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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
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out and out-of-date capital.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.
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Topic 1 – National income statistics
In short, GNP measures the income of the country’s citizens only whether earned in the country
or earned abroad.
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Topic 1 – National income statistics
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Topic 1 – National income statistics
𝑇𝑜𝑡𝑎𝑙 𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒
= 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒 𝑜𝑛 𝑔𝑜𝑜𝑑𝑠 𝑎𝑛𝑑 𝑠𝑒𝑟𝑣𝑖𝑐𝑒𝑠 + 𝐴𝑑𝑑𝑖𝑡𝑖𝑜𝑛 𝑡𝑜 𝑠𝑡𝑜𝑐𝑘𝑠
+ 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒 𝑜𝑛 𝑒𝑥𝑝𝑜𝑟𝑡𝑠 − 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒 𝑜𝑛 𝑖𝑚𝑝𝑜𝑟𝑡𝑠 − 𝐼𝑛𝑑𝑖𝑟𝑒𝑐𝑡 𝑡𝑎𝑥𝑒𝑠
+ 𝑆𝑢𝑏𝑠𝑖𝑑𝑖𝑒𝑠
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.
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Topic 1 – National income statistics
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.
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
(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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Topic 2 – Comparing growth – Criticism of using GDP
• 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).
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Topic 2 – Comparing growth – Criticism of using GDP
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.
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Topic 3 – Comparing living standards
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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Topic 3 – Comparing living standards
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.
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Topic 3 – Comparing living standards
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.
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Topic 3 – Comparing living standards
• 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.
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Topic 3 – Comparing living standards
• traditional measures do not take into account variables such as social justice and
political freedom.
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Topic 4 – National economic performance
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.
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Topic 4 – National economic performance
(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.
(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.
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Topic 4 – National economic performance
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.
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
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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Topic 5 – Economic development
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,
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Topic 5 – Economic development
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.
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Topic 5 – Economic development
• 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.
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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Topic 5 – Economic development
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 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.
Education levels are vital for future growth. Countries that invest in education are likely to grow
faster in the future.
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Topic 5 – Economic development
(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).
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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Topic 5 – Economic development
• 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.
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.
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Topic 5 – Economic development
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.
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
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.
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Topic 6 – Economic growth
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.
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.
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Topic 6 – Economic growth
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Topic 6 – Economic growth
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
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Topic 6 – Economic growth
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.
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
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 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:
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Topic 7 – Circular flow of income
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 = 𝐼 + 𝐺 + 𝑋
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Topic 8 – Aggregate expenditure
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.
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.
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Topic 8 – Aggregate expenditure
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:
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.
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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 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
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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
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Topic 8 – Aggregate expenditure
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.
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Topic 8 – Aggregate expenditure
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.
• 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.
• 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
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Topic 8 – Aggregate expenditure
in the economy and a rightward shift in the planned investment schedule as shown in
the figure.
• 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.
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Topic 8 – Aggregate expenditure
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.
• 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.
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Topic 8 – Aggregate expenditure
• Country’s GDP
Rise in country’s GDP is likely to lead to a higher demand for imports and vice versa.
• 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.
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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).
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Topic 9 – Multiplier
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.
1 1
𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 = =
𝑚𝑝𝑠 1 − 𝑚𝑝𝑐
In this model, income is either spent or saved. Equilibrium income will occur where:
1
𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 =
𝑚𝑝𝑠 + 𝑚𝑟𝑡
where mrt is marginal rate of taxation, i.e. the proportion of extra income that is taxed.
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Topic 9 – Multiplier
or
𝐼𝑛𝑗𝑒𝑐𝑡𝑖𝑜𝑛𝑠 = 𝑊𝑖𝑡ℎ𝑑𝑟𝑎𝑤𝑎𝑙𝑠
𝐼+𝐺 =𝑆+𝑇
1
𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 =
𝑚𝑝𝑠 + 𝑚𝑟𝑡 + 𝑚𝑝𝑚
where mpm is marginal propensity to import, i.e. the proportion of extra income that is spent
on imports.
or
𝐼𝑛𝑗𝑒𝑐𝑡𝑖𝑜𝑛𝑠 = 𝑊𝑖𝑡ℎ𝑑𝑟𝑎𝑤𝑎𝑙𝑠
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).
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Topic 9 – Multiplier
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
Solution
M = 1/(mps+mpm)
mps = 1/6; mpm = 1/3
M = 1/((1/6)+(1/3)) = 2
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
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Topic 10 – Income determination
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
= 𝐶𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛 + 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 + 𝐺𝑜𝑣𝑒𝑟𝑛𝑚𝑒𝑛𝑡 𝑠𝑝𝑒𝑛𝑑𝑖𝑛𝑔 + 𝑁𝑒𝑡 𝑒𝑥𝑝𝑜𝑟𝑡𝑠
𝑇𝑜𝑡𝑎𝑙 𝑠𝑝𝑒𝑛𝑑𝑖𝑛𝑔 = 𝐶 + 𝐼 + 𝐺 + (𝑋 − 𝑀)
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Topic 10 – Income determination
Note: In the Keynesian model, prices are assumed to be constant; i.e. firms change their output
not their prices.
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.
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Topic 10 – Income determination
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
𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 =
𝑎𝑏
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Topic 10 – Income determination
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 ∗
𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 =
𝑣𝑤
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Topic 10 – Income determination
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.
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Topic 10 – Income determination
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.
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Topic 10 – Income determination
𝑄1 − 𝑄 ∗
𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 =
𝑎𝑏
An increase in tax rates (without change in government in spending) will lead to a fall in GDP as
shown in the figure.
• 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.
• Value of multiplier in the figure is equal to
𝑄 ∗ − 𝑄1
𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 =
𝑎𝑏
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Topic 10 – Income determination
𝑄1 − 𝑄 ∗
𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 =
𝑎𝑏
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Topic 11 – Autonomous and induced investment;
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
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Topic 11 – Autonomous and induced investment;
Accelerator
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.
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;
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Topic 11 – Autonomous and induced investment;
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.)
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Topic 12 – Money supply
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.
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Topic 12 – Money supply
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Topic 12 – Money supply
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:
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
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:
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.
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Topic 12 – Money supply
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.
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.
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Topic 12 – Money supply
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.
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Topic 13 – Interest rate determination
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.
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Topic 13 – Interest rate determination
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.
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Topic 13 – Interest rate determination
• 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.
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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Topic 13 – Interest rate determination
• 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.
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Topic 14 – Quantity theory of money
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).
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
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Topic 15 – Unemployment
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.
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Topic 15 – Unemployment
Measuring unemployment
There are two main methods of measuring unemployment:
• Claimant count
• Labor force survey
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.
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Topic 15 – Unemployment
• 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.
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Topic 15 – Unemployment
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Topic 15 – Unemployment
• 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.
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Topic 15 – Unemployment
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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Topic 15 – 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.
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Topic 15 – Unemployment
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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Topic 15 – Unemployment
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Topic 16 – Relationship between internal and external
value of money
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.
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Topic 17 – Relationship between balance of payments and
inflation
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.
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
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Topic 18 – Fiscal Policy
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.
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Topic 18 – Fiscal Policy
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.
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Topic 18 – Fiscal Policy
• 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.
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Topic 18 – Fiscal Policy
• 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
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.
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Topic 19 – Monetary Policy
• 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.
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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Topic 19 – Monetary Policy
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
Within these two broad approaches there are several policies that can improve the aggregate
supply in the economy.
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Topic 20 – Supply side policies
• 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.
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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Topic 20 – Supply side policies
• 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
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.
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Topic 21 – Exchange rate policies
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Topic 21 – Exchange rate policies
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Topic 22 – Macroeconomic objectives
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.
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Topic 22 – Macroeconomic objectives
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Topic 22 – Macroeconomic objectives
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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Topic 22 – Macroeconomic objectives
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.
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Topic 22 – Macroeconomic objectives
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
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Topic 22 – Macroeconomic objectives
correct it first. An economy with very high unemployment and poverty levels will try to
focus on growth and reduction in unemployment.
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Topic 23 – Policies for development
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Topic 23 – Policies for development
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