NATIONAL OPEN UNIVERSITY OF NIGERIA

PRINCIPLE OF ECONOMICS II
ECO 122

FACULTY OF SOCIAL SCIENCES

COURSE GUIDE

Course Developer
Samuel Olumuyiwa Olusanya
Economics Department, National Open University of Nigeria

Course Editor
Dr. Kazeem Ajide
Economics Department, University of Lagos

Course Reviewer
Samuel Olumuyiwa Olusanya
Economics Department, National Open University of Nigeria

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CONTENT
Introduction
Course Content
Course Aims
Course Objectives
Working through This Course
Course Materials
Study Units
Textbooks and References
Assignment File
Presentation Schedule
Assessment
Tutor-Marked Assignment (TMAs)
Final Examination and Grading
Course Marking Scheme
Course Overview
How to Get the Most from This Course
Tutors and Tutorials
Summary

Introduction
Welcome to ECO: 122 PRINCIPLE OF ECONOMICS II.
ECO 122: Principle of Economics II is a three-credit and one-semester
undergraduate course for Economics student. The course is made up of twenty-one
units spread across fifteen lectures weeks. This course guide gives you an insight
to introduction to macroeconomics in an elementary way and how to study the
economy in larger dimension. It tells you about the course materials and how you
can work your way through these materials. It suggests some general guidelines
for the amount of time required of you on each unit in order to achieve the course
aims and objectives successfully. Answers to your tutor marked assignments
(TMAs) are therein already.

Course Content
This course is basically an introductory course on Macro-economics. The topics
covered include the field of macroeconomics; National income accounting; money
and banking; components of gross domestic product; aggregate demand and
aggregate supply; government and the economy; open economy macroeconomics.

Course Aims

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 The aims of this course is to give you in-depth understanding of the
macroeconomics as regards
• Fundamental concept and practices of macroeconomics

• To familiarize students with national income accounting

• To stimulate student’s knowledge of money and banking

• To make the students to understand the components of gross domestic

product

• To expose the students to differences between aggregate demand and

aggregate supply

• To ensure that the students know more about the government and the
economy.

• To make the students to understand the open economy in a

macroeconomics context.

Course Objectives
To achieve the aims of this course, there are overall objectives which the course is
out to achieve though, there are set out objectives for each unit. The unit objectives
are included at the beginning of a unit; you should read them before you start
working through the unit. You may want to refer to them during your study of the
unit to check on your progress. You should always look at the unit objectives after
completing a unit. This is to assist the students in accomplishing the tasks entailed
in this course. In this way, you can be sure you have done what was required of you
by the unit. The objectives serves as study guides, such that student could know if
he is able to grab the knowledge of each unit through the sets of objectives in each
one. At the end of the course period, the students are expected to be able to:
• Define and understand the meaning of Macroeconomics as a field of study
and know the basic macroeconomics concepts, as well as distinguish between
Microeconomics and Macroeconomics.

• Understand the transition from Microeconomics to Macroeconomics

analysis with various reasons why macroeconomics analysis is important and
understand how macroeconomics works in an economy.
• Understand the terms and measurement of national income as well as the
importance of national income and understand the meaning of Consumption
and its Components.

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• Understand the meaning of Savings and its Components and Investment and
its Components as well as to understand the meaning of Economic Welfare
and National income.

• Understand the Relationship between Economic Welfare and National

income and to understand the meaning of Money and the History of money
with its Characteristics, Functions and types of Money as well as the
Keynesian Motive of Holding Money.

• Understand the History of Nigeria Banking System and the meaning of

Commercial bank and its functions as well as the Growth and Development
of Commercial Bank in Nigeria.

• Understand Merchant banking in Nigeria and to know the Evolution of

Central Bank in Nigeria and the world at large. However, to also know the
Functions of Central Bank as well as the Relationship between Central Bank
and the government.

• Understand the Concept of personal consumption expenditure and to know

the concept of Gross private domestic investment and net exports with the
concept of Government Consumption and Gross investment.

• Understand the meaning and concept of Gross Private Domestic Investment,

to know the meaning and concept of Net Export and understand the how to
measure Gross private domestic investment and net exports.

• Understand the meaning and concept of Government Consumption and to

understand the National accounts Measurement of Government as well as to
know the meaning and concept of Gross Investment.

• Understand the meaning and nature of aggregate demand and its Curve as
well as the differences between short-run and long-run aggregate demand
and supply.

• Understand the meaning and nature of aggregate Supply and its Curve and
also to understand the meaning aggregate supply-aggregate demand model.

• Understand the analysis of shifts in aggregate demand-aggregate supply in

aggregate supply-aggregate demand model, to know the meaning of

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 Government Spending and understand the reasons for increase in
Government spending.

• Meaning of Government Spending and to understand the reasons for increase

in Government spending as well as to know how Government spending is
financed.
• Understand the meaning of Government Revenue and to know the different
types of taxation as a source of government revenue as well as to Know the
use of attributes or Principles of Taxation.

• Understand the meaning of government budget and the reasons for increase
in government expenditure as well as to know how government expenditure
is financed.

• Understand the meaning and reasons for international trade and also
understand the basis or theory of international trade as well as the analysis of
Gain from trade.
• Know the basis of terms of trade and understand the reason for international
trade as well as to know the basis or theory of international Trade
• Know the Gain from Trade and also to know the terms of Trade

Working Through The Course

To successfully complete this course, you are required to read the study units,
referenced books and other materials on the course.
Each unit contains self-assessment exercises called Student Assessment Exercises
(SAE). At some points in the course, you will be required to submit assignments for
assessment purposes. At the end of the course there is a final examination. This
course should take about 15weeks to complete and some components of the course
are outlined under the course material subsection.

Course Material
The major component of the course, What you have to do and how you should
allocate your time to each unit in order to complete the course successfully on time
are listed follows:
1. Course guide
2. Study unit

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 3. Textbook
4. Assignment file
5. Presentation schedule

Study Unit
There are 21 units in this course which should be studied carefully and diligently.

MODULE ONE THE FIELD OF MACROECONOMICS

Unit 1 Meaning of Macroeconomics

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

MODULE TWO NATIONAL INCOME ACCOUNTING

Unit 1 Meaning of National Income Analysis

Unit 2 Consumption, Savings and Investment
Unit 3 Economic Welfare and National Income

MODULE THREE MONEY AND BANKING

Unit 1 Origins of Money

Unit 2 Financial Institution
Unit 3 Central Banking

MODULE FOUR COMPONENTS OF GROSS DOMESTIC PRODUCT

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

MODULE 5 AGGREGATE DEMAND AND AGGREGATE SUPPLY

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

MODULE 6 GOVERNMENT AND THE ECONOMY

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

MODULE 7 OPEN ECONOMY MACROECONOMICS

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

Each study unit will take at least two hours, and it include the introduction,
objective, main content, self-assessment exercise, conclusion, summary and
reference. Other areas border on the Tutor-Marked Assessment (TMA) questions.
Some of the self-assessment exercise will necessitate discussion, brainstorming and
argument with some of your colleges. You are advised to do so in order to
understand and get acquainted with historical economic event as well as notable
periods.
There are also textbooks under the reference and other (on-line and off-line)
resources for further reading. They are meant to give you additional information if
only you can lay your hands on any of them. You are required to study the materials;
practice the self-assessment exercise and tutor-marked assignment (TMA) questions
for greater and in-depth understanding of the course. By doing so, the stated learning
objectives of the course would have been achieved.

Textbook and References

For further reading and more detailed information about the course, the following
materials are recommended:

Ajayi, I. (2004). Introduction to monetary Policy, 2nd edition, pg 33, IPM

publication limited.
Ajayi, I. (2004). Introduction to monetary Policy, 2nd edition, pg 41, IPM
Publication limited.
Ajayi, I. (2005) Paper presentation on Component of Goss domestic product,
IPM Publiction, Lagos.
Ajayi S.I. (1995). The Role of Central Banks in Economic Development, CBN
Economic and Financial Review, Vol 33, No Allen and Unwin
Ajayi, S. I & Ojo, O. (1981). Money and Banking, Analysis and Policy in the
Nigerian Context, London, George Allen and Unwin.
Ansari, M, Gordon, D.V. & Akuamoah, C. (1997). Keynes Versus
Wagner, Public Expenditure and National Income for Three African
Countries, Applied Economics 29, 54 3-550.
Awotu, G, Davies, D. (2011). The debate between Microeconomics and
Macroeconomics analysis, Journal vol 5, pg 56-67, Mill wall Publication
limited, Lagos.
Abdullah, H.A, (2000). The Relationship between Government Expenditure and
Economic Growth in Saudi Arabia, Journal of Administrative Science,
12(2): 173-191.
Al-Yousif, Y, (2000). Does Government Expenditure Inhibit or Promote
Economic Growth, Some Empirical Evidence from Saudi Arabia. Indian

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 Economic Journal, 48 (2).
Asertkerson, D. (2006). Principle of Economics in a large Economy, 1st edition,
Rose world Publication limited.
Akinsanya. T. (2011). Macroeconomics theory, 2nd edition, Makinon Publication
limited.
Amin, S., Arrighi, A, Frank, and Wallerstein. I (1981). Dynamics of Global
Crisis in New York, Monthly Review Press.
Amin, S. (1977). Imperialism and Unequal Development, New York Monthly
Review Press.
Brown, C.V. (2006). The Nigeria Banking System, London Allen and Unwin.
Chipman, J.S. and J.C. Moore (1972). Social utility and the gains from trade.
Journal of International Economics 2, 157{72.
Central Bank of Nigeria (1970). Amendment, No 3 Decree 1969 as amended by
Banking Amendment Decree 1970.
Central Bank of Nigeria (1959). The Bye Laws of the CBN, CBN Bulletin.
Central Bank of Nigeria (1979). Twenty Years of Central Banking in Nigeria
CBN Bulletin Lagos, Nigeria.
Central Bank of Nigeria (2001). Banking Supervision Annual Report, CBN
Bulletin
Falegan, S.B. (2005). Central Bank Autonomy, Historical and General
Perspective, CBN Economic and Fundamental Review, Vol 33 No 4.
Ewing, B., Payne, J., Thompson, M., Al-Zoubi, O. (2006). Government
expenditures and revenues, evidence from asymmetric modeling,
Southern Economic Journal, 73(1), 190-200.
Fasano, U., Wang, Q. (2002). Testing the relationship between government
spending and revenue, Evidence from GCC countries, IMF Working
Paper WP/02/201.
Fasano, U., Wang, Q. (2002). Testing the relationship between government
spending and revenue, Evidence from GCC countries, IMF Working
Paper WP/02/201.
Friedman, M. (1978). The limitations of tax limitation, Policy Review, summer,
7-14.

Jhingan, M.L. (2004). Monetary Economics, 6th edition, Vrinda Publication

Limited, Delhi, Indian.
Jhigan, M. L. (2004). Savings and interest rate analysis, 6th edition, Vrinda
Publication limited.
Jhingan, M.L. (2004). Macroeconomic theory, 11th revised edition, Vrinda Publications
limited, Delhi.
Jhingan, M.L. (2004). Monetary Economics, 6th edition, pg 127-139, vrinda
publications limited.
Karl, E. Case & Ray C., Fair, A. (2005). Principles of Economics, Prentice Hall,

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 6th ed.
Micheal, W. (2008). Macroeconomics theory, a dynamic general equilibrium
approach, Princeton University Press.
Medelling, F. (2010). Macroeconomics theory, a broader perspective 2nd Sawer
mills Press Limited.
Olusanya, S.O. (2008). Introduction to Business Loan and Finance, textbook 1st
edition pg 6-57, Bolu bestway Printers, Lagos.
Olukoya, D. H. (2010). Introduction to macroeconomics theory, 1st edition, Stop-
over Publication limited, Lagos.
Robert. H. Frank and Ben S. Bernanke, S. (2007). Principles of Economics,
McGraw-Hill Irwin, 3rd ed.
Sanya, A. (2012) Introduction to macroeconomics theory, 2nd edition, Macmillan
Press limited.
Von Furstenberg, G.M.R., Green, J., and J.H. Jeong (1986) Tax and Spend, or
Spend, 3rd edition.
Yahyah, R. (2011). Introduction to macroeconomics theory, 1st edition, Landmark
Publication Limited

Assignment File

Assignment files and marking scheme will be made available to you. This file
presents you with details of the work you must submit to your tutor for marking.
The marks you obtain from these assignments shall form part of your final mark for
this course. Additional information on assignments will be found in the assignment
file and later in this Course Guide in the section on assessment.
There are four assignments in this course. The four course assignments will cover:
Assignment 1 - All TMAs’ question in Units 1 – 6 (Module 1 and 2)
Assignment 2 - All TMAs' question in Units 7 – 12 (Module 3 and 4)
Assignment 3 - All TMAs' question in Units 13 – 17 (Module 5 and 6)
Assignment 4 - All TMAs' question in Unit 18 – 21 (Module 6 and 7).

Presentation Schedule
The presentation schedule included in your course materials gives you the important
dates for this year for the completion of tutor-marking assignments and attending
tutorials. Remember, you are required to submit all your assignments by due date.
You should guide against falling behind in your work.

Assessment

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There are two types of the assessment of the course. First are the tutor-marked
assignments; second, there is a written examination.

In attempting the assignments, you are expected to apply information, knowledge

and techniques gathered during the course. The assignments must be submitted to
your tutor for formal Assessment in accordance with the deadlines stated in the
Presentation Schedule and the Assignments File. The work you submit to your tutor
for assessment will count for 30 % of your total course mark.

At the end of the course, you will need to sit for a final written examination of three
hours' duration. This examination will also count for 70% of your total course mark.

Tutor-Marked Assignments (TMAs)

There are four tutor-marked assignments in this course. You will submit all the
assignments. You are encouraged to work all the questions thoroughly. The TMAs
constitute 30% of the total score.

Assignment questions for the units in this course are contained in the Assignment
File. You will be able to complete your assignments from the information and
materials contained in your set books, reading and study units. However, it is
desirable that you demonstrate that you have read and researched more widely than
the required minimum. You should use other references to have a broad viewpoint
of the subject and also to give you a deeper understanding of the subject.

When you have completed each assignment, send it, together with a TMA form, to
your tutor. Make sure that each assignment reaches your tutor on or before the
deadline given in the Presentation File. If for any reason, you cannot complete your
work on time, contact your tutor before the assignment is due to discuss the
possibility of an extension. Extensions will not be granted after the due date unless
there are exceptional circumstances.

Final Examination and Grading

The final examination will be of three hours' duration and have a value of 70% of
the total course grade. The examination will consist of questions which reflect the
types of self-assessment practice exercises and tutor-marked problems you have
previously encountered. All areas of the course will be assessed

Revise the entire course material using the time between finishing the last unit in
the module and that of sitting for the final examination to. You might find it useful
to review your self-assessment exercises, tutor-marked assignments and comments

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on them before the examination. The final examination covers information from all
parts of the course.

Course Marking Scheme

The Table presented below indicates the total marks (100%) allocation.
Assignment Marks
Assignments (Best three assignments out of four 30%
that is marked)
Final Examination 70%
Total 100%

Course Overview
The Table presented below indicates the units, number of weeks and assignments to
be taken by you to successfully complete the course, Principle of Economics (ECO
111).

Units Title of Work Week’s Assessment

Activities (end of unit)
Course Guide
Module 1 The Field of Macroeconomics
1 Meaning of Macroeconomics Week 1 Assignment 1
2 Differences between Week 1 Assignment 1
Microeconomics and
Macroeconomics
3 Importance of Macroeconomics Week 2 Assignment 1
Module 2 National Income Accounting
1 Meaning of National Income Week 2 Assignment 1
Analysis
2 Consumption, Savings and Week 3 Assignment 1
Investment
3 Economic Welfare and National Week 3 Assignment 1
Income
Module 3 Money and Banking
1 Origins of Money Week 3 Assignment 2
2 Financial Institution Week 4
3 Central Banking Week 4 Assignment 2

Module 4 Components of Gross Domestic Product

1 Personal Consumption Expenditure Week 5 Assignment 2
2 Gross Private Domestic investment Week 5 Assignment 2
and Net Exports

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 3 Government Consumption and Week 6 Assignment 2
Gross investment
Module 5 Aggregate Demand and Aggregate Supply
1 Meaning and Nature of Aggregate Week 7 Assignment 3
Demand Curve
2 Meaning and Nature of Aggregate Week 8 Assignment 3
Demand Curve
3 Short-run and Long-run Aggregate Week 9 Assignment 3
Demand and Supply
Module 6 Government and the Economy
1 Meaning of Government Spending Week 10 Assignment 3
2 Meaning of Government Revenue Week 11 Assignment 3
3 Budget analysis Week 12 Assignment 4
Module 7 Open Economy Macroeconomics
1 Analysis of International Trade Week 13 Assignment 4
2 Gain from Trade Week 14 Assignment 4
3 Net Export Function in the Open Week 15 Assignment 4
Economy
Total 15 Weeks

How To Get The Most From This Course

In distance learning the study units replace the university lecturer. This is one of the
great advantages of distance learning; you can read and work through specially
designed study materials at your own pace and at a time and place that suit you best.
Think of it as reading the lecture instead of listening to a lecturer. In the same way
that a lecturer might set you some reading to do, the study units tell you when to
read your books or other material, and when to embark on discussion with your
colleagues. Just as a lecturer might give you an in-class exercise, your study units
provides exercises for you to do at appropriate points.

Each of the study units follows a common format. The first item is an introduction
to the subject matter of the unit and how a particular unit is integrated with the other
units and the course as a whole. Next is a set of learning objectives. These objectives
let you know what you should be able to do by the time you have completed the
unit.
You should use these objectives to guide your study. When you have finished the
unit you must go back and check whether you have achieved the objectives. If you
make a habit of doing this you will significantly improve your chances of passing
the course and getting the best grade.

The main body of the unit guides you through the required reading from other
sources. This will usually be either from your set books or from a readings section.

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Some units require you to undertake practical overview of historical events. You
will be directed when you need to embark on discussion and guided through the
tasks you must do.
The purpose of the practical overview of some certain historical economic issues
are in twofold. First, it will enhance your understanding of the material in the unit.
Second, it will give you practical experience and skills to evaluate economic
arguments, and understand the roles of history in guiding current economic policies
and debates outside your studies. In any event, most of the critical thinking skills
you will develop during studying are applicable in normal working practice, so it is
important that you encounter them during your studies.

Self-assessments are interspersed throughout the units, and answers are given at the
ends of the units. Working through these tests will help you to achieve the objectives
of the unit and prepare you for the assignments and the examination. You should do
each self-assessment exercises as you come to it in the study unit. Also, ensure to
master some major historical dates and events during the course of studying the
material.

The following is a practical strategy for working through the course. If you run into
any trouble, consult your tutor. Remember that your tutor's job is to help you. When
you need help, don't hesitate to call and ask your tutor to provide it.

1. Read this Course Guide thoroughly.

2. Organize a study schedule. Refer to the `Course overview' for more details.
Note the time you are expected to spend on each unit and how the
assignments relate to the units. Important information, e.g. details of your
tutorials, and the date of the first day of the semester is available from study
centre. You need to gather together all this information in one place, such as
your dairy or a wall calendar. Whatever method you choose to use, you
should decide on and write in your own dates for working breach unit.
3. Once you have created your own study schedule, do everything you can to
stick to it. The major reason that students fail is that they get behind with
their course work. If you get into difficulties with your schedule, please let
your tutor know before it is too late for help.
4. Turn to Unit 1 and read the introduction and the objectives for the unit.
5. Assemble the study materials. Information about what you need for a unit is
given in the `Overview' at the beginning of each unit. You will also need both
the study unit you are working on and one of your set books on your desk at
the same time.
6. Work through the unit. The content of the unit itself has been arranged to
provide a sequence for you to follow. As you work through the unit you will
be instructed to read sections from your set books or other articles. Use the
unit to guide your reading.

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 7. Up-to-date course information will be continuously delivered to you at the
study centre.
8. Work before the relevant due date (about 4 weeks before due dates), get the
Assignment File for the next required assignment. Keep in mind that you will
learn a lot by doing the assignments carefully. They have been designed to
help you meet the objectives of the course and, therefore, will help you pass
the exam. Submit all assignments no later than the due date.
9. Review the objectives for each study unit to confirm that you have achieved
them. If you feel unsure about any of the objectives, review the study material
or consult your tutor.
10. When you are confident that you have achieved a unit's objectives, you can
then start on the next unit. Proceed unit by unit through the course and try to
pace your study so that you keep yourself on schedule.
11. When you have submitted an assignment to your tutor for marking do not
wait for it return `before starting on the next units. Keep to your schedule.
When the assignment is returned, pay particular attention to your tutor's
comments, both on the tutor-marked assignment form and also written on the
assignment. Consult your tutor as soon as possible if you have any questions
or problems.
12. After completing the last unit, review the course and prepare yourself for the
final examination. Check that you have achieved the unit objectives (listed
at the beginning of each unit) and the course objectives (listed in this Course
Guide).

Tutors and Tutorials

There are some hours of tutorials (2-hours sessions) provided in support of this
course. You will be notified of the dates, times and location of these tutorials.
Together with the name and phone number of your tutor, as soon as you are allocated
a tutorial group.

Your tutor will mark and comment on your assignments, keep a close watch on your
progress and on any difficulties you might encounter, and provide assistance to you
during the course. You must mail your tutor-marked assignments to your tutor well
before the due date (at least two working days are required). They will be marked
by your tutor and returned to you as soon as possible.

Do not hesitate to contact your tutor by telephone, e-mail, or discussion board if you
need help. The following might be circumstances in which you would find help
necessary. Contact your tutor if.
• You do not understand any part of the study units or the assigned readings
• You have difficulty with the self-assessment exercises
• You have a question or problem with an assignment, with your tutor's comments
on an assignment or with the grading of an assignment.

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You should try your best to attend the tutorials. This is the only chance to have face
to face contact with your tutor and to ask questions which are answered instantly.
You can raise any problem encountered in the course of your study. To gain the
maximum benefit from course tutorials, prepare a question list before attending
them. You will learn a lot from participating in discussions actively.

Summary
The course, Principle of Economics II (ECO 122), expose you to the field of
macroeconomics, national income accounting of a country through various terms of
national income such as gross domestic product, gross national product, net national
product, personal income, Disposable Income etc. This course also gives you insight
into money and banking which discusses the issue of money such as its functions
and the Keynesian motive of holding money and financial institutions was also
examined. The course shield more light on the components of gross domestic
product which includes personal consumption expenditure, gross private domestic
investment and net export. However, government consumption and gross
investment were also examined. Furthermore the course shall enlighten you about
the aggregate demand and aggregate supply both in the short and long run and it
will also make you to know the differences between government
spending/expenditure and government revenue as well as the budget analysis.
Conclusively it analyses the international trade in an open economy such as gain
from trade, net export function in the open economy.
On successful completion of the course, you would have developed critical thinking
skills with the material necessary for efficient and effective discussion on
macroeconomic issues: national income analysis, monetary issue, government
expenditure and macroeconomics in open economy. However, to gain a lot from the
course please try to apply anything you learn in the course to term papers writing in
other economic development courses. We wish you success with the course and
hope that you will find it fascinating and handy.

Module 1: The Field of Macroeconomics

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This module introduces you to the field of Macroeconomics. The module consists
of 3 units which include: meaning of macroeconomics, Differences between
Microeconomics and Macroeconomics and Importance of Macroeconomics.

Unit 1 Meaning of Macroeconomics

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

UNIT 1 Meaning of Macroeconomics

Unit Structure

1.1. Introduction
1.2. Learning outcome
1.3. Definition of Macroeconomics
1.4. Basic Macroeconomic Concept
1.4.1. Output and Income
1.4.2. Unemployment
1.4.3. Inflation and Deflation
1.5. Summary
1.6. References/Further Readings/Web Resources
1.7. Possible Answers to Self-Assessment Exercises (SAEs)

1.1. INTRODUCTION

We will start this unit by trying to know the meaning of macroeconomics. Therefore
we start by saying that the term “macro” was first used in economics by Ragner
Frisch in 1933, but it was only used as a methodological approach to economic
problems, it originated with the Mercantilists in the 16th and 17th centuries.
However, if you may ask, they were concerned with the economic system as a
whole. In the 18th century, the physiocrats adopted it in their table Economique to
show the ‘circulation of wealth’ (i.e the net product) among the three classes
represented by the farmers, landowners and the sterile class. Malthus, Sismondi and
Marx in the 19th century dealt with macroeconomics problems. Walras, Wicksell
and Fisher were the modern contributors to the development of macroeconomic
analysis before John Maynard Keynes. Economists such as Cassel, Marshall, Pigou,
Robertson, Hayek and Hawtrey, developed a theory of money and general prices in
the decade following the First World War, but the credit goes to John Maynard
Keynes who finally developed a general theory of income, output and employment
in the wake of the Great Depression of 1929.

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In this lecture, we will examine the definition of macroeconomics, understand the
meaning of macroeconomics as a field of study and goal of macroeconomics. The
similarities and differences between the two fields and also the importance of
macroeconomics as a separate field of study.

1.2 Learning Outcomes

At the end of this unit, you will be expected to:

i. Define and understand the meaning of macroeconomics as a field of study
ii. Know the basic macroeconomics concepts

1.3. Definition of Macroeconomics

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

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

Having defined macroeconomics in two several ways, it can be said that it is

concrete that macroeconomics is a study of "the big picture" in the economy. Rather
than focusing on individual households and firms, it examines conditions within the
economy as a whole. This is the most vital differences between micro and
macroeconomics. In more technical terms, macroeconomics looks at the factors that

17
influence aggregate supply and demand. Although macroeconomics has a much
broader focus than microeconomics does, many macroeconomic factors are
essential to making predictions and conclusions at the microeconomic level. For
instance, knowing what the unemployment rate is at the national level can help a
macroeconomist to predict future layoffs in a specific industry.

Self-Assessment Exercises 1
1. Briefly discuss the term “macroeconomics”.

2. What are the 3 types of macroeconomics?

1.4. GOAL OF MACROECONOMICS

(a) FULL EMPLOYMENT

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

According to Keynes, full employment means the absence of involuntary

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

(b) PRICE STABILITY

18
One of the goals of macroeconomics policy is to stabilize the price level. Both
economists and laymen favour this policy because fluctuations in prices bring
uncertainty and instability to the economy. Rising and falling prices are both bad
because they bring unnecessary loss to some and undue advantage to others. Again,
they are associated with business cycles. So a policy of price stability keeps the
value of money stable, eliminates cyclical fluctuations, brings economic stability,
helps in reducing inequalities of income and wealth, secure social justice and
promotes economic welfare.

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

Despite these drawbacks, the majority of economists favour a policy of stable prices.
But the problem is one of defining price stability. Price stability does not mean that
prices remain unchanged indefinitely. Comparative prices will change as fluctuating
tastes alter the composition of demand; as new products are developed and as cost
reducing technologies are introduced. Differential price changes are essential for
allocating resources in the market economy. However, since modern economies
tend to exhibit fairly rigid downward inflexibility of prices, differential price
changes can only be attained by gradual increases in the aggregate price level over
the long-run. Further, prices may have to be changed if costs of imported goods
increase or if taxation policy leads to the rise in the domestic cost of production. It
should be noted that price stability can be maintained by following a counter-
cyclical monetary policy, that is easy monetary policy during a recession and dear
monetary policy during boom.

(c) ECONOMIC GROWTH

19
One of the most important goals of macroeconomics objective in recent years has
been the rapid economic growth of an economy. Economic growth is defined as the
process whereby the real per capita income of a country increases over a long
period of time. Economic growth is measured by the increase in the amount of goods
and services in each successive time period. Thus, growth occurs when an
economy’s productive capacity increases which, in turn, is used to produce more
goods and services. However, economic growth implies raising the standard of
living of the people, and reducing inequalities of income distribution. We all will
agree that economic growth is a desire goal for a country. But there is non agreement
over the magic number viz, the annual growth rate which an economy should attain.

Generally, economists believe in the possibility of continual growth. This belief is

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

However, policy makers do not take into consideration the costs of growth. Growth
is not limitless because resources are scarce in every economy. All factors have
opportunity cost. To produce more of one particular product will mean reduction in
that of the other. New technologies lead to the replacement of old machines which
become useless. Workers are also displaced because they cannot be fitted in the new
technological set up immediately. Moreover, rapid growth leads to urbanization and
industrialization with their adverse effects on the pattern of living and environment.
People have a live in squalor and slums. The environment becomes polluted. Social
tensions develop. But growth has other more basic effect on our environment, and,
today, people are not so sure that unrestricted growth is worth all its costs, since the
price in terms of change in, deterioration of, or even destruction of the environment
is not yet fully known. What does seem clear, however, is that growth is not going
to be halted because of environmental problems and that mankind must learn to cope
with the problem or face the consequences.

(d) BALANCE OF PAYMENTS

Another goal of macroeconomic objectives has been to maintain equilibrium in the

balance of payments. The achievement of this goal has been necessitated by the
phenomenal growth in the world trade as against the growth of international
liquidity. It is also recognized that deficit in the balance of payment will retard the
attainment of other goals. This is because a deficit in the balance of payments leads
to a sizeable outflow of gold. But it is not clear what constitutes a satisfactory
balance of payments position. Clearly a country with a net debt must be at a surplus

20
to repay the debt over a reasonably short period of time. Once any debt has been
repaid and an adequate reserve attained, a zero balance maintained over time would
meet the policy objective. But how is this satisfactory balance to be achieved on the
trading account or on the capital account? The capital account must be looked upon
as fulfilling merely a short-term emergency role in times of crises.

Again, another problem relates to the question: what is the balance of payments
target of a country? It is where imports equal exports. But, in practice, a country
whose current reserves of foreign exchange are inadequate will have a mild export
surplus as its balance of payments target. But when its reserve become satisfactory,
it will aim at the equality of imports and exports. This is because an export surplus
means that the country is accumulating foreign exchange and it is producing more
than it is consuming. This will lead to low standard of living of the people. But this
cannot last long because some other country must be having import surplus and in
order to avoid it, it would impose trade restrictions on the export surplus country.
However, the attainment of a balance of payment equilibrium becomes an
imperative goal of macroeconomics policy in a country.

Finally, if the money supply is below the existing demand for money at the given
exchange rate, there will be a surplus in the balance of payments. Consequently,
people acquire the domestic currency by selling goods and securities to foreigners.
They will also seek to acquire additional money balances by restricting their
expenditure relatively to their income. The central bank, on its part, will buy excess
foreign currency in exchange for domestic currency in order to eliminate the
shortage of domestic currency.

(e). FAIR INCOME DISTRIBUTION

This goal is concerned with how to distribute income in the economy among the
population. The distance between the rich and the poor should not differ
significantly. It is usually more in the light of normative economics than positive
economics. Income distribution can also be called Social objectives.
Macroeconomic policy is also used to attain some social ends or social welfare. This
means that income distribution needs to be more fair and equitable. In a capitalist
market-based society some people get more than others. In order to ensure social
justice, policymakers use macroeconomic policy instruments. However, fair income
distribution goal is concerned with how to distribute income in the economy among the
population. The distance between the rich and the poor should not differ significantly. It is
usually more in the light of normative economics than positive economics. Therefore, to

21
achieve this goal, the government has several instruments, including taxes and
other social expenditures such as unemployment benefits and social assistance.

Self-Assessment Exercises 2

List and explain the goals of macroeconomics

1.5. Summary
In this unit, you have been able to learn what is the meaning of macroeconomics
and the basic concepts of macroeconomics. The unit takes a look at macroeconomics
as the aggregate or the average of the whole economy. The concept of
macroeconomics deals with the whole economy and gives us a deep knowledge
about individual household in the economy. Macroeconomics is seen as the study
of aggregates or average covering the entire economy, such as total employment,
national income, national output, total investment, total consumption, total savings,
aggregate supply, aggregate demand and general price level, wage level and cost
structure.

Therefore, at this junction, I belief you must have learnt a lot from the unit on the
meaning of macroeconomics analysis.

1.6. References/Further Readings

Karl E. Case and Ray C. Fair (2005) Principles of Economics, Prentice Hall, 6th
Edition.
Robert. H. Frank and Ben S. Bernanke, (2007) Principles of Economics, McGraw-
Hill Irwin, 3rd Edition.
Jhingan, M.L (2004) Monetary Economics, 6th edition, Vrinda Publication
Limited.

1.7 Possible Answers to SAEs

22
These are the possible answers to the SAEs within the content.
Answers to SAEs 1
1. Macroeconomics focuses on the performance of economies – changes in
economic output, inflation, interest and foreign exchange rates, and the balance of
payments. Poverty reduction, social equity, and sustainable growth are only possible
with sound monetary and fiscal policies.
It is also the study of whole economies--the part of economics concerned with large-
scale or general economic factors and how they interact in economies.

2. Three types of macroeconomic policies are as follows:

(i). Fiscal policy
(ii). Monetary Policy
(iii). Supply side policies.

Answers to SAEs 2
The overarching goals of macroeconomics are to maximize the standard of living
and achieve stable economic growth. The goals are supported by objectives such
as:
(i). Full Employment
(ii). Price Stability
(iii). Economic Growth
(iv). Balance Of Payments
(v). Fair Income Distribution

UNIT 2 THE DISTINCTION BETWEEN MICROECONOMICS AND

MACROECONOMICS.

23
Unit Structure

2.1. Introduction
2.2. Learning Outcome
2.3. Difference between microeconomics and macroeconomics
2.4. Transition from microeconomics to macroeconomics
2.5. Summary
2.6. References/Further Readings/Web Resources
2.7. Possible Answers to Self-Assessment Exercises (SAEs)

2.1. INTRODUCTION

In this unit, we shall try to make a clear distinction between microeconomics and
macroeconomics. You may be thinking in your mind what could have been the
differences between the two and whether they are even the same, but it is not so.
Microeconomics to some school of thought belief is a branch of economics that
deals with individual firms, their output and cost, the production and pricing of
single commodities, wages of individuals etc while macroeconomics is seen as the
branch of economics that deals with the relationship between large aggregates such
as the volume of employment, the total amount of saving and investment etc.
Therefore, in this unit, we will critically discuss their differences in detailed with
examples to distinguish them.

2.2. Learning Outcome

By the time you must have gone through this unit, you will be able to:
i. Distinguish between Microeconomics and Macroeconomics
ii. Understand the transition from Microeconomics to Macroeconomics analysis.

2.3. Difference between Microeconomics and Macroeconomics

Microeconomics is the study of individual economic units of an economy whereas

macroeconomics is the study of aggregates of an economy as a whole. For example,
when we study an individual sugar mill manufacturing firm, our study is micro
analysis but if we study the entire sugar manufacturing sector of the economy, our
study is macro analysis.
24
Also please note if we study the problem of production of a firm, our analysis is
micro study but if we study the problems of production of the whole economy, our
analysis is macro study. Both Microeconomics and Macroeconomics are inter-
dependent and complementary.

The main difference between the Microeconomics and Macroeconomics are as

follows:

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

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

individual prices and individual income, general price level and national
output, etc. output, etc.
3. Its Central problem is price Its central problem is determination of
determination and allocation of level of income and employment.
resources.
4. Its main tools are demand and Its main tools are aggregate demand and
supply of a particular aggregate supply of economy as a whole.
commodity/factor.
5. It helps to solve the central problem It helps to solve the central problem of
of what, how and for whom to full employment of resources in the
produce in the economy economy.
6. It discusses how equilibrium of a It is concerned with the determination of
consumer, a producer or an equilibrium level of income and
industry is attained. employment of the economy.
7. Price is the main determinant of Income is the major determinant of
microeconomic problems. macroeconomic problems.

Self-Assessment Exercises 1
Differentiate between Microeconomics and Macroeconomics analysis

2.4. Transition from Microeconomics to Macroeconomics

25
 In this section, we will discuss the transition of from microeconomics to
macroeconomics analysis.
However, both microeconomics and macroeconomics were used by both the
classical and the neo-classical economists in their analysis. Marshall was the one
that developed and perfected microeconomics as a method of economic analysis.
More so, Keynes was the one that developed macroeconomics as a distinct method
in economic theory. Therefore, the actual process of transition from
microeconomics to macroeconomics started with the publication of keynes’s
general theory.

Microeconomics is the study of economic actions of individuals and small groups

of individuals. It includes particular households, particular firms, particular
industries, particular commodities, individual prices, wages and incomes. Thus
microeconomics studies how resources are allocated to the production of particular
goods and services and how efficiently they are distributed. But microeconomics
studied in itself, and does not study the problem of allocation of resources to the
economy as a whole. It is concerned with the study of parts and neglects the whole,
for example according to the economists “Description of a large and complex
universe of facts like the economic system is impossible in terms of individual
items’. Thus the study of microeconomics presents an imprecise picture of the
economy. However, the orthodox economist, like Pigou, tried to apply
microeconomic analysis to the problems of an economy. Keynes thought otherwise
and advocated macroeconomics which is the study of aggregates covering the entire
economy such as total employment, total income, total output, total investment, total
consumption, total savings, aggregate supply, aggregate demand, and general price
level, wage level and cost structure. For understanding the problems facing the
economy, Keynes adopted the macro approach which brought about the transition
from micro to macro.

Microeconomics also assumes the total volume of employment as given and studies
how it is allocated among individual sectors of the economy. But Keynes rejected
the assumption of full employment of resources, especially of labour. From the
macro angle, he regarded full employment as a special case. The general situation
is one of under-employment. The existence of involuntary unemployment of labour
in capitalist economies proves that underemployment equilibrium is a normal
situation and full employment is abnormal and accidental.

Keynes refuted Piguo’s view that a cut in money wage could eliminate
unemployment during a depression and bring about full employment in the
economy. The fallacy in Piguo arguments was that he extended the argument to the
economy which was applicable to a particular industry. Reduction in money wage
26
rate can increase employment in an industry by reducing its cost of production and
the price of the product thereby raising its demand. But the adoption of such a policy
for the economy leads to a reduction in employment. When money wages of all
workers in the economy are reduced, their incomes are reduced correspondingly. As
a result, aggregate demand falls leading to a decline in employment in the economy
as a whole.

Microeconomics takes the absolute price level as given and concerns itself with
relative prices of goods and services. How the price of a particular commodity likes
rice, tea, milk, fan scooter, etc. is determined? How the wages of a particular type
of labour, interest on a particular type of capital asset, rent on a particular land, and
profits of an individual entrepreneur are determined? But an economy is not
concerned with relative prices but with the general level prices. And the study of the
general level prices falls within the domain of macroeconomics. It is the rise or fall
in the general price level that leads to inflation, and to prosperity and depression.
Prior to the publication of Keynes’s General Theory economists concerned
themselves with the determination for relative prices and failed to explain the causes
of inflation and deflation or prosperity and depression. They attributed the rise or
fall in the price level to the increase or decrease in the quantity of money. Keynes,
on the other hand, showed that deflation and depression were caused by the
deficiency of aggregate demand, and inflation and prosperity by the increase in
aggregate demand. It is thus the rise or fall in aggregate demand which affects the
general price level rather than the quantity of money.

Self-Assessment Exercises 2
Discuss the transition from microeconomics to macroeconomics.

2.5 Summary
In this unit, you have been able to learn the views of classical and neo-classical
economists about the economy in small and large dimension. The unit take us to the
level of comparison of the both the micro and macro economist about the economy.
The transition from microeconomics to macroeconomics has been the views of
classical and the neo-classical economist on both the micro and macro level of the
economy. We can then conclude that as micro economist made their view about the
economy, the macroeconomist also made their own view too about the economy.
However, it is believes that you must have read through the discussion of the two
views and will have learnt a lot about the micro and macroeconomics analysis.

27
 2.6 References/Further Readings

Sanya, A. (2012). Introduction to Macroeconomics Theory. 2nd edition, Macmillan

Press limited.
Jhingan, M. L. (2004). Macro-Economic Theory. 11th edition, Vrinda Publication

Limited, Delhi, Indian.

2.7 Possible Answers to SAEs

These are the possible answers to the SAEs within the content.
Answers to SAEs 1
Microeconomics is the study of economics at an individual, group, or company
level. Whereas, macroeconomics is the study of a national economy as a whole.
Microeconomics focuses on issues that affect individuals and companies.
Macroeconomics focuses on issues that affect nations and the world economy.

Answers to SAEs 2
Even though supply and demand applies to both fields of
economics, microeconomics is based on the trends of buyers and sellers, where
macroeconomics focuses on the various cycles of an economy, such as short and
long term debt cycle, and business cycles.

UNIT 3 IMPORTANCE OF MACROECONOMICS AS A

SEPARATE FIELD OF STUDY

28
Unit Structure

3.1. Introduction
3.2. Learning Outcome
3.3. Importance of macroeconomics
3.4. Summary
3.5. References/Further Readings/Web Resources
3.6. Possible Answers to Self-Assessment Exercises (SAEs)

3.1. Introduction

This unit examines how important macroeconomics is to the generality of the whole
economy. You may want to ask the question that of what importance is
macroeconomics in a country? However, the question may require lot of thinking
and you may end up listing a lot of point on the importance of macroeconomics
analysis. So let us start by saying that macroeconomic theory is important for several
reasons, and some of such reasons are: it provides us with tools by which we can
judge the performance of an economy. We can also say that the performance of an
economy is judged by the Gross National Product (GNP) of the economy and it is
generally assumed that the objective of the government in any country is to raise the
material wellbeing of the country. Now the question is how to define the material
wellbeing of the country. These questions are discussed in welfare economics which
forms a part of macroeconomic theory. In conclusion this unit will take you through
those reasons why macroeconomics analysis is so importance in a country.

3.2. Learning Outcome

At the end of this unit, you will be expected to:

i. Understand the various reason why macroeconomics analysis is important

ii. Understand how the macroeconomics works in an economy.

3.3. Importance of Macroeconomics

29
The study of macroeconomics is indispensable for understanding the workings of
the economy. Our main economic problems are related to the bahaviour of total
income, output, employment and the general price level in the economy. The
variables are statistically measurable thereby facilitating the possibilities of
analyzing the effects on the functioning of the economy. It gives a bird eye view of
the economic world.

For the formulation of useful economic policies for the nation, macro-analysis is of
the utmost significance; economic policies cannot be obviously based on the
fortunes of a single firm or even industry or the price of individual commodity. The
Keynesian theory of employment suggested that. Increasing total investment, total
output, total income and total consumption should raise unemployment caused by
deficiency of effective demand. Thus, macroeconomics has special significance in
studying the causes, effects and remedies of general unemployment.

The study of macroeconomics is very important for the evaluation of overall

performance of the economy in terms of national income. National income data
helps in forecasting the levels of economic activity and to understand the
distribution of income among different groups of people in the economy. It is in
terms of macroeconomics that monetary problems can be analyzed and understood
properly. Frequent change in the value of money, inflation or deflation, affect the
economy adversely. Adopted monetary, fiscal and direct control measures for the
economy as a whole can counteract them.

We may conclude that macroeconomics enriches out knowledge of the functioning

of an economy by studying the behavior of national income, output investment,
saving and consumption. Moreover, it throws much light in solving the problems of
unemployment, inflation, economic instability and economic growth.

Self-Assessment Exercises 1
List and explain Five (5) importance of macroeconomics.

3.4. Summary

30
We have learnt in this unit that importance of macroeconomics is very crucial and
represent the key to any nation’s economy. However, macroeconomics has brought
about the dissection of the economy and this has helped a lot of economist expert in
understanding the economy better.

3.5. References/Further Readings/Web Resources

Olukoya, D. H. (2010) Introduction to macroeconomics theory, 1st edition, Stop-

over Publication limited, Lagos.

3.6 Possible Answers to SAEs

These are the possible answers to the SAEs within the content.
Answers to SAEs 1

1) Understand the economy as a whole

(2) Identifying functioning of an economy
(3) Helps to the formulation of economic policies
(4) Understanding macroeconomics
(5) Understanding and controlling economic fluctuations,

Module 2: National Income Accounting

31
This module examines the national income accounting. It is made up 3 units and
meaning of National income analysis, consumption, savings and investment,
Economic welfare and National income

Unit 1 Meaning of National Income Analysis

Unit 2 Consumption, Savings and Investment
Unit 3 Economic Welfare and National Income

UNIT 1 NATIONAL INCOME ANALYSIS

Unit Structure

1.1. Introduction
1.2. Learning Outcome
1.3. Concept of National Income
1.4. Importance of National Income Accounting
1.5. Measuring GDP
1.6. National Income Measurement Problems
1.7. Summary
1.8. References/Further Readings

1.1. Introduction

National income accounting is a term used in economics to refer to the bookkeeping

system that a national government uses to measure the level of the country's
economic activity in a given time period. Such records include total revenues earned
by domestic corporations, wages paid to foreign and domestic workers, and the
amount spent on sales and income taxes by corporations and individuals residing in
the country.

National income accounting provides economists and statisticians with detailed

information that can be used to track the health of an economy and to forecast future
growth and development. Although national income accounting is not an exact
science but it provides useful insight into how well an economy is functioning, and
where money are being generated and spent.

1.2. Learning Outcome

32
At the end of this unit, you will be able to:
i. Understand the terms and measurement of national income
ii. Understand the importance of national income
iii. Know the different method of national income accounting

1.3. Concept of National Income

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

1.3.1 Gross Domestic Product (GDP)

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

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

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

ii. Final Goods and Services

33
In this case, we should note that not all goods and services that have a market value
are counted in GDP. GDP includes only those goods and services that are the end
product of the production process which are called final goods and services.

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

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

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

It should however be noted that some goods can either be intermediate or final. A
special type of good that is difficult to class as intermediate or final is a capital good.
A capital good is a long-lived good which is itself produced and used in producing
other goods and services, e.g., factories, equipments and machines. Capital goods
do not fit into the definition of final goods since their purpose is to produce other
goods. Also, they are not intermediate goods, because they are not used up during
the production process except over a very long period of time. Thus, for the purpose
of measuring GDP, economists have agreed to classify newly produced capital
goods as final goods so as to avoid double counting.

To illustrate the distinction between final goods and intermediate goods, let us
consider the following examples:

Illustration 1:
Suppose that a bag of grain has a market value of N25 (twenty naira, the price the
milling company paid for the grain). If the grain then is milled into flour, which has

34
a market value of N50.00 (the price the baker paid for the flour). The flour is then
made into a loaf of bread worth N150.00 in the market.
In calculating the contribution of these activities to GDP, we cannot add together all
the values of the grain, flour and bread, this is because the grain and flour are only
intermediate goods used in the production of bread. So, the total contribution to
GDP is N150.00 which is the market value of the loaf of bread, the final product.

Illustration 2:
A tailor charges N1000.00 for each cloth that she makes. The tailor pays her shop
apprentice N100.00 per cloth made in return for sweeping the floor and other chores.
For each clothe sown, what is the total contribution of the tailor and her apprentice
to GDP?
Answer:
The answer to this question is simply 1000.00 which is the market value of each
cloth sown. This service is counted in GDP because it is the final service, the one
that actually has value to the final user. The services the apprentice provided are
intermediate services and have value only because the services contributed to the
production of the making of the cloth; thus, they are not counted in GDP.

As earlier pointed out, intermediate goods are not counted in GDP to avoid double
counting. Double counting can also be avoided by counting only the value added to
a product by each firm in the production process.

Illustration 3:
A farmer produces N1, 000 worth of cattle milk. He sold N300 worth of milk to his
friends and uses the rest of the milk to feed his livestock, which he at the end sold
to his friends for N1, 500. What is the farmer’s contribution to GDP?

Answer:
The milk the farmer produced serves as an intermediate good and part as a final
good. The N700 (N1, 000 minus N300) worth of cattle milk that was fed to the
livestock is an intermediate good, thus, it is not counted as part of GDP. Whereas,
the N300 worth of cattle milk sold to his friend is a final good. So, it is counted.
Thus, final goods in the examples above are the N300 worth of cattle milk and the
N1, 500 worth of livestock that the farmer sold to his friend. Adding N300 to N1,
500 makes N1, 800 which is the farmer’s contribution to GDP.
As earlier pointed out, intermediate goods are not counted in GDP to avoid
double counting. Double counting can also be avoided by counting only the value
added to a product by each firm in the production process; the value added method
would be explained later in the course of the study.

35
iii. Produced within a Country during a given Period
The word ‘domestic’ used in the definition of gross domestic product tell us that
GDP is a measure of economic activities within a given country. Therefore, only
goods and services produced with the country’s borders are counted. For example,
the GDP of Nigeria includes the market value of all goods and services produced
within the Nigerian borders even if they are made in foreign-owned industries or are
produced by foreigners. Also, goods and services produced in Ghana by a Nigerian
based company like Globacom, etc. are not counted. In addition, only goods and
services produced during the current year, or the portion of the value produced
during the current year, are counted as part of the current year’s GDP.
In sum, the output produced by Nigerians abroad for example, Nigerian citizens
working for a foreign company is not counted in Nigeria’s GDP because the output
is not produced within Nigeria. In the same vein, profits earned abroad by Nigerian
companies are not counted in Nigeria’s GDP. However, the output produced by
foreigners working in Nigeria is counted in Nigeria’s GDP because the output is
produced within Nigeria. Also, profits earned in Nigeria by foreign-owned
companies are counted in Nigeria’s GDP. For example, while the output of
foreigners working in Shell, Exxon, Mobil, etc are counted as part of GDP, output
produced by Nigerians abroad are not counted.

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

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

a. Goods and services that have no market value are not included in GDP
because it would be impossible to have a correct estimate of their market
prices. Such goods and services that have no market value include those

36
 rendered free of charge. Examples include the bringing up of a child by the
mother, songs recited to friends by a musician etc.
b. Intermediate goods and services are not included in GDP. This is because
many of the intermediate goods pass through a number of production stages
or processes before they are finally purchased or consumed. If these products
are now counted at every production stage, they would be included many
times in GDP leading to the problem of double counting, and as a result, the
GDP would increase or be overstated. Therefore, to avoid double counting,
only the market value of the final products and not the intermediate products
should be included in GDP.
c. The transactions that do not arise from current year product or which do not
contribute in any form to production are excluded in GDP. Thus, the sale and
purchase of old goods, fairly used goods, and of shares, bonds and assets of
existing companies are all excluded in GDP because they do not make any
addition to national product, and the goods are simply transferred.
d. Likewise, transferred payments (monies that you do not work for) such as
payments received under social security e.g., unemployment insurance
allowance, scholarship, bursary, gifts and bequests, old age pension, and
disability pension are also not included in GNP because the recipients do not
provide any service for them.
e. The profits earned or losses incurred on account of changes in capital assets
as a result of the fluctuations in market prices are not included in GDP if and
only if they are not responsible for the current year’s production or current
year’s economic activity. For example if the price of a house increases due
to inflation, the profit earned by selling such a house will not be part of GDP,
but if a portion of the house is constructed anew during the current year, the
increase in the value of the house (after deduction of the cost of the newly
constructed portion) will be included in GDP.
Similarly, variations in the value of assets which can be ascertained
beforehand and that are therefore insured against uncertainties such as flood,
fire, etc, are not include in GDP. Note however that the depreciation of
machines, plants and other capital goods is not deducted from GDP.
f. Income earned through illegal activities such as smuggling, drug trafficking,
children trafficking, prostitution etc are not included in GDP. Also, goods
sold in the black market, are excluded although they are priced (they have
market value) and fulfil the needs of the people but from the social point of
view, they are not useful, and thus, the income received from their sales and
purchases is always not included in GDP.
There are several reasons for the exclusion of illegal activities and black market
transactions from GDP. First, it is uncertain whether or not these products were
produced during the current year or the preceding years. Secondly, many of the

37
products involved in smuggling are foreign made products and are smuggled into
the country; thus, are not included in GDP because they are not produced within the
border of the domestic country.

1.3.2. Problem of Computation of GDP

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

1.3.3. Gross National Product (GNP)

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

38
citizens of a country who are abroad. The income of citizens of a country living
abroad is termed factor income from the rest of the world. Unlike GDP, it excludes
the output foreigners residing in the domestic country. Thus, it subtracts the income
of the foreigners living in the domestic country that is called payments of factor
income to the rest of the world.
GNP therefore takes account of three components which are the income or
output of citizens of a country residing in the country (GDP), the income or output
of citizens residing abroad (factor income from the rest of the world) and excludes
the income or output of foreigners residing in the domestic country (factor income
to the rest of the world)
Because GNP considers only the output of nationals of a country, GNP is
therefore GDP plus receipts of factor income from the rest of the world less the
payments of factor income to the rest of the world. Where the difference between
the receipts of factor income from the rest of the world and the payments of factor
income to the rest of the world is termed net factor income from abroad (Nf). GNP
is therefore GDP plus net factor income from abroad: GNP = GDP + (Nf).

1.3.4. Net National Product (NNP)

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

1.3.5. Domestic Income

This is similar to GDP but is particular about income earned on the output produced.
Domestic income is the income earned or generated by all the factors of production
(land, labour, capital, entrepreneurship) within a given country from its own
resources. Domestic income includes: (i) wages and Salaries earned by labour; (ii)
rent, including imputed house rents earned by land; (iii) interest on capital; (iv)
dividends,; (v) undistributed corporate profits including the surpluses of public
sector undertakings; (vi) other incomes consisting of profits of unincorporated
firms, partnerships, self-employed, and (vii) direct taxes.
Domestic income does not include the income earned abroad and so, it is the
difference between national income and net income earned from abroad.

39
Domestic Income = National Income – Net Income earned from Abroad
DI = NI –Nf
Note however that net income earned from abroad can be positive or negative.
It is positive if income earned on exports is greater than the payment made on
imports. In this case, national income will be greater than domestic income.
Whereas, if payments made on imports exceed the receipts from exports, net income
earned from abroad will be negative, thus domestic income will be greater than
national income. Note that domestic income can be also be gross or net.

1.3.6. Personal Income

This is the total income received by the individuals of a country from all sources in
one year before it is subjected to direct taxes.

Per Capita Income /GDP Per Capita

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

Per capita income = National Income

Total Population

Per capita GDP = GDP

Total Population

1.3.7. Disposable Income (DI)

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

1.3.8. Nominal versus Real GDP

To make justice to these two terms, gross domestic product of a country may rise or
fall due to an increase or decrease in prices. The rise or fall of the gross domestic
product may, however, not be real. That is, gross domestic product might not
increase or fall in the real sense. To guide against erring on this account, real gross

40
domestic product has to be calculated. Real gross domestic product is calculated
using the prices of goods and services that prevailed in a base year rather than in the
current year. Real gross domestic product is nominal gross domestic product that
has been adjusted for inflation. In other words, inflation has been removed or taken
care of in real gross domestic product. Thus, comparisons of economic activities at
different times should be done using real gross domestic product and not nominal
gross domestic product because using nominal gross domestic product to compare
economic activities at two or more different points in time may give a misleading
answer.
Nominal GDP is the GDP measured in the current market prices of the goods and
services. In other words, it is calculated using current year prices. It can increase or
decrease, but it does not tell us if the increase or decrease is as a result of rise or fall
in inflation or price level. It is also called GDP at market or current prices. On the
other hand, real GDP is called GDP at constant prices.

Illustration 5:
Let us assume that Nigeria produces only two commodities: Rice and Yam. The
prices and quantities of these two goods in 1990 and 1991 are presented in Table
1.1.

Table 1.1: Prices, Quantities and GDP in 1990 and 1991

Quantity of Prices of Quantity of Price of Yam
Year Rice Yam (N) Yam (N)
1990 20 5 30 4
1991 40 10 60 5

a. Calculating Nominal GDP

If we calculate GDP in each of the two years as the market value of production,
then,
GDP for 1990 = (20 bags of rice x 5) + (30 bags of yam x 4)
= N220
GDP for 1991 = (40 bags of rice x 10) + (60 bags of yam x 5)
= N700
These values (N220 and N700) are referred to by the economists as GDP valued at
current year prices or nominal GDP. If we compare GDP for 1990 with GDP for
1991, we might conclude that the GDP in 1991 is 3.3 times greater than 1990 GDP,
that is (700 > 220).

41
As shown from the example, if we want to use GDP in comparing economic activity
at different point in time, there is need to exclude the effects of price changes that
is, we need to adjust for inflation.
To adjust for inflation, economists usually use a common set of prices to value
quantities produced in different years. A particular year when prices are normal or
stable is called the base year is usually selected, and the price from that year is then
used in calculating the market value of output. Thus, real GDP is calculated using
the prices from a base year; rather than the current year’s prices.

b. Calculating Real GDP

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

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

1.3.9. GDP at Factor Cost

We can find terms like GDP at factor cost in National Income accounting. GDP at
factor cost is the sum of the monetary value of all goods and services produced by

42
the factors of production or the income accruing to the various factors of production
in one year in a country.

Self-Assessment Exercises 1
Write short note on the following:
(i) Gross Domestic Product
(ii) Gross National Product
(iii) Net National Product
(iv) Domestic Product

1.4. Importance of National Income Accounting

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

43
8. Comparisons of the changes in the components of the economy over time
and across the frontiers are made possible only by the estimates in the
national income accounts.
9. It is used to forecasts about the future of an events and it can also be used to
analyse what changes are likely to occur in the economy either as a
consignment of or independently of economic and political policies.

Self-Assessment Exercises 2
Explain the importance of national income accounting

1.5. Measuring GDP

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

1.5.1. The Value-Added Approach

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

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

Let us now illustrate the value added method by using the following example: Let
assume that in the production of yam making we have already determined that the
total contribution of the production process to GDP is N200.00, which is the value
of the yam. It can be shown that we can get the same answer (N200.00) by summing
up the value added.

Suppose that bread baking is the ultimate product of these three firms (Obaka Grain
Company produces grain; Olusanya Flour produces flour; and Jelili Bread Bakery
produces the bread). Given the market value of the grain, the flour and the bread,
what is the value added by each of these three companies?
44
Solution:
Value added for any firm is the market value of its product or service minus the cost
of inputs purchased from other firms. So, for these three firms, their value added
can be calculated thus:

Obaka Grain Company:

obaka Grain Company produces N5.00 worth of grain using no inputs from other
companies. Since it purchased no input from other companies, therefore, the cost of
inputs purchased is zero naira. Obaka’s value added is therefore N5.00 [which is the
market value of its product less the cost of inputs purchased]. Thus, Obaka Grain
Company’s Value added = N5.00 – N0.00, that is, N5.00.

Olusanya Flours Company:

Olusanya flour purchased N5.00 worth of (input) grain from Obaka and used it to
produce N15.00 worth of flour. The value added by Olusanya flours company is
thus the market value of its product (N15.00) less the cost of the inputs it purchased
(N5.00), which gives N10.00. That is, N15.00 – N5.00 = N10.00

Jelili Bread Making Firm:

Finally, Jelili bread making firm buys N15.00 worth of flour from Olusanya flours
and used it to produce N30.00 worth of bread. So, the value added by Jelili bread
making firm is the market value of its product minus the cost of inputs it purchased
from Olusanya flours Company. That is, Jelili Bread Making Firm’s Value Added
= 30.00 –15.00 = N15.00. The total value added by all the firms is 5 + 10.00 + 15.00
= N30.00. However, it should be noted that the summation of the value added by
each company gives the same answer as the method of calculation of final goods
and services that is shown in illustration 1. Thus, summing the value added by all
the firms in the economy gives the total value of final goods and services, or GDP.

Table 1.2: Analysis of Value Added in Bread Production

Market Value Cost of
Company of Products (N) Purchasing Value Added
Inputs (N) (N)
Obaka Grain 5 0 5
Olusanya 15 5 10
Flours
Jelili Bread 30 15 5
1.5.2. The Income Approach

45
The income approach to the calculation of GDP measures GDP in terms of who
receives it as income.
According to this approach, national income is the sum of eight income items which
are compensation of Employees, proprietors’ Income, rental Income, corporate
Profits, Net Interest, indirect Taxes minus Subsidies, net Business Transfer
Payments, surplus of Government Enterprises.

Table 1.3
Illustration of National Income
National Income (NI) Million Naira (N’m)
Compensation of Employees xxx
+ Proprietors’ Income xxx
+ Rental Income xxx
+ Corporate Profits xxx
+ Net Interest xxx
+ Indirect Taxes minus Subsidies xxx
+ Net Business Transfer Payments xxx
+ Surplus of Government Enterprises xxx
= National Income xxxx

However, it should be noted that NI is the total income of the country but it is not
quite GDP. The NI is GDP less net factor income from abroad (which is equal to
GNP) less depreciation (which is equal to NNP) less statistical discrepancy. This is
illustrated in table below
Table 1.4
Illustration of GDP, GNP, NNP and National Income
National Income Million Naira
(N’m)
GDP xxx
Plus: Receipts of factor income from the rest of the world xxx
Less: Payments of factor income to the rest of the world (xxx)
Equals: GNP xxx
Less: Depreciation (xxx)
Equals: Net National Product (NNP) xxx
Less: Statistical Discrepancy (xxx)
Equals: National Income xxxx

The NI is the income of the country’s citizens and not the income of the residents
of the country and therefore, we need to move from GDP to GNP. After subtracting

46
depreciation from GNP, what we get is called net national product (NNP). The NNP
and NI are the same except for a statistical discrepancy (data measurement error),
which may lead to differences between the two. If the government is absolutely
accurate in its data collection, this statistical discrepancy would be zero. However,
data collection is not perfect and the statistical discrepancy is the measurement error
in each period. Therefore, NI is NNP less statistical discrepancy.

1.5.3. The Expenditure Approach

It should be noted that the expenditure approach measures the total value of all,
expenditures on goods and services by individual private businesses and public
sector (governments) in a particular period of time. In order to avoid double
counting, all expenditures on intermediate products should not be included in the
measurement.
This can be symbolically stated thus:
Y = C + I + G + (X – M)
OR
Y = C + I + G + Xn
Where
Y = The value of national income
C = Aggregate consumption expenditure
I = Private investment expenditure
G = Government expenditure
X = Exports expenditure
M = Imports expenditure
X= Net exports (Xn > 0)
<
Alternatively, national income may be computed using the output - expenditure
method.

The output - expenditure method calculates the total expenditure required to

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

The expenditure approach considers GDP in terms of expenses incurred on

purchases of goods and services produced by a country. The expenditure approach
sums the expenditure from the four main economic agents in the country which are
the households, the firms, the government and the rest of the world. More so, these
are four main categories of expenditure and these are Personal Consumption

47
Expenditure, Gross Private Domestic Investment, Government Consumption and
Government Gross investment consumption, Net Exports (X – M).

TABLE 1.5
Analysis of Components of the Expenditure Approach
National Income Million Naira
Personal Consumption Expenditure 50
Durable goods 20
Nondurable goods 25
Services 5
Gross Private Domestic Investment (I) 100
Non-residential 40
Residential 45
Change in business inventories 15
Government Consumption & Gross Invest 80
Federal 49
State and Local 31
Net Exports (X – M) 30
Exports (X) 20
Imports (M) 50
Gross Domestic Product 200

The expenditure approach calculates GDP by adding together all these four component of
spending.
In equation form, GDP = C + I + G + (X-M). The four components of the expenditure
approach are depicted in the table above.

Self-Assessment Exercises 3
List the three basic approaches to measuring GDP

1.6. National Income Measurement Problems

There are several problems that are encountered in the computation of NI, some of these
problems are:
1. Problem of double counting: the greatest difficulty in measuring national income is
that of double counting, which arises from the improper distinction between final
and an intermediate product. There is always the possibility of a good or a service
being included more than once.

48
 2. There is also the difficulty of defining “nation” in national income. Although every
nation has its political boundaries, the income earned by nationals of a country in a
foreign country beyond the territorial boundaries of that country is also included in
national income.
3. The problem of measuring non-market or domestic activities: national income is
always measured in monetary value, but there are a number of goods and services
that are difficult to measure or assess in terms of money and are therefore excluded.
Such activities include house works, child care, driving one’s car etc., they are
excluded in GDP even though, they amount to real production. However, if one
decides to send his/her children to the day-care, or hire a cleaner or a chauffeur to
drive his/her car, GDP will increase because the salaries of day-care staff, cleaners
and chauffeurs would be counted in GDP whereas, the time spent by individuals in
doing the same activities is not counted. Excluding all such activities will make
national income to be less than what it should actually be.
4. Income earned through illegal activities also makes national income to be less,
because they are excluded from GDP.
5. Measuring national income in monetary terms leads to the underestimation of real
national income. This is because national income measured in monetary value does
not include the leisure forgone in the process of production of a commodity. For
instance, if two individuals earn the same amount as income but if one of them
works for longer hours than the other, it would be right to state that the real income
of this individual has been understated.
6. Some public services cannot be estimated correctly. For example, how should
police and military services be estimated? In days of war, the forces are active but
during peace, they rest in their cantonment. Also, measuring the contribution of
profits earned on certain projects such as power project and irrigation to national
income in terms of money is a difficult task.

Self-Assessment Exercises 3
Differentiate between Income Approach, Value added Approach and Expenditure
Approach of national income.

1.7. Summary
The unit vividly takes a look at National Income Accounting, and a deep explanation
of the term was discussed at length. However, the terms of national income was
discussed such as Gross Domestic Product, Gross National Product, Net National
Product, Domestic Product, Personal Income, Disposable Income, Nominal and
Real Gross Domestic Product. However, simple calculation of National Income was

49
examined with various terms. It is at this point that you must have learnt a lot from
this unit on National Income Accounting.

1.8. References/Further Readings

Ansari, M, Gordon, D.V. and Akuamoah, C. (1997) Keynes Versus

Wagner: Public Expenditure and National Income for Three African
Countries, Applied Economics 29, 54 3-550.
Folawewo A. (2009) Introductory Economics (2009), Ibadan Distance learning
Series, university Press Ibadan.
Jhigan M. L (2004) Monetary Economics, 6th edition, vrinda Publication Limited,
Delhi.-110091.

1.9 Possible Answers to SAEs

These are the possible answers to the SAEs within the content.
Answers to SAEs 1

GDP measures the monetary value of final goods and services that is, those that are
bought by the final user to the produced in a country in a given period of time (say
a quarter or a year). It counts all of the output generated within the borders of a
country.

Answers to SAEs 2

Gross domestic product (GDP) measures total domestic economic activity and can
be measured in three different ways: the output approach, the expenditure approach
and the income approach

Answers to SAEs 3
The main difference between the expenditure approach and the income approach is
their starting point. The expenditure approach begins with the money spent on goods
and services. Conversely, the income approach starts with the income earned from
the production of goods and services (wages, rents, interest, profits). Also, value
added approach is the production, or value added, approach consists of calculating
an industry or sector's output and subtracting its intermediate consumption (the
goods and services used to produce the output) to derive its value added.

50
UNIT 2 CONSUMPTION, SAVINGS AND INVESTMENT ANALYSIS

Unit Structure

2.1. Introduction
2.2. Learning Outcome
2.3. Consumption
2.4. Savings
2.5. Investment
2.6. Summary
2.7. References/Further Readings/Web Resources
2.8. Possible Answers to Self-Assessment Exercises (SAEs)

2.1. Introduction

Savings according to Keynes, is the amount left over when the cost of a person's
consumer expenditure is subtracted from the amount of disposable income that he
or she earns in a given period of time. However, consumption is the use of any
commodity or service for the satisfaction of our wants. Investment is related to
saving and defers from consumption. Investment involves different areas of the
economy, such as business management and finance whether for households, firms,
or governments.

2.2. Learning Outcome

Having gone through this unit, you will be able to:

i. Understand the meaning of Consumption and its Components
ii. Understand the meaning of Savings and its Components
iii. Understand the meaning of Investment and its Components

2.3. Consumption

Consumption is the use of goods and services by households. Consumption is

distinct from consumption expenditure, which is the purchase of goods and services
for use by households. Consumption differs from consumption expenditure
primarily because durable goods, such as automobiles, generate an expenditure
51
mainly in the period when they are purchased, but they generate “consumption
services” (for example, an automobile provides transportation services) until they
are replaced or scrapped. More so, it is the final purchase of goods and services by
individuals constitutes consumption and it is also the aggregate of all economic
activity that does not entail the design, production and marketing of goods and
services (e.g. the selection, adoption, use, disposal and recycling of goods and
services).

2.3.1. Consumption function

It is a single mathematical function used to express consumer spending. It was

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

The simple consumption function is shown as the affine function

where

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

Autonomous consumption represents consumption when income is zero. In

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

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

increases. However, Keynes mentioned that the increases (for income and
consumption) are not equal. According to him, "as income increases, consumption
increases but not by as much as the increase in income

52
However, the aggregate consumption and can be determined by subtracting
aggregate savings from national income. The aggregate consumption any economy
depends on a number of factors. These include:

1. Government fiscal policy: A reduction in tax rate will increase disposable

income and consequently the consumption of the people.
2. Expected future change in income: If the income level is expected be
higher in future relative to the present income level, then people will tend to
consume more out of their present income.
3. Credit facilities: This is the act of enjoying a particular commodity which
are not out rightly or fully paid for but whose full payment can be made at a
future time. The more readily available these facilities a higher will be the
consumption level of the household.
4. Inherited wealth: The higher the environmentally inherited wealth by the
community or society the wealthier it becomes and the higher will be their
level of consumption all things being equal.
5. Population distribution with respect to age: The aged and the infants are
prone to consuming more than the active and productive age of the
population. Hence, the higher the population of the aged and the infants any
society the higher will be their propensity to consume from their income.
6. Societal attitudes towards current savings: The more favourable disposed
the society is towards present savings and investment, the lower will be the
consumption level.

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

Figure 1
A GRAPH SHOWING CONSUMPTION FUNCTION
C C = bo + b1Y

b0

0 Income

53
The graph above shows the relationship between consumption and income. The
graph cut the consumption axis at point bo and the equation is given as follows
C = bo + b1Y where bo is the autonomous consumption, b1 is the marginal
propensity to consume. However, it should be noted that the graph can also start
from the origin.

Fig 2

Consumer
Spending

C = Yd

bo
Real disposable income Yd
0

Figure three above also shows the relationship between consumption and income.
The Keynesian Consumption function expresses the level of consumer spending
depending on three items

• Yd – disposable income
• a – autonomous consumption (consumption when income is 0. (e.g. even
with no income, you may borrow to be able to buy food))
• c – Marginal propensity to consume (the % of extra income that is spent)
Also known as induced consumption.

Consumption Function formula

• C = a + c Yd

This suggests Consumption is primarily determined by the level of disposable

income (Yd). Higher Yd, leads to higher consumer spending.

54
This model suggests that as income rises, consumer spending will rise. However,
spending will increase at a lower rate than income.

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

2.3.2. Average Propensity to Consume (APC)

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

That is,
APC = C
Y
O < APC < I (provided 0 < C < 1)
APC = I (as C = Y),
APC< 1 (as C> Y) – dis-saving
2.3.3. Marginal Propensity to Consume (MPC)
Marginal propensity to consume is defined as the ratio of the change in consumption
to the change in income that necessitated it. That is,
MPC = ΔC =
ΔY
Where
ΔC= Change in consumption
ΔY= Change in income
0 < MPC < 1 (Marginal Propensity to consume ranges between zero and unitary)

55
 Self-Assessment Exercises 1
Discuss the factors that determine consumption.

2.4. Savings

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

2.4.1. Determination of Savings function

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

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

56
Figure 3
A GRAPH SHOWING THE SAVINGS FUNCTION
Saving
S

S = -b0 + BY

Income (Y)
0

- b0

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

2.4.2. Determinants of Savings

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

2.4.3 Average propensity to save (APS)

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

57
disposable income (income minus taxes). The inverse of average propensity to save
is the average propensity to consumer (APC).
That is,
APS = S
Y
0 < APS < I (provided 0 < S < Y)
APS = I (as S=Y)
APS = 0 (as S = 0) - zero savings

2.4.4 Marginal propensity Save

Marginal propensity to save is the ratio of the change in savings change in income
that necessitated it. It is the fraction of an increase income that is saved. .
MPS = ΔS
ΔY
Where
ΔS = Change in savings
ΔY = Change in income
0 < MPS < (MPS ranges between zero and unitary)
MPS + MPC = 1
MPS = I - MPC

Self-Assessment Exercises 2
What are the determinants of Savings?

2.5. Investment

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

58
2.5.1. Component of investment

1. Autonomous investment: This is an exogenously determined investment, that

is I = 10, is the investment that yield profit and interest rate levels in an economy,
and which is not related to the economy's growth.

2. Induced investment: This is an endogenously, determined investment, that is

I = 10 + vY defining investment as a function of income

3. Net investment: Defined as the gross investment that occurs in an economy less
capital consumption allowance (depreciation).

2.5.2. Determinants of Investment

1. Level of national income: Income and investment are positively related,

therefore the Equilibrium level of national income will be when the total demand
for all the types of goods.

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

Self-Assessment Exercises 3
What is the goal of using the expected monetary value in decision making?

59
 2.4 Summary
In this unit we have been able to discuss Consumption, savings and investment
which are the three key terms in national income accounting. However, the unit
explains the graph of savings and investment function with a simple derivation of
their formula. Average/Marginal propensity to consume and save was analyzed and
the component of investment was also examined.

2.5. References/FurtherReadings

Ajayi, I. (2004). Introduction to Monetary Policy, 2nd Edition, IPM

Publication limited.
Ajayi, I. (2004). Introduction to monetary Policy, 2nd Edition, IPM
Publication limited.
Micheal, W. (2008). Macroeconomics Theory, a Dynamic General Equilibrium
Approach, Princeton University Press.
Jhigan, M. L. (2004). Savings and Interest Rate Analysis, 6th Edition, Vrinda
Publication limited.

2.6. Possible Answers to SAEs

These are the possible answers to the SAEs within the content.
Answers to SAEs 1

Consumption function, in economics, the relationship between consumer spending

and the various factors determining it. At the household or family level, these factors
may include income, wealth, expectations about the level and riskiness of future
income or wealth, interest rates, age, education, and family size.

Answers to SAEs 2
The level of disposable income is the basic determinant of how much households
will consume or save. All things being equal, an increase in disposable income will
increase consumption expenditure/saving and vice versa. However, the key
determinants of consumption include income, savings, expectations, changes in
fiscal policy, debt levels, and the availability of goods and services.

60
Answers to SAEs 3
One of the benefits of using expected monetary value is that it forces you to think
about the likelihood of an event occurring. This is important as it means that you're
not just making decisions based on the potential impact of an event, but also on the
probability of that event actually happening.

61
UNIT 3 ECONOMIC WELFARE AND NATIONAL INCOME

Unit Structure

3.1. Introduction
3.2. Leaning Outcome
3.3. Economic Welfare and National income
3.4. Relationship between Economic Welfare and National income
3.5. Summary
3.6. References/Further Readings/Web Resources
3.7. Possible Answers to Self-Assessment Exercises (SAEs)

3.1. Introduction

In this unit we shall base our lecture on the relationship between economic welfare
and national income. This unit will also take a look at the national income as a
measure of economic welfare in an economy.

3.2. Learning Outcome

Having gone through this unit, you will be able to:

i. Understand the meaning of Economic Welfare and National income
ii. Understand the Relationship between Economic Welfare and National income

3.1 Economic Welfare and National Income

Let us start this lecture by asking ourselves what is economic welfare? You may be
thinking what can we called economic welfare and how can we say economic
welfare has been attained by different individuals. Economic welfare is a state of
the mind which reflects human happiness and satisfaction. In actuality, welfare is a
happy state of human mind. According to one of the great welfare economists A.C.
Pigou regards individual welfare as the sum total of all satisfactions experienced by
an individual; and social welfare as the sum total of individual welfare. He divides
welfare into economic welfare and non-economic welfare. Economic welfare is that
part of social welfare which can directly or indirectly be measured in money. Pigou
attaches great importance to economic welfare because welfare is a very wide term.

62
However, the range of our analysis will be restricted to the part that discusses social
(general) welfare that can be brought directly or indirectly into relation with the
measuring rod of money. But it should be note that non-economic welfare is that
part of social welfare which cannot be measured in money, for example moral
welfare.

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

First, by the income-earning method, that is longer hours of working and

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

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

Self-Assessment Exercises 1
What is difference between economic welfare and non-economic welfare?

63
3.2. Relationship between Economic Welfare and National Income

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

(a) The change in the size of national income may be positive or negative. The
positive change in the national income increases its volume, as a result people
consume more of goods and services, which leads to increase in the economic
welfare. Whereas the negative change in national income results in reduction of its
volume. People get lesser goods and services for consumption which leads to
decrease in economic welfare. But this relationship depends on a number of factors.

Moreover, let us ask ourselves a question: is the change in national income real or
monetary? If the change in national income were due to change in prices, it would
be difficult to measure the real change in economic welfare. For example, when the
national income increases as a result of increase in prices, the increase in economic
welfare is not possible because it is probable that the output of goods and services
may not have increased. It is more likely that the economic welfare would decline
as a result of increase in prices. It is only the real increase in national income that
increases welfare.

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

Third, national income cannot be a reliable index of economic welfare, if per capita
income is not borne in mind. It is possible that with the increase in national income,
the population may increase at the same pace and thus the per capita income may
not increase at all. In such a situation, the increase in national income will not result
in increase in economic welfare. But from this, it should not be concluded that the
increase in per capita income results in increase in economic welfare and vice versa.

64
Furthermore, it is possible that as a result of increase in national income, the per
capita income might have risen. But if the national income has increased due to the
production of capital goods and there is shortage of consumption goods on account
of decrease in their output, the economic welfare will not increase even if the
national income and per capita income rise. This is because the economic welfare
of people depends not on capital goods but on consumption goods used by them.
Similarly, when during war time the national income and the per capita income rise
sharply, the economic welfare does not increase because during war days the entire
production capacity of the country is engaged in producing war material and there
is shortage of consumption goods. As a result, the standard of living of the people
falls and the economic welfare decreases.

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

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

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

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

65
government gives more privileges to the richer sections and imposes regressive
taxes on the poor.

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

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

66
 Self-Assessment Exercises 2

What is the goal of using the expected monetary value in decision making?

2.4 Summary
In this unit we have learnt the meaning of welfare economics and how national
income can be used to measure welfare economics. We should know at the junction
that national income can be used to measure economic welfare and we got to know
that GNP is not a satisfactory measure of economic welfare because the estimate of
national income does not include certain services and production activities.
However, we also learnt other factor that can measure welfare other than GNP
estimate and those factors that are better to be used than the GNP.

2.5. References/Further Readings

Jhingan, M.L. (2004) Macroeconomic theory, 11th revised edition, Vrinda Publications

limited, Delhi

2.6. Possible Answers to SAEs

These are the possible answers to the SAEs within the content.
Answers to SAEs 1

Economic welfare is the part of total human welfare which can be measured in terms
of money. Non-economic welfare is the one which cannot be measured in terms of
money such as environment, law and order, and social relations.

Answers to SAEs 2
One of the benefits of using expected monetary value is that it forces you to think
about the likelihood of an event occurring. This is important as it means that you're
not just making decisions based on the potential impact of an event, but also on the
probability of that event actually happening.

67
 Module 3: Money and Banking

This module discusses an important aspect of Economics which is money and

banking. The module consists of 3 units and are: origins of money, Financial
Institution and Central Banking.

Unit 1 Origins of Money

Unit 2 Financial Institution
Unit 3 Central Banking

UNIT 1 ORIGIN OF MONEY

Unit Structure

1.1. Introduction
1.2. Objectives
1.3. What is money?
1.4. History of Money
1.5. Characteristics of Money
1.6. Functions of Money
1.7. Types of Money
1.8. Keynes Motive of Holding Money
1.9. Summary
1.10. References/Further Readings/Web Resources
1.11. Possible Answers to Self-Assessment Exercises (SAEs)

1.1. Introduction

In this unit we will try to explain what money is and why money is necessary and
important in the economy. You may be thinking that what is money? Some people
might say that money is what we spend every day but we can say that the definition
above is a lay man definition. Therefore we can say that money is historically an
emergent market phenomenon establishing a commodity money, but nearly all
contemporary money systems are based on fiat money. Fiat money, like any cheque
or note of debt, is without intrinsic use value as a physical commodity. It derives its
value by being declared by a government to be legal tender; that is, it must be

68
accepted as a form of payment within the boundaries of the country, for all debts,
public and private. Such laws in practice cause fiat money to acquire the value of
any of the goods and services that it may be traded for within the nation that issues
it.

1.2. Learning Outcomes

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

i. Understand the meaning of Money and the History of money
ii. Understand the Characteristics, Functions and types of Money
iii. Understand the Keynesian Motive of Holding money

1.3. What is Money?

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

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

(a). Double Coincidence of Want: There must be an agreement as to the type of

products and quantity of product to be exchange. The man in the advert must not
only look for another who has rice (first coincidence), but for one who has rice and

69
also needs to exchange his rice (a quarter bag) for tubers of yam (second
coincidence).

(b). Divisibility: The goods offered in barter faces the problem of divisibility. How
will a shepherd, who needs small quantities of yam, eggs, ‘tomatoes, divide his
sheep or goat as exchange?

(c). Storability: The absence of storage facilities makes barter system unattractive
as most goods used in exchange for each other are perishable ones. How do you
store the fresh portion of meats for further transactions?

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

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

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

Self-Assessment Exercises 1
How the emergence of money solve the problem of barter system?

1.4. History of Money

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

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

70
The system of commodity money eventually evolved into a system of representative
money. This occurred because gold and silver merchants or banks would issue
receipts to their depositors – redeemable for the commodity money deposited.
Eventually, these receipts became generally accepted as a means of payment and
were used as money. Paper money or banknotes were first used in China during the
Song Dynasty. These banknotes, known as "jiaozi", evolved from promissory notes
that had been used since the 7th century. However, they did not displace commodity
money, and were used alongside coins. In the 13th century, paper money became
known in Europe through the accounts of travelers, such as Marco Polo and William
of Rubruck. The gold standard, a monetary system where the medium of exchange
are paper notes that are convertible into pre-set, fixed quantities of gold, replaced
the use of gold coins as currency in the 17th-19th centuries in Europe. The use of
barter-like methods may date back to at least 100,000 years ago, though there is no
evidence of a society or economy that relied primarily on barter. Instead, non-
monetary societies operated largely along the principles of gift economics and debt.
When barter did in fact occur, it was usually between either complete strangers or
potential enemies.

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

Self-Assessment Exercises 2

Without happening there is no history, and without history there is no

happening, critically discuss the emergence of money in the world.

1.5. Characteristics of Money

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

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

be accepted immediately and without question in exchange for goods and
services. It must have full legal backing and citizens must accept them for
exchange.
2. Homogeneity: The commodity that is acceptable within a community or
areas as money must be the same. There should not be any variations in size,

71
 shape or colour. It must be capable of being identified immediately it is
tendered for exchange.
3. Stable in Value: Money must be relatively stable overtime to command
respect and acceptability, to serve as a means of deferred payment and store
of value. If money depreciates overtime or is devalued overtime, it creates
loss of confidence in it. If it persist it loses its value and people tends to look
for other commodity for exchange
4. Divisibility: Money must be divisible into convenient units as transactions
can be of varying sizes that is either in smaller quantities or bigger quantities.
However, divisibility must be possible without any damage, to the money
material.
5. Portability: The more the ease with which money can be carried about the
better. As transactions take place daily, the material used as money must be
light enough to be carried around for transactions.
6. Relative Scarcity: The substance or commodity used as money must be
relatively scare so as to retain its value. Hence Government all over the world
regulates the supply of money in circulation.

Self-Assessment Exercises 3
7. are the characteristics of money?
What

1.6 Functions of Money

1. Medium of exchange: This is the most important functions of money.

Modern economy aged on specialization and money serves as the oil which
allows the machinery of exchange that is buying and selling to run smoothly.
Money therefore renders obsolete the practice of double coincidence of
wants. The cassava farmer who needs clothes do not need to look for a cloth
seller who needs cassava before he can make exchange, all he needs is
money.

Money removes this problem created by barter as it is acceptable on its own

merit unquestionably for buying and selling of goods and services. The use
of money therefore has increased tremendously the volume of trade in the
world.

2. Store of Value: Money serves as the most convenient way of keeping

surplus incomes and wealth of the person. In a stable economy where prices
are relatively stable, money could be stored over time without the fear of risk
72
 of loss of value. It is the only asset which can be turned into other goods
immediately and without incurring any cost. This liquidity is what Keynes
considered to be money’s most distinctive function because it has both asset
and exchange functions.
3. Unit of Account: Money makes possible the operation of the price system.
It is used to measure the prices of goods and services and provides the basis
for keeping accounts, expressing the performance of businesses in terms of
calculating of profit and loss and balance sheets, etc. It also assists
international economy in expressing the currency of one country in terms of
another.
4. Standard of Deferred Payments: Money makes it possible for lending and
borrowing of money to take place. Goods and services can be bought now
and paid for in the future. Loans could be obtained now paid for later, future
contracts can be entered into. Money makes dealing in debts possible and
such institutions like banks, building societies, insurance companies, etc.

Self-Assessment Exercises 4
Money performs various functions in the economy, briefly discuss
these functions.

1.7. Types of Money

1. Legal Tender: A country legislates on a commodity and gives it full legal

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

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 Self-Assessment Exercises 5
Briefly list the various types of money.

1.8. Motive of Holding Money

Motive of holding money is classified into three ways:

1. Transactionary Motive
2. Precautionary Motive
3. Speculative Motive

1.8.1. Transactionary Motive

Day–to-day transactions are done by individuals as well as firms. An individual

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

1.8.2. PRECAUTIONARY MOTIVE

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

1.8.3. SPECULATIVE MOTIVE

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

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 Self-Assessment Exercises 6
Why is money important in the economy?

1.9. Summary

Finally we submit in this unit that money is any object or record that is generally
accepted as payment for goods and services and repayment of debts in a given socio-
economic context or country.

1.10. References/Further Readings/Web Resources

Jhingan, M. L. (2004). Monetary Economics, 6th Edition, vrinda.

Publications limited.
Olusanya, S.O. (2008). Introduction to Business Loan and Finance, 1st
Edition, Bolu bestway Printers, Lagos.

1.11. Possible Answers to SAEs

These are the possible answers to the SAEs within the content.
Answers to SAEs 1
Because everyone wants and values money, it is accepted by people everywhere in
exchange for goods and services. With money, the problem of needing to find
someone to barter with is eliminated, making it easier and more convenient for
people to get the goods and services they want.

Answers to SAEs 2
Before money was invented, people bartered for goods and services. It wasn't until
about 5,000 years ago that the Mesopotamian people created the shekel, which is
considered the first known form of currency. Gold and silver coins date back to
around 650 to 600 B.C. when stamped coins were used to pay armies. However, the
inconveniences and drawbacks of barter led to the gradual use of a medium of
exchange. If we study history of money we shall find that all sorts of commodities

75
like seashells, pearls, precious stones, tea, tobacco, cow, leather, cloth, salt, wine,
etc. have been used as a medium of exchange (i.e., money).

Answers to SAEs 3
The characteristics of money are durability, portability, divisibility, uniformity,
limited supply, and acceptability.
Answers to SAEs 4
The following points highlight the top six functions of money:
i. A Medium of Exchange
ii. A Measure of Value
iii. A Store of Value (Purchasing Power): ...
iv. The Basis of Credit: ...
v. A Unit of Account: ...
Vi A Standard of Postponed Payment:

Answers to SAEs 5
There are 4 major types of Money:
i. Commodity Money.
ii. Fiat Money.
iii. Fiduciary Money.
iv. Commercial Bank Money.
Answers to SAEs 6
Money is a medium of exchange; it allows people and businesses to obtain what
they need to live and thrive. Bartering was one way that people exchanged goods
for other goods before money was created. Like gold and other precious metals,
money has worth because for most people it represents something valuable.

76
UNIT 2 FINANCIAL INSTITUTIONS

Unit Structure

2.1. Introduction
2.2. Learning Outcome
2.3. The History of Nigeria Banking System.
2.4. Commercial Bank and its Functions
2.5. The Growth and Development of Commercial Bank in Nigeria
2.6. Merchant Bank.
2.7. Summary
2.8. References/Further Readings

2.1. Introduction

In this unit, we shall discuss what a financial institution is and their operations. But
in your mind may be thinking that financial institution means banking industry.
However, it can be banking and at the same time banking subsidiaries. At this
junction, let us define financial institution. A financial institution is a financial
intermediary that accepts deposits and channels those deposits into lending
activities, either directly by loaning or indirectly through capital markets. A bank is
the connection between customers that have capital deficits and customers with
capital surpluses.

2.2. Learning Outcomes

Having gone through the discussions in this unit, you should be able to:
i. Understand the History of Nigeria Banking System
ii. Understand the meaning of Commercial bank and its functions
iii. Know and understand the Growth and Development of Commercial Bank in
Nigeria.
iv. Understand Merchant banking in Nigeria.

2.3. The History of the Nigeria Banking System

In 1892 Nigeria's first bank, the African Banking Corporation, was established. No
banking legislation existed until 1952, at which point Nigeria had three foreign
banks (the Bank of British West Africa, Barclays Bank, and the British and French

77
Bank) and two indigenous banks (the National Bank of Nigeria and the African
Continental Bank) with a collective total of forty branches. A 1952 ordinance set
standards, required reserve funds, established bank examinations. Yet for decades
after 1952, the growth of demand deposits was slowed by the Nigerian to prefer
cash to cheque for debt settlements.

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

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

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

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

78
to deposits. Changes in Central Bank restrictions on credit and monetary expansion
affected total demand and income. For example, in 1988, as inflation accelerated,
the Central Bank tried to restrain monetary growth.

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

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

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

Other financial institutions included government-owned specialized development

banks: the Nigerian Industrial Development Bank, the Nigerian Bank for Commerce
and Industry, and the Nigerian Agricultural Bank, as well as the Federal Savings
Banks and the Federal Mortgage Bank. Also active in Nigeria were numerous
insurance companies, pension funds, and finance and leasing companies. Nigeria
also had a stock exchange (established in Lagos in 1961) and a number of
stockbrokerage firms. The Securities and Exchange Commission (SEC) Decree of
1988 gave the Nigerian SEC powers to regulate and supervise the capital market.
These powers included the right to revoke stockbroker registrations and approve or
disapprove any new stock exchange. Established in 1988, the Nigerian Deposit

79
Insurance Corporation increased confidence in the banks by protecting depositors
against bank failures in licensed banks up to N50,000 in return for an annual bank
premium of nearly 1 percent of total deposit liabilities.

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

Self-Assessment Exercises 1

The Nigerian banking system has undergone radical changes over the years; critically discuss
the evolution of banking system in Nigeria.

2.4. Commercial Bank and its Functions

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

A banking company is one which transacts the business of banking which means
the accepting for the purpose of lending all investments, of deposits of money from
the public, repayable on demand or otherwise and withdraw able by cheque, draft
or otherwise. There are two essential functions that a financial institution must
perform to become a bank. These are accepting deposit and lending to the public.
These functions are:

1. It accepts deposits from the public. These deposits can be withdrawn by cheque
and are repayable on demand.
2. A commercial bank uses the deposited money for lending and for investment in
securities.
3. It is a commercial institution, whose aim is to earn profit
80
4. It is a unique financial institution that creates demand deposits which serves as
the medium of exchange.
5. Money created by commercial banks is known as deposit money.

2.4.1 Functions of commercial Banks

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

a. PRIMARY FUNCTIONS - There are two main primary functions of the

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

(a). Demand deposit

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

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

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

2.4.2. Differences between demand deposit and fixed deposit

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

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

81
2. Advancing of loans
Commercial banks give loans and advances to businessmen, farmers, consumers
and employers against approved securities. Approved securities refer to gold, silver,
bullion, govt. Securities, easily savable stock and shares and marketable goods. The
bank advances following types of loans-

(a). Cash credit – Under this the borrower is allowed to withdraw up to a

certain amount on a given security which comprise mainly stocks of goods, but
interest is charged on the amount actually withdrawn.

(b). Overdraft – It is a most common way of lending. Under it, the borrower
is allowed to overdraw his current account balance. Overdraft is a temporary
facility.

(c). Short term loans – Under it loans of a fixed amount are sanctioned.
The sanctioned amount is credited in the debtors a/c. Bank charges interest on the
whole amount from the day it was sanctioned.

The difference between a loan and an overdraft is that, while in case of loan, the
borrower pays us interest on the amount outstanding against his account. But in the
case of an overdraft, the customer pays interest on the deal balance standing against
his account further. Loans are given against security, while overdraft made without
securities. From the borrowers’ point of view, overdraft is preferable thorough a
loan because, in case of loan, he will have to pay interest on the full amount of loan
sanctioned whether he uses it fully or not. But in the case of overdraft, he has the
facility of borrowing only as much as he requires.

4. Discounting of the bill of exchange

This is another popular type of lending by the commercial banks. Through this
method, the holder of the bills of exchange (written during trade transactions) can
get it discounted by the banks. The banks after demanding the commission pays the
value of the bills to the holder. When the bills of exchange mature, the bank gets its
payment from the party which had accepted the bill

5. Money at call

Such loans are very short period loans and can be called back by the bank at a very
short notice of say one day to14 days. These loans are generally made by one bank
to another bank or financial institutions.

82
 Self-Assessment Exercises 2
List and explain all the functions of commercial bank.

2.5. The Growth and Development of Commercial Bank in Nigeria

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

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

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

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

Self-Assessment Exercises 2
Briefly explain the stages of generation of bank in Nigeria since 1960

83
2.6. Merchant Bank

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

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

2.6.1. Functions of Merchant banks

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

Self-Assessment Exercises 3
Why merchant banks are important for an economy?

2.7. Summary

In summary, conventionally, financial institutions are composed of organizations

such as banks, trust companies, insurance companies and investment dealers. And
almost everyone has dealt with a financial institution on a regular basis. Everything
from depositing money to taking out loans and exchange currencies must be done
through financial institutions.

84
 2.8. References/Further Readings

Ajayi, S. I., & Ojo, O. (1981). Money and Banking, Analysis and Policy in the
Nigerian Context, London, George Allen and Unwin.
Brown, C. V. (2006). The Nigeria Banking System, London Allen and Unwin.
Central Bank of Nigeria. (1979). Twenty Years of Central Banking in Nigeria
Lagos, Nigeria. CBN Publication.
Central Bank of Nigeria. (2001). Banking Supervision Annual Report. CBN
Bulletin.
Falegan, S. B. (2005). Central Bank Autonomy, Historical and General Perspective,
CBN Economic and Fundamental Review, 33(4).

2.9. Possible Answers to SAEs

These are the possible answers to the SAEs within the content.
Answers to SAEs 1
The banking industry in Nigeria started during the colonial era with the
establishment of Colonial Banks, with the primary aim of meeting the commercial
needs of the Colonial Government. The banking system in Nigeria is regulated
through the Central Bank of Nigeria. This apex bank started operation on July 1,
1959. More so, the banking sector development can be divided into three phases:
Phase I: The Early Phase which lasted from 1770 to 1969. Phase II: The
Nationalisation Phase which lasted from 1969 to 1991. Phase III: The Liberalisation
or the Banking Sector Reforms Phase which began in 1991 and continues to flourish
till date.
Answers to SAEs 2
The banking industry in Nigeria started during the colonial era with the
establishment of Colonial Banks, with the primary aim of meeting the commercial
needs of the Colonial Government. The banking system in Nigeria is regulated
through the Central Bank of Nigeria. This apex bank started operation on July 1,
1959. In 1892, the African Banking Corporation and the Bank of British West
Africa, now First Bank of Nigeria, were established in Nigeria. In 1925, Due to
some difficulties the bank folded up its activities and the Bank of British West Africa
Limited (BBWA) was established to take over the activities of African Banking
Corporation. The Bank of British West Africa Limited opened its first branch in
Lagos in 1894, in the later part of the same year ,the name of the bank was change
to Standard Bank of Nigeria known as the First Bank of Nigeria limited [now a
public limited company PLC. the Anglo-Egyptian Bank and National Bank of South

85
Africa gave birth to Barclays Bank in Nigeria. In 1948, the British and French Bank
for Commerce and Industry started operations in Nigeria, which metamorphosed
into the United Bank for Africa. The first domestic bank In Nigeria was established
in 1929 and called Industrial and Commercial Bank. The bank liquidated in 1930
and was replaced by Mercantile Bank in 1931. The African Continental Bank was
created in 1949 as the only sustainable indigenous bank after the liquidation of the
Industrial and Commercial Bank. The year 1947 shows the emergence of an
agricultural bank called the Nigerian Farmers and Commercial Bank.
Answers to SAEs 3
Merchant banks help in processing loan applications for short and long-term credit
from financial institutions. They provide these services by estimating total costs
involved, developing a financial plan for the entire project, as well as adopting a
loan application for commercial lenders

86
UNIT 3 CENTRAL BANKING

Unit Structure

3.1. Introduction
3.2. Learning Outcomes
3.3. Evolution of Central Bank in the world
3.4. Functions of Central Bank
3.5. Central Bank Relationship with the government
3.6. The Birth of the Central Bank in Nigeria
3.7. Summary
3.8. References/Further Readings/Web Resources
3.9. Possible Answers to Self-Assessment Exercises (SAEs)

Central Bank

3.1 Introduction

In this unit, we will learn about how Central banking works in an economy. If we
bring our mind back to unit 2 above, we will see how comprehensively the financial
institutions work is and knowing fully well that there would be a body that will
regulate the activities of the financial institutions in the economy. So, therefore it is
necessary for us to look at central banking in the world in general and Nigeria in
particular.

3.2. Learning Outcomes

At the end of this unit, you must have:

i. Know the Evolution of Central Bank in Nigeria and the world at large
ii. Know the Functions of Central Bank
iii. Distinguish the Relationship between Central Bank and the government

3.3. EVOLUTION OF CENTRAL BANK IN THE WORLD

The history of Central Banks dates back to the time the Bank of England was
established. It is known to be one of the oldest central banks in the world. The birth
of central banking in the modern sense began with the creation of the Central Bank

87
of England. However, it took mainly the complex financial problems that wars and
economic crises produced to accord it distinctive roles that should be given to it both
in practice and theory of finance (Ajayi, 1995). The various economic, political and
social changes, which occurred between the two world wars, gave it the principles
and operations, which brought it into the center stage.

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

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

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

In the later part of the nineteenth century the Bank of England began to develop as
a true central bank and it was during this period that it learnt how to use the bank
rate as an instrument of monetary policy. The Bank of England fully accepted the

88
responsibilities of a central bank and became used to exercising its powers of control
over the commercial banks.

Self-Assessment Exercises 1
What is the main reason for the existence of central banks?

3.4. Functions of Central Bank

Traditionally, a central bank performs three main functions:

Managing the nation’s monetary system, serving as a banker to commercial banks

and acting as a financial agent for the national government. To these must be added
the unorthodox role of a central bank as an engine of economic growth. This last
function is a development of the 1930s and it is usually associated with central
banking in developing countries.

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

A central bank acts as banker to commercial banks by providing services to the

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

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

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To these must be added the new function of the central bank development. The
central bankers schooled in the bank of England tradition, a central bank has no role
to play in the development process. It should serve the purpose that a steering wheel
serves in a car, the smooth movement of the economic machine. It is not supposed
to play the role of the accelerator. The development function is a recent
phenomenon, which is usually associated with developing countries. In these
countries commercial banks are few, and those which exist are mostly expatriate
banks. In addition, money markets and institutions are either absent or rudimentary.
Given these features of the financial system, the central bank cannot adequately
perform its traditional role of stabilization. The only meaningful role that can be
assigned to the central bank in such an environment is developmental. It can be
called upon to develop the financial structure necessary for it to perform its
traditional roles in the future.

Self-Assessment Exercises 2
What are the main functions of the central bank?

3.5. Central bank Relationship with the government

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

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

Full independence is not advisable, because monetary policy is part and parcel of
overall economic policy. A responsible government would want to be seen as being

90
in full control of its economic policy and would not want to relinquish monetary
policy to an institution that is not responsible to the people. As an elected
representative of the people, the government would want to be responsible for its
action, be they good or bad. The other extreme case is equally inadvisable. A central
bank that was no more than another department of government could not initiate
and execute monetary policy effectively, as it would inevitably be subject to civil
service procedures and red tape. Moreover, the central bank is not only an organ of
government but also part of the financial system. It must therefore not be identified
with politics if it is to have prestige and command the confidence necessary to deal
with the financial community both at home and abroad.

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

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

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

Self-Assessment Exercises 3
Why is there a distinction made between a central bank and the national government?

3.6. The birth of the Central Bank of Nigeria

As far back as 1948 (before the banking boom in Nigeria), Mr J. Mars drew attention
to the desirability of having a central bank in Nigeria (Mar, 1948). Following the
failure of banks in the 950s, support for the establishment of the Central Bank of
Nigeria grew. Many nationalists advocated the establishment of central bank to put
in place regulations for the operation of banks and perform other functions related

91
to central banking and the development of the economy. The urge to set up a central
bank was resisted for quite some time by the colonial administrators on the ground
that there was no developed and highly organized money market. In 1952 the
government of Nigeria requested Mr. J.l. Fisher, an advisor to the Bank of England,
to report on the “desirability and practicability of establishing a central bank in
Nigeria as an instrument of economic development”. His report, which was
published in 1953, contained the following:

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

2. A review of Nigeria’s financial system as it then existed; and

3. The possibility of making use of the orthodox principles of central banking as

contained in (1).

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

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

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

2. The establishment of a Nigerian currency Board; and

3. The establishment of a Nigerian Bank of Issue, which would gradually evolve

into a bank.

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

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

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

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

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

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

The core mandate of the CBN, as spelt out in the Central Bank Act (1958), and
amendments (1991, 1998) include:

1. Issuance of legal tender currency notes and coins in Nigeria

2. Maintenance of Nigeria external reserve to safeguard the international values of

the legal currency.

3. Promotion and Maintenance of monetary stability and a sound and efficient

financial system in Nigeria.

4. Acting as banker and financial adviser to the Federal Government; and

5. Acting as lender of last resort

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

Self-Assessment Exercises 4
How can a central bank help increase growth in a developing economy?
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 3.7. Summary
In summary, I think you belief now that central banking in the world and in
Nigeria has a lot to do in controlling the activities of the commercial banks.
Moreover, all over the world, government have taken necessary measures to ensure
the integration of central banking more closely into the machinery for carrying out
macroeconomic policy and for many countries; a central plays a key role in a
country’s growth and development process.

3.8. References/Further Readings/Web Resources

Ajayi S. I. (1995). The Role of Central Banks in Economic Development, CBN

Economic and Financial Review, 33(3) Allen and Unwin
Central Bank of Nigeria. (1970). Amendment, No 3 Decree 1969 as amended by
Banking Amendment Decree 1970.
Central Bank of Nigeria. (1959). The Bye Laws of the CBN.

3.9. Possible Answers to SAEs

These are the possible answers to the SAEs within the content.
Answers to SAEs 1
A key role of central banks is to conduct monetary policy to achieve price stability
(low and stable inflation) and to help manage economic fluctuations. The policy
frameworks within which central banks operate have been subject to major changes
over recent decades

Answers to SAEs 2
Functions of the Central Bank
i. Currency regulator or bank of issue.
ii. Bank to the government.
iii. Custodian of Cash reserves.
iv. Custodian of International currency.
v. Lender of last resort.
vi. Clearing house for transfer and settlement.
vii. Controller of credit.

94
Viii. Protecting depositors’ interests.

Answers to SAEs 3

The distinction between a central bank and a national government exists because the
central bank focuses on monetary policy which is related to GDP as opposed to the
national government which is more concerned with taxes and spending since that is
what relates to fiscal policy.
Answers to SAEs 4
Central banks carry out a nation's monetary policy and control its money supply,
often mandated with maintaining low inflation and steady GDP growth. On a macro
basis, central banks influence interest rates and participate in open market operations
to control the cost of borrowing and lending throughout an economy.

95
 Module : 4 Components of Gross Domestic
Product

This module looks at the components of Gross Domestic Product. The module is
comprised of 3 units which include Personal Consumption expenditure, Gross
private domestic investment and Net exports, Government consumption and Gross
investment.

Unit 1 Personal Consumption Expenditure

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

UNIT 1 Personal Consumption Expenditure

Unit Structure

1.1. Introduction
1.2. Learning Outcomes
1.3. Meaning of Personal Consumption Expenditure
1.3.1 Household Final Expenditure
1.4. Summary
1.5. References/Further Readings

1.1. INTRODUCTION

Personal Consumption Expenditure is a component of the monthly Personal income

report. The PCE measures inflation by tracking changes in prices. Unlike the
Consumer Price Index, which uses a fixed basket of goods and services, the PCE
changes along with consumer spending habits. The PCE is released by the Bureau
of Economic Analysis near the first business day of each month for a period ending
two months prior. Compare to Consumer Price Index

96
 1.2. Learning Outcomes

At the end of this unit, should be able to:

i. Understand the Concept of personal consumption expenditure
ii. Know the concept Gross private domestic investment and net exports
iii. Understand the concept of Government Consumption and Gross investment.

1.3. Meaning of Personal Consumption Expenditure

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

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

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

1.3.1. Household Final Consumption Expenditure

Household final consumption expenditure (HFCE) is a transaction of the national

account's use of income account representing consumer spending. It consists of the
expenditure incurred by resident households on individual consumption goods and

97
services, including those sold at prices that are not economically significant. It also
includes various kinds of imputed expenditure of which the imputed rent for
services of owner-occupied housing (imputed rents) is generally the most important
one. The household sector covers not only those living in traditional households,
but also those people living in communal establishments, such as retirement homes,
boarding houses and prisons.

More so, the definition of household Final Consumption Expenditure includes

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

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

Self-Assessment Exercises 1
What are the three categories of personal consumption expenditures?

1.4 Summary

In this unit, you have been learnt that Personal Consumption Expenditure is the
expenditure of household on various good and services and we have also learned
the concept of household final consumption expenditure. Therefore, as household
spend on their need we can invariably infer that personal consumption expenditure
has been attained.

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 1.5. References/Further Readings/Web Resources

Asertkerson, D. (2006). Principle of Economics in a large Economy, 1st edition,

Rose world Publication limited.

2.7 Possible Answers to SAEs

These are the possible answers to the SAEs within the content.
Answers to SAEs 1
In national income accounting, private consumption expenditure is divided into
three broad categories: expenditures for services, for durable goods, and for
nondurable goods.

99
UNIT 2 GROSS PRIVATE DOMESTIC INVESTMENT AND NET
EXPORTS

Unit Structure

2.1. Introduction
2.2. Learning Outcomes
2.3. Meaning of Gross Private Investment
2.4. Measure of Net export
2.5. Summary
2.6. References/Further Readings/Web Resources
2.7. Possible Answers to Self-Assessment Exercises (SAEs)

2.1. INTRODUCTION

Before we go into the teaching of this unit, let know first of all define what is
investment? Investment in economics refers to the purchase of new capitals which
can be housing, plants and equipment, machinery and inventories. It is the spending
by firms on final goods and services, primarily capital goods and housing. It is
usually denoted by ‘I’.

However, the use of the term investment in economics is different from its common
use in daily life activities, in which case, investment is referred to as the purchases
of stocks, bonds or mutual funds. Although, a person who buys a share of a
company’s stocks acquires partial ownership of the existing physical and financial
assets controlled by the company, a stock purchased does not usually correspond to
the creation of new physical capital and so, it is not investment in the actual sense.
Gross private domestic investment is therefore the total investment in capital by the
private sector.

More so, net exports can also be seen as positive or negative. It is positive if exports
are greater than imports and this is termed trade surplus. It is negative if imports are
greater than exports. This is known as trade deficit.
One may wonder why net export is included in the component of GDP. The reason
for the inclusion of net exports in the definition of GDP is as follows: Consumption,
investment and government spending are only expenditure on goods produced both
domestically and by foreigners, so, they overstate domestic production because they
contain expenditure on foreign produced goods (i.e. imports) which have to be
subtracted from GDP to obtain a correct figure. In the same vein, consumption,

100
investment and government also understates domestic production because some of
the goods and services produced are sold abroad, and are therefore not included in
the calculation of consumption, investment or government expenditure and thus,
exports have to be added. For example, if Nigeria produces cassava and sells them
in France, the cassava is part of Nigeria’s production and should be counted as part
of Nigeria’s GDP.

2.2. Learning Outcomes

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

i. Understand the meaning and concept of Gross Private Domestic Investment

ii. Know the meaning and concept of Net Export

iii. Understand the how to measure Gross private domestic investment and net
exports.

2.3. Meaning of Gross Private Domestic Investment

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

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

1. Nonresidential investment: This is expenditures made by firms on capital

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

101
2.3.1. Specific Measure of Gross Private Domestic Investment

Gross private domestic investment is a relatively specific measure of investment, it

is a gross (versus net) measure of private (versus public) domestic (versus foreign)
investment.

1. Gross: The Gross private domestic investment includes the production of

all capital goods, including those used to replace depreciated capital.
Subtracting capital depreciation (officially known as the capital
consumption adjustment) from gross private domestic investment results in
net private domestic investment.

2. Private: However, gross private domestic investment measures investment

expenditures made by the private sector. Any capital goods purchased by
the public, or government, is included in government consumption
expenditures and gross investment.
3. Domestic: Finally, gross private domestic investment is expenditures on
capital goods used in the domestic economy. The alternative is investment
expenditures on capital goods used by the foreign sector.

2.3.2. Calculation of Gross Private Domestic Investment

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

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

Step 1:
Now let us look at the first step on how to calculate the Gross Private Domestic
investment. The first thing is to calculate the amount by which businesses in the
country have increased or decreased the value of their inventory compared to the
previous year. Moreover, inventory refers to the stock of goods businesses have to
sell. For example, the inventory of a food manufacturer would be the finished,
packaged food products ready for sale. Depending on economic conditions, this
figure may be positive or negative.
Step 2:

102
Since we have known the techniques on how calculate the first step, we will further
proceed to the second step of calculating Gross Private Domestic investment. We
will then determine the value of new real estate construction in the country.
However, this includes all types of buildings, such as single-family homes, multi-
family apartments and office buildings.

Step 3:

In this step, we will need to add up the value of all the capital items businesses
purchase to generate value. These items include office equipment, manufacturing
machinery, software and tools.

Step 4:

Step 4 is the final step where we will find the total of the three figures that represent
all the new capital in which businesses invest throughout the year. The resulting
figure is the country's gross private domestic investment.

Self-Assessment Exercises 1
1. What is the meaning of Gross private domestic investment?

2. What is net exports in GDP?

2.4. Meaning of Net Export

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

Net exports can be defined as the value of a country's total exports minus the value
of its total imports. It is used to calculate a country's aggregate expenditures, or

103
GDP, in an open economy. We can also define it as the difference between a
country's total value of exports and total value of imports. Depending on whether a
country imports more goods or exports more goods, net exports can be a positive
or negative value.

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

2.4.1. Measurement of Net Exports

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

Net Exports = Value of Exports - Value of Imports

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

Net Exports = N7 billion - N3 billion = N4 billion

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

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

Self-Assessment Exercises 2
1. What is net exports used for?
2. What are the three main determinants of net exports?

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 2.5. Summary

The unit has vividly takes a look at Gross Private Domestic Investment to net
exports but Gross private domestic investment is the official government measure
of investment expenditures undertaken by the business sector. It seeks to quantify
that portion of gross domestic product that is purchased by the business sector and
which is used, in theory at least, for investment and the acquisition of capital goods
while the net exports are also defined as the trade balance of the country and imports
deduct from GDP and exports also add to the figure.

2.6. References/Further Readings/Web Resources

Ajayi, I. (2005). Paper presentation on Component of Goss domestic product,

Mainframe Publication, Lagos.

Folawewo A. (2009). Introductory Economics. Ibadan Distance learning

Series, university Press Ibadan.

2.7 Possible Answers to SAEs

These are the possible answers to the SAEs within the content.
Answers to SAEs 1

1. Gross Private fixed investment and change in private inventories. It is measured

without a deduction for consumption of fixed capital (CFC), includes replacements
and additions to the capital stock, and excludes investment by U.S. residents in other
countries.
2. The net number calculated includes a variety of goods and services exported and
imported by the country, such as machinery, cars, consumer goods, etc. Net export
is one of the important variables used for calculating the Gross domestic product of
any country.

105
Answers to SAEs 2
1. It is a measure used to aggregate a country's expenditures or gross domestic
product in an open economy. If a country has a weak currency, its exports are
generally more competitive in international markets, which encourages positive net
exports.
2. The chief determinants of net exports are domestic and foreign incomes, relative
price levels, exchange rates, domestic and foreign trade policies, and preferences
and technology. A change in the price level causes a change in net exports that
moves the economy along its aggregate demand curve.

106
UNIT 3 GOVERNMENT CONSUMPTION AND GROSS INVESTMENT

Unit Structure
3.1. Introduction
3.2. Learning Outcomes
3.3. Meaning of Government Consumption
3.4. National Accounts Measurement of Government Spending
3.5. Gross Investment.
3.6. Summary
3.7. References/Further Readings/Web Resources
3.8. Possible Answers to Self-Assessment Exercises (SAEs)

3.1 INTRODUCTION

These include expenditures by federal, state and local governments for final goods
(such as school buildings, fighter aircrafts) and services (such as military salaries,
school teachers’ salaries, congressional salaries etc). Some of these expenditures are
counted as government consumption and some are counted as government gross
investment.
Government purchases do not include transfer payments, which are payments made
by the government for which no current goods or services are produced. Examples
of transfer payments are social security benefits, disability benefits, scholarships,
bursaries, and so on. These are not included in government consumption because
they are not purchases of anything that is currently produced and the payments are
not made in exchange for any goods or services.
Interests paid on government debt are also counted as transfers, and are excluded
from government purchases because they are not payments for current goods or
services.

3.2. Learning Outcomes

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

i. Understand the meaning and concept of Government Consumption

ii. Understand the National Accounts Measurement of Government.
iii. Know the meaning and concept of Gross Investment

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 3.3. Meaning of Government Consumption Expenditure

Government Consumption Expenditure (GCE) is a transaction of the national

account's use of income account representing government expenditure on goods and
services that are used for the direct satisfaction of individual needs (individual
consumption) or collective needs of members of the community (collective
consumption).

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

Self-Assessment Exercises 1
Discuss the term Government Consumption Expenditure

3.4. National Accounts Measurement of Government Spending

1. Government consumption expenditures and gross investment

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

2. Government current expenditures

Total spending by government is much larger than the spending included in

GDP. Current expenditures measures all spending by government on current-
period activities, and consists not only of government consumption expenditures,
but also current transfer payments, interest payments, and subsidies (and removes
wage accruals less disbursements). Payments such as transfer payments and interest
payments are excluded from the calculation of GDP because these payments do not
represent purchases of goods and services, though income from transfer and interest

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payments may fund consumption expenditures or investment in other sectors of the
economy.

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

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

Self-Assessment Exercises 2
Discuss with detailed example the measurement of Government spending

3.5. Gross Investment

Gross investment is the value of investment in buildings, machinery etc before

taking away depreciation (the fall in value of something over time). It can also be
the amount a company invests in business assets that does not account for any
depreciation. The gross figure more accurately reflects the company's actual
financial commitment to an asset from which it can derive a return on investment.

Investment has different meanings in finance and economics. In economics,

investment is the accumulation of newly produced physical entities, such as
factories, machinery, houses, and goods inventories. In finance, investment is
putting money into an asset with the expectation of capital appreciation, dividends,
and/or interest earnings. This may or may not be backed by research and analysis.
Most or all forms of investment involve some form of risk, such as investment in
equities, property, and even fixed interest securities which are subject, among other
things, to inflation risk. It is indispensable for project investors to identify and
manage the risks related to the investment.

Self-Assessment Exercises 3
What do you understand by the term “Gross investment”.

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 3.6. Summary
Government activity at the federal, state, and local levels affects the economy in
many ways. As noted above, governments contribute to economic output when they
provide services to the public and when they invest in capital. They also provide
social benefits, such as social security and Medicare, to households. Governments
also affect the economy through taxes and by providing incentives for various
business activities. In addition, governments affect the economy through their
collective saving, the difference between their revenue and spending.

3.6. References/Further Readings

Akinsanya. T. (2011). Macroeconomics theory, 2nd edition, Makinon Publication

limited.

Folawewo A. (2009) Introductory Economics (2009), Ibadan Distance learning

Series, university Press Ibadan.

3.7. Possible Answers to SAEs

These are the possible answers to the SAEs within the content.

Answers to SAEs 1
Government Consumption Expenditure (GCE) is a transaction of the national
account's use of income account representing government expenditure on goods and
services that are used for the direct satisfaction of individual needs (individual
consumption) or collective needs of members of the community (collective
consumption).

Answers to SAE 2
Two of the most common measures are government spending as a share of national
output (GDP) and government revenues as a share of GDP. Other measures may
include government spending per capita, the number of public sector employees, or
public sec- tor employment as a share of total employment.

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Answers to SAE 3
Gross Investment is defined as the total expenditure or investment that is made by
a company to acquire capital goods. Gross investment is the gross value for such an
expenditure and it does not take into consideration the factor of depreciation (which
is wear and tear of an asset over its useful life).

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 Module: 5 Aggregate Demand and
Aggregate Supply

This module discusses the Aggregate demand and Aggregate supply. The
module consist of 3units and they are: meaning and nature of aggregate
demand curve, meaning and nature of aggregate supply curve and short-run
and long-run aggregate demand and supply. The specific unit topics are as
follows:

UNIT 1: Meaning and Nature of Aggregate Demand Curve

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

UNIT 1: Meaning and Nature of Aggregate Demand Curve

Unit Structure
1.1. Introduction
1.2. Learning Outcomes
1.3. Meaning of Aggregate Demand
1.3.1. Aggregate Demand Cure
1.4. Reasons for the downward slope of the aggregate demand curve.
1.5. Summary
1.6. References/Further Readings
1.7. Possible Answers to Self-Assessment Exercises (SAEs)

1.1. INTRODUCTION

One of the most important issues in macroeconomics and to the government is the
determination of the overall price level which in turn is determined by the
interaction of aggregate demand and aggregate supply. Thus, it is important to study
the behaviour of aggregate demand and aggregate supply. This lecture examines
concepts of aggregate demand and supply.

112
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. However, the total supply of goods and
services produced within an economy at a given overall price level in a given time
period. It is represented by the aggregate-supply curve, which describes the
relationship between price levels and the quantity of output that firms are willing to
provide.

1.2. Learning Outcomes

By the end of this unit, you should be able to:

i. Understand the meaning and nature of aggregate demand

ii. Understand the meaning and nature of aggregate demand Curve
iii. Know the differences between short-run and long-run aggregate demand and
supply.

1.3. Meaning of Aggregate Demand

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

1.3.1. Aggregate Demand Curve

Having defined aggregate demand, let us take a look at how the aggregate demand
curve looks like. The aggregate demand curve shows the relationship between short-
run equilibrium output, ‘Y’, (which equals planned aggregate spending) and price
level, ‘P’ or inflation. However, it should be noted that the relationship is a negative
one, implying that an increase in price level will lead to a decrease in aggregate
output and vice versa. More so, we can conclude that the name of the curve reflects
the fact that short-run equilibrium output is determined by total planned spending
or demand in the economy. We can then get the relationship between the short-run
equilibrium output and price level shown in figure 3.1 but the overall price level is
on the vertical axis and the aggregate output is on the horizontal axis.

113
Let us take a look at the graph of aggregate demand curve from figure 3.1 bellow.
We can see that the aggregate demand (AD) curve is downward-slopping; depicting
a negative relationship between output and price level (or inflation). Therefore we
can say that an increase in the price level will reduce short-run equilibrium output.
But it should be noted that the AD curve can either be straight or curving.

Figure 1: Diagram showing the Aggregate Demand Curve

Note that the AD curve is not the sum of all the market demand in the economy. It
is not a market demand curve. It is different from an ordinary demand curve in the
sense that the logic behind the ordinary demand curve is that when price of a
commodity changes, ceteris paribus, the prices of all other commodities will not
change. However, in the case of aggregate demand curve this logic does not follow,
because when the general price level changes every other prices like wages (price
of labour), commodity prices and interest rates will change. Given this, the logic
that explains why a simple demand curve slopes downward fails to explain why the
AD curve also has a negative slope. Note that the AD curve shows a negative
relationship between a short-run equilibrium output and price level (inflation).
Economists sometimes define the AD curve as the relationship between aggregate
demand and the price level rather than inflation.

114
 Self-Assessment Exercises 1
Discuss in detailed the aggregate demand curve analysis

1.4. Reasons for the downward sloping of the Aggregate Demand Curve
a. Monetary Authority Response: Let us consider the situation when inflation
is high, the monetary authority (Central Bank of Nigeria (CBN), in the case
of Nigeria) responds by raising the interest rate. The increase in interest rate
reduces consumption and investment spending (autonomous expenditure).
The reduction in consumption and investment spending in turn reduces
short-run equilibrium output. The higher inflation which led to a reduction
in output makes aggregate demand curve to be downward slopping.
b. Effectiveness of Money Supply and Demand on Interest Rate: Aggregate
demand falls when the price level increases because the higher price level
causes the demand for money (Md) to rise. With money supply constant, the
interest rate will rise to re-establish equilibrium in the money market. It is
the higher interest rate that causes aggregate output to fall. Thus, in the end,
the increase in the price level will lead to a fall in aggregate output, which
gives a negative relationship between the two.
c. Consumption Expenditure: Consumption expenditure tends to rise when
interest rate falls and fall when interest rate rises, just as planned investment
does. The consumption link is another reason for the downward slopping
shape of AD curve. An increase in general price level increases the demand
for money, which in turn leads to an increase in the interest rate. A rise in
interest rate causes a decrease in consumption as well as planned investment,
which consequently leads to a decrease in output or income.
d. Analysis of Real Wealth Effect: Consumption depends on wealth (that is,
holding of money, shares, housing, stocks, etc) other things being equal, the
more wealth households have, the more they consume. If household wealth
decreases, the result will be less consumption now and in the future. The
price level has an effect on some kinds of wealth. For example, an increase
in the price level leads to decrease in purchasing power and lowers the real
value of some types of wealth such as stocks, housing etc. however, the
effect of a rise in general price level on wealth depends on what happens to
stock prices and housing prices when the overall price level rises. If these

115
 two prices rise by the same percentage as the overall price level. The real
value of stocks and housing will remain unchanged and this will lead to a
decrease in consumption, which leads to a decrease in aggregate output.
Thus, there is a negative relationship between the price level and output
through this real balance effect.
e. The uncertainty in the Economy: During period of inflation, aggregate
demand falls because in uncertain economic environment both households
and firms may become more cautious and reduce their spending.
f. Foreign Price of Domestic Goods: A final link between the price level and
total spending operates through the prices of domestic goods and services
sold abroad. The foreign price of domestic goods depends in part on the rate
at which the domestic currency exchanges for foreign currencies. However,
for constant exchange rate between currencies, a rise in domestic inflation
causes the prices of domestic goods in foreign markets to rise more quickly.
As domestic goods become relatively more expensive to prospective foreign
purchasers, export sales decline. Since net exports are part of aggregate
expenditure, so we find that increased inflation tends to reduce spending and
cause the AD curve to slope downward.

Self-Assessment Exercises 2
Discuss the reasons for the downward sloppy of aggregate demand curve.

1.5 Summary
In this unit, you have been learnt that the meaning of aggregate demand and
aggregate demand curve. Finally we can conclude that aggregate Demand represents
the total demand for goods and services in an economy. By defining aggregate
demand in terms of the price level and output or income, it is possible to analyze the
effects of other variables, like the interest rate, on aggregate demand through an
aggregate demand equation.

1.6. References/Further Readings

Folawewo, A. (2009). Introductory Economics. Ibadan Distance learning

Series, university Press Ibadan.

Yahyah, R. (2011). Introduction to Macroeconomics Theory, 1st Edition,

116
 Landmark Publication Limited.

3.8 Possible Answers to SAEs

These are the possible answers to the SAEs within the content.
Answers to SAEs 1
An aggregate demand curve shows the total spending on domestic goods and
services at each price level. You can see an example aggregate demand curve below.
Just like in an aggregate supply curve, the horizontal axis shows real GDP and the
vertical axis shows price level.
How do you interpret the aggregate demand curve?
The aggregate demand curve, like most typical demand curves, slopes downward
from left to right. Demand increases or decreases along the curve as prices for goods
and services either increase or decrease. Also, the curve can shift due to changes in
the money supply, or increases and decreases in tax rates.

Answers to SAEs 2
It slopes downward because of the wealth effect on consumption, the interest rate
effect on investment, and the international trade effect on net exports. Some of the
reason are also:
1. Wealth or real balance effects. As the price levels rise, the real value of the
money stock falls in response, households reduce the amount of goods and
services they buy which leads to output falling.
2. Interest rates.
3. Substitution of foreign produced goods.

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UNIT 2: Meaning and Nature of Aggregate Supply Curve

Unit Structure
2.1. Introduction
2.2 Learning Content
2.3. Meaning of Aggregate Supply
2.4. Aggregate Supply Curve
2.5. Aggregate Supply in the Short-run
2.6. Reasons for the shape of the Short-run aggregate supply curve
2.7. The long-run aggregate supply curve.
2.8. Summary
2.9. References/Further Readings
2.10. Possible Answers to Self-Assessment Exercises (SAEs)

2.1. INTRODUCTION

In this unit we are looking at the meaning of aggregate supply, so we can say that
aggregate supply is the total supply of goods and services produced within an
economy at a given overall price level in a given time period. It is represented by
the aggregate-supply curve, which describes the relationship between price levels
and the quantity of output that firms are willing to provide. Normally, there is a
positive relationship between aggregate supply and the price level. Rising prices are
usually signals for businesses to expand production to meet a higher level of
aggregate demand and also known as total output.

2.2. Learning Outcomes

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

i. Understand the meaning and nature of aggregate Supply.

ii. Understand the meaning and nature of aggregate Supply Curve.

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 2.3. Meaning of Aggregate Supply

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

Self-Assessment Exercises 1
Define the term aggregate supply

2.4. Aggregate Supply Curve

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

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

119
Based on the aforementioned, we can look at the aggregate supply curve as a “price-
output response” curve – that is, a curve that traces out the price and output decisions
of all the markets and firms in the economy under a given set of circumstances.

Self-Assessment Exercises 2
Explain the term “aggregate supply curve”

2.5. Aggregate Supply in the Short-Run

Although it is generally opined that the AS curve has a positive slope, the shape of
the short-run AS curve is a source of much controversy in macroeconomics. It is
often argued that at very low levels of aggregate output (for example, when the
economy is in a recession, the aggregate supply curve is fairly flat, and at high levels
of output (for example, when the economy is experiencing a boom), the curve is
vertical or nearly vertical. Thus, we have the AS curve sloping upward and
becoming vertical when the economy reaches its capacity or maximum output. Such
a curve is shown below in figure 2.
In figure 2, aggregate output is considerably higher at point B than at point A but the
price level at point B is only slightly higher than it is at point A. Along these points,
aggregate output is low and the resulting aggregate supply curve is fairly flat.
Between points C and D, there is no increase in aggregate output because the
economy is already in full capacity (that is utilizing all its

120
 Figure 2: The Short Run Aggregate Supply Curve

D
AS Curve
C

0 y
Aggregate Output (Income)

available resources and producing at its maximum level of output), but there is a
large increase in the price level. Thus, point C is the point where the economy begins
to operate at full capacity. As the economy approaches full capacity (point C), the
curve becomes nearly vertical but between points C and D when the economy is at
full capacity, the curve becomes vertical. In the short run, the aggregate supply curve
has a positive slope. At low levels of aggregate output, the curve is fairly flat, but
as the economy approaches full capacity, the curve becomes nearly vertical. At full
capacity, the curve is vertical.

Self-Assessment Exercises 3
Briefly explain the aggregate supply curve in the short-run

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

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

1. The Fairly Flat Shape

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

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

In figure 2, if the economy is operation at a low level of output such as at point A

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

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

ii. The Nearly Vertical/Vertical Shape

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

As aggregate output rises, the prices of labour and capital will begin to rise more
rapidly, leading firms to increase their output prices. But at full capacity (when all
122
sectors in the economy are fully utilizing their existing factories and equipment and
factors of production, where there is little or no cyclical unemployment) when it is
virtually impossible for firms to expand any further, firms will respond to any
further increase in demand only by raising prices, since they are unable to expand
output any further. At full capacity and with output remaining unchanged, the
aggregate supply curve becomes vertical.

In figure 2, moving from points C to D results in no increase in aggregate output but

a large increase in the price level, so, the economy is at full capacity at point C. It
can be seen that a little below point C, as the economy approaches point C or as the
economy approaches full capacity, the aggregate supply curve becomes nearly
vertical but at full capacity which is at point C, the curve assume a vertical shape.

Self-Assessment Exercises 4
Discuss the reason for the shape of the short-run average supply curve

2.7. The Long-Run Aggregate Supply Curve

It is interesting to know that whether or not the economy is producing at a level of

output close to full capacity, there must be a time lag between changes in input
prices and changes in output prices for the aggregate supply curve to slope upward.
Therefore, if input prices change at exactly the same rate as output prices, the AS
curve will be vertical. For example, all output and input prices increase by 10 per
cent, no firm will find it advantageous to change its level of output because the
output level that maximized profits before the 10 per cent increase will be the same
as the level that maximizes profits after the 10 per cent increase. Thus, if input prices
adjusted immediately to output prices, the aggregate supply curve would be vertical.

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

In the short-run (a period when at least one input varies and the others are fixed), at
least changes in some costs lag behind changes in price level. This is because the
short-run is a period too short for input price to quickly adjust to overall

123
macroeconomic changes. Thus, in the short-run, wage rates (price of labour) tend to
adjust slowly to overall macroeconomic changes and the AS curve cannot be
vertical. In the short-run, the wage rate may increase at exactly the same rate as the
overall price level if increase in the price level is fully anticipated. However, most
employees do not usually receive automatic pay rises as the overall price level rises,
and sometimes, increases in the price level are unanticipated. Therefore, in the short-
run, changes in costs lag behind price level changes, but ultimately move with the
overall price level.

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

P
Long run AS Curve

Short run AS Curve

0 Y
Aggregate Output (Income)

Self-Assessment Exercises 5
Differentiate between the short-run and long-run aggregate supply curve.

124
 2.8 Summary
In this unit, you have been learnt that the meaning of aggregate supply and aggregate
supply curve. Finally we can conclude that aggregate supply is the total supply of
goods and services produced within an economy at a given overall price level in a
given time period while aggregate supply curve is the relationship between the price
level and the quantity of real GDP supplied, holding all other determinants of
quantity supplied constant, is called the economy's aggregate supply curve.

2.9. References/Further Readings/Web Resources

Folawewo A. (2009). Introductory Economics. Ibadan Distance Learning

Series, University Press Ibadan.

Medelling, F. (2010). Macroeconomics theory, a broader perspective. 2nd Edition

Sawermills Press Limited.

2.10. Possible Answers to Self-Assessment Exercises (SAEs)

These are the possible answers to the SAEs within the content.
Answers to SAEs 1
Aggregate supply is the total quantity of output firms will produce and sell in other
words, the real GDP. The upward-sloping aggregate supply curve also known as the
short run aggregate supply curve shows the positive relationship between price level
and real GDP in the short run.

Answers to SAEs 2
The aggregate supply curve measures the relationship between the price level of
goods supplied to the economy and the quantity of the goods supplied. In the short
run, the supply curve is fairly elastic, whereas, in the long run, it is fairly inelastic
(steep)
Answers to SAEs 3
The short-run aggregate supply curve is an upward-sloping curve that shows the
quantity of total output that will be produced at each price level in the short run.
125
Wage and price stickiness account for the short-run aggregate supply curve's upward
slope.
Answers to SAEs 4
In the short run, the aggregate supply curve reflects the behavior of total supply
towards the price level. The curve shape is upward sloping in the short run
because the aggregate supply rises as the price level increases. Also, the short-run
aggregate supply curve is upward sloping because the quantity supplied increases
when the price rises. In the short-run, firms have one fixed factor of production
(usually capital). When the curve shifts outward the output and real GDP increase
at a given price.
Answers to SAEs 5
Short-run aggregate supply curves illustrate supply in the near future or over a
period in which capital is fixed. Long-run aggregate supply curves show supply in
the long-term in which all inputs are variable. Aggregate supply is a function of total
production within an economy and the price level.

126
UNIT 3: AGGREGATE SUPPLY-AGGREGATE DEMAND MODEL

Unit Structure
3.1. Introduction
3.2. Learner Outcomes
3.3. Aggregate Supply-Aggregate Demand Model
3.4. Shifts in aggregate Demand in the aggregate Supply-Aggregate Demand Model.
3.5. Shift in aggregate Supply in the aggregate Supply-Aggregate Demand Model.
3.6. Summary
3.7. References/Further Readings/Web Resources
3.8. Possible Answers to Self-Assessment Exercises (SAEs)

3.1. INTRODUCTION

In this unit we are looking at the meaning of aggregate supply and aggregate demand
model and how it is applied in an economy both in the short and long run. However,
the shifts in aggregate demand in the aggregate supply to aggregate demand in the
contractionary shift and positive supply shock will also be examined.

3.2. Learning Outcomes

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

i. Understand the meaning aggregate supply-aggregate demand model.

ii. Understand the analysis of shifts in aggregate demand-aggregate supply in
aggregate supply-aggregate demand model.

3.3. Aggregate Supply-Aggregate Demand Model.

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

127
Figure 4
Graph of the Aggregate Supply-Aggregate Demand Model

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

Self-Assessment Exercises 1
What is the effect of an increase in the price level on the short-run aggregate
supply curve?

3.4. Shifts in Aggregate Demand in the Aggregate Supply-Aggregate Demand

Model

The primary cause of shifts in the economy is aggregate demand. But it should be
noted that aggregate demand can be affected one way or the other by consumers
both domestic, foreign, and the government. It should be noted that any

128
expansionary policy will shifts the aggregate demand curve to the right, while
contractionary policy will shifts the aggregate demand curve to the left. Moreover,
in the long run, as we should note that long-term aggregate supply will be fixed by
the factors of production, short-term aggregate supply shifts to the left so that the
only effect of a change in aggregate demand is a change in the price level.

Figure 5
Graph of an expansionary shift in the Aggregate Supply-Aggregate Demand
model.

From the graph above, at point A where short-run aggregate supply curves 1 meets
the long-run aggregate supply curve and aggregate demand curve 1. The short run
equilibrium is where the short-run aggregate supply curve and the aggregate demand
curve meet and the long run equilibrium is the point where the long-run aggregate
supply curve and the aggregate demand curve meet.

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

But, as we move to the long run, the expected price level comes into line with the
actual price level as firms, producers, and workers adjust their expectations. When

129
this occurs, the short-run aggregate supply curve shifts along the aggregate demand
curve until the long-run aggregate supply curve, the short-run aggregate supply
curve, and the aggregate demand curve all intersect. This is represented by point C
and is the new equilibrium where short-run aggregate supply curve 2 equals the
long-run aggregate supply curve and aggregate demand curve 2. Thus, expansionary
policy causes output and the price level to increase in the short run, but only the
price level to increase in the long run.

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

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

However, if the Government pursues contractionary monetary policy, the aggregate

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

130
Let us consider the long-run analysis, we can see from the graph that as we move to
the long run, the expected price level comes into line with the actual price level as
firms, producers, and workers adjust their expectations. When this occurs, the short-
run aggregate supply curve shifts down along the aggregate demand curve until the
long-run aggregate supply curve, the short-run aggregate supply curve, and the
aggregate demand curve all intersect. This is represented by point C and is the new
equilibrium where short-run aggregate supply curve 2 meets the long-run aggregate
supply curve and aggregate demand curve 2. Therefore, we can conclude that
contractionary policy causes output and the price level to decrease in the short run,
but only the price level to decrease in the long run.

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

Self-Assessment Exercises 2
Differentiate between the expansionary and contractionary shift in aggregate
demand in aggregate supply-aggregate demand model.

3.5. Shifts in Aggregate Supply in the Aggregate Supply-Aggregate Demand

Model.

The Shifts in the short-run aggregate supply curve are much rarer than shifts in the
aggregate demand curve. Usually, the short-run aggregate supply curve only shifts
in response to the aggregate demand curve. But, when a supply shock occurs, the
short-run aggregate supply curve shifts without prompting from the aggregate
demand curve. Fortunately, the correction process is exactly the same for a shift in
the short-run aggregate supply curve as it is for a shift in the aggregate demand
curve. That is, when the short-run aggregate supply curve shifts, a short- run
equilibrium exists where the short-run aggregate supply curve intersects the
aggregate demand curve. Then the aggregate demand curve shifts along the short-
run aggregate supply curve until the aggregate demand curve intersects both the

131
short-run and the long-run aggregate supply curves. Once the economy reaches this
new long-run equilibrium, the price level is changed but output is not.

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

Figure 7

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

model.

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

Let us assume that a positive supply shock occurs, which is a reduction in the price
of oil. In situation, the short-run aggregate supply curve shifts to the right from
short-run aggregate supply curve 1 to short-run aggregate supply curve 2. The
intersection of short- run aggregate supply curve 2 and aggregate demand curve 1
132
has now shifted to the lower right from point A to point B. At point B, output has
increased and the price level has decreased and this gives rise to a new short-run
equilibrium.

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

Figure 8

Graph of an adverse Supply Shock in the Aggregate Supply-Aggregate

Demand model

We will start at this junction at point A where short-run aggregate supply curve 1
meets the long run aggregate supply curve and aggregate demand curve , but we
should note that we are in long-run equilibrium.

Let assume that if an adverse supply shock occurs which is a terrifying increase in
the price of oil. In this case, the short-run aggregate supply curve shifts to the left
from short-run aggregate supply curve 1 to short-run aggregate supply curve 2. The

133
intersection of short-run aggregate supply curve 2 and aggregate demand curve 1
has now shifted to the upper left from point A to point B. At point B, output has
decreased and the price level has increased. This condition is called stagflation. This
is also the new short- run equilibrium.

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

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

Self-Assessment Exercises 3
Differentiate between positive supply shocks from adverse supply shocks in
aggregate supply-aggregate demand model.

3.6 Summary
In this unit, you have learnt that aggregate demand is the aggregate of all the demand
in the economy. It includes consumption by households, investment by firms,
government spending and consumption by foreigners on exports. Consumption by
Nigerian households on foreign imports must be subtracted because it is included in
the measure called 'consumption by households'. An aggregate demand curve shows
the total demand in the whole economy at any given price level. However, aggregate
supply is the aggregate of all the supply in the economy. Effectively, it is the sum
of all the industry supply curves in an economy. An aggregate supply curve shows
134
the amount supplied (or the level of real output) in the whole economy at any given
price.

3.7. References/Further Readings/Web Resources

Folawewo A. (2009) Introductory Economics (2009), Ibadan Distance learning

Series, university Press Ibadan.

Awotu, G, Davies, D. (2011). The debate between Microeconomics and

Macroeconomics analysis, Journal vol 5, pg 56-67, Mill wall Publication

limited, Lagos.

3.8 Possible Answers to SAEs

These are the possible answers to the SAEs within the content.
Answers to SAEs 1
Increases in the price of such inputs cause the SRAS curve to shift to the left, which
means that at each given price level for outputs, a higher price for inputs will
discourage production because it will reduce the possibilities for earning profits. For
example, the short-run aggregate supply curve slopes upward due to the lag between
product prices and resource prices that makes it profitable for firms to increase
output when the price level rises. The long-run aggregate supply curve is vertical
when a country is at full employment.

Answers to SAEs 2

Expansionary fiscal policy occurs when the Congress acts to cut tax rates or increase
government spending, shifting the aggregate demand curve to the right.
Contractionary fiscal policy occurs when Congress raises tax rates or cuts
government spending, shifting aggregate demand to the left.

Answers to SAEs 3
A positive supply shock increases output, which causes prices to decrease due to a
shift in the supply curve to the right, while a negative supply shock decreases
production, which causes prices to rise.
135
 Module: 6 Government and the Economy

This module introduces you to the Government and the Economy. The module
consists of 3 units which include: meaning of Government spending, meaning of
Government revenue and Budget analysis.

UNIT 1: Meaning of Government Spending

UNIT 2: Meaning of Government Revenue
UNIT 3: Budget analysis

UNIT 1: Meaning and Nature of Aggregate Demand Curve

Unit Structure

1.1. Introduction
1.2. Learning Outcomes
1.3. Meaning of Government Spending
1.4. Reasons for increase in Government Spending
1.5. How Government Spending is financed
1.6. Summary
1.7. References/Further Readings

1.1. INTRODUCTION

A government is supposed to guide and direct the pace of its country's economic
activities. It is also supposed to ensure that growth is steady, employment is at high
levels, and that there is price stability. Additionally, a government should adjust tax
rates and spending.

1.2. Learning Outcomes

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

i. Meaning of Government Spending.

ii. Understand the reasons for increase in Government spending.
iii. Know how Government spending is financed.
136
 1.3 Meaning of Government Spending

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

Government spending also means Government expenditure and is a term used to

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

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

Some examples of government final consumption include the creation and

maintenance of the military, police, emergency, and firefighting organizations.
These are funded by federal and regional governments, in order to provide for both
the safety of the country from attack, and the safety of citizens from crime and
disasters. Others examples include programs such as health care, food stamps, and
housing assistance for disabled or severely low-income citizens. Public education
and public transportation infrastructure are other main categories of this form of
government spending.

Since the beginning of the 70's, every category of Nigerian government spending
has increased more rapidly than envisaged. This, primarily, can be attributed to the
discovery of crude oil and the upsurge in the prices of crude petroleum that brought
in more revenue to the government that it has ever generated.

Self-Assessment Exercises 1
Government Expenditure also means Government Spending”. Discuss
137
1.4. Reasons for Increase in Government Spending

The following reasons are the factors that lead to increase in government spending
overtime.
(a). Defence: Over the years, expenditures on defense have been on the increase in
most African countries. The need for a strong and well-armed force necessitates the
building of additional barracks, purchase of military armaments and other military
equipments. Wars and frictions in most African countries have, made such
governments to increase expenditures on defense.
(b). Population: Population in most African countries has been increasing.
Nigeria's population was 63 million in the 1963 census, but the 1991 census put the
country at 88.5 million, while latest estimate put the country at over a 200 million
people as population increases more amenities would have to be provided, more
schools have to be built, hospitals, etc.
(c). Development projects: After independence, most countries in West Africa
embarked on development projects. They began building airports, refineries,
hospitals, etc. These involved huge cost and consequently increase government
expenditure.
(d). Depreciation and devaluation of currency: Over the years most West African
countries have either devalued their currencies or allowed it to depreciate. This act
only result in high prices of goods and services which in turn increases the
expenditure of the government.
(e). Interest on debt: The public debts of most West African countries have been
on the increase over the years. Likewise the servicing of the debt have also been on
the increase and have gone to increase government expenditure.

Self-Assessment Exercises 2
Discuss the reasons for increase in Government spending.
.

1.5. How Government Spending is financed

Government generates income through various means to finance its spending, Some
of the means are as follows: Rents, royalties and profits: These includes revenue
from mining rights, rent from the use of government properties, profits from all
government businesses, etc.

138
(I).Taxation: Government get to finance its spending through various tax levied on
its citizens and corporate organization.
(II).Fines, Fees and Special Charges: These includes fines on defaulters, traffic
offences, etc., income derived from fees such as motor vehicle licenses, water rate,
toll gate, etc.
(III). Loans: This takes the form of:
a. Short-term loans: These are obtained through the sale of treasury bills and
Certificate to members of the public.
b. Medium and long-term loans: These include long term stocks sold also to
the public.
c. Foreign loans: These are loans obtained from International Monetary Fund.
World Bank, Paris Club, etc.

Self-Assessment Exercises 2
Can Government spending improve the Economy? Discuss.

1.6. Summary
In this unit we analyze that government spending (or government expenditure)
includes all government consumption and investment but excludes transfer
payments. Government acquisition of goods and services for current use to directly
satisfy individual or collective needs of the members of the community is classed
as government final consumption expenditure. Government acquisition of goods
and services intended to create future benefits, such as infrastructure investment or
research spending, is classed as government investment (gross fixed capital
formation). Finally, the first two types of government spending, final consumption
expenditure and gross capital formation, together constitute one of the major
components of gross domestic product.

1.7. References/Further Readings/Web Resources

Abdullah H.A, (2000). The Relationship between Government Expenditure and

Economic Growth. Saudi Arabia Journal of Administrative Science,

12(2): 173-191.

139
Al-Yusuf Y, (2000). Does Government Expenditure Inhibit or Promote Economic

Growth, Some Empirical Evidence from Saudi Arabia. Indian

Economic Journal, 48 (2).

1.8 Possible Answers to SAEs

These are the possible answers to the SAEs within the content.
Answers to SAEs 1
Government spending refers to money spent by the public sector on the acquisition
of goods and provision of services such as education, healthcare, social protection,
and defense while Government expenditure refers to the purchase of goods and
services, which include public consumption and public investment, and transfer
payments consisting of income transfers (pensions, social benefits) and capital
transfer.

Answers to SAEs 2
Income Elasticity and Increase in Per Capita Income, Welfare State Ideology and
Wagner's Law, Effects of War and the Need for Defence, Resource Mobilisation
and Ability to Finance, Inflation, The Role of Democracy and Socialism and The
Urbanisation Effect.

Answers to SAEs 3

According to the Keynesian theory, government spending has a positive impact on

economic growth. The Keynesian theory postulates that the more a government
spends, the higher the economic growth is as a result of expansionary fiscal policy

140
UNIT 2: MEANING OF GOVERNMENT REVENUE

CONTENTS

2.1. Introduction
2.2. Learning Outcomes
2.3 Meaning of Government Revenue
2.4. Taxation
2.5. Types of Taxes
2.6. Differences between Direct and Indirect Tax
2.7. Attributes or Principles of Taxation
2.8. Terms in Taxation
2.9. Summary
2.10. References/Further Readings/Web Resources
2.11. Possible Answers to Self-Assessment Exercises (SAEs)

2.1. Introduction

Government revenue is the income available to fund the activities of a government.

Running a country can be very expensive, and governments have a wide range of
responsibilities, such as operating the various departments, maintaining armed
forces, investing in development, and the alleviation of poverty. Many governments
tax citizens directly, based on each household's individual income. In addition to
direct taxes, there are also numerous indirect taxes on government services,
financial transactions, and commercial activities that also generate revenue.

From the early days of civilization, those in power have always relied on taxation
as a method of generating income. In areas ruled by a monarch or dictators, most of
the income was used at the discretion of the sole ruler. Today, however, government
revenue is spent on the operation of the government and for development of the
nation. Some governments, particularly those that have high-valued deposits, such
as mineral resources, rely primarily on natural resources and monopolize the
extraction of these resources to generate income. Others generate revenue by
directly taxing citizens on items such as income, everyday purchases, and business
profits.

141
 2.2. Learning Outcome

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

i. Understand the meaning of Government Revenue

ii. Know the different types of taxation as a source of government revenue
iii. Know the use of attributes or Principles of Taxation

2.3. Meaning of Government Revenue

Government revenue is money received by a government. It is an important tool of

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

Self-Assessment Exercises 1
Differentiate between Government revenue and Government Spending.

2.4. Taxation

A tax is a compulsory levy imposed by the government on individuals and business

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

142
2.4.1 Reasons why government levy taxes

1. Revenue Generation: this is one of the main sources of government revenue

Government imposes taxes to raise money to finance its expenditure. Raising taxes
is an unpopular decision and government must be able to mould and feel the pulse
of the citizenry or they may express their displeasure at the next general election.

2. Re-distribute income: Taxes are levied to achieve greater equality in the

distribution of wealth and income. Where there are great disparities of income,
aggregate demand falls, hence government can introduce a progressive tax system
which will take more money from the rich than poor. The revenue generated will be
used to further invest in projects that will be beneficial to both the poor and rich
alike.

3. Exercise Control of the Economy: Taxation can be used to regulate inflation

and deflation in an economy. A higher tax will reduce disposable income, hence
aggregate demand, a lower tax will increase disposable income thereby stimulating
aggregate demand. It is used also to achieve the objective of full employment.

4. Modifying the Influence of the Price System: By protecting infant industries

developing vital industries, increasing trade with regional trading partners lie
ECOWA, etc and improving the terms of trade.

5. To Discourage ‘Certain’ Consumption: There are some goods which are

socially undesirable as a result of the danger to health, such as alcohol and cigarettes,
danger to environment, that is, pollution emitting cars, etc. government can impose
heavy taxes on sales and high import duties on such cars to discourage their
consumption. If the goods are fairly elastic, quantity demanded will fall. To promote
expert deduction in tax on exported goods (i.e. reducing export duty) will serves as
incentives to exporter to export more goods.

6. Promote Economic Growth and Development: Such as granting tax holidays,

tax concessions to some companies over a period of time. Taxed profits could be
reinvested at lower rate and generous investment allowance should be given.

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

Self-Assessment Exercises 2
1. Define Taxation.
2. What are the reasons why Nigerian Government levy taxes on the
citizen and corporate organizations?
143
2.5. Types of Taxes

There are two types of taxes direct and indirect.

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

a. Income tax: This is a tax levied on individual’s incomes usually at a standard

rate. Personal allowances on family and other responsibilities are allowed
before the tax is levied on the remainder called taxable income. The
incidence of taxation is certain as the individual cannot shift the burden of
taxation. It is based on the Pay As You Earn (PAYE) system.

b. Corporation or company tax: This is a tax levied on the profit of the

company after all expenses have been deducted. The incidence of tax is
uncertain because it is possible for a company to shift the tax burden to the
consumers. The ability to shift or not depends on the elasticity of the products
of the company.

c. Property tax: This is a tax levied on the property of the individual. Such
taxes include tenement rates, etc.

d. Capital gains tax: This is a tax levied on capital gains (or appreciated value)
realized on all assets usually at a flat rate. Owner occupied houses, cars,
goods and chattels sold for excess of their original value (i.e. appreciated
value) are taxed.

e. Poll tax: This is a flat rate levied on every individual in a country. This type
of tax ensures everybody pays tax in the country.

f. Estate duty: This is a tax payable on the estate of a deceased person. Rate
charged are progressive depending on the value of the building.

g. Other taxes: This includes motor vehicle duties, stamp duties, land tax and
mineral-rights duties, Petroleum income tax, capital transfer tax, etc.

144
 (a). Forms of Direct Taxes
I. Progressive tax: This is a situation where tax rate increases as the size of
income increases, that is, the higher the tax base (taxable income). These
types of tax reduce income inequality and increases aggregate demand. It is
non-inflationary and yield more revenue to the government. A major
disadvantage is that it becomes a disincentive to work as the payer pays more
as he earns more income. Graphically, the tax behaves in this form.

Fig 1A
GRAPH SHOWING THE PROGRESSIVE TAXATION
Tax
30 –
Progressive Tax
25 –

20 –

15 –

10 –

0 1000 2000 3000 4000 5000

Income (NY)

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

145
 Fig 2
A GRAPH SHOWING THE REGRESSIVE TAXATION
Tax
35 –

30 –

25 –

20 –
Regressive Tax
15 –

10 –

0 1000 2000 3000 4000 5000

Income (NY)

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

146
 Fig 3
A GRAPH SHOWING THE PROPORTIONAL TAXATION

Tax
rate
(%)

10 –
Proportional Tax

Income (NY)

0 1000 2000 3000 4000 5000

2.5.1.1. Advantages of Direct Taxes

1. High Yield: A direct tax has the advantage of high yields at a low cost of
collection. Employers are required to deduct the tax each week or month from their
salary. All increase in tax guarantees higher revenue to the government.

2. Convenience: Tax deducted under the PAVE system enable the burden of tax to
be spread over the year instead of being paid lump-sum. The tax payer would have
conditioned his mind to giving out a determined amount each month rather than pay
in lump-slim at the end of the year which can become burdensome for him.

3. Certainty: The tax payer knows for certain how much will be deducted from his
income as tax and when he is to be paid. It enables him to plan on his income even
before he receives it Moreover, it is difficult to evade direct tax as it is deducted
from source, that is PAYE (pay has you earn), dividends.

147
4. Equity: Direct taxes ensure that the rich are made both the rich and poor to pay
according to their earnings. Allowances are usually given for family and other
responsibilities which are deducted from gross income to arrive at taxable income
or tax base. Furthermore, a progressive tax is added when income reaches a certain
level.

5. Redistribution of Income: Direct taxes help redistribute income and wealth

more equally. The progressive nature of the tax enables the government to generate
more revenue from the rich which it can be used to finance investment beneficial to
both the rich and the poor.

2.5.1.2. Disadvantages of Direct Taxes

1. Act as disincentive to work: High tax rate can cause disincentive to work. People
may prefer to go for leisure (which is not taxed) rather than go for work (which is
taxed) they feel that they are not getting enough from the extra work they arc putting
in as it is heavily tax. Though this is not always the general view, while some might
not want to put in extra efforts because of the interest they have on the job.

2. It encourages tax avoidance: Though PAYE system ensures that every

employee pay taxes, tax payer might be forced to falsify their family and other
responsibility allowances to get lower tax base when tax is high.

3. It Encourages Efficiency: Individuals that have business firm tends to become

less efficient where there is high tax rate to be paid by them. A situation where firm
pay 45 percent of profit as tax and workers’ pay more in tax will result in the
unwillingness of the firms to take further role to expand and for the workers to
perform effectively.

4. It Repels Foreign Capital: Investors come to invest in countries where they hope
to enjoy higher returns from capital. Consequently, any increase in tax payable on
their return which persists will discourage them and they might move their
investment to a higher yield, lower tax countries.

5. Reduce Plough back Profits: Most firms plough back certain percentage of their
profits in other to expand and venture into new areas. Where tax rate imposed on
the firm is high, it reduces the funds in the hands of the companies and ultimately
hinders the firms desired growth.

6. Reduce savings: High tax rate may sometime reduce savings. Small companies
or sole proprietors and workers rely on a fat salary or profit to enable them save part

148
of it for rainy day. But where high tax rate is applied, there will be little or nothing
to save after other expenses have been taken care of.

2.5.2. Indirect Taxes

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

However, it is possible to avoid indirect taxes because it is payable only if a

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

Under indirect tax we have:

1. Custom duties: This refers to export and import duties.

Export duties: these are taxes imposed on all exports from the country. They
constitute a source of revenue of most African countries who rely much on
income from their primary products exported. They are easy to collect.
Import duties: These are taxes levied on all import into the country. They
are usually levied at the point of entry of the goods and constitute a source
of revenue in most less developed countries. The government uses it
sometimes to discourage consumption of certain products or to promote
domestic production.
2. Excise duties: These are taxes on home-produced goods such as petrol,
cigarettes, beer and whisky, milo, etc. Higher tax rate on locally manufactured
goods discourages domestic production which may make the domestic goods
costlier than imported goods.

3. Purchase tax: This is an ad valorem tax imposed on goods at various percentages

and which is generally collected at the wholesale point. It is imposed on a wide
range of products that is, confectionery, clothing, household equipment etc.

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2.5.2.1 Advantages of Indirect Taxes

1. Convenience: The consumer is able to spread the payment of the tax burden as
and when he actually make purchases since the tax is payable only at the wholesale
stage. Most buyers of the goods are not aware that they are even paying taxes on
goods purchased. This helps to reduce the resentment they may have on the tax.

2. Reduces Imposition of High Direct Taxes: Since taxes are one of the main
sources of government revenue, the high yield of indirect taxes have made the
government not to excessively increase direct taxes to source for funds.

3. Certain and Immediate Yield: Yields from indirect taxes especially on fairly
demand are certain since the consumer has little alternative to the product. Any
increase in tax produces extra income with little time-lag as far as the elasticity of
the product remains inelastic.

4. It Does not Disturb Initiative and Enterprise: Unlike direct tax which is
deducted from his earnings directly, indirect taxes on the other hand fall on
spending. It will not lead to disincentive to work. In fact, it may lead to incentive to
work as the worker may work more hours to enable him maintain his lifestyle being
eroded by increase in price.

5. It Can be Used to Discourage Consumption: If the governments want to

discourage consumption of certain goods, or to help promote home made goods, this
is done by imposing high tax rate on the products to make it expensive. This will
reduce the purchase of these good by the consumers.

6. It serves as automatic stabilizer of the economy: The government can heavily

tax home-made goods and imported luxuries with high income elasticity, such that
as income increases,, the yield from indirect taxes also increases. The increase in
revenue from this tax helps to stabilize the economy in periods of inflation.

2.5.2.2. Disadvantages of Indirect Taxes

1. Double Taxation: To an individual, he is made to pay income tax known rates

and he also pays indirect taxes through purchases he made at rates unknown to him
likewise, producers pay income tax as individuals and also pay company tax and as
applicable import or export duties. This double taxation may discourage production.
It is regressive: If the rich and the poor buy the same goods, then they are liable to
pay the same amount of tax levied on goods. This is regressive and it does some of
the redistributive effects of direct taxation. However, imposing ad valorem tax
instead of specific tax may lessen the effect on the poor.

150
2. Discourages Domestic Production: High excise duties make domestic
manufactured goods more expensive than imported goods. Moreover, when import
duties on such goods are low, it will encourage importation of such goods rather
than promote growth in domestic production.

3. It can create inefficient industries: Import duties and subsides arc intended to
give special assistance to an industry. But if prolonged over a period of time,
government may be protecting inefficient industry. Moreover, the government
might find strong opposition if it wants to remove the protection e.g. the fertilizer
subsidy in Nigeria.

4. It may have inflationary influence: When indirect taxes are imposed, it is

reflected in high prices on the goods. Where this increase is general on all goods, a
strong labour might agitate for higher wages which may put the government into
difficulties of controlling inflation.

Self-Assessment Exercises 3
What are 3 types of taxes that the government collects as revenue?

2.6. Differences between Direct and Indirect Taxes

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

151
 Self-Assessment Exercises 4
Differentiate between direct tax and indirect tax.

2.7. Attributes or Principles of a Good Tax System

1. Economic Principle: A good tax system must ensure it does not make the
economic situation of the tax payer worse off. The government must see the payer
as an investor, consumer and saver and should ensure it does not adversely affect
the payers’ contributions.

2. Production of Revenue: The cost of collection should at least be less than the
yield from the tax. It is unwise and uneconomical to spend too collection of tax.

3. Certainty: The tax must be certain and the payer must know exactly when and
where he has to pay his tax. He should find it difficult to evade payment

4. Equity: Tax implementation must not be arbitrary or vindictive. Persons of the

same tax base should be made to pay the same amount as tax. For example if Mr.
OIusanya and Mr. Adedeji earn the same income., the same family size and other
things equal, then they must pay the same amount as tax.

5. Convenience: Tax payment should relate to how people receive and spend their
incomes. It will be out of place to ask for tax from a farmer whose produce one yield
to be harvested. But a PAYE system is convenient to salary earner while import
duties imposed at the port is convenient to the payer.

6. Neutral: A good tax system should not dislocate or distort the relative prices in
an economy.

7. Adjustable or Flexible: It should be flexible enough as an economic tool of

control, to change in policy. Import duties aimed to protect infant industry always
becomes difficult to remove or lower when the infant becomes dependent on of the
protection.

8. It Should Not be Harmful to Enterprise and Initiative: When tax rate is high
up to a point, it becomes less exciting to work. This can induce the tax payer seek
for leisure instead of striving harder for promotion or overtime.

152
9. It Must be Consistent with Government Policy: Individual taxes must be
constantly reviewed to see how they could be used to promote government policy
or to prevent their working out of harmony with it.

10. Acceptability: In a democracy, people respond to bad government policies

through general elections, government must ensure that its tax system is politically
acceptable to the people who will pay it or they might respond unfavourably to it at
be next general elections.

Self-Assessment Exercises 5
List at least five (5) attributes or principles of a good taxation
.

2.8. Terms in Taxation

1. Tax Evasion

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

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

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

The regressive nature of indirect taxes is based on the decreasing marginal

propensity to consume as income rises. Second, “consumption tax (or commodity
tax) does 'not reduce the rate of return on savings and therefore avoids the
substitution effect of the income tax, which is averse to saving.” That is why it is

153
generally suggested that the developing countries should adopt commodity' taxation
for mobilizing resources for rapid economic growth.

Self-Assessment Exercises 6
Discuss in details the impact of taxation on Economic development of in Nigeria.

2.9. Summary

The unit looks at the meaning of government revenue such as, tax which can be
direct or indirect tax. However, a good attributes of taxation was also examined and
the reasons why government levied taxes on its citizens was also discussed.

2.10 References/Further Readings/Web Resources

Abdullah H.A, (2000). The Relationship between Government Expenditure and

Economic Ewing, B., Payne, J., Thompson, M., Al-Zoubi, O. (2006)
Government expenditures and revenues: evidence from asymmetric
Modeling, Southern Economic Journal, 73(1), 190-200.
Fasano, U., Wang, Q. (2002). Testing the Relationship between Government
Spending and Revenue: Evidence from GCC countries, IMF Working
Paper WP/02/201.
Friedman, M. (1978). The limitations of Tax Limitation, Policy Review, summer,
7-14.
Von Furstenberg, G. M. R., Green, J., & J. H. Jeong (1986). Taxation and
Government Spending. Pull Muh Publicsation.

2.11. Possible Answers to SAEs

These are the possible answers to the SAEs within the content.
Answers to SAEs 1
The government revenues are expressed as the trends of incomes in the state budget
(Government revenue – GRS) and the government expenditures are expressed as
the trends of the outflow from the state budget (Government Expenditure – GES).

Answers to SAEs 2

154
1. Taxation is the imposition of compulsory levies on individuals or entities by
governments in almost every country of the world. Taxation is used primarily to
raise revenue for government expenditures, though it can serve other purposes as
well.
2. Like other countries, the main function of the Nigerian tax system is to generate
revenue for the running of the government at all levels and provide infrastructure to
the public. Effective tax drive is achieved through an efficient tax administration
and tax system reforms. Collecting taxes and fees is a fundamental way for
countries to generate public revenues that make it possible to finance investments
in human capital, infrastructure, and the provision of services for citizens and
businesses.
Answers to SAEs 3
1. Corporate tax—A percentage of corporate profits taken as tax by the government
to fund federal programs.
2. Sales tax—Taxes levied on certain goods and services; varies by jurisdiction.
3. Property tax—based on the value of land and property assets.

Answers to SAEs 4
Direct taxes are paid directly to the government and are levied on one's income and
profits. However, indirect taxes are totally opposite and are paid to the government
if one makes any purchases of goods and services
Answers to SAEs 5
A good tax system should meet five basic conditions:
(i). fairness,
(ii). Adequacy
(iii). Simplicity
(iv). Transparency
(v). Administrative ease.
Although opinions about what makes a good tax system will vary, there is general
consensus that these five basic conditions should be maximized to the greatest extent
possible
Answers to SAEs 6
For Nigerian government to effectively carry out its primary function and other
subsidiary functions, she requires adequate funding. Government responsibilities

155
has continued to increase over time especially in developing countries like Nigeria
due to the increasing size of the population, and infrastructural decay. But quite
unfortunately the revenue of the government has not been growing above her
expenditure to enable capital formation possible. Taxation is seen as an essential
part of a country’s investment and growth pattern. Taxes can inhibit investment rate
through such taxes as corporate and personal income, capital gain taxes. Finally,
taxes can slow down growth in labour supply by disposing labour leisure choice in
favour of leisure.

156
UNIT 3: BUDGET ANALYSIS

Unit Structure

3.1. Introduction
3.2. Learning Outcomes
3.3. The budget
3.4. Government Expenditure
3.5. Types of Budget
3.6. Summary
3.7. References/Further Readings/Web Resources
3.8. Possible Answers to Self-Assessment Exercises (SAEs)

3.1. Introduction

Budget is a document that explicitly describe the spending decision of the

government vis-à-vis the projected revenue and the source. Budget balance is the
difference between total government expenditure, that is, taxes minus government
expenditure. If government expenditure is denoted by G and government revenue
by T, then budget balance can be written as:
T = G or T– G = 0

3.2. Learning Outcomes

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

i. Understand the meaning of government budget

ii. Know the reason for increase in government expenditure

iii. Know how government expenditure if financed.

157
 3.3. The Budget

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

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

There are four characteristics of budget. They are:

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

The budget is an important economic document of a country. It reveals the state of

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

Self-Assessment Exercises 1
Define the term “budget”

158
3.4. Budget Concepts

1. Recurrent expenditure: These are costs known as running cost, which the
government undertakes in its day-to-day activities. These costs include wages -and
salaries, national debt interest, etc.

2. Recurrent revenue: These are receipts of monies from fines, taxes, fees, etc. by
the government.
3. Capital expenditure: These are expenditures on capital projects. Such projects
include, provision of hospitals, roads, defence, social and community services, etc.

4. Capital receipts: These are loans, aids, grants, etc. made to the government by
foreign governments or international organizations. Other arms of government can
extend such facilities.

Self-Assessment Exercises 2
Differentiate between recurrent expenditure and revenue

3.5. Types of Budget

3.5.1. Budget Surplus

A situation in which income exceeds expenditures. The term "budget surplus" is

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

When spending exceeds income, the result is a budget deficit, which must be
financed by borrowing money and paying interest on the borrowed funds, much like
an individual spending more than it can afford and carrying a balance on a credit
card. A balanced budget occurs when spending equals income.
159
3.5.2. Budget Deficit

Budget deficit is a status of financial health in which expenditures exceed revenue.

The term "budget deficit" is most commonly used to refer to government spending
rather than business or individual spending. When referring to accrued federal
government deficits, the term "national debt” is used.

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

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

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

3.5.3. Balanced Budget

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

It is commonly used in reference to official government budgets. For example,

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

160
 Self-Assessment Exercises 3
Differentiate between Budget Surplus, Budget deficit and Balanced Budget

3.6 Summary
In this unit we have learnt what a budget is, and its concepts. However, we can
finally say that a budget comprises the deficit, supply and balance budget and a
surplus budget was discuss in this unit as an anticipated profit, while a balanced
budget is that revenues that are expected to equal expenses. More so, a deficit budget
is when expenses exceed revenues. Budgets are usually compiled and re-evaluated
on a periodic basis. Adjustments are made to budgets based on the goals of the
budgeting organization.

3.7. References/Further Readings/Web Resources

Abdullah H.A, (2000). The Relationship between Government Expenditure and

Economic development, DDT Publication limited.
Ewing, B., Payne, J., Thompson, M., Al-Zoubi, O. (2006). Government
Expenditures and Revenues: Evidence from Asymmetric Modeling,
Southern Economic Journal, 73(1), 190-200.
Fasano, U., Wang, Q. (2002). Testing the Relationship between Government
Spending and Revenue: Evidence from GCC countries, IMF Working
Paper WP/02/201.
Friedman, M. (1978). The Limitations of Tax Limitation, Policy Review Summer,
7-14.
Von Furstenberg, G.M.R., Green, J., and Jeong, J. H. (1986). Tax and Spend, or
Spend

3.8 Possible Answers to SAEs

These are the possible answers to the SAEs within the content.
Answers to SAEs 1
A budget is a spending plan based on income and expenses. In other words, it's an
estimate of how much money you'll make and spend over a certain period of time,
such as a month or year. (Or, if you're accounting for the incoming and outgoing
money of everyone in your household, that's a family budget.)

161
Answers to SAEs 2
Revenue items chronicle a company's efforts to make money during a given period,
make more of it over time and keep operating coffers flush with capital. Examples
include sales, investment gains and discount rebates. Expenses represent everything
a company spends money on, generally to operate and settle commitments.
Answers to SAEs 3
A balanced budget is when the government spends an amount equal to the amount
it collects in taxes. A budget deficit is when the government spends more than it
collects in taxes. A budget surplus is when the government collects more in taxes
than it spends.

162
 Module: 7 Open Economy
Macroeconomics

This module discusses the Open Economy macroeconomics. The modules

consist of 3 units and they are: analysis of international trade, Gain from trade
and Net export function in the Open Economy. The specific unit topics are as
follows:

Unit 1 Analysis of International Trade

Unit 2 Gain from Trade
Unit 3 Net Export Function in the Open Economy.

UNIT 1 ANALYSIS OF INTERNATIONAL TRADE

Unit Structure
1.1. Introduction
1.2. Learning Outcomes
1.3. Meaning of International Trade
1.4. Reason for International Trade.
1.5. The basis or theory of international trade
1.6. Summary
1.7. References/Further Readings/Web Resources
1.8. Possible Answers to Self-Assessment Exercises (SAEs)

1.1. Introduction

Let us start this unit by defining what an open economy is. An open economy is an
economy in which there are economic activities between domestic community and
outside, e.g. people, including businesses, can trade in goods and services with other
people and businesses in the international community, and flow of funds as
investment across the border. Trade can be in the form of managerial exchange,
technology transfers, all kinds of goods and services. Although, there are certain

163
exceptions that cannot be exchanged, like, railway services of a country cannot be
traded with another to avail this service, a country has to produce its own. This
contrasts with a closed economy in which international trade and finance cannot
take place.

The act of selling goods or services to a foreign country is called exporting. The act
of buying goods or services from a foreign country is called importing. Together
exporting and importing are collectively called international trade.

1.2. Learning Outcomes

At the end of this unit, you should be able to

i. Understand the meaning of international Trade

ii. Understand the reasons for international Trade
iii. Understand the basis or theory of international trade.

1.3. Meaning of International trade

As a starting point, we can conceive of international economics as being partly

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

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

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

Self-Assessment Exercises 1
Discuss the impact of international trade on economic development in Nigeria.

164
1.4. Reasons for International Trade

International trade could therefore be safely defined as trade relation between a

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

a. Imports Serve Domestic Industry: Domestic industries would have pretty

difficult time if basic raw materials, machinery and other needs are not met.
Some domestic industrial needs are only met with mport of goods from
another country.

b. Imports Serve Domestic Consumers: International trade enlarges the range

of consumers’ choices of goods and services, without international trade
consumers will have fewer choices.

c. Exports are Vital to Many Domestic Producers: The market for nation’s
export is very important. For example, without international trade the market
for the Nigerian crude oil, columbine, cocoa, rubber, etc. would have been
limited to domestic economy.

d. Exports Serve as a Foreign Exchange Earner: Exports of goods and

services act as foreign exchange earner to the domestic economy. Foreign
exchange availability is an essential requirement for the survival of any
national economy.

e. Exports Act as Agent of Growth: Other countries' demands for goods and
services produced within a domestic economy act as a catalyst to the growth
of the total spending and hence growth in the Gross National Product of such
an economy.

Self-Assessment Exercises 2
Discuss the reasons for international trade.

.
1.5. THE THEORY OF INTERNATIONAL TRADE

165
a. The Theory of Absolute Advantage
The classical economist Adam Smith said that the basis of international trade falls
along the divide of Absolute Advantage which may be defined as the good or service
in which a country is more efficient or can produce more than the other country or
can produce the same amount with other country using fewer resources.

b. The Theory of Comparative Cost Advantage

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

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

Table 1: Comparative Advantage Matrix

Wine per man hour Cloth per man hour
England 2 units 6 units

166
Portugal 4 units 8 units

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

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

However, comparative advantage is obtained by computing the relative opportunity

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

If we are interested in relating one unit of wine to cloth, or 1 of cloth to wine; we

divide both sides by 6 and 8 respectively, i.e.
1 unit of wine relative to doth
6w:8c
6/6w = 8/6c
1w = 1.33
Or
1 unit of cloth relative to wine
6w = 8c
:. 6/8w = 8/8c
1cc = 0.75w

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

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

167
While in England, the opportunity cost of production is not the same with Portugal
for the following obvious reasons:
2w = 4c and,
The relative opportunity cost of production can be obtained also from table 9.1 by
getting one unit of wine in relative to cloth and one unit of cloth relative to wine
respectively. This is done by dividing both sides by 4 if we are to get one unit of
cloth relative to cloth in the following manner:
In England

1 unit of cloth relative to wine

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

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

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

Self-Assessment Exercises 3
Differentiate between theory of absolute advantage and comparative cost
Advantage.

1.6. Summary

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International trade is the exchange of goods and services between countries. This
type of trade gives rise to a world economy, in which prices, or supply and demand,
affect and are affected by global events. Political change in Asia, for example, could
result in an increase in the cost of labor, thereby increasing the manufacturing costs
for an American sneaker company based in Malaysia, which would then result in an
increase in the price that you have to pay to buy the tennis shoes at your local mall.
A decrease in the cost of labor, on the other hand, would result in you having to pay
less for your new shoes. More so, if you walk into a supermarket and are able to buy
South American bananas, Brazilian coffee and a bottle of South African wine, you
are experiencing the effects of international trade.

Finally, International trade allows us to expand our markets for both goods and
services that otherwise may not have been available to us. It is the reason why you
can pick between a Japanese, German or American car. As a result of international
trade, the market contains greater competition and therefore more competitive
prices, which brings a cheaper product home to the consumer.
1.7. References/Further Readings/Web Resources

Fasano, U., Wang, Q. (2002). “Testing the relationship between government

spending and revenue: Evidence from GCC countries”, IMF Working

Paper WP/02/201.

1.8. Possible Answers to SAEs

These are the possible answers to the SAEs within the content.
Answers to SAEs 1

The economic growth of any economy is a crucial issue because of it, ultimately,
forms the crux of economic development which is the desire of every economy
(Todaro, 2010). The dividend of growth is what digests into the numerous strands
of development indices that are enjoyed by the affected economy. It has, therefore,
become the focus of every economy to harness every available resource towards
enhancing sustainable growth. The external sector of the economy is one major
aspect through which growth can be enhanced. This is so because of the economic
interaction with other economies of the world, through trading, enhances the
productivity of the economy. However, International trade is simply known as the
exchange of goods and services between nations of the world. At least two countries
should be involved in the activities, that is, the aggregate of activities relating to
trading between merchants across borders. Traders engage in economic activities

169
for the purpose of the profit maximization engendered from differentials among
international economic environment of nations (Adedeji, 2006). Kehinde, Jubril,
Felix & Edun, (2012) asserts that trade can promote growth from the supply side,
but if the balances of payment cost reduce the availability of imported inputs which
enter the product of exports, thus forcing exporters to use expensive imports of
double quality. Therefore, international trade allows for the exchange of goods and
services cum foster healthy relations among countries irrespective of their level of
economic development. A country involved in international trade need not have fear
of hegemony or loss of its sovereignty because it is a mutual agreement to engage
in trade across their border. A nation not participating in international trade is at risk
of a slow pace of economic development due to the cogent fact that a country cannot
be fully endowed with all the resources essential to be utilized for sustainable
economic development.

Answers to SAEs 2
The five main reasons international trade takes place are
(i). Differences in technology
(ii). Differences in resource endowments
(iii). Differences in demand,
(iv). the presence of economies of scale and
(v) the presence of government policies. Each model of trade generally includes just
one motivation for trade.
Answers to SAEs 3
Comparative advantage is often contrasted with absolute advantage. Where absolute
advantage refers to the ability of an entity to produce a greater quantity of a product
or service, comparative advantage refers to the ability to produce goods and services
at a lower opportunity cost compared to the competition.

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UNIT 2: Gain from Trade

Unit Structure
2.1. Introduction
2.2. Learning Outcomes
2.3. Gain from trade analysis.
2.4. The terms of trade
2.5. Summary
2.6. References/Further Readings/Web Resources
2.7. Possible Answers to Self-Assessment Exercises (SAEs)

2.1. Introduction

Gains from trade are the net benefits to agents from allowing an increase in
voluntary trading with each other. In technical terms, it is the increase of consumer
surplus plus producer surplus from lower tariffs or otherwise liberalizing trade.

However, we can also say that gains from trade are commonly described as resulting
from specialization in production from division of labor, economies of scale, scope,
and agglomeration and relative availability of factor resources in types of output by
farms, businesses, location and economies, a resulting increase in total output
possibilities, trade through markets from sale of one type of output for other, more
highly valued goods.

2.2. Learning Outcomes

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

i. Understand the analysis of Gain from trade

ii. Know the basis of terms of trade

2.3. Gain from trade analysis

Arising from the law of comparative advantage as stated earlier, countries will
benefit from trade with a rise in world output without additional factor inputs when

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countries specialize in the production of those goods in which their opportunity cost
is lower.
For example, let us assume that:
a. England and Portugal are the only two countries in the world.
b. Wine and cloth are also the only two good in the world.
c. Transport cost is nonexistent. :
d. Each of England and Portugal has equal workers of say 100 each.
e. Survival need deserves that each worker has two units of cloth.

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

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

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

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

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

Therefore the following benefits will follow specialization.

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

Self-Assessment Exercises 1
With detailed examples, discuss the Gain from trade analysis.

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2.4. The Terms of Trade

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

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

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

Self-Assessment Exercises 2
What is terms of trade and its types?

2.5. Summary
Finally, gains from trade refer to the benefits to a group of people from exchanging
goods and services with other groups of people. Usually, we think of gains from
trade from countries trading with each other, but it could be districts, villages, or
even households. It does not mean everyone in the group gains it means that benefits
> losses

173
1.12. References/Further Readings/Web Resources

Amin, S., Arrighi, A, Frank, and Wallerstein. I (1981). Dynamics of Global

Crisis New York: Monthly Review Press.
Amin, S. (1977). Imperialism and Unequal Development, New York Monthly
Review Press.
Chipman, J.S. and J.C. Moore (1972). Social utility and the gains from trade.
Journal of International Economics 2(1) 157-172.

2.7. Possible Answers to SAEs

These are the possible answers to the SAEs within the content.
Answers to SAEs 1
Gains from trade are the net benefits to economic agents from being allowed an
increase in voluntary trading with each other. In technical terms, they are the
increase of consumer surplus plus producer surplus from lower tariffs or
otherwise liberalizing trade.
Gains from trade are commonly described as resulting from:
(i) specialization in production from division of labor, economies of scale, scope,
and agglomeration and relative availability of factor resources in types of output
by farms, businesses, location and economies
(ii) a resulting increase in total output possibilities
(iii). trade through markets from sale of one type of output for other, more highly
valued goods.
An example of gains from trade can be seen in the case of two countries that both
produce two different products. Both countries gain more value by trading with each
other the products they have more of but need less of.

Answers to SAEs 2
Terms of trade (TOT) represent the ratio between a country's export prices and its
import prices. TOT indexes are defined as the value of a country's total exports
minus total imports. The ratio is calculated by dividing the price of the exports by
the price of the imports and multiplying the result by 100.

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Unit 3 Net Export Function in the Open Economy

Unit Structure

3.1. Introduction
3.2. Learning Outcomes
3.3. Reasons for International Trade
3.4. The Basis of Theory of International Trade
3.5. The Gain from Trade
3.6. The Terms of Trade
3.7. Summary
3.8. References/Further Readings/Web Resources
3.9. Possible Answers to Self-Assessment Exercises (SAEs)

3.1. Introduction

Gains from trade are the net benefits to agents from allowing an increase in
voluntary trading with each other. In technical terms, it is the increase of consumer
surplus plus producer surplus from lower tariffs or otherwise liberalizing trade.

However, we can also say that gains from trade are commonly described as resulting
from specialization in production from division of labor, economies of scale, scope,
and agglomeration and relative availability of factor resources in types of output by
farms, businesses, location and economies, a resulting increase in total output
possibilities, trade through markets from sale of one type of output for other, more
highly valued goods.

3.2. Learning Outcomes

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

i. Understand the reason for international Trade

ii. Know the basis or theory of international Trade
iii Know the Gain from Trade
iv. Know the terms of Trade

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 3.3. Export

Exports depend on spending decisions made by foreign consumers or overseas firms

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

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

Another aspect of import demand is the one that changes as income changes. When
income rises, this aspect of import demand rises as well and when income falls, it
falls. Therefore, we have two components of import demand, the one that is fixed,
and the one that varies with income. Because export is exogenous while a part of
import is an increasing function of income, net exports are negatively related to
national income/national output. Let X0 represent planned export demand, Mo
represents imported basic investment good, while M1 represents an aspect of import
that changes with income, that is, marginal propensity to import. Finally let M
represent total import demand so that M equals M0 plus M1Y, where Y is national
income. Therefore, net export function can be written algebraically as follows:

X0 – M
X0 – (M0 + M1Y)
X0 – M 0 – M 1 Y
Consider a set of income level say Y = 1000, 1500, 2000, 2500, and 3000. Let
planned export demand equals 800 and let marginal propensity to import equals 0.2.
Finally, let exogenous import equals 250. We can construct net export table as
follows:

176
Table 1: Net Export Schedule
GDP (Y) Export M0 = M 1 = M = M0 + Net
(X0) 250 0.2Y M1 Export
1000 800 250 200 450 350
1500 800 250 300 550 250
2000 800 250 400 650 150
2500 800 250 500 750 50
3000 800 250 600 850 -50

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

Self-Assessment Exercises 1
What factors affect export price?”
.

3.4. Prices for International Transaction

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

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

177
to take place. Let the unit price of Nigeria currency be N (naira), while that of the
US is $, then exchange rate of naira to dollar will be:

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

What is the implication of exchange rate on export demand? Consider a US

consumer that intends to buy Nigeria products worth N1000.00, how much dollars
does he need for the transaction? Given that exchange rate is 50, we proceed thus:

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

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

Another factor that can affect trade flows is the changes in domestic price level
relative to foreign price level. Consider first a rise in domestic price. On the one
hand, foreigners will now see domestic-produced goods as more expensive relative

178
to both goods produced in their country and to goods imported from other countries.
On the other hand, domestic residents will see imports from foreign countries
become cheaper relative to the prices of home-produced goods. As a result, they
will buy more foreign goods, and imports will rise. Both of these responses will
cause the net export function to shift downwards. As it shifts downward, aggregate
demand falls. Thus, increase in domestic price will cause net export to fall.

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

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

Self-Assessment Exercises 2
Do Export and Import affected by international prices? Discuss.

3.5. Equilibrium in the Open Economy

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

To establish equilibrium in an open economy, let us rewrite our aggregate demand

function and incorporate net export component. To put the matter very simple, let
us assume that planned aggregate demand is given by:
AD = C + I + G + NX
Let C = 610 + 0.8Y; I = 220; and G = 300; NX = 10 and T = 250
Note that planned private consumption has fallen by 10-unit but this has been taken
care of by NX which is 10. Equilibrium output can be achieved as follows:
AD = 610 + 0.8 (Y – 250) + 220 + 300 + 10

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 = 610 + 0.8Y – 200 + 220 + 300 + 10
= 940 + 0.8Y
at equilibrium, AD = Y
hence, Y = 940/0.2 = 4700.
This implies that the equilibrium has been restored but in this case through net
export surplus.

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

Self-Assessment Exercises 3
How does the economy return to equilibrium in response to changes in
aggregate demand? Discuss.

3.6. Summary
Finally, in this unit we have vividly look at export in a small dimension and we have
discuss about the prices of international transaction and what happen in the
equilibrium in the open economy.

3.6. References/Further Readings/Web Resources

Karl, E. C., Ray C. F., & Sharon, M. O. (2002). Principles of Economics, Prentice
Hall, 6th Edition.

180
Robert. H. Frank and Ben S. Bernanke, (2007) Principles of Economics, McGraw-
Hill Irwin, 3rd Edition.

3.7. Possible Answers to SAEs

These are the possible answers to the SAEs within the content.
Answers to SAEs 1
The key elements include assessing your company's foreign market objectives,
product-related costs, market demand, and competition. Other factors to consider
are transportation, taxes and duties, sales commissions, insurance, and financing.

Answers to SAEs 2
When a country's exchange rate increases relative to another country's, the price of
its goods and services increases. Imports become cheaper. Ultimately, this can
decrease that country's exports and increase imports.
Answers to SAEs 3
The amount of output supplied will be greater than aggregate demand. Prices will
begin to fall to eliminate the surplus output. As prices fall, the amount of aggregate
demand increases and the economy returns to equilibrium.

181