COECB1-B44

Wrap-Up Session –Mpumelelo Booi

 Expected Exam Structure
SECTION & FOCUS WEIGHT
SECTION A (MCQS-WEEKS 0-7) 20%
SECTION B -SHORT ANSWER QUESTIONS 30%
(CHAPTERS 21,22,23,27,28 AND 29)
SECTION C – CALCULATIONS 35%
(CHAPTERS – 23,24, 28)

SECTION D – CASE STUDY 15%

(Chapter 31)
Chapter 21:
An Introduction
to the Origins
and issues of
Macroeconomics
 Main ideas
To able to:
 Describe the framework that defines how economists think about
macroeconomic problems in the short-term and in the long-term
Define the study of macroeconomics
Identify the main concerns in the study of macroeconomics
Understand the current macroeconomic situation in South Africa

Economics 3ed: Global and Southern African Perspectives © 2020 4

 Macroeconomics

Macroeconomics - is the study of the structure and performance of the

national economy, the policies of government that are used to influence
the performance of the economy.

1
 Macroeconomics

Five macroeconomic
Objective Description Key Indicators/Measures
objectives
Increase in national output - GDP growth rate
Economic Growth - Real GDP per capita
and productive capacity

Maintaining stable price levels

Price Stability - Inflation rate (3-6% target)
and controlling inflation
- Unemployment rate
Reducing unemployment and - Labor force participation
Low Unemployment
creating jobs rate
- Youth unemployment rate

Balance of Payments and Managing external economic

- Exchange rate stability
Exchange rates relationships and trade

Reducing inequality and - Gini coefficient

Income Distribution
promoting economic inclusion - Poverty rates
1
Schools
of
Econom
ic
Thought

3
Chapter 22:
Measuring GDP
 Gross Domestic Product (GDP)

GDP – is the market value of the final goods and services produced within a
country in a given time period. The definition has four parts:

1. Market value

2. Final goods and services

3. Produced within a country

4. Within a given time

10
 Measuring South Africa’s GDP

There are three methods to measure GDP:

1. The Expenditure Approach - measures GDP as the sum of expenditure on goods and services

2. The Income Approach measures GDP by summing the incomes that firms pay to households for
the factors of production.

3. The Production Approach - the sum of the values of all goods produced in the economy. The
production approach measures the value added in the production process by all participants in
the economy.

1
 Measuring South Africa’s GDP
1. The Expenditure Approach – measures GDP as the sum of aggregate expenditure on goods and

services

AE = C + I + G + X – M

Where:

C = Personal consumption expenditures – expenditures by households on goods and services

produced in SA and abroad.

I = Gross private domestic investment – the expenditure on capital equipment, buildings, and

inventory by firms. It also includes expenditure on new homes by households.

G = Government expenditure – on goods and services at all levels. It does not include transfer

payments such as social security.

1
 Nominal GDP & Real GDP
• Real GDP – is the value of final goods and services produced in a given year when valued

at the prices of a reference base year. Comparing the value of production with use of a

base year reveals the change in production. South Africa uses 2010 as a base year.

GDP is used to measure economic growth.

• Nominal GDP – is the value of final goods and services produced in a given year when

valued at prices of that year.

Real GDP is the better measure of total production as it allows for fair comparison over time.

However, it is not an accurate prediction a country’s wealth and prosperity.

1
 Nominal GDP & Real GDP
Scenario:

• An economy produces peanuts. In 2020 the country produced 400 tons of peanuts; they
sold it at R2000 per ton. In 2021 the country produced and sold 420 tons of peanuts at the
price of R2200 per ton.

• 1. Calculate the nominal GDP for 2020 and 2021 (2 Marks)

• 2. Calculate the real GDP at constant 2020 prices (base-year) (2 Marks)

• 3. Calculate and explain the growth rate of real GDP for 2021. (3 Marks)

Hint:

1
 Nominal GDP & Real GDP
Answers:

1. 2020: 400*2000 = R800 000

2021: 420*2200 = R924 000

2. 2020: 400*2000 = R800 000

2021: 420*2000=R840 000

3. (840 000 – 800 000)/800 000*100

= 5%

• The output of the economy grew by 5% from 2020 to 2021.

1
 Fluctuations of Real GDP – The Business
Cycle
Business cycles are unpredictable, however there are two phases
and two turning points:

Phases:

1. Expansion – a period which real GDP increases.

2. Recession – a period during which real GDP decreases

(negative growth)

Turning points

3. Peak – the highest level that is attained during an expansion

4. Trough – the lowest level of negative growth attained during

a recession

Recession – is a period during which real GDP decreases or has

a negative growth rate for at least two successive quarters.
2
Chapter 24:
Economic Growth
 The Basics of Economic Growth

• Economic growth – is a sustained expansion of production possibilities measured as

increase in real GDP over a given period.

• Rapid (and maintained) economic growth can transform poor Nation to rich Nations.
Examples of this include; Hong Kong, South Korea and some other Asian economies.

• Slow (or no) economic growth can result in poverty, this is the case of many African
countries. Examples include Sierra Leone, Somalia and Zambia.

1.
21
 Calculating Growth Rates
Economic growth rate – is the annual percentage change of real GDP.

Real GDP Growth Rate =

• The growth rate of real GDP tells us how rapidly the total economy is expanding.

• This measure is useful for telling us about potential changes in the balance of economic

power among nations. (It does not tell economists about changes in living standards).

• Real GDP per person or per capita real GDP – provides economists with a basis to

compare the living standards of individuals in different years within the same country or

compare living standards with other countries.

• Real GDP per person =

1.
22
 Economic Growth VS Business Cycle
Expansion
Real GDP can increase for two distinct reasons:

1. The economy might be returning to full employment in an expansion phase of

the business cycle.

2. Potential GDP might be increasing.

• The return to full employment in an expansion phase of the business cycle isn’t economic
growth, It is just taking up the slack that resulted from the previous recession.

• The expansion of potential GDP is economic growth.

• Note - your potential GDP is when factors of production are fully employed.

1.
25
 The Magic of Sustained Growth
• Sustained growth of GDP per person can transform a poor economy into a wealthy one.

• Economic growth is like compound interest. The economic growth achieved in one year
is compounded onto the economic growth of next year.

Rule of 70:

Rule of 70 – states the number of years it takes for the level of any variable to double.

• Rule of 70 =

• Note the annual % growth rate is represented as a number and not a %

1.
28
 Rule of 70 Example:
• Growth rate = 1%
Therefore:
Rule of 70 =
Rule of 70 = 70 years
• Growth rate = 6%
Therefore:
Rule of 70 =
Rule of 70 = 11.67 or 11. 7 years
• Growth rate = 12%
Therefore:
Rule of 70 =
Rule of 70 = 5.8 years
1.
29
Chapter 23:
Monitoring Jobs and
inflation
 Unemployment
Type of Definition Causes Characteristics Policy Solutions
Unemployment

Structural Mismatch between skills workers have - Technological change - Long-term - Education/training programs
and skills needed by employers
- Industry decline - Requires retraining - Skills development

- Skills obsolescence - Often sector-specific - Geographic mobility assistance

- Geographic mismatch

Cyclical/Demand Unemployment due to economic - Reduced aggregate demand - Temporary - Fiscal stimulus
Deficient downturn or recession
- Business cycle downturns - Affects most sectors - Monetary policy

- Economic crises - Follows business cycle - Counter-cyclical policies

Frictional Temporary unemployment during job - Job searching - Short-term - Job search assistance
transitions
- Career changes - Natural part of economy - Labor market information

- Labor market information gaps - Voluntary - Improved job matching

Seasonal Regular pattern of unemployment tied - Weather patterns - Predictable - Diversification

to seasons
- Tourist seasons - Industry-specific - Off-season training

- Agricultural cycles - Recurring - Temporary benefits

Classical/Real Wage Unemployment due to wages being - Minimum wage laws - Persistent - Labor market flexibility
above market-clearing level
- Strong unions - Market interference - Wage negotiations

- Wage rigidity - Labor cost issue - Productivity improvements

3
 Effect of unemployment

Unemployment is a serious personal and socio-economic problem for two main reasons:

1. Lost income and production

2. Lost human capital

Lost income and production:

• The loss of a job brings a loss of income and lost production.

• Lost production - means lower consumption and a lower investment in capital,

which lowers the living standard in both the present and the future.

• Remember the circular flow – incomes rise when there is an increase in production and
visa versa. Lower levels of demand will lower supply (production) which would decrease
company profits which will reduce investment in future expansion. 3
 Unemployment

Lost human capital:

• Prolonged unemployment permanently damages a person’s job prospects by destroying

human capital.

Human capital is destroyed through:

o The loss of skills.

o Prolonged periods of unemployment make companies reluctant to hire previously unemployed

labourers due to gaps in their CV.

o Distorts one sense of working hours and requirements.

o It limits the amount experience you can accumulate over the course of your career.

3
Quarterly Labour Force Survey

South Africa’s entire population

The population is dived into those of

working age and those who are too
young or old to work.
The working age population is dived into
labour force and not in the labour force
(Labour force - those who are able and
willing to work vs Not in the labour force
- those who are unable and unwilling to
work – discouraged)
The labour force is then divided into
those who are employed and
unemployed. 3
 Employment and Unemployment
• The cost of unemployment is spread unequally, which makes it a highly charged political
problem as well as a serious economic problem.

• Governments make strenuous efforts to measure unemployment accurately and to adopt

policies to moderate its level and ease its pain.

• Government can only adopt policies, but government does not create jobs directly.

Three Labour Market Indicators:

1. The unemployment Rate

2. The Labour Absorption Rate

3. The Labour Force Participation Rate

33
 Labour Market Indicators

1. The Unemployment Rate

The unemployment rate – the amount of unemployment is an indicator of the extent to

which people who want jobs cannot find them.

• The unemployment rate is the percentage of the people who are unemployed.

• Whenever we mention the unemployment rate, we are referring to the official (narrow)
definition of unemployment in South African the labour force.

Unemployment Rate =

Labour Force = Number of people employed + Number of people unemployed

3
 Labour Market Indicators

1. The Unemployment Rate - Example (millions of people) for 2018:

• Number of people employed = 16.380

• Number of people unemployed = 6.209

Therefore:

Labour force = 16.380 + 6.209

Labour force = 22.589

Therefore:

Unemployment rate = 6.209 divided by 22.589 times 100

Unemployment rate = 27.5%

3
 Labour Market Indicators
1. The Unemployment Rate Broad Definition - Example (millions of people) for
2018:

• Number of people employed = 16,380

• Number of people unemployed = 6,209

Therefore:

Labour force = 16,380 + 6,209

Labour force = 22,589

Unemployed = 6,209

Therefore:

Unemployment rate = (6209/22,589) x100

36
 Labour Market Indicators

2. The Absorption Rate

• The absorption rate - is the number of people of working age who have jobs is an
indicator of both the availability of jobs and the degree of match between people’s skills
and jobs.

• The absorption rate is the percentage of people of working age who have jobs.

Absorption Rate =

37
 Labour Market Indicators

3. The Labour Force Participation Rate

• Labour force participation rate – is the number of people in the labour force is an
indicator of the willingness of people of working age to take jobs.

• The labour force participation rate is the percentage of the working-age

population who are members of the labour force.

Labour Force Participation Rate =

38
 Practical Questions:
Study the scenario and complete the questions
that follow:
Working age population 35 000
Employed 15 000
Unemployed 10 000

1. Calculate the unemployment rate. Round off your answer to two decimals.

2. Calculate the labour force participation rate. Round off your answer to two decimals.

3. Calculate the labour absorption rate. Round off your answer to two decimals.
 Labour Market Indicators

1. Unemployment rate = (Number of unemployed people)/(Labour force) × 100

• Unemployment rate = (10 000)/(25 000) × 100

• Unemployment rate = 40%

2. Labour force participation rate = (Labour force)/(Working age population) × 100

• Labour force participation rate = (25 000)/(35 000) × 100

• Labour force participation rate = 71.43%

3. Labour absorption rate = (Number of employed people)/(Working age population) × 100

• Labour absorption rate = (15 000)/(35 000) × 100

40
 The Consumer Price Index (CPI)

StatsSA measures the price level by calculating the Consumer Price Index (CPI)

CPI – is a measure of the average prices paid by urban consumers for a fixed basket of
consumer goods and services. CPI tells you about the value of the money in your pocket
(purchasing power).

Reading CPI Numbers:

CPI = 100 for a period called the index reference period.

Currently the reference base period is December 2016, that is CPI = 100

48
 Measuring the Inflation Rate
A major purpose of the CPI is to measure changes in the cost of living and in the value of
money.

• Inflation rate – is the annual percentage change in the CPI

Inflation rate =

Inflation rate example:

• CPI in 2016 = 100

• CPI in 2017 = 137

Therefore,

Inflation rate =

Annual Inflation rate = 37%

49
Measuring the Inflation Rate
49
Chapter 26:
Money, the Price
Level and
Inflation
 Money

Money – any commodity or token that is generally acceptable as a means of payment.

A means of payment – is a method of settling debt.

Money serves three functions:

1. Medium of exchange

2. Unit of account

3. Store of value

50
 Money
1. Medium of exchange:

• A medium of exchange is any object that is generally accepted in exchange for goods
and services.

• Without a medium of exchange, goods and services must be exchanged directly for other
goods and services – an exchange called barter.

51
 Money
2. Unit of account:

• A unit of account is an agreed measure for stating the prices of goods and services.

• In a money economy the prices of all goods and services are expressed in monetary
terms, hence functions as a unit of account.

• Creating a budget and doing calculations are easy when all these goods have prices in
terms of rand and cents.

52
 Money
3. Store of value:

• Money is a store of value in the sense that it can be held and exchanged for goods and services
at a later stage.

• If money was not a store of value, it could not serve as a means of payment.

• Money is not alone in acting as a store of value. A house, a car and a work of art are other examples

• The more stable the value of a commodity or token, the better it can act as a store of value
and the more useful it is as money. (inflation and exchange rate)

53
 Money in South Africa
In South Africa money consists of:
• Currency
• Deposits at banks and other depository institutions

Currency:

• The notes and coins held by individuals and businesses are known as currency.

• Notes are money because the government declares them so with the signature of the Reserve
Bank Governor.

• Notes and coins inside banks are not counted as currency because they are not held by individuals
and businesses.

Deposits at banks and other depository institutions:

• Deposits of individuals and businesses at banks and other depository institutions, such as the
Postbank, are also counted as money.

• Deposits can be used by its owners to make payments and for this reason it is considered as money.
54
 Money in South Africa
Official Measures of Money:

The three main measures of money in South Africa today are known as:

1. M1 – consists of currency plus cheques deposits owned by individuals and businesses.

• M1 – does not include currency held by banks and it does not include currency
and cheque deposits owned by government.

2. M2 – consists of M1 plus short-and medium-term deposits, such as savings

deposits and money market funds.

• M2 – consists of approximately 50% of M1.

• Short term deposits - less than 30 days, such as savings

• Medium-term deposits - money deposited for less than 6 months

5
Money in South Africa

Official Measures of Money:

The three main measures of money in South Africa today are known
as:

3. M3 – is M2 plus money that is deposited for longer

time horizons, such as pension funds.
• Approximately 80% of M3 consists of M2

• Long-term deposits - deposits longer than 6 months

5
Chapter 27: The
Exchange Rate
and the Balance
of Payments
 The Foreign Exchange Market
Exchange Rates

• An exchange rate - is the price at which one currency exchanges for another currency in the
foreign exchange market.

• A strengthening of the exchange rate is called an appreciation, and a weakening is called a

depreciation.

An Exchange Rate is a Price

• An exchange rate is a price – the price of one currency in terms of another.

• The foreign exchange market is a competitive market – demand and supply determine
the price.

Example:

• If the Rand and Dollar exchange rate is $1= R14 now and the following day, it trades to $1= R13.60
(This means the Rand has appreciated against the dollar).

• But it trades $1= R15.40 in the next day (This means the Rand has depreciated against the dollar).66
 The Foreign Exchange Market
Whenever people buy things from another country, they use the currency of that country
selling the goods and/or services to make the transaction.

Trading Currencies

Foreign Exchange Market – is the market where the currency of one country is exchanged
for the currency of another.

• The foreign exchange market consists of thousands of people – importers and exporters,
banks, international investors and speculators, international travelers and
specialist traders (foreign exchange brokers).

• Dealers around the world are in continual contact by telephone and computer.

• A typical day in 2017, around $5.7 trillion (of all currencies) were traded in the foreign
67
 The Foreign Exchange Market
The Law of Supply of Foreign Exchange

• The higher the exchange rate, the greater is the quantity of South African Rands supplied in the
foreign exchange market (Ceteris paribus).

The exchange rate influences the quantity of rand supplied for two reasons:

1. Imports Effect

• The larger the value of South African imports, the larger is the quantity of South African Rands
supplied in the foreign exchange market. (Depends on the prices of foreign-produced goods and
services expressed in Rands)

• These prices depend on the exchange rate, the stronger the exchange rate the greater the volume
of SA imports.

2. Expected Profit Effect

• The stronger the exchange rate today, the larger is the expected profit from selling South African
Rands today and holding foreign currencies, so the greater is the quantity of South African Rand
69
 Exchange Rate Fluctuations
Changes in the Demand for South African Rand

The demand for the Rands in the foreign exchange market changes when there is a change in:

1. World Demand for South African Exports

• A decrease in world demand for SA exports changes the demand for the South African Rands

and causes the Rand to depreciate.

2. SA’s Interest Rate Relative to the Foreign Interest Rate

• A decrease in South African interest rates would decrease the incentive for foreign countries and

citizens to invest in the South African economy. This would lower the demand for Rands and

subsequently cause a depreciation of the Rand

3. The Expected Future Exchange Rate

• An expected depreciation of the Rand would lower the demand for due to fears of an expected
70
 Exchange Rate Fluctuations
Changes in the Supply for South African Rands
The supply for the Rands in the foreign exchange market changes when there is a change in:

1. South African Demand for Imports

• An increase in the South African demand for imports increases the supply of South African Rands
in the foreign exchange market causing a depreciation of the Rand.

2. South Africa’s Interest Rate Relative to the Foreign Interest Rate

• The larger the South African interest rate differential, the smaller the supply of SA Rand in the
foreign exchange market.

3. The Expected Future Exchange Rate

• A fall in the expected future exchange rate decreases the profit that can be made by holding
South African rand and decreases the quantity of South African rand that people want to hold –
the supply of South African rand in the foreign exchange market then increases (sell the Rand). 71
 Demand in the Foreign Exchange
Market
The quantity demanded depends on many factors, but the main ones are:

1. The exchange rate - depreciated rate or appreciated e.g., if $1= R12 demand for dollars will
be high and the opposite is true.

2. World demand for South African exports - higher quality products produced in South Africa
can be of high demand on the international market which results to the demand for the Rand

3. Interest rates in South Africa and other countries - if interest rates are high in South
Africa the demand for South Government bonds will be high.

4. The expected future exchange rate - if we expect the future exchange rate to depreciate
will buy the foreign currency now. E.g., if we expect $1 = R22 in 2021 we would rather buy the
dollars now.

72
 Exchange Rate Policy
Three possible exchange rate policies are:

1. Flexible Exchange Rate

• Determined by demand and supply in the foreign exchange market with no direct intervention by
the central bank. Most countries use this system including South Africa

2. Fixed Exchange Rate

• Determined by a decision of the government or the central bank and is achieved by central bank
intervention in the foreign exchange market to block the unregulated forces of demand and
supply.

3. Crawling Peg

• Follows a path determined by a decision of the government or the central bank and is achieved
in a similar way to a fixed exchange rate by central bank intervention in the foreign exchange
73
Exchange Rate Fluctuations

Changes in the Demand for South

African Rands
Increases (shifts to the right):
• World demand for SA imports increases

• The SA interest rate differential rises

• The expected future exchange rate rises

Decreases (shifts to the left)

• World demand for SA imports decreases

• The SA interest rate differential falls

• The expected future exchange rate falls

74
 Exchange Rate Fluctuations
FI GURE 27.5 ŚĂŶŐĞƐŝŶƚŚĞ^ƵƉƉůLJŽĨ^ŽƵƚŚ
ĨƌŝĐĂŶƌĂŶĚ Changes in the Supply for South

African Rands
Increases (shifts to the right):
• World demand for SA imports increases

• The SA interest rate differential falls

• The expected future exchange rate falls

Decreases (shifts to the left)

• World demand for SA imports decreases

• The SA interest rate differential rises

• The expected future exchange rate rises

75
Chapter 28:
Expenditure
Multipliers – The
Keynesian Model
 Important Concepts
The Keynesian model focuses on demand.

• Aggregate expenditure has four components: consumption expenditure, investment,

government expenditure on goods and services, and net exports (exports minus
imports) or AE = C + I + G + (X – M)

• Aggregate planned expenditure - is the sum of planned consumption expenditure,

investment, government expenditure on goods and services, and exports minus imports .

• Autonomous expenditure – is the sum of investment, government expenditure and

exports, which does not vary with real GDP.

There is a Two-Way Link Between Aggregate Expenditure and Real GDP:

• An increase in real GDP increases aggregate expenditure, and

76
 Fixed Prices and Planned
Expenditure
Consumption and Planned Saving

Several factors influence planned consumption expenditure and saving – the more important
ones are:

1. Disposable income - Is aggregate income minus taxes plus transfer payments.

2. Real interest rate - Higher interest rates high savings and less borrowing.

3. Wealth - Households spend more( increase consumption as the value of their assets rise, as they
feel more financially secure and confident about their assets.

4. Expected future income - If we expect future incomes to rise will consume more now as
households.

77
 Marginal Propensity to Consume and Save
Saving Function
• As disposable income increases, saving increases
Marginal Propensities to Consume and Save:
• The marginal propensity to consume (MPC) - is the fraction of a change in disposable
income that is spent on consumption.
• C = Consumption Expenditure
• YD = Disposable Income
• MPC = ΔC ÷ ΔYD or MPC =
• The marginal propensity to save (MPS) - is the fraction of a change in disposable
income that is saved
• S = Savings
• MPS = ΔS ÷ ΔYD or MPS = 81
 Marginal Propensity to Consume and
Saving

Because an increase in disposable income is either spent on consumption or saved, the

marginal propensity to consume plus the marginal propensity to save equals 1. To see this,
we can use the following equation:

C + S = YD

Therefore:

• +

• YD = 1

Or

• MPC + MPS = 1
82
 Import Function
• South Africa’s real GDP is the main influence on imports in the short run – an increase in real GDP
increases the quantity of South African imports. Additionally, an increase in aggregate expenditure
increases real GDP.

• The relationship between imports and real GDP is determined by the marginal propensity to import.

• Marginal propensity to import - is the fraction of an increase in real GDP that is spent on imports.

• It is calculated as the change in imports divided by the change in real GDP:

• MPI

• Real GDP by R 1 trillion increases imports by R0.25 trillion

• Therefore:

• MPI = 0.25

83
 The Multiplier
The Basic Idea of the Multiplier: see figure 28.5

• A R0.5 trillion increase in autonomous expenditure shifts the AE curve upward by R0.5
trillion from AE0 to AE1.

• Equilibrium expenditure increases by (0.5 × 4)R2 trillion from R13 trillion to R15 trillion.

• The increase in equilibrium expenditure is 4 times the increase in autonomous

expenditure, so the multiplier is 4.

84
 The Multiplier
• Let us calculate the multiplier for the example in Figure 28.5.

• Initially, equilibrium expenditure is R16 trillion.

• Then autonomous expenditure increases by R0.5 trillion and

equilibrium expenditure increases by R2 trillion, to R18 trillion.

• Then Multiplier = Change in equilibrium expenditure ÷

Change in autonomous expenditure

• Multiplier = R2 trillion ÷ R0.5 trillion = 4

85
 The Multiplier
The Basic Idea of the Multiplier

In Figure 28.5, the increase in autonomous expenditure of R0.5

trillion increases equilibrium expenditure by R2 trillion.

• This amplified change is the multiplier effect – equilibrium

expenditure increases by more than the increase in autonomous
expenditure.

• The change in autonomous expenditure leads to an

amplified change in equilibrium expenditure.

• Equilibrium expenditure increases by more than the

increase in autonomous expenditure

• The multiplier is greater than 1. 86

 The Multiplier
Why is the Multiplier Greater Than 1?

• The multiplier is greater than 1 because induced

expenditure increases – an increase in autonomous
expenditure induces further increases in expenditure.

The Size of the Multiplier

• To calculate the multiplier, we divide the change in
equilibrium expenditure by the change in autonomous
expenditure.

87
 The Multiplier
Imports and Income Taxes

• Imports and taxes make the multiplier smaller than it otherwise would be.

• Imports – the increase in investment increases real GDP, which in turn increases consumption
expenditure – but part of the increase in expenditure is on imported goods and services. Only
expenditure on South African-produced goods and services increases South Africa’s real GDP.

• The larger the marginal propensity to import, the smaller is the change in South Africa’s
real GDP.

• Imports and income taxes make the AE curve less steep and reduce the value of the multiplier.

• Income taxes – The increase in investment increases real GDP. Income tax payments increase so
disposable income increases by less than the increase in real GDP and consumption expenditure
increases by less than it would if taxes had not changed. The larger the income tax rate, the
smaller is the change in real GDP. 88
 Aggregate Planned Expenditure
Aggregate expenditure = Aggregate planned expenditure (AE) which is the sum of
the planned amounts of consumption expenditure

Aggregate Expenditure:

AE = C + I + G + (X – M)

C = Consumption Expenditure

I = Investment

G = Government Expenditure

X = Exports

M = Imports

89
 The Multiplier
• Multiplier is denoted by α

• Small b = MPC

• Small t = tax rate

• m = MPI

• An economy with no government: α=

• An economy with a government: α=
• An economy with a government and the foreign sector: α =

91
 Equilibrium Income or Y

Equilibrium income denoted by Y

Multiplier is denoted by 𝜶

Aggregate expenditure denoted by AE

Formula:

Y= 𝜶(AE)

OR

Equilibrium Income = multiplier Aggregate Expenditure

92
 Consumption Function
• Consumption function becomes: C = C + b(1 – t)Y

• Autonomous Consumption expenditure = C

• Marginal propensity to consume = b

• Tax rate = t

• Equilibrium Income = Y

• Autonomous consumption expenditure ‒ that part of consumption that is independent

of the level of Y. This can also be regarded as a minimum level of consumption that is
financed from sources other than income , for example, from past savings or credit.

93
 Government Expenditure

Full Employment and Government expenditure

Y = G(𝜶) We can divide b 𝜶

Therefore:

94
 Practical Questions:
An imaginary economy performs as follows:
Consumption function: C=20+0.8Yd
Equilibrium Y=C+I+G+NX
Investment expenditure/spending I=25 billion.
Government expenditure G=100 billion
Net Taxes T=0.25Y
Disposable Income Yd=Y-T
Net Exports R30 billion
The full employment level of income is estimated R 800 billion

1. What is the value of autonomous expenditure/spending?

2. What is the value of the multiplier?

3. Determine the equilibrium level of income.

4. Calculate the equilibrium level of consumption.

5. Determine the amount that government should spend to bring the economy to full employment.
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Answers

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Chapter 29:
Aggregate
Supply and
Aggregate
Demand
 Aggregate Supply
The aggregate supply–aggregate demand (AS-AD) model - explains how real GDP and the price
level are determined and how they interact.

Quantity Supplied and Supply

• Aggregate supply - is the relationship between the quantity of real GDP supplied and the price
level – we distinguish between two-time frames which is the short-run and long-run supply.

Short-Run and Long-run Aggregate Supply

• Short-run aggregate supply - is the relationship between the quantity of real GDP supplied and
the price level when the money wage rate, the prices of other resources and potential GDP remain
constant.

• Long-run aggregate supply - is the relationship between the quantity of real GDP supplied and
the price level when the money wage rate changes at the same rate as the price level to maintain
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full employment.
 Aggregate Supply

Short-Run Aggregate Supply:

• 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.

• As a result, there is a positive correlation between the price level and output, which is
shown on the short-run aggregate supply curve.

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 Short-Run Aggregate Supply:
• Figure 29.1 illustrates this relationship as the short-run aggregate
supply curve SAS and the short-run aggregate supply schedule
FI GURE 29.1
• In the short run, a rise in the price level brings an increase in the FI GURE 28.11

quantity of real GDP supplied (movement along the SAS curve) .

The short-run aggregate supply curve slopes upward.

• With a given money wage rate, there is one price level at which
the real wage rate is at its full employment equilibrium level.

• In this example, that price level is 110. If the price level rises
above 110, the quantity of real GDP supplied increases along the
SAS curve and exceeds potential GDP.

• If the price level falls below 110, the quantity of real GDP
supplied decreases along the SAS curve and is less than potential
GDP.
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 Long-run Aggregate Supply

• Long-run aggregate supply - is the relationship between the quantity of real GDP supplied and
the price level when the money wage rate changes at the same rate as the price level to maintain
full employment.

• The quantity of real GDP supplied at full employment equals potential GDP and this quantity is the
same regardless of the price level.

• The long-run aggregate supply curve is vertical which reflects economists’ beliefs that
changes in the aggregate demand only temporarily change the economy’s total output.

• In the long-run, only capital, labour, and technology affect aggregate supply because everything
in the economy is assumed to be used optimally.

• The long-run aggregate supply curve is static because it is the slowest aggregate supply curve.
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 Long-run Aggregate Supply
FI GURE 29.1
FI GURE 28.11
• Figure 29.1 illustrates long-run aggregate supply as
the vertical line at potential GDP labelled LAS.

• Along the long-run aggregate supply curve, as the

price level changes, the money wage rate also
changes so the real wage rate remains at the full
employment equilibrium level and real GDP remains at
potential GDP.

• The long-run aggregate supply curve is always vertical

and is always located at potential GDP.

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 Aggregate Supply

Changes in Aggregate Supply

• A change in the price level changes the quantity of real GDP supplied – it does not change aggregate

supply.
• Aggregate supply changes when an influence on production plans other than the price level changes.

These other influences include:

Changes in Potential GDP

• When potential GDP changes, aggregate supply changes

• An increase in potential GDP increases both long and short-run aggregate supply

• Potential GDP can increase for any of 3 reasons:

o An increase in the full-employment quantity of labour
o An increase in the quantity of capital
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 Aggregate Supply

FI GURE 29.2
Changes in Potential GDP: FI GURE 28.11

• An increase in potential GDP increases

both long-run aggregate supply and short-
run aggregate supply.

• The long-run aggregate supply curve shifts

rightward from LAS0 to LAS1 and the
short-run aggregate supply curve shifts
from SAS0 to SAS1.

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 Aggregate Supply

Changes in the Money Wage Rate

• When the money wage rate (or the money price of any other factor of production such as oil)
changes, short-run aggregate supply changes but long-run aggregate supply does not change.

What Makes the Money Wage Rate Change?

• The money wage rate can change for two reasons: departures from full employment (below natural
rate of unemployment or above natural rate wages change) and expectations about inflation.

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 Aggregate Supply
)FI,*GURE
85( 29.3
FI GURE 26.2
FI GURE 28.11

A rise in the money wage rate decreases short-run aggregate

• Supply and shifts the short-run aggregate supply curve

leftward from SAS0 to SAS2.

• A rise in the money wage rate does not change potential

FIGURE 32.8
GDP, so the long-run aggregate supply curve does not shift.

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 Aggregate Demand

• Aggregate demand – is the quantity of real GDP demanded is the total amount of final goods
and services produced in South Africa that people, businesses, governments and foreigners plan
to buy.

• These planned expenditures depend on many factors. Some of the main ones are:

1. The price level

2. Expectations

3. Fiscal policy and monetary policy

4. The world economy

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 Aggregate Demand
The Aggregate Demand Curve

• The higher the price level, the smaller is the quantity of real GDP demanded.

• Aggregate demand - the relationship between the quantity of real GDP demanded and the price
level.

• It is described by an aggregate demand schedule or curve

The aggregate demand curve slopes downward for three reasons:

1. Wealth Effect - When the price level rises but other things remain the same, real wealth decreases.

2. Substitution Effect - When the price level rises and other things remain the same, interest rates
rise.

3. Changes in the quantity of Real GDP Demanded - When the price level rises the quantity of real
GDP demanded decreases and when the price level falls and other things remain the same, the
quantity of real GDP demanded increases. 10
 Aggregate Demand

Changes in Aggregate Demand:

• A change in any factor that influences planned expenditure other than the price level
brings a change in aggregate demand. The main factors are:

1. Expectations

• An increase in expected future income increases the amount of consumption goods that
people plan to buy today and increases aggregate demand.

• An increase in the expected future inflation rate increases aggregate demand today
because people decide to buy more goods and services at today’s relatively lower prices.

• An increase in expected future profits increases the investment that firms plan to
undertake today and increases aggregate demand.
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 Aggregate Demand

2. Fiscal Policy and Monetary Policy

• The government’s attempt to influence the economy by setting and changing taxes, making
transfer payments and purchasing goods and services is called fiscal policy.

• SARB’s attempt to influence the economy by changing interest rates and the quantity of money is
called monetary policy.

3. The World Economy

• Two main influences that the world economy has on aggregate demand are the exchange rate and
foreign income (increased incomes of other countries can attract African produced goods) hence
increase in our exports. Or if the Rand appreciates in value, it will reduce South African exports.

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 Aggregate Demand

Aggregate Demand: FI GURE 29.4

• When the price level is 110, the quantity of real GDP FI GURE 29.1

demanded is R1.30 trillion, as shown by point C’ in the

figure.

• A change in the price level, when all other influences on

aggregate planned expenditure remain the same, brings
a change in the quantity of real GDP demanded and a
movement along the AD curve.

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 Fiscal Policy

Expansionary Fiscal Policy – involves an active policy approach that aims to increase
government spending, decrease taxes and increase transfer payments in an effort to combat
a recession. This policy approach reduces unemployment at the cost of higher price levels
(inflation)

Contractionary Fiscal policy – is a policy approach that reduces government spending,

increases taxes and decreases transfer payments in an effort to reduce the price level
(inflation). This policy approach reduces inflation at the cost of higher unemployment levels.

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 Monetary Policy

Expansionary Monetary policy – is an action that will increase the quantity of money in
the economy through lowering the repurchase rate (repo rate). This policy approach aims to
increase the supply of loanable funds which in turn increases aggregate demand. This policy
approach aims to stimulate the economy and reduce unemployment at the cost of inflation.

Contractionary Monetary policy - is an action that will decrease the quantity of money in
the economy through increasing the repurchase rate (repo rate). This policy approach aims to
decrease the supply of loanable funds which in turn decreases aggregate demand. This policy
approach aims to reduce inflation at the cost of higher unemployment levels

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 Aggregate Demand
Shifts of the Aggregate Demand Curve

Shifts to the left Shifts to the right

FI GURE 29.5

FI GURE 29.4

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Chapter 31:
Fiscal policy
Supply-Side Effects of Fiscal Policy
Full Employment and Potential GDP FIGURE 31.3
FI GURE 30.10
• Potential GDP is the real GDP that the full
employment quantity of labour produces
The Effects of the Income Tax
• The tax on labour income influences
potential GDP and aggregate supply by
changing the full employment quantity of
labour
• The income tax weakens the incentive to
work and drives a wedge between the take-
home wage of workers and the cost of
labour to firms
• The result is a smaller quantity of labour and
a lower potential GDP

Economics 3ed: Global and Southern African Perspectives © 2020 93

Supply-Side Effects of Fiscal Policy
Taxes on Expenditure and the Tax Wedge
• The tax wedge that we have just considered is only a part of the wedge that affects
labour-supply decisions - taxes on consumption expenditure add to the wedge because
they raise the prices paid for consumption goods and services and are equivalent to a
cut in the real wage rate
• The higher the taxes on goods and services and the lower the after-tax wage rate, the
less is the incentive to supply labour
Taxes and the Incentive to Save and Invest
• A tax on interest income weakens the incentive to save and drives a wedge between the
after-tax interest rate earned by savers and the interest rate paid by firms
• Are more serious than the effects of a tax on labour income for two reasons
• First, the quantity of labour employed, and GDP are lowered, while a tax on capital
income lowers the quantity of saving and investment and slows the growth rate of real
GDP
• Second, the true tax rate on interest income is much higher than that on labour income
because of the way in which inflation and taxes on interest income interact

Economics 3ed: Global and Southern African Perspectives © 2020 94

Supply-Side Effects of Fiscal Policy
Effect of Tax Rate on Real Interest Rate FI GURE
FI GURE 30.10
31.5
• The real after-tax interest rate influences
investment and saving plans – this subtracts the
income tax rate paid on interest income from the
real interest rate
• But the taxes depend on the nominal interest rate,
not the real interest rate so the higher the inflation
rate, the higher is the true tax rate on interest
income
Effect of Income Tax on Saving and Investment
• A tax on interest income has no effect on the
demand for loanable funds
• The quantity of investment and borrowing that
firms plan to undertake depends only on how
productive capital is and what it costs – its real
interest rate
• But a tax on interest income weakens the
incentive to save and lend and decreases the
supply of loanable funds

Economics 3ed: Global and Southern African Perspectives © 2020 95

Supply-Side
Effects of
Fiscal Policy

Economics 3ed: Global and Southern African Perspectives © 2020

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Fiscal Stimulus
Magnitude of Stimulus
• There is insufficient empirical evidence about the size of the government spending
and tax multipliers and is thus impossible for Parliament to determine the amount of
stimulus needed to close a given output gap
• Further, the actual output gap is not known and can only be estimated with error. For
these two reasons, discretionary fiscal policy is risky
Time Lags
• Discretionary fiscal stimulus actions are also seriously hampered by three time lags:
Recognition Lag
• The recognition lag is the time it takes to figure out that fiscal policy actions are
needed
Law-Making Lag
• The law-making lag is the time it takes Parliament to pass the laws needed to change
taxes or spending
Impact Lag
• The impact lag is the time it takes from passing a tax or spending change to its effects
on real GDP being felt

Economics 3ed: Global and Southern African Perspectives © 2020 97

 Thank You,
All the best with the
upcoming exams!

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