MACROECONOMICS NOTES (EC103)

Department of Economics
Great Zimbabwe University

COMPILED BY MR S. MATSVAI

LEVEL: SECOND SEMESTER

January to Nov 2017

REFERENCES
Gregory Mankiwi 3rd Edition

Dornbusch R. and Fischer S. “Macroeconomics” 6th edition, Lexicon publishers, Johannesburg

Gwartney J. et al (2001), “Macroeconomics: Public and Private Choice” 3rd edition. Academic
press

1. INTRODUCTION

- Microeconomics is the study of how households and firms make decisions and how these
decision makers interact in the broader marketplace. In microeconomics, an individual chooses
to maximize his or her utility subject to his or her budget constraint.
- Macroeconomic events arise from the interaction of many individuals trying to maximize their
own welfare. Because aggregate variables are the sum of the variables describing individuals’
decisions, the study of macroeconomics is based on microeconomic foundations.

What is Macroeconomics?
- The study of aggregate economic variables in an economy e.g. national income, employment,
money supply, interest rates, exchange rates, prices, etc
- Study of the entire economy in terms of the total amount of goods and services produced, the
total income earned, the level of employment of productive resources, and the general
behaviour of prices.
- The study of how the economic aggregates grow and fluctuate, and the effects of government
actions on them.
- Macroeconomics involves the use of statistical tools to analyze the interrelations among sectors
within the economy and how best to influence policy goals such as economic growth, price
stability, full employment and the attainment of a sustainable balance of payments.

How to aggregate
- Use index numbers to represent macroeconomic variables, e.g. unemployment rate,, trade-
weighted exchange rate, consumer price index.
- Index numbers are statistical measures that are used to give summary answers to changes in
\macroeconomic variables. They measure the change that has occurred in some broad average
over some particular time period.
- Index numbers are calculated by assigning weights (weights are chosen to reflect the
importance of each price of output) to commodity prices and relate them to some chosen base
period. The value of the index is set equal to 100 in the base period.

- e.g. Prices and Inflation

- In microeconomics, we are more interested in the prices of individual goods and services;
however, in macroeconomics we are interested in how the price level changes over time.
- Price level refers to an index number computed from the prices of a broad group of goods and
services; i.e.it is a weighted average of different prices. The common index number of prices is
the Consumer Price Index (CPI).
- The price level is calculated from a defined basket of goods and services.
- We are rarely interested in the value of the price level per se, but in its percentage change over
two given periods.
- The rate of inflation, therefore, is the percentage rate of increase in CPI from one period to
another.

Macroeconomics objectives

- These objectives measures how well an economy is performing.

1. Economic growth – is measured by changes in GDP. GDP is defined as the total value
of final goods and services produced in the geographical boundary of an economy within
a given period of time. Economic growth is experienced when GDP increases year after
year.

2. Price stability – the rate of inflation should not only be low, preferably digit, but also
stable.

3. Full employment – the unemployment rate is a measure of the total number of

unemployed person as a proportion of the labour force. When unemployment levels
fluctuates, so does output, since output is produced using labour inputs. The extent to
which employment falls short of the full employment level explains the output gap.
 Output gap is the difference between potential output and the actual output. Economic
performance is measured in terms of the general trend of output and in terms of whether
the output gap is decreasing or increasing. A. Okun, a leading analyst of the output gap,
studied the relationship between unemployment and output, i.e. real growth and
unemployment rate. Okun’s law says that the unemployment rate declines when growth
is above the trend rate of 2.25%. Specifically, 1% growth in real GDP above the trend
rate, unemployment declines by one-half percentage point. This relationship has been
found to be applicable to several countries tough with a different factor of proportionality
between unemployment and output. Full employment occurs when all the resources in an
economy are being fully utilised efficiently and effectively. An economy is said to be
experiencing full employment when it is operating on the frontier of the production
possibility curve.

4. External balance (BOP)- BOP is a record of a country’s transactions with the rest of the
world. BOP surplus occurs when foreign currency receipts are greater than outflows,
whilst the reverse is a deficit. NB, neither a surplus nor deficit is health for the economy.

5. Equitable distribution of income – an economy should have an equitable distribution of

income so as to maximise social welfare. Social welfare, according to Pareto efficiency,
is maximised when someone cannot be better-off without making someone worse-off.

AGGREGATE DEMAND AND SUPPLY

 Aggregate demand (AD) is the total amount of goods and services in the economy that
economic agents are willing to supply at a given price level. The AD can be shifted by
monetary and fiscal policies.
 Aggregate supply (AS) is the total amount of output that firms and households choose to
provide given the pattern of wages and prices in the economy. The supply function is
given by:

S x=f ( P x , P f , K ,T ) , that is AS is influenced by price of output, price of factors of

production, capital and technology.

 Households make decisions on how much labour to supply, whilst firms decides on how
much output to supply basing on both current and expected future prices.
 Shifts in either AS or AD will cause the level of output to change – thus affecting
economic growth - and will also change the price level (inflation). Through Okun’s law,
changes in output are linked to changes in the unemployment rate.

Economic Equilibrium Classical case Keynesian Case

P
 AS AS
AS
2. NATIONAL INCOME ACCOUNTING (NIC)
AD1
- The four key macroeconomic variables inAD any1 economy are economic growth,
unemployment, inflation and Current Account balance. There are obviously other issues
of concern that augment these ones. AD0
- National income AD 0
AD accounting is the set of rules and techniques for measuring the total
flow of output produced and the total flow of incomes generated in an economy.
- The NIC give Q regular estimates of GDP, the basic measure of the economy’s
performance. They also provides useful conceptualQ Q
framework for describing
relationships among three key macroeconomic variables: output, income and spending.
- National income accounts are used in a country for the purposes of planning, decision-
making and forecasting. Income is derived from the output and when received it is spent.
The most popular identity in this area is depicted by National Income=National
Output=National Expenditure, (i.e. NI=NQ=NE). This implies that there are three
definitions of national income.

1. It is the income that is earned by all economic agents during a specific period, usually a
year.
2. It is the value of output produced by all economic agents during a given period, usually a
year.
3. It is the value of the expenditure incurred by all economic agents during a given period,
usually a year.

Ray Powel (1988) notes that all the identities used in NI accounting are ex post as they
measure what has actually happened in the economy as opposed to the wishes or intentions of
the citizens.

TERMS ASSOCIATED WITH NATIONAL INCOME

1) Gross Domestic Product [GDP]

- It is the total internal output. It also represents the value of the final output produced by
all enterprises within the boundaries of a nation irrespective of the owners of the means
of production. GDP consists of value of currently produced output. That is, it excludes
transactions in existing commodities, such as existing houses. In Zimbabwe, there are
 Chinese firms, Nigerian firms, Zimbabwean firms etc and all their output will be the
national GDP.
- Chidhakwa (2000) says it is the money measure of the overall annual flow of goods and
services in an economy.
- GDP values goods at market prices, not at factor prices.

2) Gross National Product [GNP]

- It is the total national output. GNP is the value of final goods and services produced by
domestically owned factors of production within a given period of time. The income is
accumulated from Zimbabweans abroad and Zimbabweans in Zimbabwe. It is the output
produced by the people of a nation irrespective of where they are doing their business. In
Zimbabwe there are Zimbabweans who run businesses and there are also Zimbabweans
with businesses abroad and the total represents GNP. In other words, it is the total output
from factors of production owned by residents of a country.

3) Statistical Discrepancy

- In calculating national income, there may be material misstatements, omissions, errors,

and fraudulent misrepresentations, to an extent that national output totals will never be
accurate or equal to expenditure or income.

4) Nominal GDP VS Real GDP

- Nominal GDP is GDP at current prices while real GDP is GDP at constant prices or
prices adjusted to a chosen base year.

5) Per Capita Income

- This is total national income divided by total population. The idea is to try and find out
the average income distribution amongst the citizens of an economy, not necessarily
sharing the income. The ratio is a good measure of general economic performance,
though non-deterministic on its distribution.

IMPORTANCE OF NATIONAL ACCOUNTS

 It enables economists and policy makers to:

1. Assess the health of the economy by comparing levels of production at regular intervals
2. Track the long run course of the economy to see whether it has grown, has been constant,
or declined
3. Formulate policies that will safeguard and improve the economy’s health
4. Also important to politician for political mileage
5. Private business- on relation to inflation, investment

PROBLEMS ASSOCIATED WITH CALCULATING NI

i. Some firms supply wrong figures to reduce the amount of tax they are due to pay.
ii. Some goods may be produced, but not taken to the market, thus the value is not known.

iii. Illegal services such as prostitution, thefts etc, are not recorded yet substantial amounts will
be involved e.g. Zimbabweans may steal cars worth Z$10 trillion from abroad into
Zimbabwe.

iv. The black market or underground economy is also excluded. Although estimates are made,
they are usually misleading.

v. Double counting which inflates the figures of the value of output. This is when value of
intermediate goods is counted, e.g. bread contains the value of wheat and flour and to add
the value of wheat to that of flour and then that of bread involves double counting. This
problem can be avoided by taking only values of final goods.

vi. Output produced for personal consumption is not recorded as it is not taken to the market
and is difficult to quantify or value.

METHODS OF CALCULATING NI

Since output=income=expenditure, there are therefore three methods of calculating NI, i.e. the
output, income and expenditure methods.

(a) THE OUTPUT METHOD

This represents the total value of output produced by all economic agents in an economy
during a specific period of time, usually a year. The major problem associated with this
method is that of double counting i.e. when the value of a product is counted twice. This
occurs due to the presence of immediate goods, i.e. those goods, although finished, need to
be processed to produce final goods e.g. flour is an intermediate good for production of
bread. The value of flour is counted twice, firstly as flour and secondly in bread.

Simple example: sales of wheat = $ 50m

flour = $ 80m
bread = $ 120m
Total = $250m X
This is incorrect because the value of bread include value of wheat that has been used to make
bread.

- To correct this we measure the VALUE ADDED by each sector and add up the value
added to come up with the GDP figure.
- To avoid double counting we take care to include only final goods in GDP and to exclude
intermediate goods that are used up in making final goods.
- Value added = value of sales minus cost of intermediate inputs
- Intermediate inputs are inputs bought from other producers e.g. wheat not labour
Correction of the double counting method – Value addition method

Purchases ($m) Sales ($m) Value

added
wheat O 50 50
Flour 50 80 30
Bread 80 120 40
Total $120m

 In simple terms we can add up the output of all the sectors (industry) of in the economy
e.g. agriculture, mining, manufacturing, construction etc
 Simple example: Zimbabwe’s GDP 2005 ( output method)

Industry $m % contribution to GDP

agriculture 15 283 ?

Mining 3846

Manufacturing 14668

construction 1943

Finance 6370

Public administration 3324

Education 3602

Health 4200

other 2795

Electricity and water 2409

Transport &communication 4200

Distribution , hotels 15630

Real Estate 1526

Other services 2795

GDP at Factor cost 76 660

Net taxes on production 834

GDP at market prices 85 585

Further, GNP and GDP at market prices suffer the distortions caused by subsidies and taxes.
Hence, to change these variables (GNP sand GDP) to factor prices, we simply subtract the taxes
and add the subsidies. This is because when the prices where being charged at the market,
subsidies were subtracted and tax added.

(b) THE INCOME METHOD

 Add up all incomes earned by factors of production in an economy over a given period
  Production of a nation output generates income. Labour must be employed, land must be
rented, and capital must be used
 These include factor payment:-
1. Wages- payment for services for labour
2. Rent- incomes received by household and business that supply property resources. Also
to be included is imputed rent for the use of owner occupied housing
3. Proprietor's income- people earning a living but who are not employed by any one
organization e.g. consultants
4. Corporate profits- earnings of owners of corporation. Divided into three corporate
income taxes, dividends and retained earnings
N.B: GDP at factor cost- this is the sum of four components of factor income- wages, self
employment income, rent and profits.

Transfer incomes should be ignored. This is an income that is received from the government
but a person would not have provided any corresponding output, e.g. students’ grants,
unemployment benefit etc. Incomes from self provided activities should be included. The
same applies to income from black market activities. In reality however, there are serious
problems in estimating the level of ‘hidden economy’, and the poorer the economy the
greater the size of this sector and the more disastrous it is to ignore it.

Example of Income Approach:

Factor payments $m % contribution to GDP

Wages 30489

Rent 1432

Gross operating surplus 45545

Less imputed banking charges -1223

GDP at Factor cost 76242

Net other taxes on production 417

Net taxes on products (+ indirect 8925

taxes- subsidies)

GDP at market Price 85585

Net factor income from abroad -2931

Gross National Income 82654

(c) EXPENDITURE METHOD

 This involves totaling of expenditure incurred on final goods and services by all
economic agents in an economy.

 GDP = C + G + I + X – M
 1. Consumption (C)- also called personal consumption expenditure. It covers all
expenditure by household on durable goods (e.g. refrigerators), non durable
goods( bread) and consumer expenditure for services ( lawyers)
2. Government Expenditure (G)- is encompass all government purchases of goods and
services. Government purchases consumption goods like food for military and
investment type items such as computers
3. Gross private Investment (I)- these include all purchases of machinery, equipment and
tools by business enterprise, all construction and change in inventory. Gross investment
refers to all investment goods. It includes investment in replacement capital and in added
capital both those that replace machinery, equipment that were used up in producing
current output. Net Investment includes only investment in the form of added capital.
Amount of capital used up over the course of the year is called depreciation. Subtracting
depreciation from GDP gives us Net Domestic product (NDP)
4. Net exports (X – M) - is the difference between exports(X)and imports (M). Comes
because of international trade

Expenditure $m % contribution to GDP

Private consumption 113883 ?

Consumption of private non profit bodies 401

Government consumption 12605

Gross capital formation 21978

Gross fixed capital formation 18804

Total increase in stocks 3174

Net exports 163

GDP at market price 85585

Other aspects on National Accounts

1. Net National Product- which is found by subtracting depreciation ( consumption of fixed

capital) from GDP
2. Gross National Product- is found by adding net factor income from abroad to GDP. Net
factor income is found by : factor income received from abroad minus factor income
paid abroad
3. Disposable income – is personal income less personal taxes. Personal income includes
all income whether earned or unearned ( transfer payments) Personal taxes include
income taxes, personal property taxes and inheritance taxes. Disposable income can be
used for consumption or saving purposes

Nominal vs Real GDP

 Prices used to calculate GDP are nominal prices hence they change in response to
inflation. We are more interested in real income not nominal income, because we might
think that production of goods and services have increased while they are prices that are
increasing.
  So the practical issue is how we can compare market values of GDP from year to year if
the value of money itself changes in response to inflation or deflation.
 What matters to us is the quantity of goods that get produced and distributed to
household that affect their standard of living not the price of goods.
 So economist should know how to adjust from nominal to real GDP. The issue is to
deflate GDP when prices rises and inflate GDP when prices falls
 Nominal GDP (GDP at current prices)- measuring GDP for a particular year using the
actual market price of that year (PQ). It represents total money value of final goods and
services produced in a given year
 Real GDP (GDP at constant Prices)- GDP that has been deflated or inflated to reflect
changes in the price level. It removes price changes from nominal GDP. It is nominal
GDP (PQ) divided by the GDP deflator(P) or price index
 Real GDP (Q) = Nominal GDP/ GDP Deflator
= PQ/P

Adjustment Process

GDP price Index (deflator)]

 A price index is a measure of the price of a specified collection of goods and services,
called “market basket” in a given year as compared to the price of an identical (highly
similar) collection of goods and services in a reference year ( base year/ period)
 However, there are many method to come up with index numbers
 Mathematically: Price index in a given year is equal to

price of market basket in specific year

X 100
price of same basket in base year

MONEY, BANKING AND THE ECONOMY

MONEY
- Money is defined as anything that is generally acceptable as a medium of exchange and
in the settlement of transactions and debts.
- Note that while cheques are used in effecting transactions, they are not necessarily legal
tender.
- The development of money to fit into the system of trade was made both inevitable and
desirable due to the failure of the traditional barter system to stand the ever-increasing
volumes of trade between complete strangers living distances apart and also through the
development of specialization and division of labour.

FACTORS MILITATING AGAINST THE BARTER/SWAPPING SYSTEM

a) There was need for what was called double coincidence of wants. This means that for Z
to get something from X, he had to have what X wanted and at the same time want what
X offered. In most real world situations, it is regarded as rarely practical or possible.
 b) It was difficult to store one’s wealth in some forms for a long period of time.

c) It was also very difficult to fix fair prices for the goods and services. Jack Nobbs, (1983)
notes that in a barter system with 100 types of goods supplied and demanded, about 4
950 relative prices or values would be required. He says:

An enormous amount of time wasted in haggling would still make it difficult to

ascertain the value of a sheep in terms of salt.

Adam Smith, an 18th Century economist wrote:

Every prudent man in every period of society, after the first establishment of
the division of labour, must naturally have endeavoured to manage his affairs I
such a manner as to have at all times by him…………..a certain quantity of
some one commodity or other, such as he imagined few people would be likely
to refuse in exchange for the produce of their own industry.

MONEY ATTRIBUTES

 Acceptability-it should be acceptable for use in the business transactions. Whoever receives
it in payment must be able to dispose of it in bill settlement without any problem.
Acceptability principle does not claim that all the pieces of paper and minted coins are worth
their face value. It merely emphasizes that people have developed confidence in their use.

 Homogeneity- it should be uniform to avoid confusion. This relates to the various

denominations money is in. All coins and papers that are assigned equivalent values should
be similar in appearance and quality. It should not be difficult to realize that an old $10 note
is the same as one new one from the RBZ.

 Portability-should be easy to carry and walk around with in pockets and wallets so as to
avoid inconveniencing the owner. It shouldn’t be bulky, otherwise a person carrying a goat
for barter trade is in less danger from robbers that one carrying a bag of money worth the
same goat. In fact this attribute is a direct attack on inflation.

 Cognisibility-should be easily recognizable. It should be easy to differentiate between fake

money and genuine money. This attribute is closely linked to that of homogeneity, but dwells
much on appearance of money. It also emphasis that money should be quickly identified and
its value ascertained.

 Durability-It should be strong and long lasting. This points to good quality on which money
is made. This is vital because the cost of replacing money is very high since it is normally
made in such a way as to avoid counterfeit money. It explains why Zimbabwe, and any other
developing country would hire a foreign company to produce its money.

 Stability- this is a desired feature of money, which emphasizes that money should maintain
its purchasing power. This builds confidence in the people who can then easily accept it.
This is achieved by controlling the level of money supply to that commensurate to output.
No wonder in National Income accounting, Income = Output. Severe diminishing in the
 value of money (called inflation) will exert pressure on economic agents to revert to the
horrible and undesirable barter system.

 Liquidity-whatever is used as money should easily be convertible into something else at the
discretion of the holder. By this, it meets the convenience need money should provide. It is
plausible to note that this is also a function of money as it allows goods and services to be
bought and sold amongst economic agents.

 Divisibility-refers to partitioning of money into smaller units that make up the whole. There
should not be any cost or loss in value in so doing. For instance, a $10 note should be valued
the same with five pieces of $2 coins.

 Transferability-easily changes hands. This is linked to portability since what is portable can
easily be handed over to a new owner. In some societies (especially historical times), where
large pieces of stone are used as money like the South Sea in the 20 th Century, transferability
is difficult because the money is not transferable.

 Legality-The reader is challenged and taken aback to primitive era when it simply needed
society’s agreement to accept something as money. Today, the government, through the
Central Bank, has to authorize and legalise the acceptance of special pieces of paper and
metal as money. It thus becomes an offence to refuse to accept the money.

FUNCTIONS OF MONEY

 Medium of exchange - Money allows people to exchange commodities they hold e.g. A
person exchanges his labour for money and his money for goods and services. This function
makes trade faster and smoother. Its basis is that money has value and is acceptable in
transactions.

 Unit of account - Money is used as a price tag for goods and services and is a yardstick by
which community measures the value for goods and services. It allows the use of the price
system and makes it easier to express the values of commodities in relative terms.

John Stuart Mill (J. Nobbs: 1983) said:

The relations of commodities to one another remain unaltered by money; the only new
relation introduced is their relation to money itself.

Because money can be expressed in distinctive numerical terms, depending on the value, it is a
good base of accounting.

 Store of wealth/wealth - Because of its durability, stability, and purchasing power, money
can be kept as wealth. The major threat to this function is inflation. If money loses its
purchasing power, the monetary system collapses as people refuse to accept it as legal
tender. It happened in Germany in 1923 after the 1st world war and in Zimbabwe between
2000 – 2009. It should be appreciated that the value of money should be fairly stable, at least
in the Short Run, to sustain this function. The gradual decline in the value of money in the
Long run should be insignificant to economic development and should not be sufficient
enough to discourage people from using it as such. The modern economic man is busy
 assessing the ability of money to perform this function. The more it can do so, the more
money he has in hand and at the bank. The less it can do so, the less money he holds and the
more he depends on other forms of wealth like cars, houses, and other properties.

 Standard of deferred payment - Allows people to sign contracts for which payments will
be made later e.g. in a higher purchase. J. Nobbs (ibid) notes that today production is so
indirect that it could not take place unless it was financed in advance. This function however,
needs to be supported by the legal system as it is bound to be abused by the economic agents
who have an upper hand over others. Creation of Credit Sale, hire Purchase, Lease Acts is in
this direction. Note also that if inflation skyrockets, creditors lose as debtors pay money of
less value compared to that they borrowed. In that period interest rates rise to guarantee the
return. Those living on fixed incomes like pensioners will cry foul.

 A liquid asset - Easily convertible into any other form of property. It satisfies the need for
convenience. Liquidity, known even to accountants varies with easy with which one thing
(not money) can be changed into another form in a transaction. Hence money is the most
liquid asset in accounting, ahead of bank balance, debts, and stock for trade. Many
economists (including to some extent Keynes) have no problem agreeing that the demand for
cash balances by households, firms and individuals is strongly dependent on interest rates.
Hence this demand is called liquidity preference and it is shown below.

Rate of interest
(r)

Liquidity preference curve

Money demanded (Md)

 Channel of purchasing power - Also called price rationing as it allows only holders to be
able to buy commodities. As it is used in a capitalist system, it causes inequitable distribution
of itself, as it is owned in large sums by a few individuals. However, to condemn it, its use
and the capitalist system out-rightly on this basis is unfair. Even Karl Marx himself, the
father of Socialism, never cried for its abolition.
.

MOTIVES FOR HOLDING MONEY

The legendary British economist, John M. Keynes identified three major reasons why economic
agents, especially households and individuals, demand or save money. These are:
1) Transactionary motive savings- Done to cater for known future expenditure due to non-
synchronization between time of receiving income and time of spending the income. For
instance, a person may receive income once at the end of the month and spreads the spending
throughout the month. Also known as keeping money to meet recurrent expenditure.
Inflation is strongly related to this in a positive way.

2) Precautionary motive saving - This is saving for unforeseeable uncertainties e.g. illnesses,
death etc. Also called saving for the rainy days. J. Nobbs call it ‘just in case’ saving. This
applies to all economic agents.

3) Speculative motive savings - Saving with the expectation that money will appreciate in
value through a rise in interest rate. When share prices are expected to fall this demand goes
up. More easily understood when one holds onto appreciating foreign exchange. Speculative
motive saving in general is counter-productive and may cause untold losses if the money
held onto loses value instead. Only rich individuals, households, and firms whose activity
concerns funds investment are interested in this motive.

THE CLASSICAL QUANTITY THEORY OF MONEY

- The quantity equation is an identity: the definitions of the four variables make it true. If
one variable changes, one or more of the others must also change to maintain the
identity. The quantity equation we will use from now on is the money supply (M) times
the velocity of money (V) which equals price (P) times the number of transactions (T):

M ´ V = P ´ T

- V is called the transactions velocity of money. This tells us the number of times a dollar
bill changes hands in a given period of time.
- Transactions and output are related, because the more the economy produces, the more
goods are bought and sold.
- If Y denotes the amount of output and P denotes the price of one unit of output, then the
dollar value of output is PY.

M ´ V = P ´ Y

- This version of the quantity equation is called the income velocity of money, which tells
us the number of times a dollar bill enters someone’s income in a given time.

 Monetary Policy and Its Instruments

The money supply is the quantity of money available in an economy. The control over the
money supply is called monetary policy.

- The role of central banks is to influence the size of a country’s money supply and in
doing so influence the national income and the price level.
- A central bank serves four main functions: it is a banker for commercial banks, a banker
for the government, the controller of the nation’s supply of money, and a regulator of
money markets.
 - The central bank is the sole authority in an economy that issues the monetary policy to
achieve the aforementioned objectives of influencing national income and price stability.
- These objectives are called policy variables, whilst variables that it directly controls in
order to achieve the stated objectives are called policy instruments.
- NB. Whilst monetary policy influences both real output and price level in the short run, it
only affects price level in the long run.

 Policy Instruments – these are tools that the central bank uses to directly control
aggregate demand in an economy.
- The primary instruments used by central banks are:

1. Open Market Operations – involves the purchase and sale of government papers.
To expand money supply, the government buys treasury bonds and pays for them
with new money, whilst to reduce it, it sells treasury bonds and receives existing
money which it can destroy.
2. Reserve Requirements – this is the amount of money that banks are supposed to
lodge with the central bank. This directly affects money supply in an economy.
3. Discount Rate – is the rate at which the central bank charges to member banks who
need to replenish their reserves.
4. Moral Suassion
5. Seignorage
6. Sterilisation
7. Bank Rate
8.

 Determinants of Saving
1. Inflation
- Controversial- it is thru its impact on real interest rate that affect saving
- If real interest rates is negative people might not be motivated to save
- It may also influence saving through its impact on real wealth- if consumers attempt to
maintain a target rate of consumption to wealth, saving will rise with anticipated
inflation.

2. Economic growth
- Positive relationship between economic growth and saving. Higher income lead to
increase in saving
- But other say it is negative- if income grows workers anticipate increase in future
income, so they increase consumption

3. Demographic factors
- Explained by life cycle hypothesis
- High savings expected if the age structure is composed of working age
- Bequests motives also lead people to save more
 - Age structure therefore affects savings
- However in ‘our case we have experienced company closures, retrenchments, drought-
affecting savings

4. Financial development indicators

- If a country has a well diversified banks it will have higher savings
- M2 / GDP measures financial depth (development) of a country
- M2 = M1 + time deposit
- M1 are notes and coins (not saving)
- Another indicator used is the number of banks

5. Foreign saving
- Open economies can actually borrow from other countries to smooth consumption
- This means that foreign savings can act as a substitute to domestic savings

 Investment(Keynesian context)
- Investment refers to the accumulation over time of real goods which will yield a future
flow of services (Levacic 1979).
- It is a forward looking activity with irreversible aspects therefore it tends to be a volatile
component of aggregate demand.
- It determines the rate of accumulation of physical capital and is thus an important factor
in growth of productive capacity.
- Investment in the national accounts includes: business fixed investment (purchases of
durable equipment structures), residential construction investment and changes in the
business inventories.
- With higher levels of investment a country can achieve higher economic growth.

 Determinants of Investment
1. Credit rationing (Availability)
-Changes in the volume of bank credit are suggested to have a positive impact on private
investment activity in developing countries.
- Agenor and Montiel(1996) argued that the typical absence of equity markets and the
prevalence of financial repression in developing world imply that neither Tobin’s Q
theory nor standard neoclassical flexible accelerator investment functions can be applied
uncritically in developing countries.
- Credit rationing influence the behavior of investment, the easier the access to source of
funds the higher the investment.
2. Inflation.
- High and persistent inflation undermines business confidence, while encouraging
consumption at the expense of saving mobilization and investment.
- Inflation is the general price increases.
- High and unpredictable inflation rate is an important indicator of macroeconomic
instability which can have an adverse impact on private investment by distorting the
information content of relative prices thus increasing the riskness of longer term
investment.

3. Exchange rate
 - The role of imported intermediate goods in developing nations suggest that the
specification of relative factor price in empirical investment functions can not be
restricted to the wage rate and user cost of capital but must also take into account the
domestic currency price as well its availability.
- In the short run real devaluation will reduce private investment because it will raise the
cost of intermediate inputs on domestic currency terms , which will in turn reduce the
level of retained earnings, since demand will have been reduced due to rise in price.
- On the supply side , the expenditure-switching aspect of exchange rate policy on private
investment will increase the level of foreign prices measured in the domestic currency
and thus the price of traded goods relative to non traded goods in the domestic economy.

4. Public investment
- The studies has been carried out to determine the existence of “crowding in” or
“crowding out” of public investment on private investment.
- On the other hand public investment that results in large fiscal deficits may crowd out
private investment through high interest rates and credit rationing.
- On the other hand, most developing countries have a large component of government
investment concentrated on infrastructure projects (transport, irrigation)which may be
complementary with private investment.  

5. External debt (debt service ratio)

- Large external debt burdens have a strong disincentive effect on private investment.
- The existence of a large debt overhang in the form of a high ratio of external debt to GDP
reduces the future returns on investment because a high proportion of the forthcoming
returns must be used to repay the debt.
- In addition, debt service payments reduce the domestic resources available for
investment.
- It is a major source of uncertainty: the size of future transfers to creditors is uncertain,
macroeconomic policy is uncertain, the exchange rate is uncertain.
- Many developing countries face liquidity constraints in international capital markets
because of large arrears in debt service obligation

6. Interest rate
- Neoclassical theory suggests that high interest rates raise the cost of capital, which
reduces the investment rate.
- In most African economies, nominal interest rates are high but real rates are often
negative due to high inflation rates (Ndikumana, 2000).
- In such a context, the interest rate can have a negative effect on investment only through
the saving channel (in the spirit of the McKinnon-Shaw hypothesis).
- Low or negative real interest rates, discourage saving, which reduce the amount of funds
available for investment.

7. Real (GDP) output

- Theoretically this relationship can be readily derived from a flexible accelerator model,
with the assumption that the underlying production function has a fixed relationship
between the desired capital stock and the level of real output.
- In the same vein private investment has been hypothesized as a positive function of
income per capital.
 - Green and Villanuera (!991) assert that countries with higher per capita income could
denote more resources to domestic saving which could be used to finance investment
projects.

8. Taxation
- Corporate taxes have an important bearing on the firm’s investment decisions.
- The prospective after tax return on capital is a decisive factor in evaluating investment in
a new venture or expansion of an existing enterprise.
- The higher the after tax rate of return on capital the lower will be the risk of undertaking
the investment
- More precisely they can reduce the amount of retained earnings needed for further
investment.
9. Infrastructure
10. Natural Resource Endowment
11. Gvt Policies

6. INFLATION

- Inflation is a phenomenon of continuous rise in the general price level of goods and
services. Inflation is not a rise in the prices of one or just few goods, and it is also not a
just one-time rise in the prices of most commodities.
- The Consumer Price Index (CPI) is one variable that is normally used to measure
inflation. It is the cost of a given basket of goods and services.
- Thus, during inflationary periods, prices of few goods may fall, but prices of most goods
rise.
- Inflation can also be defined as a decline in the value or purchasing power of dollar. If
the supply of dollar (money) rises faster than the supply of goods and services in the
country, one would expect a decline in the value of dollar. Thus, an increase in money
supply can be a reason of inflation.

MEASUREMENT OF INFLATION

MEASURING INFLATION

1. THE GDP DEFLATOR

The calculation of real GDP gives a useful measure of inflation called the GDP deflator.
Nominal GDP reflects both the prices of goods and services and the quantities of goods
and services the economy is producing. By contrast, by holding prices constant at base-
year levels, real GDP reflects only the quantities produced. From these two statistics, we
can compute the GDP deflator, which reflects the prices of goods and services but not
the quantities produced. The deflator measures changes in prices that have occurred
between the base year and the current year.

No min al GDP
G DP Deflator = X 100
Re al GDP
 2. CONSUMER PRICE INDEX
The consumer price index is used to monitor the changes in the cost of living over time.
When the consumer price index rises, the consumer has to spend more dollars to
maintain the same standard of living. The inflation rate is the percentage change in the
price level from the previous period. The consumer price index measures the overall cost
of goods and services that the consumer buys.

Formula for calculating inflation:

Pt − Pt−1
Inflation = X 100 %
P t−1

 (t-1) – previous period or Base time where prices are assumed fixed and deviation
from which is the inflation or deflation.

 (t) – current period or second period time after which prices are compared to the
base year prices and inflation calculated.

Important inflation concepts

I. Core/underlying inflation
This is inflation due to changes in economic variables like weather, Money supply,
Interest rates, Exchange rates etc. For example a drought reduces output and raises the
affected commodity’s price.

II. Food Inflation

This is a general rise in the price of food items.

III. Non-food Inflation

This is a sustained increase in the price of other commodities and services other than
food.

Overall CPI - Weight of Food CPI x Food CPI

Non−food CPI =
Weight of non−food CPI
IV. Monthly Inflation
This measures growth of CPI over a month. Given a growth of (Z%) per month, one
would be inquisitive to know what inflation would be after a year.

V. Quarterly Inflation
Measures the percentage growth of CPI in three months.
VI. Seigniorage

Seigniorage is the revenue from printing money. When the government prints money to
finance expenditure, it increases the money supply. The increase in the money supply, in
turn, causes inflation. Printing money to raise revenue is like imposing an inflation tax.
As prices rise, the real value of the money in your wallet falls. When the government
prints new money for its use, it makes the old money in the hands of the public less
valuable. Thus, inflation is like a tax on holding money. In countries experiencing
hyperinflation, seigniorage is often the government’s chief source of revenue—indeed,
and the need to print money to finance expenditure is a primary cause of hyperinflation.

TYPES OF INFLATION

1) Monetary Inflation

Milton Friedman said that, ‘Inflation over any substantial period is always and afterwards a
result of excessive growth in the quantity of money relative to output. All other monetarist
argue in the same way that inflation is due to unjustified money supply growth, i.e. not
commensurate with output growth/level.

According to Irving Fisher (1867-9147), in his book, ‘The purchasing power of money’
(Macmillan; 1911), there exists an equation of exchange that links money to prices. He stated
the equation as:

MV=PT………………………………………… 1

Where M = money stock, V = rate at which money changes hands, P = average price
level and T = volume of transactions carried out in any economy, say in a year.

The assumptions of equation 1 are that:

i) V is fairly stable, hence Money demand is also fairly stable
ii) T is fairly stable, i.e. there is full employment in the economy

Stability assumed for V and T means that a rise in M will lead to a rise in P. But empirical
evidence shows that V and T fluctuate even in the short run and are positively related to interest
rates. The reason is that when the interest rate and inflation are high, it is costly to hold on to
money balances (hence high V) as money loses value in one’s hands yet when invested on
money markets, yields are high. On the other hand, when interest rates and inflation are low,
firstly, the money market is not lucrative, and secondly, money does not lose value at a high rate
in the bank, hence people can afford to hold large cash balances (V is low).

It may be important to note some of the important factors resulting in growth of money supply:

 Excessive borrowing by the government from the RBZ/Central Bank

 Credit creation by banks
 Increase in Net Foreign Reserve inflows as seen from the following relationship:
Excessive Money Supply dictates that people change from Investment into property and
financial assets e.g. bonds. It also means that as T cannot quickly adjust to demand caused by
increased money supply, price is bidded up leading to Demand-pull inflation.

 Demand Pull Inflation

According to monetarists, a rise in money supply will lead to an increase in aggregate demand,
but since output cannot be varied ion the short run, prices are likely to go up. Therefore, to the
monetarists, inflation is demand-pull inflation.

Demand Pull Inflation AS

Price
E1
AD1
Po E0
AD0

Quantity

Comparing the two equilibria, E0 and E1, it is shown that an increase in income leads to
an increased demand for goods, but AS is stable. This leads to higher prices.

- Demand pull inflation occurs when the demand for goods and services continuously rises
faster than their supply, prices of goods and services shall rise too.
- Demand-pull inflation is likely when there is full employment of resources and when
SRAS is inelastic. In these circumstances an increase in AD will lead to an increase in
prices.
- AD might rise for a number of reasons – some of which occur together at the same
moment of the economic cycle

 A depreciation of the exchange rate, which has the effect of increasing the price of imports
and reduces the foreign price of exports.  If consumers buy fewer imports, while foreigners
buy more exports, AD will rise.  If the economy is already at full employment, prices are
pulled upwards.
 A reduction in direct or indirect taxation.  If direct taxes are reduced consumers have
more real disposable income causing demand to rise.  A reduction in indirect taxes will mean
that a given amount of income will now buy a greater real volume of goods and services.
Both factors can take aggregate demand and real GDP higher and beyond potential GDP.
 The rapid growth of the money supply – perhaps as a consequence of increased bank and
building society borrowing if interest rates are low. Monetarist economists believe that the
root causes of inflation are monetary – in particular when the monetary authorities permit an
excessive growth of the supply of money in circulation beyond that needed to finance the
volume of transactions produced in the economy.
 Rising consumer confidence and an increase in the rate of growth of house prices – both
of which would lead to an increase in total household demand for goods and services
 Faster economic growth in other countries – providing a boost to exports overseas.

2) Cost push inflation

This is whereby firms increase prices of commodities due to rising cost of inputs. May be due
to any one or several of the following:

 Imported inflation- a rise in prices of imported raw materials due to depreciation or

devaluation of the local currency.

 Wage spiral inflation- an increase in prices to compensate for a rise in wages, as

wages are a significant cost to the firm.

 Devaluation/Depreciation of the local currency-Many Zimbabwean businesses

borrow from off-show, i.e. from foreign financiers. Settling these debts with a
depreciated currency is costly.

 High local interest rates- Thus borrowing from the domestic market is costly.

*Rising costs of production have the effects that the producer will either cut on output or
increase price or do both. The following is an illustration of cost-push inflation:

AS1
Cost-push inflation
AS0

P1 ………….E1

Po ….……………… . E0

ADo

Q1 Q0 Income
It should however, be noted that other exogenous factors like drought, sanctions and
embargoes may equally lead to inevitable shortages which are in the end inflationary.

3) Supply shortage inflation

This is when aggregate supply is less than the level required to sustain economic growth. A
situation of shortage creates a stampede on the few available commodities leading to a wave
price increases.

4) Cyclical inflation
 This is inflation associated with the shortages experienced during economic depressions and
recessions. It thus follows changes in the business cycle.

5) Hyperinflation

This is whereby prices are rising so fast that money ceases to perform its functions. This may
be so critical as to lead to an abandonment of a currency or the issuance of a new one. If the
situation continues, the monetary system collapses. This happened in Yugoslavia and
Germany during the Great Depression, in Zimbabwe between the period 2003 and 2009.

CONSEQUENCIES OF INFLATION

1) Leads to high lending rates, as lenders want to cushion themselves as high inflation
creates uncertainty, which also increases risk.

2) Discourages borrowing by producers and makes it difficult for shrinking economies to

recover as cost of finance production is high.

3) Causes a shift from Long term investment to investment in money and equity markets
where returns are more attractive.

4) Leads to currency depreciation and for Less Developed Countries (LDCs) like
Zimbabwe, which rely heavily on foreign borrowing and imported raw materials, cost of
production is likely to be high and this pushes up prices of finished goods.

5) Since from (4) above, domestic production becomes more expensive, if the commodities
are to be traded on the international market they become less competitive. As a result, the
Balance of Payments situation is worsened as the country will not be able to raise enough
forex, as it requires.

6) High poverty levels, with many people falling below the Poverty Datum Line (PDL),
that is surviving at an amount below that which is expected to sustain them.

7) Causes moral decadence like prostitution as well as social deviance behaviors like
commission of crimes.

8) Causes unemployment because prices of labour (salaries and wages) become

unsustainable and firms fire labour.

9) Causes the breakdown of the monetary system as people prefer to hold onto physical
properties to hedge against spiraling prices.

10) Hits hard on people living on fixed incomes like pensioners, thus further straining the
government (Fiscus) as it has to make more transfer payments in the form of free or
subsidized food, health, shelter and education.

11) Harms the taxpayer as government increases taxes to get more money through its fiscal
policy. This is particularly so with the workforce exposed to a progressive tax system, as
 was the situation in Zimbabwe. They are continuously pushed into higher tax brackets
creating a phenomenon called fiscal drag net. Their living standards plummet as their
incomes fall.

12) Rioting, industrial strikes, political upheavals can to some extent be attributed to high
inflation levels as cost of living rise to leave many trapped under the Poverty datum Line
(PDL). This was typical of the Zimbabwean situation during the period 2000 – 2009.

13) Redistributes income from lenders to borrowers. People who borrowed money during
low inflation time repays it when it is useless in terms of what it can purchase.

14) Causes high level of corruption, even to the extent of externalisation of foreign currency
and diversion of produce meant for local consumption to other countries.

15) Causes de-industrialization i.e. closures of firms which cannot operate in the prevailing
environment.

POLICY PRESCRIPTION AGAINST INFLATION

As the causes of inflation are diversified and intertwined, the suggested solutions below need to
be carefully studied. No one policy can cure an inflationary situation fuelled by a hoard of
causes. As such, emphasis is on policy combinations.

a) Management of Money Supply

The growth of MS should be managed to levels commensurate with increase in output. This
should be understood in the same way with as in the national income accounting where value
of output should equal incomes received. Open Market Operation system (OMOs) can be
adopted where excess liquidity is mopped up by selling certificates/treasury bills to cash
holders. But incessant borrowing by the government from the Central Bank makes control of
Money Supply difficult as this takes money back into the system.

b) Increasing the Statutory Reserve Requirement

Reserve requirements or required reserves are deposit monies banks are to keep and not use
to create more money. This reduces the money multiplier, which determines money growth.

c) Sterilization

This is merely neutralising net income flows from abroad by withdrawing a similar amount
from the economy if the net income is positive, and by adding a similar amount if it is
negative. In cases of a positive net income flow, OMOs may be used.

d) Moral suasion

This is not law, but an appeal by the Reserve Bank to the conscience of economic agents, or
more broadly, to economic stakeholders. The RBZ encourages people to understand the
importance and benefits of a low rate of inflation and hence an adoption of friendly
economic decisions that guard against inflation. Promotion of the Tripartite Negotiating
 Forums (TNFs) in Zimbabwe is typical Moral suasion that intends to adjust wages to non-
inflationary levels.

e) Fiscal policy

This normally takes the form of reducing government expenditure on non-productive sectors
and an improvement on capital projects. It also calls for reduced government borrowing from
the domestic market as this crowds out private investors and dampen future growth
prospects. Fiscal policy also entails that taxes are levied in such a way as to leave sufficient
disposable incomes to stimulate consumption and this will stimulate production and reduce
inflation.

f) Reducing Supply-side bottlenecks

Involves upgrading the production base to shoot down demand-pull inflation. Adoption of
efficient production techniques also cut on cost of production and hence leading to a cut on
cost-push inflation. Increased low-cost production results in competitive exports and
generation of foreign reserves and this leads to a stabilised currency.

7.UMEMPLOYMENT
- Unemployment of labour is a situation whereby the number of people who are willing
and able to work is greater than that the labour market can absorb.
- Nb* General unemployment covers all forms of resources, which may be lying idle in an
economy. Labour is just one of those resources. However, unemployment of labour is the
most popular and hence in most cases when one mentions the word unemployment he
will be referring to the unemployment of labour.

Number of unemployed people

Unemployment rate = X 100 %
- Labour force

- Unemployment and Inflation are usually called ‘evil twins’ considering the untold
suffering they are capable of causing on the ordinary people in society. They are
sensitive both as economic and as Political issues.

- According to an early economist, Philips, the two are negatively related. The diagram
below shows the trade-off between unemployment and inflation:
TYPES OF UNEMPLOYMENT

1) Demand deficiency unemployment

This is when economic agents are not consuming enough for the firms to produce more and
employ more resources. This is so because the demand for any product is a derived demand.
The lobbying by the EU and South Africa for a ban in the use of asbestos will, if successful,
result in retrenchments at Shaban-Mashava mine in Zimbabwe where asbestos is mined.
Close to 100 000 people work in the production of asbestos in Zimbabwe. The influx of
second hand clothes in Zimbabwe also led to many retrenchments in the textile industry.

2) Frictional unemployment

Occurs when people changing from one job to another. Hence refers to temporary and
voluntary unemployment. It also results from imperfect or complete lack of coordination
between job seekers and job offers. It may also be due to high travel costs and social ties
restricting people in relocations. These costs are also known as search costs, especially when
they include the cost of going around looking for work.

3) Seasonal unemployment
 Demand for resources to be employed including labour is determined by the period of the
year or season. It is very common in agricultural sectors and agro-based economies like
Zimbabwe experience this to a larger extent. Throughout the year farming policies which
incorporate irrigation schemes and winter farming tend to reduce the effects of seasonal
unemployment.

4) Residual or hard core unemployment

This is when people are either unemployable due to lack of required skills or do not want to
work. May also be linked to or called voluntary unemployment which is due to sheer laziness
or to the fact that people would have inherited some wealth.

5) Structural unemployment

This is when there structural rigidities in the economy making it difficult to employ
resources to full employment levels e.g. during drought or when the capital employed limits
on other forms of resources to be employed. A good example is the Zimbabwe situation in
1991 when ESAP was launched. The economy is agro-based and ESAP tended to reorient it
to Industrial and this caused severe job losses.

6) Technological unemployment

This is precisely when technological advancement ensures that labour is eliminated in the
line of production, as only a few will be required to operate the machines. The use of
sprayers, combine harvesters, weed chemicals will eventually lead to redundancy of
agricultural labour. The same with inclination in the use of computers.

7) Cyclical unemployment

This follows the business cycles and rates are high with recessions/contractions or troughs
and low with booms and recoveries.

8) The natural rate of unemployment

This occurs despite that all other macro factors are within sustainable levels e.g. inflation,
BOP, Money supply, Exchange rate, Interest rates etc.

EFFECTS OF UNEMPLOYMENT

1) High poverty levels associated with inability to buy basis commodities.

2) High moral decadence and crime rate, which in turn stifle economic growth and
development.

3) Forced migration of some population units to neighbouring countries to look for work and
decent living.

4) Political instability as people are easily incited against the government of the day.
5) Unemployment is normally associated with unprecedented levels of suicidal deaths and
murders amongst the unemployed. In Britain in every one million, deaths, 15 000 are
suicides.

6) Personal psychological torture suffered by the unemployed and their families, relatives and
friends.

7) It creates a fiscal drag net where those who are employed are overburdened by high taxes to
sustain the government.

8) It represents a cost to the government, as it has to pay out transfer payments and
Unemployment Benefits.

9) It also represents a loss of potential tax revenue to the government as people only pay tax
when employed.

10) It represents idle resources and lost productive potential. The loss was estimated by
Economist Okun’s Law, i.e. .....

SUGGESTED SOLUTIONS TO UNEMPLOYMENT

(a) Seasonal unemployment

In off-season, people should be geared for other forms of employment like fishing, winter
agriculture, arts etc. In general, therefore, development of micro-enterprises and
entrepreneurial skills is seemingly a permanent solution. However, the suggested solution is
questionable, as diversification of skills is in itself difficult to sustain in the real world.

(b) Cyclical unemployment

Re-alignment of macro-economic policies to avert recessions/contractions. Policies include

monitoring of money supply, interest rates, and inflation among others. The fiscal budget
should be more oriented towards investment and less on consumption spending.

(c) Technological unemployment

Adoption of labour-intensive technology is a policy consistent with developing economies

like Zimbabwe. However, most technology, if not all, is imported and users have no option.
Further, the choice of technology also depends on cost saving, and in the majority of cases,
labour-intensive machinery is more expensive than capital intensive over the lives of the
machines.

(d) Structural unemployment

Restructural exercises should be preceded or accompanied by informal sector entrepreneurial

development. This was overlooked by the authorities who adopted ESAP and results may
have a bearing on what the economy and people are today in Zimbabwe.
(e) Frictional unemployment

Improvement of transport and communication (especially in the form of advertising)

networks to reduce market imperfections. There is need to establish more information
centres and agencies that supply work information to those in need, especially to places that
are remote.

(f) Demand-deficiency unemployment

Dealing with the phenomenon requires a well framed long-term fiscal policy that stimulates
Aggregate Demand. Zimbabwe is among the world’s most taxing economies. As a result real
incomes fall progressively with consistent fall in output and eventual decline in employment
levels becoming certain.

8.INTERNATIONAL TRADE AND FINANCE

- International trade refers to the exchange of goods and services beyond a nation’s
boundaries.
- Closed Economy- is an economy that does not interact with other economies in the
world. An open economy is an economy that interacts freely with other economies in the
world – leading to international trade.

The Flow of Goods: Imports, Exports and Net Exports

- Exports are goods and services that are produced locally and sold abroad.
- Imports are goods and services that are produced abroad and sold domestically.
- Net exports are the value of a nation’s exports minus the value of its imports, also called
the trade balance.
- If net exports are positive, exports are greater than imports, indicating that the country
sells more goods and services abroad than it buys from other countries. In this case, the
country is said to run a trade surplus.
- If net exports are negative, exports are less than imports, indicating that the country sells
fewer goods and services abroad than it buys from other countries. In this case, the
country is said to run a trade deficit.
- If net exports are zero, its exports and imports are exactly equal, and the country is said
to have balanced trade.

REASONS FOR INTERNATIONAL TRADE

1. Climatic differences

Countries have got products that can be produced under some specific climatic conditions
while other products cannot be produced under those conditions.

2. Educational differences
 Countries have different educational standards, hence international trade will allow for
education integration. This can be explained by the hiring of Cuban Doctors in the previous
years.

3. Cultural differences

International trade allows for cultural integration i.e. different countries may take advantage
of another’s culture for economic advantage.-
4. Differences in factor endowments

Countries may have abundance of one factor and not the other. It has to import factors it
cannot sufficiently product for itself.

5. Differences in technology

Countries have got different levels of product and process technology, hence developing
nations stand to gain in any international trade in which they can purchase technology from
developed countries.

6. Law of absolute and comparative advantage

A country has an absolute in areas of production in which it is more efficient than the other.
Different countries have different areas of efficiency and a country like Zimbabwe has got an
advantage in the area of agriculture.

The absolute advantage argument states that if countries specialize in areas in which they
have absolute advantage, then world output would increase and would then trade to get
things on which they have a disadvantage in production.

The theory of comparative advantage, which was developed in the 1770s and developed in
the 1940s, deals with opportunity costs of production and countries are encouraged to
specialise in areas where they can produce commodities at a lower opportunity cost. It is
envisaged that world output would also grow when the theory of comparative advantage is
implemented.

Example:

Suppose there are two countries, A and B, and also that there are two products only, Food and
Cloth. If the countries allocate their efforts towards food production, they will produce the
following outputs in the ratio of their opportunity costs: A--------------------200 tons of food and
600 metres of cloth and B……………….500 tons of food and 300 metres of cloth.

ANALYSIS

a) Pre-trade situation

Without international trade, total food production would be 700 tons, while cloth would be
900 metres.

b) Trade situation
 If countries would specialize in areas of advantage, ‘A’ would produce cloth only as it costs
less for her (just a tone of food for 3 m of cloth) to produce while it is cheaper for ‘B’ to
produce food as it costs less compared to A (3m of cloth only will give 5 tones while for ‘A’
we need 3m to produce only 1 tone f food). Therefore the totals with specialization will be:
1000 tons of food and 1 200m of cloth. It can be noted that world output has gone up.

ARGUMENTS AGAINST INTERNATIONAL TRADE

1. The infant industry argument

The protectionist theory was propounded in the 1770s. An infant industry is one still
incapable of fair competition with established industries. This protection is sought from the
government since most of the most frightening rivals are foreign companies. International
trade hence may lead to closure of budding industries, mostly in developing countries.

2. Strategic industry argument

International trade may sometimes threaten existence of pivotal/strategic industries in a

country. Hence government has an obligation to protect such local industries from
competition, not because they are infants, but because the nation should not at any point
depend on another country for supply of a particular commodity. An example is the defence
industry and an industry for production of staple food.

3. Cultural issues argument

International trade usually leads to cultural distortions through ’culture importation’ in the
form of adopted food, dressing, and other materials treated as offensive in other countries
like pornographic print.

4. Terms of trade argument

Also used in the case of unfavourable Balance of Payment situation. Unfavourable terms of
trade exist when the value of imports exceeds the value of exports and this may in the end
lead to a depreciation or devaluation of the local currency. Therefore the government, in a
bid to maintain favourable TOT of BOP, will discourage importation of non-essentials,
normally through hiking their import duty.

5. Health argument

Certain products that do not meet set health standards are banned from entering the country.
Examples are importation of meat from disease infested areas e.g. where there is bird flu.

6. Unemployment argument

This can be linked to any other argument that may lead to closure of local industries. The
unemployment argument says that if international trade leads to closure of some industries,
effectively it leads to unemployment.
7. Anti-dumping argument

Dumping refers to the selling of a product in a foreign market at a far lower price than one at
which it is sold in the home country. This is normally done either when the seller wants to
get rid of excess output, when getting rid of reject output or merely to out- compete other
firms in the foreign countries. Because these commodities are lowly priced, this leads to
closure of local industries and all other disadvantages follow.

8. Revenue argument

Protectionism in the form of import duty/tariffs generates revenue for the government. Thus
the higher the import duty, the higher the revenue that can be raised.

Current global trends are aimed at removing all such distortions. For instance, the SADC
region intended to dissolve all forms of tariffs and other imperfections to trade such as
quotas by the end of the year 2000.

FORMS OF TRADE BARRIERS

Most people would think that protectionism or trade restriction takes the form of import
duty/tariffs, this is not correct. The following are some of the policy options in
protectionism:

(a) Tariffs

These are the monetary taxes levied on imports and have the effect of raising the
international/world price of a commodity. They cause reduced importation and consumption
and, hence lead to welfare loss. Also called import duty. Import duty can be calculated as a
% of value of imports or per quantity.

(b) Quotas

This is a limitation of quantity one can import. Can also be in terms of value or quantity, but
in most cases takes the form of quantity. This is normally practiced when the government
wants individuals to import for use only e.g. only 20l of cooking oil per person.

(c) Sanctions

These are normally punishment deprivation of import rights to discourage the victim from
adopting a certain stance. This is normally abused by rich countries to punish less developed
countries that may have crossed their paths. This s a typically exclusive trade barrier as it is
in the form of punishment and tends to be more political than it is economic.

(d) Embargoes

This is a complete ban on the trade in some identified commodities, mostly to protect the
interests of the majority. Example is an embargo on the import of arms, or dangerous drugs.
(e) Voluntary agreements

Countries may negotiate and agree on the form, quantity or value of commodities to be
traded across their borders.

(f) Exchange control/allocation system

To import one needs to have foreign currency. The foreign currency is allocated to importers
by the Central Bank. The Central Bank weighs the importance of various imports and in the
allocation of foreign exchange favours those imports that are of importance to the country at
large.