PRINCIPLES OF

MACROECONOMICS

CBA1205

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MACROECONOMICS
 Concerned with the economy as a whole
 The Prefix “macro” comes from the greek word
‘makros’ which means large.
 In Macroeconomics we focus on the big picture.
 We develop an overall view of the economic
system and we study total or aggregate
economic behaviour .The emphasis is on topics
such as total production, income and
expenditure , economic growth, aggregate
unemployment, the general price level,
inflation and the balance of payments. In
essence macroeconomics focuses on totals.

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Microeconomics vsMacroeconomics
Microeconomics Macroeconomics
The price of a single product The Consumer price index
Changes in the price of a product like Inflation (the increase in the general
tomatoes level of prices).
Production of maize The total output of all goods and
services in the economy.
The decisions of individuals The combined outcome of the
consumers/individual firms decisions of all consumers/firms in
the country.
The market for individual goods like The market for all goods and services
Bananas in the economy.
The demand for a product like cotton The total demand for all goods and
services in the economy.
An individual’s decision to work or not The total supply of labour in the
to work economy. 3
 GENERAL TERMS
 Consumer Goods: Used or consumed by
individuals or households to satisfy wants e.g.
food, wine, clothing, shoes, motor cars,
furniture households appliances, etc
 Capital Goods: Used in the production of other

goods e.g. machinery, plant and equipment

used in manufacturing and construction, school
buildings, universities residencies, roads, dams
and buildings

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CATEGORIES OF CONSUMER GOODS
 Non-Durable Goods: Used one once. Examples
include food , wine, tobacco, petrol, medicine
 Semi-durable Goods: Used more than once,

and usually last for a limited period, e.g,

clothing, shoes, sheets and blankets and
motor car tyres.
 Durable Goods: Goods that normally last for a

number of years, e.g furniture, refrigerators,

washing machines, dishwashers and motor
cars

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 FINAL GOODS AND INTERMEDIATE
GOODS
 Final Goods: They are consumed
by individuals, households and
firms, e.g, loaf of bread, etc
 Intermediate Goods: They are
purchased to be inputs in
producing other goods, e.g, flour

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 PRIVATE AND PUBLIC GOODS
Private Good: Is a good that is consumed by
individuals or households.
:All typical consumer goods (like food, clothes
and motorcars) are private goods.
:Distinguishing feature of private goods is that
consumption by others can be excluded.
Public Good: Is a good that is used by the
community or society at large.
:Consumption by individuals cannot be
excluded, e.g., traffic lights, defence and
weather forecasts.
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ECONOMIC GOODS AND FREE GOODS
 An economic good is a good that is produced
at a cost from scarce resources.
 A free good is a good that is not scarce and

therefore has no price.

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CIRCULAR FLOW OF NATIONAL
INCOME
 Refers to a simple economic model
which describes the reciprocal
circulation of income between
producers and consumers.
 National Income: the total level of

production within a given economy or

by resources of a given economy over
a specified period of time usually 1
year.
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A continuous flow of production, income and expenditure
is known as circular flow of income. It is circular
because it has neither any beginning nor an end.
In economics national income is viewed as a flow studied
through the three-pronged circular flow model of
national income:
- Two sector model (closed economy with no gvt intervention)
- Three sector model (closed economy with gvt intervention)
-Four sector model
- Five sector model

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 The two sector model of national
income
Key players are:
1.Households
The household is the basic decision making
unit/economic institution and is responsible for
aggregate demand. Households own the factors
of production, thus they sell their factors of
production(land, labour, capital and
entrepreneurship) to firms in (factor
markets).Firms then combine these factors and
convert them into goods and services. This
income is then used to purchase consumer
goods and services.
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Key players
2.Firms
A firm is a basic unit of production
Whereas households are involved in consumption ,firms
are engaged in consumption and production. Firms are
buyers in factor markets but sellers in the goods
markets.
Whereas households are responsible for spending on
consumer goods (C),firms are responsible for spending
on capital goods (I).In essence firms purchase factors of
production in the factor markets. They transform the
factors into goods and services which are then sold in
the goods market.
It is the households themselves that reconstitute
themselves into firms to facilitate production

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The two sector model cont’d
Assumptions:
The basic circular flow of income model consists of six
assumptions:
 The economy consists of two sectors: households
and firms.
 Households spend all of their income (Y) on goods and

services or consumption(C).
 All output (O) produced by firms is purchased by
households through their expenditure(E).
 There is no financial sector.
 There is no govt sector.
 There is no overseas sector meaning the economy is closed.

In essence the National income identity is:

Income=expenditure=Output
Y=E=O
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THE TWO SECTOR MODEL
 In the simple two sector circular flow of income
model the state of equilibrium is defined as a
situation in which there is no tendency for the
levels of income (Y), expenditure (E) and output
(O) to change,
Y=E=O
 This means that the expenditure of buyers
(households) becomes income for sellers (firms).
The firms then spend this income on factors of
production such as labor, capital and raw
materials, "transferring" their income to the factor
owners. The factor owners spend this income on
goods which leads to a circular flow of income.

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 The two sector model
 Not all income is consumed by households, part of it is
saved ,for future consumption. But in general ,savings come
back into the circular flow as investment.
 Thus in the two sector model the leakage/withdrawal out of
the circular flow is savings. The injections or additions into
the circular flow is investment.
 Therefore the two sector model is in equilibrium when;

withdrawals =injections
Savings = investment or when

Income =Expenditure
Income (Y) = Consumption expenditure(C
+Investment expenditure (I)
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The two sector model cont’d
Simple model:
Saving
HOUSEHOLDS

Payment Land Rent

Goods & Labour Wages
for Services
goods & Capital Interest
services Enterprise Profit

FIRMS

Investment 16
 The two sector model cont’d
At equilibrium W = J or Withdrawals equals Injections

RESOURCE
MARKET

RESOURCES INPUTS

FIRMS HOUSEHOLDS Saving

Investmen
s (W)
t
(J) GOODS & GOODS &
SERVICES SERVICES
PRODUCT
MARKET

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The two sector model cont’d

 What if W>J?
◦ This means that with the passage of time more
income is lost from the economy than is created or
generated within the economy.
◦ Economic activity declines leading to increased
unemployment in the economy.
◦ This situation can be remedied through an
appropriate mix of macroeconomic and
microeconomic policies.

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The two sector model cont’d
 What if W<J?
◦ This implies that there is more investment (or
capital creation) in the economy.
◦ Increased creation of capital or investment has
multiplier and accelerator effects on economic
activity leading to increases in national income.
◦ A sustained rise in national income leads to
economic growth and an improvement in living
standards or welfare, ceteris paribus.

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 The three sector model
Savin
HOUSEHOLDS

taxes Gds
&serv

Payment Gds & GOVERNMENT Land Rent

for Serv Labour Wages
goods & Capital Interes
subsidy Enterpri
services Profit
Grants se
Gds&serv
taxes

FIRMS

Investment 20
The three sector model cont’d
Assumptions
 The key players in the three sector model are

the households, firms and the government.

 The economy is closed
 Model builds from the two sector model, thus

interaction of households and firms is still

the same, with households supplying the
factors of production in return for factor
rewards in the factor markets. Firms produce
goods and services that they sell in the goods
market for a fee/price.

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The three sector model cont’d
 Government participates in the circular flow in the
following ways;
 It purchases goods and services from firms in the goods
market.
 It purchases factors of production (primarily labour )
from households in the factor markets.
 In return government provides households and firms
with public goods such as
defense,law,order,education,healthservices,roads and
dams.
 These services are financed by levying taxes on the
income and expenditure of households and
firms .Government also transfers some of its tax
revenue directly to needy people such as poor old age
pensioners.
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Let us explain further

Transfer payment-A one way transfer of

money for which no money, good or service
is received in exchange. Governments use
such payments as means of income
redistribution by giving out money under
social welfare programs such as social
security, old age, disability pensions,
unemployment compensation, student grants
etc

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 Three sector model
Government economic activity thus involves three
important flows;
 Government expenditure on goods and
services(including factor services) usually denoted (G).
 Taxies levied on (and paid by) households and firms (T).
 Transfer payments i.e. the transfer of income from

certain individuals and groups e.g.( the wealthy) to other

individuals and groups 9e.g the poor).However unlike
government spending and taxation ,transfer payments
do not directly affect the overall size of the production,
income and expenditure flows. We therefore focus on
government spending (G) and taxes (T)

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 Three sector model
 Government spending is an injection into the
circular flow of spending and income while taxes
constitute a leakage or withdrawal from the
circular flow of income
 Thus in the three sector model there are two

leakages, namely savings and taxes. There are

two injections ,namely investment and
government expenditure.

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NOTE THAT
In the three sector model the state of equilibrium
is achieved when;
withdrawals =injections
Savings (S)+Taxes(T) =Investment (I) +Gvt Expenditure(G)
S+T = I +G
OR
Income =Expenditure
Income (Y) = Consumption expenditure(C +Investment
expenditure (I) +Government expenditure (G)
Y = C+I+G

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 The four sector model (open economy)
 In the four sector model ,the foreign sector is
introduced.The foreign sector interacts with the
domestic economy through the exports and imports
made by households and firms.
Thus the key players in this sector are:
 Households
 firms
 Government
 foreign sector.

The two major flows between the domestic economy

and the foreign sector are exports ,which we denote
(X) and imports ,which we denote (M) or (Z).

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The four sector model cont’d
 Households provide factor services to firms,
government and foreign sector.
 In return, they receives factor payments.
Households also receive transfer payments
from the government and the foreign sector.
 Households spend their income on:
 (i) Payment for goods and services purchased
from firms;
 (ii) Tax payments to government(includes
import duties paid for goods bought from
abroad).
 (iii) Payments for imports of goods and
services.
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The four sector model (open
economy)
Firms:
 Firms receive revenue from households,

government and the foreign sector(Exports) for

sale of their goods and services.
 Firms also receive subsidies from the government.
 Firm makes payments for:
 (i) Factor services to households;
 (ii) Taxes to the government;
 (iii) Imports from the foreign sector (i.e. for raw

materials imports and other imports of final

goods).

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The four sector model (open
economy
Government:
 Government receives revenue from firms,
households and the foreign sector for sale of
goods and services, taxes, fees, etc.
Government makes factor payments to
households and also spends money on
transfer payments and subsidies.

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The four sector model (open economy)
Foreign Sector:
 Foreign sector receives revenue from firms,

households and government for export of goods

and services. It makes payments for import of
goods and services from firms and the
government. It also makes payment for the factor
services to the households.

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NOTE THAT
In the four sector model the state of equilibrium is
achieved when;
withdrawals =injections
Savings (S)+Taxes(T)+Imports (M )=Investment (I)
+Gvt Expenditure(G)+Exports (X)
S+T +M= I +G+X
OR
Income =Expenditure
Income (Y) = Consumption expenditure(C
+Investment expenditure (I) +Government
expenditure (G)+(Exports-Imports)
Y = C+I+G+(X-M)
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The five sector model
In the five sector model we introduce the financial
sector and show how financial institutions fit into the
overall picture.
The Financial Sector consists of banks and non-bank
intermediaries who engage in the borrowing and
lending of money.
When saving occurs ,there is leakage or withdrawal
from the circular flow of income. These funds are then
channelled by banks to firms that wish to borrow
and expand their production capacity by purchasing
capital goods such as machinery and equipment. This
is called investment (I).The major function of the
financial sector is to act as a funnel/channel through
which saving can be channelled back into the circular
flow in the form of investment banking.
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The five sector model cont’d

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The five sector model cont’d
 In the five sector model there are three
injections and three withdrawals:
 Injections:

1. Investment (I)
2. Govt expenditure (G)
3. Exports (X)
 Withdrawals:
1. Savings (S)
2. Taxes (T)
3. Imports (M)

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The five sector model cont’d
 In the steady state: W = J implying that:
 I+G+X = S+T+M

N.B
Taxes in international trade include the various
import tariffs and export taxes which may be
levied on goods and services
 `

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NATIONAL INCOME
CONCEPTS
AND
MEASUREMENT
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National income concepts
 National income: refers to a measure of total
output or production of a given country over
a specified period of time usually one year.
 There are various national concepts:

◦ Gross Domestic Product (GDP)

◦ Gross National Product (GNP)
◦ Net National Product (NNP)
◦ Net Domestic Product (NDP)
◦ Gross Domestic Income (GDI)
◦ Gross National Income (GNI)
◦ Net National Income (NNI)

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Gross Domestic Product (GDP)
 This is national income or output which is
produced by factors of production that are
found in or located in a particular country.
 The term domestic denotes or conveys the

idea of location of the factors of production

that are used to produce the output.
 This implies that the residency or citizenship

status of the owners of the factors of

production is immaterial when considering
this concept of national income.

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Gross National Product (GNP)
 This is the total output of an economy
produced by the nationals or citizens of an
economy regardless of where they are
working from or where they are resident.
 The key term is “national” which denotes the

ownership of the resources or factors of

production irrespective of where they are
located.
 The difference between GDP and GNP is

called Net Property Income from Abroad

(though it may be a net outflow at times).

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PROPERTY INCOME(PI)
 PI to abroad: All profits, interests and other
incomes from domestic investment which accrue
to residents of other countries e.g. profits
earned in Zimbabwe by foreign owners of
companies such as Lever Bros, Colgate-
Palmolive or BMW and interest paid by Zim to
foreign lenders. All wages& salaries of foreign
workers engaged in domestic production.
 PI from abroad: All profits, interests and other

incomes from investments abroad which accrue

to permanent residents e.g. profits earned by a
Zim Construction Company that builds roads in
the rest of the world. All wages& salaries earned
by permanent residents outside Zim. 42
Gross National Product cont’d
NPI = PI from abroad minus PI to abroad
◦ Where PI stands for Property Income
◦ NPI stands for Net Property Income
 NPI from abroad can be positive, negative or
zero.
 It is positive if PI from abroad is greater than PI
to abroad. The implication is that GDP < GNP

 It is negative if PI from abroad is less than PI to

abroad. The implication is that GDP > GNP
 It is zero if PI from abroad is equal to PI to
abroad. If NPI is zero this means that GDP = GNP
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Net National Product (NNP)
 NNP is defined as GNP less depreciation
 NNP = GNP - Depreciation
 Depreciation refers to the replacing or
repairing of existing infrastructure. It is also
called replacement investment.
 Depreciation is thus part of gross investment

in an economy. It is that part of gross fixed

capital formation which restores an
economy’s infrastructure.
 Also termed as the capital consumption

allowance.

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The difference between at market
prices and factor cost
1. GDP at market prices = GDP at factor cost +
taxes less subsidies
2. GDP at factor cost = GDP at market prices +
subsidies less indirect taxes
3. GNP at market prices = GNP at factor cost +
indirect taxes (VAT) less subsidies
4. GNP at factor cost = GNP at market prices +
subsidies less indirect taxes (VAT)

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Other measures of National Income
 Gross National Income (GNI) is Gross National
Product plus statistical discrepancy item.
 Net Domestic Income (NDI) is Gross Domestic

Product plus statistical discrepancy item. Or

GDP less depreciation + statistical
discrepancy
item.
 Net National Income (NNI) is Net National

Product plus statistical discrepancy item. Or

GDP + NPI from abroad + statistical
discrepancy item.

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Approaches of measuring national income

 There are three approaches of measuring

national income:
1. The expenditure method
2. The Output Method
3. The Income Method

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The Expenditure Method
 To determine NY through the expenditure method, we must
add all types of spending on finished or final goods and
services.
 This means we must compute consumption expenditure by

household ,investment,expenditure by government ,business

current purchases of goods and services as well as
expenditure by foreigners.These are added together to get
Gross Domestic Expenditure (GDE).Hence
 GDE=C+I+G

 With C=Consumption expenditure

I =Investment
G=Government expenditure
Where C,I,G include imported goods and services.This is because
the three do not distinguish between goods manufactured
locally and those manufactured in the rest of the world e.g.
Japanese T.V,French wine ,German machinery,italian shoes etc.
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 Secondly ,the value of all exports is added to
Gross Domestic expenditure. This accounts
for domestic expenditure sold abroad. This
results in Total Final Expenditure (TFE)
 C+I+G+X=Total Final expenditure.
 Third, the value of all imported commodities

denoted M or Z is deducted resulting in GDP

at market prices. Thus
 GDP@ mkt prices=C+I+G+(X-M)
 (X-M) is called net exports.

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The Expenditure Method
Personal Consumption Spending (C)
 Consumer spending by households. This is

spending on consumer goods and services. It

entails expenditure by households on:
 Consumer durable goods eg- cars, fridges,

dvd players,...
 Semi-durable goods eg clothing
 Perishables eg food, newspapers and

magazines

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The Expenditure Method Cont’d
 Consumer spending on services eg services
of lawyers, doctors and counsellors.

Gross Investment(I)
 All investment spending by the Zimbabwean

govt and business firms.

 Investment spending has three components,

namely-
1. All final purchases of machinery, equipment
by the govt and businesses.

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The Expenditure Method Cont’d
2. All construction is investment spending
3. Changes in inventories are reckoned as
investment.
 Investment- enhancing capacity to produce.
Investment in human capital is excluded
when measuring investment spending.
 Investment spending is facilitated by the
purchase of tools, machinery and
equipment.
 Construction: of dams, factories, buildings
and other infrastructure is included.
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The Expenditure Method cont’d
 Owner occupied houses are reckoned as
investment because they may be let out to
generate income over time especially for
businesses in the real estate sector.

Inventory changes as investment

 GDP is designed to measure total current

output. Thus we have to make an effort to

measure all current produced output which
has been left unsold in company warehouses
or storage spaces.

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The Expenditure Method cont’d
 Thus GDP incorporate the market value of all
currently produced output.
 If inventories and other works in progress

were to be excluded from the GDP measure

then the measure/statistic would understate
the current produced level of output.
 What about a decline in inventories?
 This must be deducted in figuring out current

GDP since the economy would have spent on

total output by an amount which exceeds
current production..

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 The difference being that some of the GDP
taken off the market this year does not reflect
current production but rather a drawing down
of inventories which were at hand at the
beginning of the year.

Physical increase in stocks

 This is added to GDP as they represent an

increase in production.

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The Expenditure Method cont’d
Non-investment transactions
The transfer of paper assets or 2nd hand
tangible assets or the buying and selling of
financial instruments is reckoned as
investment only in Finance and Banking
parlance.
 Nevertheless, such transactions are not

regarded as investment in Economics since

no new output would have been added to the
economy.

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The Expenditure Method cont’d
 Investment in economic terms is the
construction/manufacture of new capital assets
which give rise to jobs and income
Gross investment & Net Investment
 Gross investment also called gross capital
formation includes the production of all investment
goods, that is, those that are to replace worn out
infrastructure, plant, machinery and equipment
plus any additions to the economy’s capital stock.
 Therefore Gross Investment includes both

replacements and added investments.

 Net investment refers only to the added

investments that have occured in the current year.

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The Expenditure Method cont’d
Govt current purchases of goods & services (G)
 It includes all defence expenditure and all

current govt spending at provincial and local

levels on finished goods and services and all
direct purchases of resources especially
labour.
It excludes the following:
 All govt spending on new non-defence

durable assets (it’s part of I)

 All govt transfer payments eg pensions, UB

and relief aid because they do not reflect any

current production but merely government
receipts to certain specific households.
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The Expenditure Method cont’d
 Net Exports (X-M or Xn) Spending
 It is the difference between:
 Exports- spending by foreigners on

domestically produced output.

 Imports-spending by residents and citizens

on foreign produced output.

 The net exports spending represents

activities associated with international trade.

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 The Expenditure Method Template
Consumer expenditure xxx
General Gvt Expenditure xxx
Gross Fixed Investment xxx
Value of physical increase in socks xxx
Total Domestic Expenditure xxx
Exports of goods and Services xxx
Total Final Expenditure xxx
Imports of goods and Services xxx
Gross Domestic Product at market prices xxx
Less: All indirect taxes xxx
Add: Subsidies xxx
GDP at Factor cost xxx
Net Income from abroad (NI from abroad-NI to abroad) xxx
GNP at factor cost xxx 60
 Practise Questions
Question one:Calculate GNP at factor cost
Consumer expenditure 73656
General government final consumption 26562
Gross domestic fixed investment 23427
Investment in stocks 359
Exports of goods and services 34837
Imports 36564
Indirect taxes 28197
Subsidies 15000
Net property income from abroad 1179
Question two
Using the same data calculate NNP at factor cost if
depreciation is calculated at 12000.
61
The Income Method
 This is the total income earned by households during the
year.
 This approach adds together factor incomes
 This method records the value of current production by
aggregating all factors of production engaged in current
production .This implies that wages,rent ,interest and profit
are added together.
 GDP is the sum of the incomes earned through the
production of goods and services. This is:
 Income from people in jobs and in self-employment
+
Profits of private sector businesses
+
Rent income from the ownership of land
=
Gross Domestic product (by factor incomes)
62
The Income Method cont’d
 Only those incomes that are come from the
production of goods and services are
included in the calculation of GDP by the
income approach. We exclude:
 Transfer payments e.g. the state pension;

income support for families on low incomes;

the Jobseekers’ Allowance for the
unemployed and other welfare assistance
such housing benefit
 Private transfers of money from one

individual to another

63
The Income Method cont’d
 Income not registered with the tax
authorities. Every year, billions of pounds
worth of activity is not declared to the tax
authorities. This is known as the shadow
economy or informal economy.
 Published figures for GDP by factor incomes

will be inaccurate because much activity is

not officially recorded – including subsistence
farming and barter transactions

64
The Income Method cont’d
 The adjustments
1. Compensation of employees
The largest share of GDP is normally paid as
wages & salaries by businesses and the govt
to their employees.
NB- a large fraction of wages and salaries
flow to the govt as taxes & a certain part
flow to their pension schemes and insurance
schemes.

65
The income method cont’d
2. Rent
This is money which is paid for occupying
space. The money is received by businesses
and households that supply property
resources to the economy. It includes
monthly rental payments that tenants make
to landlords and lease payments firms pay
for the use of office & factory space.
 Net rental income is taken into account in
figuring out GDP.

66
The income method cont’d
 Net rental income = Gross rental income –
depreciation of the rented property
3. Interest
 This comprises money paid by private
businesses to suppliers of money capital
(which intermediates the creation of physical
capital resources in the economy).
 It includes interest on savings deposits,
certificates of deposit and corporate bonds.

67
The income method cont’d
 4. Profits
 They are divided into:

-proprietors’ income which consists of net

income of sole proprietors and other
unincorporated businesses.
-business earnings or profits that accrue to
owners of registered corporations.
-national income accounts sub-divide
profits into three categories elaborated on
the next slide.

68
The Income method cont’d
a. Corporate income taxes- levied on
corporations’ net earnings and thus flow to
govt.
b. Dividends- these are part of profits which
flow to a firms’ shareholders who are
households.
c. Undistributed corporate profits also called
retained earnings. This fraction of profits is
retained to acquire new plant & equipment
or just for expansion.

69
The income method cont’d
 Stock appreciation
◦ Stocks of raw materials may rise in (nominal or
currency denominated) value without a physical
appreciation of the same. This flows to owners of
the stock as income.
◦ In figuring out GDP this (nominal or currency
denominated) appreciation in stock must be
subtracted.

70
Income Approach Basic Template

Wages xxx
Rent xxx
Interest xxx
Profits xxx
Total Domestic Income xxx
Stock appreciation (xxx)
Residual Error xxx
GDP at factor cost xxx

71
 Practice Questions
Study the data below and attempt the questions that
follow;
Income from employment 226.4
Gross trading Profits of companies 65.6
Gross trading surpluses of public Co. 6.4
Stock appreciation 4.9
Interest Income 3.2
Income from rent 24.8
Income from self employment 33
Government expenditure 55

1.Calculate GDP@ factor cost

72
Question two
Using the data below calculate GDP at factor cost
Income from capital resources 13.2
Net Rental income 124.8
Income from formal employment 452.8
Gross trading profits of companies 165.6
Gross trading surpluses of public firms 826.4

73
Question three (more comprehensive question)
Incomefrom employment 900
Gross trading profits of companies 130
Gross trading surpluses of state owned firms (-32)
Stock appreciation 10
Interest income 7
Income from rent 50
Income from self employment 66
Net property income from other countries 58
Capital consumption allowance 19

Calculate Net National Product at factor cost using

the data above.
74
Question four
Calculate GNP at factor cost using the data below
Income from employment 78639
Income from self employment 10208
Income from rent 7771
Gross trading profits of companies
12445
Gross trading surpluses of public corporations and
other public enterprises 4580
Imputed charge for the consumption of non traded
capital 1012
Stock appreciation 6557
Net property income from abroad 1179

75
The Output Method
 The output method measures the value added at
the industry level.
 Basically, the measurements tell us how the
industries perform over time or in a particular
year. They can measure structural changes in the
country.
 The methodology involves estimating the value
added or intermediate output of goods. Take for
example a car industry. Suppose that the cost of
producing a car is $50,000.
 Assume that to make the car the manufacturer
requires $500 worth of steel, which the
manufacturer buys from the steel industry.
76
The Output Method cont’d
 Steel in this case represents the ‘intermediate
product’, which is used only at some point in
time during the production of other good (the
car, in this case) rather than in the form of a
final consumption good.
 The value of the car quoted earlier at $50,000
has already incorporated the cost of the steel.
 Including the $500 worth of steel into the
calculation of national income will actually lead
to double counting. The same goes to other
intermediate products like pig iron (say cost
$300) and rubber ($500).
77
The Output Method cont’d
Value Added Approach
 Intermediate Products (An Example of a Car

Industry)
Pig Iron $300
Rubber $500
Steel $500
Other Components $48,700
Final Output $50,000

78
The Output Approach cont’d
 Therefore, in the calculation of national income, one
can either 1) add up the value of all the intermediate
products ($300 + $500+ $500 + $48,700) or 2)
simply taking the final value of the car ($50,000).
 To summarize, the output approach in measuring
the national income involves the following three
stages;
1) estimate the gross output in various sectors,
2) determine the intermediate output and
3) estimate the reduction in the value of assets from
wear or tear (more commonly known as
depreciation).

79
The output method cont’d
 GDP/GNP can be obtained from either:
(1) directly or by summing all the different
intermediate products in
(2) while National Income Product (NNP) is
obtained by deducting (3) from (1) and/or (2).
(REFER TO PRECEDING SLIDE FOR
EXPLANATION OF NUMBERS IN BRACKETS)

80
 VALUE ADDED IN A FIVE STAGE PROCESS

STAGE OF PRODUCTION SALES VALUE VALUE ADDED

Firm A Sheep Ranch 120 -
Firm B Wool processor 180 60
Firm C Suit manufacturer 220 40
Firm D Clothing wholesaler 270 50
Firm E Retail clothier 350 80
Total sales 1140
Value added(Total Income) 350
Thus the national income is $350(which is the same
as the market value of the final good at the retail
clothier) looking at the value added at each stage of
production .The value added approach avoids double
counting by measuring and cumulating the value
added at each stage.
81
Valued Added Approach Template

Mining xxx

Agriculture xxx

Tourism xxx

Manufacturing xxx

Construction xxx

GDP at market prices xxx

82
Exercise
Use the output approach to calculate GDP at
factor cost
Agriculture, forestry and fishing 5.9
Energy and water 24.2
Construction 21.5
Manufacturing 85.6
Adjustment for financial services 20.6
Services and distribution 237.9

83
Question two
N.B:Remember NY=NE=NO
 Study the data below and answer the questions that follow;

Income from employment 226.4

Gross trading profits of companies 65.6
Gross trading surpluses of public companies 6.4
Stock appreciation 4.9
Interest income 3.2
Income from rent 24.8
Income from self employment 33
Agriculture, forestry and fishing 5.9
Energy and water 24.2
Construction 21.5
Manufacturing 85.6
Adjustment for financial services 20.6
Services and distribution 237.9

Use the income approach and the output approach to calculate GDP@
factor cost. Your answer should prove that NY=NO.
Comment on the additions and subtractions that you have made to ensure
84
agreement between the two methods.
Measurement at current prices and
at constant prices
 An important distinction needs to be made
between GDP at current prices( Nominal GDP)
and GDP at constant prices (Real GDP).
 It is essential to distinguish between Nominal

and real values.

Question
Mayibongwe Sibanda earned a salary of $4000
a month in 2009
Samuel Pirikisi earned a salary of $4000 per
month in 2015.
Were the two salaries the same?
85
 Answer
 Nominally (in monetary or $ terms ) Mayibongwe and

Samuel earned the same salary. In real terms ,however,

(i.e. bearing in mind the inflation during this period
Mayibongwe earned more than Samuel. Although the
amounts are the same in monetary terms ,they actually
differ because of the value(purchasing power) of money
changes over time.
 Nominal means ‘in terms of the name'. the nominal

value of something is therefore its face value. Nominal

values are therefore also called monetary values.
 Real means actual or essential. The real value of a

salary is its actual or essential value in terms of what it

can buy(purchasing power).The real value of money
depends on the prices of goods and services. As prices
increase the real value of money decreases.

86
 Nominal versus Real GDP
 GDP or any national income measure is usually
expressed in nominal or currency denominated terms.
However we are not only interested in GDP during a
particular period. We also want to know what
happened to GDP from one period to the next.
However in a world in which prices tend to increase
from one period to the next it makes little sense to
compare monetary values .We have to allow for the
fact that prices may have increased. To solve this
problem national accountants convert nominal GDP
(GDP at current prices ) to real GDP (GDP at constant
prices).This is done by valuing all commodities
produced each year in terms of the prices ruling in a
certain year called the base year.For example if the
base year was 2004 ,it means each year’s GDP was
also expressed at 2004 prices. 87
 Nominal and Real GDP practical example
Suppose an economy produces three goods ,i.e,apples,bananas
and oranges. In 2004 100apples were produced and sold at
50cents each,200 bananas were produced at 25cents each
and 150 oranges were produced at 30 cents each. In 2009
150 apples were produced and sold at $1 each,200 bananas
were produced and sold at 40cents each and 100 oranges
were produced and sold at 50cents each.
Question
Calculate nominal GDP (GDP at current prices ) for the year
2004 and the year 2009.
Calculate Real GDP for the year 2009 using 2004 as the base
year.
Calculate the increase in nominal GDP.
What was the increase in terms of real GDP.

88
 SOLUTION
Nominal GDP in 2004 Nominal GDP in 2009 Real GDP in 2009
(at 2004 Prices)
100 apples @50c = $50 150 apples @$1 = $150 150 apples @50c = $75

200 bananas@ 25c = $50 200 bananas@ 40c = $80 200 bananas@ 25c = $50

150 Oranges @ 30c = $45 150 Oranges @ 50c = $50 150 Oranges @ 30c =
$30

$145 $280 $155

Increase in nominal GDP between 2004 and 2009

280-145/145 *100 =93.1%
155-145/145 *100 =6.9%
Notice that when using real GDP production actually increased by just
6.9 % as we eliminated the effect of price increases. Using
nominal/face values it seemed like production had increased by 93.1%
because of increase in the prices of goods. Thus real GDP is a better
measure if we want to make meaningful analysis and comparisons
between different years.

89
Nominal vs Real national income cnt’d
 Inflation overstates national income whilst,
 Deflation understates national income.
 This implies that there is need for adjustment of
nominal national income figures so that the
effects of inflation or deflation are removed from
the statistics.
 The adjustment process makes use of an
appropriately designed statistical index called a
national income deflator e.g. the GDP deflator.The
difference betweeen nominal and real GDP
indicates what happened to prices.Thus the GDP
deflator can also be used to calculate an inflation
rate.
90
Nominal vs real national income
cont’d
N om inal G D P
G D P deflator = 100
R eal G D P
If the GDP at current prices in 1994 was 107221and
123126 million in 1995; whereas Real GDP was
257292 in 1994 and 254175 million in
1995 ,calculate the GDP deflator for 1994 and
1995.What was the inflation rate in 1995
GDP deflator 1994=107221/257292*100=41.7%
GDP deflator 1995=123126/254175*100=48.4
Inflation rate=48.4-41.7/41.7*100=16.1%

91
 Fill in the rest of the table

Year GDP at GDP@ constant GDP Deflator Inflation rate

current Prices (2000) prices
1994 107221 252792 41.7 -
1995 123126 254175 48.4 16.1
1996 143255 254221
1997 167098 259561
1998 200448 270463
1999 240639 276940
2000 276060 276060
2001 310074 273249
2002 340963 267257
2003 383071 270181
92
 GDP deflator is also defined as a
selected index expressed in
hundredths as follows:
 GDP deflator = Price index / 100

93
Nominal vs real national income cont’d
 If in 1964 GDP was US $ 64 billion and CPI
was 125, Real GDP is calculated as follows:
 Real GDP =Nominal GDP/GDP deflator

= 64/(125/100)
= 64 x 100/125
= $ 51.2 billion
 If in 1980 GDP was US $ 64 billion and the

CPI was 92
Real GDP = 64/(92/100)
= 64 x 100/92
= $ 69. 57 billion
94
TUTORIAL QUESTION
Discuss the usefulness of National income
statistics .What are the problems associated with
the use of national income statistics in
comparing performance between different
countries. How can these problems be
overcome. [50 marks]

95
NATIONAL INCOME
DETERMINATION

96
National Income Determination
 It involves analysing how changes in gvt
expenditure, imports, exports and investment
affect income, employment and inflation.
 Models used are :
 1. The Simple Keynesian Model
 2. The Aggregate Demand & Aggregate

Supply Model
 3. The Neoclassical Model

97
The Keynesian model of income determination
 The model is based on the seminal works of John M Keynes whose
views gained prominence in the 1930s and 1940s during and after
the Great Depression of 1929.
 Keynes was an advocate of government intervention in economic
activity.
 He advocated for government intervention because of the negative
impact on global economies as a result of the great depression of
1929.
 The great depression occurred because of the free market
principles associated with the classical tool of macroeconomic
management. Keynes suggested that if there is a fall in aggregate
demand/ expenditure, it is necessary for government to intervene
by way of increasing government expenditure so as to sustain
employment and thus ensure that the economy does not
experience the painful consequences of a full economic depression.98
The Simple Keynisian Model
In the simple Keynesian model income is
defined as follows;
 Y = C+S ……………………………………………..

(1)
 Where Y =National income
 C = Aggregate level of Consumption in the

economy
 S = Savings

Note that :From (1) : C=Y –S……… (2)

S =Y –C……… (3)

99
The Simple Keynesian model
The Consumption function
The relationship between private consumption
expenditure and total income is called the
consumption function (C). The consumption
function has three important characteristics;
 Consumption increases as income
increases(There is a positive relationship
between consumption spending and income.)
 Consumption is positive even if income is zero-

this reflects the influence of non income

determinants of consumption spending.
 When income increases ,consumption increases

but the increase in consumption is less than the

increase in income because part of the
additional income is saved.
10
0
Graphical illustration of the Notice that the
consumption function increase in
consumption when
income increases is
smaller than the
increase in income.

10
1
The consumption function
 Notice that the consumer spent $5000 even
when income was zero. That part of
consumption which is independent of the
level of income is called autonomous
consumption.
 Total consumption spending can therefore be

split into two components ,that is, induced

consumption (dependent on income) and
autonomous consumption (independent of
income ).

10
2
 As income increases ,consumption increases but the
increase is smaller than the increase in income .Hence
∆C is smaller than ∆Y. The ratio between the change
in consumption and the change in income is one of
the most important ratios in macroeconomics. It is
called the marginal propensity to consume and is
usually denoted by the symbol c .It is equal to the
slope of the consumption function.
 In symbols the marginal propensity to consume is
expressed as ;
 c = ∆C
∆Y
The Marginal propensity to consume (MPC)
indicates the proportion of an increase in income
that will be used for consumption. It can never
be greater than one .It lies somewhere between
zero and one (0 ‹ c ‹ 1) .
10
3
The Keynesian Model cont’d

Equation for the consumption function:

C= a + cY
where
C =Total consumption
a = Autonomous consumption
c = Marginal propensity to consume (MPC)
Y = Total income
cY = induced consumption

10
4
 MPC or c : the fraction or proportion of income
that a household consumes rather than saves.
 For example, suppose that the MPC is 4/5.
This means that for every dollar that a
household earns, the household spends 80c
(0.8 of a dollar) and saves 20c.
 MPS or s : the fraction or proportion of income
that a household saves rather than
consumes.if MPC is 4/5 then MPS is 1/5.
 In essence MPC+MPS=1 or (c+s =1) 10
5
The savings function
Remember : S =Y –C……… (3)
Thus :
S=Y – [a + cY] since C= a + cY
= Y - a- cY
=-a +Y(1-c)
Since (1-c)=s
Savings can be expressed as follows:
 S = -a + s Y

 Where S = Total Savings

Y =national income
-a = dissaving to facilitate
autonomous consumption
s = slope of the savings function or
the marginal propensity to save (MPS)

10
6
Savings Function
S=-a + cY

10
7
The savings function cont’d
 Given S = -a + s Y
If changes are introduced then
Δ S =s Δ Y
s=ΔS
ΔY

s is the Marginal Propensity to Save (MPS)

MPS = Δ S/ Δ Y
(0 ‹ s ‹ 1)

10
8
 Since in the two sector economy income is
either consumed or saved, this means that:
 Y=C+S
 Y = a + cY + -a + sY
 Y = a – a + cY + sY
 Y = Y(c+s)
 Y/Y = {Y(c+s)}/Y
 1 = c+s
 In essence MPC+MPS=1
10
9
Relationship between income and saving
 There is a direct relationship between income and
saving, that is, If income increases ,saving also
increases but by less than the increase in income.
It means as income increases ,proportion of
income saved increases.
 At lower levels of income ,saving is negative. In the

initial stages when there is very low

income ,consumption expenditure is more than
income leading to negative saving (dissaving).For
instance ,if income is $3000 and consumption
expenditure is $5000 then saving will be negative
(-2000).It is called dissaving.
11
0
 Investment spending
 Aggregate spending in our hypothetical economy
consists of consumption spending by households
and investment spending by firms .Investment
spending refers to the purchase and production
of capital goods .Investment is not primarily a
function of income. In the simple Keynesian model
investment is exogenously determined ,that is,
investment is autonomous. It is usually regarded
as independent of the level of income .
11
1
Investment diagram

11
2
The 45 degree line The 450 line is an important
Keynesian tool.The line indicates
all possible points where the
value of the variable on the
vertical axes (y) is equal to the
value of the variables on the
horizontal axes (x).In
mathematical terms we have
plotted the function /equation
AE >Y y=x . At each point on the curve
the value of y is equal/the same
as the value of x.Both axes are
drawn to the same scale .This
curve forms a 45 degree angle
with each of the axis. In this
Y>AE instance along this line total
spending(AE) is equal to total
income (Y).This line therefore
shows all possible equilibrium
points.At any point above the
line AE >Y (excess demand).Any
point below the line Y >AE
(excess supply). 11
3
The equilibrium level of income
Equilibrium occurs where
AE=Y , in this case its $7000.
When aggregate spending is
greater than total production
(A>Y) firms experience an
unplanned decrease in
inventories .This is because
current production is
insufficient to meet the
demand for goods and
services. Firms have to then
draw on their stocks or
inventories to meet the
demand. This incentivizes
firms to increase their
production in the next period.
When aggregate spending is
less than income (Y>AE),then
firms will experience an
unplanned increase in
inventories. They find they
cannot sell all the goods and
services produced during the
period and they lower their
production in the next period.
11
4
Equilibrium When inventories
decrease ,GDP rises
until it is at the
equilibrium level.
When inventories
increase production
falls returning the
economy to the
equilibrium position.

11
5
Equilibrium
The equilibrium level of
national income for this two
sector model is $1000.In the
aggregate expenditure
function AE/Yad the
autonomous components of
expenditure is A = I +a ,that
is investment plus
autonomous consumption
( 300+200).The slope (0.5) is
the same as that of the
consumption
function ,therefore the
aggregate expenditure
function can be viewed as a
consumption function which
has been shifted upwards
parallel to itself by a vertical
distance equal to investment
expenditure (I) which is
exogenous($300). Inventories
decrease by -100 if AE>Y .
Inventories increase by 100 if
AE <Y. 11
6
Equilibrium algebraically (2 sector model
 According to the expenditure approach ,equilibrium
occurs where AE=Y along the 45 degree line.
 Thus :
Since AE = C + ɪ and AE =Y

it means Y = a +cY + ɪ
Y –cY= ɪ +a
Y (1-c) = ɪ +a then divide both sides by (1-c)

Y = 1 (ɪ +a )
1-c

or Y =1 (A ) A represents Autonomous expenditures

MPS
11
7
 Therefore the equilibrium level of national
income is the reciprocal of marginal
propensity to save (MPS) * (A) autonomous
expenditure.
 1/MPS =k ;k is called the multiplier
 In essence Y = k *A
 This implies that national income is

derived by multiplying k by autonomous

expenditure. National income will increase
by k times.

11
8
Exercise
 Assume consumption function C=500+0.75Y
and I =1500.Draw the AE function and determine the
equilibrium level of national income .Calculate total
consumption expenditure at the equilibrium level of
national income.
Answer Answer (second method)
Y=k.A
At equilibrium : Y =AE Y=1/MPS *A
AE = C+ I Y =1/(1-c)*a+I
Y= 1/(1-0.75)*(500+1500)
Y = 500 +0.75 Y +1500 Y = $8000
Y =2000+0.75Y
Y -0.75Y =2000
0.25Y/0.25 =2000/0.25
Y= $ 8000

11
9
Consumption at an equilibrium income of 8000
 C =500+0.75y
 = 500 + 0.75(8000)
 = 6500
 b. Diagram

AE=Y
Aggregate
exp(AE)
AE=2000+0.75Y

8000 C=500+0.75Y

6500

National income (Y)

8000
12
0
 The question can also be worked out using
the withdrawal injection approach.
 Remember that ;
 S = -a + sY where s = (1-c)
 S = -a +(1-c)Y
 S =-500+ (1-0.75)Y
 S = -500 +0.25Y

Since in the two sector model equilibrium

occurs where
 S=I
 -500 +0.25Y = 1500
 2000=0.25Y
 $8000= Y

12
1
Withdrawal /injection approach
Savings, Investment

S=-500+0.25Y

I =1500

0 National income (Y)

Ye=8000

-500

12
2
 Itis clear that national income has
increased by 4 times (k.A).This is the size
of the multiplier k.
 k = 1/(1-c)

Or
 k = 1 /MPS

 In the question; k=1/(1-0.25) =4 times.

 Thus since Y = multiplier (k)*Autonomous expenditures (A)
 k.A= k(I+a) = 4*(1500+500) =$8000

12
3
The Multiplier (k)
 The expenditure multiplier is the ratio of the change in
total output induced by an autonomous expenditure
change.
 The ratio between the eventual change in income and the
initial investment is called the multiplier
 In Keynesian economic theory, a factor that quantifies the
change in total income as compared to the injection of
capital deposits or investments which originally fueled the
growth. It is usually used as a measurement of the effects
of government spending on income

Remember :In the Keynesian model, government and

private investment spending are considered to be
autonomous while consumption is not because it is a
function of income. 12
4
The multiplier:an example
 Suppose a large corporation decides to build a
factory in Plumtree and spends 100 million. The
money will go to the workers, owners of construction
companies, material and equipment suppliers in the
construction industry. Thus the investment spending
of 100mn would raise the incomes of households in
the economy by a similar amount. But the process
does not stop there .The owners and workers of
firms above will not simply keep the 100mn in the
bank. They will spend most of it as determined by
the marginal propensity to consume (MPC)if the MPC
is 4/5 or 80 cents it means they will spend 80 cents
out of each dollar and they will save the rest. Total
spending in the economy will therefore increase by
$80mn.This 80mn is an addition to the demand for
goods and services in the economy in the same way
as the 100mn original investment. 12
5
The multiplier cont’d
 The households concerned will buy goods and
services to the value of 80mn.This raises the
incomes of the workers and owners of the shops
and other firms that sell the goods and services to
them. At this stage the total spending and income in
the economy has already increased by 180mn
( 100mn (original investment)+80mn (spent by
those who received the original 100mn).This is still
not the end of the story .The shopkeepers and
others who receive the 80mn will also spend 80% of
it (64mn) and keep the rest. 12
6
 And so the process continues. In each round
there is additional spending and income (one
person expenditure is another persons
income).Every additional dollar that is spent
lands in someone's pocket and part of that
dollar is spent again. The additional amounts
become progressively smaller but by the time
the process ends ,the total increase in income
will be much greater than the initial injection of
100mn in the form of investment spending by
the large corporation. This is caused by the
multiplier which is the ratio of the change in
total output/income induced by an autonomous
expenditure change (∆Y/∆I).In the simple
Keynesian model it is calculated as 1/MPS . We
shall deal with the three sector and open sector
multipliers later.[∆I can also be expressed as ∆A
12
7
The multiplier chain of spending and income
Multiplier (k) = 1 / (1 - MPC) = 1 / (1 - 0.8) = 1 / 0.2 =
5times
 Y= k. A =5*100 =500mn

Table 1:The multiplier chain of spending and income

Round number Additional spending Cumulative Total ($
and income in this
round
1 100 100
2 80 180
3 64 244
4 51.2 295.2
5 40.96 336.16
…. … …
… … … 12
8
The Multiplier
 As a result of the multiplier effect, small changes in
investment or government spending can create
much larger changes in total output. A positive
aspect of the multiplier effect is that
macroeconomic policy can effect substantial
improvements with relatively small amounts of
autonomous expenditures. A negative aspect is
that a small decline in business investment can
trigger a larger decline in business activity and,
thereby, create instability. 12
9
Exercise
You are given the following;
C = 400 + 0.75 Y
Ī = 400.
Calculate
1. Equilibrium level of income
2. Equilibrium level of national income If investment
increases from $400 b to $500b. Graphically
illustrate your answer.
3. The size of the multiplier
4. Show the multiplier chain of spending and
income using the increased exogenous investment
as additional spending in round 1.Do as many
rounds as you can.
13
0
 The Keynesian model :2 sector
 Generally, to find the total change in national
income we use the formula:
∆Y = 1 (∆ ɪ)
(1-c)
Where
c = Marginal propensity to consume
∆ ɪ/ (∆A) =initial change in investment spending
(1-c) = Marginal propensity to save.
1
The reciprocal of MPS is the
(1-c) is the multiplier (k) multiplier. Thus making k
the subject of the formulae
we have (∆Y/∆I =k

13
1
The Keynesian model cont’d

 In general the final level of national income is

calculated as follows:

 Yfinal = Yinitial + Δ Y

= 3200+ 400

= $3600 bn

13
2
Exercise
 Given that
 C=1000+0.75Y
 I=3000

Deduce
i. Equilibrium level of income
ii. The multiplier k
iii. If Investment changes to 4500 ,what is the
change in national income.
iv. What is the new level of equilbrium income.

13
3
National income in a closed
economy with government
 Assumptions
 The initial assumption is that the government

exists to expend on essential services.

 Taxes are assumed away (T =T0 ).

 Gvt expenditure is also taken to be

autonomous.In other words government
spending G is related to political objectives
rather than to the level of income.There is thus
no systematic relationship between G and Y.G is
independent of the level of income
(G =G0 ).
13
4
National income in a closed economy with
government
Aggregate spending thus becomes;
AE = C+I+G
Derivation of Equilibrium Algebraically becomes;
Recall at equilibrium : AE =Y
AE = C + ɪ +G and C=a +c Y

it means Y = a +cY + ɪ+G

Y –cY= a +ɪ+ G
Y (1-c) = a +ɪ+ G then divide both sides by (1-c)

Y=1 ( a +ɪ+ G )
1-c

(A )
Notice that the multiplier remains unchanged.
or Y =1 However G Aincreases
represents Autonomous
aggregateexpenditures
spending and13
raises the level of production and income 5
Introduction of Taxes in closed economy model

 We introduce taxes into the model and drop the

assumption that there is no tax. This is a more
realistic model because government spending
has to be financed .Government spending is
financed largely from taxes. It is therefore
important to understand tax and its implications
on the Keynesian model of income
determination. One injection (G) and one
withdrawal (T) are added to the economy.
13
6
TAXES (T)
 Government raises revenue through direct taxes
(taxes on income) and indirect taxes (taxes on
goods and services).Personal income tax and value
added tax are the two most important sources of
Government revenue in most economies.As
incomes increase people have to pay more tax.As
they spend more they pay more vat.It is safe to
assume that there is a direct link between taxes (T)
and income (Y).We assume that taxes are a certain
proportion (t) of income Y.
 Thus : T =t Y………………………………….(1)
 Where T is Total Tax
t is the tax rate /marginal propensity to tax.

13
7
TAXES (T)
 Taxes have the impact of reducing disposable
income (after tax income) ,that is, income
available for spending. We then distinguish
between Total income (Y) and disposable income
(Yd).Disposable income (Yd) is simply the income
that households have available after they have
paid taxes. Thus ;
 Yd = Y – T ………………(2)……..since T=t Y we can also write

Yd = Y – tY …......................... then collect like terms and we have

Yd = (1– t)Y ……………………(3)

Equation 3 states that Yd is equal to a fraction of (1-t) of total income .If t
=0.20 then (1-t)=0.80.So in this case disposable income would be 80
percent of total income.The 20% is paid to the government as taxes.
13
8
TAXES
 The introduction of taxes means that we also
have to modify the consumption function to
indicate that households cannot spend their
total income. They can only spend their
disposable (or after tax) income. We then
substitute total income Y in the consumption
function with disposable income Yd .Thus

 C = a + cYd Remember Yd = (1– t)Y


So C= a + c (1-t)Y

13
9
National income in 3sector model with tax
Aggregate spending thus becomes;
AE = C+I+G
Derivation of Equilibrium Algebraically becomes;
Recall at equilibrium : AE =Y
AE = C + ɪ +G and C=a +c Yd
and Yd = (1-t)Y

it means Y = a +c (1-t)Y + ɪ+G

Y –c (1-t)Y = a +ɪ+ G
Y (1-c (1-t) ) = a +ɪ+ G then divide both sides by (1-c (1-t )

Y=1 ( a +ɪ+ G )
1-c(1-t)

or Y =1 (A) A represents Autonomous expenditures

1-c (1-t)

14
0
The multiplier for closed economy with taxes
The multiplier (k) for a 3 sector model where there
is taxation will be;
k = 1
1-c (1-t)
 Tax is a leakage/withdrawal from the circular flow.

This means that a smaller proportion of any

addition to aggregate spending A will be passed on
in each round of the multiplier process. The
introduction of the proportional tax thus reduces
the size of the multiplier.
 Recall that for an economy without taxes the

multiplier is;
k = 1
 1-c or 1/MPS 14
1
 Numerical example
 To test that the introduction of a tax reduces
the multiplier consider the following;
 Suppose c=0.75 and t = 0.20 then

 Multiplier without taxes = 1/1-c

=1/1-0.75
4 times
1

Multiplier with taxes =
1  c (1  t )

1
Note that : When calculating the 1  0.75(1  0.20)
multiplier with taxes ,the calculation
in brackets (1-t) is done first .The =2.5 times
result is then multiplied by c, and
only then is the subsequent result
subtracted from 1 and inverted
(divided into 1). 14
2
 Thus the introduction of tax in the model :
 Leaves autonomous spending (A) unchanged. It

is still (a+ I+ G).

 Reduces the multiplier.
 Reduces the equilibrium level of national

income.
Exercise
 Given C= 10+3/5 Y I =30
 G = 20
 T=1/6 Y

Calculate
Equilibrium level of national income .
The multiplier.
14
3
 Tutorial question
Question One
Derive the equilibrium condition of a closed economy with no taxes
Suppose autonomous consumption is 100 million and MPC is
2/3.Government spending is 500million and investment spending
is 1500.
 Calculate Equilibrium level of national income
 The multiplier
 If Investment increases from 1500 to 2500 what is the resultant

change in national income.

Question two
Derive the equilibrium condition of a closed economy with taxes.
Using the same data as above, assume that government then
introduces a proportional tax at a rate of 25%.What is the new
equilibrium level of national income. Calculate the size of the
multiplier. If investment increases from 1500 to 2500 ,what is the
resultant change in national income. Comment on your
answer.Diagramatically illustrate your answer.
14
4
exercise
 C=100+0.8Yd
 I =100

 G = 400

 T= 0.3Y

i. What is meant by the Marginal propensity to consume and the

marginal propensity to save.
ii. What are the numerical values of these concepts for the economy
depicted above
iii. Determine the equilibrium level of national income .
iv. Suppose Investment changes from 100 to 200
v. What is the new equilibrium level o0f national income.
vi. Determine the size of the multiplier. Of what significance is the
multiplier to policy makers.
vii. Calculate the savings function of this economy.
viii. Making use of the consumption function above ,explain the
concept of autonomous consumption. How is it possible that
autonomous consumption can be positive.

14
5
Keynesians Model in the Open Economy
 An injection and a withdrawal are
introduced.
 The injection is exports (X)
 The withdrawal is imports (M)
 Exports and Imports are related to each other

in that they occur in international trade and

exports finance imports.
 It is assumed that both X and M are

autonomous.
 Therefore, AE for the open economy is;
 AE =C+I+G+(X-M)
 X-M is called Net Exports

14
6
 Exports do not affect the size of the
multiplier.Like any other injection they have
the impact of increasing aggregate
spending .However with imports the result is
different.When spending and income
increases in the domestic income ,this
automatically results in an increase in
imports.There is thus a positive relationship
between imports and income.Imports reduce
aggregate spending on domestically
produced goods because they leak income
out of the circular flow.

14
7
Imports
 Imports reduce aggregate spending ,and
therefore also total income Y,ceteris
paribus.If we assume that the level of imports
dependent on income.if income Y is the main
determinant of imports M,then the import
function resembles the consumption
function. Imports then have an autonomous
component (z) and an induced component
(mY),where m is the marginal propensity to
import. The import function can be written
as;

M  z  mY
14
8
The Keynesian model for open economy
 At equilibrium, AE=Y
Y = C+I+G+(X-M)
Y= a+ c(1-t)Y +I+G+(X-M) Since M =z+ mY

Y = a+ c(1-t)Y +I+G+X -(z+mY)

= a+ c(1-t)Y +I+G+X –z-mY collect terms and solve for Y
Y- c(1-t)Y +mY =a+I +G +X -z
Y= 1 (a + I +G+X –Z)
1-c (1-t) +m

Y= 1 (A) where A is Autonomous expenditures.

1-c (1-t) +m
Y = k.A
14
9
The multiplier for the open economy

 The multiplier (k) for the open economy is

smaller than that for the 2 sector model

because of imports and taxes.

Y= 1

1-c (1-t) +m

15
0
Factors affecting the size of the multiplier

 MPC-The higher the MPC ceteris paribus the higher

the multiplier.
 Degree of thrift in an economy-thrift refers to the
culture of saving. Saving is beneficial to individuals
but for the economy as a whole, a higher level of
saving reducing NY. The degree of thrift affects the
size of the multiplier(k) negatively, as the level of
thrift increases, the multiplier decreases.
 Degree of openness in an economy-from previous
page, it was observed that the open economy
multiplier is smaller than the closed economy
multiplier, which implies that the more open an
economy is, the lower level of K
15
1
 Practise Question
Assume that :
 c=0.88
 m =0.20
 t = 0.30
 Where c =Marginal propensity to consume
m = Marginal propensity to import
t = Marginal propensity to tax /the tax rate

Calculate the multiplier (k) for

i. 2 sector model
ii. The 3 sector model with government intervention
iii. The open economy

15
2
EXERCISE
Derive the equilibrium condition for the open economy where imports
are just induced by income.
Study the data below and attempt the questions that follow;
 C = 15000+0.80Yd

 I = 25600

 G=17800

 X=25000

 M =0.25Y

 T= 0.20Y

1. What type of an economy is represented by the data above.

2. Calculate the equilibrium level of national income.
3. Comment on the size of the multiplier for the economy given
above
Question two
Using the same data above assume that there were autonomous
imports (z) valued at 35000.The import function becomes
M =35000+0.20Y.Calculate q1-3.

15
3
Tutorial
Planned investment (I) I=200
Government purchases (G) G=640
Exports (X) X=175
Imports as a function of national M=0.45Y
income (Y)
Savings Function (S) S=-150 +0.25Y

1. Deduce the allocative mechanism of the above economy.

2. Calculate the consumption function.
3. The closed economy equilibrium level of national income
4. The open economy equilibrium level of national income
5. The closed economy multiplier
Question two
Using the same data above calculate the open economy equilibrium
level of national if the government of this economy introduces
taxes given by the function T=0.35Y .

15
4
NATIONAL INCOME
DETERMINATION

THE GAPS
The AD/AS MODEL
THE AD/AS MODEL
The AD-AS Model addresses two deficiencies
of the AE Model:

 No explicit modeling of aggregate supply.

 Fixed price level

THE AD/AS MODEL
 The AD-AS model consists of three curves:

 The aggregate demand curve, AD.

 The short-run aggregate supply curve, SAS.

 The long-run aggregate supply curve, LAS.

THE AD/AS MODEL
 The AD-AS model is fundamentally different
from the microeconomic supply/demand
model.
'Aggregate Demand' The total amount of goods
and services demanded in the economy at a
given overall price level and in a given time
period. It is represented by the aggregate-
demand curve, which describes the relationship
between price levels and the quantity of output
that firms are willing to provide.
THE AD/AS MODEL
 The aggregate demand (AD) curve shows ;
 combinations of price levels and real income

where the goods market is in equilibrium.

 The AD curve is an equilibrium curve.
 The AD curve can be derived from the AE

model:
Deriving the Aggregate Demand Curve
Aggregate
expenditure
AE=Y

AE1(P1<P0)
B
AEo (Po)

Real income
Y0 Y1
DERIVING THE AGGREGATE
DEMAND
Price Level

P0 A

B
P1

Aggregate
Demand

Y0 Y1 Real Output
The Slope of the AD Curve
 The AD is a downward sloping curve.
 Aggregate demand is composed of the sum
 of aggregate expenditures:
 Expenditures = C + I + G + (X - M)
The Slope of the AD Curve
The slope of the AD curve is determined by
 the wealth effect,
 the interest rate effect,
 the international effect, and
 the multiplier effect.
The wealth effect
Wealth effect – a fall in the price level will
 make the holders of money and other
financial assets richer, so they buy more goods
and services.
 The Interest Rate Effect
 Interest rate effect – a lower price level
raises real money balances, lowers the interest rate,
and increases investment spending.
 The interest rate effect works as follows:

a decrease in the price level

increase of real cash

banks have more money to lend

interest rates fall

 The International Effect
 International effect – as the Zimbabwean price level
falls (assuming exchange rates do not change), net
exports will rise.
 Exports rise
 Imports fall

The international effect works as follows:

a decrease in the price level
the fall in price of our goods relative to foreign
goods
our goods become more competitive
internationally
exports rise and imports fall
The multiplier effect
 Initial changes in expenditures set in motion a process
in the economy that amplifies the initial effects.
 Multiplier effect – the amplification of initial
changes in expenditures.
The multiplier effect works as follows:
an increase in the price level
 exports fall and imports rise
 Canadian firms lose sales and cut output
 our incomes fall
 households buy less
 firms cut back again and so on.
 Shifts in the AD Curve
Except for a change in the price level,
 anything that changes aggregate
 expenditures shifts the AD curve.

The main shift factors are:

 Foreign income.
 Exchange rate fluctuations.
 Expectations about future output or prices.
 The distribution of income.
 Monetary and fiscal policies
Foreign Income
 When our trading partners go into a
recession, the demand for Zimbabwean
goods(exports) will fall.
 The ZIM AD curve shifts to the left.
Exchange Rates
 When a country’s currency loses value
relative to other currencies:
 Export goods produced in that country become

less expensive.
 Imports into that country become more

expensive.
 The AD curve will shift to the right.
 Exchange rates

 When a country’s currency gains value, the

AD curve shifts to the left.

 Foreign demand for its goods decreases.

 Its demand for foreign goods increases.

Expectations
 If businesses expect demand to be high in
the future, they will want to increase their
capacity to produce, so the demand for
investment will increase.
 For consumer, expectations of a strong

economy or higher incomes or prices in the

future will cause consumption to increase.
 In both cases, the AD curve will shift to the

right.
Distribution of income
 Wage earners tend to spend a greater
percentage of their income than earners of
profit income, who tend to be wealthy.
 It is likely that AD will shift to the right if the

distribution of income moves from earners of

profit to wage earners.
Monetary and fiscal policy
Macro policy is the deliberate shifting of the
 AD curve to influence the level of income in
the economy.
 Expansionary macro policy shifts the curve to
the right.
Contractionary macro policy shifts it to the left
Fiscal policy
 If the federal government spends lots of
money, AD shifts to the right.
 If it raises taxes, household incomes will fall,

they will spend less, and AD shifts to the left.

Monetary Policy
When the Central Bank expands the
money supply, it lowers interest rates.
AD will shift to the right and vice versa.
Short-Run Aggregate Supply Curve

The short-run aggregate supply (SAS)

curve specifies how a shift in the aggregate

demand curve affects the price level and real

output in the short run, other things constant.

Short-Run Aggregate Supply Curve
 The Short-run aggregate supply (SAS)

curve shows how firms adjust the quantity of

real output they will supply when the price

level changes, holding all input prices fixed.

Short-Run Aggregate Supply Curve

Price
level

SAS

Real output
Slope of the SAS Curve

 The SAS curve is upward-sloping.

 The SAS curve reflects the fact that firms

adjust both price and quantity in response to

changes in aggregate demand.

Slope of the SAS Curve
 Price adjustments may happen quickly or
slowly.
 High menu costs – the costs associated with

changing prices – can result in reluctance to change prices.

a menu cost is the cost to a firm resulting from changing its prices. The
name stems from the cost of restaurants literally printing new menus,
but economists use it to refer to the costs of changing nominal prices in
general. In this broader definition, menu costs might include updating
computer systems, re-tagging items, and hiring consultants to develop
new pricing strategies as well as the literal costs of printing menus. More
generally, the menu cost can be thought of as resulting from costs of
information, decision and implementation resulting in
bounded rationality. Because of this expense, firms sometimes do not
always change their prices with every change in supply and demand,
leading to nominal rigidity (also known as sticky prices).
Shifts in the SAS Curve
The SAS curve shifts when a shift factor
changes – ceteris paribus:
 Changes in costs of production.
 Changes in expectations of inflation.
 Productivity.
 Excise and sales taxes.
 Import price
Shifts in the SAS
 Costs of production include wage rates,
interest rates, energy prices, and prices of
other factors of production.
 SAS will shift in response to the change in

productivity, as well as change in costs of

production.
 Shifts in the SAS
 When input prices are raised, the curve shifts
up.
 When input prices are lowered, the curve

shifts down.
 An increase in productivity reduces the cost

of production and shifts the SAS curve down.

 A decrease in productivity shifts the curve up.
Shifts in the SAS Curve
Price
level SAS1
Input prices
increase

SAS0

Real output
Long Run Aggregate Supply Curve

The long-run supply curve shows the

amount of goods and services an economy

can produce when both labor and capital

are fully employed.

Long-Run Aggregate Supply Curve
The LAS is vertical.
 At potential output, a rise in the price level

means that all prices, including input prices

rise.
 Available resources do not rise, thus, neither

does the potential output.

 Long-Run Aggregate Supply Curve
Price
Level Long Run aggregate
supply (LAS)

Real output
Potential Output and the LAS Curve

 The position of the long-run aggregate

supply curve is determined by potential

output.

 Potential output – the amount of goods and

services an economy can produce when both

labor and capital are fully employed.

Shifts in the LAS Curve

The LAS curve will shift whenever there are

changes in:

 Capital

 Available resources

 Growth-compatible institutions Technology

Entrepreneurship.
Equilibrium in the Aggregate
Economy

Changes in the AD, SAS, and LAS curves affect

short-run and long-run equilibrium.

 Short-Run Equilibrium
 Short-run equilibrium is where the SAS and

AD curves intersect.

 Increases in aggregate demand lead to

higher real output and a higher price level.

 An upward shift in the SAS curve leads to

lower real output and a higher price level

 Short run Equilibrium:Shift in
agrregate demand
Price
Level

SAS
F
P1
E
P0

AD1

AD0

Y0 Y1 Real output
Short Run Equilibrium:Shifts in aggregate
Supply

SAS 1
Price
level SAS0

G
P1
E
P0

AD

Y1 Y0 Real output
Long-Run Equilibrium

 Long-run equilibrium is where the AD and

long-run aggregate supply curves intersect.

 In the long run, output is fixed and the price

level is variable.

 SAS will adjust to meet AD at LAS in the long

run.
Long-Run Equilibrium
 Aggregate demand determines the price

level.

 Increases in aggregate demand lead to

higher prices.
 Long Run Equilibrium:Shift in Aggregate Demand

 P0
Price
Level

P1 H

P0 E

AD1

AD0

Real output
Integrating the Short-Run and Long-Run
Frameworks

 The economy is in both short-run and long

run equilibrium when all three curves
intersect in the same location.
 The ideal situation is for aggregate demand

to grow at the same rate as aggregate supply

and potential output
Long Run Equilbrium
FULL EMPLOYMENT
 Full employment refers to an economic
situation in which all the available resources
are fully utilised, that is , there are no
resources which are wasted or which are lying
idle in the economy.
Situation where the economy is operating at
an output level considered to be at full
capacity. i.e. it is not possible to increase real
output because all resources are full utilized.
A nation experiencing full
Longemployment
run macroeconomic
equilibrium requires that the
real GDP be equal to potential
GDP and corresponds to a
situation of full employment.
That is, long run
macroeconomic equilibrium
entails the economy being on
its vertical long run supply
curve. This contrasts with the
short run equilibrium situation
in which real GDP may be less
than or greater than or equal
to potential GDP.This economy
is experiencing equilibrium
level of output. They are
achieving full employment and
price stability. At full
employment both the short
run equilibrium and long run
equilibrium at a real GDP is
equal to potential GDP
THE GAPS
 When an economy is operating below
capacity or beyond the full employment level
two types of gaps occur, that is;
 Deflationary gap
 Inflationary gap

 The above gaps can be depicted using the

AD/AS model as well as the aggregate
expenditure model.
DEFLATIONERY GAP
 This gap is caused by insufficient aggregate demand
in the economy which causes the equilibrium level of
national income to occur at a level which is below the
full employment level of national income Ye <Yfe.
 This is the difference between the full employment
level of output and actual output. For example, in a
recession, the deflationary gap may be quite
substantial, indicative of the high rates of
unemployment and underused resources.
 Deflationary gap is the amount by which aggregate
demand falls short of aggregate supply at the level of
full employment.AD <AS
 If the economy remains at this level for a long time,
there would be an excess supply of factors of
production (i.e., unemployment
deflationary /recessionary gap
Price The economy is experiencing a
Level demand deficient recession
shown by the difference
LRAS
between Y1 and YFe .There will
also be price level instability in
SRAS the form of deflation as
Pe average prices will fall from Pe
to P1. Thus a deflationary gap
P1 occurs where
AD < AS .

ADO
AD1

YFe Real
Y1
GDP
Deflationary
gap
Deflationary gap using aggregate
expenditure
Equilibrium level
of national
income
(Ye) is
150bn ,however
Full employment
of national
income (Yfe) is
250bn.The
difference/gap
between Yfe and
Ye is called the
inflationary
gap.AE is way
below production
in the economy.
Eliminating the deflationery gap
 This gap is eliminated by implementing policies
that are meant to boost production such as
increasing government spending and reducing
taxes (expansionary fiscal policy). When this is
done the AD curve will shift parallel to itself from
AD1 to AD0 which coincides with the full
employment level of output.
INFLATIONARY GAP CONT’D
 The inflationary gap occurs if full employment
national income exists below the equilibrium
level. Inflationary gap . Yf < Ye.
 The economy will be operating at a level
above the full employment level output. Due
the limitation of the economy to fulfill this
increased demand the average price level in
the economy increases resulting in inflation.
 It is caused by excess aggregate demand in

the economy.AD >AS

 When an economy is operating
beyond full employment the AD

Inflationary Gap curve

Shifts outwards from AD1 to AD2
.This causes a relatively small
increase in the level of output
and unemployment in the
economy from Yf to Y1 but a
relatively large increase in the
price level because resources are
now scarce. There tends to be
high demand pull inflation due to
limited supply. A high inflation
rate erodes peoples incomes and
reduces standards of living
overtime. Since wages are not
rising ,but prices are rising
Households will become poor in
real terms. For this reason the gvt
may find it desirable to reduce
the level of AD in the economy.
They will then use contractionery
fiscal policy.
Inflationary gap using aggregate expenditure

Equilibrium
level of national
income
Is (Ye) is
200bn ,however
Full
employment of
national income
(Yfe) is
100bn.The
difference/gap
is called
inflationary
gap. Aggregate
spending is far
above real GDP.
ELIMINATING INFLATIONARY GAP
 This gap is eliminated by using
contractionary fiscal policy. This is reducing
government spending and increasing taxation
in the economy. This leads to a downward
parallel shift of aggregate demand from AD2
to AD1 which coincides with the full
employment level of output.
The economy beyond Potential
 When the economy operates below
potential,firms can hire additional factors of
production without increasing costs.
 Once the economy reaches its potential,

firms compete for inputs and costs rise

causing inflationary pressures.
 The economy will slow down by itself or the

government will introduce policies to reduce

output and eliminate the inflationary gap.
THREE POLICY RANGES
 There is now consensus among economists
that short-run aggregate supply curve has
segments or ranges
 An economy has three policy ranges where

the effect of an expansion of AD on the price

level will be different:
 The Keynesian range (Horizontal range)
 The intermediate range. (Upward sloping

Range).
 The Classical range (Vertical Range)
THREE POLICY RANGES

Or Classical range

Keynesian or

Price level Price level very

Price level partially flexible
fixed fixed
KEYNISIAN RANGE
 The Keynesian range – when the economy
is far from potential income, and there is little
fear that an increase in aggregate demand
will cause the SAS curve to shift up and
cause inflationary pressure.
 The SAS is horizontal in this range, because

all firms are quantity adjusters and will not

increase prices.
KEYNISIAN RANGE
 In the Keynesian range an increase in
aggregate demand will increase income and
have no effect on the price level.
 The price/output path of the economy is

horizontal so that prices are fixed.

 The Keynesian range corresponds to the

recessionary gap and it is because of this

that Keynesian economics is sometimes
called depression or recession economics.
THREE POLICY RANGES
 This implies that during this horizontal
(Keynesian ) range of output , the economy
can expand its production without facing
much rise in unit cost of production. This is
in fact the stage when the economy is in the
grip of severe recession or depression with a
lot of idle capacity in the form of unemployed
labor, unutilized machinery and other capital
equipment.
KEYNISIAN RANGE
 These idle or unused resources can be put to
use without causing any rise in unit cost of
production and therefore without any upward
pressure on the price level. The unemployed
labor would be willing to work at the current
wage rate (that is, without any need for
offering higher wage rate to them). Since
other resources are lying unused, no
shortages or bottlenecks will be experienced
causing higher cost per unit or rise in the
price level, if aggregate output is expanded in
this range.
THE INTERMEDIATE RANGE
 The intermediate range – when the
economy is between the two ranges (between
Keynesian and classical), both the price level
and real output will rise.
 The ratio between the two increases is

determined by how close the economy is to

its potential income.
 In the intermediate range, the price/output

path of the economy is upward sloping.

 The economy is usually in this range.
THE INTERMEDIATE RANGE
 the output levels increase causing rise in
price level, that is, aggregate supply curve
slopes upward in this range. There are more
than one reasons for this upward-sloping
range of AS curve. First, the national economy
consists of several industries and resource
markets and full-employment is not attained
simultaneously in all industries and in respect
of all types of workers.
THE INTERMEDIATE RANGE
 For example, as the national production expands in
this range some indus­tries, say electronics and
computer hardware may experience shortage of
skilled engineers engaged in these industries,
while some industries such as textile industries
may be still facing quite large unemployment.
 Due to the shortage of engineers for some crucial
industries, bottlenecks in produc­tion may arise
which push up the cost in these industries while
the economy as a whole is still operating below
full-employment level. Secondly, in order to
overcome shortage of skilled workers such as
engineers, as mentioned above, less efficient or
less skillful workers may be employed resulting in
rise in unit cost of production.
THE INTERMEDIATE RANGE
 Similarly, even before fall employment of resources, is reached
in the economy as a whole, some industries may experience
shortage of raw materials due to expansion of production in
them encounters rising unit costs of production.

 Further, the older and less efficient machines may be used by

some firms and industries when they reach close to capacity
production. But most important factor responsible for rising
cost is the diminishing marginal products of factors such as
labor as more of them are employed in expanding production.
Even with constant wages, diminishing marginal productivity of
labor implies rise in unit cost of produc­tion and hence rise in
price level.

 For all these reasons, unit cost of production increases even

before full-employment output is reached and product prices
must rise as aggregate output is expanded in response to the
increase in aggregate demand if firms have to recover the rising
costs.
CLASSICAL RANGE

 The Classical range –the economy is above

the level of potential output so that any
increase in aggregate demand will increase
factor prices.
 The SAS curve is pushed up by the full

amount of the aggregate demand increase

CLASSICAL RANGE
 In the Classical range, an increase in
aggregate demand will push up the price
level and not affect real output.
 The price/output path is vertical so that

prices are flexible.

 The Classical range corresponds to the

inflationary gap.
CLASSICAL RANGE
 Aggregate supply curve in this range is highly
steep or vertical straight line or near the full-
employment level of output. The highly steep
aggregate supply curve implies that any
further rise in the price level will fail to cause
much increase in aggregate output because
the economy is already using its available
resources fully and operating at or near its
potential output.
INTERNATIONAL TRADE AND
BALANCE OF PAYMENTS
FREE TRADE & BOPs
 INTERNATIONAL TRADE
◦ This refers to a situation in which countries trade
with each other
◦ It is conducted by open economies who export and
import goods with each other.
◦ Countries which engage in international trade are
called close economies and are said to be existing
in autarky.
Political Factors that determine trade:
 Political systems e.g communism vs

capitalism
 Trade blocks formed by politicians e.g

SADC;ASEAN,ECOWAS
 Degree of political freedoms
 Agreements with other countries.
 Wars
 Trade missions including embassies
Other reasons for International trade
 Differences in resource endowments
Different countries have different natural resources e.g. Saudi
Arabia,Iraq,Kuwait,Nigeria,Angola,Venezuela have oil.
 Differences in climate

Botswana has conducive climate for cattle ranching whilst

Canada has a conducive climate to produce cereals
 Differences in Technology

Countries such as Japan ,Korea,UK and USA are well advanced in

terms of technology.
 Differences in culture and experiences

Some cultures are rich ,exotic and interesting e.g. Some

Europeans will go to India to experience Indian culture on the
River Ganges.
Tourists from developed countries also visit many African
countries to experience the diverse African Culture
Some people will go to France ,Paris known for its wines and
romantic atmosphere sob as to experience love etc
Other Factors: Economic Factors
There are 2 main schools of thought which
seek to explain the flow of trade btw
countries.
 The absolute advantage theory
 Pure absolute advantage theory
The absolute advantage theory
 propounded by Sir Adam Smith.

 It refers to a situation in which a country or

an economy is able to produce more of a

particular commodity or commodities than

another using the same quantity of resources.

The absolute advantage theory
 There are 2 forms of absolute advantage (AA)
namely:
(i)Pure absolute advantage: This is a situation in
which a given economy is able to produce more
of say 2 commodities than another country
using the same quantity of resources.
(ii) Reverse absolute advantage (RAA): This is a
situation In which one economy has an AA in
the production of commodity A whilst another
economy has AA in the production of
commodity B. See table overleaf
Reverse absolute advantage (RAA):
Wheat (tonnes) Cloth (Yards)
Zimbabwe 10 6
Lesotho 5 10
 Zim. has an AA in the production of wheat
whilst Lesotho has an AA in the production of
cloth.
 As a result of RAA, the 2 countries can gain

from specialisation, i.e., Zim. Will specialise in

the production of wheat whilst Lesotho will
specialise in the production of cloth and the
gains will be realised from trade as shown
overleaf.
Reverse absolute advantage (RAA):
Wheat (tonnes) Cloth (Yards)
Zimbabwe +10 -6
Lesotho -5 +10
Gains from +5 +4
specialisation

 From the above table , it can be realised that the

transfer of one unit of resources in Zim. from
cloth production to wheat production leads to
an increase in wheat production by 5 tonnes.
 Similarly for Lesotho, a transfer of one unit of
resources from wheat production to cloth
production leads to an increase in cloth
production by 4 yards.
Reverse absolute advantage (RAA):

 Thus, the 2 countries will engage in

international trade so that each of them is

able to acquire the commodity it is not

producing.
Pure/Total Absolute Advantage
:
Wheat (tonnes) Cloth (Yards)
Zimbabwe 100 60
Swaziland 5 10

 From the above table, Zim. has an AA in the

production of both wheat and cloth.
 It can be seen that one unit of resources in

Zim. produces more wheat than in Swaziland.

 From AA perspective, it is therefore concluded

that they are no gains from specialisation and

international trade.
Pure/Total Absolute Advantage
 Nevertheless, this kind of reasoning is faulty
or weak because it is based on output instead
of comparing resource costs, i.e., opportunity
costs.
 This led to the development in the 19th century

of the comparative advantage theory which

instead of generalising from outputs of
commodities uses the opportunity cost
approach
The Comparative Advantage theory
 This approach was developed by David Ricardo, a
British Economist. He propounded that a country
will specialise in the production of a good where it
has a lower opportunity cost as compared to
another country.
Example:
Wheat (tonnes) Cotton
Zimbabwe 10 4
Botswana 9 2

 The table above shows output produced by the

different countries. To deduce specialisation
opportunity cost ratios are calculated.
 Table of opportunity cost ratios is overleaf
The Comparative Advantage theory
Table of opportunity ratios:
Wheat (tonnes) Cotton

Zimbabwe 4/10= 0.4 10/4=2.5

Botswana 2/9=0.22 9/2=4.5

 To compute the opp. cost ratio say for wheat

production in Zimbabwe a question is asked, what is
the opportunity cost of foregoing cotton production
in favour of wheat production?
 If Zim. concentrates on wheat production, for the 10

that it gains from wheat it foregoes 4 of cotton.

 This implies that wheat production in Zim has the

following opp. cost implications:

10 wheat/10 = 4 cotton/10
Therefore, 1 wheat = 40% of cotton.
Other Economic Factors
 Similarly for Botswana, I unit of wheat = 22.2%
of cotton. The same reasoning can be applied
in the context of cloth production.
 This implies that I unit of cotton = 2.5 of

wheat (Zim) while I unit of cotton = 4.5 of

wheat (Botsw).
 Therefore, Zim. Specialises in cotton
production because it has lower opp. cost ratio
of 2.5 compared to 4.5 and Botswana
specialises in wheat production because it has
a lower opp. cost ratio of 22.2% compared to
that of Zim. which is 40% for the same
commodity.
 Classwork Exercise-Con: 15 mins
1. Study the following table and answer the
questions which follow:
Wheat (tonnes) Cloth (Yards)

Zimbabwe 200 120

Swaziland 10 20

(i)State which country has an absolute advantage

in the production of both wheat and cloth. [1
mark]
(ii)Deduce the opportunity cost ratios and explain
how Zimbabwe and Swaziland will specialise.
[12 marks]
2. State and explain any two political factors which
affect trade . [2marks]
Classwork Exercise: Answer
Wheat (tonnes) Cloth (Yards)

Zimbabwe 120/200 = 0.6 200/120 =1.67

Swaziland 20/10 = 2 10/20 =0.5

Classwork Exercise: Answer
 From the above assumptions, it can be
recognised that even though Zim. has an AA
in the production of both wheat and cloth, it
has a comparative advantage in wheat
production since it has a lower opp. cost ratio
of 0.6 compared to 2 of Swaziland.
 Similarly, Swaziland has a comparative
advantage in cloth production since it has a
lower opp. cost ratio of 0.5 compared to that
of Zim. of 1.67.
 Hence, Zim. specialises in the production of

wheat and Swazi in the production of cloth.

 Tutorial
Country Wheat (tonnes) Fish (tonnes)
South Africa 1 4

Zimbabwe 0.5 3

Study the data above and attempt the following questions.

i. According to sir Adam Smith which economy has pure absolute
advantage?
ii. Use the intuitive approach to deduce changes in global output and
derive a conclusion on whether according to Sir Adam specialization is
beneficial
iii. Use the Ricardian approach to deduce the mutually beneficial trading
ratio and explain the gains from specialization that will be enjoyed by
Malaysia and Malawi?
 Limitations of the Absolute
Advantage Theory
 It looks at the absolute values of commodities
and ignores the concept of opp. cost.

N.B: All the other limitations of this theory are the same as that of
comparative advantage theory
Limitations of Comparative Advantage Theory:
 The theory is very naïve. It is very simple and it
assumes 2 economies and 2 products which is a very
unrealistic assumption because in real life a single
economy can produce hundreds and even thousands
of commodities. In that case the theory breaks down.
 The quality of the goods is not taken into account.
The theory assumes homogeneity in commodities
produced which may not be necessarily the case, e.g,
Zim. Marange diamonds are different from Botswana
diamonds.
 Free trade is assumed which is usually distorted by
trade restrictions such as tariffs and existence of
economic blocks.
 Transport costs are assumed to be zero in the models.
 The advantages of these theories may be

cancelled out by extra costs like

commissions, customs duties, agents fees

and various other selling costs which are

associated with the movement of goods in

the international market.

 Tutorial
Country Wheat (tonnes) (Fish in tonnes)
Malawi 0.5 2
Malaysia 0.25 1.5
Study the data above and attempt the following questions.
i. According to sir Adam Smith which economy has pure absolute
advantage?
ii. Use the intuitive approach to deduce changes in global output and
derive a conclusion on whether according to Sir Adam specialization
is beneficial
iii. Use the Ricardian approach to deduce the mutually beneficial trading
ratio and explain the gains from specialization that will be enjoyed by
Malaysia and Malawi?
FREE TRADE
 This refers to the flow of international trade in
the absence of any gvt interference.
 If some industries are protected by their gvts in

their engagement with their competitors, this is

called protectionism.
 Free trade is ideal state which doesn’t exist in

the real world because they are degrees of

protection in all economies on earth.
 Nevertheless, countries located to each other

geographically usually form trade within which

they endeavour to have as much of trade as
possible, e.g European Union.
 Arguments For Free trade
Also known as arguments against protectionism.
 The technology transfer argument: If there is free

trade between countries, it is generally easy for

technology to be transferred from countries
which have an abundances of human capital as
well as physical capital, e.g., it is easy to transfer
technology from MEDC’s to LEDC’s.
 Optimisation of output: If there is free trade, it is

generally easy for factors of production to move

across international boundaries and thus augurs
well for the optimisation of world output.
 Free trade facilitates specialisation, which leads to

efficiency, creativity and innovation.

Argument For Free Trade Cont’d
 Free trade facilitates factor mobility and thus
factor price equalisation.
 Free trade eliminates the deadweight loss( i.e.,

the loss in consumer and producer welfare

due to inefficiency of gvt protected industries,
infant industries and monopolies).
Competition forces inefficient countries to
look for least cost techniques of production.
 Free trade increases consumption possibilities

since no country produces everything that the

citizens need.
Argument against Free Trade
 Also known as argument for protectionism
 The infant industry argument: Even though free
trade is desired, it may expose local infant
industries to the harmful effects of international
trade. Competition in world markets ay
sometimes be intense and cut-throat.
 Strategic industries argument: There are some
sectors of the economy which the gvt cannot
open to free trade for strategic reasons e.g.,
electricity generation in Zim.
 The unimpeded flow of commerce may result in
forex rate fluctuation which ay lead to BOP
deficits. This was the case with SE Asian ‘tigers’
in the late 1990s ,e.g,. HongKong, Japan
Arguments Against Free Trade
 Fiscal revenue argument: Import duty and
other taxes charged at the boarders(or ports
of entry) by the gvt are a source of revenue
for the gvt which can be used to stimulate
economic activity.
 Anti-dumping argument: Some firms from

MEDCs are known for the tendency to sell

out-dated products in LEDCs/developing
countries. This is call international
commodity dumping. It crushes local
industries which produce import substitutes,
creates unemployment and leads to a
reduction in societal welfare.
Types of Protection
 There are 2 types namely:
 (i) tariff barriers
 (ii) non-tariff barriers

Tariffs
 These are taxes that are placed on imported

goods and services.

 The aims of introducing tariff are as follows:

-To reduce consumption of imported goods

and services
-To increase the consumption of imported
substitutes which are produced locally.
Types Of Protection
Tariffs cont’d
 -To raise revenue for the gvt. The gvt usually

taxes the following type of goods:

(a) Goods which are not essential for human
survival
(b) Goods which are import demand
elastic(luxuries).
 The problem with tariffs is that they may lead

to retaliation from trade partners, i.e., tariff

wars.
 They can be quantity based.
Types of Protection
Non-Tariff barriers
 Quotas: These are volumes restriction of

imports. Specific limits are placed on the

quantity of a particular pdct that can be
imported. Quotas may lead to shortages and
trading partners may retaliate.
 Subsidies: A country’s export basket can

become competitive in foreign markets if the

gvt subsidies export-oriented industries.
Subsidies reduces production costs and
hence make domestically produced good
cheaper in world markets.
Types of Protection
Non-Tariff barriers cont’d
Embargoes: This is a complete barn of specifies
commodities because of their harmful effects on
domestic consumers, e.g., drugs, certain types
of books, certain types of foods.
Voluntary Export Restrictions: Sometimes two
economies can reach a bi-lateral agreement to
restrict amount of a certain commodity/ies
which either of the countries or both are
exporting to each other.
 Types of Protection
Non-Tariff barriers cont’d
Exchange Rate Controls: A country can manipulate
its own currency to make exports cheaper and
imports expensive. Such a policy is called
devaluation. This is a process by which the gvt
reduces the value of its own currency vs. the value
of the other currencies.
Export Taxes: In some countries such as the UK, the
gvt imposes a tax on exports of goods whose
demand is high locally. This is meant to reduce
imports ,e.g. pharmaceutical products.
 BALANCE OF PAYMENTS(BOPs)
 This refers to record of a country’s transaction with its
trading partners within a given period of time usually a
yr.
 It is also called a record of country’s external
transactions.
 In the BOPs account, external transactions are
systematically recorded using the accounting principle
of double entry.
 The Balance of Payments (BoP) records all transactions
that cross a country’s borders. The simplest way to
think about it is as a record of all payments going out to
foreigners (with the reasons for those payments), and all
payments coming into the country from foreigners (with
the reasons for those payments). We give the payments
coming in a plus sign / CR, and the payments going out
a minus sign/DR.
BOPs
 The BOPs has 2 major and 2 minor
components namely:
 (a) the current account (major)

 (b) the capital account (major)

 (c)the balancing item(minor)

 (d) the official financing account(minor)

The Current Account
 The current account on the balance of payments
measures the inflow and outflow of goods, services
and investment incomes.
The main components of the current account are:
i. Trade in goods (visible balance/Balance of trade)
ii. Trade in services (invisible balance) e.g. insurance
and services
iii. Investment incomes e.g. dividends, interest and
migrants remittances from abroad
iv. Net transfers – e.g. International aid

A deficit on the current account means that the value

of imports is greater than the value of exports. A
surplus on the current account means that the value
of imports is less than the value of exports.
The current Account
 (i) The visible balance(Balance of Trade/BOT)
-It is computed as follows: BOT= Visible Exports
or merchandise Exports less Visible/merchandise
Imports
 (ii) The Invisible Balance(I.B)

-It is computed as follows: Invisible Exports less

Invisible Imports.
-Invisibles includes such items as services, i.e
tourism, banking, insurance, brokerage, transport,
military.
Invisible exports and imports are also called
service exports/imports
BOPs
-(iii) Net Unilateral Transfer: these are transfers
associated with the gvt multi-lateral financial
institutions as well as donor agencies, e.g, IMF,
World Bank. They are called unilateral transfers
because they are international transfers of
liquidity or forex , not associated with any
commercial activities. Also called current
transfers. A transfer is a payment that is not
made in exchange for anything. Basically, a gift.
You’re not getting a good or service for it.
-(iv) Net investment Income: This includes
investment income such as interest, dividends
and rents earned from other countries. It is net
investment income because foreign residents
have invested in Zim, and the outflow of
investment income due to foreign residence has
to be subtracted from investment income
earned by domestic residents from their
investment in other countries.
Therefore, current account balance = BOT + I.B
+ NUT + NII.
The Capital Account

Consists of 2 main balances namely:

(i) The balance associated with long-term
capital flows.
(ii) The balance associated with short-term
capital flows.
-The capital account is defined as a record of
external assets and liabilities.
-It records investment and other financial flows.
BOPs
 It involves the movement of capital (money)
rather than goods and services, i.e., it is
concerned with international loans and
investments.
 It includes such item as:

(a) Zim. investment in other countries.

(b) Investment of other countries in Zim.
(c) Borrowing and lending to/from other
countries by Zimbabwean fin. Institutions.
(d) Gvt loans from/ to other countries.
BOPs
(c) The Balancing Item (Bi): This is an item for
statistical discrepancies, which are made in the
compilation of BOPs statistics.
(d) Official Financing Account: This balance is
equal in magnitude, but opposite in sign to the
CAB + KAB + Bi , so that the BOPs Account’s
balance at zero.
Balance Of Payments (BOPs) Template
Current Account
1. Visible Exports xxx
2. Visible Imports (xxx)
3. BOT xxx
4. Invisible Exports xxx
5. Invisible Imports (xxx)
6. I.B xxx
7. NUT xxx
8. NII xxx
9. Current Account Balance xxx
Capital Account
10. Long-term Capital Inflows xxx
11.Long-term Capital Outflows (xxx) xxx
Official Financing Balance ad Changes in
Reserves
 The official financing bal. as noted above , is
opposite in sign to the combined CAB + KAB
+ Bi which shows the state of the BOPs, i.e.,
whether they are in surplus or in deficits.
 If the figure which results is positive, this

implies a BOPs surplus which leads to an

increase in forex reserves. A positive BOPs
situations is associated with a negative
official financing bal.
Official Financing Balance ad Changes in
Reserves
 Therefore, if the official bal. is negative, this
means that forex reserves are increasing by
the modulus of the official financing bal.
 If the official financing bal. is positive, this

represents a drawing down of forex reserves

since a positive official financing bal.
coincides with a negative BOP.
 Class Exercise
 You are given the following BOPs statistics for Yog
Republic:
Transactions Billions
(US Dollars)
Balance of Trade 300
Invisible Balance (250)
Net Unilateral transfer 80
Net Factor Income (15)
Balancing Item 15
World Bank Loan to Yog Republic 300
Contributions of Yog Republic to Ex-im Bank
100
Calculate:
(i) The balance on Current Account [6 marks]
(ii) The BOPs position [6 marks]
(iii) Comment on changes in reserves [3
marks]
Answer for (i) and (ii)
Current Account
Balance of trade 300
Invisibles Balance (250)
Net unilateral Transfers 80
Net Factor Income (15)
Current Account Balance 115
Capital Account
World Bank Loan to Yog Republic 300
Contributions of Yog Republic to Ex-im (100) 200
Bank
Balancing item 15
BOPs position (Surplus) 330
Balance for Official Financing (330)
BOPs 0
(iii) The official financing bal. as noted from
previous page , is opposite in sign to the
combined CAB + KAB + Bi = -USD330 billion.
This implies a BOPs surplus of USD330 billion
which leads to an increase in forex reserves.
Generally, a positive BOPs situations is
associated with a negative official financing bal.
Practise
 Study the following table and answer the
questions that follow and compile the BOP
account.
Exports 65000
Interest,profit and dividends 1080
Services (net) 2400
Imports 63200

Current Transfers -1810

Increase in external assets 30830
(Net)
Balancing item 1710
Increase in external liabilities 28570
(Net)
Tutorial
Calculate:The Balance of trade;The balance on
current account;The balance of official
financing.What will be the change in reserves.
Visible Exports 800
Net Private investment 320
Visible imports 495
Repayment to IMF loan 100

Balancing item 120

Invisible exports 240

Change in reserves ?
Invisible imports 200
EXCHANGE RATES
KEY TERMS
 Nominal Exchange Rate: Is a monetary exchange rate
before an adjustment for inflation.
 Real Exchange Rate: Is an exchange after an appropriate
adjustment for inflation has been made.
 Hard Currency: Is a currency which is needed in large
volumes in international trade, e.g USD and Euro
 Soft Currency: Is a currency which is not needed in large
volumes (is not in much demand for the purpose of
international trade).
 Strong Currency: Is a currency whose exchange
rate/volume in terms of another currency is high, .e.g
Pula vs Rand.
 Weak Currency: Is a currency whose value is low in terms
of other currencies in the exchange market, e.g., Zim $
b4 2009.
Exchange Rates
 In international trade it becomes necessary
for individuals in different countries who
want to buy and sell from one another to
exchange currencies. There are
approximately 150 different currencies in
circulation in the world today. In the process
of trading between nations, foreign
exchanges of currency must be made.
Exchange Rates
 The Exchange Rate: This is the value of one
currency expressed in terms of another currency.
For example:
 • The exchange rate of the US dollar in the UK:

$1 = ₤0.65
 • The exchange rate of the British pound in the

US: ₤1 = $1.56
The British pound is stronger than the US dollar
 $1 worth of US goods will cost a British consumer

only ₤0.65
 ₤1 worth of British goods will cost a US

consumer $1.56
Appreciation and depreciation

 If one currency gets stronger relative to another

(its exchange rate increases), the currency has
appreciated. Example: The dollar is now worth
₤0.8; the dollar has appreciated
 • If one currency gets weaker relative to another
(its exchange rate decreases), the currency has
depreciated. Example: The pound is now worth
$1.25; the pound has depreciated
In the market for dollars :
The exchange rate, or “Price", is the number of pounds per dollar.
The supply and demand is for dollars.
In the market for pounds
The excg rate or price is the number of dollars per pound. The Ss&Dd is for poun
₤/$ British ₤ in the US
$US in Britain $/₤
S$ S₤

0.65 1.56

D$ D₤

Qe Q$ Qe Q₤
Notice:The value of one currency is the reciprocal of
the value of the other currency.
0.65 =1/1.56 and ………1.56 =1/0.65
Calculating exchange rates
 Once you know the value of one currency expressed in terms of
the original ,we can easily calculate the value of the other
currency in terms of the original.
1USD Euro British Indian Australian Canadian South New Japane Chinese
pound Rupee $ S African Zealand s Yen Yuan
Rand $

1USD= 0.81 0.64 55.51 0.95 1 8.23 1.23 78.13 6.36

Inverse 1.23 1.56 0.02 1.05 1 0.12 0.81 0.013 0.16

 The first row tells us how much one dollar costs in each of the foreign currencies.
In other words it’s the dollar exchange rate in Europe,Britain,India,,Australia ,and
so on ……..
 The second row tells us how much the foreign currency costs to Americans .For
example,
One Euro’s worth of goods from Germany costs Americans 1.23. So 100 euros of
output would cost $123.
One rand of South African output would cost Americans $0.12 .But 100 rand of
output would cost $12.
 The value of one currency is always the inverse of the other currency’s value.
Calculating prices using exchange rates
With the knowledge of exchange rates, we can easily calculate how much a
good produced abroad in one currency will cost a foreign consumer who is
spending another currency.
1USD Euro British pound Indian Rupee Australian $

1USD= 0.81 0.64 55.51 0.95

Price of a $1000 American 1000*0.81 =810 E 1000*0.64 1000*55.51= 1000*0.95 =

product in each currency =₤640 5551r 950 AU$

 In each case we have simply multiplied the price of the good in US dollars by the
exchange rate of the dollar in each country.
 If the dollar were to appreciate the price of the $1000 American product would go up
for foreign consumers. This helps explain why American net exports decrease when
the exchange rate rises.
 If the dollar were to depreciate ,US products would become cheaper to foreign
consumers ,which is why net exports will rise when a currency depreciates.
Supply and demand of forex
The domestic market demand for The domestic market can get forex
forex is specifically for the following: supply when:
(i) To pay for imported (i) Foreigners pay for domestic
commodities or services exports
(ii) For repayment of foreign loans/ (ii) There are capital inflows, e.g.,
investing in other countries( If when foreigners buy shares on
the investment conditions are the Zim’s Stock Exchange or
attractive) when foreigners invest in local
Thus, the demand for forex curve is money market.
associated with importers Thus, the supply curve for forex (S
The forex market is in equilibrium if forex) is upward sloping like an
the demand for forex is equal to ordinary supply curve, as it is
supply forex. associated with export of goods and
services.
The forex market:Who supplies?Who demands?
In a particular currency's forex market ,both domestic stakeholders and
foreign stakeholders play a role .For example the market for US dollars in
Britain:
American households , firms, banks
and the government supply dollars to
US$ in Britain Britain ,so that they can buy British
₤/$ goods, services, financial and real
S$ assets.

In the market for pounds in the US,

0.65 the demand and supply are
reversed . Americans demand
pounds and the British supply
them!

D$ British households ,firms, banks and

the British government demand dollars
Qe ,which they wish to have in order to
Q$ buy American goods,services,financial
and real assets.
 Exchange Rates
The forex market : Demand and Supply
Recall the laws of supply and demand ,which explain why demand slopes
downwards and supply slopes upwards.In a forex market the explanations are
as follows:
Upward arrow shows that as the dollar
get stronger Americans want to buy
US$ in Britain more British goods ,so they supply
₤/$ more $.
S$
Demand for currency is inversely related to the
currency’s value. Because as a currency
becomes less expensive so do the goods,
0.65 services and assets of that country. Foreigners
will wish to buy more of the country’s goods,
therefore they demand greater quantities of the
currency as it depreciates. Supply of a currency
is directly related to the currency’s value. As it
appreciates ,foreign goods become cheaper ,so
D$ holders of the currency will supply greater
quantities in order to buy more foreign goods,
Qe services and assets.
Q$
Downward arrow along demand
curve shows that as dollars get
cheaper ,so do American goods and
assets so Brits want more/demand
more US $
The foreign exchange market- Changes in the exchange rate
We now know that an exchange rate is determined by supply and demand for a cur
Therefore if supply or demand change, the exchange rate changes.

$US in Britain
₤/$ British ₤ in the US
$ $/₤ S₤
S $
A
p S₤1
p ₤
r 0.80 Depreciates
e
c
i 0.65 1.56
a
t
e 1.25
s

D$1
D$ D₤

Qe Q$ Qe Q1 Q$
Assume that demand for dollar increases in Britain:
The demand curve shifts outwards causing the dollar to become more scarce in Britain. The dollar
appreciates. In order to buy more dollars British households,firms,government or banks must supply
more pounds. Pounds become less scarce in the US market, and therefore depreciate. An appreciation
Ways of Quoting Exchange Rate Exchange Rates

The price quotation system:

• This is the normal way of quoting exchange
rates ,i.e., expressing one currency in terms
of another e.g. 1USD:ZAR 16.
• This means in the forex market one green
back sells for R16 this way of quoting the
stronger currency is expressed in terms of
the weaker one.
Ways of Quoting Exchange Rate Exchange Rates

The volume quotation system

• This is a system in which a weak currency is
expressed in terms of a stronger one, e.g., ZAR
1 : US$0.06.
• This implies that R1 is equivalent to 6 cents.
NB: This method makes the weaker currency the
of the formula.
The determination of the exchange rate

There are two approaches used in the

determination of exchange rates;

 Elasticities approach

 Monetary approach
Elasticity Approach

 In the absence of government intervention, the exchange

rate is determined by the forces of demand and supply.
 The elasticity approach puts special emphasis on trade-
related explanations for the demand and supply of forex.
 Consequently, the level of demand and supply is the one
that determine the exchange rate.
 This means that the elasticity of dd and ss of goods and
services in the global market influences the exchange rate.
 Exchange Rates
Elasticity approach
In the diagram, imports are demand Rand in Zimbabwe
inelastic so the dd curve for forex is also
$/R S R2
inelastic as shown by its steep slope.
assume the economy experiences a fall
SR1
in exports maybe due to an external
shock like the increase in the price of oil 25
in global markets.
-This means that the supply of forex will
shift upwards from S1 to S2 and the $Z 10
will depreciate from ZAR1:Z$10 to
ZAR1:Z$25 and the quantity of
forex ,i.e., Rands will fall from R20 m to
R14million, i.e., 30% decrease. DR
The above result implies that a unit
change in the exchange rate lead to a 14 20 Q$
less than unit change (20%) in the volume
of foreign currency traded.

30/150 =0,20
Monetary approach
 This approach makes use of the purchasing power
parity (PPP) theorem.
 The PPP states that the exchange rate btw any 2
currencies is the rate which equalise the domestic
purchasing power of the 2 currencies.
 This implies that the exchange is equal to the ratio
of the average price level in 2 countries and can be
expressed as follows:
 Exchange ratePPP = Er + Pd + Pw where
Er is the Nominal Exchange rate
Pw is the world/foreign price level
 -If 50 oranges cost the same in Zim. as in UK, the
exchange rate is Z$1 : £1 where 50 oranges will be
representing the same basket of goods
Monetary approach
 If on the other hand, 50 oranges are £5 in the UK and $10 in
Zim., according to the PPP theory the exchange is £1 : Z$2.
 The above exchange rate implies that if any economy
experiences an upsurge in inflation whilst another economy
remains stable, then the exchange rate btw the currencies of
the 2 countries should depreciate in favour of the country
whose economy has not experienced any inflation.
 If that rate does not hold the country with higher prices in
turn will import goods from a country with lower prices
 This means that the exports of the country with lower prices
would be promoted leading to a balance of trade surplus.
 In contrast, the country with higher prices will experience a
balance of trade deficits since it wld be importing more.
Criticisms of the Purchasing Power parity theorem

-The PPP theory is very unrealistic and rarely

applies in the real world because it does not take
into account the factors of production in the
determination of prices.
(i) It overlooks transport costs which have a
greater influence on the prices of commodities.
(ii) It is very difficult to obtain identical bundles of
commodities in different countries.
(iii) Some commodities are not traded , e.g., hair
cuts.
 Exchange Rates
Exchange Rate Regimes
 There are 3 types of exchange rate systems. An exchange rate can be
determined in several ways depending on the degree of control by the
nation’s government over the value of its currency.
 Floating exchange rates :When a currency’s value against other
currencies is determined solely by the market demand for and supply of it
in the other countries’ forex market. Neither governments nor central
Banks make any effort to manipulate the value of the currency. If for
instance a member of the EU is either experiencing economic problems
such as a high budget deficit as was the case with Greece then the value
of the EURO in relation to the USD will decline as it happened.
- Fixed exchange rates :When a currency’s value against one or more other
currencies is set by the government or Central Bank in order to promote
particular macroeconomic objectives. Exchange rate fixing requires
governments or Central banks to intervene in the forex market to
manipulate the value of the currency. This is a scenario where the
monetary authorities of a particular economy fix the value of their own
currency in relation to the other currencies at a certain level that may
coincide with a specific equilibrium or be it either above or below the
equilibrium exchange rate.
 Exchange Rates
Exchange Rate Regimes
- Managed exchange rates: When a currency value against one or more
currencies is allowed to fluctuate between a certain range by the
country’s government or Central Bank. If the exchange rate gets
below a certain level or above a certain level ,then the government or
central bank will intervene to bring it back within the desired range.
In this exchange rate regime, a hybrid is created of the flexible
exchange rate system and the fixed exchange rate system
- This implies that to the flexible exchange rate system, an upper and
lower bound are created within which the exchange rate is created by
the forces of dd and ss.
 Exchange Rates
Determinants of floating exchange rates
 We know that exchange rates are determined by the demand for and supply of
currencies. But what determines the supply and demand. There are several
determinants of exchange rates.

If any of the following determinants change ,the demand and supply of a currency
will change and it will either appreciate or depreciate against other currencies
As a country’s exports become more popular among international consume
Tastes and demand for its currency will increase and supply of other countries currency
preferences its forex market will increase.

There is a direct relationship between the interest rates in a country and

Relative value of its currency. At higher interest rates foreigners will demand m
financial assets from the country, and therefore more of the currency.
Interest rates

If a country’s inflation rate is high relative to its trading partners, deman

for the country’s exports will fall and demand for its currency will fall.
Relative Price inflation is lower at home than abroad, foreigners will demand more of i
Levels o exports and its currency.

inflation
 Exchange Rates
Determinants of floating exchange rates

If any of the following determinants change ,the demand and supply of a currency
will change and it will either appreciate or depreciate against other currencies

If international financial investors expect a country’s currency to appreciate

Speculation the future, demand for it will rise today. If a currency is expected to depreci
demand for it will decrease today. Speculation is simply betting on the fut
value of an asset or currency.

As incomes rise abroad, foreigners will demand more of a country’s curren

Relative If foreign incomes fall, there will be less demand for a country exports and
currency. If domestic incomes rise, ceteris paribus, demand for fore
Incomes currencies will rise and supply of the foreign currency will increase abroad
households wish to buy more imports.
 Exchange Rates
Determinants of floating exchange rates
British ₤ in the US $ in Britain
$/₤ ₤/$ S $

S₤
S$1

0.65

1.80
0.55
1.56

D₤1
D₤ D$

Qe Q1 Q₤ Qe Q1 Q$
What could cause demand for pounds to increase?
Tastes: If British goods become fashionable in the US.
Interest rates: If the Central Bank of England increased interest rates, Americans would wish
to invest in British assets.
Price levels :If US inflation were to increase whilst British inflation remained low ,American
would demand more relatively cheap British goods.
Speculation: If investors in the US expected the pound to get stronger, the demand fo
pounds would increase today.
 Exchange
Economic effects of appreciation and Depreciation Rates

Inflation Rate Economic Unemployment Balance of

Growth Rate Payment
As a result of Inflation will Growth will Unemployment The current
Appreciation be lower likely slow could rise if net account
since down since a exports decline. should
imported stronger Also domestic move into
goods ,servic currency will firms may deficit(since
es and raw reduce net decide to move net exports
materials are exports, a production will fall) and
now cheaper component of overseas where the financial
AD costs are now account
lower due to towards a
strong currency. surplus ,as
financial and
real assets
become
 Exchange
Economic effects of appreciation and Depreciation Rates

Inflation Rate Economic Unemployment Balance of

Growth Rate Payment
As a result of Inflation will Growth should Unemployment The current
Depreciation increase since increase since should fall as account
imports are the country’s net exports should
more exports are increase shifting move into a
expensive ,an cheaper and AD out. surplus
d there could more Domestic firms (since net
be cost push attractive to may choose to exports will
inflation if foreigners .AD relocate some increase)
raw material will increase of their and the
costs rise for leading to overseas financial
producers. short run production to account
growth. the now cheaper towards
domestic deficit as
market. financial and
Fixed Exchange Rate Regime Exchange Rates
I
I
If a government or central bank wishes to peg its exchange rate against another currency,
it must undertake interventions in the forex markets in order to maintain the desired
exchange rate .Consider the market for US dollars in Britain.

Assume the British government $US in Britain British ₤ in the US

wishes to peg the British pound
at ₤ 0.65 per dollar and $1.56 per ₤/$ $/₤ S₤
S$
pound.
• If the demand for pounds rises
Britain will have to increase its 0.65 1.56
supply to keep it weak.
• If the demand for British
pounds falls, Britain will have D$
to intervene to reduce its D₤
supply and keep it strong Qe Q$ Qe Q₤

Methods for maintaining a currency peg

Interest rates :The CB can raise or lower interest rates to change foreign
demand for its currency.
Official reserves : The CB can buy or sell foreign currencies to manipulate
their supplies and exchange rates.
Exchange controls :The gvt can place limits on the amount of foreign
investment in the country.
Fixed Exchange Rate Regime Exchange Rates
I
I
Assume America’s demand for British goods is much higher than British’s demand for
American goods. This means the supply of US dollars in Britain is growing faster than
demand. Under a floating exchange rate system this would cause the dollar to depreciate
in Britain.
To maintain the dollar at ₤0.65: $US in Britain
The CB can lower British interest rates ₤/$
S $
Lower interest rates in Britain would lower demand for
financial investments in Britain, reducing demand for the S $1
pound in the USA and thus supply of the dollar in
0.65
Britain .The dollar would appreciate.
The CB can print pounds and buy US dollar on the forex
market. D $1
Britain could increase the supply of pounds in the US by D $

buying up dollars to hold in its foreign exchange reserves; Qe Q1 Q$

Demand for dollar would rise and the dollar will appreciate.
The government can implement stricter exchange controls
By putting strict limits on the amount of foreign currency CB and gvt
that can enter China for investments ,the supply of US$ intervention keeps
would decrease and again the dollar would appreciate.
D$ high and S$ low
keeping the exchange
rate high
Managed exchange Rate Regime Exchange Rates

Strict ‘pegs’ of currencies’ values are rather rare these days .More common are
interventions by governments and Central Banks to manage the exchange rate of their
currency ,keeping it within a range that is considered beneficial for the nation’s
economy.Consider the market for Euros in Switzerland [CHF if for Swiss franc].
The Swiss National Bank (SNB) wishes to Euros in Switzerland
maintain an exchange rate of between 1.1 CHF CHF/$
and 1.3 CHF per euro: SE
Assume Europeans wish to save money in
Switzerland ;the supply of euros increases to SE1.
To maintain the minimum exchange rate of 1.3
1.1 CHF/euro ,the SNB must intervene .
 Lower interest rate, buy euros or implement DE1
1.2
exchange controls to reduce the inflow of SE1
euros .
If Swiss demand for euros grew to DE 1 the SNB 1.1
would have to intervene to bring the ER down
to the maximum of 1.3 CHF/euro . D E
 Raise Swiss interest rates ,sell euros from
its foreign Exchange reserves,or implement Qe QE
controls on the outflow of CHF.
Evaluating Floating versus Fixed/Managed Exchange Rates
 Why might a country’s government or central bank choose to intervene in its
foreign exchange market? There are several arguments against and for
managed or fixed exchange rates.
 Pros of a floating exchange rate (cons of managed exchanged rates)

Monetary policy freedom ;with a floating exchange rate ,a central bank may
focus its monetary policies on domestic macroeconomic goals. Interest rates
may be altered to stimulate and contract AD ,rather than to manipulate
demand for the currency.
Automatic Adjustment: a floating exchange rate should be the right exchange
rate ,meaning that it reflects the true demand for the nations currency abroad.
Through management ,a government may overvalue or undervalue its currency
on forex markets ,which can lead to persistent deficits or surpluses in the
current and financial accounts of the balance of payments.
Foreign reserves : A central bank committed to managing its currency’s
exchange rate must keep large reserves of foreign currencies on hand to
intervene in forex markets to manage its exchange rates. This is money earned
from export sales that is not being spent on imports ,and therefore represents
a type of forex saving upon the nation’s households.
Evaluating Floating versus Fixed/Managed Exchange Rates
They are also arguments against a floating exchange rate and for managed or
fixed rates.
 Cons of a floating exchange rate (Pros of managed exchanged rates)

Reduced risk of speculation : A country with a floating exchange rate is

vulnerable to speculation by international investors. If investors speculate the
country’s currency will appreciate, it will likely do so and harm the nation’s
producers and reduce growth rate. Management prevents such speculative
shocks to the exchange rate.
Inflation controls: If a low income developing nation has few exports the world
demands, it may have a very weak currency, making it expensive to import
much needed capital. A government policy that brings up the value of the
currency may help make capital goods cheaper and give the country an
advantage in its path towards growth and development.
Competitive trade advantage: A country that keeps its currency artificially weak
or undervalued against other currencies is likely doing so in order to give its
exporters a competitive advantage in international trade. A weak currency
contributes to persistent current account surpluses, and keeps employment
and economic growth rates high.
Investor Confidence: When less developed countries are seeking foreign
investors, a volatile floating exchange rate may deter potential
investment ,reducing the country’s growth potential .Managed stable exchange
rates may encourage foreign investors to pull their money into the economy.
Terminology Associated with Exchange
Rate Policy
(1) Terms associated with the operation of dd and
SS on their own:
(a) Appreciation: This is an increase in the value of
a currency compared to another currency due to
the interaction of dd and ss of forex, e.g.,
ZAR1 : Z$12 ZAR1 : Z$6 (The Zim $ has
appreciated by 50%).
(b) Depreciation: This is when a currency reduces
or loses its value compared to another bcoz of
dd and ss in the forex mrkt,e.g., ZAR1:Z$20
ZAR1 : Z$30 ( the Zim $ has depreciated by
50%).
Terminology Associated with Exchange Rate
Policy
(2) Exchange rate movement due to exchange
rate policy on the part of the gvt:
(a) Revaluation: This is a very rare policy
measure in which a grossly undervalued
currency has its value raised by the gvt in
relation to other currencies.
(b) Devaluation: This is a situation in which the
value of a currency is reduced by gvt in
relation to the value of other currencies
because of 2 main reasons:
Terminology Associated with Exchange Rate Policy

(a) If the currency is overvalued in relation to

the other currencies.
(b) If the gvt wants to reduce imports and boost
exports so as to correct the BOPs deficits.
MONEY ,BANKING AND
THE PRICE LEVEL

31
1
MONEY, BANKING AND THE PRICE
LEVEL
The Concept of Money
 Money: anything that is generally acceptable

as a medium of exchange of goods and

services in an economy and at the same time
acts as a measure and store of value.
 Money is what is declared by legislative fiat or

authority to be such.
 In virtually all economies on earth, notes and

coins are used as forms of money.

31
2
 The operational definitions of money
There are three broad money aggregates:
 M1: M1 is defined solely on the basis of the function of money as
a medium of exchange. This is called narrow money. It comprises
of notes and coins + demand deposits with the banking sector
(RBZ, commercial banks, merchant banks, discount houses)
 M2: A more broader definition of money.M2=M1 plus all short
term and medium term deposits of the domestic private sector
with monetary institutions. The short term and medium deposits
are not immediately available as a medium of exchange. They are
deposits invested for a certain period i.e. less than 30 days for
short term deposits and less than six months for medium term
deposits and can only be withdrawn earlier at considerable cost.
They are therefore regarded as quasi money (or near money).Thus
M2 can be defined as money +quasi money. In essence M2 is M1
+ savings deposits + 30 day fixed deposits with commercial
banks
 M3: M3 is equal to M2 plus all long term deposits
 The long term deposits in question have a maturity of longer than
six months .This is called broad money. 31
3
EVOLUTION AND DEVELOPMENT OF
MONEY
 Animal money: In ancient India, according to
Veda, Go Dhan (cow –wealth) was accepted as a
form of money. In Roman state up to 4th century
BC, cow and sheep were officially recognized as
money used for collecting taxes and fines.
 Commodity money: In many countries, a number
of commodities like bows, arrows, animal skins,
shells, beads ,precious stones, rice, tea were used
as money. The selection of commodity was
dependent on factors like the location of the
community, climate of the region, cultural
economic development of the society. For
example, community living close to sea shore
chose shells, fish hooks as money.

31
4
Definition and functions money

3. Metallic money (uncoined metals and coins): Along with

the growth of society from pastoral to commercial stage,
the composition of money also changed from animal and
commodity money to metallic money.initially iron and
copper were very popular forms of money but when they
became too abundant they lost their value and were
replaced by scarcer metals such as Gold and silver which
are now mainly used as money.
4. Paper money: Initially paper receipts against metallic
money carried by merchants for safety. Later, scarcity of
metals led to the introduction of convertible paper
currency i.e. paper money convertible into metals. But in
the later stage, paper money developed into fiat money
i.e. paper money not convertible into metals.

31
5
EVOLUTION AND DEVELOPMENT OF
MONEY
5. Credit money: Mainly cheques issued against the demand
deposits.
6. Near Money: In recent days near money are also accepted as
money since they provide almost all the major functions of
money. Such money are bills of exchange, treasury bills, bonds,
debentures, savings certificates etc.
7.e-money: Also known as e-currency, electronic cash, electronic
currency, digital money, digital cash, digital currency, cyber
currency refers to money or scrip which is only exchanged
electronically.Typically,this involves the use of computer
networks ,the internet and digital stored value
systems .Electronic Funds Transfer (EFT) and direct deposit are
all examples of electronic money. Electronic money only exists
in banking computer systems and is not held in any physical
form. e-money is exchanged electronically over a technical
device such as a computer or mobile phone.This type of money
is now the in thing in many developing countries.
31
6
Eight characteristics of good money
 Acceptability-should be widely accepted so that one is able to
use it anytime and anywhere.
 Scarcity-should not be easily available. Its scarcity makes it more
valuable.
 Portability-must be easy to carry and transfer to other
individuals.
 Durability-the item must be able to withstand being used
repeatedly. It should last for a long time.
 Homogeneity-all versions of the same denomination of currency
must have the same purchasing power.
 Divisibility-should be easily divided into smaller units of value.
 Stability – should maintain its value.
 Recognisability- we don’t want to take courses in distinguishing
and estimating the value of our money thus good money must
be easily recognizable.

31
7
Functions of Money
 There are three basic functions of money and a fourth
surrogate one:
1. Medium of exchange: Money facilitates financial
transactions in a modern economy. Money eliminate the
need to conduct barter trade which is primarily based on the
existence of double coincidence of wants. This is associated
with M1 money definition.
2. Store of Value: This means money has the ability to hold
value over time. This makes money a useful mechanism for
transforming income in the present into future purchases.
This function is valuable if we look at the barter system.
Imagine you are a farmer. You have a crop to sell, let's say
apples. How would you make future purchases? Your
apples might spoil and lose their value. Not so with money.
good money must maintain a constant purchasing power for
a long period of time. Inflation primarily undermines this
function of money. Glass which is easily broken can not be
used to store value or wealth.
31
8
Functions of money cont’d
 Unit of Account: Money is used to measure exact
worth of a commodity in the modern economy.
Money as a denominator of goods and services in the
modern economy facilitates the whole accounting
profession.
 Standard of deferred payments: The existence of
money facilitates the entire credit economic system
upon which rests much of economic activity. During
the barter system there was a problem of future
payments. Money has helped for the future payments
of present borrowings. This is based on the ability of
money to work or function as a unit of account.

31
9
CREDIT CREATION
 An important function performed by the
commercial banks is the creation of credit.
The process of banking must be considered
in terms of monetary flows ,that
is ,continuous depositing and withdrawal of
cash from the bank. It is only this activity
which has enabled banks to manufacture
money. Therefore banks are not only
purveyors of money but manufacturers of
money.
Need for Credit Creation
 Commercial banks are called the factories of
credit.
 They advance much more than what the

collect from people in the form of deposits.

 Through the process of credit creation,

commercial banks provide finance to all

sectors of the economy thus making them
more developed than before.
Credit Creation
 The basis of credit money is the
bank deposits.
 The bank deposits are of two

kinds viz.,
◦ Primary deposits, and
◦ Derivative deposits
Primary Deposits
 Primary deposits arise or formed when cash
or cheque is deposited by customers.
 When a person deposits money or cheque,

the bank will credit his account.

 The customer is free to withdraw the amount

whenever he wants by cheques.

 These deposits are called “primary deposits”

or “cash deposits.”
Primary Deposits
 It is out of these primary deposits that the
bank makes loans and advances to its
customers.
 The initiative is taken by the customers

themselves. In this case, the role of the bank

is passive.
 So these deposits are also called “passive

deposits.”
Derivative Deposits
 Bank deposits also arise when a loan is
granted or when a bank discounts a bill or
purchase government securities.
 Deposits which arise on account of granting

loan or purchase of assets by a bank are

called “derivative deposits.”
 Since the bank play an active role in the

creation of such deposits, they are also

known as “active deposits.”
Credit Creation
 When the bank buys government securities, it
does not pay the purchase price at once in
cash.
 It simply credits the account of the
government with the purchase price.
 The government is free to withdraw the

amount whenever it wants by cheque

 The power of commercial banks to expand

deposits through loans, advances and

investments is known as “credit creation.”
Process of Credit Creation
 The banking system as a whole can create
credit which is several times more than the
original increase in the deposits of a bank.
This process is called the multiple-expansion
or multiple-creation of credit.
 Similarly, if there is withdrawal from any one

bank, it leads to the process of multiple-

contraction of credit.
The money creation process cont’d
 Let us then look at an example of how money is
created using the money creation theory or
money multiplier as follows:
 Assumptions of the theory
 We assume the existence of a single
commercial bank called CBD Bank
 We assume a reserves requirement ratio of 10%
 We assume that no cash leaks out of the system.
 Assume the initial balance sheet appears as

follows:
Assets (US$) Liabilities (US$)
Cash 200 000 Capital 200 000
32
8
The money creation process cont’d
 In the balance sheet the owner of the bank Mr Mthombeni
contributes $200 000 as capital to the formation of the
bank. This means that the bank has an asset of $200 000
cash and a liability of $200 000 capital.
 Since the RRR is 10% this means that $20 000(10% of
200000) is retained as reserves and the bank lends $180
000 ( 200000-180000) to say Mr Mgutshini who opens
an account with CBD and uses the whole loan amount to
buy a machine for $180 000 from Belmont Machine
Manufacturers who have an account with the bank.
 This implies that Mr Mgutshini’s account is debited with
$180 000 which is credited to the account of Belmont
Machine Manufacturers.

32
9
The money creation process
continued
CBD bank is able to lend 80% of $180 000 which
is $162 000. The balance sheet below shows the
result of three lending rounds:
Balance Sheet B
Assets US$ Liabilities US$
Round 1 180 000 Deposit 180 000
Round 2 162 000 Deposit 162 000
Round 3 145 800 Deposit 145 800
487 800 487 800

33
0
The money creation process cont’d
 The initial deposit of US$200 000 has created
$487 800 total assets at the end of the third
round courtesy of the fractional RRR system.
The rounds for lending are infinite
theoretically. Thus a formula is used to
calculate the size of the credit creation
multiplier.
 In general the total money or credit (M) is:
S = A/(1-r) where S is the sum of
the infinite convergent geometric series, A is
the first term, r is the common ratio.
33
1
The money creation process cont’d
 Customizing the maths series formula to credit
creation yields:
M = D/(1-r) where M is total
credit created, D is the initial deposit and r is
still the common ratio. It can be deduced that r
= (1-RRR) substituting in the above formula
yields:
M = D/[1-(1-RRR)]
= D/(1-1+RRR)
= D/RRR implying that the
money multiplier is m = 1/RRR
33
2
The money creation process cont’d
 Using the formula on the preceding slide, the
total credit created can be deduced to be:
 M = 200000/(1-(1-0.1) = $2 000 000
 Or M = 200000/0.1 = $2 000 000

33
3
Process of Credit Creation: A more
robust example of multiple credit
expansion
 The process of multiple credit-expansion can
be illustrated by assuming
◦ The existence of a number of banks, A, B, C etc.,
each with different sets of depositors.
◦ Every bank has to keep 10% of cash reserves,
according to law, and,
◦ A new deposit of Rs. 1,000 has been made with
bank A to start with.
Process of Credit Creation
 Suppose, a person deposits $1,000 cash in Bank A. As a
result, the deposits of bank A increase by $1,000 and
cash also increases by $1,000. Under the double entry
system, the amount of $1,000 is shown on both sides.
 The balance sheet of the bank at the onset is as follows:

Balance Sheet of Bank A

Assets $ Liabilities $

New cash 1000 New Deposit 1000

Total 1000 1000

Process of Credit Creation
 Suppose X approaches the bank and asks for a loan equivalent to everything
that the bank can lend. The bank will only be able to advance $900 to X
because they are required to keep 10 % of the funds as a reserve which is
(10% 0f 1000)=100.bank A balance sheet would then appear as follows.

Balance Sheet of Bank A

Assets $ Liabilities $
Cash 100 Deposit 1000
Reserve
Loan to X 900

Total 1000 1000

Process of Credit Creation
 Suppose X purchase goods of the value of Rs. 900 from Y and
pay cash.
 Y deposits the amount with Bank B.
 The deposits of Bank B now increase by Rs. 900 and its cash
also increases by Rs. 900. After keeping a cash reserve of Rs.
90, Bank B is free to lend the balance of Rs. 810 to any one.
 Suppose bank B lends Rs. 810 to Z, who uses the amount to
BalanceThe
pay off his creditors. Sheet of Bank
balance B of bank B will be as
sheet
follows:
Assets $ Liabilities $
Cash reserve 90 Deposit 900
Loan to Z 810
Total 900 900
Process of Credit Creation
 Suppose Z purchases goods of the value of Rs. 810 from S
and pays the amount.
 S deposits the amount of Rs. 810 in bank C.
 Bank C now keeps 10% as reserve (Rs. 81) and lends Rs.
729 to a merchant. The balance sheet of bank C will be as
follows:
Balance Sheet of Bank C
Assets $ Liabilities $

Cash reserve 81 Deposit 810

Loan 729

Total 810 810

Process of Credit Creation
 Thus looking at the banking system as a
whole, the position will be as follows
Name of bank Deposits ($) Cash Reserve Loans ($)
($)
Bank A 1000 100 900

Bank B 900 90 810

Bank C 810 81 729

Total 2710 271 2439

 Thus the credit multiplier /money multiplier
for this economy is:
 m =1/RRR
=1/0.1
= 10 times
Therefore total money created(M) in the
economy is:
M=A/[1-(1-RRR)]
=1000/[1-(1-0.1)]
=1000/0.1
=$10000

34
0
 Alternatively total money created is :
 M=D/RRR

= 1000/0.1
= $10000

Thus the total money created is $ 10000 (wow!!!)

34
1
Limitation on Credit Creation
1. If no money is deposited with banks then banks will be unable to
create money.
2. Banks are usually risk averse and may not lend all the money they
have at their disposal.
3. Customers themselves may be risk averse and may not be willing to
apply for loans from banks.
4. Amount of Cash: The power to create credit depends on the cash
received by banks. If banks receive more cash, they can create more
credit vice versa.
5. Cash Reserve Ratio: All deposits cannot be used for credit creation.
Banks must keep certain percentage of deposits in cash as reserve.
6. The Banking Habits of the People: The loan advanced to a customer
should again come back into banks as primary deposit.
7. Nature of Business Conditions in the Economy: Credit creation will be
large during a period of prosperity, while it will be smaller during a
depression.
 Limitation of Credit Creation
8. Leakages in Credit-Creation: The funds may not flow
smoothly from one bank to another. Some people may keep a
portion of their amount as idle cash.
9. Sound Securities: A bank creates credit in the process of
acquiring sound and profitable assets, like bills, and
government securities.
10. Liquidity Preference: If people desire to hold more cash,
the power of banks to create credit is reduced.
11. Monetary Policy of the Central Bank: The extent of credit
creation will largely depend upon the monetary policy of the
Central Bank of the country. The Central Bank has the power
to influence the volume of money in circulation and through
this it can influence the volume of credit created by the banks.
 The demand for money
 The demand for money is the amount that the various
participants in the economy plan to hold in the form of
money balances. The demand for money does not
relate to the amounts of money that people want. The
demand for money is concerned with the choices of
those participants who earn an income or possess
wealth. They must decide in which form to hold their
income or wealth. The opportunity cost of holding any
money balance is the interest that could have been
earned had the money been used to purchase bonds
instead. Money will only be held if it provides a service
that is valued at least as highly as the opportunity cost
of holding it.The demand for money is therefore
directly related to the functions that it performs.

34
4
 THE DEMAND FOR MONEY
 There are 3 approaches for studying money
demand. These are:
1. The classical approach
2. The Keynesian approach
3. The monetarist approach

34
5
The Classical approach to money demand
 This approach is attributed to the 20th century economist
Irving Fisher (1912) who crystallised the equation of
exchange from the writings of David Hume and other
economic philosophers.
 The equation is MV = PT or MV=PQ
 where M stands for the money stock in the economy,
 V is the transactions velocity of circulation (measured as the
number of times that an average dollar circulates in the
economy in the conduct of commercial transactions),
 P is the general price level,
 T is the total level of transactions in the economy.
 Q is the real value or physical quantity of goods and services
 Observe that T and Q are used interchangeably but convey
the same thing.

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6
 The classical approach
 This identity states that the quantity of goods
and services (Q) produced during a
period ,multiplied by their prices (P),is equal
to the money supply (M),multiplied by the
velocity of circulation of money (V).In essence
this theory states that there is a direct
relationship between the quantity of money in
an economy and the level of prices of goods
and services sold.

34
7
The classical approach
 Assume the money supply is $100 and Q =200 units of
physical products and also that the average price of
each unit is $2.What is the velocity of circulation.
 MV=PT
 V=PT/M
 V=2*200/100
= 4 times.
This means that with a money supply of $100 ,each dollar has to
be used in final transactions four times to accommodate a GDP
of 400 dollars.
Note that the equation of exchange is an identity. The question
is how then do the monetarists convert this identity into a theory
which can be used to predict what will happen in an economy if
the quantity of money changes.

34
8
The classical approach cont’d
 Assumptions
1. V is assumed to be constant since it is determined by
technology and institutional factors such as the length
of the payment period, pattern of expenditure, access
to credit and expectations about future inflation.
2. T is also assumed to be constant since transactions
that can be conducted per a given period of time are
fixed.
3. The quantity of money is the main influence of
economic activity. A change in money supply results
in changes in price levels or change in supply of
goods and services.
4. Aggregate output at full employment level.

34
9
The classical approach cont’d
 If V is stable then the equation of exchange is converted from an
identity or definition into a theory which enables us to predict the
effects of changes in the quantity of money. This theory is known as
the quantity theory of money.
 The assumptions imply that the equation of exchange can be re-
written as follows:
 MV/V = PT X 1/V
 M = 1/V X PT
 Let k (constant) = 1/V
 Therefore: M = k PT
 Or MV =PT
 According to the above formulation, money demand is a function of
the change in the general price level since k and T are constant over
time. Because K is constant ,the level of transactions generated by a
fixed level of PT determines the quantity of money demanded.

35
0
Classical approach …cntd
 Remember our example where the velocity of
circulation was equal to 4.Assume that the
quantity of money increases from 100 to 150 by
50 percent.This will lead to an increase in PT
/PQ by the same percentage.
 Since MV=PT
= 150*4=600 (PQ increases from 400 to 600 by 50 %)
In essence since T is constant and remains at 200 it means
that
600/200=$3 (which is the new price level in the economy.
Thus an increase in the money supply will raise prices from
$2 to $3 )
OR

35
1
Classical approach ….cntd
 OR we can work it out this way
M = k PT
 Since M=150

 K =4

 150=1/4 PT (then multiply both sides by 4)

 150 *4 =1/4*4 PT

 600= PT

 Since T is constant at 200 this means

 600/T =P

 600/200=3

 Thus the new price is $3 which shows that an increase in money

supply will cause inflationary pressures in the economy. The theory
asserts that Q is determined in the long term by the quantity and
quality of the various factors of production. Therefore changes in M
are said to affect only prices in the long run.

35
2
 Criticisms of the equation of
exchange
 It based on very rigid and unrealistic
assumptions in that money was seen as
neutral and only affecting prices.
 In the 1930s V was observed to be variable,

implying that money is not neutral but affects

real economic variables such employment,
real GDP and investment.

35
3
Keynes’ Liquidity Preference Theory
 J M Keynes, a British economist formulated
his money demand on the basis of three
motives:
1. The transactions motive
2. The Precautionary motive
3. The Speculative motive

35
4
Transactions demand for money
 This is associated with the narrow definition of money and places
emphasis on the medium of exchange function of money.
 The first reason to hold money is the transaction motive. In a money
economy all participants have to hold money as a medium of exchange.
Without money it is impossible to enter into transactions. The need to
hold money arises because participants payments and receipts do not
coincide. For example wages and salaries are normally paid weekly or
monthly, while purchase of goods and services occur more regularly.
Workers therefore have to hold money to buy food and other
commodities between paydays. The amount of money required for
transactions purposes will depend mainly on the total value of the
transactions concerned. This in turn, will depend on the level of income
in the economy. The transactions demand for money is therefore a
function of national income.
 The size of transaction balances depends mainly on the level of income
and the time interval between receipts and disbursements of income.
 Since this is based on patterns of expenditure that tend to be constant
over time, Td is assumed to be fixed or constant.

35
5
Precautionary demand for money
 This is associated with the need to retain
some money for contingencies or unforeseen
occurrences which may be bargain purchases
or calamities in the near future.
 This is also assumed to be constant since

occurrence of situations like sickness or

bargain purchase opportunities in the future
tends to be constant over time.

35
6
The speculative demand for money
 This demand for money is predicated on the use of money to store value
or wealth.
 Economic agents willingly hold money balances over and above their
transactions and precautionary demand for money because of their
desire to hold money as an asset that is perfectly liquid and relatively
free of risks (except inflation of course).To understand the speculative
demand for money ,we must consider the choice between holding
money (which earns little or no interest) and holding bonds (which
earns interest).The choice between holding wealth in the form of money
or bonds will depend on the interest rate.It follows, therefore,that the
quantity of money demanded for speculative purposes will be higher
when the interest rate (and therefore the opportunity cost of money) is
low. Likewise the quantity of money demanded for speculative purposes
will be low when the interest rate is high (since the opportunity cost of
money is then also high).Therefore there is a negative relationship or
inverse relationship between the quantity of money demanded for
speculative purposes and the level of the interest rate.

35
7
 Speculative demand for money
cont’d
 The speculative demand for money is
primarily determined by the interest rates as
follows:
 Money holdings/money balances are a

substitute of holding wealth in terms of other

financial assets such as bonds or Treasury
Bills (TBs).
 The future value (FV) of a bond is:
 FV = PV + PV (r) where PV is the present value

or price of a bond and r is the interest rate

35
8
 Speculative demand for money cont’d
 FV = PV (1+r)
 PV = FV/(1+r)
 The above formulation of PV tells us that the PV or price
of a bond is inversely related to the interest rate
implying that if the interest rate is increasing the price
of a bond will be decreasing, and vice versa.
 Since bonds are reckoned as a normal good of the
money markets, a rise in the interest rate implies a
decline in their price, thereby increasing their quantity
demanded, ceteris paribus.
 If the quantity demanded of bonds increases, this
implies a running down of money balances. This implies
a negative relationship between the interest rate and
money holdings associated with the speculative motive.

35
9
Money Demand – Keynes’ model
 Summing the three motives yields:
 Td + Pd + Sd = Md
 Where Td is constant transactions demand for

money.
 Pd is constant precautionary demand for

money.
 Sd is speculative demand for money holdings

which is inversely related to changes in the

interest rate.

36
0
 Liquidity Preference cntd…
 The transactions and precautionary demand
for money are both related to the need to
actively employ the money balances
concerned. In these cases the purpose is to
spend money. Thus we add Td and Pd and
call them the demand for active balances. On
the other hand the speculative demand is not
directly linked to transactions .In this case the
purpose is to hold money passively as a store
of value. We therefore call this the demand
for passive balances.
36
1
 Liquidity preferance:A summary
Function Motive Active /Passive Main
determinant

Medium of Transactions Active balances Income

exchange Precautionary

Store of value Speculative Passive balances Interest rate

36
2
Keynes’ Money Demand cont’d
 The foregoing analysis implies that the overall demand for money is
inversely related to changes in the interest rate. The negative slope
reflects the inverse relationship between the interest rate and the
quantity of money demanded for speculative purposes. The position
of the demand curve is mainly determined by the demand for active
balances which is determined by the income level. Any increase in
income shifts the total demand curve to the right while a decrease in
the income level will cause the demand curve to shift to the left.

36
3

Money market equilibrium
An equilibrium is said to exist in the money market if money
demand is equal to money supply. The price of money (the interest
rate ) is determined by supply and demand. At higher interest rates
there will be excess supply of money. At lower interest there will be
an excess demand for money.

36
4
Money market equilibrium cont’d
 Money supply is perceived as fixed since it is
determined by the government through the
central bank of an economy.
 Therefore, it can not be argued that it is

determined by interest rates in the economy

since it is an institutional variable.
 It is asserted that if the govt sees fit, it may

through the central bank increase money

supply without reference to interest rates.

36
5
MACROECONOMIC
PROBLEMS
INFLATION
 Refers to the sustained rise in the general price level in an
economy over a period of time caused by macroeconomic
factors and economic sector specific factors.
 inflation also reflects an erosion in the purchasing power of
money
 Inflation is the stage of too much money chasing too few
goods.”
 Inflation is considered a global phenomenon. It takes place
because of rapidly rising prices of goods and services,
resulting in the decline of the value of money.
 The rate at which the general level of prices for goods and
services is rising, and, subsequently, purchasing power is
falling.

36
7
INFLATION cont’d
Degrees of inflation
1. Creeping inflation: Inflation rates between
1% and 35%
2. Galloping inflation: inflation rates between
36% and 99%
3. Hyperinflation: inflation rates beyond 100%
Other degrees
 Walking or trotting Inflation
 Stagflation
 Deflation

36
8
Creeping Inflation

Creeping or mild inflation is when prices rise 3% a

year or less. According to the U.S. Federal
Reserve, when prices rise 2% or less, it's actually
beneficial to economic growth. That's because this
mild inflation sets expectations that prices will
continue to rise. As a result, it sparks increased
demand as consumers decide to buy now before
prices rise in the future. By increasing demand,
mild inflation drives economic expansion.
Walking Inflation

This type of strong, or pernicious, inflation is

between 3-10% a year. It is harmful to the
economy because it heats up economic growth
too fast. People start to buy more than they
need, just to avoid tomorrow's much higher
prices. This drives demand even further, so that
suppliers can't keep up. More important,
neither can wages. As a result, common goods
and services are priced out of the reach of most
people.
Galloping Inflation

When inflation rises to ten percent or greater, it

wreaks absolute havoc on the economy. Money
loses value so fast that business and employee
income can't keep up with costs and prices.
Foreign investors avoid the country, depriving it
of needed capital. The economy becomes
unstable, and government leaders lose
credibility. Galloping inflation must be
prevented.
Hyperinflation

Hyperinflation is when the prices skyrocket

more than 50% -- a month. It is fortunately very
rare. In fact, most examples of hyperinflation
have occurred when the government printed
money recklessly to pay for war. Examples of
hyperinflation include Germany in the 1920s,
Zimbabwe in the 2000s, and during the
American Civil War.
Stagflation

Stagflation is just like its name says: when

economic growth is stagnant, but there still is
price inflation. This seems contradictory, if not
impossible. Why would prices go up when there
isn't enough demand to stoke economic
growth? It happened in the 1970s when the U.S.
went off the gold standard. Once the dollar's
value was no longer tied to gold, the number of
dollars in circulation skyrocketed. This increase
in the money supply was one of the causes of
inflation.
Deflation

Deflation is the opposite of inflation -- it's

when prices fall. It's caused when an asset
bubble bursts. That's what happened in
housing in 2006. Deflation in housing prices
trapped those who bought their homes in 2005.
In fact, the Fed was worried about overall
deflation during the recession. That's because
deflation can turn a recession into a depression.
During the Great Depression of 1929, prices
dropped 10% -- a year. Once deflation starts, it
is harder to stop than inflation.
Types of Inflation
Demand-pull Inflation
Cost-push Inflation
Pricing Power Inflation
Sectoral Inflation
Cost –Push inflation
 As the name suggests, if there is increase in the cost of
production of goods and services, there is likely to be a forceful
increase in the prices of finished goods and services. For
instance, a rise in the wages of laborers would raise the unit
costs of production and this would lead to rise in prices for the
related end product.
Cost-Push inflation: this type of inflation is driven by costs of
production such as:
1. Rent
2. Wages
3. Interest
4. Fuel
5. Overheads
6. Raw material costs
7. electricity

37
6
Cost push inflation
 It tends to be serious in economies where
relative scarcities of factors of production are
increasing due to depletion of key resources
or
 Due to increased competition for resources

among producers or firms in an economy due

to economic growth or the entry of foreign
producers into the domestic economy as a
result of liberalization of investment rules.

37
7
Cost- Push Inflation
Demand-pull inflation
 This type of inflation occurs when total demand for
goods and services in an economy exceeds the
supply of the same. When supply is less than
demand , the prices of these goods and services will
rise, leading to a situation called demand-pull
inflation.
An increase in AE or AD is a key driver of this type of
inflation.
 It may be associated with an uncured inflationary gap
in an economy.
 It is eliminated by policies which are meant to reduce
the inflationary gap in an economy like restrictive
fiscal policy, trade policy or restrictive monetary
policy.
37
9
Causes of Demand Pull Inflation
 Demand pull inflation can be caused by any
(or a combination) of the various components
of aggregate demand ,that is,
 Increased consumption spending by
households (C) ,for example, as a result of a
greater availability of consumer credit or the
availability of cheaper credit as a result of a
drop in interest rates.
 Increased investment spending by firms (I),for
example ,as a result of lower interest rates or
an improvement in business conditions and
profit expectations.
 Increased government spending (G),for
example, to combat unemployment or to
provide more or better services to the
population at large.
 Increased export earnings (X) as a result of

improved economic conditions in the rest of

the world or because of increases in the
prices of important export products.
Demand-Pull Inflation
Imported inflation
 This type of inflation is driven by prices of
imported inputs.
 Zimbabwe is a landlocked
economy .Imported inputs include fuel,
maize, wheat, spare parts, etc
 If prices of these inputs increase in global

markets, the general price level might also

increase, ceteris paribus.
 It is a component of or a special type of cost

push inflation.

38
3
Pricing Power Inflation
 Pricing power inflation is more often called
administered price inflation. This type of inflation
occurs when businesses, households and industries
decide to increase the price of their respective goods
and services to increase their profit margins.
 A point noteworthy is pricing power inflation does not

occur at the time of financial crises and economic

depression, or when there is a downturn in the
economy. This type of inflation is also called
oligopolistic inflation because oligopolies have the
power of pricing their goods and services.
Sectoral Inflation
 Takes place when there is an increase in the price of the goods
and services produced by a certain sector of industry. For
instance, an increase in the cost of crude oil would directly affect
all the other sectors, which are directly related to the oil industry.
Thus, the ever-increasing price of fuel has become an important
issue related to the economy all over the world. For example,in
the aviation industry when the price of oil increases, the ticket
fares would also go up. This would lead to a widespread inflation
throughout the economy, even though it originated in one basic
sector. If this situation occurs when there is a recession in the
economy, there would be layoffs and it would adversely affect the
work force and the economy in turn.
Consequences of Inflation
Economic Consequences
1. Penalizes those on fixed incomes
2. Benefits borrowers at the expense of lenders
3. Discourages savings and encourages dead-end
consumption
4. Discourages investment in the real economy
5. Encourages speculative activities in the economy
6. Discourages investment in human capital by
rechanneling resources to recurrent expenditure
7. Scares away foreign investment
8. May lead to the collapse of a currency
9. Makes it difficult to implement macroeconomic policies
10. Brain drain

38
6
Consequences of inflation
 Social and political consequences of inflation
1. Social vices eg prostitution, drug trafficking,
money laundering, smuggling
2. Break up of families and decay of society in
terms of cohesion
3. Social unrest
4. Political unrest
5. Unemployment leading to theft, robberies,
etc increasing.

38
7
 Measures to Control Inflation
 Given that inflation shows the imbalance between supply and demand
of goods at current prices , measures must be taken to reduce demand
or increase supply of goods and services.
The supply side Measures
 Increased Production

The supply of goods and services can be increased by

increasing agricultural and industrial production.
Agricultural production can be increased by providing an
adequate supply of agricultural inputs at low prices, the
modernization of agriculture and scientific farm
management as well as adequate water supply for
irrigation. Industrial production can be increased by
increased foreign direct investment, industrial credit
growth, fiscal concessions, etc.
 Control of illegal Activities
There are some illegal activities that cause significant
inflation in a country. These include activities like
hoarding, smuggling, profiteering, black markets, etc. In the
case of smuggling, large quantities of staples like sugar,
butter, wheat, rice, etc are exported abroad illegally in order
to obtain higher prices. At times artificial shortages are
created in the local markets to raise prices and obtain
higher profits. All activities of this evil must be controlled
through advertising, as well as punishment.
 Peace and Security
Production and distribution of goods and services can be
affected by the existence of disturbances and insecurity in
society. In such circumstances, investors are hesitant to
invest for fear of potential loss. The production of
industrial products is also affected by unpleasant events
such as strikes ,therefore, peace and security must be
ensured to maintain the supply of goods and avoid the
danger of famine.
 Incomes Policy
 Cost push inflation or stagflation creates a policy

dilemma which cannot be solved by demand

management (i.e. monetary and fiscal policies aimed at
influencing aggregate demand).In essence if the problem
is on the supply side then solutions must be sought from
the supply side. An incomes policy implies some form of
government intervention in the determination of wages
and prices. The action taken by the authorities may vary
from the formulation of guidelines for the determination
of wages and prices to compulsory control measures.
Incomes policy usually entails a call to workers to limit
their demands for nominal wage adjustments to the
average productivity increase in the economy, and to
firms to limit their profit margins. If prices can then be
kept constant, such an agreement ensures that the
relative shares of wages and profits in the economy also
remain constant. For an incomes policy to work it has to
appear equitable to all parties involved and there must be
 Main Energy Sources
The supply of agricultural and industrial products is highly
dependent on energy availability. If the energy source is
expensive, the cost of production of goods and services will
be expensive too. Increased production costs raise prices and
cause inflation. Therefore all necessary measures must be be
taken to provide major sources of energy in industrial and
agricultural sectors of the economy at reasonable costs.
The demand side
Control of Money Supply
An increase in money supply without corresponding increases
in output increases inflation. It increases Aggregate
demand/aggregate spending thus fueling inflation. Therefore,
to control inflation, measures must be taken to control the
money supply. The money supply can be controlled with the
help of monetary policy in which the central bank uses
restrictive/contractionary monetary policy.Various methods,
such as bank rate policy, open market operations, changes in
reserve requirements, credit rationing , direct controls on
lending etc can be used. High interest rates and slow growth
of the money supply are the traditional ways through which
central banks fight or prevent inflation.
 Population Control
In most developing countries, the population is increasing
very quickly but the production of goods and services is
not increasing at the same pace. This imbalance between
supply and demand of goods and services produced causes
inflation. Therefore, to control inflation, appropriate
measures should be taken to control the population e.g the
one child policy of China.
 Fiscal Policy measures
Fiscal policy refers to government policy of public spending
and taxes. The main objective of fiscal policy is to maintain
stability in the general price level. During inflation, the
government should reduce its expenditure on unproductive
activities and increase direct tax rate so that the purchasing
power of the population is reduced. Due to a reduction in
the purchasing power of the population, demand for goods
and services will be reduced, thus controlling inflation.
In essence the fiscal measures that can control
inflation include the following;
 Reduction in unnecessary expenditure.
 Increase in Taxes.
 Increase in savings
 Adopt Surplus Budget(collecting more

revenue and spending less).

 Stop Repayment of Public Debt until

inflationary pressures are controlled.

 There should be no Deficit Financing
Deficit financing is a practice in which a gvt spends more
money ,than it receives as revenue, the difference being
made up by borrowing or minting new funds. The purpose
of deficit financing is to meet the additional costs of the
budget deficit. This causes money supply to increase in the
country and causes inflation. Therefore the deficit financing
should be discouraged and all development costs must be
met through taxes and debt.

Direct Measures
 There are several other options available to the government to
control inflation including wage and price freeze, the
rationing of goods, establishment of public service shops, the
price review committees, boards of price stabilization, etc.
These direct measures are often used by the government to
control inflation.
Deflation
It refers to continuous fall in price level. This happens in
recession period. If it last for longer period, it harms the
growth & development of the economy.
The Government should adopt policies which are similar to
the situation of recession. Eg.
 Increase income by reducing taxes
 Generate employment
 Adopt policies which enhance production
UNEMPLOYMENT
 The unemployed: refers to those who are able
to work and are actively looking for work but
can not find it.
 Unemployment rate = Total unemployed X

100
Total labour force
 Total labour force equals to 15-65 years of

ages who are able to work, are at work and

also those currently searching for work.

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7
TYPES OF UNEMPLOYMENT
1. Frictional unemployment/Search
unemployment
2. Technological unemployment
3. Regional unemployment
4. Demand deficiency unemployment
5. Real wage unemployment
6. Disguised unemployment
7. Structural unemployment

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8
Frictional Unemployment
 This is associated with normal labour turnover.
 People leave jobs for many reasons and they take
time to find new jobs, young persons enter the
labour force, but new workers do not often fill
the jobs vacated by those who leave.
 This movement takes time and gives rise to a
pool of persons who are ‘frictionally’
unemployed.
 The frictionally unemployed are those moving
between jobs.

39
9
Frictional Unemployment cont’d
 Frictional unemployment would occur even if
the occupational industrial and regional
structure of unemployment were unchanging.
 Solution: Establish job information centres to

reduce the extent of frictional unemployment.

This has been done successfully in Japan and
other developed economies.

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0
Technological Unemployment
 This type of unemployment is caused by
changes in technology.
 As technology changes in an economy certain

skills experience a reduction in demand.

 Example is that of bank (manual) clerks when

the banking industry computerized.

 Solution: Retrain labour skills. Establish more

vocational training colleges and centres to

retrain manpower in skills that are in
demand.

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1
Regional Unemployment
 This type of unemployment occurs when certain
geographical and economic regions experience
industrial decline due to exhaustion of resources or
economic decline.
 Example are the mining towns such as Mhangura and
Kamativi in Zimbabwe which have higher levels of
unemployment because of the closure of the mines.
 Solution: People should be relocated to new industrial
regions, retrained in new skills.
 Alternatively, people in the affected areas maybe
given funding to start income generating projects
which are independent of the declining economic
activities.

40
2
Demand deficiency unemployment
 This type of unemployment is also called
cyclical unemployment and refers to
unemployment which occurs because
aggregate desired expenditure or Aggregate
Demand (AD) is insufficient to purchase all
the output of a fully employed labour-force.
 This type of unemployment is associated with

a recessionary or deflationary gap.

 It was indirectly covered under national

income determination.

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3
Demand deficiency unemployment cont’d

Solution: This type of unemployment is solved

through expansionary fiscal policy.
Expansionary fiscal policy increases
aggregate demand in the economy thereby
eliminating the deflationary gap associated
with demand deficiency unemployment.

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4
Real Wage Unemployment
 This type of unemployment is caused by a
wage rate that is pegged above the
equilibrium wage rate.
 The effect of this wage rate is to cause labour

quantity supplied to be greater than labour

quantity demanded.
 The excess labour supply is the full extent of

unemployment in the economy associated

with the disequilibrium wage rate.

40
5
Real Wage Unemployment
 Solution: Allow market forces to determine
the equilibrium wage rate.
 Eliminates the excess labour supply or

unemployment thereby restoring stability in

the economy.

40
6
Disguised Unemployment
 This type of unemployment is associated with
over employment of labour in sensitive
industries or sectors of the economy like the
civil service.
 Even if the extra workers are retrenched

productivity in the firms is not affected. At

times productivity of workers may actually
increase after retrenching the excess labour
units.

40
7
Disguised unemployment cont’d
 Solution: Eliminate this type of
unemployment by shedding off excess labour
units.
 Create employment for excess labour units in

other sectors of the economy like the Small to

Medium Enterprises (SMEs) sector of
economy.

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8
Structural Unemployment
 Caused by structural rigidities in the
economy.
 Zimbabwe is an agro-based economy, which

is vulnerable to the occurrence of droughts

and other adverse climatic conditions.
 Virtually all economies are prone to the

occurrence of business cycles. These

business cycles are associated with increased
unemployment during economic recessions
and/or depressions.

40
9
Structural Unemployment cont’d
 Solution: Diversify the economic base.
Different sectors of the economy can not all
be impacted by the occurrence of business
cycles or droughts to the same extent.
 Employ economic restructuring programmes

like what has been successfully done by

Ireland.

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0
SCHOOLS OF THOUGHT ON
INFLATION AND UNEMPLOYMENT
 We will examine two schools of thought i.e.
The Keynesians
This school of thought perceives inflation as a
demand side phenomenon occasioned by excessive
aggregate demand in the economy. It is a generally
held idea in Keynesian economics that when inflation
rates are increasing ,it is highly likely that demand
side factors explain the surge in inflation. Similarly
according to the Keynesians unemployment is a
demand side phenomenon caused by insufficiency
of aggregate demand. This unemployment is called
demand deficiency unemployment.
 In Keynesians economics the excessive
aggregate demand is associated with over
reliance on government initiated policies such as
tax reductions and government
expenditure(expansionary fiscal
policy),exacerbated by depressed production and
oligopolistic industries pushing up prices.

The monetarists
They look at the economy from both the demand
side and from the supply side. They believe
inflation is caused by too much money. Too
much in circulation causes inflation.
 Notice that the two schools of thought come
together in this way:
 The monetarist believe too much money
leads to excessive aggregate demand which
fuels inflation. Thus on excessive aggregate
demand the two schools converge but they
diverge on what causes the excess aggregate
demand. Remember in Keynesian economics
too much aggregate demand is caused by over
reliance on government initiated policies such
as tax reductions and government expenditure
increases. According to Monetarists events in
the money markets and financial markets may
generate inflation and or lead to
unemployment in the economy.
Activity
 In your groups discuss the Monetarist and

Keynesian views on inflation and

unemployment. You are expected to produce
a comprehensive presentation.
MONETARY AND FISCAL
POLICY
What is Monetary Policy?
It is the process by which the central bank
or monetary authority of a country
regulates

1. the supply of money

2. availability of money and
3. cost of money or rate of interest in
order to attain a set of objectives
oriented towards the growth and
stability of the economy.
GOALS OF MONETARY POLICY
1. Full employment
2. High levels of economic growth
3. Low inflation levels or price stability
4. BOPs balance or equilibrium
5. Exchange Rate stability
6. Eradicate inflationary and deflationary gap
 Objectives of Monetary

Policy
It is concerned with the changing the supply
of money stock and rate of interest for the
purpose of stabilizing the economy by
influencing the level of aggregate demand.

 At times of recession monetary policy

involves the adoption of some monetary tools
which tends to increase the money supply and
lower interest rate so as to stimulate aggregate
demand in the economy.

 At the time of inflation monetary policy

seeks to contract aggregate spending by
tightening the money supply or raising the rate
of return
 Objectives of Monetary
Policy
To ensure the economic
stability at full employment or
potential level of output.

 To achieve price stability

by controlling inflation and
deflation.

 To promote and
encourage economic growth in
Types of monetary policy
Contractionary / Tight monetary policy
“Tight monetary policy, also called
contractionary monetary policy, tends to
curb inflation by contracting/reducing the
money supply”.it is usually used when the
economy is expanding too rapidly or there
is an inflationary gap.
Expansionary /Easy monetary policy
“Easy monetary policy, also called
expansionary monetary policy, tends to
encourage growth by expanding the money
supply.It is usually used when there is a
recession or deflationary gap in an
How does expansionary monetary
policy work
 Lowers interest rates and makes it cheaper to borrow;
this encourages firms to invest and consumers to
spend.
 Lower interest rates reduce the cost of mortgage
interest repayments. This gives households greater
disposable incomes and encourages spending.
 Lower interest rates reduce the incentive to save .
 Lower interest rates reduce the value of the currency,
making exports cheaper thus increasing export demand
 A contractionary monetary policy would work in the
opposite direction/way that an expansionary policy
works.
Tools of monetary Policy
 The central bank has various tools at their
disposal for managing the level of aggregate
demand in the economy. Through increasing
or decreasing the money supply ,a central
bank has influence over the interest rates in a
nation ,and therefore over the level of
investment and consumption amongst firms
and households.
 Tools of Monetary Policy
Quantitative Tools
Open Market Operations
Bank Rate/Discount rate
Cash Reserve Requirement
Prescribed asset ratios /Liquidity asset ratios
Special deposit
Qualitative Tools

Credit rationing
Credit ceiling
Moral persuasion
Direct quantitative controls on lending
Bank rate /Discount rate
 When a bank experiences a shortage of
liquidity ,it can either change other assets
into cash or borrow to eliminate the shortage.
The funds required are obtained from other
institutions including other banks which
have excess funds. If all the banks have the
same liquidity problem the Reserve Bank ,as
banker’s bank, acts as the lender of last
resort. Banks can then obtain credit at what is
known as the discount window.
Bank rate …….cntd
 The reserve bank will offer overnight loans against
securities offered by the bank at the discount
window by banks. These loans are offered at a rate
called the bank rate or discount rate.
 The bank rate is therefore the interest rate at
which a nations Central Bank lends money to
domestic banks. Lower bank rates can expand the
economy, when unemployment is high, by lowering
the cost of funds to borrowers. Conversely higher
bank rates help to reign in the economy, when
inflation is higher than desired, by increasing the
cost of funds to borrowers.
Open Market Operations
(OMOs)
This consists of the sale or purchase of domestic financial
assets (mainly treasury bills and government
securities[government stock, land bank bills and municipal
stock.]) by the central bank in order to exert a specific
influence on the interest rates and the quantity of money/
money supply.
 To increase money supply Ms the central bank buys TBs or
shorten their tenor or duration or life span.If the securities
are purchased from a bank the central bank will pay for
them by means of a book entry. The bank will now have
excess reserves which may be used to create demand
deposits. When the central bank buys securities ,it tends
to pay higher prices to induce market participants to part
with their securities. The prices of securities will therefore
tend to rise and the interest rates will drop.

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6
Open Market Operations
 To reduce Money supply the central bank would sell TBs at
attractive rates (or increase their tenor, duration or
lifespan).The central bank sells government securities on
the open market ,reducing the cash reserves of the banks
(directly or indirectly) which in turn leads to the reduction of
the money supply. In essence the banks excess funds will be
wiped off meaning that their ability to create demand
deposits is stifled. When the central bank sells securities it
tends to offer a lower price to encourage take up. The prices
of securities will fall whilst the interest rate goes up.
 Money supply may be increased or decreased to affect
aggregate expenditure or aggregate demand in the economy.
 Note that an increase in the bank rate should be
accompanied by the sale of securities by the central bank and
a consequent decrease in the money supply. On the other
hand a decrease in the bank rate should be supported by the
purchase of securities by the central bank and an increase in
the money supply.
The Reserves Requirement Ratio (RRR)
 This is the percentage of a bank’s total deposits from
households that must be kept on reserve at the Central bank.
For example if a commercial bank has $1 billion deposits and
RRR is 0.2,this means that 20% of $1bn has to be kept in
reserve at the Central Bank.
 To increase money supply ,the Central bank decreases the
RRR. This frees up reserves and brings back funds to the
banking system. This means that commercial banks can lend
out a greater proportion of their total reserves which leads to
an increase in the money supply and a decrease in the
interest rate.
 This would be considered an expansionary monetary policy. A
lower RRR means that there is more money available to be
lent out by commercial banks. An increase in the supply of
money brings down the cost of borrowing ,making more
money available to lend to households ,firms and other
borrowers to help pay for consumption and investment. 42
8
The Reserves Requirement Ratio
(RRR)
To reduce money supply the Central Bank


increases the RRR.This means that commercial

banks have to send more of their total reserves
to the Central bank. This takes money out of
circulation. There will be less liquid money in
the economy causing the money supply to
decrease. The increase in the scarcity of money
in the banking system causes the interest rate
to rise. Commercial banks will now charge a
higher interest rate to borrowers ,therefore,
there will be less money available for loans to
households reducing the level of consumption
and investment in the economy.
Prescribed Asset Ratios
 This refers to requirements of liquid asset
reserves over and above the RRR.
 These are imposed by the central bank in

order to control liquidity in the money

markets.
 The policy instrument is also used to control

inflation which is driven by excess money

supply linked to money market trading
activities.

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0
Direct quantitative controls on
lending
In the past, especially during the 1980s and
also in the 2000s (2003-2008) during the
quasi-fiscal period the govt through the
central bank directed lending to strategic or
key sectors of the economy.
 These sectors of the economy included

mining, agriculture and tourism.

 This was meant to boost employment and

hence enhance economic growth.

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1
Moral Suasion
 The central bank governor meets the senior
managers of banks or bank executives to discuss
pertinent issues affecting the monetary sector.
 The central bank by means of consultation and
persuasion ,influences the banks in a certain
direction to increase or decrease money supply
especially if it does not wish to use other policy
instruments.
 The resolutions made in those meetings are not
legally binding but are generally adhered to by
banks for the good operation of the banking
system.

43
2
Credit ceiling and deposit
control
 Credit ceiling _ Banks are informed by means of
proclamation that their outstanding loans should
not exceed a certain limit at a specified date.
 Deposit control_ Financial institutions are
instructed as to the rates they may pay or may
require clients to pay on deposits.
 However these two have been abolished in some
countries as they inhibit the working of the market
mechanism.
 Note that the most commonly used tools of
monetary policy are OMOs ,RRR and the discount
rate.
FISCAL POLICY
 The use of government spending and taxation to
promote the economy’.
 According to Samuelson fiscal policy is concerned
with all those activities which are adopted by the
government to collect revenues and make the
expenditures so that economic stability can be
attained without inflation and deflation.
 The policy of the government regarding the level of
government spending and transfers and the tax
structure.
 Fiscal policy is the use of government revenue
collection (taxation) and expenditure (spending) to
influence the economy
 Manipulation of public spending ,taxation and
borrowing to achieve macroeconomic objectives.
Objectives:
 Economic stabilization
 Economic growth
 Employment generation
 Reduction in inequalities of income and wealth
 Increase in capital formation
 Price stability and control of inflation
 Effective mobilization of resources
 Balanced regional development
 Increase in national income
 Development of infrastructure
 Foreign exchange earnings
Types of Fiscal policy
1)Neutral fiscal policy : It is usually undertaken when an
economy is in equilibrium. Government spending is fully
funded by tax revenue and overall the budget outcome has a
neutral effect on the level of economic activity.
2) Expansionary fiscal policy: It involves government
spending exceeding tax revenue, and is usually
undertaken during recessions.
3)Contractionary fiscal policy: It occurs when
government spending is lower than tax revenue, and is
usually undertaken to pay down government debt.
Government Expenditure
 Includes both Central and Local Government
Spending
 Three Main Areas

◦ Capital Expenditure
 Schools, Hospitals, Roads etc.
◦ Current Expenditure
 Day to Day running of public services e.g. Pay teachers
◦ Transfer Payments
 Money transferred from tax payers to benefit claimants
or pensioners etc.
Expansionary Fiscal policy

 Expansionary fiscal policy means that the government is increasing government spending and reducing
taxation in an attempt to increase the money available in the economy.
 Governments will run a large budget deficit and spend on capital projects to boost AD and
general economic activity .

G>T

T G

Contractionary Fiscal policy

 Contractionary fiscal policy is when the government increases taxation and reduces government spending in
an attempt to reduce money in the economy and as a result inflation.

G<T

T G
LETS GO PRACTICAL…….
 Remember …
 The goals of fiscal policy are to ensure
 Full employment
 Stable prices
 Economic Growth etc etc
A nation experiencing full employment
Long run macroeconomic
equilibrium requires that the
real GDP be equal to
potential GDP and
corresponds to a situation of
full employment. That is,
long run macroeconomic
equilibrium entails the
economy being on its
vertical long run supply
curve. This contrasts with
the short run equilibrium
situation in which real GDP
may be less than or greater
than or equal to potential
GDP.
This economy is
experiencing equilibrium
level of output. They are
achieving full employment
and price stability . At full
 What would happen to the economy above if
one of the determinants of aggregate
demand such as Consumption or Investment
falls ?
 Obviously there will be a decrease in the

level of Aggregate demand in the economy.

 Let us examine what happens closely.
 The economy experiences a
deflationary /recessionary gap
Price
Level
LRAS A fall in consumption and
investment will shift
Aggregate demand curve to
SRAS the left from AD0 to AD1.The
Pe economy experiences a
demand deficient recession
P1 shown by the difference
between Y1 and YFe .There will
ADO also be price level instability in
AD1 the form of deflation as
YFe Real average prices will fall from Pe
Y1
GDP to P1. Thus a deflationary gap
Deflationary occurs where
gap AD < AS .
 A decrease in consumption and investment
has several negative consequences;
 A decrease in the price level (deflationary)
 A decrease in national output (Recession)
 An increase in unemployment.

All the above scenarios are negative, so the

government may try to intervene so as to
stimulate the amount of economic activity and
return the economy to full employment. Thus
the goal of fiscal policy would be to shift AD
back out to the point where it intersects AS at
the full employment level. What policies could
the government use?
Dealing with the deflationary gap
using fiscal policy
 What is needed is an expansionary fiscal
policy. This includes decreasing taxes and
increasing government spending. But the
question is;
How would each of these affect Aggregate
Demand and return the economy to full
employment???
What kind of taxes are decreased???
Expansionary fiscal policy at
work
1. Decrease Income taxes of Households
Gvt decrease income tax on households. This means
more income for consumption (C). C is a component
of AD thus this has the effect of increasing
Aggregate demand and helps move the economy to
full employment. Prices increase ,national output
increases and unemployment level decrease. An
increase in aggregate demand leads to demand pull
inflation returning prices to full employment level.
N.B :Government can also decrease corporate taxes,
give firms tax exemptions or rebates ,reduce indirect
taxes (VAT ,excise duties on alcohol,fuel,cigarretes
etc)
Direct injection of Government spending
Government increases the amount of taxpayers
money that it spends on infrastructure, public
works,defense ,healthcare. An increase in G will
shift aggregate demand outwards which has the
effect of reversing the deflation ,increasing the
price level thus stabilising prices, increasing the
output level from Y1 to YFe therefore
increasing unemployment.
When then is contractionary fiscal
policy used
 Contractionery fiscal policy involves increasing taxes and decreasing
government spending.
 Why would the gvt use this policy??They use it to eliminate an
inflationary gap in the economy.
 Assume something in the economy happens that causes AD to
increase causing severe demand pull inflation. For example ,a
depreciation of a nations currency or fall in the exchange rate will lead
to an increase in exports and a fall in imports. Thus net exports will
increase. This causes AD to increase shown by the AD curve shifting
to the right. This causes demand pull inflation shown by a rise in the
price level and a decrease in unemployment and in the short run the
level of national output/income will increase beyond the full
employment level. The decrease in unemployment may sound like a
good thing ,but when an economy is already producing at the full
employment level it has a healthy and desirable level of
unemployment in the economy. Anything lower than the natural level
of unemployment tends to be highly inflationary.
Inflationary Gap
An increase in net exports causes AD
to
Shift outwards from AD1 to AD2 .It
would cause a relatively small
increase in the level of output and
unemployment in the economy from
Yf to Y1 but a relatively large increase
in the price level because resources
are now scarce. There tends to be
high demand pull inflation due to
limited supply. A high inflation rate
erodes peoples incomes and reduces
standards of living overtime. Since
wages are not rising ,but prices are
rising Households will become poor
in real terms. For this reason the gvt
may find it desirable to reduce the
level of AD in the economy. They will
then use contractionery fiscal policy.
Contractionery fiscal policy at
work
Increasing Income tax of Households
An increase in taxes on households will lead to a
decrease in disposable income. As disposable income
falls households will start to consume at a lower level.
Consumption is a component of AD, so a fall in C will
cause AD to decrease and shift back to the left returning
the economy back to the full employment level. A fall in
AD brings inflation down reducing the price level,
causing a rise in the level of unemployment. This would
be considered bad but since this economy was operating
unnaturally low levels of unemployment. An increase in
unemployment is beneficial for the economy.
Reducing Gvt spending
 Gvt can cut back on its expenditures and
public works projects,defense or anything
they spend money on. A decrease in Gvt
spending reduces aggregate demand falls –
reduces price level and national output
output and raising the level of unemployment
back to the natural level
ACTIVITY
 In your groups discuss how the gvt would
then use monetary policy and fiscal policy to
deal with an ;
a) Inflationary gap
b) Deflationary gap
Brief overview of the major schools of
thought on Monetary and Fiscal policy
 Classical and Keynesian views of fiscal policy.
 The belief that expansionary and contractionary
fiscal policies can be used to influence
macroeconomic performance is most closely
associated with Keynes and his followers. The
classical view of expansionary or contractionary
fiscal policies is that such policies are unnecessary
because there are market mechanisms—for
example, the flexible adjustment of prices and
wages—which serve to keep the economy at or
near the natural level of real GDP at all times.
Accordingly, classical economists believe that the
government should run a balanced budget each
and every year.
 Keynes and his followers believed that the way to combat
the prevailing recessionary climate was not to wait for
prices and wages to adjust but to engage in expansionary
fiscal policy instead. Keynesians argue that expansionary
fiscal policy(cutting taxes and increasing government
expenditure) provides a quick way out of a recession and
is to be preferred to waiting for wages and prices to adjust,
which can take a long time. As Keynes once said, “In the
long run, we are all dead.” Keynesians, argue that wages
are sticky downward and will not adjust quickly enough to
reflect the reality of unemployed resources.

 Consequently, the recessionary climate may persist for a

long time. The way out of this difficulty, according to the
Keynesians, is to run a budget deficit by increasing
government expenditures in excess of current tax receipts.
The increase in government expenditures should be
sufficient to cause the aggregate demand to increase ,
restoring the economy to the natural level of real GDP.
 Keynesians also argue that fiscal policy can
be used to combat expected increases in the
rate of inflation. Where an economy has
already attained full employment of resources
but aggregate demand is increasing they
believe a contractionary fiscal policy should
be used.This includes increasing taxes and
reducing gorvenment expenditure.This will
have the desired effect of reducing aggregate
demand back to the full employment level.
 Secondary effects of fiscal policy.
Classical economists point out that the
Keynesian view of the effectiveness of fiscal
policy tends to ignore the secondary
effects that fiscal policy can have on credit
market conditions. When the government
pursues an expansionary fiscal policy, it
finances its deficit spending by borrowing
funds from the nation's credit market.
Assuming that the money supply remains
constant, the government's borrowing of funds
in the credit market tends to reduce the amount
of funds available and thereby drives up
interest rates
 Higher interest rates, in turn, tend to reduce
or “crowd out” aggregate investment
expenditures and consumer expenditures
that are sensitive to interest rates. Hence, the
effectiveness of expansionary fiscal policy in
stimulating aggregate demand will be
mitigated to some degree by this crowding‐
out effect.
 The same holds true for contractionary fiscal
policies designed to combat expected inflation. If
the government reduces its expenditures and
thereby reduces its borrowing, the supply of
available funds in the credit market increases,
causing the interest rate to fall. Aggregate
demand increases as the private sector increases
its investment and interest‐sensitive consumption
expenditures. Hence, contractionary fiscal policy
leads to a crowding‐in effect on the part of the
private sector. This crowding‐in effect mitigates
the effectiveness of the contractionary fiscal
policy in counteracting rising aggregate demand
and inflationary pressures.

Classical view of monetary
policy.
The classical economists' view of monetary
policy is based on the quantity theory of
money. According to this theory, an increase
(decrease) in the quantity of money leads to a
proportional increase (decrease) in the price
level. The quantity theory of money is usually
discussed in terms of the equation of exchange,
which is given by the expression
MV =PY
 In this expression, P denotes the price level,
and Y denotes the level of current real GDP.
Hence, PY represents current nominal
GDP; M denotes the supply of money over which the
Fed has some control; and V denotes the velocity of
circulation, which is the average number of times a
dollar is spent on final goods and services over the
course of a year. The equation of exchange is
an identity which states that the current market
value of all final goods and services—nominal GDP
—must equal the supply of money multiplied by the
average number of times a dollar is used in
transactions in a given year. The quantity theory of
money requires two assumptions, which transform
the equation of exchange from an identity to a
theory of money and monetary policy.
 Recall that the classical economists believe that the
economy is always at or near the natural level of
real GDP. Accordingly, classical economists assume
that Y in the equation of exchange is fixed, at least
in the short‐run. Furthermore, classical economists
argue that the velocity of circulation of money tends
to remain constant so that V can also be regarded
as fixed. Assuming that both Y and V are fixed, it
follows that if the Fed were to engage in
expansionary (or contractionary) monetary policy,
leading to an increase (or decrease) in M, the only
effect would be to increase (or decrease) the price
level, P, in direct proportion to the change in M. In
other words, expansionary monetary policy can only
lead to inflation, and contractionary monetary policy
can only lead to deflation of the price level.
Keynesian view of monetary policy.
 Keynesians do not believe in the direct link
between the supply of money and the price
level that emerges from the classical quantity
theory of money. They reject the notion that
the economy is always at or near the natural
level of real GDP so that Y in the equation of
exchange can be regarded as fixed. They also
reject the proposition that the velocity of
circulation of money is constant .
 Keynesians do believe in an indirect link
between the money supply and real GDP.
They believe that expansionary monetary
policy increases the supply of loanable funds
available through the banking system,
causing interest rates to fall. With lower
interest rates, aggregate expenditures on
investment and interest‐sensitive
consumption goods usually increase, causing
real GDP to rise. Hence, monetary policy can
affect real GDP indirectly.
 Keynesians, however, remain skeptical about the
effectiveness of monetary policy. They point out that
expansionary monetary policies that increase the
reserves of the banking system need not lead to a
multiple expansion of the money supply because banks
can simply refuse to lend out their excess reserves.
Furthermore, the lower interest rates that result from
an expansionary monetary policy need not induce an
increase in aggregate investment and consumption
expenditures because firms' and households' demands
for investment and consumption goods may not be
sensitive to the lower interest rates. For these reasons,
Keynesians tend to place less emphasis on the
effectiveness of monetary policy and more emphasis on
the effectiveness of fiscal policy, which they regard as
having a more direct effect on real GDP.
Monetarist view of monetary policy.
Since the 1950s, a new view of monetary policy,
called monetarism, has emerged that disputes the
Keynesian view that monetary policy is relatively
ineffective. Adherents of monetarism, called
monetarists, argue that the demand for money is
stable and is not very sensitive to changes in the
rate of interest. Hence, expansionary monetary
policies only serve to create a surplus of money
that households will quickly spend, thereby
increasing aggregate demand. Unlike classical
economists, monetarists acknowledge that the
economy may not always be operating at the full
employment level of real GDP
 Thus, in the short‐run, monetarists argue that
expansionary monetary policies may increase
the level of real GDP by increasing aggregate
demand. However, in the long‐run, when the
economy is operating at the full employment
level, monetarists argue that the classical
quantity theory remains a good
approximation of the link between the supply
of money, the price level, and the real GDP—
that is, in the long‐run, expansionary
monetary policies only lead to inflation and
do not affect the level of real GDP.
 Monetarists are particularly concerned with
the potential for abuse of monetary policy
and destabilization of the price level. They
often cite the contractionary monetary
policies of the Fed during the Great
Depression, policies that they blame for the
tremendous deflation of that period.
Monetarists believe that persistent
inflations (or deflations) are purely monetary
phenomena brought about by persistent
expansionary (or contractionary) monetary
policies.
 As a means of combating persistent periods
of inflation or deflation, monetarists argue in
favour of a fixed money supply rule. They
believe that the Fed should conduct monetary
policy so as to keep the growth rate of the
money supply fixed at a rate that is equal to
the real growth rate of the economy over
time. Thus, monetarists believe that monetary
policy should serve to accommodate
increases in real GDP without causing either
inflation or deflation.
ECONOMIC DEVELOPMENT
STRATEGIES
CBA 1205
LECTURE NOTES

46
8
Economic Development Strategies
1. Import substitution industrialization
2. Export Led/Oriented Industrialization
3. Technology driven industrialization/Mixed
strategies

46
9
Import Substitution Industrialization
(ISI)
 Looking inward as a source of growth
 Import substitution is an approach

which substitutes externally produced goods

and services, especially basic necessities such
as energy, food, and water, with locally
produced ones, by producing goods
domestically rather than importing.
 This enables money to flow within the local

circular flow of income, without being

withdrawn to foreign economies.

47
0
Import Substitution
Industrialization (ISI) cont’d
 In the long-term, the rationale is that the increased
demand for domestic goods will move domestic
industries along a learning curve so that they can
ultimately compete in equal ground with foreign firms.

 Necessary Conditions of ISI:

1. Existing protective barriers
2. Devalued currencies ( ↑Exports, ↓Imports)
3. Subsidies available to domestic producers
4. Government policy in selection of which goods to
produce domestically

47
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Import Substitution Industrialization
(ISI) cont’d
 Two Basic Strategies of Import-substitution:
 implementing barriers to imports (e.g. tariffs)

and/or
 perhaps encouraging domestic producers

with subsidies (if government funds are

available).

47
2
Import Substitution
Industrialization (ISI)
 The use of a tariff to reduce imports so as to

promote domestic industries.

47
3
Import Substitution
Industrialization (ISI) cont’d
 Domestic output is initially at Q0 and imports
are Q0→Q1.
 A tariff of S world + tariff0 would lower

imports to Q2→Q3 and a higher tariff would

lower imports even further to Q4→Q5.
 Domestic production increases accordingly to

Q2 or Q4.

47
4
Import Substitution
Industrialization (ISI) cont’d
 The use of a tariff plus a govt subsidy to
domestic producers to encourage domestic
industrialization.

 Tariffs and Subsidies

Tariff protection can also be mixed with a

degree of domestic subsidies (shown in the
diagram on the next slide).

47
5
Import Substitution Industrialization
(ISI) cont’d

47
6
Import Substitution
Industrialization (ISI) cont’d
 A tariff together with a subsidy increases
domestic output from Q0 to Q4.
 Note that the quantity of imports as a result

is equivalent to those at the highest tariff

levels in the previous diagram, but the
increase in domestic production is higher and
the market price lower due to the effect of
the subsidy.
 Domestic production increases to Q5 rather

than Q4 (as shown in the diagram above

where tariff levels are where Sworld + tarrif1).

47
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Export-Oriented Industrialization
(EOI)
 ‘Export-Oriented Industrialization (EOI)’ is a
trade and economic policy aiming to speed-
up the industrialization process of a country
through exporting goods for which the nation
has a comparative advantage.
 Export-led growth implies opening domestic

markets to foreign competition in exchange

for market access in other countries.

47
8
Export Oriented Industrialization
(EOI) cont’d
 Example of countries used this strategy are
Japan, South Korea, Taiwan and Singapore
in the post World War II period.
 Export led growth strategy refers to

Government efforts to increase exports on

the assumption that they can improve not
only foreign exchange earnings but also
increase productivity and growth.
 Many third world Countries have

comparative advantages over the developed

Countries in the production of some goods
and services. 47
9
Export Oriented Industries (EOI) cont’d

 Thus, the strategy involves the expansion of

these sectors and concentrating on the
export of these goods and services to
developed Countries.
 The rationale behind this is to use the export

earnings to finance the process of

development.

48
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Export Oriented Industrialization (EOI) cont’d

 Thus, the strategy involves the expansion

of these sectors and concentrating on the
export of these goods and services to
developed Countries.
 The rationale behind this is to use the

export earnings to finance the process of

development.
 The export led growth strategy is outward

oriented as it links domestic economies

with the world.

48
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Export Oriented Industrialization
(EOI) cont’d
 Instead of trailing growth by protecting domestic
industries lacking comparative advantage, the
strategy involves promoting growth through the
export of manufactures goods.
 In the post war (WWII) period, export promotion in
Europe and Japan sought to overcome the severe
foreign exchange constraints associated with
reconstruction.
 Japan pioneered a new model of trade policy that
combined relatively restrictive policies towards
imports and inward foreign investment with
aggressive promotion of export industries.

48
2
Technology driven Strategies
 These are industrialization programs which
involve the signing of technology based trade
protocols between countries and multilateral
instituitions to facilitate the transfer of
technology from developed countries or
economies to developing
economies.Technolgy driven strategies are
based on the perspective that the bridging of
the technological gap reduces
underdevelopment and augurs well for a fast
growing economy.
48
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Technology Strategies
 Periods during which output per capita
doubled:
 United Kingdom 1780-1838
 United States 1839-1886
 Japan 1885-1919
 Turkey 1957-1977
 Brazil 1961-1979
 Rep. Of Korea 1966-1977
 China 1977-1987

48
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Technology Strategies cont’d
 A Technology driven taxonomy of products
 Primary products

• Manufactured products – Resource based:

e.g. food, wood & forestry products, processed
minerals, petroleum products – Low technology:
e.g. textiles, clothing, footwear, toys, sports
goods, simple metal products
 Medium technology: e.g. automotive products,

TVs, machinery, chemicals, steel

 High technology: Advanced ICT and electrical,

pharmaceuticals, aerospace, precision

instruments
48
5
Technology Strategies cont’d
 Global exports are increasingly driven by
innovation
 Only 13 countries account for 90% of

developing world’s total manufactured

exports:
◦ Taiwan, Mexico, Hong Kong, China, South Korea,
Singapore, Malaysia, Indonesia, Thailand,
Philippines, India, Brazil, South Africa.

48
6
Technology Strategies cont’d
 Back to the 1970s - Technological change and
industrialization
 Embodied (and imported) technological
change – Linked to fixed capital investment
(which was considered as the driving force of
development)
 Then, emphasis shifted on investment
decisions, relative prices and appropriate
technologies – An interesting debate had
emerged on the short-term cost of
technological transactions
48
7
Technology Strategies cont’d
 Back to the 1970s – Endogenous
Technological in Developing Countries
• Differences in the efficiency of process
industry plants with similar technologies.
• Diverging industrialization trajectories
among different economies.
• Insights from evolutionary thinking on
knowledge accumulation [learning].
Knowledge accumulation became
revolutionary.

48
8
Technology Strategies cont’d
 Different Types of ‘Innovation’/Technical
Change 1. Continuous incremental,
engineering-based improvement: process
technology, methods of organising
production, diversification and upgrading in
product specifications and designs, etc.
 2. Continuous improvement in technologies
linking stages in value chains: hardware (e.g.
transport and computer-based system s) and
organisation/management.

48
9
Technology Strategies cont’d
3. Technology search (and research and
training) for acquiring and absorbing
technology
4. Acquisition of technology: machinery and
equipment, and in the designs and
specifications of materials, products and
components

49
0
Technology Strategies cont’d
5. Design, (reverse) engineering and project
management: for new production facilities, to
diversify/upgrade products, or to source
components, materials and equipment from
local suppliers
6. Research and development, plus design and
engineering: to introduce technologies that
cannot be acquired (competitively) from
foreign sources, and for introducing new
products and processes that perm it
competitive entry to domestic or foreign
markets independently of foreign technology
sources. 49
1