Macroeconomics

A2 MACROECONOMICS
IMRAN GILANI
MBA – LUMS (LAHORE UNIVERSITY OF MANAGEMENT SCIENCES)
0333-6107771
imran.gilani@gmail.com
www.facebook.com/imran.gilani.academy1
Topic 1 – National income statistics
TOPIC 1: NATIONAL INCOME STATISTICS

National income is the total income of residents of a country measured at factor cost, allowing
for capital consumption or depreciation. Government needs to measure national income of the
country to assess economic performance. It uses a variety of measures to calculate national
income and all these measures collectively are called national income statistics. Government
can use the following measures for calculating national income:
• Gross domestic product (GDP)

• Gross national product (GNP)
• Net domestic product (NDP)
• Net national product (NNP)
The difference between gross and net measures is that net measures subtract capital
consumption or depreciation from gross measures. Capital consumption (also called
depreciation or replacement investment) covers investment that is undertaken to replace worn
out and out-of-date capital. Gross measures take total investment in the economy in a year and
ignore the impact of capital consumption. Therefore, gross measures do not show the addition
in capital stock. Net measures on the other hand include net investment (i.e. gross or total
investment minus capital consumption). Since these measures take into account the capital
consumption, the net measures show addition in capital stock.
It must also be remembered that these measures are taken at factor cost and not market value.
However, it is easier to calculate market values of goods and services produced in an economy.
Therefore, national income is
• initially measured at market prices (i.e. prices charged for goods and services in shops);
• indirect taxes and subsidies are adjusted from market prices; and
• this gives the national income at factor costs.
𝑁𝑎𝑡𝑖𝑜𝑛𝑎𝑙 𝐼𝑛𝑐𝑜𝑚𝑒 (𝐺𝐷𝑃) 𝑎𝑡 𝑓𝑎𝑐𝑡𝑜𝑟 𝑐𝑜𝑠𝑡

= 𝑁𝑎𝑡𝑖𝑜𝑛𝑎𝑙 𝑖𝑛𝑐𝑜𝑚𝑒 (𝐺𝐷𝑃) 𝑎𝑡 𝑚𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒𝑠 𝒎𝒊𝒏𝒖𝒔 𝑖𝑛𝑑𝑖𝑟𝑒𝑐𝑡 𝑡𝑎𝑥𝑒𝑠 𝒑𝒍𝒖𝒔 𝑠𝑢𝑏𝑠𝑖𝑑𝑖𝑒𝑠
(i) Gross Domestic Product (GDP)

GDP is the value of total output produced in an economy in a year by activities located in that
country. This is the most widely used measure of national income and is necessary for
calculating other measures as well. GDP is calculated by adding up:
• consumers’ spending,
• government spending,
• total investment,
• differences between imports and exports, and
• changes in stock.
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(ii) Gross National Product (GNP)

GNP is value of total output produced in a year that takes into account the net income of
residents from activities carried out abroad as well as in the home country. GNP is calculated
as:
𝐺𝑁𝑃 = 𝐺𝐷𝑃 − 𝑁𝑒𝑡 𝑝𝑟𝑜𝑝𝑒𝑟𝑡𝑦 𝑖𝑛𝑐𝑜𝑚𝑒 𝑓𝑟𝑜𝑚 𝑎𝑏𝑟𝑜𝑎𝑑
Net property income from abroad is the income that

• country’s residents earn on their physical assets (such as from factories and leisure
parks) and financial assets (such as shares and bank loans) owned abroad minus
• returns on assets (physical and financial) held in the country but owned by foreigners.
In short, GNP measures the income of the country’s citizens only whether earned in the country
or earned abroad.
(iii) Net Domestic Product (NDP)

NDP is equal to GDP minus capital consumption. It shows the addition in capital stock.
(iv) Net National Product (NNP)

NNP is equal to GNP minus capital consumption and also show addition in capital stock.
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Topic 1.1: Ways of measuring GDP
There are three ways of measuring GDP:

• output measure
• income measure
• expenditure measure
All of the measures must give the same result as all of them measure flow of income produced
in an economy. A simple circular flow of income assumes that:
• value of output in an economy (output measure) must be equal to
• income of factors of production such as wages, rent, interest and profits (income
measure) that must be equal to
• expenditure in the economy assuming all income is spent (expenditure measure).
(i) Output measure

It measures the value of output produced in an economy in a year. It includes output from all
industries such as manufacturing, construction, distribution, hotel and catering, agriculture etc.
• It is important to avoid counting output twice. The problem occurs as the value of
output of raw material manufacturer is added to the value of output of finished goods
manufacturer. For example if the value of cars sold by car manufacturer is added to
value of output of tire firms. This leads to double counting.
• Solution to this problem is that only value added is included in the measure of output.
Value added is the difference between sales revenue received and the cost of raw
materials and components used. It is equal to the payments made to the factors of
production in return for producing the good or service. For example, if a TV
manufacturer buys components costing $10,000 and sells the TVs for $25,000, then, the
amount of value added is $15,000 and this amount is added to the measure of output.
This way the duplication of costs in the output measure is avoided.
(ii) Income measure

It calculates the total income of the factors of production. The value of output produced is
based on the costs involved in producing that output. Costs can include wages (to workers),
rent (on land), interest (on capital), and profit (to entrepreneurs). It therefore represents the
income paid to the factors of production. Output measure and the income measure should
therefore give the same result.
• It is important to include only payments received in return for providing a good or
service.
• Transfer payments, i.e. transfer of incomes from taxpayers to groups of individuals for
welfare payments, is not included because this does not represent income earned on
producing an output.
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(iii) Expenditure measure

Total amount spent in a year (expenditure) should be equal to total output and also total
income. Whatever is produced in the economy is either sold or added to stock. GDP according
to the expenditure measure must therefore be equal to:
𝑇𝑜𝑡𝑎𝑙 𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒
= 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒 𝑜𝑛 𝑔𝑜𝑜𝑑𝑠 𝑎𝑛𝑑 𝑠𝑒𝑟𝑣𝑖𝑐𝑒𝑠 + 𝐴𝑑𝑑𝑖𝑡𝑖𝑜𝑛 𝑡𝑜 𝑠𝑡𝑜𝑐𝑘𝑠
+ 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒 𝑜𝑛 𝑒𝑥𝑝𝑜𝑟𝑡𝑠 − 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒 𝑜𝑛 𝑖𝑚𝑝𝑜𝑟𝑡𝑠 − 𝐼𝑛𝑑𝑖𝑟𝑒𝑐𝑡 𝑡𝑎𝑥𝑒𝑠
+ 𝑆𝑢𝑏𝑠𝑖𝑑𝑖𝑒𝑠
Following adjustments are needed:

• Addition to stocks means that some of the output is unsold and therefore must be
accounted for (added). Reduction in stocks means that previous year output was sold
and should therefore be subtracted from the measure.
• Exports represent a country’s output and creates income and should therefore be added
in the measure. Imports on the other hand represent spending on goods and services
made in foreign countries and create income for people in foreign countries.
• Adjustment for taxes and subsidies is needed to convert measures at market price into
measures at factor costs.
Note: Any difference between GDP as calculated by the expenditure and the income measures
gives a rough approximation of the size of the shadow economy.
Money and real GDP

Money or nominal GDP is GDP measured in terms of prices operating in the year in which the
output is produced. It is also referred to GDP at current prices and is not adjusted for inflation.
The drawbacks of using money GDP is that it may give misleading impression of an economy’s
performance. Following example may clarify the point:
• In any year 100m units are produce in an economy at an average price of $5
• Therefore, GDP = 100 x 5 = $500m
• In the next year the economy again produced 100m units at a new average price of $6
• New GDP = $600m
• Gives a misleading picture
o Shows that GDP is apparently increasing
o However there is no actual change in production
o The rise in GDP is only because of a change in prices
This shows that the value of money GDP is affected by

• change in production of goods and services, and
• change in prices.
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Value of money GDP may rise (as shown in the example above) even if there is no change in
production if prices have risen. Money GDP therefore gives a misleading picture of the
economy. To get a truer picture, economists convert money into real GDP.
Real GDP reflects the GDP at constant prices, i.e. at the prices operating in a selected base year.
The figures therefore adjust the GDP for inflation and only reflect the change in actual
production in the economy.
𝑃𝑟𝑖𝑐𝑒 𝑖𝑛𝑑𝑒𝑥 𝑖𝑛 𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟

𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 = 𝑀𝑜𝑛𝑒𝑦 𝐺𝐷𝑃 ×
𝑃𝑟𝑖𝑐𝑒 𝑖𝑛𝑑𝑒𝑥 𝑖𝑛 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑒𝑎𝑟
For example
• GDP in 2001 (base year) = $800bn
• GDP in 2002 = $864bn; price index = 105
• Real GDP = 864 x (100/105) = $822.86bn
• % change in real GDP = [(822.86 – 800)/800] x 100 = 2.86%
GDP deflator is the price index that is used to convert money into real GDP. It measures the
price of product produced rather than consumed in a country.
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Topic 2 – Comparing growth – Criticism of using GDP
TOPIC 2: COMPARING GROWTH – CRITICISM OF USING GDP

Economic growth is measured as percentage change in real GDP. It can be calculated as:
𝐺𝐷𝑃𝑡 − 𝐺𝐷𝑃𝑡−1 𝐺𝐷𝑃𝑡

𝐺𝑟𝑜𝑤𝑡ℎ (𝑔) = � � × 100 = [ − 1] × 100
𝐺𝐷𝑃𝑡−1 𝐺𝐷𝑃𝑡−1
Issues that need to be considered when comparing growth

(Criticism of national income statistics)
(i) Real GDP should be used instead of nominal GDP

Explained earlier
(ii) Statistical inaccuracies

National income statistics are calculated from millions of different returns to the government.
Inevitably mistakes are made: returns are inaccurate or simply not completed.
(iii) Existence of shadow economy (hidden economy) – Official GDP figures may
underestimate the true changes in output
Shadow economy is defined as the undeclared economic activity for which government has no
record and is thus not included in the official GDP figures. People may not declare their true
income because of various reasons:
• Evade paying tax – May not declare payments for undertaking jobs in spare time.
• Carrying out illegal activity – like smuggling goods.
It is difficult to measure the shadow economy, however, we can get an idea of size of shadow
economy by looking at the different between GDP as measured by measured by expenditure
and income methods. People will be spending what they earn but will not declare it. The higher
the expenditure compared to income, the higher will be the size of the shadow economy.
Comparing ‘g’ over time would be possible if the size of the hidden economy is relatively
constant. In such a case, rate of growth may be calculated reasonably accurately. However, if
the size of hidden economy is changing over time, then, growth calculations will be random and
will not be a good reflection of the economic activity.
International comparisons of ‘g’ are made difficult because of the difference of size in shadow
economy across countries. The size of hidden economy in a country is influence by following
factors:
• Marginal rate of taxation – the higher the rate of tax, the higher is the incentive to hide
income.
• Penalties imposed for illegal activity and tax evasion – the higher the amount of penalty,
the lower would be the incentive to cheat and vice versa.
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• Risk of being caught – if revenue department is very efficient and chances of being
caught are high, incentive to cheat will reduce and vice versa.
• Social attitudes towards different illegal activities – higher acceptance of crime leads to
a larger size of hidden economy.
Size of hidden economy is generally expected to be higher in developing economies.
(iv) Low levels of literacy in some countries – official GDP figures may not be accurate
Low literacy rates mean that it will be difficult for government officials to measure the
economic activity accurately. Some people will be unable to fill out tax forms, others may fill tax
forms inaccurately. This will mean that official figures will be inaccurate.
(v) Presence of non-market goods and services (home produced goods) – leads to
inaccurate official GDP estimates
GDP figures only include marketed goods and services, i.e. goods and services which are bought
and sold and have a price attached to them. Non-marketed goods and services are goods and
services which are produced but either not traded or are exchanged without money changing
hands. These goods and services though produced are not recorded in the GDP. Some of the
examples of such products can be:
• domestic services provided by homeowners
• painting and repairs undertaken by homeowners
• voluntary work
Proportion of goods and services that people produce for themselves and the amount of
voluntary work undertaken
• varies over time (making comparisons over time difficult);
• varies between countries (making comparisons across countries difficult).
(vi) Output of public goods and services that are not sold is difficult to value – leads to
inaccurate GDP figures.
Defense and police services are examples of government goods that are provided but are not
sold to the public. It is therefore difficult to find their market value. Such services can be valued
at cost. But doing this may distort output. For examples, if productivity increased in fire service,
fewer firemen are needed leading to cost reduction in the fire department. Output (if recorded
on cost) would have officially fallen whereas the level of service is either unchanged or has
actually improved. There are alternatives to this approach to measure the output levels.
Government can use a variety of key performance indicators to estimate output (such as
number of students for education).
(vii) Nature of economic growth

It is important to consider the nature of growth in the economy. Very high levels of growth may
not be sustainable in the LR.
• SR ‘g’ may be greater than the ‘trend growth’, i.e. the productive potential of the
economy. This may happen because of high demand; machinery working flat out; and
workers persuaded to work long hours of overtime. However, it may not be sustainable
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because machines will eventually wear out and will need to be repaired, and workers
will get tired and will need to reduce the number of hours of work.
• Growth may not be sustainable in the LR if:
o it is achieved by depleting natural resources (rise in fish catches, excessive
deforestation, pumping a lot of underground water). High levels of use of natural
resources will mean that fewer resources are available to future generations.
This reduces the ability of future generations to sustain high levels of economic
growth.
o it creates pollution that leads to lower fertility of land and poor health of
workers.
Summary
The following table summarizes the discussion above.
Comparing growth Over Time Across Countries

Better to use Real GDP Real GDP
Size of shadow economy Varies over time; growth is Varies across countries;
useful if the size of shadow makes comparisons
economy is stable over time difficult
Literacy levels Change over time Varies across countries
Non-market goods and services Vary over time Vary across countries
Government services provided free Vary over time Vary across countries
of cost
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Topic 3 – Comparing living standards
TOPIC 3: COMPARING LIVING STANDARDS

Comparing living standards over time
Countries need to see whether the economic policies adopted have led to an improvement in
living standards or not. Following issues need to be kept in mind when comparing living
standards over time.
• Income levels in the economy reflect the living standards of individuals. Higher income
levels, other things remaining same, should lead to better living standards. However, as
discussed earlier, it is better to use real GDP than nominal GDP.
• Real GDP figures over time may not be a good reflection of change in income levels of
individuals as the size of population also changes over time. Therefore, a more realistic
measure for judging living standard is to calculate real GDP per capita (per head) which
can be calculated as:
𝑅𝑒𝑎𝑙 𝐺𝐷𝑃
𝑅𝑒𝑎𝑙 𝐺𝐷𝑃 𝑝𝑒𝑟 𝑐𝑎𝑝𝑖𝑡𝑎 =
𝐶𝑜𝑢𝑛𝑡𝑟𝑦 ′ 𝑠 𝑝𝑜𝑝𝑢𝑙𝑎𝑡𝑖𝑜𝑛
Real GDP per capital will increase if % increase in GDP is greater than % increase in
population. An increase in real GDP per capita shows an improvement in living
standards. However, there may be problems of using this measure to compare living
standards over time.
o There are problems in measurement of real GDP as already discussed and
summarized below.
 Existence of shadow economy;
 High levels of illiteracy;
 Presence of non-marketed goods and services; and
 Valuing goods and services provided by the government which are not
sold.
o Real GDP is not evenly distributed. An increase in real GDP per capita which is
not shared amongst the population would mean that some people will get very
rich whereas a lot of people will remain very poor.
o Change in real GDP may not reflect true change in quantity of goods and services
enjoyed by consumers if level of undeclared economic activity changes. A rise in
undeclared economic activity may actually mean that people are experiencing
higher living standards than reflected in real GDP figures.
o Real GDP figures tell us about the level of output and do not say the type and
quality of products produced nor do they tell the method by which these goods
are made.
• To check improvement in living standard, we need to consider the type of goods and
services produced in the economy in addition to change in GDP. A rise in GDP does not
guarantee rise in living standards if increase in output is in the form of increase in police
services etc. Types of products that raise living standards include:
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o consumer goods and services (housing, food, clothing etc.);

o producing more capital goods so that LR productive potential may increasing
leading to increase in living standards in the LR;
o better quality goods being made because a fall in quality of goods and services
produced will lead to a fall in living standards.
• We also need to see how goods and services are being produced. Living standards
improve if working conditions improve. For instance, if working hours fall, management
techniques improve, and the health and safety conditions at work improve, these will
lead to an improvement in living standards. Otherwise there will deterioration in living
standards.
• Need to look at the environment as well to check improvement in living standards. If
quality of environment declines, then an increase in real GDP may still lead to a fall in
living standards. If more resources are spent on cleaning up the environment, it will lead
to increase in GDP but a fall in living standards.
• There are many other factors that affect the standard of living. Some of these may
include:
o political freedom;
o civil liberties;
o justice; and
o fear of crime.
• Economists therefore use a wide range of indicators to assess living standards. They can
look at:
o number of TVs per household;
o infant mortality rate;
o energy use per capital and
o like that.
Economists therefore do not just look at income levels (GDP) and instead use composite
indicators to assess living standards. Composite indicators use a number of indicators of
living standard. Two of the famous composite indices are briefly explained below.
o Net Economic Welfare (NEW) or Measurable Economic Welfare (MEW)

This index was developed in 1972 by two American economists – William
Nordhaus and James Tobin. The index adjusts GDP figures to take into account
other factors which have an impact on quality of people’s lives
 Factors that improve living standards (such as increase in leisure hours)
are added to the GDP figure, and
 Factors that reduce living standards (such as rising crime and pollution
levels) are deducted.
However, this method is difficult to use in practice because of difficulty and high
cost of measuring value of non-marketed goods or bads.
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o United Nations Human Development Index (HDI)

UNHDI takes into account
 real GDP per capital (PPP$);
 life expectancy at birth
 educational attainment as measured by adult literacy and primary,
secondary, and tertiary enrolment ratio.
These factors are included because of the belief that people’s welfare is
influenced not just by the goods and services available to them but also by their
ability to lead a long and healthy life and to acquire knowledge.
HDI values shows distance a country has to make to reach the maximum value of
1. An improvement in HDI value over time will reflect an improvement in living
standards.
Comparing living standards between countries

Countries at times make comparisons with other countries to see where they are placed in
terms of living standards. These comparisons also citizens to know which countries allow better
living standards and also helps governments in taking steps to reduce the differences and offer
better living standards to their citizens. Following issues need to be kept in mind when
comparing living standards over time.
• Country with higher income levels is expected to enjoy a better living standard.
However, following issues need to be kept in mind:
o Better to use real GDP.
o Use real GDP per capita as population size across countries will vary.
o Additional problems of using GDP to compare living standards:
 Size of shadow economy differs across countries;
 Literacy levels vary across countries;
 Size of non-marketed goods and service vary across countries; and
 Size of free public goods also vary across countries.
• Real GDP per capita of different countries must first be converted into a common
currency to make comparisons possible. It is a common practice to convert all GDP
figures into dollars ($) to make comparisons possible. This will also avoid the distortions
that results from movements in exchange rates.
• Exchange rates need to be adjusted to reflect purchasing power parity (PPP). Cost of
living in different countries will be different. Citizens in a country where cost of living is
low will enjoy better living standards than citizens in a country with higher cost of living.
o Therefore, it is better to use PPP$ real GDP per capita to compare income levels
across countries.
• In addition to above adjustments, we need to look at income distribution. If income is
unevenly distributed, only a small number of households will benefit from high average
income and the population in general will experience lower living standards.
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• Income alone is not a good guide to living standards. We need to look at other factors
such as
o difference in working hours;
o working conditions in each country;
o political freedom;
o fear of crime;
o quality of environment; and
o type and quality of products produced.
• Economists use a wide range of indicators to assess living standards. They can look at:
o number of TVs per household;
o infant mortality rate;
o energy use per capital and
o like that.
Economists therefore do not just look at income levels (GDP) and instead use composite
indicators to assess living standards. Composite indicators use a number of indicators of
living standard. Two of the famous composite indices are:
o Net Economic Welfare (NEW) or Measurable Economic Welfare (MEW) –
explained above
o United Nations Human Development Index (HDI) – explained above
A country’s ranking by HDI does not always match its ranking in terms of real
GDP per capital. The following will improve (deteriorate) a country’s ranking in
HDI:
 higher (lower) life expectancy at birth;
 higher (lower) educational attainment, i.e. higher (lower) adult literacy
rate, and higher (lower) primary, secondary and tertiary enrolment ratio.
Note: We can do a similar analysis for NEW or MEW. Factors that improve living
standards will increase a country’s ranking whereas factors that deteriorate
living standards will lead to a fall in country’s ranking.
International comparisons of living standards – a word of warning

Problems related to inter-country comparisons (whether amongst similar or different types of
economies) are listed below:
• fluctuations in the exchange rate against US dollar – large movements can affect eh
GNP/GDP per head measure
• measuring purchasing power, particularly in economies where prices are not well known
• an allowance is made for the size of the subsistence sector – this can be large in
emerging and less developed economies
• the shadow or informal economy is not included and can often be at least 25% of GNP
• no allowance is made in GNP per head for the distribution of income
• countries with a high GNP per head may have achieved this through the serious
denigration of their physical environment or through excessive expenditure on defense
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• traditional measures do not take into account variables such as social justice and
political freedom.
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Topic 4 – National economic performance
TOPIC 4: NATIONAL ECONOMIC PERFORMANCE

Macroeconomics allows economists to compare the economy over time and across countries.
An economy is a system which attempts to resolve the basic economic problem of scarcity. An
economic system should try to maximize the satisfaction of individuals if it is to be considered
efficient. There are many indicators of economic performance which are discussed below. It
must however be noted that the economic performance is a much broader term and does not
just include income as an indicator.
(i) Output and income

One of the criteria that need to be considered is the size of the economy in terms of how much
is being produced. The more that is produced, the better is usually considered the economic
performance. High output levels will mean higher incomes for the factors of production that
should lead to higher levels of consumption and higher standards of living in the economy.
Higher income levels would also mean higher tax collection for the government that will enable
the government to invest in desirable projects such as health, education and infrastructure.
Countries often consider economic growth as a criterion for comparing economic performance.
Economic growth is defined as the rate of change of output. Economic growth is generally
considered to be desirable as individuals prefer to consume more rather than fewer goods and
services. Higher growth will ensure that income levels will rise over time leading to higher
consumption and standard of living. Periods when the economy fails to grow at all, or when
output levels shrink (recession or depression) are periods when the economy is performing
poorly.
(ii) Unemployment
Unemployment takes place if the resources in an economy are not fully utilized. Economy will
then be producing inside its PPC. This represents a waste of resources and output could be
higher if resources were fully utilized. High levels of unemployment mean that many of the
workers are out of job. This leads to increase in poverty in the economy. High unemployment is
an indication of poor economic performance whereas low unemployment is an indicator of
good economic performance. Low levels of growth are associated with rising levels of
unemployment. Over time, technological change allows an economy to produce more with
fewer workers. If there is little or no economic growth, workers are made redundant through
technological progress. If growth is negative, firms will lay off workers and unemployment will
rise.
Fast economic growth will tend to lead to net job creation. More jobs will be created than are
lost through the changing structure of the economy. Therefore, another way of judging the
performance of an economy is to consider its rate of job creation.
However, there is a trade-off between unemployment and inflation. Lower levels of

unemployment usually lead to higher levels of inflation and vice versa.
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(iii) Inflation
Inflation is the rate of change of average prices in an economy. Low inflation is generally
considered to be better than high inflation. This is because inflation has a number of adverse
effects. High levels of inflation will mean that purchasing power of consumers will fall, country
will lose its international competitiveness leading to a loss of exports, and inflation will give
incorrect signals in the market system. Extremely high levels of inflation (hyperinflation) are
experienced by some countries that wreaks the economic policies. Negative inflation (deflation)
is also not considered desirable as it is generally associated with recession.
(iv) Current account balance (trading balance)

Trading balance reflects the difference between exports and imports of a country. A deficit in
trading account (imports greater than exports) means that it must be finance either through
borrowing or through fall in foreign exchange reserves. Surplus in trading account (exports
greater than imports) means that the foreign reserves of the economy will increase. This will
also ensure higher output and lower unemployment. Deficits become especially alarming when
foreign banks and other lenders refuse to lend any more money.
(v) Equity (distribution of income)

An economy may enjoy higher income levels but if this income is not evenly distributed, then,
the benefits of growth will only accrue to a few in the society. A major economic objective of
governments is to ensure that income is equitably divided (this does not mean equal
distribution of income and wealth).
(vi) Environment
An objective of the government is to reduce environmental damage. The higher the damage to
the environment, the less sustainable will be the growth in the economy. Governments do not
aim to eliminate pollution and environmental damage, however, they set targets and impose
limits on different environmental outcomes of economic activity.
(vii) Other indicators

There are many other indicators of economic performance. Some of the additional measures
that are considered by the government are:
• provision of health services;
• provision of education;
• provisions of law and order;
• increase in competition;
• increase in choice for consumers;
• lower cost of production;
• provision of clean drinking water;
• reduction in poverty levels; and
• like that.
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Government objectives
Governments attempt to manipulate the economy to improve its economic performance. Four
main macroeconomic objectives of the government include:
• maintaining a high level of economic growth;
• achieving low levels of unemployment;
• low levels of inflation; and
• a balanced current account over time.
Governments also pursue other policy objectives that may include:

• achieving equitable distribution of income and wealth;
• reduce damage to the environment;
• achieve sustainable growth;
• reduce poverty levels;
• increase health and education facilities; and
• like that.
To achieve these objectives, governments use different policy measures which may include:
• fiscal policy;
• monetary policy;
• foreign exchange policy; and
• supply side policies.
Conclusion
Governments cannot necessarily achieve all their objectives at any single point in time. There
are frequently trade-offs that have to be made. For instance, a lower unemployment will lead
to higher levels of inflation. Government will hence have to prioritize which objectives it wants
to achieve in the SR.
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Topic 5 – Economic development
TOPIC 5: ECONOMIC DEVELOPMENT

Economic development is an issue that confronts all economies. Countries have been divided
into various groups according to how developed or underdeveloped their economy is. However,
it is difficult to define what exactly economic development is. Two definitions of economic
development are given below:
• World Bank’s ‘World Development Report’ of 1991 says, “The challenge of
development… is to improve the quality of life. Especially in the world’s poor countries,
a better quality of life generally calls for higher incomes – but it involves much more. It
encompasses as ends in themselves better education, higher standards of health and
nutrition, less poverty, a cleaner environment, more equality of opportunity, greater
individual freedom, and a richer cultural life.
• M. P. Todero defines it as “Development…. must represent the whole gamut of change
by which an entire social system, tuned to the diverse basic needs and desires of
individuals and social groups within that system, moves away from a condition of life
widely perceived as unsatisfactory toward a situation or condition of life regarded as
materially and spiritually better.”
Both the definitions of development suggest that development must be seen as a

multidimensional process. However, the definitions also acknowledge the importance of
economic growth for achieving development.
Economic growth occurs when an economy achieves an increase in national income (GNP) in
excess of its rate of population growth. This leads to an increase in GNP per capita. Economic
growth is at times seen as synonymous to economic development. There was a belief that
sustained economic growth can lead to poverty reduction. It was assumed that growth will lead
to higher output and higher income levels. This will have a trickle-down effect and the benefits
will be passed down to poorer members of the society in terms of jobs and other economic
benefits. In reality, however, economic growth has led to benefits for poorer members of
society in some countries, while it has resulted in unchanged or decreased living standards for
poor in many countries. Economic development hence needs to be looked from a much
broader perspective. Economic development is the process of improving people’s economic
well-being and quality of life whereas economic growth only refers to actual annual percentage
change in output.
Classification of economies
The world can be divided into groups of countries.
• First world countries
Fist world countries are a small group of rich industrialized countries: the United States,
Canada, France, Italy, Germany, the UK and Japan (known as ‘G7’ countries), other countries in
Western Europe and Australia and New Zealand. They are also known as developed countries,
indicating that they have reached an advance stage of economic development.
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• Second world countries

It is now a historical term and used to refer to the former communist countries of Eastern
Europe and USSR. These countries are now sometimes called transition economies.
• Third world countries

These are a large group of countries in Asia, Africa and Latin America which have lower incomes
than first world countries. They are sometimes called developing economies, indicating that
their economies are still developing. They are also called less developed countries (LDC).
Third world countries differ greatly amongst themselves. Sometimes the poorest are called
fourth world countries or low income countries or least developed countries. The richer third
world countries are known as middle income countries. Further classification include:
o lower middle or upper middle income countries (according to World Bank),
o emerging economies are fast growing middle income countries such as Mexico,
Thailand, and Malaysia,
o newly industrialized countries (Tiger economies) such as South Korea, Singapore,
and Taiwan, indicating that their economies now have a strong industrial base,
Indicators of economic development

(i) Classification according to level of income
One way of classifying economies is according to the value of their GDP per capita. World Bank
uses this measure to classify countries as low income, middle income (subdivided into lower
and upper middle), or high income. Low-income and middle-income economies are sometimes
known as developing economies. The threshold for these categories in 2009 is listed below:
Classification GDP per head ($) This threshold is updated each year to account for
international rates of inflation (thresholds are
Low income 905 or less
constant in real terms over time).
Middle income
Lower middle 906 to 3,595
The benefit of using this approach is that it is
Upper middle 3,596 to 11,115
simple and convenient. Furthermore, it is an easy
High income 11,116 or above
way of identifying those economies that need help
and international aid. However, the drawback is that it takes a limited view of development (i.e.
based only on income). It is also misleading to assume that all countries classified as
‘developing’ are at the same stage of development.
(ii) Classification according to level of indebtedness

Economies can be classified according to the degree of their indebtedness. Economies can be
classified as:
• severely (highly) indebted;
• moderately indebted; and
• less indebted.
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Categorization depends on a number of measures, the most important of which is proportion of

GNP which is devoted debt servicing. International indebtedness is seen as a major obstacle to
economic development. High levels of debt servicing mean that governments will be left with
very few resources to spend on development activities such as providing health and education
to the population.
Characteristics of developing economies

It is wrong to assume that all developing economies are similar. There is a lot of diversity
amongst developing economies. Therefore, it is also wrong to assume that all developing
economies will need same policy prescription. However, many of these countries share some
characteristics (‘unity in diversity’).
(i) GDP per head

This was also discussed at the start of the topic where economies were classified according to
GDP per head. Developing countries have low income levels and low GDP per capita.
(ii) Physical capital

Developing countries have far less physical capital per capita than the developed countries. This
includes not just factories, offices and machines, but also infrastructure capital such as roads
and railways, communication, as well as schools and hospitals. This limits their ability to grow. If
a country is to grow, it must increase its stock of physical capital in order to push out its PPC.
(iii) Economic structure

Economic activity can be placed into three sectors:
• Primary sector – includes agriculture and extractive industries such as oil extraction and
coal mining.
• Secondary sector – includes all manufacturing industries and construction sector.
• Tertiary sector – includes the service sector.
Developing economies have high dependency on primary sector. In 1990s agriculture

contributed between 30% and 60% of output of low-income countries. This makes developing
economies vulnerable to forces of nature. A draught or floods can have a major impact on
income levels, exports and living standards in the economy.
High income countries are more dependent on secondary and tertiary sectors and are hence
less affected by natural disasters. Average agricultural contribution in GDP of high-income
countries was only 5% or less of GDP.
(iv) Population growth, health and mortaility

In 2008, around 85% of world’s population lived in developing economies. Observers suggest
that the theories of Malthus can be applied to the current population problems of the
developing countries. Malthus’s theory is summarized in following points:
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• Country’s population had a tendency to grow in geometric progression over time (1, 2,
4, 8, 16, 32, 64 …).
• Food supplies tend to increase only in arithmetic progression (1, 2, 3, 4, 5, 6, 7 …).
• This happens because land is fixed in supply whereas labor is a variable factor that
increases over time. An increasing labor will mean that diminishing returns will set in
over time.
• Over time population increases would outstrip increase in food supplies leading to food
shortages. This shortage will put a ‘check’ on world population because of:
o famines bought be overpopulation,
o diseases and epidemics caused by malnourishment, and
o wars to gain access to limited world resources.
• Malthusian theory however can be criticized on following ground.
o The theory fails to recognize the impact of changes in technology (such as
mechanization, application of more affective fertilizers and insecticides, and
introduction of new high yield seeds) on food production and distribution.
o These changes have enabled food supplies to grow to a level that was capable of
supporting a much higher level of world population.
Despite these criticisms, some of the developing countries exhibit the problems identified by
Malthus. Malnutrition and famine remain features of some developing countries. These
problems however are caused by a wide range of factors and not just the Malthusian analysis.
These factors are listed below.
• Uneven distribution of resources in the world,
• poor management of agriculture sector,
• vulnerability to sudden shocks such as flood and drought,
• inability to respond to these shocks, and
• crippling impact of international debt.
(v) Population structure

Developing economies have much higher fertility rates (average number of children born to a
woman over her lifetime or simply children per woman) than the developed economies. This
leads to greater increases in their total population and also brings associated problems.
Developing countries therefore tend to have a large number of very young people. This creates
a high proportion of dependent, non-productive members of the population leading to very
high dependency ratios. This means that a proportionally small working population has to
produce enough goods and services to sustain themselves and a large number of dependents.
This gives rise to conditions of poverty and creates pressure to force young into the workforce.
It is estimated that over 100m children now live or work on the streets.
Developed economies also have problems with the age structure of their populations. The birth
rate is slow and below the rate required to replace the present population. This results in a
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decrease in population. It also results in an ageing population. It is estimated that in EU two-

thirds of the population will be over 65 by year 2050. Dependency ratios are again high and this
creates problems of feeding the old with too few young.
Developing countries also have problems of ageing populations. The cause tends to be more
one that people are living longer rather than birth rates falling.
The concept of Optimum Population

Optimum population is said to exist when output per head is greatest, given existing quantities
of other factors of production and the current state of technical knowledge. As population
grows
• it can make better use of stock of other
factors of production such as land and
capital. This is because increasing returns
are enjoyed as population grows and the
output per head increases. If as the
population increases the output per head
continues to grow we could consider the
country to be underpopulated.
• As the population continues to grow we
would expect the output per head to
eventually peak. This is the level of optimum population given as P1 in the figure.
• Output per head then declines as decreasing returns are experienced. Output per head
starts to decrease and the country is considered to be overpopulated.
The curve can however shift over time due to changes in state of technology and the quantity
of other factors of production. An improvement in state of technology and an increase in
quantity of other factors of production such as capital will shift the curve outward leading to an
increasing in optimum size of the population. The optimum population of the country is
therefore not fixed and can change over time.
The criteria for assessing under- or overpopulation are purely economic and may be disputed
by others.
(vi) Educational attainment (investment in human capital)

• Least developed countries would expect to have the lowest proportions of the total age
group enrolled in education.
• Lack of schooling and income impact literacy rates and developing economies tend to
have low levels of literacy rates.
Education levels are vital for future growth. Countries that invest in education are likely to grow
faster in the future.
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(vii) Income distribution

Income is generally unevenly distributed in developing economies. This is partly because
income-generating assets (such as land) are owned by the few. The 2009 World Development
Report gave date on the share of the poorest 20% of the population in national income.
• The most extreme cases were in South America. In Bolovia, the figure was just 1.5%, in
Argentina 3.1% and in Brazil, 2.9%.
• In Africa, the lowest figure was 3.5% in South Africa. More typical figures were in the
range 5-7%.
• Transition of Eastern European countries from central planning to market economies
has increased inequality.
(viii) Unemployment
Developing countries tend to suffer from higher levels of unemployment and
underemployment than developed countries. This happens because developing countries have
surplus labor and shortages of other factors of production (especially capital and
entrepreneurship).
(ix) External trade

Foreign trade of many developing countries tends to show great reliance upon export of
primary produce. Manufactured goods as a proportion of exports are low in developing
countries and high in developed countries. This leads to following problems:
• Reliance of developing countries on export of primary produce.
• This makes them vulnerable in their trading relationships because of the demand and
supply conditions in markets for primary products.
o Demand for primary products tends to be price inelastic.
o Supply of primary products tends to be price inelastic.
o Supply is also dependent on the weather conditions and the size of harvest.
o The supply is subject to frequent shifts.
o Market is hence subject to frequent and severe price fluctuations.
o Price fluctuations can destabilize economies of developing countries.
• Demand for primary goods is income inelastic.
o Increase in world incomes means that there is little impact on demand of
primary goods. Most of the income increase is spent on manufactured goods.
• There is tendency for terms of trade of primary goods to decline over time compared to
manufactured goods.
o Developing economies therefore receive a relatively lower price for their
exports.
o They have to pay a relatively higher price for imports of manufactured goods.
o This leads to balance of payment problems.
The number of developing countries that are heavily reliant upon primary products has
declined as these countries have set up manufacturing bases. Some examples are given below:
• In 2006, 92% of China’s exports were manufactured goods.
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• In India the figure was 70%, 74% in Malaysia and 81% in Pakistan.
• Sub-Saharan African countries however continue to suffer from the problem and have
very little exports of manufactured products. In 2006, manufactured exports made up
only 18% of Tanzania’s exports of goods.
(x) Urbanization
There are still high proportions of populations in developing economies who live in rural area.
On average over half of the population of developing countries is classified as rural. However
developing countries show very rapid rates of rural-urban migration. This can cause extra
pressure on resources in already overcrowded urban area. There is pressure on the
infrastructure, housing, roads and schools.
Developed countries on the other hand already have majority of their populations living in
urban areas. They have developed infrastructure that cope with the demand of high demand
for housing, roads and schools.
(xi) Technology
There is a large gap between use of technology between developed and developing countries.
This covers a wide range of applications including
• new production techniques,
• new more efficient means of communication, and
• electronic storage and retrieval of information.
Only 5% of world’s computers are located in developing countries. Developing countries lack
technical skills and infrastructure. Internet provides an opportunity for developing countries
but lack of skills and infrastructure proves to be a barrier in fully realizing its potential.
(xii) Multinational corporation and foreign direct investment (FDI)

A multinational corporation (MNC) or transnational corporation is defined as a firm that
operates in more than one country, i.e. headquartered in one country but with production or
service operations in more countries. For example, Coca-Cola, Nestle, P%G, Toyota, and Honda.
FDI involves capital flow between countries. It involves setting up branches or factories in a
foreign country. It should not be confused with portfolio investment which is the purchase of
shares by foreign investors in businesses that are located in another country. MNCs because of
their worldwide operation are one of the major sources of FDI for developing countries.
However the reaction to their operation is mixed. The major benefit of FDI to the host country
is:
• improvement in capital account of balance of payment,
• increase in production potential as new capacity is installed,
• increased output, income and employment, and
• increased exports or reduced imports.
However, there are certain drawbacks of MNCs as well such as:
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• political influence over host country’s government, and

• repatriation of profits.
(xiii) External debt

Some of the developing countries are categorized as heavily indebted poor countries (HIPC).
This means that one of the two key debt ratios is exceeded.
• The first is the relationship between debt service ratio and the GNP.
• The second is the relationship between the present value of debt service to exports.
Country is considered
• heavily indebted if either
o the proportion of debt service exceeds 80% of GNP or
o the present value of debt service exceeds 220% of exports.
• moderately indebted if either ratio exceeds 60% of the critical level.
High debt levels divert resources to debt repayment and away from spending on health and
education, on infrastructure and poverty relief. This presents an obstacle to development of
these economies.
(xiv) Institutional structures, governance and corruption

Poorest developing countries are characterized by weak financial systems which are often
inaccessible to most of the population. The rule of law is weak and government is often highly
corrupt. A wide range of different forms of government are found in Third World countries
ranging from democracies in India and South Africa to military dictatorships in Burma.
Conclusion
A well-known development economist has summarized the problems that stem from these
common characteristics as follows:
‘Widespread and chronic absolute poverty, high and rising levels of unemployment and
underemployment, wide and growing disparities in the distribution of income, low and
stagnating levels of agricultural productivity, sizeable and growing imbalances between
urban and rural levels of living and economic opportunities, serious and worsening
environmental decay, antiquated and inappropriate educational and health systems,
severe balance of payments and international debt problems, and substantial and
increasing dependence on foreign and often inappropriate technologies, institutions and
value system.’
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Topic 6 – Economic growth
TOPIC 6: ECONOMIC GROWTH

Increases in productive capacity are known as economic growth. The productive potential of an
economy can fall as well as rise. It is not possible to measure the productive capacity of an
economy directly because there is no way of producing a single monetary figure for the value of
variables such as machinery, workers and technology. Instead, economists use changes in GDP
as a proxy measure. The problem with using GDP is that, in the SR, GDP fluctuates around the
long term rate of growth. These fluctuations are known as business cycle (trade cycle, economic
cycle). It has four main phases:
• Peak or boom
• Downturn
• Recession or trough or slump or depression
• Recovery or expansion
Changes in actual and potential output of goods and services

A change in actual output of goods and services is achieved by better utilization of factors of
production. If the economy is producing inside PPC (e.g. point X in the figure), there is
underutilization of existing factors of production. This can be because of lack of aggregate
demand in the economy. The economy can increase its output levels by moving from point X to
any point on PPC (e.g. point Y). This can be achieved by increasing aggregate demand through
fiscal and/or monetary policy. Following measures
may be taken by the government:
• Expansionary fiscal policy including
increase in government spending and
decrease in taxes.
• Expansionary monetary policy including
decrease in interest rates and increase in
money supply.
This would lead to an increase in output and GDP
and is considered as actual economic growth.
In the long run, further increases in output can only be achieved if potential output of the
economy grows. This is represented by a shift in PPC (from PPC1 to PPC2). Therefore, LR
explanation of growth needs to focus on factors which increase the productive potential of an
economy.
Factors contributing to economic growth

The position of PPC is determined by an economy’s production function. This shows the
maximum output that can be produced by an economy taking into account the current factors
of production and the current state of technical expertise.
In order to achieve economic growth which can be sustained it is necessary to:
29
• Increase the quantity of resources at the disposal of the economy

• Increase the quality of resources at the disposal of the economy
• Improve state of technical expertise
Increasing the quantity of resources

Size of labor can be increased by:
• growth in population in developing countries that increases supply of labor;
• net immigration (where number of immigrants are greater than number of emigrants);
• encouraging female worker participation;
• increasing retirement age etc.
Capital can be increased by investment in capital goods. This will have a trade-off with
producing consumer goods and can have implications for living standards in the SR.
Enterprise can be increased through training and government policies encouraging risk-taking.
Land cannot be increased in total, however, government can adopt reclamation schemes that
improve the land available for use. This however is covered in capital as it needs investment
before land is available.
Increasing the quality of resources

Improvement in quality of resources will increase their productivity. This will mean that more
goods and services could be produced with same resources available. This should lead to
outward shift in PPC.
Quality of labor can be improved through education and training (this is called investment in
human capital) and is essential for future growth potential of the economy. Other things that
need to be improved to get benefit from human capital are:
• Workers need to be sufficiently educated to cope with the demands of existing stock of
capital.
• Workers need to be flexible. Increasingly workers are being asked to change roles within
existing jobs. They are often required to change jobs because of change in structure of
the economy. This requires flexibility. Flexibility requires broad general education as
well as in-depth knowledge of a particular task.
• Workers need to contribute to change. Ability of workers to take responsibility and
solve problems will be increasingly important in the future.
Quality of capital goods

• improves over time with the introduction of new technology (requires investment in
R&D);
• in developing countries improves as they import capital equipment from developed
countries.
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Quality of land for agriculture can improve through:

• application of fertilizers and pesticides;
• use of farm machinery;
• better irrigation and drainage system.
Obstacles to increases in quantity and quality of resources in developing countries

The main obstacle to increases in the quantity and quality of resources in developing countries
are elaborated below.
• Opportunity cost of diverting resources from their current use.
• It is difficult to improve the quality of labor. There are shortages of schools, teachers
and textbooks. Devoting more resources to education means such resources have to
diverted from some other use (opportunity cost). Many children are required to work to
support family incomes.
• Developing countries find it difficult to improve quality of capital stock. Many
developing countries are barely above the subsistence therefore they find it difficult to
divert resources away from current consumption. These countries then acquire
necessary resources for investment through taking foreign loan or aid. This leads to the
problem of indebtedness and creates a heavy burden on the economy in the form of
future repayments of debt. This leads to too few resources available to the economy for
development projects. One possible solution to this problem is the provision of
development aid to these countries by donor agencies.
• It is also difficult for the developing countries to improve the state of technology. New
technology improves the production techniques and allows higher levels of production
with the same resources. However technology improvement requires substantial
investment in R&D which is expensive and has very high opportunity cost for developing
countries. Over 90% of world’s R&D takes place in developed economies. This allows
them to maintain their dominance of world markets in manufactured goods. New
technology developed in the richer countries is suitable to their factor conditions. For
example, rich countries tend to use capital-intensive production methods and new
technology allows them to economize on use of highly skilled and expensive labor. They
also produce for mass market allowing them to get scale economies necessary for use of
high-tech equipment. Developing economies on the other hand have large supplies of
unskilled labor and they often produce for much smaller markets. As a result, new
technologies cannot be easily transferred from developed countries to developing
countries.
Possible solutions for overcoming these problems include:

• Increasing savings ratio that leads to diversion of resources from consumption to
investment hence increasing the amount of capital in the economy.
• Acquiring foreign loan and aid. However, there are associated problems with this
solution.
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Benefits of economic growth

Economic growth can provide following benefits to the society:
• More choice of goods and services available to a country’s citizens which raises their
material living standards.
• Helps in poverty reduction as high growth leads to high income levels that can be used
to reduce poverty levels.
o Higher growth can lead to higher employment and poverty reduction.
o Higher growth leads to higher incomes and higher tax collections that can be
used to give higher benefits to the poor.
• Stable levels of economic growth increases firms’ and consumers’ confidence. Stable
growth means that firms will find it easier to predict future that will help them in
planning their investment. Stable growth therefore encourages higher levels of
investment in the economy.
• High growth levels give international prestige and power to the economy (e.g. India and
China).
Cost of economic growth

• There is an opportunity cost involved in achieving economic growth if the economy is
operating at full employment level. Economy will have to divert resources away from
producing consumer goods to producing capital goods leading to a reduction in current
consumption. This is however a SR cost as higher investment levels lead to higher
output and consumption in the LR.
• Growth brings increased stress and anxiety. Growing economies undergo structural
changes that increase stress and anxiety. For instance,
o workers have to learn more skills;
o workers may have to change their occupation and place of living;
o may be accompanied by increases working hours and pressures to cope up with
new ideas and improvements;
o overworked machines may lead to machine break-downs in future.
• High growth may lead to depletion of natural resources and damage to the
environment. Economies should look for ways to grow without polluting the
environment.
• Some economists argue that growth is increasing inequalities of income and wealth. It is
commonly argues today that the benefits of globalization are going mainly to the rich
countries of the world and to MNCs and very little is going to poor developing countries.
Sustainable development
Sustainable development ensures that economic growth improves living standards and the
quality of life not only in the present but also for the future. Very rapid growth may be achieved
at the expense of living standards of future generations. This happens because of reckless use
of resources and environmental pollution. A very good example is the excessive use of natural
gas in Pakistan during last decade that has resulted in alarmingly low levels of gas available for
32
future use. An economy needs to look for methods of achieving sustainable growth and this is
one of the major objectives of the government. Some of the examples are given below:
• materials such as aluminum, paper and glass should be recycled;
• more use of renewable energy sources;
• improvements in technology may both increase output and reduce pollution;
• cutting back on CO2 emissions;
• reducing landfill; and
• dumping less waste into rivers and seas.
To achieve sustainable development, there is a need to balance economic, social and

environmental objectives.
• Economic objectives require a better use of scarce resources. Sufficient resources must
be available to invest in human capital (education and training) as well as physical
capital (investment and R&D). These are essential for ensuring that PPC shifts outward
and the economy gets higher production possibilities in the future.
• Social objectives focus on the distribution of the benefits of growth. Food, housing,
health care and secondary education are essential if people’s lives are to be productive.
A sustainable approach involves
o an educational system that gives girls the same opportunities as boys,
o serious efforts about reducing fertility rates,
o controlling the spread of HIV/AIDS, and
o providing for the elderly.
• Environmental objectives require the responsible use of natural resources. Mineral
extraction and forest depletion should be done in such a way that the benefits are not
just short-term. Providing people with access to clean drinking water and proper
sanitation.
Achieving sustainable development is difficult but the costs of not following it are too high for it
to be ignored.
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Topic 7 – Circular flow of income
TOPIC 7: CIRCULAR FLOW OF INCOME

Circular flow of income in an open economy
Circular flow of income is a model of the economy which shows the flow of goods, services and
factors and their payments around the economy. Consider a very simple model of the economy
where there is no foreign trade (a closed economy) and no government. There are only
households and firms who spend all their income and revenue.
• Households
o They own the wealth of the nation (stock of land, labor and capital). They
provide factor services to the firms. In return they receive factor payments
(income) in the form of wages, interest, rent and profits.
o They buy goods and services produced in the economy and in return make
payment (expenditure) to the firm.
• Firms
o They produce goods and services (output) by hiring factors of production and
make payment to these factors.
o Firms also invest and buy capital goods produced in the economy.
However, there are two more sectors of the economy – government and international trade.
• Government performs following functions:
o It buys some goods and services produced by the firms.
o It hires some of the factors of production.
• Foreign trade
o Some of the goods and services produced in an economy are exported to foreign
countries.
o Local expenditure of firms and consumers is not always on buying local goods
and services, they also spend on imports (i.e. products manufactured in foreign
countries).
The following figures describes the circular flow of income.
The inner circle shows the real flow of products and factor services. Products are purchased by
households, firms, and government and some of the products are also exported. Factor services
are hired by both firms and the government.
Outer circle shows the money flow of spending and incomes. Consumers buy goods and
services and make payment to the firms who in turn make payments to the factors of
production which becomes their income. In a simple case, it is assumed that all income is spent;
and that households and firms are the only sectors involved in economic activity. In practice,
some income is saved, some is taxed, and some is spent on imports. These are the withdrawals
from the circular flow of income. The withdrawals then equal:
35
Topic 7 – Circular flow of income
𝑊𝑖𝑡ℎ𝑑𝑟𝑎𝑤𝑎𝑙𝑠 (𝑊) = 𝑆𝑎𝑣𝑖𝑛𝑔𝑠 (𝑆) + 𝑇𝑎𝑥𝑒𝑠 (𝑇) + 𝐼𝑚𝑝𝑜𝑟𝑡𝑠 (𝑀)
𝑊𝑖𝑡ℎ𝑑𝑟𝑎𝑤𝑎𝑙𝑠 = 𝑆 + 𝑇 + 𝑀
Additionally, consumer spending is not the only expenditure that takes place in the economy.
Additional expenditure comes from investment, government spending, and spending by
foreigners on exports. These are the injections to the circular flow of income. The injections are
therefore equal to:
𝐼𝑛𝑗𝑒𝑐𝑡𝑖𝑜𝑛𝑠 (𝐽) = 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 (𝐼) + 𝐺𝑜𝑣𝑒𝑟𝑛𝑚𝑒𝑛𝑡 𝑠𝑝𝑒𝑛𝑑𝑖𝑛𝑔 (𝐺) + 𝐸𝑥𝑝𝑜𝑟𝑡𝑠 (𝑋)
𝐼𝑛𝑗𝑒𝑐𝑡𝑖𝑜𝑛𝑠 = 𝐼 + 𝐺 + 𝑋
36
Topic 8 – Aggregate expenditure
TOPIC 8: AGGREGATE EXPENDITURE

Aggregate expenditure is the total amount which will be spent at different levels of income at a
given time period. Total spending in a given time period is done by:
• Households (consumption);
• Firms (Investment);
• Government (Government spending); and
• Foreigners (Net exports).
Total spending can then be calculated as:
𝑇𝑜𝑡𝑎𝑙 𝑠𝑝𝑒𝑛𝑑𝑖𝑛𝑔
= 𝐶𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛 + 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 + 𝐺𝑜𝑣𝑒𝑟𝑛𝑚𝑒𝑛𝑡 𝑠𝑝𝑒𝑛𝑑𝑖𝑛𝑔 + 𝑁𝑒𝑡 𝑒𝑥𝑝𝑜𝑟𝑡𝑠
𝑇𝑜𝑡𝑎𝑙 𝑠𝑝𝑒𝑛𝑑𝑖𝑛𝑔 = 𝐶 + 𝐼 + 𝐺 + (𝑋 − 𝑀)
We will now discuss each component of aggregate expenditure separately to find out what
affects the amount spent in each component.
Consumption (consumer spending)

Consumption is the spending by households on goods and services to satisfy their current
needs, e.g. spending on food, clothes, travel and entertainment. Saving is what is not spent out
of income. This might take the firm of increasing the stock of cash, or an increase in money in a
bank or building society account, or it might take the form of stocks of shares.
The main influences on consumption are explained below.
• Level of disposable income

Disposable income is the income left after deducting direct taxes from and adding state
benefits to income. This is the amount that is available for consumers to spend.
𝐷𝑖𝑠𝑝𝑜𝑠𝑎𝑏𝑙𝑒 𝑖𝑛𝑐𝑜𝑚𝑒 = 𝐼𝑛𝑐𝑜𝑚𝑒 − 𝐷𝑖𝑟𝑒𝑐𝑡 𝑡𝑎𝑥𝑒𝑠 + 𝑆𝑡𝑎𝑡𝑒 𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠
o Higher the level of disposable income, higher will be the amount of spending
other things remaining same.
o An increase (decrease) in tax rates leads to a fall (rise) in disposable income
hence leading to a fall (rise) in spending.
o An increase (decrease) in state benefits leads to an increase (decrease) in
disposable income hence increasing (decreasing) spending.
37
• Propensity to consume (and propensity to save)

Average propensity to consume (apc) is the proportion of disposable income that is
spent.
𝐶𝑜𝑛𝑢𝑚𝑝𝑡𝑖𝑜𝑛 𝐶
𝑎𝑝𝑐 = =
𝐼𝑛𝑐𝑜𝑚𝑒 𝑌
𝑎𝑝𝑐 = 1 − 𝑎𝑝𝑠
o Total spending rises with rise in incomes, apc tends to fall with rise in income.
o At low income levels, there is dissaving, i.e. consumption is greater than
disposable income which is financed by either drawing from past savings or
through borrowing.
o As income rises, some of the income is saved and saving is equal to:
𝑆𝑎𝑣𝑖𝑛𝑔 = 𝐷𝑖𝑠𝑝𝑜𝑠𝑎𝑏𝑙𝑒 𝑖𝑛𝑐𝑜𝑚𝑒 − 𝑐𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛
o Hence, at low levels of income, apc is high and as income increases apc falls.
o Rich tend to have lower apc and higher aps.
Average propensity to save (aps) is the proportion of disposable income which is saved.
𝑆𝑎𝑣𝑖𝑛𝑔 𝑆
𝑎𝑝𝑠 = =
𝐼𝑛𝑐𝑜𝑚𝑒 𝑌
𝑎𝑝𝑠 = 1 − 𝑎𝑝𝑐
At low levels of income, there is dissaving (i.e. saving is negative). As income increases,
total savings and aps tend to increase.
Marginal propensity to consume (mpc) is the proportion of extra income which is spent.
Rich have lower mpc than poor.
∆𝐶
𝑚𝑝𝑐 =
∆𝑌
𝑚𝑝𝑐 = 1 − 𝑚𝑝𝑠
For the whole economy, the mpc is likely to be positive (greater than zero) but less than
one.
38
Marginal propensity to save (mps) is the proportion of extra income which is saved. Rich
tend to have higher mps than poor.
∆𝑆
𝑚𝑝𝑠 =
∆𝑌
𝑚𝑝𝑠 = 1 − 𝑚𝑝𝑐
The relationship between consumption and income can be shown using a consumption
function which shows the amount of consumption at different levels of income. A
simple, linear consumption function is given as:
𝐶 = 𝑎 + 𝑏𝑌
The y-intercept (a) shows the autonomous

consumption, i.e. the amount spent even when
income is zero. This is because of dissaving and
does not change with the level of income.
Slope (b) shows mpc and the term bY show

income-induced consumption, i.e. spending
which is dependent on income.
However, it is not realistic to assume that the

consumption function will be a straight line as
the mpc changes with a change in income. At
higher levels of income, mpc tends to be lower.
Therefore the consumption function will
increase at a decreasing rate as shown in the
figure.
The relationship between savings and income can be shown using a savings function
which shows the amount of saving at different levels of income. A simple, linear saving
function is given as:
𝑆 = −𝑎 + 𝑠𝑌
The y-intercept (–a) shows autonomous

dissaving, i.e. amount of savings that people
draw when income is zero. This does not
change with the level of income.
39
Slope (s) shows mps and the term sY shows income-induced saving, i.e. saving which is
determined by the level of income.
However, it is not realistic to assume that the saving function will be a straight line as
mps increases with increase in income. Therefore the saving function will increase at an
increasing rate as shown in the figure.
• Wealth
Wealth of a household is made up of two parts – physical wealth (houses, cars and
furniture), and monetary wealth (cash, stocks and shares, assurance policies, and
pension rights). Increase in wealth is likely to lead to increase in consumption (known as
wealth effect). There are two important ways in which the wealth of households can
change over a short time period.
o A change in price of houses. An increase in price of houses will encourage
households to borrow more money secured against the value of their home and
spend.
o A change in value of stocks and shares. An increase in price of stocks and shares
will encourage households to sell part of their portfolio and spend the proceeds.
Value of stocks and shares is affected by the rate of interest. Fall in rate of
interest leads to increase in price of shares and vice versa.
• Inflation
Inflation is a general increase in price levels. It leads to a fall in purchasing power of
households. A fall in purchasing power leads to a decrease in consumption.
• Income distribution
If income becomes more evenly distributed because of increase in direct tax rates and
state benefits, consumption is likely to increase. This happens because rich have lower
mpc than poor. If state transfers income from rich (taxing them) to poor (giving state
benefits), then rise in consumption by poor (having higher mpc) is greater than fall in
consumption by the rich (having lower mpc).
• Rate of interest
40
A fall in interest rates is likely to lead to higher consumption. This happens because of
three factors:
o Reduced returns on savings induce households to save less and spend more.
o Lower interest rates mean that it is cheaper to buy on credit hence increasing
demand for goods and services.
o Lower interest also decreases cost of previous borrowings that gives more
money to households to spend.
• Availability of credit
Easier access to loans and credit increases total spending in the economy.
• Expectations
If people are optimistic about the future (better job prospects, increase in salaries and
profits etc.) then they are likely to spend more. On the other hand pessimism (fear of
unemployment and reduced incomes) will encourage savings and discourage
consumption.
• Composition of households
Young people and old people tend to spend a higher proportion of their income than
those in middle age. Young people tend to spend all their income and move into debt to
finance the settings up of their homes and the bringing up of their children. In middle
age, the cost of homemaking declines as a proportion of income and household chose to
build up their stock of savings in preparation for retirement. Older people (retired) will
run down their stock of savings to supplement their pensions. If there is a change in age
composition of households in the economy, there could be change in consumption and
savings. The more young and the old the households, the greater will tend to be the level
of consumption.
41
Investment
Investment is spending by firms on capital goods such as factories, offices, machinery, vehicles
and like that. (NOTE: purchase of shares is not called investment in economics, rather it is
considered as saving.) Amount of investment in the economy is influenced by many factors
some of which are summarized below.
• Changes in consumer demand

An increase in consumer demand is likely to motivate firms to increase capacity that is
likely to increase investment in the economy. The overall impact of changes in demand
on investment is understood using the accelerator concept which is explained in a later
topic.
• Rate of interest
Fall in interest rates is likely to increase investment. Firms find it cheaper to borrow and
invest. Also firms with retained profits find that the opportunity cost of capital has
reduced which is likely to induce them to invest more. This can be explained by using
the concept of marginal efficiency of capital. Another reason why lower interest rates
affect investment is that lower interest is likely to increase consumer demand hence
affecting investment.
Marginal efficiency of capital (MEC) is the rate of return on an investment project. At

any point in time in the economy as a whole, there exists a large number of possible
individual investment projects. The following table shows MEC of different projects in an
economy. If the rate of interest is 20%, then firms having to borrow money will make a
loss if they undertake a project with MEC less than 20%. Hence, planned investment will
be $4 billion. At an interest rate of 5 %, all investment projects will with an MEC of 5% or
more will be profitable. Hence, planned investment will be $16 billion. So the conclusion
is that planned investment in the economy will rise if the rate of interest falls. This is
shown in the following figure.
MEC (% per year) Planned investment

($bn per year)
20 4
15 8
10 12
5 16
• Change in technology
New technology raises productivity of capital goods and firms are likely to switch to new
technology. This will raise the rate of return on investment projects. This raises the level
of planned investment at any given rate of interest. This leads to increase in investment
42
in the economy and a rightward shift in the planned investment schedule as shown in
the figure.
• Cost of capital goods

Fall in price of capital equipment or fall in installation of capital goods will lead to
increase in expected rate of return on investment projects leading to a rightward shift in
the planned investment schedule. Rise in price of capital goods will reduced the
expected return on investment projects leading to a leftward shit in the planned
investment schedule.
• Expectations
Optimism about future (improving economic conditions and likely increase in demand
for product) will encourage firms to invest more (rightward shift in investment
schedule). Pessimism will lead to lower levels of investment (leftward shift in
investment schedule).
• Government policy
Investor-friendly government policies can increase investment in the economy
(rightward shift in planned investment schedule). For instance, a reduction in corporate
taxes (taxes on company profits) and subsidies to firms is likely to leads to an increase in
private sector investment.
43
Government spending
Government spending includes spending by government on things such as health, education,
infrastructure development and like that. The size of government spending varies from country
to country. In a modern economy, government will fund defense, police, roads and education
(public and merit goods). In a free market economy, the private sector is expected to provide
more of these goods, but in a mixed economy, the state will provide many of these goods.
Budgets
Government announcements about changes in spending are made in budgets. Budgets are
annual plans of the government about its expenditures and sources of revenue (primarily
taxation). A balanced budget is a budget where government revenue is equal to government
expenditure. Governments seek to balance budgets in the LR however they face deficits or
surpluses more frequently. A budget deficit takes place when government expenditure is
greater than tax revenue. This will mean that the government will have to finance the deficit by
increasing its public sector borrowing requirement (PSBR). This is called deficit financing. A
budget surplus takes place when tax revenues are greater than government expenditure.
Government can use its surplus to reduce its PSBR.
Influences on government policy

Government spending is influenced by many factors.
• Government policy
Government spending takes place because of various reasons. Government may spend
to provide public and merit goods and services, and to provide products that are
considered to be strategically important, or may produce goods and services that
require a natural monopoly.
Government may also decide to increase economic activity by increasing spending. This
is especially true during recessions. Keynes suggested that the government can make its
way out of a recession by increasing government spending.
• Tax revenue
Higher tax revenues enables to a government to spend more without additional
borrowing.
• Other factors (e.g. demographic changes)

Demographic changes will force government to spend money to cater to their needs.
For instance an increase in the number of children will force government to invest in
education. Increase in number of elderly will force government to spend on healthcare
and state pensions.
44
Net exports (exports minus imports)

Net exports are equal to exports (goods and services sold to foreigners) less imports (goods and
services bought from foreigners). These are included in aggregate expenditure because some of
the goods that are produced in an economy are not sold in the country. They are purchased by
foreigners (exports) and hence must be included in aggregate expenditure to find out GDP.
Similarly, some of the expenditure by households, firms and government is on foreign
manufactured goods (imports) and since this is not a part of GDP, therefore, it must be
subtracted from aggregate expenditure. Net exports is influenced by many factors.
• Country’s GDP
Rise in country’s GDP is likely to lead to a higher demand for imports and vice versa.
• Other countries’ GDP

Rise in income levels in foreign countries is likely to increase demand for country’s
exports and vice versa.
• Relative price and quality competitiveness of country’s products

A lower price of country’s products (due to improved productivity, government
subsidies etc.) or a perception of a better quality product (achieved through marketing
and branding) is likely to give improved competitiveness to a country’s products leading
to an increase in exports and a fall in imports. Higher prices and poor quality are likely to
reduce net exports.
• Exchange rate
Depreciation (fall in value of exchange rate) will make exports cheaper and imports
more expensive. The quantity of exports must rise and the quantity of imports must fall.
The value of exports and imports will depend on the price elasticity of demand for
exports and imports. Elastic demand will mean that export revenue will increase and
import revenue will fall leading to an increase in net exports. Inelastic demand on the
other hand will lead to a fall in net exports.
Appreciation (rise in value of exchange rate) will reduce quantity of exports and increase
quantity of imports. Elastic demand will mean that net exports will fall. Inelastic
demand will mean that net exports will rise.
45
Topic 9 – Multiplier
TOPIC 9: MULTIPLIER
Multiplier is a numerical estimate of the relationship between a change in spending and a final
change in economic activity; this estimate and the formula by which it is derived can be used to
explain the process by which this change takes place. Multiplier effect explains the tendency for
a change in aggregate expenditure to result in a greater change in GDP. This happens because a
rise in expenditure creates income. Some of the additional income is spent that creates more
income. The initial injection hence creates a multiplier effect and the change in income is much
higher than the change in spending.
The procedure can be explained with the help of an example. Assuming no international trade
and government intervention and that mpc is equal to 80% (mps = 20%), an injection of a new
investment (an increased spending on new factories) of $200 million will lead to creation of
additional income equal to $1,000. This is explained in the table. The initial investment of
$200m creates additional income for factors of production equal to $200 million. Since mpc is
80%, $40 million is saved and an additional $160 million is spent in the economy.
Additional Additional This additional spending creates additional
Expenditure income Savings Expenditure income of $160 million out of which $32m is
200.00 200.00 40.00 160.00 saved and $128m is spent. This process
160.00 160.00 32.00 128.00 continues till the amount of withdrawals
128.00 128.00 25.60 102.40 (savings in this case) are equal to the initial
102.40 102.40 20.48 81.92 injection, i.e. GDP will rise until $200m of
81.92 81.92 16.38 65.54
additional spending is matched by $200m of
65.54 65.54 13.11 52.43
additional saving. By this time the total
52.43 10.49 41.94 amount of additional income that is created
52.43
is $1,000m which is 5 times more than the
initial injection.
Total 1,000 200
Value of multiplier
Value of multiplier can be calculated after change in income has occurred. The value of
multiplier is given as a change in income to a change in initial injection.
∆ 𝑖𝑛 𝑖𝑛𝑐𝑜𝑚𝑒 ∆𝑌
𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 = =
∆ 𝑖𝑛 𝑖𝑛𝑗𝑒𝑐𝑡𝑖𝑜𝑛 ∆𝐽
In the above example, the change in income was $1,000m and the change in injection was
$200m. Therefore, the value of multiplier was 5.
Value of multiplier can also be estimated in advance of the change. In this case it depends on
the marginal propensity to withdraw (savings, taxation and imports).
47
1
𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 =
𝑚𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑝𝑟𝑜𝑝𝑒𝑛𝑠𝑖𝑡𝑦 𝑡𝑜 𝑤𝑖𝑡ℎ𝑑𝑟𝑎𝑤
In the above example, the only withdrawal was savings and mps was 20% (0.2). The value of
multiplier was hence again equal to 5. If withdrawals from the circular flow are larger, less of
the increase in injection would have continued to flow round the economy creating a lower
increase in national income. The multiplier model hence states that the higher the withdrawals
(leakages) from the circular flow, the smaller will be the increase in income hence smaller the
value of the multiplier.
Multiplier in a two-sector economy

In a two sector economy with households and firms only with no government intervention and
international trade (closed economy)
• there is only one withdrawal – saving and
• only one injection – investment.
The value of multiplier is thus equal to:
1 1
𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 = =
𝑚𝑝𝑠 1 − 𝑚𝑝𝑐
In this model, income is either spent or saved. Equilibrium income will occur where:
𝐴𝑔𝑔𝑟𝑒𝑔𝑎𝑡𝑒 𝑒𝑥𝑝𝑒𝑑𝑖𝑡𝑢𝑟𝑒 = 𝑜𝑢𝑡𝑝𝑢𝑡

𝐶+𝐼 =𝑌
or
𝐼𝑛𝑗𝑒𝑐𝑡𝑖𝑜𝑛𝑠 = 𝑊𝑖𝑡ℎ𝑑𝑟𝑎𝑤𝑎𝑙𝑠
𝐼=𝑆
Multiplier in a three-sector economy

In a three sector economy with households, firms and government with no international trade
(closed economy)
• there are two withdrawals – saving and taxes and
• two injection – investment and government spending.
1
𝑚𝑝𝑠 + 𝑚𝑟𝑡
where mrt is marginal rate of taxation, i.e. the proportion of extra income that is taxed.
Equilibrium income will occur where:
48

𝐶+𝐼+𝐺 =𝑌
or
𝐼+𝐺 =𝑆+𝑇
Multiplier in a four-sector economy

In a four sector economy with households, firms, government and international trade (open
economy)
• there are three withdrawals – saving, taxes and imports and
• three injections – investment, government spending and exports.
1
𝑚𝑝𝑠 + 𝑚𝑟𝑡 + 𝑚𝑝𝑚
where mpm is marginal propensity to import, i.e. the proportion of extra income that is spent
on imports.
Equilibrium income will occur where:

𝐶 + 𝐼 + 𝐺 + (𝑋 − 𝑀) = 𝑌
or
𝐼+𝐺+𝑋 =𝑆+𝑇+𝑀
Factors that affect mps, mrt and mpm have been discussed in different parts of the course
(factors affecting mps and mpm were discussed in the previous topic).
Uses and Limitations

Multiplier is a useful concept that helps government is developing its policies. It is useful for the
government to estimate the amount of spending that is needed to overcome a deflationary gap
and remove unemployment. It also helps the government in deciding on spending cuts to
overcome inflationary gap and hence inflation.
However, there are limitations to this model.

• It is difficult to measure the exact size of the multiplier. The concept is most useful if
estimates are available before a policy prescription is accepted by the government. An
49
over- or under-estimation of the value of the multiplier will lead to creation of

inflationary and deflationary gaps (discussed in detail in a later topic).
• Changes can happen in the economy that can alter the size of the multiplier over time.
• The multiplier effect is not instantaneous. It takes time for money to flow round the
circular flow. Hence there are time lags between the increase in government spending
(or any injection) and the final increase in national income.
Examples from past papers
1. June 2006, Q20
Solution
apc = C/Y = 8,000/10,000 = 0.8 = mpc
Multiplier = 1/(1-mpc) = 1/0.2 = 5
Change in income = change in injection x multiplier = 100m x 5 = $500m
2. November 2005, Q19
Solution
M = 1/(mps+mpm)
mps = 1/6; mpm = 1/3
M = 1/((1/6)+(1/3)) = 2
3. November 2004, Q21
Solution
M = 1/(mps+mrt); mrt = 0.4;
To calculate mps, disposable income = 0.6; spend = 5/6 of disposable income = 5/6 x 0.6 = $0.5;
saving = $0.1; mps of total income = 0.1
M = 1/(0.1 + 0.4) = 2
50
Topic 10 – Income determination
TOPIC 10: INCOME DETERMINATION

Equilibrium level of national income can be determined by using the Keynesian 45° diagram.
The model predicts that the level of income is determined where aggregate expenditure is
equal to output.
Aggregate expenditure is the total amount which will be spent at different levels of income at a
given time period. Total spending in a given time period is done by:
• Households (consumption);
• Firms (Investment);
• Government (Government spending); and
• Foreigners (Net exports).
Total spending can then be calculated as:
𝑇𝑜𝑡𝑎𝑙 𝑠𝑝𝑒𝑛𝑑𝑖𝑛𝑔
= 𝐶𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛 + 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 + 𝐺𝑜𝑣𝑒𝑟𝑛𝑚𝑒𝑛𝑡 𝑠𝑝𝑒𝑛𝑑𝑖𝑛𝑔 + 𝑁𝑒𝑡 𝑒𝑥𝑝𝑜𝑟𝑡𝑠
𝑇𝑜𝑡𝑎𝑙 𝑠𝑝𝑒𝑛𝑑𝑖𝑛𝑔 = 𝐶 + 𝐼 + 𝐺 + (𝑋 − 𝑀)
Keynesian 45° diagram

The model is explained by use of a figure. The
45° line shows all combinations of points where
the value of two axes are equal, i.e. it shows all
points at which the level of aggregate
expenditure equals the level of output and
income. Hence, the 45° line shows all possible
points of equilibrium where aggregate
expenditure is equal to income and output.
Aggregate expenditure on the other hand is

equal to C+I+G+(X-M) and is shown on the graph as a separate line that starts above the origin
(because of autonomous expenditure). The point where the aggregate expenditure line cuts the
45° line is the point of equilibrium and the national income (GDP) must be equal to Q*. The
economy will always move toward this point. If there is any disequilibrium, there will be a
tendency in the economy to move toward this point.
• If aggregate expenditure is greater than current output (such as Q1)
o There is an incentive for firms to produce more.
o They will employ more factors of production.
o This will cause a rise in GDP.
o Economy move towards Q*.
51
• If aggregate expenditure is less than current output (such as Q2)

o Firms will reduce their production till the output matches aggregate expenditure.
o They will employ fewer factors of production causing a reduction in GDP.
o Economy move towards Q*.
It must be noted that induced expenditure (caused by a change in income) is represented as a

movement on the line and not a shift in the line.
Note: In the Keynesian model, prices are assumed to be constant; i.e. firms change their output
not their prices.
Shifts in aggregate expenditure

Aggregate expenditure will shift upward if there is:
• an increase in autonomous consumption
• an increase in investment (e.g. due to lower interest rates)
• an increase in government spending (e.g. expansionist fiscal policy)
• an increase in exports (e.g. due to a lower exchange rate)
• a decrease in imports (e.g. due to quotas)
Aggregate expenditure will shift downward if there is:

• a decrease in autonomous consumption
• a decrease in investment (e.g. due to pessimism)
• a decrease in government spending
• a decrease in exports (e.g. due to poor quality products)
• an increase in imports (e.g. due to removal of barriers)
The slope of the aggregate expenditure depends on mpc. A change in mpc will lead to a change
in the slope of AE line and hence a change in equilibrium. An increase in mpc will pivot the line
upward leading to an increase in GDP and a fall in mpc will pivot the line downward leading to a
fall in GDP.
The impact of an increase in aggregate expenditure

is explained below. Let us assume that there is an
increase in autonomous consumption. This will lead
to an increase in aggregate expenditure on all levels
of income and the aggregate expenditure curve will
shift upward as shown in the figure. This leads to
disequilibrium at the initial output level Q and the
economy starts moving toward a new equilibrium
Q1. Some key points that need to be understood
are listed below:
• Increase in aggregate expenditure is equal to LM.
52
• This results in an increase in output from Q to Q1.

• This is clear from the figure that the change in income and output level is greater than
the change in aggregate expenditure.
• Change in output level hence depends on the value of the multiplier. The higher the
value of the multiplier, higher will be the change (increase or decrease) in output levels
for a change (increase or decrease) in aggregate expenditure.
• We can also calculate the value of multiplier from the figure. Multiplier is equal to
change in income (output) divided by change in injection (aggregate expenditure).
Change in AE is equal to LM and change in income level is Q1 – Q. Therefore, multiplier is
equal to:
𝑄1 − 𝑄
𝐿𝑀
Keynesian policy to combat unemployment

Keynes suggests that an economy should increase government spending if it wants to overcome
unemployment in the short run. An increase in government spending will increase AE and will
lead to an increase in output level in the economy. This leads to more employment of factors of
production. According to Keynes, consumption and investment levels are not easily adjusted in
the SR because of a change in monetary or fiscal policy. Therefore, the government must
intervene to correct the disequilibrium and reduce unemployment in the economy by
increasing its spending.
Inflationary gap
Inflationary gap is a situation where there is
excess demand in the economy, above that
which is normally needed to ensure full
employment. Or we can say that inflationary gap
exists if the level of aggregate expenditure
exceeds the level of output at full employment.
This causes upward pressure on prices and leads
to inflationary pressure in the economy. This is
shown in the figure.
• Equilibrium level is Q*.
• Full employment level is Q1.
• The vertical distance between 45° line and the AE line is the inflationary gap.
• Inflationary gap is thus equal to distance ab.
• Inflationary gap depends on the value of the multiplier.
𝑄 ∗ − 𝑄1
𝑎𝑏
53
To overcome inflationary pressure, government can use deflationary fiscal or monetary policy
to reduce aggregate expenditure, such as reducing government spending, increasing taxes and
increasing interest rates (reduces consumption and investment), and reducing money supply
(reduces consumption and investment). However,
the government needs to have a good estimate of
the value of the multiplier to determine the
amount of inflationary gap.
• If value of multiplier is overestimated, this
will mean that government will reduce
spending by a less amount which means
that the inflationary gap will remain.
• If value of multiplier is underestimated,
this will mean that reduction in AE will be
greater than desired leading to
deflationary gap.
Deflationary gap
Deflationary gap is the difference between the level of demand in the economy and the level of
output that is needed to achieve a normal level of economic activity such as full employment.
This is also defined as a situation where the level
of aggregate expenditure is below the level of
output at full employment. This means that there
be unemployment in the economy. This is shown
in the figure.
• Equilibrium level is Q*.
• Full employment level is Q1.
• The vertical distance between 45° line and
the AE line is the deflationary gap.
• Deflationary gap is thus equal to distance
vw.
• Deflationary gap depends on the value of the multiplier.
𝑄1 − 𝑄 ∗
𝑣𝑤
To overcome unemployment in the economy, government can use expansionary fiscal or

monetary policy to increase aggregate expenditure, such as increasing government spending,
reducing taxes and reducing interest rates (increases consumption and investment), and
increasing money supply (increases consumption and investment). Keynes suggests that in SR
government will have to increase government spending financed by borrowing to reduce
unemployment. This is because consumption and investment may not increase rapidly
following a change in policy. This time lag means that unemployment will prevail for some
period of time. Hence the need for government to intervene and increase spending if it wants
54
to bring change in the SR. However, the government needs to have a good estimate of the
value of the multiplier to determine the amount
of deflationary gap.
• If value of multiplier is overestimated, this
will mean that government will increase
AE less than desired. This will mean that
deflationary gap will remain.
• If value of multiplier is underestimated,
the government will increase AE by a
higher amount leading to inflationary gap.
55
Withdrawals and injections

For income to be in equilibrium, it is necessary for injections of extra spending into circular flow
of income to be equal to withdrawals (leakages) from circular flow 1. Injections are autonomous
addition to the circular flow of income and include government spending, investment and
exports. Withdrawals (leakages) are autonomous withdrawals from circular flow of income
which does not give rise to a further round of income and include savings, taxation and imports.
Equilibrium income in two-sector economy

We are assuming a two-sector economy with households and firms only. The only injection is
Investment and the only withdrawal is Savings.
Equilibrium takes place where savings are equal to
investments. The following figure shows this
equilibrium.
• Investment is drawn as a straight line in this
diagram and is assumed to be unrelated to
the level of national income. Investment
tends to be related to interest rates and
expectations about the future level of
income rather than the present income level in the economy.
• Saving function has already been discussed in a previous topic. It starts below the origin
because of dissaving and the slope of the line represents mps.
• Equilibrium takes place where savings are equal to investment and the equilibrium
output is therefore Q*.
An increase in savings will lead to a fall in national income as shown in the figure.
• Saving increases by amount ab.
• This leads to a new equilibrium at Q1 which
is less than the previous output.
• Decision of households to save more leads
to lower income levels and hence lower
savings. This is referred to as paradox of
thrift.
• The extent of fall in output depends on the
value of multiplier.
Income = Expenditure = Output

Income = Consumption + Savings + Taxes = C + S+ T
Expenditure = C + I + G + (X – M)
Therefore,
C+I+G+X-M = C+S+T
Cancelling C and taking M to the right side
I+G+X=S+T+M
Injections = Withdrawals
56
• Value of multiplier in the figure is equal to
𝑄1 − 𝑄 ∗
𝑎𝑏
Equilibrium income in four-sector economy

We are assuming a four-sector economy with households, firms, government and international
trade. Injections include investments, government spending and exports and withdrawals
include savings, taxes and imports. Equilibrium
takes place where withdrawals (S+T+M) are equal
to injections (I+G+X). Figure shows this equilibrium.
• Investment, government spending and
exports are drawn as a straight line. It is
assumed that these are unrelated to
national income. Investment tends to be
related to interest rates and expectations
about the future level of income rather than
the present income level in the economy.
Government spending depends on government policy and not the level of income.
Government may or may not spend more in a boom or recession. Exports are also
assumed to be autonomous, i.e. they are unaffected by the level of national income.
Rather they are affected by comparative prices, quality and income levels in foreign
countries.
• Savings, taxes and imports are assumed to be related to income levels and they increase
with an increase in the national income depending on mps, mrt and mpm.
• Equilibrium takes place where withdrawals are equal to injections and equilibrium
output is therefore Q*.
An increase in tax rates (without change in government in spending) will lead to a fall in GDP as
• Taxes increase by amount ab.
• This leads to a new equilibrium at Q1 which
is less than the previous output.
• The extent of fall in output depends on the
value of multiplier.
𝑄 ∗ − 𝑄1
𝑎𝑏
An increase in government spending will lead to an increase in output levels.

• Government spending increases by amount ab.
57
• This leads to a new equilibrium at Q1 which is higher than previous output.

• The extent of rise in output depends on
the value of multiplier.
𝑄1 − 𝑄 ∗
𝑎𝑏
The following table summarizes the impact of

changes in injections and withdrawals on the
national income.
Change Impact on GDP

Increase in injections (I or G or X) Increase
Decrease in injections Decrease
Increase in withdrawals (S or T or M) Decrease
Decrease in withdrawals Increase
Combined impact (e.g. T + G) Uncertain (Decrease with increase in taxes;
rise with increase in government spending;
overall impact depends on the extent of the
two).
58
Topic 11 – Autonomous and induced investment;
Accelerator
TOPIC 11: AUTONOMOUS AND INDUCED INVESTMENT; ACCELERATOR

Autonomous investment is investment that is undertaken independently of changes in income,
e.g. firms may buy more capital goods because it is
more optimistic about the future or because the
rate of interest has fallen.
• An increase in autonomous investment
leads to an increase in aggregate
expenditure and a shift in the AE upwards.
This leads to an increase in output from Q to
Q1 and the amount of change in income
depends on the value of the multiplier.
• Autonomous investment can also decrease because of pessimism or increase in interest
rates leading to a downward shift in AE and a fall in income.
Induced investment is investment that is influenced by changes in income levels. As income

levels increase, demand in the economy increases that encourages firms to buy more capital
equipment. Firms only add to their capital stock if GDP continues to rise. Induced investment is
represented by a movement on the AE line. This process is explained by the concept of
accelerator.
Accelerator
Accelerator theory focuses on induced investment and emphasizes volatility of investment. It
links investment to changes in output in the economy. Accelerator theory states that
investment depends on the rate of change in income (hence consumer demand). It states that a
change in income will cause a greater proportionate change in investment. The accelerator
coefficient can be calculated as:
∆𝐼
𝐴𝑐𝑐𝑒𝑙𝑒𝑟𝑎𝑡𝑜𝑟 =
∆𝑌
It must be noted that accelerator theory suggests that changes in investment depends on the
rate of change in demand (income).
• If GDP is rising at a constant rate, induced investment will not change because firms will
continue to buy same number of machines each year to expand capacity.
• An increase in the rate of growth of income will have a significant impact on the level of
investment.
This can be explained with the use of a table. We are making following assumptions when
constructing the table:
• Firms start with eight machines
• One machine wears out every year
• Each machine produces 100 units per year
59
Accelerator
Year Consumer %Δ # of # of Replacement I Induced I Total I %Δ

demand machines machines
at start required
of period
1 800 - 8 8 1 0 1 -
2 1,000 25 8 10 1 2 3 200
3 1,600 60 10 16 1 6 7 133.3
4 1,800 12.5 16 18 1 2 3 (57.1)
5 1,800 0 18 18 1 0 1 (66.7)
6 1,700 (5.6) 18 17 0 0 0 (100)
The table illustrates the following points that support the statements made earlier.
• When demand for consumer goods rises by 25% in year 2, the demand for capital goods
rises by 200%.
• When the rate of growth in demand of consumer goods increase to 60% in year 3,
demand for capital goods still increases by 133%.
• Year 4 is unique in the sense that the demand for consumer goods has increased but the
rate of growth of demand has fallen from 60% to 12.5%. This leads to a fall in
investment by roughly 57%.
• In later years as consumer demand plateaus or falls, the level of investment keeps
falling.
Hence, the above discussion supports the assertion that change in investment depends on the
rate of change of growth in consumer demand and not the change in level of demand.
The simplest form of the accelerator theory can be expressed as:
𝐼𝑡 = 𝑎(𝑌𝑡 − 𝑌𝑡−1 )
where It is investment in time period t, Yt – Yt-1 is the change in real income during year t, and a
is the accelerator coefficient or capital-output ratio. Capital-output ratio is the amount of
capital needed in the economy to produce a given quantity of goods. So if $10 of capital is
needed to produce $2 of goods, then capital-output ratio is 5.
Limitations
There are however limitations of the theory, some of which are discussed below. Increase in
demand for consumer goods does not always result in greater percentage change in demand
for capital goods because of following reasons:
• firms may already have spare capacity and they do not need to invest more as demand
increases;
• firms do not expect rise in consumer demand to last hence they may not satisfy extra
demand by investing in capital goods;
60
Accelerator
• firms may not be able to buy as many capital goods as they wish may be because the
capital goods industry may be working close to full capacity;
• model assumes that capital-output ratio is constant over time, however, capital-output
ratio may change with advances in technology; i.e. fewer machines may be needed to
produce output;
• there are significant time lags before changes in investment respond to changes in
income.
The impact of above factors will be that the investment may not increase or may not increase
as expected because of changes in demand and income levels. Despite these qualifications,
evidence suggests that net investment is to some extent linked to past changes in income. The
link is however relatively weak suggesting that other influences must be at work to determine
investment. (These factors have already been discussed in a previous topic.)
61
Topic 12 – Money supply
TOPIC 12: MONEY SUPPLY

Money supply is the total amount of money circulating in the economy. Government measures
money supply to gain information about trends in aggregate demand, state of financial
markets, and need for and effectiveness of monetary policy.
Measuring money supply

Money is defined as an instrument that performs fours functions (medium of exchange, unit of
account, store of value, and a standard for deferred payment) and possesses certain
characteristics (acceptable, portable, durable, divisible, scarce, and difficult to copy). The extent
to which items carry out these functions varies and can change over time. Governments use a
variety of measures of money supply to reflect roles of particular items. There are two main
measures of money supply:
• Narrow money is money which is used as a medium of exchange and consists of

o notes and coins in circulation;
o cash held in banks; and
o balances held by banks at the central bank.
This is sometimes referred to as the monetary base.
• Broad money consist of

o all of the above plus
o range of items that are commensurate with money’s function as a store of value
(near monies, i.e. assets which fulfill some but not all of the functions of money.
In particular, they act as units of account and stores of value but cannot be used
as mediums of exchange. However, they are convertible into a medium of
exchange quickly and at little cost, e.g. time deposits.).
The standard measures of money supply used are shown in the following table.
Measure Definition
M0 Currency in the hands of the public plus reserves held on behalf of commercial
banks.
M1 Notes and coins outside the banking system plus current account balances.
M2 M1 plus short-term time and savings deposits, foreign currency transferable
deposits and repurchase agreements.
M3 M2 plus travelers cheques, short-term bank notes, long-term foreign currency time
deposits and money market mutual funds.
M4 M3 plus treasury bills, negotiable bonds and pension funds.
63
Sources of money supply

There are three main causes of increase in money supply:
• Increase in commercial bank lending;
• Increase in government spending financed by borrowing from the banking sector;
• More money entering than leaving the country.
Increase in money supply is one of the major causes of increase in aggregate demand and
government uses changes in money supply to affect the AD and hence level of inflation in the
economy and unemployment. The three sources of money are now discussed in more detail
below.
(i) Commercial bank lending and credit creation

Commercial banks create money when they lend. Loans made by banks (called an advance by
bankers) are credited to borrower’s account hence creating a new deposit. Banks can create
more deposits than they have cash and other liquid assets. The process is briefly described
below:
• From experience, banks have found that only a small proportion of deposits are cashed.
People tend to make large payments by making use of cheques, credits cards, electronic
transfers, and direct debits. This means of payments involve transfer of money using
entries in the records rather than paying out cash.
• Banks, therefore, do not have to hold cash equal to its deposits. It only needs to hold
cash equal to a small proportion of deposits. This shall satisfy the needs of the
customers. The proportion of liquid assets held by bank to total liabilities is called
liquidity ratio. The banks must be careful in calculating the liquidity ratio. Lower
liquidity ratio will mean that:
o the bank is able to lend more; but
o the must be able to meet customer’s demand for cash.
If they keep too low a ratio and people start to cash more of their deposits, then, there
is a risk of run on the banking system. Customers have to believe that there is enough
cash and liquid assets to pay out all their deposits even though, in practice, this is not
going to be the case.
• Extra loan that a bank gives will create a new deposit (e.g. $100).
• Bank will only keep a small proportion of the loan equal to the liquidity ratio (e.g. 10% =
$10) and will be able to lend the remaining amount ($90) to its customers.
• This extra lending ($90) creates extra deposit, and hence extra lending. The process
continues till the total liquidity reserves are equal to the initial loan ($100).
• The total amount of deposits and loans created are much higher than the initial loan
given by the bank.
• The amount of new deposits and advances created depend on the liquidity ratio and can
be predicted using credit multiplier.
64
Credit multiplier
Credit multiplier (also called bank or credit creation multiplier) shows by how much additional
liquid assets will enable banks to increase their liabilities. Value of credit multiplier depends on
the liquidity ratio. It can be calculated as:
𝑇𝑜𝑡𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑛𝑒𝑤 𝑑𝑒𝑝𝑜𝑠𝑖𝑡𝑠 𝑐𝑟𝑒𝑎𝑡𝑒𝑑

𝐶𝑟𝑒𝑑𝑖𝑡 𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 (𝐶. 𝑀. ) =
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑙𝑖𝑞𝑢𝑖𝑑 𝑎𝑠𝑠𝑒𝑡𝑠
For instance, if total deposits rise by $600m because of a new cash deposit of $100m, then, CM
is equal to 6 (600/100).
This can also be calculate using the liquidity ratio and is equal to:
100
𝐶. 𝑀. =
𝑙𝑖𝑞𝑢𝑖𝑑𝑖𝑡𝑦 𝑟𝑎𝑡𝑖𝑜
For example, if liquidity ratio is 10%, then, CM is equal to 10 (100/10).
This will help banks to calculate how much they can lend after an initial change in liquid asset.
This can be calculated using the following formula:
∆ 𝑖𝑛 𝑙𝑜𝑎𝑛𝑠 (𝑎𝑑𝑣𝑎𝑛𝑐𝑒𝑠) = ∆ 𝑖𝑛 𝑡𝑜𝑡𝑎𝑙 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 − ∆ 𝑖𝑛 𝑙𝑖𝑞𝑢𝑖𝑑 𝑎𝑠𝑠𝑒𝑡𝑠 (𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑑𝑒𝑝𝑜𝑠𝑖𝑡)
For example, if liquidity ratio is 10% and the liquid assets rise by $40m.
• CM = 100/liquidity ratio = 100/10 = 10
• Increase in total liabilities (or deposits) = Change in liquid assets x CM = 40 x 10 =
$400m
• Change in loans (advances) = Change in total liabilities – Change in liquid assets
= 400 – 40 = $360m
Banks, however, may not lend in practice as much as the CM implies because of:
• lack of firms and households wanting to borrow;
• lack of creditworthy borrowers.
If banks keep lending to borrowers with poor credit ratings (US sub-prime market), then this
can have serious consequences for bank’s liquidity and can create a financial crisis.
Banks may also change liquidity ratio if:

• people alter the proportion of their deposits they require as cash (higher withdrawals
lead to higher liquidity ratios);
• other banks alter their lending policies;
• country’s central bank requires banks to keep a set liquidity ratio (an increase in
statutory liquidity reserves reduces money supply).
65
Central banks may seek to interfere and influence commercial banks’ ability to lend. Central
banks may engage in open market operations, i.e. buying or selling government securities to
change bank lending.
• Sell government securities to the public to reduce bank loans. Purchasers will pay by
drawing on their deposits in commercial banks and so cause the commercial banks’
liquid assets to fall.
• Buy government securities leading to increase in banks’ deposits and hence increasing
their ability to give loans.
(ii) Deficit financing

If government spends more than it raises in taxation (budget deficit), then it will have to borrow
to finance the deficit. Government can borrow by selling government securities. The impact of
selling government securities on money supply will depend on how the securities are sold. The
following discussion highlights the issues.
• If it borrows by selling government securities (including National Savings Certificates) to
non-bank private sector (non-bank firms and the general public)
o Purchasers will be likely to draw money out of their bank deposits.
o Rise in liquid assets resulting from increased government spending.
o Fall in liquid assets as money is withdrawn.
o Since rise and fall in liquid assets are equal, there will be no impact on money
supply.
• If deficit financed by borrowing from central bank
o Government spends cheques drawn on the bank.
o Spending increases commercial banks’ liquid assets.
o Increases their ability to lend.
o Impact is an increase in money supply.
• If deficit financed by borrowing from commercial banks
o Government securities count as liquid assets.
o These can be used as a basis for loans (included in liquidity reserves).
o Government spending increases commercial banks’ deposits and their ability to
lend.
o Borrowing does not reduce their liquidity reserves and their ability to lend.
o The net impact is that the ability of commercial banks to lend increases leading
to an increase in money supply.
Note: Selling of government securities reduces money supply. If it is not used to finance budget
deficit, then the impact is a decrease in money supply. The above discussion is assuming that
the sale of government spending is being used to finance budget deficit.
(iii) Total currency flows of balance of payment
66
This refers to the total outflow or inflow of money resulting from international transactions as
recorded in the current account, financial account, capital account and balancing item.
• Net inflows of money into the country will be converted into local currency, hence,
leading to an increase in money supply.
• Net outflows of money will lead to a fall in money supply.
67
Topic 13 – Interest rate determination
TOPIC 13: INTEREST RATE DETERMINATION

Interest rate is the price of money. This is because lenders expect to receive interest if money is
supplied for loans to money markets. Equally, if money is demanded for loans from money
markets, borrowers expect to have to pay interest on the loans.
Monetarists and Keynesians disagree over how the rate of interest is determined.
• Most monetarists support the loanable funds theory, i.e. that the rate of interest is
determined by demand and supply of loanable funds.
• Keynesians argue that the rate of interest is determined by the demand and supply of
money.
Loanable funds theory

The loanable funds theory states that the rate of interest is determined by the demand and
supply of loanable funds.
Demand for loanable funds comes from:

• firms wanting to invest;
• households wanting to borrow and consume;
• government seeking to fund budget deficit.
Government demand is not very sensitive to a change
in interest rates. However, a rise in the rate of interest
will lower firms’ (refer to MEC) and households’
demand. The demand curve for loanable funds hence
slopes down from left to right.
Supply of loanable funds depends on:

• people’s willingness to save (and therefore funds which can be lent out)
• the ability of banks to lend.
Higher rates of interest will increase the return from
savings leading to increase in savings and supply of
loanable funds. The supply curve is therefore upward
sloping.
The rate of interest is determined where the demand

and the supply curves intersect as shown in the figure.
Demand curve and supply curve may shift over time.

Demand may increase because of positive expectations,
lower prices of goods, and favorable government policy. Supply may increase because of
increase in money supply and pessimism in the economy.
69
An increase in supply of loanable funds will lower rate of interest and cause an extension in
demand for loanable funds as shown in the figure.
Liquidity preference theory

Keynes developed liquidity preference theory to explain the demand for money. He identified
three main motives why households and firms may decide to hold part of their wealth in money
form. The three motives are:
• transactions motive
• precautionary motive
• speculative motive
(i) Transactions motive

Transaction motive is the desire to hold money to make everyday purchase and meet everyday
payments. The amount of money held is influenced by:
• income received – Generally, the more income received, the higher the amount which
will be held. This is because the higher the level of income, the greater will be the
spending in the economy. The more households spend, the more money they need to
use to complete transactions.
• frequency of income payments – Generally, the more infrequently the payments are
received, the higher the amount which will be held.
• price of goods and services – increase in price will mean that demand for money will
increase as households and firms will need more money to buy goods and services.
(ii) Precautionary motive

Precautionary motive is the desire to hold money to meet unexpected expenses and to take
advantage of unforeseen bargains.
Money resources held for transactions and

precautionary motives are sometimes referred to as
active balances as they are likely to be spent in the
near future. These expenses are relatively interest
inelastic so that a rise in the rate of interest will not
have a major impact on the money held for
transactions and precautionary motives.
(iii) Speculative motive

Speculative motive is the desire to hold money when households and firms believe that the
returns from holding financial assets are low. These are idle balances and are interest elastic,
i.e. are dependent on the rate of interest. At higher interest rates, the demand for money will
be low and at lower interest rates, demand for money will be high. This can be explained using
an example.
• One financial asset which firms and households may decide to hold is government
bonds (government securities which represent loans to the government).
70
• Price of government bonds are dependent on interest rates prevailing in the market.
• There is an inverse relationship between price of a bond and interest rates. At higher
interest rates, bonds have a low price and at lower interest rates, bonds have a higher
price. An increase in interest rates result in a decrease in price and vice versa.
• Households and firms are likely to hold money when price of bonds is high (low interest
rates) and is expected to fall. This is because
at higher prices, they will not be foregoing
much interest and because they will be
afraid of making a capital loss.
• Speculative demand for money will be low
when price of bonds is low (interest rates
are high) because now the expectation will
be that price of bonds may rise leading to
significant capital gains. Households and
firms will invest in bonds and will not hold a
lot of cash.
Combined demand should be downward sloping as

Interest rate determination (Keynesian theory)

Keynesians argue that interest rate is determined by demand and supply of money (and not
loanable funds). Demand for money is influenced
by three motives explained by liquidity
preference theory. Supply of money is
determined by the monetary authorities and is
fixed in the short run. Interest rate will be
determined where the combined demand (of
transactions, precautionary and speculative
motives) cuts the supply curve as shown in the
figure. In this case interest rate is R.
• At interest rates above R, there is excess
supply of money. Households start buying bonds which increases bond prices and
reduces interest rates. This takes them toward the equilibrium.
• At interest rates below R, there is excess demand of money. Households start selling
bonds leading to a fall in their price and increase in interest rates. This takes them
towards the equilibrium.
An increase in money supply by the government will lead to a fall in interest rates. The rate of
interest falls because:
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• rise in money supply will result in some households and firms having higher money
balances than they want to hold;
• they will use some of these extra balances
to buy financial assets;
• rise in demand for government bonds will
cause the price of bonds to rise;
• increase price of bonds means that the
interest rate has fallen.
An increase in demand for money (higher income
levels, higher price levels, less frequent payment
of income, or an increase in perceived risk of
holding non-monetary assets such as bonds or
shares) will lead to higher interest rates.
Liquidity trap
Liquidity trap is a situation described by Keynes where it would not be possible to drive down
the rate of interest by increasing money supply. This is likely to occur when rate of interest is
very low and price of bonds very high.
• Speculators would expect price of bonds to fall in the future,
• if the money supply is increased, they would
hold all extra money;
• they would not buy bonds for fear of making
a capital loss and because the return from
holding such securities would be low.
The figure shows that at rate of interest R, demand

for money becomes perfectly elastic and increase in
money supply has no effect on the rate of interest.
Different markets, different rates of interest

We have assumed that there is one market for money and one equilibrium rate of interest in
the economy. In reality, there are many markets for money and many rates of interest in an
economy, e.g. the Treasury Bill market, credit card market, and mortgage market. If all these
markets were perfect, and all loans and borrowings were identical, then the rate of interest in
all markets would be the same. But there are many barriers between markets and loans which
are not identical. Hence, interest rates differ. The rates of interest in different markets are
however linked with each other. If interest rates are increased by the central banks, the major
banks respond by increasing their interest rates too. There is hence a ripple effect into the rest
of the economy and the interest rates tend to increase throughout.
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Topic 14 – Quantity theory of money
TOPIC 14: QUANTITY THEORY OF MONEY

Monetarists believe that change in money supply will have a significant impact on the price
level of a country. They believe that changes in money supply cause an equal percent change in
price levels. This can be explained using the Fisher equation.
𝑀𝑉 = 𝑃𝑇
where
M = Money supply
V = Velocity of circulation of money; the number of times money changes hands over a
period of time
P = Price levels
T = Transactions (total number) made over a period of time or output in the economy
(also represents real GDP)
Both sides represent total expenditure (GDP) in the economy. Monetarists say that V and T
remain constant in the SR and are unaffected by changes in money supply. Changes in money
supply hence bring same proportionate change in price levels. For example, if M=100, V=5, P=2,
T=250, then, keeping V and T constant, a rise of money by 50% (M=150) will cause price levels
to increase by 50% (P=3). This is explained below.
MV = PT
Initially, 100 x 5 = 2 x 250 = 500
If money supply increase to 150, then keeping V and T constant
MV = 150 x 5 = 750 = PT = P x 250
Therefore,
P=3
Keynesians however dispute validity of quantity theory. They argue that changes in money
supply can affect any or all of the three variables (V, T and P), therefore, it is not possible to
predict the impact on price levels following a change in money supply. For example, if in the
above example, M rises by 50% (M=150), V rises by 20% (V=6), T rises by 40% (T=350) then P
will rise by 30% (P=2.6).
MV = PT; 150 x 6 = 900 = P x 350; P ≈ 2.6
or MV = PT
+50% +20% = change in P +40%; Change in P = +30%
Remember that
• Change in T represents change in real GDP;
• Change in MV or PT represent change in monetary GDP.
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Topic 15 – Unemployment
TOPIC 15: UNEMPLOYMENT

Unemployment refers to a situation where people are both able and willing to work but are
unable to find a job. Economists measure both level of unemployment and rate of
unemployment.
• Level of unemployment refers to the number of people who are unemployed.
Unemployment will increase over time because:
o Number of workers gaining jobs is less than the number of people losing their
jobs.
o There is a rise in the number of people seeking work but the number of jobs in
the economy remains static.
• Rate of unemployment refers to the number of people unemployed as a percentage of
the number of people in the labor force. It is more realistic to use the rate of
unemployment as a measure of unemployment because the number of people in labor
force change over time hence leading to a change in the level of unemployment.
Similarly different countries have different sizes of population and hence different levels
of unemployment. For comparing unemployment over time or across countries, it is
more useful to use rate of unemployment.
Drawbacks (costs) of unemployment

LR unemployment is considered to be a great social evil and following drawbacks are associated
with unemployment.
For those who are unemployed and their dependents
• Lower incomes
• Mental and physical illness
o Unemployment is often equated with failure both by the unemployed and by
society in general. Studies suggest that unemployed suffer from a wide range of
social problems including
 above average incidence of stress,
 high rates of divorce,
 suicide,
 physical illness and mental instability,
 and that they have higher death rates.
• Evidence suggests that the longer the person is out of work, the less likely it is that the
unemployed person will find a job. This is because of two reasons.
o Being out of work reduces the human capital of workers. They miss out on
training and work experience and are not able to learn latest developments in
their occupation.
o Employers use length of time out of work as a crude way of sifting through
applicants for a job.
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For the local communities

• Higher levels of crime
• Violence on the streets and vandalism (London riots of 2011)
• Areas of high unemployment tend to become run down.
o Shops go out of business.
o Households have no spare money to look after their properties and their
gardens.
o Increased vandalism further destroys the environment.
For taxpayers
• Tax payers have to pay more taxes because:
o government has to pay out increased benefits to the unemployed; and
o government loses revenue because unemployed would have paid taxes if they
had been employed.
For the whole economy

• Country’s output will be below its potential level (working inside PPC – use graph to
show this)
• There are social costs such as increased violence and depression which are borne by the
unemployed and the communities in which they live.
Full employment and Natural rate of unemployment

Full employment is a debatable topic and is often considered to be achieved when
unemployment falls below 4% (this varies a lot between different countries). This is because at
any particular time some people may be experiencing a period of unemployment as they move
from one job to another job.
Natural rate of unemployment or non-accelerating inflation rate of unemployment (Nairu) is

the level of unemployment which exists when the aggregate demand for labor equals the
aggregate supply of labor at the current wage rate and so there is no upward pressure on the
wage rate and the price levels. The inflation rate is constant, with the actual inflation rate
equaling the expected inflation rate. This is largely a monetarist concept.
Monetarists argue that natural rate of unemployment cannot be reduced in the LR by

expansionary monetary or fiscal policy. It can however change over time. Factors which
determine the natural rate of unemployment are supply-side factors. Over time natural rate of
unemployment may fall as a result of:
• an increase in labor mobility
• an improvement in the education and training of workers
• a reduction in trade union restrictive practices
• a reduction in state unemployment benefits
• a cut in income tax.
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Measuring unemployment
There are two main methods of measuring unemployment:
• Claimant count
• Labor force survey
(i) Claimant count

It measures the number of people in receipt of unemployment-related benefits.
The advantages of this method are:

• It is relatively cheap and quick to calculate. It is based on information that government
collects as it pays out benefits.
However, the figure obtained may not be entirely accurate. The limitations of this method are
listed below.
• It may include some people who are not really unemployed.
o Some of those receiving unemployment benefit may not be actively seeking
employment (voluntary unemployment).
o Some may be working and claiming benefit illegally.
• It may omit some people who are genuinely unemployed.
o There may be a number of groups who are actively seeking employment but do
not appear in the official figures. These groups may include:
 elderly,
 those below a certain minimum age,
 those on government training schemes,
 married women looking to return to work, and
 those who do not choose to claim benefits.
• The measure changes every time there is a change in the criteria for qualifying for
benefits.
• Cross-country comparisons of unemployment may be difficult as different countries may
have different criteria for qualifying for benefits.
(ii) Labor force survey

It uses the International Labor Organization (ILO) definition of unemployment which includes as
unemployed all people of working age who, in a specified period, are without work, but who
are available for work in the next two weeks and who are seeking paid employment. In this
method government carries out Labor Force Survey (LFS) from a sample and estimates
unemployment based on the above definition. ILO unemployment tends to be above claimant
count unemployment in a recovery and boom situation, but roughly equal to it in a recession.
The benefits of using this approach are as follows:
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• It picks up some of the groups not included in the first measure (such as those not
claiming benefits, and married women looking to return to work).
• It makes international comparisons easier as they measure is based on internationally
agreed concepts and definitions.
However, the measure has certain limitations that are listed below.
• Data are more expensive and time consuming to collect than the unemployment benefit
measure.
• The data is subject to sampling errors.
• There are a lot of practical problems of data collection.
Reasons why ILO figures vary significantly (higher unemployment) from Claimant count
The reasons why ILO figures may vary significantly from claimant count figures may include the
following.
• Many female unemployed workers may be actively seeking work (included in ILO
figures) but may be excluded from claimant count because their partners earn so much
that they do not qualify for benefit.
• Older workers (in 50s or 60s) may be collecting a pension and do not qualify for
receiving benefits (not included in claimant count) but may be looking for work
(included in ILO count).
• Workers who are made unemployed cannot claim benefit for a number of weeks (not
included in claimant count) though they would be counted as unemployed in ILO survey.
Reasons why both methods may underestimate overall unemployment

The reasons may include the following.
• They do not include part-time workers, e.g. if you are working a few hours a week but
seeking a full-time job you would not be counted.
• Anyone on government training and work scheme will not be counted even if they
would want to work full time.
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Causes (Types) of unemployment

Monetarists believe that even at the natural rate of unemployment, when the labor market is in
equilibrium, some people will still be unemployed. These are the people who are not able or
willing to work at the current wage rate. This equilibrium unemployment can be divided into
two main categories:
• Frictional unemployment
• Structural unemployment
Keynesians however think that, in addition to these causes of unemployment, people can be
without work because of a lack of aggregate demand. This will affect the whole economy and is
referred to:
• Cyclical unemployment or demand-deficient unemployment
(i) Frictional unemployment

Frictional unemployment is unemployment which arises when workers are between jobs. There
will always be frictional unemployment in a free market economy and it is not regarded by
most economists as a serious problem. The higher the level of unemployment benefits or
redundancy pay, the longer workers will be able to afford to search for a good job without
being forced into total poverty. The different forms of frictional unemployment are described
below.
• Search unemployment
This arises when workers do not accept the first job or jobs on offer but spend time
looking for a better-paid job. This also arises when employers hold out in the hope of
recruiting more productive workers. The better the job information available to
unemployed workers through newspapers, job centers etc., the shorter the time
workers should need to spend searching for jobs, the lower will the rate of
unemployment.
• Causal unemployment
It refers to workers who are out of work between periods of employment including, for
example, actors, TV script writers, and roof repairers.
• Seasonal unemployment
In the case of seasonal unemployment, demand for workers fluctuates according to the
time of the year. During certain periods of the year, people working in the tourist,
building and farming industries may be out of work. There is little that can be done to
prevent this pattern occurring in a market economy where the demand for labor varies
through the year.
(ii) Structural unemployment

Structural unemployment is the unemployment that arises due to changes in the structure of
the economy. Over time the pattern of demand and supply changes. Some industries expand
and some contract. There will be employment opportunities in those industries that are
expanding and there will be unemployment in those industries that are contracting. However
because of labor immobility, workers may not move smoothly between industries leading to
structural unemployment. There are various forms of structural unemployment.
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• Technological unemployment
In this case, people are out of work because of introduction of labor-saving techniques.
For instance, in many EU countries a high number of banking staff have lost their jobs in
recent years with the introduction of telephone and internet banking.
• Regional unemployment
This refers to unemployment occurring in particular areas of the country due to change
in structure of the economy. This primarily happens because of geographical immobility
of workers.
• Sectoral unemployment
This refers to unemployment that takes place in certain sectors of the economy. For
instance, the steel and shipbuilding industries in the UK declined sharply in the late
1970s and early 1980s leaving a considerable number of skilled workers unemployed.
The problem persisted because of occupational immobility where the skills of the
workers were not needed in other sectors of the economy and the workers had to be
retrained before finding employment in other sectors.
• International unemployment
This occurs when workers lose their jobs because demand switches from their industries
to more competitive foreign industries. This occurs in many developed economies when
manufacturing industries move to developing countries where costs are lower.
(iii) Cyclical unemployment

According to Keynes, cyclical unemployment results from a lack of aggregate demand. This
affects the whole economy and results in unemployment. The figure shows the labor market
initially at equilibrium at wage rate W (aggregate demand for labor is ADL1 and aggregate
supply of labor is ASL).
• Then there is a fall in aggregate demand.
• As a result of a fall in aggregate demand, firms reduce their output.
• Reduced output leads to decrease in aggregate demand for labor and the curve shifts to
ADL2.
• If workers resist wage cuts, then demand-
deficient unemployment of Q1 – Q2 will exist.
• Even if wage rates fall, this type of
unemployment may persist. This is because a
cut in wages would reduce demand for
goods and services further, which would
cause firms to cut back their output further
and make more workers redundant.
Frictional and structural unemployment are caused

by supply side factors whereas cyclical unemployment is caused by a lack of demand in the
economy. Aggregate demand and supply analysis can be used to distinguish between demand
side and supply side causes of unemployment. The following figure shows an economy in short
run equilibrium at output level OA.
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• SR equilibrium at output level OA. Output at

OA does not represent the productive
potential of the economy.
• LRAS curve is to the right at OB. OB
represents the productive potential of the
economy.
• There is cyclical or demand-deficient
unemployment at point OA and the
economy is in recession.
o An increase in aggregate demand from AD1 to AD2 will restore full employment.
o Government can use expansionary fiscal (reduction in tax rates and increase in
government spending) and/or monetary (increase in money supply and decrease
in interest rates) policies to increase aggregate demand.
• Supply side causes of unemployment include frictional and structural unemployment. At
full employment level OB, there is likely to be some frictional and structural
unemployment. This is because the LRAS curve is drawn on the assumption that there
are limited resources and markets may work imperfectly.
o Some workers may be structurally unemployed because they do not have the
right skills for the jobs on offer in the market. Training and education will enable
workers to acquire new skills and get employed. This will lead to rightward shift
of LRAS curve.
o A fall in frictional and structural unemployment is shown by a rightward shift of
the LRAS curve.
Cyclical unemployment is also called involuntary unemployment because unemployed workers

cannot choose to go back to work, because there are no jobs available. All other types of
unemployment (frictional and structural) are examples of voluntary unemployment because
people refuse opportunities of work at existing wage rates. Seasonal workers can find odd jobs
(at low wages) that they can fill in the months where they are out of work from their main
occupation. Structurally unemployed could get a job if they were prepared to accept a lower
rate of pay or worse conditions of work. Natural rate of unemployment is then the percentage
of workers who are voluntarily unemployed. The economy is said to be at full employment
when there is no involuntary unemployment in the economy.
All economies have been affected by the global downturn since 2008.The ILO estimated that by
the end of 2009 global unemployment would be about 220 million, a rate of around 7%. In the
US, the unemployment rate in mid-2009 was higher at 8.1%, whilst in Japan it was at its highest
ever since 1960 of 4.4%. In South Africa, the unemployment rate was a massive 21.9%.
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Phillips curve and the relationship between inflation and unemployment

Phillips curve is a result of research done by a New Zealand economist, Bill Phillips, on the
relationship between rate of change of money wage rates (an indicator of inflation inflation)
and unemployment. He analyzed the relationship between changes in money wages (taken as
an indicator of inflation) and unemployment in
UK over the period 1861 – 1957. He found an
inverse relationship between the two as shown in
the figure.
• A fall in unemployment may cause rise in
inflation. This occurs because lower
unemployment leads to higher aggregate
demand which then leads to higher price
levels. Rise in inflation also puts upward
pressure on wages as workers demand
higher salaries.
• Higher unemployment leads to lower growth in money wages because workers press
less strongly for wage increases when fewer alternative jobs are available and because
firms resist wage demand more firmly when profits were level (as in times of high
unemployment).
The traditional Phillips curve suggests a trade-off theory of inflation, i.e. that a government can
select its optimum combination of inflation and unemployment and can trade off the two.
Government cannot simultaneously achieve twin objectives of lower inflation and lower
unemployment. If government decides to lower unemployment, it must accept that it will lead
to higher inflation. However, this interpretation is questioned by monetarists.
Monetarist view
Monetarists argue that the trade-off between inflation and unemployment is only in the short
run. In the long-run, expansionary fiscal or monetary policies will have no impact on
unemployment, but will only raise the inflation rate. This is explained through the long run
Phillips curve or the expectations-augmented Phillips curve.
Long run Phillip curve (expectations-augmented Phillips curve)

According to Milton Friedman, natural rate of
unemployment will not change in the long run
because of an expansionary monetary or fiscal
policy. These will only lead to inflation in the
economy. He therefore suggests that the long
run Phillips curve (LRPC) will be a straight line as
shown in the figure and will depend on the
natural rate of unemployment. Expansionary
fiscal or monetary policy will only reduce
unemployment in the short run and the long run
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impact will be that the economy will move back to the natural rate (U*) only with a higher rate
of inflation. The process is explained below.
• Period 1
o The economy is at its LR equilibrium, i.e. natural rate of unemployment, at point
A. There are no demand and supply surprises.
• Period 2
o Government starts expansionary monetary (increase money supply and reduce
interest rates) or fiscal (reduce taxes and increase government spending) policy.
o This results in rapid increase in output, firms recruit worker more vigorously, and
this results in reduction of unemployment rate.
o Output exceeds its potential, capacity utilization rises, firms increase prices
(there is excess demand), and wages and prices begin to accelerate.
o The result is that the economy moves up and to the left on SRPC1 to point B.
o Lower unemployment rate therefore raises inflation.
o The key point is that during this phase inflation expectations remain unchanged.
o The short run trade off occurs because of money illusion where employees join
the workforce as they see a rise in money wages and not their real wages.
• Period 3
o Firms and workers begin to expect higher inflation as wages and price rise.
o Higher expected rate of inflation is incorporated into wages and pricing
decisions.
o Higher expected rate of inflation thus shifts the SRPC upward to SRPC2 and the
economy moves to point C.
• Period 4
o Higher expected rates of inflation lead to very high increase in wages and prices.
o Firms see their profits declining and in some cases start incurring losses.
Consumers find prices to be very high.
o Consumers decide to reduce consumption and firms decide to reduce output.
o This leads to contraction in the economy which brings output back to its
potential.
o Unemployment rate returns to the natural rate.
o Inflation declines because of higher unemployment but the rate of inflation is
higher in period 4 than in period 1.
The long run Phillips curve (LRPC) hence establishes that as long as:
• unemployment is less than natural rate, inflation tends to increase; and
• if unemployment is less greater than natural rate, inflation tends to fall.
• Stability is achieved when unemployment is equal to natural rate of unemployment (on
LRPC). At this point, inflation neither increases nor decreases. Hence, the only level of
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unemployment consistent with stable inflation rate is natural rate of unemployment.

LRPC must therefore be drawn as a vertical line rising straight up at natural rate of
unemployment.
This has many implications for economic policy.

• LRPC shows the minimum level of unemployment that an economy can sustain in the
LR. Nations cannot push unemployment below the natural rate for long without igniting
upward spiral of wage and price inflation.
• Nation may be able to ride SRPC by using expansionist policies. It will drive
unemployment rate below the natural rate in the SR but will eventually lead to rising
inflation and the unemployment will get back to the natural rate.
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Topic 16 – Relationship between internal and external
value of money
TOPIC 16: RELATIONSHIP BETWEEN INTERNAL AND EXTERNAL VALUE OF MONEY

Internal value of money refers to the purchasing power of money and is affected by the rate of
inflation. Higher rates of inflation will reduce the purchasing power of money. External value of
money refers to the exchange rate of the country’s currency. The internal value country’s
currency is closely connected to its external value. Let us understand this using a scenario.
• Scenario – Higher inflation rate in country A than in country B (its competitor)

o Higher inflation means higher prices in country A and the value of country A’s
currency falls.
o Higher prices in country A will lead to fall in demand for its products
internationally (lower exports).
o Results in fall in demand for country A’s
currency.
o Lower prices in country B means that
imports into the country will increase.
o Results in increase in supply of country
A’s currency.
o Fall in demand and increase in supply of
country A’s currency results in
depreciation of country A’s currency.
• Depreciation of currency affects internal purchasing power of country’s money.
o Raises price of country’s imports in terms of local currency.
o Each unit of currency now buys fewer of the now more expensive finished
imported products. This means a reduction in purchasing power of currency.
o Depreciation also leads to increase in price of imported raw material. This drives
up the prices of domestically produced goods leading to a reduction in
purchasing power of money.
o Another reason for increase in price levels is that depreciation makes exports
cheaper leading to an increase in demand for exports. This increases aggregate
demand in the economy leading to increase in price levels.
o Depreciation hence fuels local inflation and leads to a reduction in the
purchasing power of currency.
Lower inflation in country A, on the other hand, will lead to higher exports and lower imports
leading to appreciation of country’s currency. An appreciation of currency moderates inflation
for two reasons:
• Higher exchange rate leads to a fall in import prices, which then feeds through to lower
domestic prices.
• Higher exchange rate leads to a fall in aggregate demand. Exports will fall and imports
will rise. Fall in aggregate demand leads to a fall in price levels. The extent to which
aggregate demand falls depends upon the price elasticity of demand for exports and
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Topic 16 – Relationship between internal and external
value of money
imports. The higher the price elasticities, the greater will be the change in export and
import volumes to changes in prices brought about by the exchange rate movement.
The internal and external values of the money therefore tend to be directly related.
86
Topic 17 – Relationship between balance of payments and
inflation
TOPIC 17: RELATIONSHIP BETWEEN BALANCE OF PAYMENTS AND INFLATION

Balance of payments is financial record of the international trading transactions of a country.
Inflation refers to general and sustained increase in price levels in the economy.
Marshall-Lerner condition
Marshall-Lerner condition states that a fall or devaluation of the exchange rate will improve a
balance of payments deficit when the combined price elasticities of demand for exports and
imports are greater than one. If demand for exports and imports is price-elastic, a fall in
exchange rate will result in a rise in export revenue and reduced import expenditure hence
leading to improvement in balance of payments.
However, rise in exports leads to a rise in demand for locally produced goods and services and a
depreciation of local currency. This can lead to rise in rate of inflation because of:
• increase in aggregate demand of locally produced goods (increased exports);
• increase in local price of imported goods; and
• increase in price of imported raw material (fuelling cost-push inflation).
This rise in inflation can lead to worsening of balance of payments in the long run.
J-curve effect
J-curve effect is explained for a single change (depreciation or appreciation) in exchange rate of
a currency. In some countries, fall in exchange rate will actually worsen the balance of
payments deficits before it improves it as shown
in the figure.
• This happens because in the SR, demand
for exports and imports tends to be
inelastic.
o A fall in exchange and subsequent
fall in price of exports and rise in
price of imports means that the
export revenue will fall and import
revenue will increase.
o This leads to a deterioration of balance of payments.
o Demand for exports and imports are inelastic in the SR because:
 Many countries need to import raw materials, supplies and components
for producing their exports.
 Many contracts are fixed and cannot be changed in the SR.
 There may be no alternative domestic supplier (in case of imports) and
hence firms may need to keep importing.
• In the LR, demand for exports and imports tends to become price-elastic.
o In the LR, contracts can be revised and domestic producers can increase supply,
thus leading to a reduction in import volumes.
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Topic 17 – Relationship between balance of payments and
inflation
o The impact of price changes (fall in price of exports and rise in price of imports)
in the LR therefore should be that the export revenue will increase and import
revenue will fall.
o This leads to improvement in the balance of payments.
We can also draw a reverse J-curve to show the impact of one time appreciation of country’s
currency. If the demand for imports and exports are
inelastic in the short run, then an appreciation will lead
to improvement in balance of payments in the short
run. However, as demand become elastic in the long-
run, the impact of appreciation will be a deterioration of
balance of payments. This is shown in the figure.
Comparative inflation rates

If a country’s inflation rate rises above that of its main
competitors, its price competitiveness will fall. Prices
will rise more rapidly in the country than price rise in competing countries. This will result in
reduction in exports (country has become less competitive) and rise in imports (competitors
have become more competitive). This leads to deterioration in balance of payments.
If country’s inflation rate falls below that of its main competitors, its price competitiveness will
improve leading to increase in exports and fall in imports. This will lead to improvement in
balance of payments.
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Topic 18 – Fiscal Policy
TOPIC 18: FISCAL POLICY

Fiscal policy deals with decisions about spending, taxes and borrowing of the government. The
fiscal policy of the government is usually formulated and announced in the form of an annual
budget that outlines the revenues and expenditures of the government for the forthcoming
year.
• Main source of revenue for the government are taxes. These can be direct or indirect
taxes, corporate tax, wealth tax and like that.
• The main areas of public spending can be defence, education, roads, health and like
that.
• Government is said to have a balanced budget if revenues are equal to expenditure. This
rarely happens although most of the governments may set this as a long term aim.
• In most years, there are budget deficits when spending exceeds revenues. Government
will have to increase its borrowing (PSBR – Public Sector Borrowing Requirement) to
finance budget deficit.
• Budget surplus (again rare) is said to happen when revenues exceed expenditures. This
allows the government to pay back some of its debt.
Objectives of fiscal policy

Fiscal policy as an instrument of policy is used to achieve three main policy goals or objectives.
• To improve macroeconomic performance by having lower unemployment, lower
inflation, higher economic growth and better BoP. It does this by influencing demand
side of the economy.
• To achieve a more desirable distribution of income and wealth by taxing the rich and
providing benefits to the poor.
• To correct market failure at the microeconomic level by providing public and merit
goods, taxing consumption of demerit goods and negative externalities, providing
subsidies on production of positive externalities, improving mobility of labor and
increasing competition in product markets.
Fiscal policy and Aggregate demand (and expenditure)

Government’s fiscal policy can have a direct impact on the aggregate expenditure and hence
the level of income and employment in the economy.
Expansionary fiscal policy

An expansionary fiscal policy refers to fiscal policy that is used to increase aggregate demand. It
involves lowering of tax rates and an increase in government spending. Lower tax rates have an
impact on both consumption and investment. Consumer will find that with lower tax rates their
disposable income has increased. This will encourage them to spend more. For firms, lower tax
rates will have multiple effects. First, it will increase their product’s demand as consumers
spend more. Second, firms will have higher retained profits that lead to higher investment.
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Third, lower taxes will increase return from prospective projects that lead to increase in
investment. Higher government spending will usually increase demand in those sectors where
the government decides to invest, for instance in education, construction and defence.
• Expansionary fiscal policy therefore leads to an increase in aggregate expenditure.
• The impact of this on income and employment depends on many things such as the
value of the multiplier, and whether there is an inflationary or a deflationary gap. (For
more details on this, refer to topic 10.)
• If the economy was in recession or there was a deflationary gap, this policy should lead
to an increase in output, income and employment. This should lead to improvement in
the living standard.
• However, if the economy was already operating close to the full employment level
(inflationary gap), then, this can lead to a rise in inflation. Monetarists would argue that
this will not have any impact on unemployment in the LR. It will only cause a rise in
inflation.
• Another problem that can arise due to increase in aggregate demand is that it can lead
to an increase in imports and deterioration in the balance of payments.
• Higher aggregate demand also leads to environmental damage as more natural
resources are used.
• Rise is demand also usually leads to a change in income distribution where rich tend to
become richer.
• Keynesians generally prefer and recommend that to overcome recession, government
should increase government spending. The resulting increase in aggregate expenditure
and its multiplier effect should take the economy out of recession. They believe that
lower tax rates will have a slower impact as firms and consumers are slow to react to
this initiative.
Deflationary or contractionary fiscal policy

A deflationary or contractionary fiscal policy refers to fiscal policy that is used to reduce
aggregate demand. It involves increasing taxes and lowering government spending. Higher
tax rates reduce disposable income and lead to a fall in aggregate demand. It also lowers
retained profits of firms and therefore reduces investment in the economy. Lower
government spending again lowers demand especially in those sectors where government
has decided to decrease spending.
• Contractionary fiscal policy therefore leads to a fall in aggregate expenditure and the
impact again depends on the value of the multiplier, and the inflationary and
deflationary gap.
• This policy is useful in periods of high inflation (inflationary gap) when a fall in aggregate
expenditure leads to a fall in output and hence a fall in the inflationary pressure.
• It can also be used to improve balance of payments where lower aggregate demand
leads to lower imports and firms are forced to sell their products abroad leading to
higher exports. This is referred to as expenditure dampening measure.
• However, this policy leads to fall in GDP and arise in unemployment.
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Fiscal policy and macroeconomic objectives

It can be seen from the above discussion that there are a lot of trade-offs and fiscal policy has
different impact on different objectives.
• Expansionary fiscal policy leads to a fall in unemployment and a rise in GDP (growth).
However, it is inflationary and it can lead to balance of payment problems.
• Contractionary fiscal policy may lower inflationary pressure and improve BoP but it
leads to higher unemployment and lower GDP.
• Government can also try to use fiscal policy to influence distribution of income. It can
tax the rich and provide benefits to the poor to bring more fairness in distribution of
income.
Based on the above discussion, it is very difficult to say whether a uniform fiscal policy will be
successful in all countries. Countries should rather change the policy according to the problems
that they are facing.
• Countries that are in recession or have continuous high level to unemployment will like
to use expansionary policy. But they need to keep in mind that it can lead to rise in
inflation and may have negative impact on BoP.
• Countries that are facing high levels of inflation or consistent deficits in BoP will like to
use contractionary policy but at the expense of lower growth and high unemployment.
We can also conclude that fiscal policy needs to be used in conjunction with other policies if the
government wants to achieve lower inflation and unemployment, higher growth and a current
account equilibrium.
Automatic (built-in) stabilizers

Automatic stabilizers are changes in fiscal policy unprompted by government which stimulate
aggregate demand when an economy is going into recession or which reduce aggregate
demand in an expansionary mechanism. This
mechanism reduces the impact of changes in the
economy on national income
• Government spending and taxation are both
automatic stabilizers.
• During recession, government automatically
increases its spending on unemployment
benefits. The fall in aggregate demand is
therefore less than what it would otherwise have
been.
o Tax revenues tend to fall at a faster rate
than a fall in income as lower incomes
have lower tax rates. With government collecting less tax, disposable incomes
are higher than they would otherwise be and therefore consumption can be at a
higher level than would be the case without automatic stabilizers.
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• During boom, government spending falls due to less unemployment. Tax revenues
increase at a faster rate than the increase in income. Therefore, aggregate demand will
be lower than it would otherwise be with these automatic stabilizers therefore limiting
the inflationary pressure in the economy.
Discretionary (Active) fiscal policy

Discretionary fiscal policy is the deliberate manipulation of government expenditure and taxes
to influence the economy. Government can do this by altering tax rates or changing level of
government spending to influence economy activity by influencing aggregate demand.
• During recession, government would like to raise aggregate demand by using
expansionary fiscal policy.
• During boom, government would like to use contractionary policy to reduce aggregate
demand.
Fiscal policy and Aggregate Supply

Apart from affecting aggregate demand, fiscal policy can also be used to affect aggregate supply
by changing incentives facing firms and individuals.
Limitations of fiscal policy to manipulate aggregate demand

• Conflicting policy objectives: It can manipulate one variable such as lower
unemployment but then may harm other such as higher inflation or deteriorating BoP.
• Time lags: Some fiscal policy measures take less time to have an impact on the economy
and others take a longer time. Changing income tax rates, social security payments and
public sector wages will all act quickly to change demand. Long term capital projects
such as road building or hospital building take a longer time to have an impact on the
economy.
o This problem may actually lead to unforeseen problems. For instance, a time lag
may mean that extra spending in the economy may take place when the
economy is already in boom leading to overheating and high inflation.
• Inadequacy of economic data: Government’s statistics may have many inaccuracies. In
addition to that, an effective fiscal policy will need a good understanding of the value of
the multiplier. Over- or under-estimating this leads to policy errors.
• Fiscal and monetary policy: Fiscal and monetary policies are linked with each other and
this at times limits the effectiveness of fiscal policy. If government increases its spending
to increase aggregate demand, it will have to finance this spending through extra
borrowing from financial institutions. This raises interest rates and leads to a fall in
aggregate demand. Therefore ability of fiscal policy to act alone is in question.
o However, fiscal policy may be a good measure when an economy is in deep
recession. This is because economy is in a liquidity trap and interest rates cannot
fall further. Government spending therefore creates extra demand without
increasing interest rates.
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• National debt: Continuous deficits can build up national debt that will make it difficult
for governments to finance extra expenditures. This will limit the ability of governments
to use fiscal policy.
• Undesirable side effects: Government action to reduce aggregate demand by increasing
taxes creates a disincentive for workers to work and firms to invest. This leads to a fall in
aggregate supply.
• Political decision: Sometimes it is difficult to use fiscal policy because it is politically
unpopular. For instance, a government may resist spending cuts and tax increases if
they may be politically unpopular.
The overall conclusion then is that governments do use fiscal policy to achieve certain
macroeconomic objectives. However, there are both limitations in use of this measure as well
as trade-offs as described above. Governments therefore try to use fiscal policy along with
other policy measures to achieve multiple objectives.
Tax systems
Progressive tax is the tax where as income rises, the average rate of tax increases, i.e. people
pay a greater proportion of their income in tax. The most common example to this is income
tax.
Regressive tax is the tax where as income rises, the average rate of income tax falls, i.e. people
pay a smaller proportion of their income in tax. Indirect taxes are an example of regressive tax.
Proportional tax is the tax where as income rises, the proportion paid in tax remains constant.
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Topic 19 – Monetary Policy
TOPIC 19: MONETARY POLICY

Monetary policy is the attempt by government or a central bank to manipulate the money
supply and the interest rates to achieve the fulfillment of policy goals such as price stability.
These policies are usually under the control of an autonomous central bank that takes its
decisions independent of the government.
Monetary policy and Aggregate demand (and expenditure)

Monetary policy can have a direct impact on the aggregate expenditure and hence the level of
income and employment in the economy.
Interest rates
Rate of interest is the price of money. The higher the rate of interest, the lower will be the level
of aggregate demand (AD) and vice versa. Interest rate affects AD in following ways.
• Consumer durables: Lower interest rates encourage consumers to borrow and spend on
consumer durables hence increasing their demand.
• Housing market: Lower interest rates reduce mortgage payments leading to a rise in
demand in the housing market.
• Wealth effect: Lower interest rates cause a rise in demand for shares and houses leading
to a rise in their prices. Higher prices mean that wealth of individuals has risen which
encourages them to increase consumption expenditure.
• Exchange rate: Fall in interest rates leads to a fall in value of domestic currency which in
turn leads to cheaper exports and dearer imports. Export demand therefore rises and
import demand reduces. This leads to a rise in AD.
• Savings: Lower interest rates discourage savings leading to a rise in consumption.
• Investment: Lower interest rates make new projects more attractive. This leads to an
increase in investment in those projects (refer to MEC).
Money supply
Increase in money supply leads to a fall in interest rates and a rise in AD and vice versa. There
are a number of ways in which government can control money supply and hence interest rates
in the economy.
• Open market operations: By buying and selling government securities, the central bank
can influence money supply. When central bank sells government securities, there is a
fall in money supply; and when central bank buys government securities, there is a rise
in money supply.
• Statutory liquidity reserve: Central banks can force commercial banks to hold certain
assets as a percentage of their total assets. The higher the amount of liquidity reserve,
the lower is the amount of credit creation and therefore lower is the money supply.
Money supply and the budget deficit

Government can finance its budget deficit by following ways:
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• It can borrow from non-bank sector which does not affect money supply but raises
interest rates as government competes with other firms for borrowed money.
• It can borrow from banking sector which results in an increase in money supply.
Policy objectives
High interest rates and Lower money supply leading to fall in AD
Government can reduce money supply and increase interest rates to control high inflation
rates.
• High interest rates shift AD to the left leading to a fall in price levels.
• However, this leads to a fall in equilibrium output and hence a rise in unemployment.
o Although monetarists argue that in the LR, the economy will only operate at full
employment and hence change in interest rates will have no impact on rates of
unemployment.
o According to Keynesians, the impact of interest rates depends on how close the
economy is to the full employment level. The closer the economy is to the full
employment level, the lower is the impact on output and unemployment and the
more is the impact on inflation.
• Higher interest rates will also discourage investment that will lead to reduction in
economic growth.
• Higher interest rates lead to appreciation of currency that reduces exports and increases
imports leading to a worsening of current account deficit.
Low interest rates and High money supply leading to rise in AD

Government can increase money supply and reduce interest rates to encourage growth and
come out of recession.
• Low interest rates increase shift AS to the right leading to a rise in output and fall in
unemployment.
o Monetarists although believe that this effect is only SR and in the LR the
economy comes back to natural rate of unemployment.
• Higher demand levels however lead to increase in price levels.
o Exact impact on prices depends on how close the economy is operating to the
full employment level. If the economy is in deep recession, then, rise in AD is
likely to increase employment without impacting price levels.
• Lower interest rates encourage investment that is likely to lead to higher growth.
• Lower interest rates lead to depreciation of currency that increases exports and reduces
imports leading to a improvement in current account deficit.
Trade-offs
The use of monetary policy can have trade-offs between objectives.
• Rise in interest rates may reduce inflation in the SR but results in increase in
unemployment and reduction in growth. It may also lead to deterioration of BoP as
currency devalues due to higher investment. Fall in interest rate has the opposite
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impact – lower unemployment, higher growth, and an improvement in BoP but at the
cost of higher price levels.
• Higher interest rates benefit the savers at the expense of the borrowers and vice versa.
• Monetary policy may at times also conflict with other policy measures. For instance, the
central bank may be tightening the monetary policy when the government is using
expansionary fiscal policy. The policies need to be adopted such that there is
consistency in the policies.
Limitations
Central banks face a number of problems when using monetary policy as an instrument to
achieve the objectives.
• Time lags: There are significant time lags between change in interest rates and its
impact on the economy.
• Uncertainty: Increase in interest rates may hit poor more than the rich as poor are more
likely to be net borrowers.
o Similarly, in recession, lowering interest rates may not persuade them to spend
more if they are worried about job prospects and future markets.
o Increasing mobility of financial capital makes it difficult for a country to operate
interest rates significantly different from its competitors. A very low level of
interest rates will lead to outflow of hot money leading to BoP problems.
• Different measures of money supply: There are many different measures of money
supply and it is difficult for the central bank to control money supply. There is evidence
that money supply can change its character if a central banks attempts to control it.
The overall conclusion then is that use of monetary policy has certain benefits but also certain
limitations. It may be useful in controlling inflation or reducing unemployment but not both.
Hence, government has to make trade-offs at least in the SR. There are also certain limitations
that reduce the effectiveness of monetary policy. Governments therefore try to use monetary
policy along with other policy measures to achieve multiple objectives.
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Topic 20 – Supply side policies
TOPIC 20: SUPPLY SIDE POLICIES

Supply side policies refer to government policies designed to increase the productive potential
of the economy and push the long run aggregate supply curve to the right.
Supply side policies and macroeconomic objectives

Supply side policies lead to a rightward shift in the LR aggregate supply curve. It can thus
achieve following macroeconomic objectives.
• Higher supply leads to increase in output levels leading to growth in the economy.
• Higher AS leads to a fall in price levels. Supply side policies when used along with
expansionary fiscal and monetary policies can increase the growth rate in the economy
while controlling inflation.
• Supply side policies can also be useful in reducing unemployment, especially reducing
the natural rate of unemployment through training and educating the workforce and
like that.
• Effective supply side policies improve competitiveness of local products hence leading
to an increase in exports and fall in imports. This improves the current account of BoP.
Supply side policies

There are two broad approaches to supply side policies.
• Supply side economists believe that free market promotes economic efficiency and the
government’s role should be to use market-oriented policies to remove barriers in the
working of free markets.
• Interventionist economists believe that free markets may fail to maximize economic
efficiency and the government should use interventionist policies to correct market
failure.
Within these two broad approaches there are several policies that can improve the aggregate
supply in the economy.
Labor market policies

The following policies are all designed to improve the quality and quantity of labor. Higher
quantity of labor will increase productive potential of the economy shifting PPC and LRAS cure
outward. Increased quality will improve the productivity of labor leading to rise in AS.
• Legislation against trade unions: Reduction in trade union power makes labor markets
more flexible and efficient leading to an increase in AS.
• Education and training: Government spending on education and training improves
workers’ human capital leading to increase in their productivity levels and an increase in
AS. It should also be noted that improved training, especially for those who lose their
job in an old industry, will improve the occupational mobility of workers in the
economy.
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• Income tax rates: Very high marginal rate of tax acts as a disincentive to work. Lower
tax rates are therefore likely to motivate workers to work more leading to a rise in LRAS.
• Unemployment benefits: Higher unemployment benefits act as a disincentive to work.
Lowering unemployment benefits encourage workers to work leading to an increase in
LRAS.
• Minimum wages: Minimum wages prevent some workers who would be prepared to
work for lower pay from getting jobs. This lowers AS. Free market economists argue for
abolition of minimum wages.
Product market supply side policies

All of the policies in the product market are designed to increase competition, and so efficiency.
If the productivity of an industry improves, then it will be able to produce more with a given
amount of resources, shifting the LRAS curve to the right.
• Privatization: Privatization breaks up state monopolies to create competition. This
promotes efficiency that leads to rightward shift in the LRAS.
• Deregulation: Reducing government rules and laws to control industry will increase its
efficiency and productivity leading to an increase in LRAS.
• Free trade: Promoting free trade allows countries to specialize and increase its
productivity leading to rightward shift in LRAS.
• Help for businesses: Government can encourage businesses with grants, lower tax rates
etc. to encourage them to invest and increase AS.
Capital market policies

Increasing the capital stock such as factories, offices and roads will increase AS.
• Profitability: Government can take steps to increase profitability of firms. This will
encourage higher investment in the country. One measure that the government can
take is to reduce corporate tax rates which will increase firms’ profitability.
• Increasing sources of capital available to firms: Government can encourage private
sector to provide financial capital to small businesses by giving tax incentives to
individuals putting up share capital for a business.
Interventionist approaches
• Firms may not be able to provide education and training to their workers. In this case, it
should be the government’s duty to provide workers with necessary education and
training.
• If there is insufficient investment in the economy, then, state should set up state-owned
enterprises or subsidize investment by private industry.
Limitations
Supply side policies have become very popular however they also have certain limitation.
• Cutting income tax may encourage some people to work fewer hours if they are content
with their earnings.
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• Lowering welfare benefits will not succeed in reducing unemployment if there are no
jobs available.
• Privatization may not increase efficiency if privatized industries act as a monopoly and
do not take into account external costs and benefits.
Supply-side policies tend to be long-term and uncertain in their measurable outcome as they
require structural changes to be made to increase aggregate supply in the economy. They
therefore have little relevance from the point of view of short-term economic management.
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Topic 21 – Exchange rate policies
TOPIC 21: EXCHANGE RATE POLICIES

(Mainly a revision of AS topics)
Exchange rate policy refers to the government’s decision of selecting a method of determining
the exchange rate of a country’s currency.
• Government can influence the exchange rate of its currency by changing interest rates
and by buying and selling its own currency.
• Raising value of currency (appreciation)
o It can be achieved by increasing interest rates or by buying its currency in the
foreign exchange market.
o Appreciation puts downward pressure on inflation but is harmful for BoP as
exports become expensive and imports become cheaper. Lower exports and
higher imports also reduce GDP and increase unemployment.
• Reducing value of currency (depreciation)
o It can be achieved by reducing interest rates or by selling its currency in the
foreign exchange market.
o Depreciation leads to improvement in BoP which results in higher GDP and lower
unemployment. However, depreciation of currency can lead to inflationary
pressures in the economy.
Exchange rate systems

Floating exchange rate system
Floating exchange rate system allows market demand and supply forces to determine exchange
rate without influence of the government.
• Benefits – There is an automatic adjustment mechanism and the government does not
have to hold large foreign exchange reserves.
• Drawbacks – There may be a lot of uncertainty due to frequent movement of exchange
rates. Depreciation of currency may be inflationary. There can also be immense
speculation in such a system.
Fixed exchange rate system

Fixed exchange rate system sets the exchange rate of the currency with other currency.
However, to maintain the peg , the government will have to frequently intervene in the market.
• Benefits – There is less uncertainty and a control on inflation.
• Drawbacks – There is no automatic adjustment mechanism and the government has to
frequently intervene in the market to hold the peg which requires government to hold
large foreign exchange reserves. Government may also use deflationary policies to
reduce imports which may lead to lower growth and higher unemployment.
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Single currency (€)

Many countries in the European Union operate a single currency – Euro.
• Benefits
o It reduces transaction costs as firms and households that are taking part in trade
within Europe do not have to convert from one currency to another.
o It reduces exchange rate uncertainty as there is a single currency. This improves
trade within the Euro-zone.
o There is increased transparency as it is easier for consumers to compare prices of
products in different countries.
• Drawbacks
o Country has to give up some of its powers, i.e. of setting interest rates which is
now done by a common central bank – European Central Bank.
o There is additional cost of printing and circulating notes and coins initially.
Difficulties faced in setting exchange rate policy

• Country cannot set its own exchange rate if it is a member of a single currency.
• If the country decides to operate a fixed exchange rate system, then, it is difficult to
decide the exchange rate. One solution to this is that it should be set at the LR
equilibrium level so that it reduces uncertainty and speculative pressures. However, it is
difficult to determine the long run equilibrium level. If the government overestimates
the value, then, there will be a speculation and a downward pressure on the exchange
rate. Government will have to regularly intervene in the foreign exchange market. This
may lead to a reduction in the foreign exchange reserves.
• Floating exchange rate, on the other hand, is subject to a lot of uncertainty and
speculation.
Exchange rate policy and macroeconomic objectives

Through setting or controlling its exchange rate, the government may be able to achieve some
of its macroeconomic objectives.
• Depreciation of currency
o It leads to fall in price of exports and increase in price of imports. If the demand
for exports and imports is elastic, this leads to improvement in BoP.
o Higher exports and lower imports increase output levels and GDP which also
leads to lower unemployment.
o However, it is inflationary as the cost of imports rises and the demand for export
rises.
• Appreciation of currency
o It leads to rise in price of exports and a fall in price of imports. Lower import
prices and lower demand for exports result in a fall in price levels locally.
o However, lower demand for exports and higher demand for imports leads to
deterioration in BoP.
o Lower exports and higher exports also result in lower GDP and higher
unemployment.
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Limitation in use of exchange rate policy

Changing exchange rates to achieve macroeconomic objectives may not always work as its
effects can be offset by other factors. For instance, depreciation may not lead to improvement
in BoP if the demand is inelastic or the quality of the local products fall. There are also some
time lags between adoption of the policy and its impact on the economy. It is also important to
note that there are trade-offs. Achieving one objective such as improvement in BoP through
depreciation of currency has an impact on other objectives such as higher inflation.
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Topic 22 – Macroeconomic objectives
TOPIC 22: MACROECONOMIC OBJECTIVES

The government has four key macroeconomic policy objectives:
• to control inflation;
• to control unemployment;
• to maintain a current account equilibrium; and
• to secure high economic growth.
Apart from these objectives, government also aims to achieve sustainable growth and equity in
distribution of income and wealth, to avoid exchange rate fluctuations and like that.
Government can use a range of policies – fiscal, monetary, supply side and exchange rate (all
discussed in previous topics) – to achieve these objectives. It must be remembered that each
policy has its limitations and that the objectives may be in conflict with each other so that it
may become difficult to achieve all objectives at the same time.
Explaining Fiscal, Monetary and Supply side policies using AD and AS (revision of AS)
Demand-side policies in the SR
Government can use expansionary fiscal and monetary policies to increase aggregate demand
(AD). This will include steps to (i) reduce taxes, (ii) increase government spending; (iii) reduce
interest rates; and (iv) increase money supply. Increase in AD leads to rightward shift in AD as
shown in the graph below. This has following impact
on the economy.
• Increase in output levels that leads to higher
economic growth and lower unemployment.
The economy starts moving towards PPC.
• Lower interest rates mean that hot money
moves out of the country. This leads to
depreciation of currency. Assuming demand
for exports and imports to be elastic,
depreciation in currency leads to
improvement in current account balance.
• However, there is an increase in price levels.
Demand-side policies in LR – Monetarist version

According to Monetarists, an increase in AD due to expansionary fiscal or monetary policy will
lead to rise in price levels without having an impact on output levels or unemployment in the
long run.
• This is because the economy operates at full capacity in the LR.
• An increase in AD will have no impact on output and hence unemployment but higher
demand levels will force prices up.
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This can be shown on a figure.

• Assume there is a rise in aggregate demand, which shifts the aggregate demand curve
from AD1 to AD2.
o In the short run, this will result in a
movement up the SRAS1 curve.
o Output will rise from OL to OM and this
will be accompanied by a small rise in
the price level from ON to OP. This will
move the economy from A to B.
• This leads to long run disequilibrium. The full
employment level of output is OL. The
economy is therefore operating at over full-
employment.
o Firms will find it difficult to recruit labor, buy raw materials and find new offices
or factory space.
o Firms respond by bidding up wages and other costs leading to a leftward shift in
the SRAS to SRAS2.
o The economy will return to long run equilibrium as short run aggregate supply
curve shifts from SRAS1 to SRAS2.
o Aggregate demand once again equals long run aggregate supply at C. Price levels
increase to OR.
• Therefore increase in AD without any change in LRAS is purely inflationary with no
change in output levels in the LR.
Demand-side policies in LR – Keynesian model

Impact of rise in AD on price levels and output levels depends on the stage of the LRAS.
• If AD increases when LRAS is perfectly elastic (from AD1 to AD2) – economy is in deep
recession – then, there is no change in price levels (remains P1) but the output levels will
increase (from Q1 to Q2) and unemployment decrease. Therefore, it is very desirable for
the government to use expansionary policies
when the economy is in deep recession.
Keynesians specially argue for use of
government expenditure to come out of
recession as other measures may have a
significant time lags and consumption and
investment may not respond quickly during a
recession.
• If AD increases when LRAS is upward sloping
(from AD2 to AD3) – economy is getting
closer to full employment – then, both price
levels and output levels will rise (from P1 to P2 and from Q2 to Q3) leading to lower
unemployment.
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• If AD increases when LRAS is perfectly inelastic (from AD3 to AD4) – economy is

operating at full employment – then, there is no change in output levels (remains Q3) as
the economy is operating at full capacity. There is no change in unemployment. Increase
in AD therefore only leads to increase in price levels (P2 to P3).
Supply side policies

Supply side policies leads to an increase in AS and a rightward shift in the AS curve. Increase in
AS leads to an increase in output levels, lower unemployment and lower price levels. It also
makes country’s goods internationally competitive leading to rise in exports and fall in imports.
It therefore results in improvement in current account of BoP. This is generally recommended
by many economists as the long run policy that should be adopted by the government for long
run success of the economy and to make local firms more competitive internationally.
• Supply side policies are very popular with the monetarists.

o An increase in AS will reduce price levels and increase output levels (or national
income).
• However, supply side policies, according to Keynesians, will only be beneficial if the
economy is operating close to full capacity.
o Supply side policies will shift the LRAS in the vertical part.
o This will lead to increase in output levels and a fall in price levels.
o However, according to Keynesians, there will be no impact on the economy of
supply side policies if the economy is operating in the elastic part of the supply
curve (recession). According to them, economy can only come out of recession
by adopting demand side policies.
These policies and their limitations have already been discussed in previous topics. Students
should also use MULTIPLIER analysis and inflationary and deflationary gaps when attempting
this question.
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Policies to achieve macroeconomic objectives

Government can use fiscal, monetary, supply side and exchange rate policies to achieve its
macroeconomic objectives. These policies with their impact on objectives have already been
discussed in previous topics. A summary is given below.
Policies to control inflation

Specific policy to control inflation will depend on the cause of inflation.
• Cost-push inflation can be controlled by stemming the decline in exchange rate, giving
subsidies, changing inflation expectations of future and reducing or removing minimum
wages.
• Demand-pull inflation can be controlled through contractionary fiscal and monetary
policy. Raising income taxes and cutting government spending are at times not very
convenient for governments as they are politically unpopular. Therefore, governments
widely use increase in interest rates as a tool to reduce aggregate demand.
The result of contractionary policies is mixed. Whereas it reduces price levels and may
improve current account, it also leads to lower output and GDP and higher
unemployment. This is therefore considered as a useful measure in the short run to
control inflation.
• LR – Supply side policies can be used in the LR to reduce price levels while maintaining
or increasing output levels and reducing unemployment.
Policies to overcome unemployment

• Expansionary fiscal and monetary policies can be used in the SR to increase AD and
lower unemployment. It also increases output levels and GDP of the economy. However,
it also has adverse effects and can result in higher price levels and possible deterioration
of current account balance.
• In LR, supply side policies are more useful to combat unemployment, especially the
natural rate of unemployment.
Policies to stimulate economic growth

• If economy is operating inside PPC, then, output levels can be increased by increasing
AD using expansionary fiscal and monetary policies. This is also referred to as
reflationary policies. Reflation refers to a situation where the government explicitly
seeks to increase the level of economic activity through use of expansionary fiscal
and/or monetary policies. However, they may eventually result in an inflationary gap.
• For continuous increase in production of more goods and services, economists agree on
use of supply side policies – improving quality and quantity of factors of production,
increasing labor productivity, and making use of improved technology.
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Policies to correct BoP disequilibria (recap of AS)

• Expenditure-dampening (or reducing) measures: This includes deflationary fiscal and
monetary policies to reduce AD. Lower AD will result in (i) lower imports and (ii) higher
exports as firms seek to sell their products in foreign markets. Such policies however can
slow down the economy and can result in increase in unemployment.
• Expenditure-switching measures: These include use of protectionist measures (tariffs,
exchange controls, quotas, export subsidies etc.) to move demand away from foreign
products toward domestically produced goods and services. They are not very popular
as generally economies are opening up and also because of fear of retaliation by trading
partners.
• Devaluation: A lower exchange rate will make exports more competitive and imports
less attractive. However, its impact on BoP will depend on elasticities of demand of
exports and imports. (Please refer to Marshall-Lerner condition and J-curve discussed in
topic 17.)
• Supply side policies: These are more effective in the long run as increase in AS lowers
the price levels of locally manufactured goods making them more competitive
internationally results. This results in lower imports and higher exports leading to
improvement in BoP.
Conflicts between objectives

As discussed above, the policy objectives may clash and it may not be possible for a
government to achieve all the objectives simultaneously. It therefore will have to make a trade-
off.
• Increase in AD can achieve objectives of economic growth and lower unemployment but
at a cost of higher inflation and BoP problems.
• Lower AD achieves the objective of lower inflation and better BoP but at the expense of
lower growth and higher unemployment.
• However, with use of supply side policies, it is becoming easier for economies to achieve
multiple objectives simultaneously. These lead to higher output levels, lower
unemployment, lower price levels and improvement in BoP. However, these policies are
long run as there is a significant time lag between investment in the policy and its
impact on the economy.
Conclusion
We can therefore make following conclusions.
• Governments have four major macroeconomic objectives.
• It uses different policy measures to achieve these.
• However, most of the time, the objectives conflict with each other.
• Hence, government has to make a trade-off.
• Which objective is most important? This is difficult to say. It varies from government to
government. An economy that is facing very high price levels will definitely give priority
to controlling inflation. An economy with continuing fall in trade balances will try to
111
correct it first. An economy with very high unemployment and poverty levels will try to
focus on growth and reduction in unemployment.
112
Topic 23 – Policies for development
TOPIC 23: POLICIES FOR DEVELOPMENT
113
Topic 23 – Policies for development
Monetarists and Keynesians on page 11b chapter 11
AD and AS on page 21b chapter 11
114

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A2 MACROECONOMICS

TOPIC 1: NATIONAL INCOME STATISTICS

• Gross domestic product (GDP)

𝑁𝑎𝑡𝑖𝑜𝑛𝑎𝑙 𝐼𝑛𝑐𝑜𝑚𝑒 (𝐺𝐷𝑃) 𝑎𝑡 𝑓𝑎𝑐𝑡𝑜𝑟 𝑐𝑜𝑠𝑡

(i) Gross Domestic Product (GDP)

(ii) Gross National Product (GNP)

Net property income from abroad is the income that

(iii) Net Domestic Product (NDP)

(iv) Net National Product (NNP)

Topic 1.1: Ways of measuring GDP

There are three ways of measuring GDP:

(i) Output measure

(ii) Income measure

(iii) Expenditure measure

Following adjustments are needed:

Money and real GDP

This shows that the value of money GDP is affected by

𝑃𝑟𝑖𝑐𝑒 𝑖𝑛𝑑𝑒𝑥 𝑖𝑛 𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟

TOPIC 2: COMPARING GROWTH – CRITICISM OF USING GDP

𝐺𝐷𝑃𝑡 − 𝐺𝐷𝑃𝑡−1 𝐺𝐷𝑃𝑡

Issues that need to be considered when comparing growth

(i) Real GDP should be used instead of nominal GDP

(ii) Statistical inaccuracies

(vii) Nature of economic growth

Comparing growth Over Time Across Countries

TOPIC 3: COMPARING LIVING STANDARDS

o consumer goods and services (housing, food, clothing etc.);

o Net Economic Welfare (NEW) or Measurable Economic Welfare (MEW)

o United Nations Human Development Index (HDI)

Comparing living standards between countries

International comparisons of living standards – a word of warning

TOPIC 4: NATIONAL ECONOMIC PERFORMANCE

(i) Output and income

However, there is a trade-off between unemployment and inflation. Lower levels of

(iv) Current account balance (trading balance)

(v) Equity (distribution of income)

(vii) Other indicators

Governments also pursue other policy objectives that may include:

TOPIC 5: ECONOMIC DEVELOPMENT

Both the definitions of development suggest that development must be seen as a

• Second world countries

• Third world countries

Indicators of economic development

(ii) Classification according to level of indebtedness

Categorization depends on a number of measures, the most important of which is proportion of

Characteristics of developing economies

(i) GDP per head

(ii) Physical capital

(iii) Economic structure

Developing economies have high dependency on primary sector. In 1990s agriculture

(iv) Population growth, health and mortaility

(v) Population structure

decrease in population. It also results in an ageing population. It is estimated that in EU two-

The concept of Optimum Population

(vi) Educational attainment (investment in human capital)

(vii) Income distribution

(ix) External trade

(xii) Multinational corporation and foreign direct investment (FDI)

However, there are certain drawbacks of MNCs as well such as:

• political influence over host country’s government, and

(xiii) External debt

(xiv) Institutional structures, governance and corruption

TOPIC 6: ECONOMIC GROWTH