non-monetary measures.
These measures are discussed below:
i) Export Promotion. The Nigeria government should adopt export promotion measures to correct
disequilibrium in the balance of payments. This includes substitutes, tax concessions to exporters,
marketing facilities, credit and incentives to exporters, etc.
The government may also help to promote export through exhibition, trade fairs; conducting
marketing research and by providing the required administrative and diplomatic help to tap the
potential markets.
ii) Import Substitution. The government may resort to import substitution to reduce the volume of
imports and make it self-reliant. Fiscal and monetary measures may be adopted to encourage
industries producing import substitutes. Industries which produce import substitutes require special
attention in the form of various concessions, which include tax concession, technical assistance,
subsidies, providing scarce inputs, etc. Non-monetary methods are more effective than monetary
methods and are normally applicable in correcting an adverse balance of payments.
iii) Exchange Control. It is an extreme step taken by the monetary authority to enjoy complete
control over the exchange dealings. Under such a measure, the central bank directs all exporters to
surrender their foreign exchange to the central authority. Thus it leads to concentration of exchange
reserves in the hands of central authority. At the same time, the supply of foreign exchange is
restricted only for essential goods. It can only help controlling situation from turning worse. In short
it is only a temporary measure and not permanent remedy.

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 iv.) Tariffs. Tariffs are duties (taxes) imposed on imports. When tariffs are imposed, the prices of
imports would increase to the extent of tariff. The increased prices will reduced the demand for
imported goods and at the same time induce domestic producers to produce more of import
substitutes. Non-essential imports can be drastically reduced by imposing a very high rate of tariff.
v.) Encourage foreign Investors. Since all foreign capital inflow are recorded in the credit entries
of the Balance of payments account, increases in foreign direct investment and other public assistance
might help to correct deficit in balance of payments account.
vi.) Deflation. Deflation means falling prices. Deflation has been used as a measure to correct deficit
disequilibrium. A country faces deficit when its imports exceeds exports.
Deflation is brought through monetary measures like bank rate policy, open market operations, etc
or through fiscal measures like higher taxation, reduction in public expenditure, etc. Deflation would
make our items cheaper in foreign market which will result to rise in our exports. At the same time
the demands for imports fall due to higher taxation and reduced income. This would build a
favourable atmosphere in the balance of payment position. However Deflation can be successful
when the exchange rate remains fixed.
vii.) Exchange Depreciation. Exchange rate depreciation means decline in the rate of exchange of
domestic currency in terms of foreign currency. This device implies that a country has adopted a
flexible exchange rate policy.
Suppose the rate of exchange between Nigeria naira and US dollar is $1 = N. 40. If Nigeria
experiences an adverse balance of payments with regard to U.S.A, the Nigeria demand for US dollar
will rise. The price of dollar in terms of naira will rise. Hence, dollar will appreciate in external value
and naira will depreciate in external value. The new rate of exchange may be say $1 = N. 50. This
means 25% exchange depreciation of the Nigeria currency.
Finally, exchange depreciation will stimulate exports and reduce imports because exports will
become cheaper and imports costlier. Hence, a favourable balance of payments would emerge to pay
off the deficit.
The Balance of Payments (BOP) is the method countries use to monitor all international monetary
transactions over a specific period. It is a system of recording all a country's economic transactions
with the rest of the world over a period of one.

Summary of Study Session 7

In this Study Session, you were taught the meaning of term of trade, balance of trade and the balance of
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payments. Terms of trade is defined as, an index of the price of export over the index of price of imports of
a nations. While balance of trade is explained as the difference between a nation’s exports and its imports.
Also, it is noted that, BOPs is a record of a nation’s transactions with all other nations for a given year. A
credit transaction is a receipt of payments from foreigners, whereas a debit transaction leads to a payment
abroad. Owing to double-entry bookkeeping, a nation’s balance of payments should always balance. From a
functional viewpoint, the balance of payments identifies economic transactions as (a) current account
transactions and (b) capital and financial account transactions. The capital and financial account of the
balance of payments shows the international movement of loans, investments, and the like. Capital and
financial inflows (outflows) are analogous to exports (imports) of goods and services because they result in
the receipt (payment) of funds from (to) other nations. The balance on goods and services is important to
policymakers because it indicates the net transfer of real resources overseas. It also measures the extent to
which a nation’s exports and imports are part of its gross national product. Furthermore, reasons why nations
needs BOPs was identified while problems in computing BOPs was discussed. Lastly, the causes and
solutions to BOPs deficits in Nigeria were briefly explained.
Self-Assessment Questions for study Session 7
SAQ 7.1 Briefly discusses three reasons why a nation such as Nigeria needs Balance Of Payments (BOPs)
accounting?
SAQ 7.2 What are the measures that the Nigeria government can adopt to correct or reduce Balance Of
Payments (Bops) deficits in the economy?
Multiple choice Questions
Section A. Select the most appropriate letter (A, B, C, D) that best answers each of the following questions:
1. Every international transaction automatically enters the balance of payments
(a) Once either as a credit or as a debit.
(b) Twice, once as a credit and once as a debit.
(c) Once as a credit.
(d) Twice, both times as debit.
2. If Nigeria exports price index rose from 150 in 1998 to 220 in 2010 and her import price index rose
from 150 to 160 in the same periods. The Nigeria terms of trade (TOTnb) will be…
(a) 150, 137.5
(b) 180, 160
(c) 175, 135
(d) 185, 145
3. Which one of these measures cannot utilize to correct balance of payment (BOPs) deficit in Nigeria?
(a) Import promotion

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(b) Export promotion
(c) Import substitution
(d) Exchange control
4. Which one of the following expressions is the most accurate regarding current account (CA) of
BOPs?
(a) = Export – Import
(b) CA = Import – Export.
(c) CA=Export=Import.
(d) CA = Export + Import.
5. When a country’s currency depreciates,
(a) Foreigners find that its exports are more expensive, and domestic residents find that imports from abroad
are more expensive.
(b) Foreigners find that its exports are more expensive, and domestic residents find that imports from abroad
are cheaper.
(c) Foreigners find that its exports are cheaper; however, domestic residents are not affected.
(d) None of the above.
6. One of these is not the causes of balance of payments (BOPs) deficits in Nigeria.
(a) Poor performance of the non-oil sector
(b) Import substitution strategies
(c) High servicing of debt
(d) Export promotion
7. The record of a country's imports and exports of goods and services is called its:
(a) Balance of trade.
(b) Terms of payments.
(c) Balance of payments on current account.
(d) Visible trade balance.
8. A central bank’s international reserves include:
(a) Any gold that it owns.
(b) Any silver that it owns.
(c) any gold that it owns and foreign and domestic assets
.(d) any silver that it owns and foreign and domestic assets.
9. The record of a country's imports and exports of goods and services plus net investment incomes and
current transfers of money to and from abroad, is called its:
(a) Visible trade balance.

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(b) Balance of payments on current account.
(c) Balance of trade
(d) Balance of payments.
10. The situation whereby a country imports more than her exports is:
(a) A trade deficit.
(b) A recession.
(c) An expansion.
(d) A trade surplus.
Links to OERs
https://socialsci.libretexts.org/Bookshelves/Economics/Book%3A_Macroeconomics_(OpenStax)/10%
3A_The_International_Trade_and_Capital_Flows/0Introduction_to_the_International_Trade_and_
Capital_Flows
https://socialsci.libretexts.org/Bookshelves/Economics/Book%3A_Macroeconomics_(OpenStax)/10%
3A_The_International_Trade_and_Capital_Flows/10.6%3A_The_Difference_between_Level_of_Tr
ade_and_the_Trade_Balance
http://www.streetdirectory.com/travel_guide/141653/trading/history_of_trade.html
http://www.barternewyork.net/history-of-bartering.html
http://kalyan-city.blogspot.com/2011/03/what-is-trade-meaning-and-nature.html
http://www.investopedia.com/terms/b/barter.asp
http://www.preservearticles.com/201012271793/barter-system.html
http://www.bms.co.in/difference-between-internal-trade-and-international-trade/
http://www.economicsdiscussion.net/international-trade/difference-between-international-trade-and-
internal-trade/1914
http://www.investopedia.com/terms/t/terms-of-trade.asp
http://www.investopedia.com/terms/q/quota.asp
http://markets.ft.com/research/Lexicon/Term?term=import-control
http://economics.about.com/od/economicsglossary/g/termsoftrade.htm
http://www.economicsonline.co.uk/Global_economics/Terms_of_trade.html
http://www.hsc.csu.edu.au/economics/global_economy/tut7/Tutorial7.html
http://www.yourarticlelibrary.com/trade-2/7-major-factors-affecting-the-terms-of-trade-economics/11061/
http://catalog.flatworldknowledge.com/bookhub/reader/28?e=fwk-61960-ch05_s01
Reference/Suggestions for Further Readings
Adebayo, A. (1999) ‘Economics, A simplified approach’ Volume 2, African International
publication Limited. ISBN 978-2837-24-5.
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Amacher, R.C. & Ulbrich, H.H. (1986) Principles of Macroeconomics, South-Western Publishing Co.
Anyanwu, J.C. & Oaikhenan, H.E. (1995) Modern Macroeconomics: Theory and Applications in Nigeria,
Joance Educational Publishers.
Shapiro, E. (1996) Macroeconomics Analysis, Golgotia Publications (P) Ltd, New Delhi.
Olofin, S. (2000). An Introduction to Macroeconomics, Malthouse Press Ltd, Ibadan.
Branson, W. H. (1972) Macroeconomic Theory and Policy, Harper and Row Publishers, New York,
London.

Should you require more explanation on this study session, please do not hesitate to contact your e-
tutor via the LMS.

Are you in need of General Help as regards your studies? Do not hesitate to contact the DLI
IAG Center by e-mail or phone on:

[email protected] 08033366677

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 STUDY SESSION 8:
INFLATION AND UNEMPLOYMENT

Introduction

Inflation has been the major concern of most developed and developing nations of the world due to its
consequential negative effects on economic development and individual purchasing power. Also important,
as a macroeconomic problem, is the problem of unemployment. In fact, both problems are seen as “twin”
economic problems in economic analysis. In this session we shall examine in more detail the concepts,
“inflation” and “unemployment”. Also, we examine what causes inflation, who suffers from inflation, what
can be done to get rid of inflation and what causes unemployment? All of these are vital to the economy.
Therefore, in this section we explore in detail the determinants of inflation. Is it caused by excessive wage
growth, by the level of demand growing too fast or by costs pushing up prices, and why does inflation matter?
A lot of effort is put into controlling inflation, so it is important to know who it affects and how. In this
section we also examine the various different ways economists have suggested for controlling inflation -
some of them more practical than others.

Learning Outcomes for Study Session 8

8.1 Explain the term inflation and unemployment and how they are measured.
8.2 Explain the possible causes of inflation and how to control it in an economy
8.3 Explain why some analysts prefer measures of labor force utilization that differ from the
official unemployment rate.
8.4 Discuss economists’ notions of frictional, structural, and cyclical unemployment.
8.5 Describe the classical theory of unemployment.
8.6 Describe theories of labor market imperfections.
8.7 Discuss the concepts of “natural rate” of inflation, unemployment, and their relation to empirical
evidence.

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 Key Terms: Inflation, Unemployment, Deflation, Consumer price index,
Producer price index, Phillips curve, Fical policy, Monetary policy

8.1 Inflation
Definition of Inflation
Inflation is the overall general upward price movement of goods and services in an economy (often caused
by increase in the supply of money), and usually measured by the Consumer Price Index and the Producer
Price Index. Over time, as the cost of goods and services increase, the value of the Naira falls because a
person would not be able to purchase as much with that naira as he/she previously could. While the annual
rate of inflation has fluctuated greatly over the last half century, ranging from nearly zero inflation to 23%
inflation, the monetary authority actively tries to maintain a specific rate of inflation, which is usually 2-3%,
which varies depending on circumstances.
In other words, inflation can be defined as a persistent and continuous increase in the general price level
without a corresponding increase in the supply of goods and services. Inflation rate is computed as changes
in the Consumer Price Index (CPI) over time. The rate of inflation may be mild if it does not exceed 5%.
When it goes beyond 5%, it is called a creeping inflation. When the rate of inflation is up to 20%, it is called
a galloping inflation. It becomes a runaway inflation when the percentage is over 50%.

What is inflation?

Inflation is the overall general upward price movement of goods and services in an economy (often caused
by increase in the supply of money), and usually measured by the Consumer Price Index and the Producer
Price Index. Over time, as the cost of goods and services increase, the value of the Naira falls because a
person would not be able to purchase as much with that naira as he/she previously could.

Basic Terms and Terminology

• Consumer Price Index (CPI)
CPI is an inflationary indicator that measures the change in the cost of a fixed basket of products and
services, including housing, electricity, food, and transportation. The CPI is published monthly by
the CBN. It is also called cost-of-living index.

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 • Producer Price Index(PPI)
PPI is an inflationary indicator published by the CBN to evaluate wholesale price levels in the economy.
It is also called Wholesale Price Index.
• Deflation
Deflation is a decline in general price levels, often caused by a reduction in the supply of money or credit.
Deflation can also be brought about by direct contractions in spending, either in the form of a reduction
in government spending, personal spending or investment spending. Deflation has often had the side
effect of increasing unemployment in an economy, since the process often leads to a lower level of
demand in the economy. It is the direct opposite of inflation.

Causes of inflation
Inflation can be caused by a variety of different factors, and for each factor there are several different
theoretical explanations. Here, we examine some of these theories of the causes of inflation. The causes of
inflation are best explained by looking at aggregate supply and demand. As shown by the diagram below,
any change in either AS or AD will cause a change in the price level.

Fig 8.1 Demand Pull Inflation

If aggregate demand increases to AD1 or aggregate supply decreases to AS2, the price level increases - this
is inflation. If both happen together the inflation is even worse. If the inflation is caused by an increase in
demand, then it is known as demand-pull inflation. The growth in demand literally pulls up prices. However,
if the inflation is caused by a change in aggregate supply, then it is usually known as cost-push inflation. In
practice, the two are often linked together as increases in demand may cause labour shortages, which in turn

102
push up wages. Firms, who have to pay the higher wages, are then forced to put their prices up to maintain
their margins.
It is also important to examine the role of the amount of money in the economy. The quantity theory of
money shows how increased growth in the money supply can cause inflation. This happens because the extra
money boosts the level of demand, and so causes demand-pull inflation.
Cost-push inflation occurs when businesses respond to rising production costs, by raising prices in order to
maintain their profit margins. There are many reasons why costs might rise:
i. Rising cost of imported raw materials – major cause of inflation in countries that are heavily
dependent on exports of these commodities or alternatively by a fall in the value of the naira in the
foreign exchange markets which increases the Nigerian price of imported inputs. A good example of
cost-push inflation was the decision by Power Holding Company to raise substantially the prices for
gas and electricity that it charges to domestic and industrial consumers substantially.
ii. Rising labour costs - caused by wage increases which exceed any improvement in productivity. This
cause is important in those industries which are ‘labour-intensive’. Firms may decide not to pass
these higher costs onto their customers (they may be able to achieve some cost savings in other areas
of the business) but in the long run, wage inflation tends to move closely with price inflation because
there are limits to the extent to which any business can absorb higher wage expenses.
iii. Higher indirect taxes imposed by the government– for example a rise in the rate of excise duty on
alcohol and cigarettes, an increase in fuel duties or perhaps a rise in the standard rate of Value Added
Tax or an extension to the range of products to which VAT is applied. These taxes are levied on
producers (suppliers) who, depending on the price elasticity of demand and supply for their products,
can opt to pass on the burden of the tax onto consumers. For example, if the government were to
choose to levy a new tax on aviation fuel, then this would contribute to a rise in cost-push inflation.
iv. Cost-push inflation can be illustrated by an inward shift of the short run aggregate supply curve. This
is shown in the diagram below. Ceteris paribus, a fall in SRAS causes a contraction of real national
output together with a rise in the general level of prices.

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 AD

Fig 8.2 Cost Push Inflation 1

Demand-pull inflation on the other hand occurs when there is full employment of resources and when SRAS
is inelastic. In these circumstances, an increase in AD will lead to an increase in prices. AD might rise for a
number of reasons – some of which occur together at the same moment of the economic cycle.
• A depreciation of the exchange rate, which has the effect of increasing the price of imports and
reducing the foreign price of Nigerian exports. If consumers buy fewer imports, while foreigners
buy more exports, AD will rise. If the economy is already at full employment, prices are pulled
upwards.
• A reduction in direct or indirect taxation. If direct taxes are reduced consumers have more real
disposable income causing demand to rise. A reduction in indirect taxes will mean that a given
amount of income will now buy a greater real volume of goods and services. Both factors can take
aggregate demand and real GDP higher and beyond potential GDP.
• The rapid growth of the money supply – perhaps as a consequence of increased bank borrowing if
interest rates are low. Monetarist economists believe that the root causes of inflation are monetary –
in particular when the monetary authorities permit an excessive growth of the supply of money in
circulation beyond that needed to finance the volume of transactions produced in the economy.
• Rising consumer confidence and an increase in the rate of growth of goods – both of which would lead
to an increase in total household demand for goods and services
• Faster economic growth in other countries– providing a boost to Nigeria’s exports overseas
Another problem that can cause inflation is people's expectations of inflation. This sounds odd, but when
you consider that people build their expectation of inflation into their wage claim, you can see that this in
itself can be a cause of inflation. If you expect inflation to be 5%, you may reasonably expect a wage rise in
excess of this. If you manage to get that wage increase, then that may cause further cost-push inflation as
firms are then facing higher costs. The higher inflation may then raise people's expectations further - a vicious

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circle. Expectations can be a bit like a self-fulfilling prophecy. Higher expectations can actually cause higher
inflation.
Cost-push inflation happens when costs increase independently of aggregate demand. It is important to look
at why costs have increased, as quite often costs are increasing simply due to the economy booming. When
costs increase for these reasons it is generally just a symptom of demand-pull inflation and not cost-push
inflation. For example, if wages are increasing because of a rapid expansion in demand, then they are simply
reacting to market pressures. This is demand-pull inflation causing cost increases. However, if wages rise
because of greater trade union power pushing through larger wage claims - this is cost-push inflation. Cost-
push inflation is shown on the diagram below. The aggregate supply curve shifts left because of the cost
increase, therefore pushing prices up.

Fig 8.3 Cost Push Inflation 2

Sources of rising costs

i. Wages
If trade unions gain more power, they may be able to push wages up independently of
consumer demand. Firms then face higher costs and are forced to increase their prices to pay
the higher claims and maintain their profitability.
ii. Profits
If firms gain more power and are able to push up prices independently of demand to make
more profit, then this is considered to be cost-push inflation. This is most likely when markets
become more concentrated and move towards monopoly or perhaps oligopoly.
iii. Imported inflation
We now work in a very global economy and many firms import a significant proportion of
their raw materials or semi-finished products. If the cost of these products increases for

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reasons out of their control, then once again firms will be forced to increase prices to pay the
higher raw material costs. This could happen for several reasons:
a. Exchange rate changes - If there is depreciation in the exchange rate, then
our exports will become cheaper abroad, but our imports will appear to be
more expensive. Firms will be paying more for their overseas raw materials.
b. Commodity price changes - if there are price increases on world commodity
markets, firms will be faced with higher costs if they use these as raw
materials. Important markets would include the oil market and metal markets.
c. External shocks - this could be either for natural reasons or because a
particular group or country has gained more economic power. An example of
the first was the Kobe earthquake in Japan, which disrupted world production
of semi-conductors for a while. An example of the second was when OPEC
forced up the price of oil four-fold in the early 1970s.
d. Exhaustion of natural resources -As resources run out, their price will rise
gradually. This will increase firms' costs and may push up prices until they
find an alternative source of raw materials (if they can). This has happened
with fish stocks. Over-fishing has put many types of fish and fish-based
products under extreme pressure, forcing their price up. In many countries
equivalent problems have been caused by erosion of land when forests have
been cleared. The land quickly becomes useless for cultivation.
e. Quantity theory of money - In theory what quantity would you like? The
classical economist’s view of inflation revolved around this theory, and this
theory was in turn derived from the Fisher Equation of Exchange. This
equation says that:
MV = PT
where: M is the amount of money in circulation, V is the velocity of circulation
of that money
P is the average price level, and T is the number of transactions taking place
The equation is in fact an identity/truism. It says that the amount of the money
stock times the rate at which it is used for transactions will be equal to the
number of those transactions times the price of each transaction. It will always
be true, as it simply says that National Income will be equal to National
Expenditure and basic macroeconomics tells us that this is true anyway.

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Phillips Curve
The Phillips Curve is a relationship between unemployment and inflation discovered by Professor A.W.
Phillips. The relationship was based on observations he made of unemployment and changes in wage levels
from 1861 to 1957. He found that there appeared to be a trade-off between unemployment and inflation, so
that any attempt by governments to reduce unemployment was likely to lead to increased inflation. This
relationship was seen by Keynesians as a justification of their policies. However, in the 1970s the curve
appeared to break down as the economy suffered from unemployment and inflation rising together
(stagflation).
The curve sloped down from left to right and seemed to offer policy makers a simple choice - you have to
accept inflation or unemployment. You can not lower both. Or, of course, accept a level of inflation and
unemployment that seemed to be acceptable.

Fig 8.4 Philips Curve 1

The existence of rising inflation and rising unemployment caused the government many problems and
economists struggled to explain the situation. One of the most convincing explanations came from Milton
Friedman - a monetary economist. He developed a variation on the original Phillips Curve called the
expectations-augmented Phillips Curve.
Expectations - Augmented Phillips Curve
The Phillips Curve showed a trade-off between unemployment and inflation. However, the problem that
emerged with it in the 1970s was its total inability to explain unemployment and inflation going up together
- stagflation. According to the Phillips curve, they were not supposed to do that, but throughout the 1970s
they did. Friedman then put his mind to whether this could be adapted to show why stagflation was occurring,
and the explanation he came up with was to include the role of expectations in the Phillips Curve. Hence,

107
the name 'expectations-augmented'. Once again, the supreme logic of economics comes to the fore. See figure
8.5
Friedman argued that there were a series of different Phillips curves for each level of expected inflation. If
people expected inflation to occur then they would anticipate and expect a correspondingly higher wage rise.
Friedman was therefore assuming no 'money illusion'- people would anticipate inflation and account for it.
We therefore got the situation shown below:

Fig 8.5 Philips Curve 2

The Phillips Curve is a relationship between unemployment and inflation discovered by Professor
A.W. Phillips. The relationship was based on observations he made of unemployment and changes
in wage levels from 1861 to 1957.

Wage-price Spiral
It is very easy to muddle demand-pull and cost-push inflation. This potential for muddling is made worse by
the fact that the two types can often interact to cause a wage-price spiral. This is most likely to happen when
the economy is nearing its potential. When this happens, any increase in demand implies that firms need to
expand output to meet the demand. If firms are at or near their full capacity, they will seek to attract resources
to expand - labour being part of these resources. Any skilled labour is likely to be employed and so firms
have to offer more attractive packages to persuade people to move from one job to another, thus increasing
their costs.
Employees will want to be compensated for the higher prices, as they do not want to see their purchasing
power fall. They will then push for higher wages. The higher wages push up costs again, and so the firms

108
will raise again. If prices go up again, then people will push for higher wages and so it goes on. The higher
wages push up prices, which in turn push up wages, which in turn push up prices, and so on.
A wage-price spiral can be very difficult to get rid of, as people quickly build the increased level of inflation
into their expectations. That is why it is called a spiral as inflation spirals up and up fuelled by increased
wages.

What is Philips Curve?

The Phillips Curve is a relationship between unemployment and inflation discovered by

Professor A.W. Phillips.

Controlling Inflation
The most appropriate cure for inflation depends on what you think the cause is. If a doctor thinks you have
flu, then they would not treat you for a sprained ankle. The same should be true for economies. The problem
is that doctors often agree far more about what is wrong with the patient than economists do about economies.
That aside, a considerable amount of research has gone into the causes of inflation, and a much more
sophisticated understanding has emerged.
So, what cures are there? As we have said, the cure has to relate to the cause. If you think that inflation is
caused by demand growing faster than the economy can cope with (demand-pull inflation), the solution is to
try to control the level of demand. If you think inflation is caused by a lack of capacity or by costs rising in
the economy, then supply-side solutions may be required. If you think that inflation is caused by excessive
monetary growth, then it will be most appropriate to put in place policies to control the level of money supply
growth. In practice, all of these will be appropriate to a greater or lesser extent; indeed they are inter-linked
and cannot be looked at in isolation.
In practice, the most emphasis generally goes into looking at the level of demand. Is it growing faster than
supply? If so, do we need to slow the economy down a little? What causes changes in demand? How do
people react to interest rate changes? In addition, supply side policies tend to be rather long term in nature
whereas demand can be influenced more quickly - in economic terms anyway.
The quantity theory of money suggests that control of the money supply will help in the fight against
inflation. To say this is easy, but to do it is a lot more difficult. In the early 1980s, the government set money
supply growth targets for a number of years to try to reduce inflation and influence people's expectations.
The strategy was fraught with problems and the broad money measure targeted tended to go well outside its
target range frequently. We now have an inflation target instead and use interest rates to influence money

109
supply growth indirectly. However, there are various alternative techniques for controlling the money supply
that have been suggested over the years.
Direct controls on lending
Direct controls are regulations and requirements imposed on the banks and other financial institutions. They
may take various forms, but usually set limits on the amount the banks can lend. They are also often termed
credit controls. They were used as a tool of monetary policy in the 1950s and 1960s, but were dropped as the
complexity and sophistication of the financial system increased. It would now be very difficult to use them,
and there is little will to use them anyway. This is because it is widely acknowledged that they introduce all
sorts of rigidities and reduce the amount of competition in financial markets.
Demand-side policies
It is universally acknowledged that if the level of demand in the economy grows too fast, it may cause
inflation. This is shown in the diagram below. As aggregate demand shifts to the right, the price level
increases - inflation.

Fig 8.6 Demand-side Policies

If we want to control demand-pull inflation, we have to control the level of demand. If demand is growing
too fast, this means putting in place deflationary policies. Think of the economy as a balloon. If there is too
much air in the balloon, it will be at risk of bursting, so you need to deflate it a little. The same is true of the
economy. Deflationary policies reduce the level of demand in the economy, and so avoid the dangers of the
economy bursting (with the inflation and balance of payments problems that go along with that).
What are the demand-side policies available? It is possible to use both fiscal and monetary policy to influence
demand.

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Fiscal policy
Fiscal policy is the use of government expenditure and taxation to influence the economy. It can be used as
both a demand-side and supply-side weapon, but here we are focusing on its use to reduce demand. To reduce
aggregate demand, the government somehow has to spend less itself or use its tax-setting powers to persuade
other people to spend less. That way consumption (a key component of aggregate demand) is reduced.
Deflationary fiscal policies might include: cutting government expenditure (e.g. on defence, education,
health, social welfare payments and so on), increasing the level of income tax (to reduce people's disposable
income, and therefore their purchasing power) and increasing indirect taxes (VAT, petrol, cigarettes and so
on).
Monetary policy
Interest rates are the main weapon of monetary policy. Increasing interest rates will have a variety of effects
on aggregate demand.
Supply-side Policies
The economy can cope with increasing demand if the capacity of the economy grows fast enough. Demand-
pull inflation only happens when aggregate demand grows faster than the ability of the economy to produce
the goods. Therefore, if we can boost the capacity of the economy we may help to avoid inflationary
problems. Supply-side policies are policies that are aimed at doing this. Classical economists argue that these
are the main policies necessary, and that the government should not aim to manage the level of demand in
the long run. This follows from Say's Law, which says that 'supply creates its own demand'. Supply-side
policies are aimed at making markets work better and removing possible market imperfections. They could
include:
• Improved education and training
• Reducing the power of trade unions to increase the flexibility of wage-setting
• Reducing taxes to encourage investment and risk-taking
• Reducing the level of tax to motivate people to work harder
• Removing unnecessary regulations from markets that may hinder efficiency and innovation
The effect of these policies should be to shift the aggregate supply curve to the right. We can see this on the
diagram below. The economy clearly has a greater capacity to produce and can cope with a higher level of
aggregate demand before there is any increase in the price level.

111
 Fig 8.7 Supply-side Policies

Effects of Inflation
Inflation may redistribute income:
(1). Fixed income groups will be hurt because their real income suffers. Their nominal income does
not rise with prices.
(2). Savers will be hurt by unanticipated inflation, because interest rate returns may not cover the cost
of inflation. Their savings will lose purchasing power.
(3). Debtors (borrowers) can be helped and lenders hurt by unanticipated inflation. Interest payments
may be less than the inflation rate, so borrowers receive “dear” money and are paying back “cheap”
dollars that have less purchasing power for the lender.
(4). If inflation is anticipated, the effects of inflation may be less severe, since wage and pension
contracts may have inflation clauses (COLAs) built in, and interest rates will be high enough to cover
the cost of inflation to savers and lenders.
(a) “Inflation premium” is the amount that interest rate is raised to cover the effects of
anticipated inflation.
(b) “Real interest rate” is defined as the nominal rate adjusted for inflation
Unexpected deflation, which is a decline in price level, will have the opposite effect of anticipated inflation.
Many families are simultaneously helped and hurt by inflation because they are both borrowers and earners
and savers. Effects of inflation are arbitrary, regardless of society’s goals.
Disinflation: this is the process of bringing the inflation rate down. Policy makers respond to inflation
quickly as a form of preventive medicine for the economy, because disinflation is very difficult and costly

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once a higher rate of inflation has occurred. The only way they believe that inflation can be reduced is
through policies to depress the economy, which then increase unemployment.
8.2 Unemployment
This section introduces you to standard macroeconomic labor topics such as the definition of the
unemployment rate, the different types of unemployment, and theories of the causes of unemployment.
You will learn about labor market institutions and aggregate demand issues. You will also be introduced to
the “natural rate of unemployment” hypothesis. In the final section, you will be introduced to changes in
labor force participation rates and questions of labor market “flexibility.”
What is unemployment?
The standard ILO definition of unemployment is based on the following three criteria which should be
satisfied simultaneously: "without work", "currently available for work" and "seeking work". Accordingly:
The "unemployed" comprise all persons above a specific age who during the reference period were:
(a) "without work", i.e. were not in paid employment or self-employed;
(b) "currently available for work", i.e. were available for paid employment or self employment during
the reference period, and
(c) "seeking work", i.e. had taken specific steps in a specified reference period to seek paid
employment or self-employment."
Notwithstanding the criterion of seeking work, persons without work and currently available for work who
made arrangements to take up paid employment or undertake a self-employed activity at a date subsequent
to the reference period (future engagements) should be considered as unemployed. Persons temporarily
absent from their jobs with no formal job attachment (lay-offs) who were currently available for work and
seeking work should be regarded as unemployed.
How is unemployment measured?
• Labor force participation rate = 100 * Labor Force/Adult Population (age 18+)
• Labor Force = Number employed + Number unemployed
• Unemployment Rate = 100 * Number unemployed/Labor Force
To be unemployed one must be looking for work. A retiree, for example, is not “unemployed,” but is not in
the labor force.

Summary of Study Session 8

In this study session, we have examined the term inflation and unemployment. We looked at the possible
causes of inflation in an economy. We also examined some of the control measures that are available; we
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also differentiated between unemployment and underemployment, the different types of unemployment as
well as the possible causes of unemployment and the measurement of unemployment
Types of Unemployment
(a) Structural Unemployment: It is also known as Marxian unemployment or long-term
unemployment. It is due to slower growth of capital stock in the country. The entire labour force
cannot be absorbed in productive employment because there are not enough instruments of
production to employ them.
(b) Seasonal Unemployment: Seasonal unemployment arises because of the seasonal character of
a particular productive activity so that people become unemployed during the slack season.
Occupations relating to agriculture, sugar mills, rice mills, ice factories and tourism are seasonal.
(c) Frictional Unemployment: It arises when the labour force is temporarily out of work because
of perfect mobility on the part of the labour. In a growing and dynamic economy, in which some
industries are declining and others are rising and in which people are free to work wherever they
wish, some volume of frictional unemployment is bound to exist. This is so because it takes some
time for the unemployed labour to learn new trades or to shift to new places, where there is a demand
for labour. Thus, frictional unemployment exists when there is unsatisfied demand for labour, but
the unemployed workers are either not fit for the jobs in question or not in the right place to meet this
demand.
(d) Cyclical Unemployment: It is also known as Keynesian unemployment. It is due to deficiency
of aggregate effective demand. It occurs when business depression occurs. During the times of
depression, business activities are at low ebb and unemployment increases. Some people are thrown
out of employment altogether and others are only partially employed. This type of unemployment is
since the total effective demand of the community is not sufficient to absorb the entire productive of
goods that can be produced with the available stock of capital. When the businessmen cannot sell
their goods and services, their profit expectations are not fulfilled. So the entrepreneurs reduce their
output and some factors of production become unemployed.
(e) Disguised Unemployment: Disguised unemployment is the most widespread type of
unemployment in developing countries. In developing countries, the stock of capital does not grow
fast. The capital stock has not been growing at a rate fast enough to keep pace with the growth of the
population, the country’s capacity to offer productive employment to the new entrants to the labour
market has been severely limited. This manifests itself generally in two ways:
• the prevalence of large-scale unemployment in the urban areas;
• The growing numbers engaged in agriculture, resulting in ‘disguised unemployment’.

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 In disguised unemployment, there is an existence of a very backward agricultural economy. People
are engaged in production with an extremely low or zero marginal productivity. Since the
employment opportunities in non-agricultural sector are not sufficient, most of the workers are bound
to work in the agricultural sector. This gives rise to the concept of ‘disguised unemployment’, in
which people are unwillingly engaged in occupations, where their marginal productivity is very low.
Public Policy toward Unemployment
• Unemployment insurance – A tradeoff between efficiency and equity.
• Many programs are targeted at alleviating the pains of structural unemployment - education and
training provided by local organisations.
Self-Assessment Questions (SAQs) for Study Session 8
SAQ 8.1 Define what an economist means by the term 'inflation'.
SAQ 8.2 Mention four types of unemployment you know?
Multiple Choice Questions
1. Demand-pull inflation may be caused by:
a) An increase in costs
b) A reduction in interest rates
c) A reduction in government spending
d) An outward shift in aggregate supply
2. Inflation:
a) Always reduces the cost of living
b) Always reduces the standard of living
c) Reduces the price of products
d) Reduces the purchasing power of money
3. An increase in injections into the economy may lead to:
a) An outward shift of aggregate demand and demand-pull inflation
b) An outward shift of aggregate demand and cost-push inflation
c) An outward shift of aggregate supply and demand-pull inflation
d) An outward shift of aggregate supply and cost-push inflation
4. An increase in aggregate demand is more likely to lead to demand-pull inflation if:
a) Aggregate supply is perfectly elastic
b) Aggregate supply is perfectly inelastic
c) Aggregate supply is unit elastic
d) Aggregate supply is relatively elastic
5. An increase in costs will:
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a) Shift aggregate demand
b) Shift aggregate supply
c) Reduce the natural rate of unemployment
d) Increase the productivity of employees
6. The effects of inflation on the price competitiveness of a country's products may be offset by:
a) An appreciation of the currency
b) A revaluation of the currency
c) A depreciation of the currency
d) Lower inflation abroad
7. According to the Phillips curve, unemployment will return to the natural rate when:
a) Nominal wages are equal to expected wages
b) Real wages are back at long-run equilibrium level
c) Nominal wages are growing faster than inflation
d) Inflation is higher than the growth of nominal wages
8. In the short run unemployment may fall below the natural rate of unemployment if:
a) Nominal wages have risen less than inflation
b) Nominal wages have risen at the same rate as inflation
c) Nominal wages have risen more than inflation
d) Nominal wages have risen less than unemployment
9. The Phillips curve shows the relationship between inflation and what?
a) The balance of trade
b) The rate of growth in an economy
c) The rate of price increases
d) Unemployment
10. The quantity theory of money allows monetarists to obtain a number of economic predictions by
assuming a constant
a) velocity of money
b) nominal output
c) overall price level
d) stock of money
Links to OERs
https://socialsci.libretexts.org/Bookshelves/Economics/Book%3A_Economics_(Boundless)/23%3A_I
nflation_and_Unemployment/23.1%3A_The_Relationship_Between_Inflation_and_Unemployment
https://socialsci.libretexts.org/Bookshelves/Economics/Book%3A_Principles_of_Macroeconomics/16

116
%3A_Inflation_and_Unemployment/16.1%3A_Relating_Inflation_and_Unemployment
https://socialsci.libretexts.org/Bookshelves/Economics/Book%3A_Principles_of_Economics/31%3A_
Inflation_and_Unemployment/31.2%3A_Explaining_InflationUnemployment_Relationships

References/Suggestions for Further Readings

Ajayi, S.I. and Ojo, O. (2006), “Money and Banking: Analysis and Policy in the Nigerian context” Daily
Graphics Nigeria Limited.
Amacher, R.C. and Ulbrich, H.H. (1986) Principles of Macroeconomics, South-Western Publishing Co.
Anyanwu, J.C. and Oaikhenan, H.E. (1995) Modern Macroeconomics: Theory and Applications in Nigeria,
Joance Educational Publishers.
Ekpo A.H. (2000) Fiscal and Monetary Policy During Structural Adjustment in Nigeria, Nigerian Economic
Society, Ibadan.
Olofin S. (2000) An Introduction to Macroeconomics, Malthouse Press Ltd, Ibadan.
Olofin, Sam(2001), “An Introduction to Macroeconomics” Malthouse Press Limited
Shapiro, E. (1996) Macroeconomics Analysis, Golgotia Publications (P) Ltd, New Delhi.
William H. Branson (1972) Macroeconomic Theory and Policy, Harper and Row Publishers, New York, Lo

Should you require more explanation on this study session, please do not hesitate to contact your e-tutor via
the LMS.

Are you in need of General Help as regards your studies? Do not hesitate to contact the DLI IAG
Center by e-mail or phone on:

[email protected] 08033366677

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 STUDY SESSION 9:
ECONOMIC GROWTH AND DEVELOPMENT

Introduction

This session introduces the students to basic concept of economic growth and development and the fact that
these two concepts are interrelated the attainment of development is not feasible without growth
actualization, and that growth actualization is not sufficient to transform an economy to development. This
statement may sound ironical, but it simply implies that economic growth is a necessary condition for
economic development but not a sufficient condition. There are many countries that have gainfully attained
a threshold of economic growth but failed to transform such economic growth to economic development.
This would be clearer as you progress in this session.

Learning Outcomes for Study Session 9

At the end of this study session, you should be able to:
9.1 Conceptualize economic growth and development
9.2 Describe the basic differences between economic growth and development
9.3 List and explain major characteristics of developing and developed countries
9.4 Discuss the objectives of every economy
9.5 Explain reasons why economic growth may not lead to economic development
9.6 Describe the basic measures of economic growth
9.7 Summarize some relevant statistics about growth
9.8 Discuss the sources of growth
9.9 Distinguish between growth and development
9.10 Explain why economies at different stages in development have different institutional
needs.
9.11 Conceptualize of Business Cycles
9.12 Describe the periodic cycles
9.13 List and explain major contributors to the theory of business Cycles
9.14 Discuss the macroeconomic policies to control Trade (Business) Cycles
9.15 Explain causes of business cycles
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 Key Terms: Economic growth, Economic development, Business cycles, Low standard of
living, Low level of productivity, Unemployment, Under-employment, Entrepreneurship
9.1 The Concept of Economic Growth and Development
The aftermath of the Second World War generated the interest of economists in the study of economic
development. However, the need on the part of many nations to address the slogan that "poverty anywhere
is a threat to prosperity everywhere” further strengthened the interest in the subject matter.
Development, being an embodiment of many indicators, is difficult to define precisely. To buttress this
statement, Todaro (1977) argues that development is not purely an economic phenomenon because it
encapsulates (comprises) more than material and financial side of people's lives. Further, he stresses that
development is a multidimensional process involving re-organisation and reorientation of entire economic
and social systems. The terms growth and development are often misused by laymen to mean the same thing.
But this is not so. 'The discussion below focuses on the distinction between growth and development.
Fashola (1998) argues that economic growth is an aspect of economics that deals with national income
objectives; whereas development incorporates other objectives such as: equitable welfare distribution,
national self reliance, balanced sectorial development, balanced regional development; ecological balance,
social and environmental stability, among others.
Todaro (1977) contends that growth stimulates improvement in incomes and output while development
involves radical changes in institutional, social, and administrative structures, as well as in popular attitudes
and sometimes even customs and beliefs.
Schumpeter (1934) stresses that growth is a gradual and steady change in the long run which comes about
by a general increase in the rate of savings and population. Development, on the other hand, is a
discontinuous and spontaneous change in the stationary state which forever alters and displaces the
equilibrium state previously existing.
Maddison (1970) is of the opinion that the raising of the income levels in rich countries is economic growth.
But the achievement of the same objective in underdeveloped countries is economic development.
Kindleberger (1952). advances that economic growth means more output while development implies both
more output and changes in technical and Institutional management by which it is produced and distributed.
Bakare (1999) perceives development as the process of optimizing the resources of a nation to meet the needs
of the people and their enlightened aspiration and endowing them with the capacity to sustain their
achievement. It needs to be stated that growth is a necessary but not a sufficient condition for attaining
development. Without growth there cannot be development, but without development, there can be growth.
Bakare-Aremu (2009) defines economic growth as a continuous increase in national output which is
identifiable by sustainable increase in per capita income which translates to general wellbeing of an average
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citizen. However, when this leads to structural positive transformations, then development is implied.
It is also necessary to say that the existence of growth in a country may not lead to development especially
in a situation where there is growing income; inequality which can strengthen abject poverty. Moreover,
Inter-sectoral imbalance will not promote development because an increase in national output not
accompanied by equitable distribution of income will create setback for sectors such as housing, utilities,
health services, food production, transport, and communication. As such, development cannot be sustained
because diseases, mortality rate, starvation, misery, and industrial inefficiency cannot be eradicated. Other
reasons why economic growth may not lead to development can be attributed to environmental degradation,
moral, intellectual, and spiritual decadence.

9.1 Differentiate between economic growth and economic development.

9.1 Economic growth is an aspect of economics that deals with national income objectives;
whereas development incorporates other objectives such as: equitable welfare distribution,
national self reliance, balanced sectorial development, balanced regional development;
ecological balance, social and environmental stability, among others

9.2 Reasons Why Economic Growth May Not Promote Economic Development
According to Bakare (1998), economic development is a gradual process and as such one can discuss it in
terms of relativity. It is on this basis that countries over the world are classified into developed, developing
or Less Developed Countries (LDC).
The circumstances or situation whereby economic growth will fail to promote economic development can
be stated and explained below:
• Inadequate growth in comparison with population.
• Widening inequality in the distribution of income.
• Imbalance in inter-sectoral development.
• Environmental degradation and ecological disturbances,
• Moral, intellectual, spiritual and social decadence.
• Economic dependence.
Inadequate Growth in Comparison with Population
If economic growth is not growing significantly relative to population, it may fail to promote economic
development. For example, an economic growth of 3 - 4% in comparison with population growth of 10%
due to relaxation of immigration law may not enhance development. Summarily:

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 G (GNP) > G (POP) = Development.
G (GNP) = G (POP) = No Development.
G (GNP) < G (POP) = Under Development
Where:
G Growth
GNP Gross National Product
POP Population
> Greater than
< Less than
Income Distribution
Even if the growth in GDP exceeds the population growth and income is not well distributed, the unequal
income distribution will lead to widening gap between the rich and the poor, therefore, violating one of the
objectives of economic development.
Imbalance in Sectoral Development
The industrial sector, the oil sector among others may be in a country, but when facilities such as housing,
health, water, law and order, among others are not developing, the country may not witness development.
Moreover, if the per capita increases from expansion in the oil and industrial sectors, development cannot be
said to have occurred because poor health could lead to dehumanising ailments such as typhoid and
tuberculosis which hinder development.
Environmental Degradation and Ecological Disturbances
When ecological balance is disturbed, through oil spillage, air, water and land pollution and industrial
pollution of the environment through pumping of toxic gas, carbon mono-oxide, lead etc, it may cause health
problems such as migraine, high blood pressure and cancer. When there is ecological disturbance such as
blockage of water canals, etc., it makes it impossible for water to enter the drainage system and this may
cause flooding. Cutting of too many trees also causes desert encroachment.
9.3 The Development Objectives
The development objectives popularly pursued by most countries are:
• Growth in income: This entails growth of the aggregate output.
• Equitable distribution of income: The income generated should be equitably distributed to every
region, sector, class, etc. This should aim at bridging the gap between the poor and the rich.
Otherwise, there will be deepening poverty which may cause violence, unrest, conflict, civil war, etc.
• Employment promotion: There must be provision of jobs for the skilled, semi-skilled and unskilled
labour to reduce the incidence of social menace (e. g. armed robbery) in the society.

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 • Self reliance: There must be improvement in balance of payment (BOP), external economy, food,
security, reduction in stock of external debt. This also extends to strategic needs such as energy,
security, defence, etc. (to protect territorial integrity).
• Price stability: There should be negligible inflation. Low price fluctuation. The prices of goods and
services should be stable over a period of time.
• Balanced development: There must be balance in the nation and in the sectoral units. Not necessarily
at the same rate but it should meet the need for development. There should be regional balance to
reduce rural- urban migration.
• Environmental preservation and maintenance of ecological balance: This implies that residential
environment must be free of oil spillage, air pollution, etc. The drainage system must also be efficient
to prevent flooding of water.
9.4 Common Characteristics of Developing Nations
The common characteristics of developing nations could be discussed under the following six sub -headings,
low standard of living, low level of productivity, high rates of population growth and dependency burdens,
high and rising levels of unemployment and under
-employment, substantial dependence on agricultural production and primary products exports, and
dominance, dependence and vulnerability in international relations. These are discussed below.
❖ Low standard of living: In developing nations, general levels of living tend to be very low for most
people. This is true not only in relation to their counterparts in rich nations but often also in relation
to small elite groups within their own societies. These low levels of living are manifested
quantitatively and qualitatively in the form of:
(a) Low income (poverty);
(b) Inadequate housing.
(c) Poor health facilities.
(d) Limited or no education.
(e) High infant mortality.
(f) Low life and work expectancy; and
(g) In many cases a general sense of malaise and hopelessness.

The Gross National Product (GNP) per capital tend to be very low for most developing countries. It
is often used as a summary index of the relative economic wellbeing of the people in different nations.
The GNP itself is the most used measure of the overall level of economic activity.
Also, there is relative slower growth rate in the GNP per capita of developing countries when
compared to their developed counterpart. In addition, the absolute income gap between rich and poor
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 nations continues to widen.
❖ Low level of productivity:
In addition to low standard of living, developing countries are characterized by relatively low levels of
labour productivity. The level of labour productivity (i.e. output per worker) is extremely low compared
with those in developed countries.
To raise productivity, domestic savings and foreign finance must be mobilized to generate new
investment in physical capital goods and also to build up the stock of human capital (e:g. management
skills) through investment in education and training.
❖ High rates of population growth and dependency burdens:
The population rate of developing nations is high when compared to the developed nations. This could
be accounted for by low birth rate and a striking increase in crude birth rate in developing countries.
Death rates in the developing countries are also high relative to the more developed nations but because
of the improved health conditions and the control of major infectious diseases in the less developed
countries death rates differences are substantially smaller than the corresponding differences in birth
rates.
The major implication of high birth rate in less developed countries is that children under the age of 15
are more in those countries than in developed countries. Therefore, most active labour years in less
developed countries is used to support children more than in developed countries. On the other hand, the
proportion of people over the age of 65 and above are more in developed countries. Older people as well
as children are often referred to as economic/dependency burden in the sense that they are non-productive
members of the society and therefore must be supported financially by a country's labour force.
The overall dependency burden is more in less developed countries than in developed countries.
Therefore, the less developed countries would not only contend with high rates of population growth but
they also must struggle with greater dependency burden than the rich nations.
❖ High and Rising Levels of Unemployment and Under-Employment:
One of the principal manifestations of factors contributing to the low levels of living in 'developing
nations is their relatively inadequate or inefficient utilization of labour in comparison with the developed
nations.
Under-utilization is manifested in two forms; first, it occurs as under-employment of those people who
are working less than they could. Under-employment also includes those who are normally working full
time but whose productivity is so low that a reduction in hours would have a negligible impact on total
output.
The second form is open unemployment of those who are able and often eager to work but for whom no
suitable jobs are available. Substantial dependence on agricultural production and primary products

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 exports is also a common feature of underdevelopment. The vast majority of people in developing
nation’s live and work in rural areas. The basic reason for the concentration of people and production in
agricultural and other primary production activities in developing countries is the simple fact that at low
level of income the major priorities of any person are food, clothing and shelter.
Agricultural productivity is low not only because of large number of people in relation to available land
but also because in less developed countries agriculture is often characterized by primitive technologies,
poor organization and limited physical inputs.
PRODUCTION = Limited Land + Insufficient Capital + Primitive Technology+ Poor
Organization
For many less developed countries a significant factor contributing to the persistence low levels of living,
rising unemployment and growing income inequality is the high unequal distribution of economic and
political power between the rich and poor nations. These unequal strengths are manifested not only in
the dominant power of rich nations to control the pattern of international trade but also in their ability to
dictate the terms' of technology, foreign aid and private capital transferred to developing nations.
Another important aspect of international transfer process which serves to inhibit the development of
poor nations and very significantly contributing to the persistent underdevelopment is the transfer of
values, attitudes, institutions, standard of behaviour, structures, cultures, etc. from developed to
developing nations. All these usually stimulate corruption and economic plunder by the privileged
minority.
Finally, the penetration of rich countries attitudes, values and standards also contribute to a problem
widely recognised and referred to as the international brain drain - the migration of professional and
skilled personnel who were often educated in the developing countries at great-expenses to the various
developed nations e.g. doctors, nurses, engineers, lecturers and economists, etc.

9.5 Measurement of Economic Growth

Economic growth is the relative change in the real value to volume of goods and services produced by a
country for final demand (i.e. demand by households, consumers, governments, capital formation and net
exports); represent the national product, national output, or national income. At market value, national output
represents revenue or earnings by the business (or production) sector. Such earnings are ultimately income
to the factors of production, namely, wages to labour, rent to land and real estate interest to capital and profit
to entrepreneurship or the business. In precise terminology, we speak of Gross Domestic Products (GDP)
and Gross National Products (GNP) in volume of national income. GDP refers to the market disposable value
of output produced within the country i.e. produced domestically. On the other hands, GNP refers to total
income accruing to the nation or at the disposal of the nation. Therefore, to obtain the GNP, we subtract

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GDP, all incomes that are repatriated abroad to foreign owned factors of production (such as interest on
foreign loan, dividends to foreign shareholders, and part salaries repatriated abroad on account of expatriate
personnel) and add all incomes from abroad on account of the citizens of or residents in the country. What
is subtracted is referred to as factors payments to abroad (FP) and what is added is referred to as factors
income (FI).
The difference between factor payments to and incomes from abroad is the net factor payments (NFP). The
net factors payment is almost always positive for developing countries on account of substantial foreign
investment, foreign equity ownership, and-management of the modern sector of their economies by
expatriates.
Thus we can state:
GNP = GDP - FP +Fl
= GDP- (FP-FI)……………………………….(1)
= GDP - NFP
GNP is almost always significantly smaller than GDP
GNP is more relevant than GDP for measuring economic growth since GNP is the nationally available
income to the people and hence more related to their material welfare as opposed to GDP which is income
generated within the country but partly belonging to the people of other countries who jointly own the
resources employed in generating the GDP. Since the average income of the people is more significant than
total income, as far as economic welfare is concerned, GNP per head of the population is preferred to total
GNP for the purpose of measuring economic growth.
Other measures of economic growth are the volume of electricity generated per head, total energy consumed
per head and index of industrial production net of population growth. These measures may be more reliable
than per capita GNP, because the internal measurement is compounded by the changing price levels which
have to be estimated and adjusted for in evaluating the real GNP or GDP at constant prices of a given year.

9.2 How does GDP differ from GNP?

9.2 By GDP we mean total value of product produced in a country irrespective of nationality of the
producers, while GNP only consider those products( goods and services) produced by citizenry of a
particular country.

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9.6. Economic Growth, Business Cycles, Unemployment, and Inflation
Like people, the economy has moods. Sometimes it is in wonderful shape- it’s expansive; at other times, it
is depressed. Like people whose moods are often associated with specific problems (headaches, sore back,
an itch), the economy’s moods are associated with various problems.
Macroeconomics is the study of the aggregate moods of the economy, with specific focus on problems
associated with those moods- the problems of growth, business cycles, unemployment, and inflation. These
four problems are the central concern of macroeconomics.
Economists use changes in real gross domestic product (real GDP) i.e. the market value of goods and
services produced in an economy stated in the prices of a given year as the primary measurement of growth.
When people produce and sell their goods, they earn income, so when an economy is growing; both total
output and total income are increasing. Such growth gives most people more the current year than they had
the previous year. Since most of us prefer more to less, growth is easy to take.
The U.S. Department of Commerce traced U.S. economic growth in output since about 1890 and discovered
that, on an average, output of goods and services grew about 3.5 percent per year. Although in recent years,
this rate has decreased to slightly under 3 percent. This 2.5 to 3.5 percent growth rate is sometimes called
the circular trend growth rate. The rate at which the actual output grows in anyone year fluctuates, but on an
average, the U.S. economy has been growing at that long-term trend. Since population has also been growing,
per capita economic growth (i.e. growth per person) has been less than 2.5 to 3.5 percent. This growth trend
can be divided into two components, one reflecting growth of population, and one consisting of increased
productivity (output per input). When economists talk about economic growth, they generally mean this
long-term growth trend of real GDP of 2.5 to 3.5 percent per year.
Economic growth (per capita) allows everyone in a society, on average, to have more. Thus, it is not
surprising that most governments are generally searching for policies that will allow them to grow. Indeed,
one reason market economies have been so successful is that they have consistently channeled individual
efforts toward production and growth. Individuals feel a sense of accomplishment in making things grow
and, if sufficient economic incentives and resources exist, individuals' actions can lead to a continually
growing economy. Politically, growth, or predictions of growth, allows governments to avoid hard
distributional questions of who should get what part of existing output: With growth there is more to go
around for everyone. A growing economy generates jobs, so politicians who want to claim that their policies
will create jobs generally predict those policies will create growth.
Of course, there are also costs to material growth-pollution, resource exhaustion, and destruction of natural
habitats. These costs lead some people to believe that we would be better off in a non-material-growth society
that de-emphasize material growth. (That does not mean we should not grow emotionally, spiritually, and
intellectually; it simply means we should grow out of our material good. Many people believe these

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environmental costs are important, and the result is often an environmental-economic growth stalemate or
trade off. To reconcile the two goals, some have argued that spending on the environment can create growth
and jobs, so the two need not be incompatible. Unfortunately, there is a problem with this argument. It
confuses growth and jobs with increased material consumption-what most people are worried about. As more
material goods made available by growth are used for pollution control equipment, less is available for the
growth of an average individual's personal consumption, since the added material goods created by growth
have already been used. What society gets, at best, from these expenditures is a better physical environment,
not more of everything. Economists have thought a lot about growth and have many ideas about it. But they
have no magic recipe of policies that can be directly related to growth. They, however, have specified some
of the ingredients of that recipe. Five of the most important causes of growth are the following:
- Institutions with incentives compatible with growth;
- Technological development;
- Available resources;
- Capital accumulation-investment in productive capacity; and
- Entrepreneurship.
Let us consider each in turn.
i. Institutions with Incentives Compatible with Growth: The importance of economic institutions
cannot be over-emphasized. Those institutions are vitally necessary for growth. Growth-compatible
institutions i.e. institutions that foster growth must have incentives built into them that lead people to
put effort - to work hard- and must discourage people from activities that inhibit growth such as
spending a lot of their time in leisure pursuits or in gaining income for themselves by creating
impediments for others. Let us consider some examples of each.
When individuals get much of the gains of growth themselves, they have incentives to work harder.
That is why private ownership of property plays an important role in growth. Many economists focus
on private property ownership and markets when considering pro-growth policies. In the former
Soviet Union, individuals did not get much of the gain of their own initiative, and hence often spent
their time in pursuits of other activities not fostering economic growth. Another example of a growth
compatible institution is the corporation, a legal creation that gives owners limited liability, thereby
encouraging large enterprises because people are more willing to invest their savings when they have
limited liability than they would be if they did not.
Many developing countries follow a type of mercantilist policy in which government approval is
necessary before any economic activity is allowed. Government officials' income often comes from
bribes offered to them by individuals who want to be able to undertake economic activity. Such
policies inhibit economic growth. Many regulations, even reasonable ones, also tend to inhibit

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 economic growth because they inhibit entrepreneurial activities. But we should mention that to ensure
that the growth is of a socially desirable type, some regulation is necessary. The policy problem is in
deciding between necessary and unnecessary regulation.
ii. Technological Development: Growth is sometimes thought of as the same things getting bigger, or
as getting more of the same things. That is an incorrect view of growth. While growth in some ways
involves more of the same, a much larger aspect of growth involves changes in technology--changes
in the goods we buy, and changes in the way we make goods. Think of what this generation spends
its income on: CDs, cars, computers, fast food, and compare these to what the preceding generation
spent money on: LP records, cars that would now be considered obsolete, and tube and
transistorradios.
Contrast this with the goods the next generation might spend its income on: video brain implants
(little gadgets in your head to receive sound and full-vision broadcasts - you simply close your eyes
and tune in to whatever you want, if you have paid your cellular fee for that month), electric cars
(petrol cars will be considered so quaint and polluting), and instant food (little pills that fulfill all
your nutritional needs, letting your brain implant gadget supply all the ambiance)-Just imagine! You
probably can get the picture even without a video brain implant.
How does society get people to work on these new developments to change the very nature of what
we do and how we think? One way is through economic incentives; another is with institutions that
foster creativity and bold thinking; a third is through institutions that foster hard work. There are, of
course, trade-offs. Institutions that foster hard work and require discipline, such as the Japanese
educational system, do not do as good a job at fostering creativity as the U.S. educational system,
and vice versa: the U.S. educational system is not great at fostering hard work. Thus, many of the
new technologies of the 1980's have been thought up in the United States, but have been translated
into workable products in Japan.
Still, the United States has done well on the technology front. Important developments in
biotechnology, computers, and communications have developed in the United States, and those
developments have helped fuel growth in the 1990s. Those new industries are absent from European
Union countries, which is one important reason why those countries have grown far more slowly than
has the United States.
iii. Available Resources: If an economy is to grow it will need resources. England grew in the late 1700s
because it had iron and coal; and the United States grew in the 20th century because it had a major
supply of many resources, and it imported people, a resource it needed. Of course, you have to be
careful in thinking about what is a resource. A resource in one time period may not be a resource in
another, or it may depend on the technology being used. So creativity can replace resources, and if

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 you develop new technology fast enough, you can overcome any lack of existing resources. Even if
a country does not have the physical resources it needs, if it can import them, it can grow as did Japan
following World War II.
iv. Investment and Accumulated Capital: At one point, capital accumulation (where capital was
thought of as buildings and machines) and investment were seen as forming the key element in
growth. While buildings and machines are still considered key elements in growth, it is now generally
recognized that the growth recipe is far more complicated. One of the reasons for this recognition is
the empirical evidence; for instance, the former Soviet Union invested a lot and accumulated lots of
capital goods, but their economy did not grow much because that capital was often internationally
obsolete. Another reason for this de-emphasis on capital accumulation is a recognition that products
change, and useful buildings and machines in one time period may be useless in another. The value
of the capital stock depends on the future; and there is no real way of measuring the value of capital
independently of its future expectation of earnings. Capitals’ role in growth is extraordinarily difficult
to accurately measure empirically.
A third reason for this de-emphasis on capital accumulation is that it became clear that capital was
far more than machines. Capital also includes human capital; that is, people's knowledge. Social
capital, i.e. the habitual way of doing things that guides people in how they approach production - is
another type of capital. For example, the existence of money and a well-developed financial market
makes many investment projects possible that otherwise would not be possible, and hence such
institutions are a type of social capital. In a way, anything that contributes to growth can be called a
type of capital, and anything that slows growth can be called a destruction of capital. With the concept
of capital including such a wide range of things, it is difficult to say what is not capital and this makes
the concept of capital less useful.
v. Entrepreneurship: Entrepreneurship can be defined as the ability to get things done. This ability
involves creativity, vision, and a talent for translating that vision into reality. When a country's
population demonstrates entrepreneurship, it can overcome deficiencies in other ingredients that
contribute to growth.
Turning the Sources of Growth into Growth: The five sources of growth cannot be taken as given.
Even if each of these five ingredients exists, they may not exist in the right proportions. For example,
economic growth depends upon people saving and investing rather than consuming their income.
Investing now helps create machines that in the future can be used to produce more output with less
effort. Growth also depends upon technological change, i.e. finding new, better ways to do things.
For instance, when Nicolas Appert discovered canning (the ability to cook and store food in a sealed
container so it would not spoil), the economic possibilities of society expanded enormously. But if,

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 when technological changes occur, the savings are not there to finance the investment, the result will
not be growth. It is the combination of investing in machines and technological change that plays a
central role in the growth of any economy.
There are, of course, many other sources of growth. Nonetheless, this brief introduction should
identify some growth issues to keep in the back of your mind as we consider other goals, because
policies that sometimes seem to help alleviate other problems, like unemployment or inflation, can
have negative effects on growth.
9.7. Business Cycles
While the circular/cyclical, or long-term, trend is a 2.5 to 3.5 percent increase in GDP, there are numerous
fluctuations around that trend. Sometimes real GDP is above the trend; at other times GDP is below the
trend. This phenomenon has given rise to the term business cycle. A business cycle is the upward or
downward movement of economic activity, or real GDP, that occurs around the growth trend.
Until the late 1930s, economists took such cycles as facts of life. They had no convincing theory to explain
why business cycles occurred, nor did they have policy suggestions to smooth them out. In fact, they felt that
any attempt to smooth them through government intervention would make the situation worse.
Since the 1940s, however, many economists have not taken business cycles as facts of life. They have hotly
debated the nature and causes of business cycles and of the underlying growth. In this session we distinguish
two groups of macroeconomists: Keynesians (who generally favor activist government policies) and
Classical (who generally favor laissez-faire or non-activist policies). Classical economists argue that
fluctuations in economic activity are to be expected in a market economy. Indeed, it would be strange if
fluctuations did not occur when individuals are free to decide what they want to do. We should simply accept
these fluctuations as we do the seasons of the year. If you have no policy to deal with some occurrence, you
might as well accept such occurrence. Keynesian economists claim that fluctuations can and should be
controlled. They argue that expansions (the part of the business cycle above the long-term trend) and
contractions (the part of the cycle below the long-term trend) are symptoms of underlying problems of the
economy, which should be dealt with by government actions. Classical economists respond that individuals
have rational expectations i.e. expectations about the future based on the best current information and will
anticipate government's reaction, thereby undermining government's attempts to control cycles. Which of
these two views is correct is still a matter of debate.
If prolonged contractions (recessions) are a type of cold the economy catches, the Great Depression of the
1930s was double pneumonia. Production of goods and services fell by 30 percent from 1929 to 1933, leading
to changes in the U.S. economy's structure. The new structure included a more active role for government in
reducing the severity of cyclical fluctuations. It is observed that since the late 1940s business cycles' duration
has increased, but, more important, the average length of expansions has increased while the average length

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of contractions has decreased.
How to interpret these statistics is the subject of much controversy. As is the case with much economic
evidence, the data are subject to different interpretations. Some economists argue the reduction in
fluctuations' severity is an illusion. If the severity of the fluctuations has been reduced (which most
economists believe has happened), one reason is that changes in institutional structure were made as a result
of the Great Depression. Both the financial structure and the government taxing and spending structure were
changed, giving the government a more important role in stabilizing the economy. Consideration of that
stronger government role is a key element of macroeconomics.
9.8. The Phases of the Business Cycle
Much research has gone into measuring business cycles and setting official reference dates for the beginnings
and ends of contractions and expansions. As a result of this research, business cycles have been divided into
phases, and an explicit terminology has been developed. The National Bureau of Economic Research in the
US announces the government's official dates of contractions and expansions. In the postwar era (since
mid-1945), the average business expansion has lasted about 51 months. A major expansion occurred from
1982 until mid-1990, when the U.S. economy fell into a recession. In mid-1991 it slowly came out of the
recession, but slow growth remained.
Business cycles have varying durations and intensities, but economists have developed a terminology to
describe all business cycles and just about any position we might find ourselves in on the business cycle.
Since this terminology is often used by the press it is helpful to go over it.
The top of a cycle is called the peak. A boom is a very high peak, representing a big jump in output. (That is
when the economy is doing great, almost everyone who wants a job has one and everyone is happy).
Eventually, an expansion peaks. (At least, in the past, they always have). A downturn describes the
phenomenon of economic activity starting to fall from a peak. In a recession the economy is not doing so
great, many people are unemployed, and a number of people are depressed. Formally, a recession is a decline
in real output that persists for more than two consecutive quarters of a year.
Insert figure and label appropriately
A depression is a large recession. There is no formal line indicating when a recession becomes a depression.
In general, a depression is much longer and more severe than a recession. This ambiguity allows some
economists to joke, "When your neighbor is unemployed, it is a recession; when you're unemployed, it's a
depression." If pushed for something more specific, we would say that if unemployment exceeds 12 percent
for more than a year, the economy is in a depression.
The bottom of a recession or depression is called the trough. As total output begins to expand, the economy
comes out of the trough; economists say it is in an upturn, which may turn into an expansion, i.e. an upturn
that lasts at least two consecutive quarters of a year. An expansion leads us back up to the peak. And so it

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goes.
This terminology is important because if you are going to talk about the state of the economy, you need the
terminology to explain it. Why are businesses so interested in the state of the economy? They want to be
able to predict whether it is going into a contraction or an expansion. Making the right prediction can
determine whether the business will be profitable or not. That is why a large amount of economists' activity
goes into trying to predict the future course of the economy.
9.9 Leading Indicators
Economists have developed a set of indicators to give a good idea of when a recession is about to occur and
when the economy is in one. These signs are called leading indicators, i.e. indicators that tell us what is likely
to happen 12 to 15 months from now, much as a barometer gives us a clue about tomorrow's weather. They
include:
- Average weekly claims for unemployment insurance.
- New orders for consumer goods and materials.
- Vendor performance, measured as a percentage of companies reporting
- Slower deliveries from suppliers.
- Index of consumer expectations.
- New orders for nondefense capital goods.
- Number of new building permits issued for private housing units.
- Stock prices-50 common stocks.
- Interest rate spread-10-year government bond less federal funds rate.
- Money supply, M2.
These indicators are combined into an index of leading indicators that is frequently reported in the popular
press. Economists use leading indicators in making forecasts about the economy. Leading indicators are
called indicators, not predictors, because they are only rough approximations of what is likely to happen in
the future. For example, before building a house, you must apply for a building permit. Usually this occurs
six to nine months before the actual start of construction. By looking at the number of building permits that
have been issued, you can predict how much building is likely to begin in six months or so. But the prediction
might be wrong, since getting a building permit does not require someone to build. Business economists
spend much of their time and effort delving deeper into these indicators, trying to see what they are really
telling us, as opposed to what they seem to be telling us.

Summary of Study Session 9

From the foregoing, the student is expected, having gone through this session, to be clear about the meaning
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of economic growth as it differs from economic development, that while economic growth is a necessary
condition for economic development, it is not sufficient to guarantee development. As such, the student
should be able to explain the difference between developed nations and developing nations through their
salient characteristics. The various ways through which growth could be measured are explicitly discussed
in this session. The student also learnt that economic growth and subsequent development is the primary
goal of every nation. Therefore, those policies that could lead to improvement in economic activities were
discussed. There is no nation that is stationary, so the concept of business cycle was discussed to make
explicit the working of the economy. The student has also learnt the meaning of trade cycles as explained by
various school of thoughts, they should also know that the activities in the economy could be the source of
business cycles and could also be generated from outside. This implies that shocks that normally bring
disequilibrium or short falls could be internally or externally motivated.

Self-Assessment Questions (SAQs) for Study Session 9

S.A.Q 9.1
(a) Define economic growth as it defer from economic development
b) Enumerate and explain reasons why economic growth may not lead to economic development.
SAQ 9.2
a) What are developmental objectives?
b) List and explain common features of developing country
Multiple Choice Questions
1. If GDP for Barbados is N260 million in 2005 and its population is 260, 000, GDP per capita is
a. 1000
b. 260
c. 0.001
d. 259740
2. If GNP per capita at constant prices for Liechtenstein a microstate of 29,000 people located on the Rhine
River between Switzerland and Austria is US$555 and US$560 in 2004 and 2005 respectively, the real
economic growth from 2004 to 2005 is
a. 5%
b. 0.901%
c. 0.090%
d. 0.991%
3. Economic growth from current year (c) to previous year (p) is given by
a. [(GDPc – GDPp)/ GDPp]*100
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b. [(GDPc – GDPp)* GDPp]*100
c. GNPc-(GDPp*100)
d. [GDPp – GDPc]*100
4. All of the following are high-income countries except
a. Singapore
b. U.K
c. Japan
d. South Africa
5. Which of the following countries is not a low-income country?
a. Indonesia
b. India
c. Malaysia
d. Nigeria
6. Economic development refers to
a. economic growth.
b. economic growth plus changes in output distribution and economic structure.
c. improvement in the well-being of the urban population.
d. sustainable increases in Gross National Product.
7. If GNP for Vatican City, the smallest country in the world is 200 million euros in year 2001 and its
population is 890, GNP per capita is
a. 2000 - 890
b. 200/ 890
c. 200,000,000 / 890
d. 200
8. Which of the following characteristics are most likely found in developing countries?
a. high population growth rates.
b. large number of people living in poverty.
c. very traditional methods of agricultural production.
d. all of the above
e. none of the above
9. Which of the following could not be considered a major economic system?
a. capitalism.
b. communism.
c. socialism.

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d. physical quality of life index.
10. Which of the following is an example of "portfolio investment"?
a. An American places funds in a savings account in Nigeria
b. Tokyo Bank of Japan buys Union Bank of the Nigeria
c. Saturn Corp. (owned by General Motors) builds a new factory in Abuja
d. An American puts $10,000 into a money market fund
Links to OERs
https://socialsci.libretexts.org/Bookshelves/Economics/Book%3A_Principles_of_Macroeconomics_(Curtis_an
d_Irvine)/13%3A_Economic_growth
https://socialsci.libretexts.org/Bookshelves/Economics/Book%3A_Macroeconomics_(OpenStax)/07%3A_Econ
omic_Growth/7.1%3A_The_Relatively_Recent_Arrival_of_Economic_Growth
https://socialsci.libretexts.org/Bookshelves/Economics/Book%3A_Principles_of_Macroeconomics/19%3A_Ec
onomic_Development/19.3%3A_Keys_to_Economic_Development
References/Suggestions for Further Readings
Ajayi, S.I. and Ojo, O. (2006), “Money and Banking: Analysis and Policy in the Nigerian context” Daily
Graphics Nigeria Limited.
Amacher, R.C. and Ulbrich, H.H. (1986). Principles of Macroeconomics, South-Western Publishing Co.
Anyanwu, J.C. and Oaikhenan, H.E. (1995) Modern Macroeconomics: Theory and Applications in Nigeria,
Joance Educational Publishers.
Ekpo A.H. (2000) Fiscal and Monetary Policy During Structural Adjustment in Nigeria, Nigerian Economic
Society, Ibadan.
Olofin S. (2000) An Introduction to Macroeconomics, Malthouse Press Ltd, Ibadan.
Olofin, Sam (2001), “An Introduction to Macroeconomics” Malthouse Press Limited
Shapiro, E. (1996) Macroeconomics Analysis, Golgotia Publications (P) Ltd, New Delhi.
William H. Branson (1972) Macroeconomic Theory and Policy, Harper and Row Publishers, New York,
London.
Should you require more explanation on this study session, please do not hesitate to contact your e-tutor
via the LMS.

Are you in need of General Help as regards your studies? Do not hesitate to contact the DLI IAG
Center by e-mail or phone on:

[email protected] 08033366677

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 STUDY SESSION 10:
MACROECONOMICS OF DEVELOPING AND TRANSITIONAL
ECONOMIES

Introduction

This session introduces the students to branch of the macroeconomics of developing and transitional
economies, this aspect of development economics has to do with recent events or macroeconomics outcomes
of developing and newly developed and other transitional economics. In this session, student will be
introduced to new trends in developing economics.

Learning Outcomes for Study Session 10

At the end of this study session, you should be able to:

10.1 Explain the macroeconomics of developing and transitional economics
10.2 Discuss the differing goals of developed and developing economies
10.3 Explain economic growth as an appropriate goal for developing countries
10.4 Discuss basic indicators of transitional economies
10.5 Explain reasons why goals of developed and developing economies differs
10.6 Explain what is meant by transitional economies
10.7 Evaluate economic differences between developed and transitional economies

Key Terms: Transitional economy, Economic growth, Developed economy,

Liberalization, Macroeconomic stabilization, Restructuring and privatization, Legal and
institutional reforms

10.1 The Concept of Transitional Economies

Transition Economy or Transitional Economy is an economy which is changing from a centrally planned
economy to a market economy. Transition economies undergo a set of structural transformations intended to
develop market-based institutions. These include economic liberalization, where prices are set by market
forces rather than by a central planning organization. In addition to this trade barriers are removed, there is
a push to privatize state-owned enterprises and resources, state and collectively run enterprises

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are restructured as businesses, and a financial sector is created to facilitate macroeconomic stabilization and
the movement of private capital. The process has been applied in China, the former Soviet
Union and Eastern bloc countries of Europe and some Third world countries, and detailed work has been
undertaken on its economic and social effects.
The transition process is usually characterized by the changing and creating of institutions,
particularly private enterprises; changes in the role of the state, thereby, the creation of fundamentally
different governmental institutions and the promotion of private-owned enterprises, markets and independent
financial institutions. In essence, one transition mode is the functional restructuring of state institutions from
being a provider of growth to an enabler, with the private sector its engine. Another transition mode is
changing the way that economy grows and practice mode. The relationships between these two transition
modes are micro and macro, partial and whole. The truly transition economics should include both the micro
transition and macro transition. Due to the different initial conditions during the emerging process of the
transition from planned economics to market economics, countries uses different transition model. Countries
like P.R.China and Vietnam adopted a gradual transition mode, however Russia and some other East-
European countries, such as the former Socialist Republic of Yugoslavia, used a more aggressive and quicker
paced model of transition.
The term transition period is often used to describe the process of transition from capitalism to socialism,
preceding the establishment of fully developed socialism

What is a Transitional economy?

Transitional Economy is an economy which is changing from a centrally planned economy to a market
economy. Transition economies undergo a set of structural transformations intended to develop market-
based institutions.
10.2 Macroeconomics of Developing and Transitional Economies
Macroeconomic policy is an art in which one takes the abstract principles learned in positive economics, i.e.
the abstract analysis and models that tell us how economic forces direct the economy – and examines how
those principles work out in a particular institutional structure to achieve goals determined in normative
economics, i.e. the branch of economics that considers what goals we should be aiming for. In this section
we examine another aspect of that art.
A developing economy is an economy that has a low level GDP per capita and a relatively underdeveloped

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market structure, and has not recently had an alternative, developed, economic system. A transitional
economy is an economy that has had an alternative, developed, socialist economic system, but is in the
process of changing from that system to a market system.
Economists use the terms developing and transitional, rather than growing, to emphasize that the goals of
these countries involve more than simply an increase in output; these countries are changing their underlying
institutions. Put another way, these economies are changing their production function; they are not increasing
inputs given a production function. Thus, development refers to an increase in productive capacity and
output brought about by a change in the underlying institutions, and growth refers to an increase in output
brought about by an increase in inputs.
The distinction can be overdone. Institutions, and hence production functions, in developed as well as in
developing countries are continually changing, and output changes are essentially a combination of both
changes in production functions and increases in inputs. For example, in the 1990s the major Western
economies have been restructuring their economies, i.e., changing the underlying economic institutions -
as they work to compete better in the world economy. As they restructure, they change their methods of
production, their laws and their social support programs. Thus, in some ways, they are doing precisely what
developing and transitional countries are doing: developing rather than just growing. Despite the ambiguity,
the distinction between growth and development can be a useful one if you remember that the two blend into
each other.
The reason economists separate developing and transitional economies is that these economies have different
institutional structures and a different weighting of goals than do Western developed economies. These two
differences (in institutional structure and in goals) change the way in which the lessons of abstract theory are
applied and discussed.
The next section begins with a consideration of how the goals of developing countries differ from the goals
of developed countries. Then we turn our attention to how the institutions differ. In the process of that
discussion, we consider the general conduct of macroeconomic policy in developing countries, and present
some case studies that bring to life important aspects of the macroeconomic problems they face.
10.3 The Transition Indicators
The existence of private property rights may be the most basic element of a market economy, and therefore
implementation of these rights is the key indicator of the transition process.
The main ingredients of the transition process are:
• Liberalization – the process of allowing most prices to be determined in free markets and
lowering trade barriers that had shut off contact with the price structure of the world's market
economies.

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• Macroeconomic stabilization – bringing inflation under control and lowering it over time, after
the initial burst of high inflation that follows from liberalization and the release of pent-up
demand. This process requires discipline over the government budget and the growth of money
and credit (that is, discipline in fiscal and monetary policy) and progress toward sustainable
balance of payments.[4]
• Restructuring and privatization – creating a viable financial sector and reforming the
enterprises in these economies to render them capable of producing goods that could be sold in
free markets and transferring their ownership into private hands.
• Legal and institutional reforms – redefining the role of the state in these economies,
establishing the rule of law, and introducing appropriate competition policies.
According to Oleh Havrylyshyn and Thomas Wolf of the International Monetary Fund, transition
in a broad sense implies:
- liberalizing economic activity, prices, and market operations, along with reallocating
- resources to their most efficient use.
- developing indirect, market-oriented instruments for macroeconomic stabilization.
- achieving effective enterprise management and economic efficiency, usually through
- privatization.
- imposing hard budget constraints, which provide incentives to improve efficiency; and
- establishing an institutional and legal framework to secure property rights, the rule of
- law, and transparent market-entry regulations.
Edgar Feige, cognizant of the trade-off between efficiency and equity, suggests that the social and
political costs of transition adjustments can be reduced by adopting privatization methods that are
egalitarian in nature, thereby providing a social safety net to cushion the disruptive effects of the
transition process.
The European Bank for Reconstruction and Development (EBRD) developed a set of indicators to
measure the progress in transition. The classification system was originally created in the EBRD's
1994 Transition Report but has been refined and amended in subsequent Reports. The EBRD's overall
transition indicators are:
- Large-scale privatization
- Small-scale privatization
- Governance and enterprise restructuring
- Price liberalization
- Trade and foreign exchange system
- Competition policy

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 - Banking reform and interest rate liberalization
- Securities markets and non-bank financial institutions
- Infrastructure reform

ITQ 10.2 Mention four indicators of a Transitional economy

ITA 10.2 The main ingredients of the transition process are: Liberalization, Macroeconomic
stabilization –Restructuring and privatization and Legal and institutional reforms
10.4 Differing Goals of Developed and Developing Countries
When discussing macro policy within Western developed economies, we did not dwell on questions of
normative goals of macroeconomics. Instead, we used generally accepted goals in the United States as the
goals of macro policy - achieving low inflation, low unemployment, and an acceptable growth rate - with a
few caveats. You may have noticed that the discussion focused more on what might be called stability goals,
i.e. achieving low unemployment and low inflation-than it did on the acceptable growth rate goal. We chose
that focus because growth in Western developed countries is desired because it holds unemployment down,
and because it avoids difficult distributional questions, as much as it is desired for its own sake. The U.S.
economy has sufficient productive capacity to provide its citizens, on average, with a relatively high standard
of living. The problem facing Western societies is as much seeing that all members of those societies share
in that high standard of living as it is raising the standard.

Growth and Basic Needs

In the developing countries, the weighting of goals is different. Growth (i.e. an increase in the economies'
output) and development (i.e. a transition of the economies' institutions so that the economies can achieve
higher levels of output) are primary goals. When people are starving and the economy is not fulfilling
people's basic needs of adequate food, clothing, and shelter, then a main focus of macro policy will be on
how to increase the economy's growth rate through development so that the economy can fulfill those basic
needs.
10.5 Economic Growth as an Appropriate Goal for Developing Countries
When Classical economics developed, its focus was almost totally on economic growth. Early developers of
that Classical economics such as Adam Smith, Thomas Malthus, and David Ricardo took growth as
economics' central area of concern. As Western market economies grew, the focus of macroeconomics
changed from issues of long-run growth to issues of short-run stability. The macroeconomics models
developed nowadays reflect that change in focus. Keynesian economics, specifically, has a short-run focus,

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and has little relevance to long-term growth.
In summary, the goals of developed and developing countries differ; for developing countries, growth in
economic output is a more generally agreed-upon goal than it is for developed countries. The central policy
question facing these developing countries is: What set of macro policies will lead to growth?
Developing and transition countries differ from developed countries not only in their goals, but also in their
macroeconomic institutions. These macroeconomic institutions are qualitatively different from institutions
in developed countries. Their governments are different; their financial institutions, i.e. the institutions that
translate savings into investment are different; their fiscal institutions i.e. the institutions through which
government collect taxes and spend its money are different; and their social and cultural institutions are
different. As a result of these differences, the way in which we discuss macroeconomic policy is different.
One of the differences concerns very basic market institutions- such as Western style property rights and
contract law. In certain groups of developing countries, most notably Sub-Saharan Africa, these basic market
institutions do not exist; instead, communal property rights and tradition structure economic relationships.
In the transition economies, where the government previously owned large portions of the economy,
ownership is often unclear. Decades ago, before the government owned large portions of the economy, there
was private ownership, and claims based on those old conditions are surfacing, often placing clouds on
current "ownership" and control. How can one talk about market forces in such economies? On a more
mundane level, consider the issue of monetary policy. Talking about monetary policy via open market
operations (the buying and selling of bonds by the central bank) is not all that helpful when there are no open
market operations, as there are not in many developing countries. Let's now consider some specific
institutional differences more carefully.
Views of how activist macroeconomic policy should be are necessarily contingent on the political system an
economy has. One of the scarcest commodities in developing countries is socially-minded leaders. Not that
developed countries have any overabundance of them, but at least in most developed countries there is a
tradition of politicians seeming to be fair and open-minded, and a set of institutionalized checks and balances
that limits leaders using he government for their personal benefit. In many developing countries, those
institutionalized checks and balances on governmental leaders often do not exist.
Let us consider a few examples. First, consider Saudi Arabia, which while economically rich, maintains
many of the institutions of a developing country. It is an absolute monarchy in which the royal family is the
ultimate power. Assuming a member of that family comes to the bank and wants a loan that, on economic
grounds, does not make sense. What do you think the bank loan officer will do? Grant the loan, if the banker
is smart. Thus, despite the wealth of the country, it is not surprising that many economists believe the Saudi
banking system reflects it political structure, and may soon find itself in serious trouble.
A second example is the new transition economies of the former Soviet Union. They face enormous political

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instability, and in the 1990s the largest growth industry there was the private protection agency business. In
such an institutional setting, government policy often has little to do with economics or what is good for the
economy, and any proposed macroeconomic policy must take that into account.
A final example is Nigeria, which had enormous possibilities for economic growth in the 1980s because of
its oil riches. It did not develop. Instead, politicians fought over the spoils and bribes became a major source
of their income. Corruption was rampant and the Nigerian economy went nowhere. Unfortunately, there are
many other examples as this.
As a result of the structure of government in many developing countries, many economists who, in Western
developed economies favor activist government policies may well favor Classical laissez-faire policies for
the same reasons that early Classical economists did - because they have a profound distrust of the
governments. That distrust, however, must have limits. Even a laissez-faire policy requires some government
role in setting the rules. So, there is no escaping the need for socially-minded leaders.

Summary of Study Session 10

This study session discussed the meaning and characteristics of a transitional economy. It also explains why
weak institutions has made it for public policy to be adopts as a means of developing these countries. In
many developing countries, the institutionalized checks and balances on governmental leaders often do not
exist and thereby making it difficult for these economies to transit properly.
Self-Assessment Questions (SAQs) for Study Session 10
S.A.Q 10.1 briefly discuss Macroeconomics of Developing and Transitional Economies
S.A.Q 10.2 Explain four indicators of Transitional economy
Multiple Choice Questions
1. Transitional economies means
a. a change from capitalistic economy to socialism
b. Structural transformation
c. a movement of an economy from government dominance to private ownership of properties and market-
oriented economy.
d. none of the above
2. the following are basic ingredients of transitional process except;
a. economic liberalization
b. privatization of government owned ventures
c. nationalization of private properties and businesses
d. legal and institutional reforms
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3. which of these is odd as regard developing and transitional economies
a. private ownership of means of production and distributions.
b. market driven economy
c. restructuring of legal and other institutional arrangement
d. nationalization
4. Which of the following countries is not a transitional economy?
a. Indonesia
b. India
c. Malaysia
d. Benin Republic
5. Main goal of every developing and transitional economies is;
a. Attainment of economic growth and eventual economic development.
b. Economic growth.
c. Improvement in the well-being of the urban population.
d. None of the above.
6. One of the following economist is highly associated with study of transition economy.
a. Adolf Wagner
b. Isaac Jones
c. Edgar Feige
d. Robert Miller
7. EBRD represents
a. Economic Bureau of Reconstruction and Development
b. European Bank for Reconstruction and Development
c. European Bureau Restructuring and Development
d. None of the above
8. The existence of a private property rights are the most basic elements of market economy and its
implementation is the basic indicator of....................................
a. Economic Transformation
b. Transition Process
c. Economic development
d. Economic restructuring
9. An economy which is changing from a centrally planned economy to a market economy is a
a. Pseudo Economy
b. Transition Economy

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 c. Transformed Economy
d. None of the above
10. Transition economy process includes a movement for controlled economy to a liberalized economy
with...............................
a. Changes in institutional base
b. Changes from social to market determined economy
c. Changes in all restriction that hinders market operations
d. All the above
Links to OERs
https://socialsci.libretexts.org/Bookshelves/Economics/Book%3A_Principles_of_Macroeconomics/20
%3A_Socialist_Economies_in_Transition/20.3%3A_Economies_in_Transition%3A_China_and_Rus
sia
https://socialsci.libretexts.org/Bookshelves/Economics/Book%3A_Macroeconomics_(OpenStax)/19%
3A_Macroeconomic_Policy_Around_the_World/19.1%3A_The_Diversity_of_Countries_and_Econo
mies_across_the_World
https://socialsci.libretexts.org/Under_Construction/Purgatory/Workshops/4CD_OER_Hackathon/de
lmar/1%3A_Welcome_to_Economics/1.5%3A_How_Economies_Can_Be_Organized%3A_An_Over
view_of_Economic_Systems
References/Suggestions for Further Readings
Collander, D.C. (1998): Macroeconomics, Third Edition, Irwin McGraw-Hill, Boston, chapters 7 and 20.
Bakare, I. O. A (1999); Principle and Practice of Economics (Macro Approach), Samuelsson Publisher,
Lagos, Nigeria.
Raamson Publishing, Lagos, Nigeria.
Fashola, M.A (1998): The Principles of Macroeconomics and Policy Extension For Development
Amacher, R.C. and Ulbrich, H.H. (1986) Principles of Macroeconomics, South-Western Publishing Co.
Anyanwu, J.C. and Oaikhenan, H.E. (1995) Modern Macroeconomics: Theory and Applications in Nigeria,
Joance Educational Publishers.
Shapiro, E. (1996) Macroeconomics Analysis, Golgotia Publications (P) Ltd, New Delhi.
Olofin S. (2000) An Introduction to Macroeconomics, Malthouse Press Ltd, Ibadan.
William H. Branson (1972) Macroeconomic Theory and Policy, Harper and Row Publishers, New York,
London.
Ekpo A.H. (2000) Fiscal and Monetary Policy During Structural Adjustment in Nigeria, Nigerian Economic
Society, Ibadan.

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 Should you require more explanation on this study session, please do not hesitate to contact your e-
tutor via the LMS.
Are you in need of General Help as regards your studies? Do not hesitate to contact the DLI IAG Center by
e-mail or phone on:

[email protected] 08033366677

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APPENDIX: 1 ANSWERS TO SELF-ASSESSMENT QUESTIONS
S.A.Q 1.1 What is Macroeconomics?
Economic theory is divided into two broad categories – Microeconomics and Macroeconomics.
Macroeconomics is the branch of Economic Science which studies the economic behavior of individuals;
that is individual units – a person, a particular household, or a particular firm. It is a study of a particular unit
rather than all the units combined.
As against the above, Macroeconomics may be defined as that branch of economic analysis which studies
the behavior of all the units, combined. In other words, Macroeconomics studies the aggregates, such as the
aggregate level of economic activity including output, employment, general price level and money.
SAQ 1.2 What do understand by Interest and Total Consumption as Macroeconomic goals?
(a) An interest rate is the rate at which interest is paid by borrowers (debtors) for the use of money that they
borrow from lenders (creditors). Specifically, the interest rate is a percentage of principal paid a certain
number of times per period for all periods during the total term of the loan or credit. Interest rates are
normally expressed as a percentage of the principal for a period of one year, sometimes they are expressed
for different periods like for a month or a day. Different interest rates exist parallelly for the same or
comparable time periods, depending on the default probability of the borrower, the residual term, the
payback currency, and many more determinants of a loan or credit. For example, a company borrows
capital from a bank to buy new assets for its business, and in return the lender receives rights on the new
assets as collateral and interest at a predetermined interest rate for deferring the use of funds and instead
lending it to the borrower. A commercial bank can usually borrow at much lower interest rates from the
central bank that companies can borrow from the commercial bank. Interest-rate targets are a vital tool
of monetary policy and are taken into account when dealing with variables like investment, inflation,
and unemployment. The central banks of countries generally tend to reduce interest rates when they wish
to increase investment and consumption in the country's economy. However, a low interest rate as a
macro-economic policy can be risky and may lead to the creation of an economic bubble, in which large
amounts of investments are poured into the real-estate market and stock market. In developed economies,
interest-rate adjustments are thus made to keep inflation within a target range for the health of economic
activities or cap the interest rate concurrently with economic growth to safeguard economic momentum.
(b) Macroeconomists are interested in aggregate consumption for two distinct reasons. First, aggregate
consumption determines aggregate saving, because saving is defined as the portion of income that is not
consumed. Because aggregate saving feeds through the financial system to create the national supply of
capital, it follows that aggregate consumption and saving behaviour has a powerful influence on an
economy’s long-term productive capacity. Second, since consumption expenditure accounts for most of
national output, understanding the dynamics of aggregate consumption expenditure is essential to

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 understanding macroeconomic fluctuations and the business cycle. Consumption is normally the largest
GDP component. Many persons judge the economic performance of their country mainly in terms of
consumption level and dynamics. The Keynesian Theory of consumption is that current real disposable
income is the most important determinant of consumption in the short run. Real Income is money income
adjusted for inflation. It is a measure of the quantity of goods and services that consumers have buy with
their income (or budget).
S.A.Q 1.3 Explain Macrostatics, Comparative Macrostatics and Macrodynamics?
Macrostatics is the method, which is used to explain certain aggregative relations in a stationary state. It does
not show the process by which the national economy reaches the final equilibrium. It deals with the final
equilibrium of the economy at a particular point in time. This method presents a “stand still” picture of the
economy as a whole at a particular point of time. This can be illustrated with the simple Keynesian equation.
(c) Y = C+I
(d)
(e) Where: Y = Total Income
(f) C = Total Household Consumption, and
(g) I = Total Investment
This equation merely tells us that Y is equal to the aggregate of C and I. But it throws no light on the process
bye which this equality between Y on the one side and C + I o the other side has been reached. In other
words, the process of adjustment, which led to the final equilibrium, does not come into limelight at all under
macrostatics.
Comparative Macrostatics: The various macro-variables in an economy such as total consumption, total
investment, total income etc. keep changing with time. As a result, the economy keeps on reaching different
levels of equilibrium. The method of comparative macrostatics involves a comparable study of the different
equilibria attained by the economy. But the method does not analyze the process of adjustment through which
the economy moves form one equilibrium to another.
Macrodynamics: This method is the most realistic method of Macroeconomics analysis. In this method, we
study how the equilibrium in the economy is reached consequent upon changes in the Macroeconomics
variables and aggregates. This involves a detailed analysis of how the economy moves from one equilibrium
position to another – including all the factors that may disturb the equilibrium positions. In essence, under
macrodynamic analysis, nothing of consequence is omitted.
Answers for MCQs of Study Session 1
1. D (2 ) A (3) D ( 4) C (5) D

Self-Assessment Questions for Study Session 1

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SAQ 2.1 Explain why a washing machine sold to a dry cleaner is a final good though it is fixed investment
(capital) used to produce other goods. Is there a double –counting problem if this sale is added to
GDP?
Answer
Capital is not excluded from being a final good. A final good is a finished good bought by the final user and
not for resale. The final user is the dry-cleaner, so the sale would be included in GDP and no double-
counting takes place.
SAQ 2.2 Using the expenditure approach, net exports are total exports minus total imports. If the expenditure
by foreigners for Nigeria products exceeds the expenditures by Nigeria citizens for foreign products,
net exports will be a positive contribution to Gdp. Explain how net exports affect Nigeria economy.
Describe both positive and negative impacts on Gdp. Why do we use net export to calculate gdp
rather than just add exports to other expenditure components of gdp?
Answer
Using the expenditure approach, net exports are exports minus imports. If the expenditure by foreigners for
Nigeria products exceeds the expenditures by Nigerian for foreigner products, net exports will be a
positive contribution to GDP. If the foreigners spend less for Nigeria products than Nigerians spend
for foreign products, GDP is reduced.
Net exports are used for national income computation because actual consumption, investment, and
government spending do not exclude the amount of expenditure for imports.

Answers for MCQs for Study Session 2

(1) B (2) D (3) B (4) D (5) A (6) B (7) D (8) B (9) C (10) C
SAQ 3.1: What do you understand by laissez-faire?
Answers
Laissez-faire or “leave it alone” is the principle of non-governmental interference in economic affair which
was fully supported by the classical economists. The term was introduced by Adam smith. In the words of
Adam Smith, ”The state man, who should attempt to direct private people in what manner they ought to
employ their capitals, would not only load himself with a most unnecessary attention, but assure an authority
which could safely be trusted, not only to no single person, but to no council or senate. Whatever and which
would nowhere be so dangerous as in the hands of a man who had folly and presumption enough to fancy
himself fit to exercise it”. What Smith implied here is that an unregulated (free) market was a remarkably
efficient one.
Recently, laissez-faire economics has been embraced by the Chicago school, who not only believe in the
existence of a free market economy but has advocated that some privately imposed restrictions on trade are

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socially beneficial. Laissez-faire (free or unregulated market) therefore creates market incentives which
encourage people to work harder, then save and invest, bargain and create new products and technologies. If
government should interfere with the workings of the market, it might inflict more harm than good on the
market. Its intervention might impair the market’s efficiency and slows down economic growth.

SAQ 3.2: Explain explicitly Keynes theory and his criticisms of the Classicalists

Answer
Explicitly, prior to the depression of 1930s, economists (classicalists) believe that any idle resources caused
by a recession in the form of unemployed workers, empty factories and idle bank reserves creates what is
called the disequilibrium condition. In addition, this disequilibrium condition would correct itself. For
example, wages would decline until it was attractive enough for businesspeople to live more workers and fix
them up. Interest rates on its own would drop up to the level where it would be attractive enough to
businesspeople to borrow for the acquisition of machinery and inventory.
The great depression of 1930s therefore created the enabling ground for Keynes to launch his theory since
the idle resources would not find their own way back to work. He criticized the classical and observed that
it is possible to achieve equilibrium condition in the marketplace at a production level in which quantity
demanded at a price clears the market and the same time, in the short run, to have a part of the labour market
that are cut out of the market without any employment opportunity.
Keynes explained further that when there is a decline in consumer demand, business people also react to this
by curtailing their investment Inventory and machinery. This action causes further reduction in consumer
demand and this sparks off idle capacity in factories and consequently resulting to layoffs. Due to economic
uncertainty, workers in anticipation of being laid off curtail their debt obligations and also put up a savings
behavior to take care of “rainy days”.
We saw earlier that savings flows to investment. The classical economists believe that the interest rate will
fall under this circumstance to a level which make borrowing ant investment attractive to business people.
In addition, they are of the opinion that low interest rate will discourage workers from savings.
Keynes’ opposition to the classical proposition is that when factories are empty of inventories and demand
is slackens, there is no rate of interest so low that makes borrowing and investment attractive to business
people. In addition, when a worker is disengaged or foresees layoffs, there is no rate of interest so low as to
discourage savings.
Keynes argued further that as workers are laid off, it is true that they would be willing to accept jobs for less
pay, but due to the fact that demand is declining and inventories are already higher than what the market
demands, they will not employ workers even if the workers are willing to take lower wages.
On the long run it might be possible for business people to modify or change their production methods, and
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employ more people, but in the short run, they cannot modify or change their machineries. Therefore, the
businesspeople can produce to meet up with the reduced level of demand without the need to utilize the idle
resources. The only way out of this depression according to Keynes is to stimulate demand.
Demand in an economy is a function of many things including disposable income. Keynes suggested
stabilization policy for business cycles. He proposed that government should reduce tax (so as to boost
disposable income) and run a deficit when demand shrinks and idle reserves exist. These measures will
stimulate demand and increase income level, employment and avert a recession.
Answers for MCQs for Study Session 3
(1) C (2) D (3) B (4) A (5) C (6) D (7) B (8) A (9) C (10) C
SAQ 4.1 SAQ 4.1 What is the factors affecting consumption and savings
(i) Expectations: People who expect a pay rise often start spending more even before the extra
income is received and converse is the case when they anticipate being laid off.
(ii) Wealth: The amount of wealth an individual owns will affect the person’s ability and willingness
to consume. Wealth changes can also affect spending pattern.
(iii) Expectations of rising prices: This too can affect one’s consumption and saving behavior. For
instance, an anticipation of future rise in prices can lead to more consumption now.
(iv) Price levels or real-balance effect: Rising price levels reduce the real value of money balances
and cause people to reduce spending.
(v) Taxes: The major link between total and disposable income is tax. A change therefore in tax
policy may affect spending pattern.
(vi) Credit: The availability of credit encourages people to spend above their current income. On
the other hand, the need to meet up with past debt repayments places a limit on current
consumption.
(vii) Changes in patterns of income distribution: You will recollect that households in any economy
have different MPCs; and MPC varies based on household income level. However, consumption
of poorer households will increase if incomes of those households are raised. Note that Udoji
arrears increased consumption substantially in Nigeria in the 1970s.
(viii) Some cultural factors: Consumption and savings are greatly influenced by people’s cultural
beliefs. In Nigeria for instance, some extravagant burial rites lead to excessive consumption and
depression of savings.
SAQ4.2 What are the major determinants of investment decisions?
(i) Expectation: The desire to invest is influenced by, the expectations of future income and sales.
No firm would want to purchase a new plant and equipment neither unless his managers are
convinced that people would later buy the extra product of the plant and equipment nor would
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 producers want to accumulate larger inventories of goods if they thought sales were going to fall.
The favourable expectations of future sales therefore are a necessary condition for investment
spending.
(ii) Technology and innovation: Changes in technology and innovation increase the level of
investment. More recently, technological advances and cost reductions have stimulated an
investment spree in laptop computers, cellular phones, video conferencing, fiber-optic networks,
and anything associated with the internet.
(iii) Rate of interest: The major determinant of desired investment spending is the rate of interest.
Business firms often borrow money in order to purchase plant and equipment. The higher the rate
of interest, the costlier it is to invest. We would expect a lower rate of investment spending at
higher interest rates and more investment at lower rates (ceteris paribus).

Answers for MCQs for Study Session 4

(1) D (2) B (3) A (4) E (5) B (6) C (7) A (8) C (9) B (10) E
SAQ 5.1 Examine what you understand by Money Market.
Answer
There are two main types of money market. One is the money market and the other is the capital market. The
money market proper deals with short-term funds while the capital market deals with long-term funds. By
short-term funds we mean that are required for any period up to about three years. Funds that are required
for longer periods can be regarded as long-term funds.
The money market in West Africa is made-up of a number of markets in different financial institutions.
These include treasury bills, the call money fund and treasury reserve certificates.
Treasury bills were first issued in Nigeria and Ghana in 1960. They were initially issued monthly, later they
were issued every two weeks and now they are issued every week. The Treasury bill market is a market in
funds for ninety-one days. Those who need funds for such a period and those who have funds to lend for
such a period operate in this market. The call money market meets the requirements of those who wish to
borrow or lend money on an overnight basis or for a few days. In Nigeria, it was established in July 1962
when a Special Fund was created at the central bank which was charged with the responsibility of
administering it. At the end of every day, participating institutions who have surplus money put it in the fund
on an overnight basis and those who need money to balance their books borrow from it. Under this
arrangement, the funds deposited are withdrawn able on demand and interest is paid or charged at a rate
determined by the central bank.
Another popular instrument in Nigeria money market is the treasury reserve certificate. This provides a
market for borrowers and lenders for periods longer than those provided by the call money scheme or treasury

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bill at shorter than the long-term government security which matures after one or two years and is intended
to bridge the gap between treasury bills and development loan stocks.
There are other instruments in Nigeria’s money market like commercial papers. Treasury certificates,
pension funds, bankers acceptances, bankers unit funds etc. the various institutions that serve as money
markets in Nigeria are the CBN commercial and merchant banks, insurance companies, discount houses and
other financial institutions. The following are functions of Money Markets;
1. It allocates savings into investment and tends to obtain equilibrium between the demand for and
supply of loanable funds thereby promoting rational allocation of resources.
2. A money market promotes liquidity and safely of financial assets and thereby it encourages savings
and investment.
3. A money market promotes financial mobility by enabling the transfer of funds from one sector to the
other.
S.A.Q 5.2 Discuss and differentiate between discretionary fiscal policy and expansionary monetary.
Answer
If an economy is in recession, the government should engage in Expansionary Fiscal Policy - increase
government spending and/or reduce taxes, increase budget deficit. G > T (spending is greater than tax
revenue), so the government has to borrow money from individuals, businesses or foreigners. Expansionary
fiscal policy (active budget deficit) would involve some combination of: i) cuts in personal income taxes, ii)
cuts in corporate taxes, and iii) increased government spending, and a possible budget deficit.
The Government can also pursue Restrictive Fiscal Policy to reduce aggregate demand (AD) by raising taxes
or cutting government spending, running a smaller budget deficit or a budget surplus. Restrictive fiscal policy
in response to an expansionary "overheating" will also combat inflation.

Answers for MCQs for Study Session 5

A (2) C (3) A (4) B (5) D (6) B (7) C (8) D (9) A (10) A
SAQ 6.1 Explain the term trade by barter?
Answer
Barter trade is a system of exchange by which goods or services are directly exchanged for other goods or
services without using a medium of exchange, such as money. In its traditional and simplest form, barter is
a method of trade which encourages the exchange of commodities or services between reciprocal traders
without the use of cash. Traditionally this takes the form of an exchange for value on a direct party to party
basis where the needs and wants of the parties are satisfied by the barter transaction.
ii. International trade is the exchange of capital, goods, and services across international borders or territories.
Trading-partners reap mutual gains when each nation specializes in goods for which it holds a comparative

152
advantage and then engages in trade for other products. In other words, each nation should produce goods
for which its domestic opportunity costs are lower than the domestic opportunity costs of other nations and
exchange those goods for products that have higher domestic opportunity costs compared to other nations.
In addition to comparative advantage, nations engaged in trade for the following reasons:

SAQ 6.2 Explain three reasons why nations embark on international trade?
Answer
Differences in natural resources: Nations have different amounts of labour, land, and capital. Nigeria and
Saudi Arabia may have a lot of oil, but perhaps not enough lumber. It will thus have to trade for lumber.
Japan and China may be able to produce technological goods of superior quality, but they may lack many
natural resources. They may trade with Thailand or Indonesia for inputs.
Gains from specialization: Countries may gain economies of scale from specialization, experiencing long
run average cost declines as output or productivity increases.
Benefits of increased competition: More competition leads to lower prices for consumers, greater
responsiveness to consumer wants and needs, and a wider variety of products.
Answers for MCQs for Study Session 6
B (2) D (3) C (4) C (5) D (6) D (7) D (8) D (9) D (10) B
SAQ 7.1 Briefly discusses three reasons why a nation such as Nigeria needs Balance Of Payments (BOPs)
accounting?
Answer
(i) A nation such as Nigeria needs BOPs due to the following reasons:
(a) it shows the account of export and import of the country and this act as a signal for the government to
adjust her domestic policies when import is greater than export.
(b) It provides historical data on export and import over a period of time and this can be utilize for planning
purposes. As well, it helps to provide data for net foreign investment component of the Country income
(c) It serves as an indicator of economic and political stability. For example, if Nigeria has consistently
positive BOPs, this could mean that there is significant foreign direct investment within the economy. It may
also mean that the country does not export much of its currency.
SAQ 7.2 What are the measures that the Nigeria government can adopt to correct or reduce Balance Of
Payments (Bops) deficits in the economy?
Answer
The measures that the Nigeria government can adopt to correct or reduce Balance Of Payments (Bops)
deficits include the following:
(a) Through export promotion strategy. When the government adopt export promotion measures, this will

153
help to correct disequilibrium in the balance of payments. This includes tax concessions to exporters,
marketing facilities, credit and incentives to exporters, etc.
(b) Through Import Substitution strategy. The government may resort to import substitution to reduce
the volume of imports and make it self-reliant. Fiscal and monetary measures may be adopted to encourage
industries producing import substitutes
(c) Exchange rate Control. Herein, the monetary authority enjoys complete control over the exchange rate
dealings. Under such a measure, the central bank directs all exporters to surrender their foreign exchange to
the central authority. Thus it leads to concentration of exchange reserves in the hands of central authority.
At the same time, the supply of foreign exchange is restricted only for essential goods. It can only help
controlling situation from turning worse.
Answers for MCQs for Study Session 7
B (2) A (3) A (4) A (5) D (6) D (7) A (8) C (9) B (10) A
SAQ 8.1 Define what an economist means by the term 'inflation'.
Answer
Inflation is the overall general upward price movement of goods and services in an economy (often caused
by increase in the supply of money), and usually measured by the Consumer Price Index and the Producer
Price Index. Inflation could assume the following forms; (i) Demand- Pull inflation (ii) Cost – Push inflation
(iii) Imported Inflation (iv) War caused inflation
SAQ 8.2 Mention four types of unemployment you know?
Answer
(a) Structural Unemployment: It is also known as Marxian unemployment or long-term unemployment. It
is due to slower growth of capital stock in the country. The entire labour force cannot be absorbed in
productive employment, because there are not enough instruments of production to employ them.
(b) Seasonal Unemployment: Seasonal unemployment arises because of the seasonal character of a
particular productive activity so that people become unemployed during the slack season. Occupations
relating to agriculture, sugar mills, rice mills, ice factories and tourism are seasonal.
(c) Frictional Unemployment: It arises when the labour force is temporarily out of work because of perfect
mobility on the part of the labour. In a growing and dynamic economy, in which some industries are
declining and others are rising and in which people are free to work wherever they wish, some volume of
frictional unemployment is bound to exist. This is so because it takes some time for the unemployed labour
to learn new trades or to shift to new places, where there is a demand for labour. Thus, frictional
unemployment exists when there is unsatisfied demand for labour, but the unemployed workers are either
not fit for the jobs in question or not in the right place to meet this demand.
(d) Cyclical Unemployment: It is also known as Keynesian unemployment. It is due to deficiency of

154
aggregate effective demand. It occurs when business depression occurs. During the times of depression,
business activities are at low ebb and unemployment increases. Some people are thrown out of employment
altogether and others are only partially employed. This type of unemployment is due to the fact that the total
effective demand of the community is not sufficient to absorb the entire productive of goods that can be
produced with the available stock of capital. When the businessmen cannot sell their goods and services,
their profit expectations are not fulfilled. So the entrepreneurs reduce their output and some factors of
production become unemployed.
Answers for MCQs for Study Session 8
B (2) D (3) A (4) B (5) B (6) A (7) C (8) D (9) D (10) A
SAQ 9.1 (a) Define economic growth as it defer from economic development
b) Enumerate and explain reasons why economic growth may not lead to economic development.
Answer
1a) Economic growth is defined as the expansion in a nations real output or it can be define as the
expansion in a nations capability to produce goods and services its people want.
Economic growth refers to an increase in real aggregate output (real GDP) reflected in increased real per
capital income. The rate of economic growth is measured as the percentage increase in real GDP overtime.
Economic development on the other hand is a sustainable increase.
In real GDP that implies increased real per capital income, better education and health as well as
environmental protection, legal and institutional reforms and an efficient production and distribution system
for goods and services.
b) Reasons why Economic growth may not lead to economic development.
i) Inadequate growth in comparison with population: If economic growth is not growing significantly
relative to population, it may fail to promote economic development e.g. an economic growth of 3-4% in
comparison with population growth of 10% due to relaxation of immigration law may not enhance
development.
ii) Income Distribution: If the growth in GDP exceed the population growth and income is not well
distributed, the unequal income distribution will lead to widening gap between the rich and the poor,
therefore violating one of the objectives of economic development.
iii) Imbalance in sectorial development: The industrial sector, the oil sector among others may be
expanding in a country but when facilities such as housing, health, pipe borne water, law and order among
others are not developing such country may not witness development. Moreso, if the per capital income
increases from expansion in the oil and industrial sectors, development cannot be said to have occurred
because poor health facilities could lead to dehumanizing ailments such as typhoid, tuberculosis etc which
hinders development.

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iv) Environmental degration and ecological disturbances: When ecological balance is disturbed, through
oil spoilage, air pollution, water and land pollution and industrial pollution of the atmosphere through puffing
of toxic gas, carbon mono-oxide, lead particles etc, it may cause health problems, also when there is
ecological disturbance such as blockage of drainages, water canals etc. it makes it impossible for water to
enter the oceans and this may cause flooding.
v) Moral, intellectual, spiritual and social decadence: When there is high desire for looting, examination
malpractices, cult practices, injustice, lack of accountability and transparency, undue favouritism, red
tappism among others, all these cannot promote development.
vi) Economic development dependence: There will not be development if a country is a perpetual
exporters of primary products which are highly income inelastic while the manufactured products they
import have high income elasticity. Thus, the price of primary products does not increase rapidly and at times
faces price fluctuation
SAQ 9.2(a) What are developmental objectives
b) List and explain common features of developing country
Answer
(a) Developmental objectives are as follows:
i) Growth in income: Every country desire that there should be growth in the national income which
can promote development.
ii) Equitable distribution of income: The main aim is to bridge the gap between the poor and the rich
therefore the income generated should be equally distributed to every region, sector, classes, etc for
development to take place.
iii) Employment promotion: There must be provisions of jobs for the skilled, semi-skilled and unskilled
labour to reduce the incidence of social menace (e.g. armed robbery) in the society.
iv) Self-reliance: There must be improvement in balance of payment, external economy, food, security,
reduction in stock of external debt. This also extend to strategic needs such as energy, security, defence etc.
v) Price stability: There should be negligible inflation. No price fluctuation. The prices of goods and
services should be stable over a period of time.
vi) Balance development: There must be balance in the nation, in the sectorial units, there must be
balance. Not necessarily at the same rate but it should meet the need for development requirement. There
should be regional balance to reduce rural-urban migration.
vii) Environmental preservation and maintenance of ecological balance: This imply that residential
environment must be free of oil spillage, air pollution etc. the drainage system must also be efficient to
prevent flooding of water.
(b) Features of developing country:

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a) Low standards of living: In developing nations general standards of living tend to be very low for the
vast majority of the people. These low standards of living are manifested quantitatively and qualitatively in
the form of low income (poverty), inadequate housing, poor health, limited or no education, high infant
mortality, low life and work expectancy and sometimes a general sense of hopelessness.
b) Health: In addition to struggling on low income, many people in the developing nations fight a
constant battle against malnutrition, disease and ill health. The average life expectancy in developing nations
in 2003 was 57 years as compared to 74 years in developed nations. Medical care is an extremely scarce
social service in many parts of the developing world.
c) Low levels of productivity: In addition to low standards of living, developing countries are
characterized by relatively low levels of labour productivity. Throughout the developing world, levels of
labour productivity (output per worker) are extremely low compared with those in developed countries.
d) Dependence on agricultural production and primary product for exports: The external sector
comprises imports and exports. Normally, primary products in LDCs account for between 80-90% of exports
earnings but in the developed countries it is about 35%.
e) Dominance, dependence and vulnerability in international relations: This is a significant factor
contributing to the persistence low level of living, rising unemployment and growing income inequality is
the highly unequal distribution of economic and political power between the rich and poor nations. The rich
nations often dictate the terms of technology, foreign and private capital transferred to developing nations.
Another important aspect of international transfer process serve to inhibit the development of poor nations
very significantly contributing to the persistence underdevelopment is the transfer of values attitudes
institutions, standard of behaviour, structures, cultures etc, from developed to developing nations. All these
usually stimulate corruption and economic plunder by the privilege minorities.

Answers for MCQs for Study Session 9

(1).A (2).B (3).A (4).D (5).A (6).B (7).C (8).D (9).D (10). A
S.A.Q 10.1 Briefly discuss Macroeconomics of Developing and Transitional Economies
Answer
Macroeconomic policy is an art in which one takes the abstract principles learned in positive economics, i.e.
the abstract analysis and models that tell us how economic forces direct the economy – and examines how
those principles work out in a particular institutional structure to achieve goals determined in normative
economics, i.e. the branch of economics that considers what goals we should be aiming for. In this section
we examine another aspect of that art.
A developing economy is an economy that has a low-level GDP per capita and a relatively underdeveloped
market structure, and has not recently had an alternative, developed, economic system. A transitional

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economy is an economy that has had an alternative, developed, socialist economic system, but is in the
process of changing from that system to a market system.
S.A.Q 10.2 Explain four indicators of Transitional economy
The main indicators of the transition process are:
Liberalization – the process of allowing most prices to be determined in free markets and lowering trade
barriers that had shut off contact with the price structure of the world's market economies.
Macroeconomic stabilization – bringing inflation under control and lowering it over time, after the initial
burst of high inflation that follows from liberalization and the release of pent-up demand. This process
requires discipline over the government budget and the growth of money and credit (that is, discipline in
fiscal and monetary policy) and progress toward sustainable balance of payments.[4]
Restructuring and privatization – creating a viable financial sector and reforming the enterprises in these
economies to render them capable of producing goods that could be sold in free markets and transferring
their ownership into private hands.
Legal and institutional reforms – redefining the role of the state in these economies, establishing the rule of
law, and introducing appropriate competition policies.[5]
According to Oleh Havrylyshyn and Thomas Wolf of the International Monetary Fund, transition in a broad
sense implies:
Answers for MCQs for Study Session 10
C (2) C (3) D (4) D (5) A (6) C (7) B (8) B (9) B (10) D

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APPENDIX II: GLOSARRY OF KEY TERMS
Balance of payment: It is the difference between a nation’s exports and its imports. That is, BoT is the
difference between the value of goods and services exported out of a country and the value of goods and
services imported into the country.
Balance of trade: It is the difference between a nation’s exports and its imports. That is, BoT is the
difference between the value of goods and services exported out of a country and the value of goods and
services imported into the country.
Business cycles: It is the upward or downward movement of economic activity, or real GDP, that occurs
around the growth trend.
Classical economists: Classicalists averred that with laissez-faire (hands-off government policies), the
economy would better achieve the goals of price stability, full employment, and economic growth.
Consumption It is the total expenditure by consumers on final goods and services. It refers to expenditures
by households (consumers) on final goods and services.
Disposable income: It represents the amount of income consumers can choose to spend or not spend (save)
in each period
Economic development: It is the process of optimizing the resources of a nation to meet the needs of the
people and their enlightened aspiration and endowing them with the capacity to sustain their achievement.
Economic growth: It is a continuous increase in national output which is identifiable by sustainable increase
in per capita income which translates to general wellbeing of an average citizen.
External trade: It refers to buying and selling between two or more countries.
Fiscal policy: It refers to the manipulation of expenditure resources and taxation power by the government
for the purpose of managing the economy.
Inflation: Is the overall general upward price movement of goods and services in an economy (often caused
by increase in the supply of money), and usually measured by the Consumer Price Index and the Producer
Price Index.
Internal, Home or Domestic trade: It is conducted within the geographical and political boundaries of a
country. It can be at local level, regional level, or national level
Macroeconomics: It is the branch of economic analysis which studies the behavior of all the units,
combined. In other words, Macroeconomics studies the aggregates, such as the aggregate level of economic
activity including output, employment, general price level and money.
Monetary policy: It is a government policy which influence the economy through changes in the banking
system reserves that impact the money supply and credit availability in the economy.
National Income: It refers to the monetary value of all the goods and services produced in a country during
an accounting period, usually a year.
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Savings: It is that part of disposable income not spent on current consumption (i.e., disposable income less
consumption
Terms of trade: It is a measure showing the price index of a nation’s exports in terms of its imports. In other
word, terms of trade show the relationship between the prices at which a country sells its exports and the
prices paid for its imports.
Trade: It is the activity or process of buying, selling, or exchanging of goods and services among two or
more persons or countries which is backed by means of payment in each period.
Trade by barter: It is an act of trading whereby goods and services are exchanged between two or more
parties without the use of money.
Transitional economy: An economy which is changing from a centrally planned economy to a market
economy. Transition economies undergo a set of structural transformations intended to develop market-
based institutions
Unemployment: The ILO defined unemployment is based on the following three criteria which should be
satisfied simultaneously: "without work", "currently available for work" and "seeking work". Accordingly:
The "unemployed" comprise all persons above a specific age who during the reference period were: (a)
"without work", i.e., were, not in paid employment or self-employed. (b) "currently available for work", i.e.,
were available for paid employment or self-employment during the reference period, and (c) "seeking work",
i.e., had taken specific steps in a specified reference period to seek paid employment or self-employment."
Investment: It refers to the creation of new capital stock. Investment can be broken down into two main
categories (fixed investment and inventory investment). When business firms purchase new plant and
equipment for the purpose of expanding or improving their output capabilities, such purchases are called
fixed investment. Firms also acquire inventories of goods that can be used to satisfy consumers’ demands.
Such expenditures are called inventory investment.

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