PRINCIPLES OF

MACROECONOMICS

CBA1205

1
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.

2
Microeconomics vsMacroeconomics
Microeconomics Macroeconomics
The price of a single product The Consumer price index
Changes in the price of a product like tomatoes Inflation (the increase in the general 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 decisions of all
consumers/individual firms consumers/firms in the country.
The market for individual goods like Bananas The market for all goods and services 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 to work The total supply of labour in the economy.
A firm’s decision to export its goods and The total exports of goods and services to other
services countries.
A firms decision to import a product from The total imports of goods and services from
abroad other countries.
A firms decision on whether to increase its Change in the total supply of goods and 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

4
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

5
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

6
 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.

7
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.

8
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.

9
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

10
 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.

11
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

12
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

13
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.

14
 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)
15
 The two sector model cont’d
Simple model:
Saving
HOUSEHOLDS

Land Rent
Payment Goods & Labour Wages
for goods Services 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 Savings

Investment
(W)
(J)
GOODS & GOODS &
SERVICES SERVICES
PRODUCT
MARKET

17
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.

18
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.

19
 The three sector model
Saving
HOUSEHOLDS

taxes Gds
&serv

GOVERNMEN
Gds & Rent
Payment T Land
Serv Wages
for goods Labour
& services Capital Interest
subsidy
Enterprise Profit
Grants
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.

21
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.

22
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

23
 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)

24
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.

25
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

26
 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).

.
27
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.

28
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).

29
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.

30
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.

31
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)

32
33
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.

34
The five sector model cont’d

35
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)

36
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

37
NATIONAL INCOME
CONCEPTS
AND
MEASUREMENT
38
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)

39
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.

40
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).

41
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

43
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.

44
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)

45
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.

46
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

47
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.

48
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.

49
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

50
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.

51
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.

52
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.

53
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..

54
 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.

55
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.

56
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.

57
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.

58
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.

59
 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
Less: Depreciation or Capital Consumption Allowance xxx
NNP 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
agreement between the two methods.
84
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

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 current GDP@ constant GDP Deflator Inflation rate
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
2004 432753 276464

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.

100
Graphical illustration of the Notice that the increase in
consumption function consumption when income
increases is smaller than
the increase in income.

101
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 ).

102
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) .

103
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

104
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)

105
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)

106
Savings Function
S=-a + cY

107
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)

108
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

109
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.

110
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 .

111
Investment diagram

112
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 y=x . At
each point on the curve the value of y is
equal/the same as the value of x.Both
AE >Y axes are drawn to the same scale .This
curve forms a 45 degree angle with each
of the axis. In this instance along this
line total spending(AE) is equal to total
income (Y).This line therefore shows all
possible equilibrium points.At any point
Y>AE above the line AE >Y (excess
demand).Any point below the line Y
>AE (excess supply).

113
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.

114
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.

115
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.

116
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

117
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.

118
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)
At equilibrium : Y =AE Y=k.A
Y=1/MPS *A
AE = C+ I
Y =1/(1-c)*a+I
Y = 500 +0.75 Y +1500 Y= 1/(1-0.75)*(500+1500)
Y =2000+0.75Y Y = $8000

Y -0.75Y =2000
0.25Y/0.25 =2000/0.25
Y= $ 8000

119
 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

120
 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

121
Withdrawal /injection approach
Savings, Investment

S=-500+0.25Y

I =1500

0 National income (Y)

Ye=8000

-500

122
 It is 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

123
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.

124
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.

125
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.

126
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 (A –all autonomous
spending/investment).

127
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 and Cumulative Total ($

income in this round

1 100 100
2 80 180
3 64 244
4 51.2 295.2
5 40.96 336.16
…. … …
… … …
n … 500
128
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.

129
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.

130
 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

131
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

132
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.

133
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 ).

134
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

or Y =1 (A ) A represents Autonomous expenditures

MPS Notice that the multiplier remains unchanged. However G

increases aggregate spending and raises the level of
135
production and income
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.

136
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.

137
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.

138
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

139
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)

140
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

141
 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

Multiplier with taxes =

Note that : When calculating the
multiplier with taxes ,the calculation in
=2.5 times
brackets (1-t) is done first .The result is
then multiplied by c, and only then is the
subsequent result subtracted from 1 and
inverted (divided into 1).
142
 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.

143
 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.

144
 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.

145
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

146
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.

147
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;

148
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

149
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

150
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

151
 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
152
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.

153
Tutorial
Planned investment (I) I=200
Government purchases (G) G=640
Exports (X) X=175
Imports as a function of national income M=0.45Y
(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 .

154
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 Deman

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

investment expenditures increase.

 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 fullLong
employment
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 Level The economy is experiencing a
demand deficient recession shown by
the difference between Y1 and YFe
LRA
.There will also be price level
S
instability in the form of deflation as
SRA average prices will fall from Pe to P1.
Pe S Thus a deflationary gap occurs where
AD < AS .
P1

AD1 ADO

YFe Real GDP

Y1
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 curve
Shifts outwards from AD1 to AD2 .This
Inflationary Gap 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 flexible

Price level partially 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 indus-tries, 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 produc-tion 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
produc-tion 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

12.Short-term Capital inflows xxx

13. Short-term Capital outflows (xxx) xxx
14. Capital Account Balance 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
Calculate:
Contributions of Yog Republic to Ex-im Bank 100
(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 Bank (100) 200
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 (Net) 30830

Balancing item 1710

Increase in external liabilities (Net) 28570
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 $1.25; the pound has
depreciated
In the market for dollars :
The exchange rate, or “Price", is the number of pounds per dollar.
The supply and demand is for dollars.
In the market for pounds
The excg rate or price is the number of dollars per pound. The Ss&Dd is for pounds
₤/$ 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 Japanes Chinese Yuan
pound Rupee S African Zealand $ Yen
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 $1000 American product 1000*0.81 =810 E 1000*0.64 =₤640 1000*55.51= 1000*0.95 =
in each currency 5551r 950 AU$

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 forex is The domestic market can get forex supply
specifically for the following: when:
(i) To pay for imported commodities or (i) Foreigners pay for domestic exports
services (ii) There are capital inflows, e.g., when
(ii) For repayment of foreign loans/ foreigners buy shares on the Zim’s
investing in other countries( If the Stock Exchange or when foreigners
investment conditions are attractive) invest in local money market.
Thus, the demand for forex curve is Thus, the supply curve for forex (S forex) is
associated with importers upward sloping like an ordinary supply
The forex market is in equilibrium if the curve, as it is associated with export of
demand for forex is equal to supply forex. 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 Britain ,so that
US$ in Britain they can buy British goods, services, financial
₤/$ and real assets.
S$

In the market for pounds in the US, the

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

D$ British households ,firms, banks and the

British government demand dollars ,which
Qe they wish to have in order to buy American
Q$ 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 more British
US$ in Britain 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, services and assets of that country. Foreigners
0.65 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 holders of the currency will supply greater
quantities in order to buy more foreign goods, services and
D$ assets.

Qe
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 currency.
Therefore if supply or demand change, the exchange rate changes.

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

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 of one currency is always accompanied by a
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 inelastic so Rand in Zimbabwe
the dd curve for forex is also inelastic as shown
$/R S R2
by its steep slope.
assume the economy experiences a fall in exports
SR1
maybe due to an external shock like the increase
in the price of oil in global markets. 25
-This means that the supply of forex will shift
upwards from S1 to S2 and the $Z will depreciate
from ZAR1:Z$10 to ZAR1:Z$25 and the quantity 10
of forex ,i.e., Rands will fall from R20 m to
R14million, i.e., 30% decrease.
The above result implies that a unit change in the
DR
exchange rate lead to a less than unit change
(20%) in the volume of foreign currency traded.
14 20 Q$
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.
ii) 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 chang
and it will either appreciate or depreciate against other currencies
Tastes and As a country’s exports become more popular among international consumers, demand fo
preferences currency will increase and supply of other countries currency in its forex market will increas

Relative There is a direct relationship between the interest rates in a country and the value o
Interest rates currency. At higher interest rates foreigners will demand more financial assets from
country, and therefore more of the currency.

Relative Price If a country’s inflation rate is high relative to its trading partners, demand for the country
Levels o exports will fall and demand for its currency will fall. If inflation is lower at home th
inflation abroad, foreigners will demand more of its exports and its currency.
 Exchange Rates
Determinants of floating exchange rates
If any of the following determinants change ,the demand and supply of a currency will chang
and it will either appreciate or depreciate against other currencies

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

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

As incomes rise abroad, foreigners will demand more of a country’s currency. If for
Relative
incomes fall, there will be less demand for a country exports and its currency. If dome
Incomes incomes rise, ceteris paribus, demand for foreign currencies will rise and supply of the for
currency will increase abroad ,as 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 i
British assets.
Price levels :If US inflation were to increase whilst British inflation remained low ,Americans would deman
more relatively cheap British goods.
Speculation: If investors in the US expected the pound to get stronger, the demand for pounds would increas
today.
 Exchange
Economic effects of appreciation and Depreciation Rates

Inflation Rate Economic Unemployment Balance of

Growth Rate Payment
As a result of Inflation will be Growth will Unemployment The current
Appreciation lower since likely slow down could rise if net account should
imported goods since a stronger exports decline. move into
,services and raw currency will Also domestic firms deficit(since
materials are reduce net may decide to move net exports will
now cheaper exports, a production overseas fall) and the
component of AD where costs are financial
now lower due to account
strong currency. towards a
surplus ,as
financial and
real assets
become more
attractive to
foreign
investors.
 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 the should fall as net account should
imports are more country’s exports exports increase move into a
expensive ,and are cheaper and shifting AD out. surplus (since
there could be more attractive to Domestic firms net exports will
cost push foreigners .AD may choose to increase) and
inflation if raw will increase relocate some of the financial
material costs leading to short their overseas account
rise for run growth. production to the towards deficit
producers. now cheaper as financial
domestic market. and real assets
become less
attractive to
foreign
investors.
 Exchange Rates
Fixed
I Exchange Rate Regime
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 wishes to $US in Britain British ₤ in the US

peg the British pound at ₤ 0.65 per dollar
and $1.56 per pound. ₤/$ $/₤ S₤
S$
• If the demand for pounds rises Britain
will have to increase its supply to
0.65
keep it weak. 1.56
• If the demand for British pounds falls,
Britain will have to intervene to
reduce its supply and keep it strong D$
D₤
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.
 Exchange Rates
Fixed
I Exchange Rate Regime
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 pound in the USA and S $1
thus supply of the dollar in Britain .The dollar would appreciate.
0.65
The CB can print pounds and buy US dollar on the forex market.
Britain could increase the supply of pounds in the US by buying up
dollars to hold in its foreign exchange reserves; Demand for dollar would D $1
D$
rise and the dollar will appreciate.
The government can implement stricter exchange controls Qe Q1 Q$
By putting strict limits on the amount of foreign currency that can enter
China for investments ,the supply of US$ would decrease and again the
dollar would appreciate.
CB and gvt intervention
keeps D$ high and S$
low keeping the exchange
rate high
 Exchange Rates
Managed exchange Rate Regime
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 maintain an Euros in Switzerland

exchange rate of between 1.1 CHF and 1.3 CHF per CHF/$
euro: SE
Assume Europeans wish to save money in Switzerland
;the supply of euros increases to SE1. To maintain the
minimum exchange rate of 1.1 CHF/euro ,the SNB must 1.3
intervene .
Lower interest rate, buy euros or implement DE1
1.2
exchange controls to reduce the inflow of euros . SE1
If Swiss demand for euros grew to DE 1 the SNB would
1.1
have to intervene to bring the ER down to the
maximum of 1.3 CHF/euro .
Raise Swiss interest rates ,sell euros from its DE
foreign Exchange reserves,or implement controls on the
outflow of CHF. Qe QE
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

311
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.

312
 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.

313
EVOLUTION AND DEVELOPMENT
OF MONEY
Animal money: In ancient India, according to Veda, Go
Dhan (cow –wealth) was th
accepted as a form of money. In
Roman state up to 4 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.

317
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.

318
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.

319
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

328
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.

329
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

330
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.

331
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

332
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

333
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 pay off his
creditors. The balance sheet of bank B will be as follows:

Balance Sheet of Bank B

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

340
Alternatively total money created is :
M=D/RRR
= 1000/0.1
= $10000

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

341
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.

344
 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

345
 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.

346
 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.

347
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.

348
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.

349
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.

350
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

351
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.

352
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.

353
 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

354
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.

355
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.

356
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.

357
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

358
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.

359
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.

360
 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.

361
 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

362
 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.

363
 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.

364
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.

365
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.

367
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

368
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

376
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.

377
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.

379
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.

383
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

386
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.

387
 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 a tripartite agreement (between
government ,employers and trade unions.
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.

397
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

398
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.

399
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.

400
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.

401
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.

402
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.

403
 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.

404
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.

405
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.

406
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.

407
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.

408
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.

409
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.

410
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
 #ff
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
 #ff
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
 #ff
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 the economy
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
economy.
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.

426
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.

428
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.

430
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.

431
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.

432
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
employment both the short run
equilibrium and long run
equilibrium at a real GDP is equal
to potential GDP
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

LRA A fall in consumption and investment

S will shift Aggregate demand curve to
the left from AD0 to AD1.The
SRA economy experiences a demand
Pe S deficient recession shown by the
difference between Y1 and YFe .There
P1 will also be price level instability in
the form of deflation as average
prices will fall from Pe to P1. Thus a
AD1 ADO deflationary gap occurs where
AD < AS .
YFe Real GDP
Y1
Deflationary gap
 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

468
Economic Development Strategies
1. Import substitution industrialization
2. Export Led/Oriented Industrialization
3. Technology driven industrialization/Mixed strategies

469
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.

470
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

471
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).

472
Import Substitution Industrialization
(ISI)
The use of a tariff to reduce imports so as to promote
domestic industries.

473
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
Q 4.

474
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).

475
Import Substitution Industrialization
(ISI) cont’d

476
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).

477
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.

478
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.

479
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.

480
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.

481
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.

482
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.

483
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

484
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

485
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.

486
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

487
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.

488
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.

489
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

490
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.

491