MACROECONOMICS

Notes

Written by Giya.G, Abel.S and substantially revised and edited by

Ndlovu.E
DEPARTMENT OF ECONOMICS
MIDLANDS STATE UNIVERSITY

©2010
 CHAPTER ONE

INTRODUCTION

Macroeconomics

Macroeconomics is concerned with the study of the whole economy. Macroeconomics is

concerned with the study of economy wide aggregates, such as the analysis of total output and
employment, total consumption, total investment and national product. (Vaish,1995). It is
concerned with the behaviour of the economy as a whole- with booms and recessions, the
economy’s total output of goods and services and growth of out[put, the rates of inflation and
unemployment, balance of payments, exchange rates etc. Because it is closely related to real
world issues, macroeconomics also involves many non-economic factors such as political,
historic, cultural and sociological factors. (Dornbusch et al, 1998).

Macroeconomic Problems
These arise when the economy suffers from high unemployment, inflation, or a balance of
payments deficit. Therefore the government sets itself certain macroeconomic objectives:

 Low unemployment

 Low inflation

 A balance of payments surplus

 Economic growth

Macroeconomics and Microeconomics

The line between macroeconomics and microeconomics is less sharp than it used to be, but it is
still there.

What makes this module different is that we focus on the economy as a whole.
 Instead of talking about the demand and supply of (say) pizza, we talk about the demand and
supply of output.

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 Instead of talking about what determines the demand for workers in the pizza industry, we talk
about what determines the total demand for workers.

BUSINESS CYCLE

Business Cycles (or trade cycle)

A business cycle is the more or less regular pattern of expansion (recovery) and contraction
(recession) in economic activity around a growth trend (Dornbusch et al, 1998). Business cycles
can also be described as the periodic booms and slumps in economic activities. The ups and
downs in the economy are reflected by the fluctuations in aggregate economic magnitudes, such
as, production, investment, employment, prices, wages, bank credits etc. The upward and
downward movements in these magnitudes show different phases of a business cycle (Dwivedi,
1996). Basically there are only two phases in a cycle, namely prosperity and depression.
Considering the intermediate stages between prosperity and depression, the various phases of
trade cycle may be enumerated as follows:
1) Expansion
2) Peak
3) Recession;
4) Trough
5) Recovery and expansion

Phase of Business Cycles

line of cycle

Peak steady growth line

Growth
Rates prosperity depression
expansion trough
peak recovery
trough

Time

Expansion or prosperity (or boom)

This boom is characterised by increase in output, employment, investment, aggregate demand,
sales, profits, bank credits, wholesale and retail prices per capita output and a rise in standard of
living. The growth rate eventually slows down and reaches the peak. However:

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  A boom increases spending on imports, causing balance of payments problems.

 Once high levels of employment have been reached, output cannot be increased any further
and the boom causes inflation.

Peak
 Thisis characterized by slacking in the expansion rate, the highest level of prosperity, and
downward slide in the economic activities from the peak.

Recession
The phase begins when the downward slide in the growth rate becomes rapid and steady. Output,
employment, prices, etc. register a rapid decline, though the realised growth rate may still remain
above the steady growth line. So long as growth rate exceeds or equals the expected steady
growth rate, the economy enjoys the period of prosperity, high and low. When the growth rate
goes below the steady growth rate, it marks the beginning of depression in the economy.
Depression begins when growth rate is less than zero i.e. the total output, employment, prices,
bank advances etc. decline during the subsequent periods. In other words there is a slump in the
economy. [A slump reduces spending on imports, thus improving the balance of payments.
Reduced total spending lowers inflationary pressure.] The span of depression spreads over the
period growth rate stays below the secular growth rate or zero growth rate in a stagnated
economy.

Trough
This is the phase during which the downtrend in the economy slows down and eventually stops
and the economic activities once again register an upward movement. Trough is the period of
most severe strain on the economy.

Recovery
When the economy registers a continuous and rapid upward trend in output, employment, etc, it
enters the phase of recovery though the growth rate. When it exceeds this rate, the economy once
again enters the phase of expansion and prosperity. If economic fluctuations are not controlled
by the government, the business cycles continue to recur as stated above.

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Why worry about business cycles?
Business cycles, cause not only harm to business but also misery to human beings by creating
unemployment and poverty. Governments in many countries assume the role of a key player in
employment and stabilization. Stabilization broadly means preventing the extremes of ups and
downs or booms and depression in the economy without preventing factors of economic growth
to operate.

Trade Cycles or business cycles- simplified diagram

Government Macroeconomic Policies

Macroeconomic Policy Objectives

All governments like to achieve the following 4 major macroeconomic policy objectives:

(a) Full employment of labour force.

(b) A stable price level.

(c) B.O.P equilibrium ( surplus is desirable)

(d) A satisfactory rate of economic growth.

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On full employment, of labour force it is not possible to achieve this in the strictest sense. The
use of official unemployment statistics as basis for setting policy objectives is also suspect. The
list by government includes those defined as being unemployed by government rather than those
who would be willing to take up paid employment should it become available. Some people on
the register may be unemployable-aged, disabled, criminals and those not intending to work.

Table below shows some of the policies the government can use to try to get full employment,
stable prices etc.

Policy Description
Fiscal Changes in government expenditure and taxation
Monetary Changes in the money supply and interest rates
Prices and incomes Legal or voluntary limits on price and wage increases
Regional Measures to help depressed areas
Industrial Government planning of industry
Commercial Quotas, tariffs, exchange controls or free trade
Exchange rate Encouraging a depreciation or appreciation of sterling

Problems of Policy Timing

The timing of policy events may be crucial to the efficiency and effectiveness of policies. There
are basically three forms of time lag to consider in relation to the behaviour of policy makers and
operation of the economy.
(a) Recognition lag- authorities perceive problems after some time.
(b) Administration lag- it takes time to set up the necessary administrative machinery in motion.
For example Parliament approves income tax measures after debate but monetary policy
options take days or hours to implement.
(c) Implementation lag- by the time the policy is implemented, new issues have arisen hence
new policies have to be implemented/formulated or adapt the policy instruments introduced.

Chief Instruments of Economic Policy

The two important subdivisions of economic policy are the monetary policy and the fiscal policy.
These two policies are applied as mutually complementary policies to serve as instruments of
government’s economic policy which is applied to achieve certain social goals. Often the two

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overlap, because it is almost impossible to envisage any major fiscal or monetary measure which
does not affect the other.
A. Fiscal Policy. This is the policy of government with regard to level of government spending
and tax structure. Government expenditure includes transfer payments, government current
expenditures and budgetary balance (extent of borrowing). Taxation (i) provides the funds to
finance expenditure. (ii) Can also be used for income redistribution. Taxes are subdivided
into direct and indirect. (i) Direct taxes – these are levied directly on persons / corporates and
include income tax, corporate tax, poll tax and inheritance taxes, import duties. Typical uses
for this instrument are a reduction in income inequalities, regulate aggregate demand,
protection of domestic producers, reduce poverty, and provision of infrastructure and to
adjust balance between aggregate demand and supply. Import duties are important sources of
revenue in many African countries. Countries impose import tariffs for some or all of the
following reasons: (a) Revenue, protection to local producers, (b) discriminate between
essential and non-essential goods and (c) B.O.P purposes. (ii)Indirect tax is levied on a thing
and is paid by an individual by virtue of association with that thing, e.g. local rates on
property, sales taxes and excise duties. Tax structure can be regressive proportional or
progressive. Tax incentives may be given - investment allowances, tax holidays, accelerated
depreciation allowances, duty-free imports; no-tax concessions may be given by government
for e.g. provision of roads, water and power. In some African countries rural taxation- was
used e.g. Cameroon, Mali and Sudan.

Problems of Fiscal Administration

(a) Tax evasion
(b) Shortage of trained and experienced staff.
(c) Corruption.
(d) attitudes towards payment of taxes.
(e) poor co-ordination of budgets with development plans.

B. Monetary Policy- the manipulation of the volume of credit, interest rates and other monetary
variables. Monetary policy is a policy which employs central bank’s control over the supply,
cost and use of money as an instrument for achieving certain given objectives of economic

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policy. The policy is used to improve credit and saving facilities and to regulate
macroeconomic balance of the economy. All governments run deficits in that their total
spending exceeds the value of their tax and other current receipts. The deficit is financed by
long-term borrowing from abroad and from local residents. Sometimes the long-term
borrowings will not cover the gap which means it has to be financed by other means.
Government usually fills the gap by short-term borrowing from the central and commercial
banks. This borrowing from the banking system (deficit financing) usually has highly
expansionary effects on money supply. In other words it increases the money supply by the
amount of the deficit but is likely also to result in secondary increases in money supply by
increasing the cash base of the banking system and hence its ability to lend more to private
borrowers. (N.B. Expansionary does not mean inflationary). Monetary policy can be used for
anti-inflationary purposes. Much industrial and commercial expansion is financed by bank
credit (especially for working capital) so to restrict bank lending is liable to place a brake on
new investment and economic expansion. It is possible for credit restrictions to be pushed to
the extent of forcing a deflation on the economy, with serious avoidable loses of output and
employment. Some economists have argued in favour of the use of high interest rates to curb
aggregate demand. The effect of a move along these lines is to encourage the holding of
larger money balances, reducing the pressure of demand for commodities.
Critique of the interest rate Reservations to the interest rate issue have been raised:
(a) Higher interest rates may discourage investment and thus impede the development of the
economy. It can be counter argued that higher interest rates will raise the productivity of
new investments because now only projects which promise large returns will be
undertaken. Hence it may be possible to sustain the overall rate of economy growth even
from a reduced volume of investment.
(b) A successful induction of people to substantially increase their money holdings may due
to the withdrawal of purchasing power from commodity markets may be deflationary.
(c) Several studies have found the elasticity of demand for money with respect to the cost of
holding it to be rather small. If this is the case, it would take a very large rise in interest
rates to affect a significant increase in the demand for money.

Limitations of the state in achieving Macroeconomic Policy Objectives

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(i) too many ministries, often with competing interests, too many public corporations
and too many boards of one kind or another.
(ii) Too much corruption of civil service, civil servants badly motivated.
(iii) Too much red tape.
(iv) Too much political instability with governments often changed by military coups and
other unconstitutional means. Governments are therefore preoccupied with tasks of
maintaining their own popularity, authority and power.

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CHAPTER TWO

NATIONAL INCOME ACCOUNTING

National Income is the outcome or the end result of all economic activities. Economic activities
generate two kinds of flows (i) money flows- these are in exchange for services of factors of
production in the form of flows- these are in exchange for services of factors of production in the
form of wages, rent, interest and profits (i.e factor earnings) (ii) Product flows, are flows of
consumer goods and services and productive assets. All human activities which create goods and
services that can be valued at market price are broadly the economic activities.

Macroeconomics deals with a number of large totals or aggregates, which are used to
conceptualize and measure key components of the economy. The most fundamental of these is
the total output of goods and services, conventionally referred to as the national income. (Official
data in most countries is now actually reported on a "domestic" rather than a "national" basis.
The distinction, which is unimportant for most purposes, relates to the treatment of investment
income received from non-residents and paid to non-residents. "Domestic income" is that
produced within a country by all producers operating there, whether foreign or not. "National
income" is that produced only by "nationals" of that country, whether they are producing it there
or elsewhere.) 

There is nothing inconsistent in referring to total output as income. Although what is earned as
income can be measured separately from what is produced, the two aggregates are necessarily
the same in amount. Before going on to see why, note that in either case such large totals can be
expressed only in terms of money, not physical products as such. It is impractical to try to
measure output or income in real, physical terms, simply because it is impossible to sum apples
and oranges or any of the millions of goods and services which are produced and received as
income in a modern economy. Instead, physical quantities must be converted to a common
measure and the measure used for this purpose is the national unit of account, the dollar, pound,
or other currency. 

The value of total output or income in an economy during some accounting period, usually a
year or quarter of a year, is a significant statistic. It is generally used as an indicator of the
economy’s performance. Because a larger output or income is equated with a rise in the
economic well being of a country’s population, a higher output or income is considered desirable
and a lower one undesirable. The economy’s overall performance is tracked by the changing

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value of the total output or income statistic. Similarly, comparisons of relative well-being among
different countries are based on these statistics and a host of political and social as well as
economic implications flow from their behaviour over time.

The Circular Flow

A modern economy can be simply modeled in the aggregate by thinking of it as comprising two
key sectors, households which consume produced goods and services and which supply labour
and other productive services to firms, which use the labour and other productive services
supplied by households to produce the goods and services the households consume. Households
supply the services of productive factors (land, labour, capital, etc.) and the firms convert these
inputs into produced goods and services which return to the households. Owners of firms are, of
course, also part of the household sector where they function in their other capacity as consumers
of goods and services. 

The real flows of productive services and produced outputs have corresponding flows of money
payments associated with them. Firms pay out wages and salaries in return for labour services,
rents to owners of land and other natural resource inputs, and interest and profits to suppliers of
capital and entrepreneurial inputs. Householders consequently have money income with which to
pay for the produced goods and services that flow to them from firms. Thus, there are money flows

corresponding to the real flows, but they move, of course, in the opposite direction.

Circular Flow of Income

Services of factors of Production

Goods and services

H/H
OL FIR
DS MS

Spending

Incomes

Because the flows of payments for produced goods and services and payments for factor inputs
are continuous, aggregate income/output in this simple model could be measured at any point,
metering the flow anywhere in the circuit. If measured in terms of spending on produced goods

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and services, it would be natural to call this a measure of total spending or total expenditure. If
measured in terms of outlays made for the services of productive factor inputs, it would be total
income (from the point of view of the owners of those factor inputs). Obviously the two totals
would have to be the same.

This is a greatly simplified model. One thing missing is the possibility of saving. If households
do not spend all their income on produced goods and services, but hold some of it back as
savings, every time income flows into the household sector the flow of payments made to
producers will diminish. This is a "leakage" of income/spending from the system and the volume
of the flow would diminish—the level of national income would fall. But if there are savings,
there could also be new investment. If businesses borrowed income saved by households and
used it to finance the building of new plant or for other business purposes, it would be injected
back into the income stream (in the form of payments to workers and other factor owners who
supplied the necessary real inputs needed to produce the new capital). Banks and other financial
intermediaries serve as the nexus through which savings are converted into investment spending
and returned to the income stream.

In the simple economy above we can write the identity of output produced and output sold as Y
≡ C+I. That is all output produced is either consumed or invested. The corresponding identity for
the disposition of personal income is that the income is allocated on C (Consumption) and part is
saved (S). This implies that Y ≡ C+S. It also flows that C+I ≡ Y ≡ C + S. Subtracting C from
both sides gives I ≡ Y - C ≡ S which shows that saving is also income less consumption and also
investment is identically equal to saving.

If another complication, government, is added to the simple model, another potential for a
leakage of income from the system is introduced. Governments impose taxes (T) on households
(and firms) and this results in a diversion of income from the private sector to government. This
is another leakage and it too has a corresponding potential for injecting such income back into
the stream, this time in the form of government spending on produced goods and services.
Taxation reduces disposable income. Disposable income is given by Yd ≡ Y-T and also Yd ≡
C+S. Thus C+S ≡ Yd ≡ Y-T

Finally, most real world economies are not closed loops. Instead they are "open" to the rest of the
world, with leakages from domestic income/expenditure flows in the form of payments made for

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goods and services produced abroad ( imports, M) and injections of income back into the
domestic flows as a result of sales of goods by domestic firms to consumers abroad (exports, X).
As already seen, there can also be important flows of savings and investment between one
country and the rest of the world.

Circular Flow of Income

Services of factors of Production

Goods and services

H/H FIR

Spending

Incomes

LEAKAGES/WITHDRAWALS INJECTIONS
Savings Investments
Taxation Government Expenditure
Imports Exports

From the diagram Y = C + I + G + (X-M) = C + S + T

The important ideas to understand at this point are that national income or expenditure can be
thought of as a continuous flow which can be measured in different ways ( Product ≡ income ≡
expenditure on the product) and that this simple process is complicated by the possibilities of
leakages and injections arising from private saving and investing; government taxation and
spending; and foreign trade and capital movements.

THE NATIONAL ACCOUNTS

All the economies today measure the volume of aggregate income, usually defined as Gross
Domestic Product, in much the same way.

Gross Domestic Product (GDP)

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Refers to the total monetary value of all goods and services produced within the geographic
boundaries of a nation during a given year. The word “domestic” implies that only the income
produced in that country is accounted for. The income that arises from investments and
possessions owned abroad is thus not included in the GDP estimates.

Calculation of GDP

-calculated simply by valuing the outputs of all “final” goods and services at “market” prices
( i.e. actual prices at which they are bought and sold) and then adding the total. N.B. The market
value of all intermediate products- those used to produce the final output is excluded from the
calculation of GDP since the values of intermediate goods are already implicitly included in the
market prices of the final goods. “Gross” implies not all output was available for private/public
consumption and investment, part went to replace or maintain worn out capital equipment.

Nominal and Real GDP

Two measures of GDP are given: nominal GDP (also called current dollar GDP) and real
(constant dollar) GDP. Nominal GDP measures the value of output at the prices prevailing at the
time of production, while real GDP measures the output produced in any one period at the prices
of some base year. The growth rate of the economy is usually taken to be the rate at which real
GDP is increasing.

Whatever their minor differences, all national accounting conventions follow the basic pattern
identified in the preceding discussion of the circular flow of income and expenditure. There are
always at least two main calculations, one which sums total expenditures on goods and services
produced, the other of total income received as a result of producing those same goods and
services. Because both are measures of the same thing they must, by definition, yield the same
total. 

In national accounting in ex-post sense expenditure on production is always equal to production

and income. Product ≡ Income ≡ Expenditure on the product

Why two measures if the total must be the same? One reason is that two estimates provide a
check on one another with respect to accuracy. Another is that the two measures break down into
different components, some of which are more useful for certain purposes than others.

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GROSS NATIONAL PRODUCT (GNP)

This is the most important and widely used measure of national income. It is the most
comprehensive measure of a nation’s productive activities. It is defined as the value of all final
goods and services produced during a specific period, usually one year (Dwivedi, 1996). In other
words it refers to that part of the GDP that is actually produced and earned by or transferred to
resident nationals of that country. Earnings of foreigners which arise out of their domestic
economic activities are thus excluded. For Zimbabweans working abroad their income is
included in the GNP of Zimbabwe. Where there is substantial foreign participation in the
economy and a large part of total domestic income is earned and repatriated by foreigners and
foreign companies as in many LDCs, GDP will be much larger than GNP. As a result statistics of
GDP growth may give a false impression of the economic performance of a particular
developing nation. GNP is therefore a more appropriate measure of national income.

NET NATIONAL PRODUCT (NET NATIONAL PRODUCT)

Net National Product = Gross National Product– Depreciation. Net National Product (NNP) is
calculated by deducting from GNP the depreciation of existing capital stock over the course of
the period. The production of GNP causes wear and tear to the existing capital stock, for
example, machines wear out as they are used. It is a more accurate measure of national product
but in real life GNP is mostly because net investment (Gross Investment – Depreciation) is
difficult to measure especially as rate of depreciation is not known (straight line, declining or
reducing balance?) or may be quite inaccurate. Depreciation estimates may also not be quickly
available.

MEASUREMENT OF NATIONAL INCOME

There are three methods or approaches for measuring total output, namely :

1). Expenditure

2). Income method

3). Value Added or Output approach

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A. The Expenditure Approach

Measuring total output by the expenditure method involves breaking down total spending on all
goods and services produced into four categories: (a) Expenditures by consumers on goods and
services (abbreviated simply to the letter C); (b)Expenditures by businesses on capital goods
(total investment spending, I); (c) Expenditure by government on goods and services, G); and
(d) Net exports (the total value of exports minus the total value of imports, X-M). Because all
spending done in the country falls into one or other of these four categories, we can say that total
expenditure is the sum of C+I+G+(X-M). We now examine each of these four main components
of total spending. 

Consumption (C)

Consumption spending is the total of all outlays made by households on final goods and services.
In all countries it is by far the largest component of total spending. It covers spending on an
enormous range of items, including durable goods like television sets and cars, non-durable
goods like food and clothing, and personal services such as legal advice, hairdressing, and dental
care. But it usually excludes spending on houses, which is customarily (and arbitrarily) treated as
investment expenditure. C also excludes purchases of second-hand goods that were produced in
some earlier accounting period so as not to double count the value of such output.

Government Expenditure on Goods and Services (G)

All governments payments to factors of production in return for factor services rendered are
counted as part of the GDP. Much of the spending done by governments in the developed
countries today takes the form of simple transfers of income from taxpayers to those eligible for
the wide range of income supplements available to assist the elderly, the sick and the
unemployed, or as payments of interest to holders of the public debt. Such transfer payments do
not represent spending on current production and consequently, are not counted in national
income determination. What is counted is government spending on goods and services, many of
which are bought by the government on behalf of the public and which are ultimately
"consumed" by households: education, health care services, national defence, roads, water and
sewage systems, postal services. Because so many of these goods and services are provided
"free" or in other ways that bypass markets, it is difficult to determine their value in the same
way that the value of the other items entering into C would be determined. Consequently,

15
national income accountants value government spending on the basis of what the government
pays for the goods and services it requires.

Another complication with government spending on goods and services is that such spending is
often done on things like highways which are themselves capable of being used to assist in the
production of other goods. Logically, such spending should be thought of as investment spending
and included in the next category to be discussed. Some countries produce their accounts in such
a form that government spending can be separated into two categories, current spending on
goods and services, and investment spending, but if the main concern is to understand the causes
of year-to-year cyclical fluctuations in the level of national income rather than the causes of its
longer term growth (which may be strongly affected by the level of investment as opposed to
current spending) it is convenient to stick with the traditional categories of spending which
emphasize the different motivations driving the spending decisions of ordinary consumers,
private investors and governments. Here, investment spending refers to private investment
spending unless otherwise stated.

Investment (I)

Investment is the production of goods that are not for immediate consumption. The goods are
called investment goods (inventories and capital goods including residential housing) The total
investment in an economy is called Gross Investment.

We count the construction of new houses as part of GDP, but we do not add trade in existing
houses. We do however, count the value of the estate agents commission in the sale of existing
houses as part of GDP. The estate agent provides a current service in bringing buyer and seller
together, and that is appropriately part of current output.

Total or gross investment Expenditure may be divided into two main categories:

(i) Expenditure on capital goods—purchases of plant and equipment either to replace

existing capacity that is wearing out or to increase capacity. This is often called fixed
capital formation.

(ii) Expenditure on inventories. Many businesses find it convenient or necessary to hold

certain supplies of goods on hand, in which case investment in inventories may be

16
 considered voluntary. But business conditions are uncertain and so firms may also find
themselves holding stocks because they miscalculated demand. In either case, firms are
considered to be investing when they accumulate inventories. On the other hand, if their
inventories decrease they are "disinvesting." Inventory investment is highly volatile,
changing greatly in amount and composition from year to year.

Gross investment, then, is the total amount of (usually private) spending during the accounting
period on capital goods (defined as structures, machinery and equipment, and inventories).
Because capital by its nature consists of things that are used in the production of other goods and
services, it is inevitable that it will wear out or "depreciate." The amount necessary for
replacement is called Depreciation or capital consumption allowance. Gross Investment –
Depreciation = Net Investment. Unless it is continually renewed, the stock of capital in the
economy will gradually be depleted.

Handling depreciation is one of the more difficult parts of national income accounting. Again,
the best treatment depends on what the data are meant to be used for. If the concern is with the
long-term growth of the economy, net investment (total investment during the accounting period
minus depreciation) is the important concept because it measures the growth of the economy’s
capital stock over time. But if the purpose is to understand short term, annual fluctuations in the
level of total spending it is better to work with gross investment. 

Net Exports (X-M)

A significant part of total spending in most countries goes toward the purchase of goods
produced abroad rather than domestically. As noted in discussing the circular flow, such outlays
represent spending which leaks from the domestic economy to the rest of the world and is
consequently treated as a negative entry in measures of total domestic spending. But it is offset
to a greater or lesser degree by the spending of non-residents on goods produced and exported to
international markets. It is often convenient, therefore, to take domestic spending on imports and
foreign spending on exports as a combined value, usually called net exports, a value which may
be positive or negative in any accounting period depending on which component, exports or
imports, is larger.

Summing these four expenditure components, C+I+G+(X-M), gives a single figure, the total
amount of spending done in the economy during the accounting period. It should be possible to

17
arrive at exactly the same figure by summing all income received in the economy during the
accounting period. (GDP = Y = C+I+G+(X-M),

B. Measuring Total Output by the Income Method

As seen in discussing the circular flow, what the firms producing the national output see as costs
of production, owners of productive factors see as income. Factor costs and factor incomes are
consequently the same thing viewed from different perspectives.

GDP = wages+ rents + interest + non-income charges

Quantitatively, by far the most important and certainly the simplest factor costs to measure are
the payments made by employers for labour services. These payments are usually reported in the
official statistics under a heading such as "Wages, salaries, and supplementary labour income,"
with the latter term referring to employee benefits such as pensions, workers’ compensation
benefits, and employer contributions to unemployment insurance funds or other worker social
security schemes. Most other factor payments, however, are much more difficult to track.
Consider a farming operation. How should any net income derived from farming be classified?
Part of it must be a return to the services of land the farmer is using ( rent). Part must be a return
to the farmer’s own input of labour (wages). Part might be considered a return to setting up and
operating the business(profit). These are difficult to separate. Because of such problems, the
national accounts typically use definitions of factor payments which owe more to convenience
than to the logic of factor classification: net income of farm operators, corporation profits, net
income of unincorporated business, and interest and other investment income. Summing all these
items yields the total amount received during the accounting period by the owners of productive
factors. But if this figure for factor costs or income is compared with the total arrived at by the
expenditure method, it falls considerably short of the amount expected.

Indirect taxes and subsidies result in a discrepancy between the market price and the factor cost
of goods and services. The market price of most goods and services includes indirect taxes, such
as general sales tax, value- added tax and excise taxes with the result that the market price is
greater than the price the seller of the good or service receives. On the other hand, subsidies paid
to producers to keep the market price of certain goods and services lower than it would otherwise
be, result in the producers’ income being greater than the market price. To calculate the GDP at

18
factor cost, i.e. the amount received by the factors of production that produced the goods and
services concerned, we therefore have to deduct indirect taxes from the GDP at market prices
and add back subsidies. Thus: factor cost ≡ market price – indirect taxes + subsidies. This point
becomes important when relate GDP to the incomes received by the factors of production.

C. Output Approach or the Value Added Method

A third method is available for estimating the total output of the economy and it is called the
"value added method" because it simply sums the net value of the output produced by all the
firms in the economy. GDP is the value of final goods and services produced. The insistence on
final goods is simply to make sure that we do not double count This approach measures GDP in
terms of values added by each of the sectors of the economy. This is conceptually simple, but in
practice complex because of the need to avoid double counting. There are many interactions
among firms in a modern economy. Many produce goods that are sold not to final users as
consumer goods, but to other firms. Consider a firm producing power supply devices for
computers. It buys components from suppliers, assembles them, and sells the finished product to
another firm which incorporates it into a computer. If the value of the power supplies was
measured when they were produced and again as part of the price of the finished computer, total
output would obviously be exaggerated. Dealing with this requires that the value of each firm’s
output be reduced by the amount of all payments made by that firm to obtain inputs. This
involves considerable work, but the resulting data are often very useful because they yield a
breakdown of national output on an industry-by-industry basis. In formula terms:

Value Added = output of firm - output purchased from other firms.

If we follow the course of this process, we will see that the sum of values added at each stage of
process is equal to the final value of the item sold. Value added is also the basis for the Value
added Tax (VAT).

A problem associated with the value added approach is valuation of inventories of goods
produced but unsold. Unsold inventories are valued at market prices yet profits ( or losses) have
not been realised; prices may fall or rise; goods may not be sold. This means that a rise in market
prices causes a rise in value of the existing inventories. To avoid this distortion a correction is

19
made to eliminate changes in the value of inventories due to price changes; that is stock
appreciation should be deducted from the value.

The table below summarizes the relationships. For example from the third and fourth columns
NNP at market prices – indirect taxes add subsidies = national income at factor cost.
Net factor
payments

Depreciation

Indirect taxes
GDP at GNP less
market at market subsidies
prices prices NNP at
market National Various*
prices Income items
at
factor Personal Personal
cost Income Tax
Personal
Disposable
income
* includes income that does not accrue to personal sector e.g. corporate taxation and corporate saving

Uses of National Income Accounting

1. Assists government in planning the economy. The accounts will show growth or stagnation
in the economy, alerting policymakers to the sort of action which ought to be taken. Since
national income accounts break the performance of the economy down into its component
parts, they provide policymakers with specific information regarding the formulation and
application of economic policy.

2. Permits us to measure the level of production in the economy over a given period of time and
to explain the immediate causes of that level of performance.

3. By comparing the national income accounts over a period of time, the long-run course which
the economy has been following can be plotted.

20
4. To compare standards of living of different countries- the problem is the countries being
compared use different currencies. The simplest means of dealing with the problem is to use
the Exchange rates between countries to convert the GNP of each nation to a common
currency e.g. US$. Most international comparisons use this method. The second method used
is Purchasing Power Parity. (a) Exchange rate conversion- the method is simple and
straightforward but this does not meet our needs fully. We are seeking to measure differences
in standard of living among areas, but exchange rate reflects purchasing power of currencies
for goods traded in international markets. Goods and services not traded on international
market may not be correctly taken into account. (b) Purchasing power parity- the method
involves determination of the relative purchasing power of each currency by comparing the
amount of each currency required to purchase a common bundle of goods and services in the
domestic market of the currency’s country of origin. This information is then used to convert
the GNP of each nation to a common monetary unit. Estimates using Purchasing Power
Parity method are a more accurate indicator of international differences in per capita GNP
than exchange rate conversion method.

5. As a measure of welfare and national development, GNP per capita may be rising over a
period of time implying a rise in economic welfare and economic development. Criticisms
include the following- output of weaponry may rise, crime may rise (use of more police),
motor vehicle production (more pollution) may also rise (showing increasing GNP) yet in
terms the people are not better off or even worse off. Output may also have been of capital
goods. GNP per capita gives no indication of how national income is actually distributed and
who is benefiting from growth of production. A rising level of absolute and per capita GNP
may obscure the reality that the poor are no better off than before. As an index of improved
economic welfare GNP growth rates are inadequate for the generality. Despite its
shortcomings, GNP provides a useful measure especially if it is accompanied by indicators
like life expectancy, infant mortality rates, education, literacy and income distribution.

6. For soliciting international aid from other countries or multilateral organizations.

7. National income and product estimates by sector of origin of national product reveal
contributions made by different sectors of the economy.

21
PROBLEMS OF GDP MEASUREMENT
GDP data are far from perfect measures of either economic output or welfare. Problems of GDP
measurement are:
(1) Badly measured outputs-some outputs do not go through the market, e.g. government output
(such as defence) is not sold in the market. Also there is nothing comparable available that
would make it possible to estimate the value of government output. It is therefore valued at
cost. Other non-market activities, including do -it- yourself work and volunteer activities, are
also excluded from GDP.
(2) Unrecorded economy- many transactions that go through the market escape measurement.
e.g. payment for a handyman’s services is not recorded in the GDP data as it is unlikely to be
declared, illegal traffic in drugs. The main problem is that the relative importance of such
activities may have been changing. If such activities become more important over time , then
measured real GDP will understate the rate of growth of total economic activity. Why there
might have been an increase in unrecorded transactions (i) rising tax rates (which make it
more tempting not to declare sales or income,) and the growing importance of the so called
informal activities outside the modern sector of the economy.
(3) Data revisions- when they first appear, GDP data are not firm estimates. The reason is that
many of the data are not measured directly, but are based on surveys and guesses.
Considering the GDP is supposed to measure the value of all production of goods and
services in the economy, it is not surprising that not all the data are available within a few
weeks after the period of production. The data are revised as new figures come in, as the
CSO and RBZ improve their data collection methods and estimates.

Adjusting National Income Data to Allow for Price Changes

One difficulty with using money values to express national accounting magnitudes is that the
value of money may change over time. If there is a general rise in all prices, or a fall in all prices,
the monetary unit either decreases or increases in value. Trying to measure distance with a ruler
that shrank or expanded significantly between measurements would obviously be a frustrating
and not very useful activity. Inflation, defined as a general rise in the price level, or deflation, a
general fall in the price level, are common enough to make it necessary to adjust national income
data to remove the effect of changes in the purchasing power of the dollar or other monetary unit
22
being used to measure the value of total output. This is done by developing indexes which show
how the prices of the goods and services produced in any one year have changed relative to the
prices of those goods and services in some other year. Setting up these indexes of prices is not
difficult in principle, although it can be an expensive, time-consuming task in practice. Consider
a simple example in which only a single commodity is the subject of interest, men’s shoes. In the
following table the price of men’s shoes in each year is compared with the price prevailing in
one particular year. The base year in the example is year 2000, (this can be written as 2000=100)
although it could have been any one of the five years. The price in any particular year is then
divided by the price in the base year to get the ratio of prices shown in the third column. Because
these ratios are usually expressed as percentages, they are then multiplied by 100 to obtain the
price index numbers shown in the last column.

Year 1999 2000 2001 2002 2003

Price($) 20 40 50 60 80

Price Ratio 20/40=0.5 40/40=1 50/40=1.25 60/40=1.5 80/40=2

Price Index 50 100 125 150 200

 

These index numbers can now be used to adjust the data on the value of men’s shoes produced in
each year, thereby eliminating the effect of price changes from the series. Suppose the following
production information is available.
 

Year 1999 2000 2001 2002 2003

Output in Current $ 5 20 30 50 90

Output in Constant$ 10 20 24 33.3 45

The current dollar values shown in the second column turn out to be quite misleading as an
indicator of the real changes in output. Because prices were lower in Year 1999 than in the base
year (Year 2000), the output in Year 1999 was understated, whereas, because prices in Years
23
2000, 2001, and 2003 were higher than in the base year, the current dollar production values
overstated the volume of output. The conversion to (Year 2000) constant dollars in the third
column was done by dividing the current dollar values of output for each year by the relevant
index number (expressed as a percentage).

Men’s shoes are only one of thousands of commodities which are included in the total national
income and, in practice, it is not feasible to develop price indexes for each item in this way.
Instead, price indexes are built up for groups of commodities which are often defined in terms of
who buys them. For example, a commonly used index measures changes in the amounts
households spend on a selected bundle of goods and services. One of the problems with this kind
of index is that it is very costly to determine which goods should be included in such a bundle.
Surveys must be made of household buying habits to determine which goods households are
buying in significant quantities and the relative importance of various goods in typical household
budgets. Because of this, years may elapse between redefinitions of the goods which are included
in the index which makes the information the index provides of dubious value toward the end of
the redefinition cycle. 

When constructing large price indexes for adjusting national income data, most statistical
agencies build up a general index from a large number of specific commodity group indexes, so
that changes in expenditure patterns within the component groups will not seriously affect the
outcome. This composite index is known as a gross domestic product deflator. It can be used to
convert any current dollar value of gross domestic product to a constant dollar basis using the
relation: 

Nominal GDP/Real GDP x 100 = GDP Deflator

GDP price deflator is an index calculated from nominal and real GDP. Thus, if the deflator is
known to have a value of 125 and nominal (current dollar) gross domestic income is 50 billion
dollars, real gross domestic income is $40 billion.

The measurement of per capita income

All countries have adopted the conventions (the United Nations Standard National Accounts) for
the calculations of Gross National Product (GNP) and Gross Domestic Product (GDP), and GNP

24
or GDP per capita is the commonest indicator of the level of development. Economic growth
refers to an increase in either of these indicators. There are however well known problems
associated with the calculation of national income in poor countries and its use as an indicator of
development:

1. The necessary data are often incomplete, unreliable or not available

2. The accounting conventions are not necessarily appropriate; the services of women working
in the household are excluded from national statistics yet in many poor countries, especially
in sub – Saharan Africa, women are often responsible for running the family farm as well as
working in the household.
3. In most poor countries, there is a large subsistence sector – that is, farmers may well
consume all or large proportion of what they produce, rather than sending it to the market
where it would be counted for the purposes of calculating national income. Statisticians make
an allowance for this non- marketed component of output, and for rural capital formation that
may not enter the national accounts – house building, irrigation ditches – but it is generally
accepted that the value of the activities is underestimated, thus biasing downwards the
national income figures for poor countries.
4. Income may be overstated for developed economies because a number of items that are
included as income might better be seen as costs and hence excluded from income- the cost
of travelling to work, for example, or the cost of heating the home in temperate climates.
5. Per capita (average) incomes tell us nothing about the distribution of income. Two countries
with similar per capita income distributions, with important implications for the welfare of
their populations and the nature and characteristics of the development process.

Significant problems arise when international comparisons of income levels are made. Income
data measured in national currencies have to be converted into a common currency, usually the
US dollar, and an exchange rate must be chosen. If poor countries artificially maintain
overvalued exchange rates (that is, the price of foreign currencies in terms of their domestic
currency is too low), this will overstate the income of the country expressed in US dollars.
Offsetting this, however, is the fact that many goods and services in poor countries are not traded
and hence have no impact on the exchange rate. Many of these necessities of life in poor

25
countries – basic foodstuffs for example- are very low priced in dollar terms, and a haircut in
Zimbabwe will cost less than one in Paris or London.

According to World Bank data:

 Mozambique with an estimated GNP per capita of US 60 in 1992 was the poorest country in
the world;
 Switzerland, with a GNP per capita of US$36080, was the richest

Is the average Swiss citizen 600 times better off than the average Mozambican? To put that
question slightly differently, does it make sense to state that in Mozambique, on average, people
live on 16 cents a day?
Clearly nobody in a developed economy could survive on such a low income. Given that the
majority of Mozambicans do survive, it must be the case that the necessities essential for survival
cost less in Mozambique than for example in Switzerland, and/ or $60 is not a meaningful
estimate of per capita income in Mozambique. This is not to deny that a huge gap exists between
the average incomes of very rich and very poor countries, nor should it lessen our concern with
such inequalities. But it does mean that the gap on average is not as great as the statistics would
suggest and a number of attempts have been made to compute more meaningful comparisons.

Measurement of the Standard of Living

The value of this year's national income is a useful measure of how well-off a country is in
material terms. However, inflation increases the money value of national income but does not
provide us with any more goods to consume. Real national income is found by applying the
equation:

Real national income = Money national income/Retail price index x 100.

The standard of living refers to the amount of goods and services consumed by households in
one year and is found

(i) by applying the equation:

Standard of living = Real national income/ Population = national income per capita

26
A high standard of living means households consume a large number of goods and services.
Or

(ii) by counting the percentage of people owning consumer durables such as cars, televisions,
etc. An increase in ownership indicates an improved standard of living. Or

(iii) by noting how long an average person has to work to earn enough money to buy certain
goods. If people have to work less time to buy goods, then there has been an increase in the
standard of living.

Interpretation of the Standard of Living

An increase in the standard of living may not mean a better life-style for the majority if:

 Only a small minority of wealthy people consume the extra goods.

 Increased output of certain goods results in more noise, congestion and pollution.

 Leisure time is reduced to achieve the production increase.

 There is an increase in the amount of stress and anxiety in society.

Common Misunderstanding

1. The various measures of the national product give us a tally of the nation’s income for a
year. However this does not measure the nation’s wealth .The nation has great stock of
capital goods .The stock of national capital is the sum total of everything that has been
preserved from all that has been produced throughout our economic history. Interestingly,
perhaps the greatest asset of modern economies is the skill and education of the workforce.
This is called ‘human capital’ but is not included in measures of net capital stock owing to
difficulty of measurement.
2. If we are assessing someone’s wealth, one of the first things we would look at is how much
money they had and whether they owned stock and shares. However these are excluded
from the calculation of national wealth. Why? The answer is because we have already
counted them in the form of real wealth such as buildings and machines. Money and other
financial assets are only claims upon wealth and hence are simply paper certificates of

27
 ownership. Similarly, varying the amount of money in the economy does not directly make
it any richer or poorer.

DETERMINATION OF EQUILIBRIUM NATIONAL INCOME

Equilibrium is that position in which the opposing forces of change are in balance. In a two
sector income equilibrium equation is Y = C + I where C = a + bY e.g. 50 + 0.75Y

According to Keynesian theory of income and employment, national income depends upon the
aggregate effective demand. If aggregated effective demand falls short of the output at which all
those able and willing to work are employed, unemployment in the economy will result.
Consequently there will be a gap between economy’s actual and optimum potential output. On
the contrary if the aggregate effective demand exceeds the economy’s full employment output
inflation will result.
Equilibrium aggregate income and output is determined at that point at which total expenditure
or aggregate demand function C + I + G + (X - M) cuts the 45 0 equality line (Expenditure =
Income). N.B. Equilibrium does not mean full employment output.

MULTIPLIERS
When there is an increase in the level of injections, part of it will be received by a household as
extra income. The households will probably act so that part of this extra income is then spent and
part is saved. This extra consumer spending then gives rise to a series of further incomes and
expenditures. The overall increase in spending is much higher than the initial injection. This
effect is known as the multiplier effect. The greater the proportion of the extra income that is
spent (the Marginal Propensity to Consume), the bigger the multiplier effect will be. The
multiplier is defined as the ratio of the change in national income to the change in expenditure
that brought it about. The change in expenditure might come from for example private
investment (investment multiplier) or government expenditure (government expenditure
multiplier) or exports (exports multiplier). If we let k be the multiplier;

28
 ΔY
k i= =Investment⋅Multiplier
ΔI
ΔY
k g= =IGovt . Expenditure . multiplier
ΔG
ΔY
k X= =Exports⋅Multiplier
ΔX

Investment Multiplier
Investment Multiplier ki
Y
k i = I  Investment  Multiplier

To clarify the investment multiplier supposing there is an injection of $120m to build factories
and other capital goods. The impact of this investment will be more than the $120m initially
invested. The $120m spent is thus income to those who supplied the equipment, resources etc.
How much of this $120m which has been received as income will be spent depends on the
keenness of the recipients to spend it, in other words their marginal propensity to consume.
Marginal Propensity to consume (MPC) would thus be the fraction of the income likely to be
spent. Of all income earned part will be spent, part will be consumed, ie. Y = C + S
Consumption/ Income earned = MPC = Marginal Propensity to Consume

Amount Saved or Amount earned or income = MPS (Marginal Propensity to Save) and therefore
MPC + MPS = 1. Assuming a marginal propensity of 2/3, then $80m of the $120m will be spent
in the next stage. In the next stage of the $80m income, $53m will be consumed. The greater the
MPC the greater the income that is consumed hence the greater the amount spent at subsequent
stages. To calculate the multiplier

ki = 1/(1-MPC) = 1/MPS. From the example above ki = 1/(1-2/3) = 1/ (1/3)= 3. The greater the
MPC the greater the multiplier. This means that the total increase in the national product brought
about by the investment of an initial sum of $120m is $360m.

This analysis assumes away taxation and also price increases due to high demand for goods and
services. Imports have also not been taken into account. In reality once demand increases prices
may stabilize for a short while if factories have been operating at less than full capacity but when
that happens, i.e. full capacity is reached prices start to rise. The rise will also depend on whether
the economy is inward looking or outward looking in terms of raw material inputs. If inputs are

29
imported this pushes up prices of the inputs and as a result increase in national output of $360m
will not be realized because of the leakages. Increase in demand for finished products also causes
a derived demand for material inputs hence cost of finished goods and ancillary services will
rise. On the whole there would be a decline in the quantities that would be purchased, due to
increases in prices. Anticipated expenditure is thus not equal to actual expenditure realized. The
tax structure may be increased especially as the tax base has been widened. Once the rate of tax
has increased then disposable income diminishes hence this affects the amount of purchases vis-
à-vis savings.

Simple Investment Multiplier

Importance of the multiplier for economic policy purposes stems from the assumption that a
given initial change in autonomous investment spending causes a magnified change in the
equilibrium income in the economy. Multiplier theory states that the increase in total income
occasioned by any given increase in autonomous investment (or consumption) outlay is a certain
multiple of the original increase in autonomous expenditure and the magnitude of the increase in
total income depends upon the value of the MPC. The investment multiplier Ki and MPC are
related in such a manner that the higher the MPC the higher the investment multiplier and vice
versa.

1 1
K i= =
1 − b 1− MPC

To derive we start with Y = C + I = C + Ī and C = a + bY

Substituting in the equilibrium equation ( Y = C + I ) this becomes

Y = a +bY + Ī

Y(1-b) = a + Ī

aI
Y=
1−b
dY 1
= =K i
d I 1−b

Ki = 1/MPS MPS = 1 – MPC

30
The operation of the simple investment multiplier in the economy is thwarted by many leakages.
Consequently the actual income generated consequent upon any given increase in autonomous
investment expenditure will be less than the product of the investment multiplier K i and the
given increase in autonomous investment ΔI. In other words ΔY < ΔĪ. K i . Examples of a
leakages (imports); inflation (increased money spending fails to increase real consumption);
savings (higher MPS lowers the multiplier while a lower MPS raises the multiplier. Regressive
tax policy and other fiscal measures involving redistribution of income in favour of the richer
sections of the economy also reduce the size of the multiplier as do paying off debts, or if the
increase is invested in securities.

So far we focused on the simple investment multiplier where investment was treated as
autonomous, i.e. not related to income changes. In reality increases in income also causes
increases in investment. Thus like consumption the changes in investment in the economy are
induced by change in the level of income. Induced investment is positively related to the level of
income such that an increase in income induces an increase in investment and net investment in
any given time period will be equal to the increase in aggregate demand. It is therefore more
realistic to treat total investment as being composed partly of the autonomous investment and
partly of induced investment. Investment demand function in the form I =. I A + eY where ĪA is
autonomous investment and eY is the induced investment 0<e<1.
Derivation
Y=C+I and C= a + bY; and I =. IA + eY substituting gives
Y=a+bY+I A +eY
Y  1−b−e =a+I A
a+I A
Y=
1−b−e
dY 1 1
K i= = =
dI A 1−b−e 1−MPC−MPI

This is the super multiplier. The inclusion of induced investment in the model raises the value of
the investment multiplier.

31
Paradox of Thrift
The inclusion of the induced investment in the model shows the interesting phenomenon of the
“paradox of thrift” which reveals that an attempt on the part of the community to save more out
of any given income will lead to an actual decrease in the amount it will succeed in saving. In
short, the attempt to save more will be self-defeating. In fact the community may paradoxically
end up with reduced total saving.

Government Expenditure Multiplier

From the definition this multiplier is kg
ΔY
K g= =G ovt . Exp . M ultiplier
ΔG
Government expenditure can influence economic activity in a country. It can influence national
output and employment levels to name a few. The multiplier applies equally to government
expenditure as it does to investment. In a simple model on the determination of national income
or output, aggregate demand is given by the formula Y=C+I+G, that is aggregate demand = Y =
Consumption + Investment + Government Expenditure. If MPC =2/3 as before the change in
national will be $360m. This implies that an increase in employment for the factors used to
produce that much in output will result.
Knowledge of government expenditure multiplier would help the government in deciding on
what expenditure level would be necessary to reach the full employment level.

E=Y E=Y
AD2

C,I,G AD1 C,I,G AD1

Recessionary gap ∆G
Full employment Full employment

700 1000 700 1000

National Product National Product

In the diagrams, assuming that MPC=2/3, the multiplier is 3 an the present equilibrium is such
that the national product (aggregate demand) is at $700m and the full employment level is at

32
$1000m then the government can increase its expenditure to wipe the recessionary gap by
spending only $100m.

Government Spending-Investment Multiplier

When investment (I) varies as income varies, then a change in government spending leads to a
modified multiplier – the government spending – investment multiplier, kgi
1
k gi=
MPS − MPI

where MPI = marginal propensity to invest out of income. If MPC =2/3 and MPI =1/6 (MPS = 1
– 2/3=1/3)
1 1 1
K gi= = = =6
MPS−MPI 1 1 16
−
3 6
From this a change in government expenditure, hence aggregate demand of $120m leads to a
magnified change in income of $720m because of the multiplier factor.
∆Y = kgi ∆G = 6 x $120 = $720m.

Government Expenditure Multiplier in a closed economy, with taxes

If we assume a closed economy
E = C + I+ G

G=G
1. 0 - Government expenditure is exogenous

2. T=tY - The tax (T) depends on the tax rate (t), which is the function of income
Budget Surplus or Deficit = G – T; G is Government expenditure; T is Taxation
If G>T there will be a budget deficit.
If G<T there will be a budget surplus.
C=C 0 +c 1 Y d Yd
3. where is disposable income
Y d =Y −T
4. Disposable income equals total income less taxation.
Y d =Y −tY
=  1−t  Y
I=I
5. 0 Investment is exogenous (independent of income)

Expenditure (E) = Income (Y)

33
E=Y
Y=C+I+G
Y=C 0 +c1 Y d +I 0 +G 0
Y − c 1 1−t  Y=C 0 +I 0 +G 0
 1−c 1 1−t  Y=C0 +I 0 +G0
1 −c 1  1−t  Y=C 0 +I 0 +G 0
C +I +G 0
Y= 0 0
1− c 1  1−t 
0 <c 1 1 0 < t< 1
Government multiplier
ΔY dY 1
= =
ΔG 0 dG 1−c 1 1 −t 

Alternative approach
S=S 0 +S 1 Y d
1.
I=I 0
2.
G=G
3. 0

4. T=tY
Y =Y −T=  1−t Y
5. d
C+I+G=C+S+T
S+T=I+G
S0 +s 1 Y d +T=I 0 +G 0
S0 +s 1  1−t Y+tY=I 0 +G 0
s1 1−t Y+tY=−S 0 +I 0 +G 0
Y [ s 1 1−t +t ]=−S 0 +I 0 +G 0
−S +I +G 0
Y= 0 0
s 1  1−t +t
dY 1
=
dG 0 s 1  1−t  +t

The higher the MPS and taxes the lower the amount consumed. The lower the MPS and taxes the
higher the expenditure rate and figure.

Government Expenditure Multiplier in an open economy, with taxes

S=S 0 +S 1 Y d
1.
I=I 0
2.
G=G
3. 0

4. T=tY

34
 0 ≤ M 1≤1
5. M=M0 +M1Y
M = import function
M1 = marginal propensity to import
M0 = autonomous imports
Y d =Y −T=  1−t Y
6.
X=X
7. 0 exports are exogenous because imports depend on the exchange rate. It
also depends on the world price. The marginal propensity to import depends on the exchange
M 1 e,P w ,P d 
rate. ( . Exports are exogenous in a small country because they are determined by
other countries.

C+I+G+ X − M =C+S+T
8. I+G+X=S+T+M
injections = leakages
I 0 +G 0 +X 0 =S 0 +s 1 Y d +tY+F 0 +M 1 Y
−M 0 − S 0 +I 0 +G 0 +X 0 =s 1  1− t Y+tY+M 1 Y
= s 1  1−t +t+M 1 Y

−M 0 − S 0 +I 0 +G 0 +X 0
=Y
s 1 1 −t +t+M 1

dY 1
multiplier= =
dG 0 s 1 1 −t +t+M 1

Government purchases of goods and services when added to the level of private consumption
and business investment demand cause an increase in the equilibrium income in the economy.
This is so because government purchases of goods and services not financed by an increase in
taxes, increase the aggregate effective demand and consequently increase the equilibrium income
in the same manner in which an increase in consumption and/or investment outlay raises the
equilibrium income.

Taxes on the other hand have the same impact on the economy as saving. An increase in
government taxes will, ceteris paribus, decrease the equilibrium income. Government purchases
involve government expenditure on goods and services. Total government expenditure can be
separated into government purchases of goods and services (G) and government transfer
payments (R). Their impact on the economy is different. While G involve direct consumption of
the purchased goods and services by government and therefore raise aggregate demand by the
full amount of government expenditure. In the case of transfer payments (R), government pays
35
money to individuals in the form of old age insurance, unemployment dole payments, etc. After
including government sector in a 3 sector closed economy, equilibrium aggregate income will be
Y = C + I + G with no increase in the government taxes and autonomous investment, the
government purchases multiplier will be equal to the simple investment multiplier.
ΔY 1
K i= =
ΔG 1−b

Derivation. This can be derived as follows: Y = C + I + G and C = a + bY; I = Ī A where ĪA is

autonomous investment. G = Go= autonomous government expenditure.

Y =abY I AG o or G 
aI A G
Y=
1−b
dY dY 1
= =
d G dG o 1−b

This is the multiplier in the absence of government taxes and transfer payments with only
autonomous investment.

Government transfer multiplier. A government transfer multiplier operates like the simple
multiplier except that its value is generally smaller than the value of the simple multiplier for
either government purchases or investment. Normally different transfer payments would have
different multipliers. For example, the transfer multiplier for interest payments would be smaller
than that for the unemployment compensation payments since interest payments are mostly
received by high income families owning government bonds. These families’ MPC is low while
the unemployment compensation payments are received by the low income and poor families
whose MPC is generally high.

Tax Multiplier. The tax multiplier would be negative because a tax would cause a negative
change in the disposable personal income of the community. The disposable personal income

Yd = Y –T+R where R is transfers. (It is assumed that T and R are autonomously determined.) C
= a + bYd and therefore ΔC= bΔYd
ΔC= bΔ (Y –T+R) and ΔC= bΔY –bΔT+bΔR)

The impact of taxes on consumption and therefore, on income is negative. Derivation is Y = C +

I+G

36
Y=a+bY d  I A G

Substituting for Yd gives

Y=a+b  Y −T+R  I A  G

⇒Y 1−b =a−bT+bR+ I A
a−bT+bR+ I AG
Y=
1−b
ΔY b
=− =K t
ΔT 1−b
Similarly
ΔY b
= =K r
ΔR 1−b

for the transfers multiplier.

Lump sum tax multiplier

Lumpsum tax is tax that is a fixed amount. The lumpsum tax multiplier
ktx= - MPC/MPS. This has a negative sign because as tax increases consumption falls. If MPC =
¾; MPS = ¼, then ktx= - MPC/MPS.= -(3/4)/ (1/4) = -3.
If MPC = 2/3 ; MPS = 1/3 then ktx= - MPC/MPS = -(2/3)/ (1/3)= -2.
∆Y = ktx.∆T T = Tax.
With a tax cut of say $10m
∆Y = ktx.∆T=-2 (-10) = $20m.

Balanced Budget multiplier

When a budget is balanced G=T hence ∆G = ∆T. If both G and T increase by $10m, income
increases by $10m. The multiplier for a balanced budget kBB.=1 ;
∆Y = kBB.x ∆G = 1 x ($10m) = $10m this would be an expansionary budget. If there is a cut of
say $10m , ∆Y= kBB.x ∆G= 1 x (-10) = -$10m and this is a contractionary budget.

Foreign trade multiplier. For an open economy, income and output will increase from one
period to the next as total exports increase or its total imports decrease because as a result of both
these changes the economy’s net exports expand. Conversely, domestic economy’s income and
output will fall over time as its total exports decline or total imports rise as both these changes

37
will tend to cause a fall in net exports. From this it follows that the effect of imports and exports
on economy’s equilibrium income and output originates from those factors that determine the
economy’s imports and exports.

Generally, a country’s total exports depend on the price of goods in the country relative to their
prices in other countries, tariff and trade policies prevalent in the country and availability of
foreign currencies in the foreign exchange markets, income in other countries, own imports of
the country, etc. Some of the more important factors that determine a country’s exports are not
directly related to conditions within that country. Consequently, it is assumed that gross exports
of a country are autonomously determined, i.e. exports are determined by the external factors.
The volume of imports is determined by similar factors. However many of these factors are
influenced by conditions within the country. Ceteris paribus, a country’s total imports are
determined by the level of national income. In other words assuming given international price
differences and unchanging tariff, trade and foreign exchange restrictions a country’s imports are
functionally related to her national income.

Assuming a linear relationship between national income and imports of the following form
which defines the import function as M = Ma + mY, where Ma is the autonomous spending on
imports and m is the marginal propensity to import (MPM).

In the four sector open economy the equilibrium income is given by the equation Y = C + I +G
+ (X-M) or by the equation S +T + M = I + G + X. Since our consumption is defined by the
equation of the consumption function C = a + b(Y-T) and imports are defined by the import
function equation M = Ma + mY, by substituting for the terms C and M the above equilibrium
income can be written as
Y = a + b(Y-T) + I + G +X – (Ma + mY). This can be rewritten as
1
Y=  a−bT+I+G +X − M a 
1−b+m

Where 1/ (1-b+m) is the foreign trade multiplier for the economy in which exports are wholly
autonomously determined while both consumption spending and import expenditure are linear
functions of the level of national income. If taxes are assumed to be functionally related to the
level of income so that the total tax function is T = d + tY, the equilibrium national income
would then be

38
 1
Y=  a−bd+I+G +X − M a 
1−b+bt+m

Where 1/(1-b+bt+m) is the foreign trade multiplier for the system in which consumption,
imports and taxes are all linear functions of the level of domestic income. Furthermore if we treat
investment spending also linearly related to the level of income so that the investment demand
function can be written as I = Ia + eY, the equation for the equilibrium aggregate income will
become

1
Y=  a− bd+I a +G +X − M a 
1− b − e+bt+m

in which consumption, investment, imports and taxes are all linear functions of the level of
national income. The foreign trade multiplier, also called the export multiplier, operates in
exactly the same manner, as does the ordinary investment multiplier. An increase in country’s
exports causes an increase in the incomes of the exporters and factors employed in the export
industries that in turn spend a part of their increased incomes on domestic goods. In short, the
larger the marginal propensities to save and import, smaller will be the value of the foreign trade
multiplier and vice versa.
ΔY 1 dY
= =
ΔX 1− b− e+bt+m dX

is the foreign trade multiplier for the economy in which the consumption, investment, imports
and taxes are all linear functions of the level of national income. A look at the multiplier brings
home the fact that ceteris paribus the value of the foreign trade multiplier is inversely related to
the value of the marginal propensity to import m such that higher m is associated with lower
foreign trade multiplier and vice versa.

Criticisms of the Multiplier Analysis

1. Simple multipliers analysis is faulty because it neglects the role of induced investment
resulting from induced consumption in the determination of equilibrium income.

39
2. Multiplier analysis derives the multiplier on the assumption of constant MPC. Over the
short period ( short-run) of a trade cycle, the marginal propensity to consume is not
constant.

3. Assumes that labour and other fixed resources are idle or under-utilized in the economy.

4. Bottlenecks of particular kind of labour or at particular places may block the expansion of
employment and output in the economy.

40
CHAPTER THREE
MONEY AND BANKING THEORY

Origins of Money
The earliest method of exchange was barter in which goods were exchanged directly for other
goods. Problems arose when either someone did not want what was being offered in exchange
for the other good, or if no agreement could be reached over how much one good was worth in
terms of the other.

Valuable metals such as gold and silver began acting as a medium of exchange. Governments
then decided to melt down these metals into coins.

By the seventeenth century people were leaving gold with the local goldsmith for safe keeping.
Receipts of £1 and £5 were issued which could then be converted back into gold at any time.
Soon these receipts were recognized as being 'as good as gold' and were readily taken in
exchange for goods. Goldsmiths became the first specialist bankers and their receipts began to
circulate as banknotes.

Only the Reserve Bank of Zimbabwe can issue banknotes in Zimbabwe. However, notes are not
usually used to buy expensive items such as cars. The buyer is more likely to write out a cheque,
which instructs his bank to transfer money from his account into the account of the seller. Hence
bank deposits act as money.

Functions of Money

Money is something which people generally accept in exchange for a good or a service. Money
performs four main functions:

 a medium of exchange for buying goods and services;

 a unit of account for placing a value on goods and services;

 a store of value when saving;

 a standard for deferred payment when calculating loans.

41
Properties or Characteristics of Money

Any item which is going to serve as money must be:

 acceptable to people as payment;

 scarce and in controlled supply

 stable and able to keep its value

 divisible without any loss of value

 portable and not too heavy to carry.

Gresham’s Law- ‘ bad money drives out good money’

If there are two types of money, and one is more valuable than the other , the inferior money gets
used/ circulated and it drives the valuable / superior money out of circulation. People will hoard
the good money and spend it.

MONEY SUPPLY

Definition

The money supply is the total amount of assets in circulation, which are acceptable in exchange
for goods. In modern economies people accept either notes and coins or an increase in their
current account as payment. Hence the money supply is made up of cash and bank deposits.

Credit Creation

Some customers leave money in the bank earning interest. A bank can use these idle deposits to
make loans to people who then buy goods. Shopkeepers receive extra money, which they
redeposit with the bank. Some of this redeposited money is left to earn interest and can be re-
lent. The bank has therefore created money. If all customers were to try to cash their deposits at
once, there would not be sufficient cash. The amount of money the bank can create therefore
depends on the ratio of cash to liabilities that they hold. The higher this cash ratio the less money
the bank can re-lend or create.

42
How do banks create money?
 Assume a single bank, Barclays bank
 Mr. Moyo deposits $20000 cash in the bank.
 By depositing $20000 in the bank, money changes its form from cash to deposit.
 Mrs. Maphosa wants to borrow money for business.
 Barclays Bank can lend because it knows Mr. Moyo will not withdraw all at once. But it
knows it must keep some cash as a reserve say 10% therefore Barclays lends $18000 to
Mrs. Maphosa.
 By lending money to Mrs. Maphosa, the bank increases money supply to $38000 from
just $20000. The bank is able to create money because people have confidence that the
cheques signed by the bank are honoured.
1
=
If the reserve ratio is r then the basic definition of money multiplier (m) r

The change in total deposits (AD) =( 1/r x Deposit)

When r = 0.1 and deposit = 20000, then
The change in total deposits = D=
1 1
ΔD = × D eposit= × 20000 = 200000
r 0 .1

From this calculation changes in deposits can be as high as $200000 from an initial deposit of
$20000. If the reserve ratio increases, it limits the change in deposits because most of the
deposits are kept as reserves and not lent.
 Limits to banks to create money will depend on:
 Amount of reserves (liquid) assets
 Reserve asset ratio
 Willingness of people to borrow
 Desire of people to hold cash.
 What is regarded as reserve asset must be defined by law. The following assets can
however be regarded as reserve assets:
 Cash balance with central bank
 Foreign exchange

43
  Treasury bills
 Gold etc.
Definitions of money
M 0 =B= M onetary base
1. = currency a nd reserves . It is also called high powered
money.
M 1 =currency an d M 1−
2. Demand deposits notes and coins in circulation with public. It is
sometimes referred to as ‘narrow money’
M 2 = M 1
3. Savings deposits with banks. It is sometimes referred to as broad money.
M 3= M 2
4. Other savings deposits etc.

Determining Money Supply

R
r=
D
1.
c
C=
2. D

Where r - reserve ratio

R - Reserve assets
D - Demand deposits
C - Currency ratio
c - Notes and coins in circulation

in countries like Zimbabwe, the currency ratio is very high because many people keep notes and
coins at home. This is because the banking system can at times be inconvenient.

M s =c+D
M s =CD+D M s =M 1
3.
= 1 +C  D

44
 B=c+R
B=CD+rD
B
∴D=
4.  C+r  B − M onetary base

M s =  1 +C  D

 1 +C 
= B
 C+r 
1 +C
m=
M s =mB C+r
Where

- m is the money multiplier and is greater than 1 (m>1)

- the reserve ratio can be separated into required reserve ratio  r r and excess reserve ratio

 r s

r=r r +r s

- Banks hold excess reserve ratio because

1. Most banks are prudent (prudential banks ) and sensible to see whether lending is
profitable.
M1
2. Limited liability of banks to create since people may not be willing to borrow due to
high interest rates.

1+C
M s= B
C+rr +r s
=mB

DEMAND FOR MONEY

D
- M refers to the amount of money held by the general public in an economy.
- The main reasons for holding money are:
1. Transactional reason/ motive
2. Speculative motive

45
 3. Precautionary motive.

MONETARY POLICY

What is Monetary Policy?

It is the use of money or its cost, the interest rate to fine tune some economic variables such as :

 Inflation

 Economic growth

 Investment

 Interest rates

 Balance of payments

Objective of monetary policy

In general monetary policy has two major objectives:

1. To reduce inflation (stability objective)

2. To boost economic growth (growth objective)

Instruments / Measures/tools of monetary policy

 Monetary policy measures are used to increase or decrease the amount of money,
depending on the situation prevailing.

 Each instrument can be used in 2ways, either to increase or decrease the amount
of money in circulation

The following are some of common instruments:

1. Bank rate

46
 2. Open market operations

3. Rediscount rate

4. Repurchase Agreement

5. Selective credit controls

6. Moral Suasion

7. Reserve requirements

These instruments can be classified into the general or quantitative instruments and the selective
or qualitative instruments.

General or quantitative instruments

These include open market operations, changes in the minimum legal cash reserve ratio and
changes in the bank or discount rate. These instruments influence the credit creating capacity of
the commercial banks in the economy by operating directly or indirectly on their excess cash
reserves.

Selective or qualitative instruments

The instruments affect the types of credit extended by the banks. They affect the composition
rather than the size of the loan portfolios of the commercial banks. The immediate object of
imposing the selective credit controls is to regulate both the amount and the terms on which
credit is extended by the banks for selected purposes. The selective credit control instruments
enable the central bank to restrict unhealthy expansion of credit for specific purposes; without at
the same time airing credit expansion in general.

Use of the Instruments/ Measures /Tools

The instruments are contractionary or expansionary, depending on the liquidity situation. When
there is too much money, monetary tools are used in contractionary way. When there is less
money, monetary tools are used in an expansionary way.

47
 Bank Rate/ Rediscount Rate
When banks borrow from the Central Bank directly, they are charged a bank rate.

When they borrow indirectly through the discount houses, they are charged rediscount rates.

 This is the rate at which the central bank discounts first class bills.

 It is a benchmark for commercial bank lending rates.

 An increase in the bank rate increases lending rates and reduces the amount of money.

 A decrease in the bank rate reduces lending rates and increases the amount of money.

Open market operations

This is buying and selling of government securities e.g. bonds (TBs). When there is too much
money, the government sells securities. The government takes the money and the public holds
securities. To reduce money supply, the government sells bonds to the public and pays with
currency (notes + coins in circulation). This reduces money available for spending. The success
of the instrument depends on whether the public wants to buy bonds or not. To persuade people
to buy bonds, the government raises interest.

When there is inadequate money, the government buys securities. The government takes the
securities and the public holds money. Money is injected into the economy.

Selective credit controls

When there are liquidity problems, the central bank and even banks have preferential treatment
of clients. Credit is allocated to some selected sectors. For example, credit can be allocated to
export or productive sectors. Rationing of credit- this involves imposing a ceiling upon its
(Central Bank’s) discounts for any one bank or rejecting a proportion of each discount
application whenever total demand for loans exceeds the amount the central bank is prepared to
discount on any one day.

Regulation of consumer credit

48
The regulation of consumer credit is employed to regulate the terms and conditions under which
bank credit repayable in installments could be extended for purchasing or carrying the consumer
durable goods. The regulation of consumer credit is quite important in combating inflation by
restricting the aggregate consumer demand for those goods which are in short supply in
industrially developed countries where consumer credit is largely used to finance domestic
purchases. In countries where there is no consumer credit and the banks do not participate in
financing the purchase of consumer durables to any significant degree, the method cannot be
effective in curbing the inflationary pressures in the economy.

Moral Suasion

It involves direct solicit with the Central Bank. The central bank persuades financial institutions
to be supportive of the prevailing monetary policy stance. When there is too much liquidity,
institutions are persuaded to tighten their credit allocation systems. When there is a shortage of
liquidity, institutions are persuaded to loosen their credit allocation systems. This measure is not
mandatory but persuasive and as a result it is difficult to influence the currency ratio c/D and
consequently money supply.

The instrument would succeed only if the commercial banks follow scrupulously the leadership
of the central bank. This will however depend on the strength of the central bank and the prestige
enjoyed by it among the member banks. In countries with highly liquid monetary conditions and
where the central bank cannot undertake open market operations on a massive scale to
counteract the high bank liquidity, it is advisable for the central bank to use moral suasion.

Reserve Requirements

When bank deposits are made, part of the money is kept as bank reserves and the rest is lent out
as loans. The reserve requirement is the amount of money that is kept as reserves. The
percentage of money kept as reserves is called the reserve requirements ratio. When there is too
much money, the reserve ratio is increased to reduce credit creation. When there is a shortage the
reserve ratio is reduced to increase credit creation so as to increase money supply. The
government can regulate the required reserve ratio
s
 r r . rr  ⇒  m ⇒ M
Increasing required reserve ratio reduces the lending base. The instrument is not without its
limitations: If their cash reserves are swollen, commercial banks will not care at all for the

49
increase in the minimum legal cash reserves ratio requirement unless the increase is very high.
They might also conduct their operations with a lower cash reserves ratio if they are optimistic
about the future, while a fall in the minimum legal reserves ratio may fail to induce them to lend
in depression. A counteracting force may arise from a change in the banking practices. If
percentages of minimum legal cash reserves required to be kept with reserve banks differ for
different kinds of deposits held by banks e.g. with a minimum legal cash reserves ratio of 10%
against the demand deposits and of 3% against the time deposits, a transfer of bank funds from
the former to the latter would enable the banks to expand credit and to that extent would induce
them to disregard the credit restriction policy enforced by the central bank.

Publicity

Central banks may employ the instrument of publicity in order to publicise the economic facts in
the weekly statements of their assets and liabilities, monthly bulletins containing review of credit
and business condition, and detailed annual reports stating their operations and activities, the
state of affairs of the money market and banking system and general review of the trade,
industry, agriculture, etc. in the country. By resorting to publicity, the central bank enlists public
opinion in favour of its monetary policy and thereby combats opposition to its policies among
political, financial and business interests. However the method of publicity has the scope of
useful application in industrially advanced countries where public opinion is enlightened. In the
developing countries where people are mostly less educated and even those who are educated are
not acquainted with the technique of banking the method of publicity is of little use in controlling
credit

50
CHAPTER FOUR
UNEMPLOYMENT
What is unemployment?

Definition

Unemployment is the pool of people above a specified age who are without work, are currently
available for work and are seeking work during a period of reference. Unemployment results
when the available workplaces cannot adapt to the job seekers. When the number of persons,
who offer their working capacities, exceeds the number of available workplaces, this leads to a
lack in workplaces.

Unemployment has become a serious economic problem. Majority of people can only make
living by working for others. Many millions of people are both able and willing to work, but
simply cannot find a job. Unemployment is an overwhelming concern of policymakers and the
general public. Unemployment often implies a waste of human resources that could otherwise be
producing goods and services to satisfy the needs of society. At the same time, it can mean
extreme personal hardship for the Unemployed, and therefore it is an important social concern.
Unemployment rate fluctuates widely over time within a given country, in line with the business
cycle. Unemployment increases during recession and declines during booms.

Measurement of Unemployment

When calculating the level of unemployment the government only counts those people who
register as unemployed and claim benefit. A large number of people seeking work either do not
register or do not claim benefit and are now excluded from official figures. Unemployment rate
is the number of unemployed people as a proportion of the labour force. The labour force is all
those with work or all those seeking work.

The unemployment rate is the percentage of the labour force officially jobless. Full employment
occurs when the number of notified job vacancies exceeds the number of registered people
unemployed.

51
Unemployment Trends

Unemployment is a flow and not a stock. There are always inflows onto the unemployment
register, and there are outflows off the register as people get jobs or join training schemes.

If all inflows rise and all outflows except training fall then overall unemployment will rise.
Young people, women, the over-fifties and ethnic minorities tend to be the hardest hit. Inner
cities and manufacturing areas also tend to have above-average unemployment.

Natural rate of unemployment

It is that rate which corresponds to macroeconomic equilibrium, in which expected inflation is

equal to its actual level. It is that rate of unemployment to which the economy will return after a
cyclical, recession or boom.

The natural rate of unemployment is sometimes called the “the full employment” rate of
unemployment conveying the sense that unemployment is excessive only when actual
unemployment exceeds the natural level.

We generally refer to the gap between actual unemployment and the natural rate as cyclical
unemployment. In other words, cyclical unemployment is the amount of unemployment that can
be reduced by expansionary macroeconomic policies without setting off an endless rise in the
rate of inflation.

Types of unemployment

We have to differentiate between a few types of unemployment:

1. Cyclical unemployment: if a country has an economical boom then people have jobs, if there
is an economic recession people lose jobs. Cyclical unemployment is unemployment above the
natural rate.

2. Frictional unemployment: This arises because people are always flowing into and out of
unemployment. New workers are constantly entering the labour force, and existing workers
frequently leave one job and look for another. During these transitions they spend time on their
job searches e.g. you stop working in December and start your new work in March, these period
between these months is called frictional unemployment

52
3. Structural unemployment: Structural unemployment can occur in factories when too old
machines, cannot produce enough, sell less products, cannot pay their staff, more unemployed
people. It is unemployment that exists when the economy is operating at the natural rate. The
natural rate of unemployment (Un) reflects many different phenomena and forces such as union
power, which raises real wages above full employment real wages.

4. Hidden unemployment: dismissed people don’t ask for a new job, they also don’t register for
unemployment benefits, e.g. women after their maternity leave often stay at home with their
children. It can also include the discouraged, those nominally having jobs for which they are paid
but in fact doing nothing; and those who can be withdrawn from rural areas because of their zero
marginal product.

5. Seasonal unemployment: e.g. tourism-areas, construction sector, and agricultural sector. In

the rural areas or farming areas, everyone is fully employed during the rain season and
harvesting periods but thereafter demand for labour is very low. The unemployment is mostly
where there is single cropping

6. Structural Unemployment. This occurs when economic readjustments are not fast enough
during economic growth, so that severe pockets of unemployment occur in areas, industries and
occupations in which the demand for factors of production is falling faster than is the supply.
Policies that discourage movement among regions, industries and occupations can raise
structural unemployment.

7. Technological Unemployment- this comes about as a result of technological change.

Why unemployment is studied

1. The income aspect- income can mostly be earned if one is employed. Most economies gain
from employment of their nationals.

2. The production aspect of employment- concern is on the labour utilisation. If labour is

unemployed there is a waste of productive resources.

53
3. Recognition aspect- the type of employment determines social status and self-esteem. Studies
found that people who had been unemployed for two or more years had self-esteem.

Causes of Unemployment

1. Rapid growth of labour forces due to high population growth rate in developing countries. Fast
growth of labour force places a strain on the ability of the economy to generate new work
opportunities on a sufficient scale to absorb rising numbers (economic dualism and rural- urban
migration).

2. Education system also contributes – the size of the educated labour force is growing more
rapidly than the economy can absorb.

3. Shortage of saving and investment- investment per worker in developing countries is often
less than that in developed countries.

4. Inefficient land tenure systems in many developing countries cause them not to be able to
utilise their expanding labour resources.

5. Inappropriate developmemnt strategies they pursued and technologies adopted. They engaged
in import substitution strategies hence limited jobs.

6. Engineering bias, minimum wage laws, government salary structures, influence of trade
unions, pay policies of multinational corporations all help to raise the urban wages well above
competitive market clearing levels.

7. Laws and conventions holding down interest rates, tax concessions for foreign investors
similarly hold the price of capital well below levels which would reflect their scarcity in the
economy.

Consequences of unemployment /Costs of Unemployment

Lost Output
The opportunity cost of each unemployed person is their foregone output.
Increased Benefit Payments
Each extra person who becomes unemployed stops paying tax ( perhaps $4000) and starts
receiving benefit (upwards of $5000). The government therefore has to raise a additional funds
to finance unemployment benefits for unemployed. As the figure falls the government pays out

54
less unemployment benefits and receives more in tax. The savings to the exchequer from this
will be considerable.

Lost Tax Revenue

Growing unemployment means less direct and indirect tax revenue. When people lose their jobs
they will stop paying income tax, and their spending will fall considerably reducing government
receipts from VAT and other indirect taxes.

Human Costs of Unemployment

The long-term and youth unemployed feel increasingly isolated and removed (alienated) from
society. There will also be increased NHS costs as people's health often suffers when they are
unemployed, and there will be increased costs to society in terms of crime.

In our society where money means success the unemployed feel useless and consider themselves
a failure. Studies have shown that people who have been unemployed for some time develop a
low self esteem.They are dissatisfied and depressed and this may lead to alcoholism drug
problems and homelessness and even to crime.

Especially for families it’s difficult because they do not have enough money to afford their
basics of life. So because of that that government has to help financially, but this causes high
costs for working people who have to support the unemployed.

High risk groups

There are some high-risk groups, for example youths, women with little children after their
maternity leave or elderly people aged 50 and over. Lots of those people cannot find a (good)
job.

Young people are part of the high-risk group because in most cases they do not have any
practical experience and there are lots of young people searching for the same few jobs. That is
why there is a high selection rate on the job market. Firms want to employ young people with
lots of experience who want to work almost 24 hours a day and earn just a little pocket money.

Women in general, but especially women with little children who want to work again after their
maternity leave are another high-risk group. Their problem is that the probability of their needing
time off to nurse sick children is very high, especially if they have little kids. Another problem is

55
that those women have not worked for the time of their child nursing and there might be new
trends, new developments or things like that.

The last high-risk group is the large group of over 50 year old people. Their problem is that they
cost too much. If a firm employs younger workers they do not have to pay as much as they
would for an older person. That is why they are fired. And it is almost impossible for those
people to find a new work place.

Solution of unemployment
Possible solutions:

Early retirement

Job-sharing

New jobs (new economy)

A general reduction of working hours

Reduction of overtime

It is very hard to find good solutions in the long run. Some ideas such as job-sharing or early
retirement are in discussion. But my opinion on that is that both, job-sharing and early retirement
are not the right way because if you share your job you won't earn enough money to afford the
basics of life for your family.

Early retirement sounds nice but it means a huge amount of costs for all the other working
people who have to pay for that. So this cannot be the right way, I suppose.

A good solution would be the attendance of further training courses, so that unemployed people
are trained to find a new job and learn new skills. The only problem about that are the costs,
which are very high and the question is who is going to pay them.

Population control- if there is population restraint the growth of developing country labour force
will be in check.

Overhaul of the education systems to change from their present academic, elitist, white-collar job
orientation to vocational and technical training systems to produce artisans and technicians the
countries desperately need.

56
Sectoral priorities which particularly favour the development of small-scale agriculture and the
informal sector. Small-scale agriculture and the informal sector are labour intensive, so their
development will both generate more employment and raise productivities of those already
working in them.

Incomes policies designed to prevent formal sector wage levels from being raised by
institutional factors to levels well above the true economic value of unskilled labour. This
involves attention to the government‘s own pay policies, its policies towards the trade unions,
towards multinational firms and towards minimum wage legislation.

Rural development and decentralisation- this involves coordination of programmes for the
improvement of agriculture, water, transport; access to goods and services and appropriate land
tenure- aim is to reduce rural- urban migration.

Informal Sector:The development of the sector is attractive because it does not require complex
and expensive infrastructure and has high potential for creating jobs. It uses mostly locally
produced resources or raw materials. It can be a major source of income generation both for rural
and nonagricultural informal sections of the economy. It creates a platform for the exchange of
locally produced goods and services. It provides strong base for local entrepreneurs. It is also a
source of government revenue when these sectors grow and become registered.

Problems of the informal sector in Zimbabwe

 Procedures to be followed in obtaining licences and project approval are discouraging and
they (operatives in the sector) pay high rentals to landlords.

 Because of the high corporate tax, they would rather remain unregistered. If they are taxed
they face financial problems and hence cannot pay minimum wages.

 Lack of adequate transport and infrastructure to facilitate delivery of produce to the target
market.

 Lack of technological support and managerial, technical and marketing skills.

 Lack of project planning and implementation.

 Inability to obtain loan and credit facilities hence due to lack of collateral security, 90% of
microenterprises are automatically eliminated from getting financial assistance.

57
However it must be pointed out that the development path whereby there is heavy emphasis on
iunformal sector enterprise and small business development has limitations, although it provides
employment and income. The disadvantage of informal enterprise is it does not lead to
development of high technology non traditional export.It does not invest in new technique,
generate new skills and develop new products.

Types, Causes, and Remedies for Unemployment

Table below summarises the main causes and remedies for different types of unemployment.

The average length of time workers remain unemployed is a critical measure of the seriousness
of the unemployment figures. If the average length of unemployment is short then the economy
will be healthier and people will not lose their skills from long periods without work.

Employment and training schemes that have been used in the 1980s and 1990s

Scheme Description
Restart Programme Interviews and training for the long-term unemployed
Community Local projects for the long-term unemployed
Programme
New Workers Scheme A subsidy to employers taking on youth unemployed
Job Search Scheme Return fare and allowances for job interviews
Job Release Scheme Older workers retire early with an allowance and are replaced by an
unemployed person
Job Splitting Scheme A subsidy to employers who encourage job sharing
Youth Training Two-year work experience and training for school leavers
Scheme
Job Training Scheme Retraining scheme for unemployed adults

Causes and remedies of unemployment

58
Type Description Cause Remedy
Frictional Workers temporarily Delays in applying Improve job
between jobs interviewing and information, eg
accepting jobs computerised job centres
Structural Workers have the Declining industries Subsidies and improve
wrong skills in the and the immobility of the mobility of labour
wrong place labour
Cyclical All firms need fewer Low total demand in Increased government
workers the economy spending or lower taxes
Technological Firms replace workers Automation and Retraining
with machines information
technology
International Overseas firms replace High-priced/low- Tariffs quotas or sterling
UK producers quality UK goods depreciation
Regional High unemployment in Local concentration of Regional aid, eg
one area declining industries relocation grants
Seasonal Unemployment for part Seasonal variation in Retraining
of the year demand
Voluntary Workers choose to More money 'on the Remove the low-paid
remain unemployed dole' than from from the liability to pay
working income tax

CHAPTER FIVE
INFLATION

DEFINITIONS
There are several definitions:
(a)This is a persistent rise in the general level of prices or a persistent fall in the purchasing
power of money. The value or purchasing power of money refers to the amount of goods or
services a unit of money can buy. It should be noted that the definition implies that an increase in
some particular price is not inflationary if compensated by falls in other prices.
(b) Inflation is the general and prolonged rise in the price level.
(c) Inflation can also be defined as to the continual increase in prices.
Inflation means the value of money is falling because prices keep rising.

59
MEASURES OF INFLATION

1. Cost of living Index (*COLI)-

also called the retail price index or consumer price index. This is the most frequently used
measure and is based on observations of prices of a ‘basket’ of goods selected as a
representative of the spending patterns of consumers within some specified range of incomes.

2. Wholesale price index-

is the index which measures prices of commodities commonly bought and sold by
wholesalers. This index has an advantage over the consumer price index in that it gives an
earlier warning of an upsurge in prices than a retail index. It takes time for a rise to work its
way through to the shops and markets.

3. The GNP deflator-

This is derived from comparisons of GNP estimates in current prices and in constant prices.
Prices of consumer goods, capital goods etc. are taken into consideration when compiling
this.

Calculating the Retail Price Index

The retail price index (RPI) can be used to measure inflation. The retail price index (RPI) is a
monthly survey carried out by the government which measures price changes. The following
procedure is used:

 A basket of goods and services consumed by the average family is listed. For example,
food, clothing and transport are included in the basket.

 The price of items in the basket in the base (first) year is noted.

 Each item in the basket is given a number value (weighted) to reflect its importance to the
average family. For example, food has a higher weighting than transport.

 The price of goods in the basket is recorded every month compared with base year as a
percentage (price relative) using the equation:

Price relative = Current price/Base price x 100

60
  The price relative of each item is then multiplied by its weighting.

 The new RPI is found using the equation:

RPI = Total weightings x Price relative/Total weightings

The value of the RPI in the base year is always 100. After twelve months the price of good
items in the basket may have risen by 25 per cent and that of housing by 20 per cent while
the cost of transport is unchanged. Table below shows how the RPI for year two might then
be calculated.

The RPI = Total weightings x Price relative/Total weightings = 12 100/100 = 121

Calculation of the retail price index

Basket Weighting Price relative Weightings x price relative

Food 60 125 7500
Housing 30 120 3600
Transport 10 100 1000
Total 100 12100
The rate of inflation is the percentage change in the RPI over the last twelve months and is
calculated using the equation:

Rate of inflation = (Current RPI - Last RPI)/Last RPI x 100

At the beginning of year two the rate of inflation is:

(121 - 100)/100 x 100 = 21 per cent

Problems in Using the Retail Price Index

 The RPI is narrow.

 Which items should be included in or excluded from the basket of goods?

61
  Different families have different tastes hence different weightings. How is an average
family found?

 Not all regions in the country experience identical price changes.

 For a while new products ( eg mobile phones) may not be included in the index.

Advantages and Effects of Inflation

Not everyone suffers from inflation. Some parts of society actually benefit:

 The government finds that people earn more and so pay more income tax.

 Firms are able to increase prices and profits before they pay out higher wages.

 Debtors (borrowers) gain because they have use of money now, when its purchasing
power is greater.

Disadvantages of Inflation

 People on fixed incomes are unable to buy so many goods.

 Creditors (savers) lose because the loan will have reduced purchasing power when it is
repaid.

 Domestic goods may become more expensive than foreign-made products so the balance
of payments suffers.

 Industrial disputes may occur if workers are unable to secure wage increases to restore
their standard of living.

CAUSES OF INFLATION

Supply oriented Explanations

These explanations concentrate on the cost push and structuralist theories.

62
Cost-push Inflation
Cost Push Theory- this ascribes inflation to increases in cost, which are independent of the state
of aggregate demand. For most manufacturers in developing countries, the cost of imported
goods is continuously rising because of world inflation. This both directly raises the cost of
living through higher prices for finished goods imports and indirectly through more costly
imported materials used by domestic producers. In addition, trade unions may force wages up
more rapidly than increases in productivity, raising unit labour costs. Other groups e.g farmers
organizations, may also be strong enough to prevent their own position from being eroded, and
the generally low degree of competition in modern industrial sector allows manufacturers to pass
cost increases on to consumers perhaps adding an enlarged profit margin for themselves.

Cost-push Inflation occurs when a firm passes on an increase in production costs to the
consumer. The inflationary effect of increased costs can be the result of:

 Increased wages, leading to

1. a wage-price spiral, which occurs when price increases spark off a series of wage
demands which lead to further price increases and so on;

2. a wage-wage spiral, which occurs when one group of workers receive a wage
increase which sparks off a series of wage demands from other workers. Wages may
also rise due to the trade unions, which may force the wages to rise. This squeezes
profits of firms and they raise price to meet target profits.

 Increased import prices which can be the result of:

1. a rise in world prices for imported raw materials;

2. a depreciation of the domestic currency.

 Increased indirect taxation

 Interest rate raises the costs of production and the general price levels. The central bank
can respond by tightening money supply, which in itself raises interest rates, which
increases costs of production and increases prices.

63
Pure cost inflation- aggregate demand held constant

With increases in costs, manufacturers shift supply from S1 to S2 toi S3. This implies loss of
output, more unemployment, and rise in price level from P y to Px. There is strong union
resistance to reduction in wages, cost plus pricing policies of firm selling in oligopolistic and
monopolistic markets where prices are determined by costs, not state of demand. The ability to
pass increases to the public makes producers less resistant to wage claims and other cost raising
pressures.

S3
S2
Px S1

Py

D
Qx Qy

Cost Push with Demand Adjustments

In the previous diagram there was increased unemployment, reduction in capacity utilisation and
this may not be in the public’s and government’s interest. The government would find itself
under pressure to increase aggregate demand enough to prevent output and employment from
falling (see diagram below).

S3

Pz S2

price S1

64
 D3

Py D2

D1

Qx

In the diagram, for every upward movement in the supply curve, government will induce a
compensating increase in total demand (D1 to D3) so as to “validate” the cost increase and
prevent output from falling below Qx. The effect is to increase the rate of inflation with price
level going up to Pz.

Structuralist Theory of Inflation

This theory postulates that inflation will accompany economic development because of
disequilibria created by the structural changes that are necessary to the development process. As
the economy develops, incomes rise and as the incomes rise the composition of demand changes
and so does the structure of output. There is however no guarantee that the productive structure
will prove sufficiently adaptive to the changing composition of demand to avoid the emergence
of disequilibria in product markets. Demand is greater than supply in some cases while supply is
greater than demand in others. Foreign trade sector will be unable to earn enough foreign
exchange to meet the growing import needs of the economy. The foreign exchange scarcities will
also tend to push up prices.

Domestic food production lags behind demand. Agricultural production is often inelastic with
respect to price. Increased demand will have to result in large price rises before output responds
much. Food prices thus tend to move ahead of the general price level. This may induce higher
prices in the industrial sector too as trade unions lodge wage claims to protect worker against
effects of higher food prices.

Export earnings lag behind import needs because of the slow expansion of world demand for
primary products exported by less developed countries. Artificial barriers of developed countries
make matters worse. Official aid flows fall far short of filling the gap between export earnings
and import requirements.

Import prices join agriculture prices in setting the inflationary pace dragging other prices up
behind them. Devaluation of national currency or imposition of import controls both cause price
rises. Import substitution strategy also causes inflation. If therefore developments within the
economy are balanced, major disequilibria in product markets and on balance of payments may
be avoided thus resulting in mild inflation.
65
Demand-pull Inflation

Demand-pull inflation occurs when there is 'too much money chasing too few goods' because the
demand for current output exceeds supply.

Demand inflation is caused by an excess of aggregate demand for goods and services over
available supplies at a given level of prices. The natural market response to such a situation is a
rise in prices towards a market clearing equilibrium in which once more D=S. A new equilibrium
may not be achieved because of propagating forces which raise both demand and costs and thus
push prices ever higher.

Inflation is not an inevitable outcome of an increase in demand. It all depends on the price
elasticity of supply. If the elasticity is large, a small price increase may call forth a large increase
in output so that the inflation impact is slight.

In the short run, the main determinants of the supply elasticity will be the extent to which
suppliers are operating below productive capacity and the availability of foreign exchange. If
there is much surplus capacity, the principal effect of an increase in demand will be to induce
greater output, rather than to initiate an inflationary spiral. Similarly, if there is surplus foreign
exchange, the effect will be to induce a larger volume of imports. For the economy as a whole, a
large danger of demand inflation is when there is a foreign exchange constraint and the economy
is operating at near full capacity. The possibility of demand inflation is greater the nearer the
economy is to being on its production possibility frontier.

The monetarist school of inflation (led by Milton Friedman) tries to explain the origins of
demand inflation.. The essence of the monetarist position is that inflation is always and
everywhere a monetary phenomenon. The greater the monetization of the economy the greater
the inflation. People whose economic lives are entirely monetized will be more strongly affected
by inflation than those who still meet many of their needs for themselves.

The consequence of an increase in the supply of money greater than an increase in the demand
for money will be a rise in the demand for products and hence will tend to cause inflation. People
desire the convenience of holding money balance but if they6 desire they will spend the surplus
on goods and services.

Assuming the supply of money is under the control of the state and the demand for money is a
function of the level of real income, the extent of monetization of economic activity and the net

66
utility of holding money, there will be an increase in demand if real income goes up. There will
be a larger transactions demand for money. Barter transactions or subsistence production become
monetised. The demand for money will also rise if interest rates on bank deposits go up or if the
people expect slower inflation. NB. Monetarists are not contending that any increase that any
increase in the supply of money is inflationary.

An economy can increase the quantity of money without inflation to extent that it is growing in
real terms, that economic activity is becoming monetised and that the net utility of money is
going up. In particular a rapidly developing economy can absorb more non-inflationary money
supply increases than a stagnant one. As long as money supply is expanded to meet non-
inflationary needs, monetary stringency may retard the pace of development.

The figure below shows increased demand and increased prices as consumers compete to buy up
goods still available.

A major source of inflationary pressure is the government which can print money to buy goods.
The monetarist view of inflation can be stated in the equation:

MV = PT

Where M = the money supply,

V = the number of times each unit of money changes hands (the velocity of circulation),

P - the average price of goods, and

67
T = the number of goods bought (transactions).

Monetarists believe that the values of V and T are fixed so that any increase in the money supply
 M s  , must raise the level of prices (P), and this is inflationary. There is always an associated

price increase with money supply to balance the 2 sides of the equation.

Remedies of Inflation
There are many ways for businesses, consumers and government to halt or control inflation. The
traditional Keynesian approach is to categorise inflation as being either demand pull or cost push
in nature.

Cost-push Remedies

 Introduce price and income policies to free price and wage increases. The policies may be
statutory or voluntary. Ceiling of wages or salary increases may be set. There may also be
interference in the exchange rate system to keep down prices of imported goods. Labour
can help fight inflation by also trying to increase productivity and cooperating with
management in controlling the wage- price spiral, that is, not setting excessive wage bids.
Business can help fight inflation by trying to increase the productivity of workers. This
would decrease costs.

 Indexation. This consists of periodic and automatic revision of incomes, financial asset
values, the exchange rates and other variables so as to compensate for the effects of
inflation.

 Encourage an appreciation of domestic currency.

 Reduce indirect taxation.

Demand-pull Remedies
For the Keynesians, where inflation is demand pull, they advocate demand management policies:

 Reduce government spending ( G).

 Increase income tax (T) to reduce consumer spending.

 Reduce people’s ability to borrow money by increasing interest rates and tightening
credit regulations.

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  Reduce non-essential government expenditure. (T-G) is the budget deficit which is
financed by issuing government paper (treasury bills,money) thereby contributing to the
national debt. As G falls so will the deficit.

 Control the supply of money. Assuming a direct relationship between the supply of
money and aggregate income (Y=f(M)), a reduction in the money supply causes a
preferable multiplied reduction in the aggregate demand. Interest rates can be raised to
depress capital investment and credit financial consumer purchase. (This of course would
have adverse effect if inflation is experienced before full employment is reached.).

 Construction should be postponed in so far as feasible because this reduces investment in

buildings, machinery and inventories. This reduces aggregate demand. Production should
also be geared towards reasonable demand and unnecessary stockpiling of raw materials
and semi-finished products should be avoided.

However plausible these suggestions (or solutions) may be flimsy, for government before any
economic issue can be decided the political half of the issue must be solved. This often causes
government to ignore the economic issues or try to solve it in a roundabout, often unsuccessful
manner. The business world is motivated by self interest hence in this situation of inflation, it
seems risky to postpone expansion of the production facilities, to keep prices steady and profits
low.

The consumer on the other hand is confronted by the savings paradox. He knows that more
savings and less consumption would help fight inflation, but it is inflation itself that is preventing
the consumer from saving more, by inducing him to spend now rather than later.

Some undesirable effects of Inflation

(1) Unjustified wealth transfers occur from net money creditors to net money debtors.

(2) When union wage contracts do not have inflation escalator clauses, and workers notice an
actual decline in their real wages, they may frequently resort to strikes creating social
instability.

(3) Assuming a country has fixed rates of exchange and its domestic inflation rate is higher than
the inflation rate in the countries with which it is trading, it would be less competitive in the
world markets. Its exports would be less and it imports more, leading to balance of payments
problems.

69
(4) Tax revenues of government are automatically increased because inflation pushes income
earners into higher tax brackets (where tax system is progressive). This may defeat the
economic policy of reaching full employment because total spending decreases
automatically.

(5) The usefulness of money as a store of value may be reduced and people will start to use
money substitutes and will reduce their money balances and invest more in real assets, like
houses, education, automobiles, etc.

(6) The operation of the credit market for example will be less effective by increasing the risk of
borrowing and lending.

Inflation-does anyone gain?

1. Government- where there is inflation, tax resource will be redistributed in favour of the
government budget. Inflation benefits the budget by reducing the real cost of servicing of the
debt.

2. Farmers- where food production is relatively inelastic with respect to price.

3. Importers- where a fixed exchange rate is maintained they can raise prices on local sales of
imports and get a premium.

Inflation- The losers

1. Creditors.
2. With a fixed exchange rate domestic producers of exports and of imports substitutes will be
losers.
4. Consumers of farmers products.
5. Economically inactive groups e.g. housewives.
6. Modern sector wage labour force.
7. Pensioners and others on fixed income.
CAUSES FOR AND AGAINST INFLATION
PROINFLATION CASE

It is argued that inflation is necessary if there is to be growth in the economy. Inflation

accompanies growth. It is also argued that inflation redistributes incomes in such a way as to
raise saving and investment thus accelerating growth. According to the view, company profits
and government budget are likely to benefit from inflation at the expense of consumers
especially urban wage labour force. Company profit margins rise and they often reinvest large
proportion of increases in profits rather than paying them out to shareholders. Workers on the
other hand consume almost all their income.

70
Government also gains from inflation, it is argued, because of inflation tax on money balance,
i.e. on everyone. The public has to forego expenditure on goods and services. The reduction in
spending releases real resources in the economy which can then be used for investment.

Some economists advocate for growth with inflation, in the belief that the inflationary trend will
be reversed with time.

ANTIGROWTH WITH INFLATION ARGUMENTS

It is argued that inflation penalizes saving because it reduces the purchasing power of income set
aside. There is also a high propensity to borrow, as repayments are cheaper.
Investment/planning decisions are difficult under uncertainty, due to inflation. Inflation may lure
firms into unproductive investment decisions because their accounts will most probably mislead
them about their current profitability. Because depreciation of capital equipment is mainly based
on historical costs, during inflationary times, firms tend to underestimate the depreciation and
overestimate company profit. Many profits of manufacturing and trading companies in times of
rapid inflation are often the result of stock appreciation hence the swollen profits are therefore
illusory.

Domestic inflation will raise the cost of producing exports. The profitability of exports declines
thereby undermining the balance of payments position of a country.

71
CHAPTER SIX
INTERNATIONAL TRADE

Introduction
Basic condition of the world community is one of mutual interdependence. All countries of the
world rely for their national well being on international trade and payments. Foreign currency or
foreign exchange is used for effecting payments. The rate at which one country’s currency is
exchanged for another. for example Z$1800 / 1Rand is the exchange.

Exchange Rates

An exchange rate is the price of one currency in terms of another. For Zimbabwe, the dollar
exchange rate means the number of pounds (£) can one dollar ($) buy. The exchange rate is
determined by the supply and demand for dollars) and is $2 per pound in the diagram below:

Demand for dollars

British want to exchange pounds for dollars for two reasons:

1. To buy Zimbabwean goods and services;

2. To lend or invest in Zimbabwe.

The diagram above shows the number of dollars demanded at each and every exchange rate. This
is the D curve.

72
Supply of Dollars
Zimbabweans want to exchange dollars for pounds for two reasons:
1. to buy British goods and services;

2. to lend or invest in Britain.

In the diagram above S shows the number of dollars supplied by Zimbabwe at each exchange
rate.

Changes in the Exchange Rate (flexible exchange rate)

A fall in the value of the dollar (depreciation) means one dollar now buys fewer pounds. The
dollar depreciates if Britons demand fewer dollars (shown in the diagram below) or if
Zimbabweans offer more dollars. Zimbabwean exports become cheaper and its imports become
dearer. Hence, a dollar depreciation improves the balance of payments.

A rise in the value of the dollar (appreciation) means one dollar now buys more pounds.
Zimbabwean exports become dearer and its imports become cheaper. Hence a dollar appreciation
worsens the balance of payments.

Benefits of Trade
Participation in the international economy can improve living standards and the rate of economic
development. This is in 3 ways:
1. Trade provides countries with an escape from confines of their national economies. It creates
more profitable investment opportunities and this leads to accelerated growth.
2. By giving access to the products of other nations, it avoids the need to strive for self
sufficiency within national boundaries- technology developed elsewhere is available.

73
3. Capital flows, an integral feature of world trade and payments give developing countries
access to the savings of richer nations, to augment their own. Capital is obtainable from
private sources as well as from ‘aid’ from foreign governments and agencies eg. World Bank.

Reasons for Trade

Domestic Non-availability

International trade is the exchange of goods and services between countries. An import is the
Zimbabwean purchase of a good or service made overseas. An export is the sale of a
Zimbabwean-made good or service overseas.

A nation trades because it lacks the raw materials, climate, specialist labour, capital or
technology needed to manufacture a particular good. Trade allows a greater variety of goods and
services.

Principle of Comparative Advantage

The principle of comparative advantage states that countries will benefit by concentrating on the
production of those goods in which they have a relative advantage.

For instance, France has the climate and the expertise to produce better wine than Brazil. Brazil
is better able to produce coffee than France. Each country benefits by specialising in the good it
is most suited to making.

France then creates a surplus of wine which it can trade for surplus Brazilian coffee.

Protectionism

Advantages of Protectionism
Protectionism occurs when one country reduces the level of its imports because of:

 Infant industries. If sunrise firms producing new-technology goods (eg computers) are to
survive against established foreign producers then temporary tariffs or quotas may be
needed.

 Unfair competition. Foreign firms may receive subsidies or other government benefits.
They may be dumping (selling goods abroad at below cost price to capture a market).

 Balance of payments. Reducing imports improves the balance of trade.

74
  Strategic industries. To protect the manufacture of essential goods.

 Declining industries. To protect declining industries from creating further structural

unemployment.

Disadvantages of Protectionism
 Prevents countries enjoying the full benefits of international specialization and trade.

 Invites retaliation from foreign governments.

 Protects inefficient home industries from foreign competition. Consumers pay more for
inferior produce.

Protection Methods
Methods of trade restriction
Tariffs
For every unit of import a charge is put and this fixed amount for every unit of import is the
tariff. Tariffs (import duties) are surcharges on the price of imports. The diagram below uses a
supply-and-demand graph to illustrate the effect of a tariff.

75
Note that the tariff

 raises the price of the import;

 reduces the demand for imports;

 encourages demand for home-produced substitutes;

 raises revenue for the government.

A tariff can be specific or advalorem. A specific tariff is a fixed amount for every amount of
imports. An advalorem tariff is the charge per value of import.

Quotas
Quotas restrict the actual quantity of an import allowed into a country. Note that a quota:

 raises the price of imports;

 reduces the volume of imports;

 encourages demand for domestically made substitutes.

A quota is a non tariff restriction. Another example of a non tariff restriction is an embargo. An
embargo is a complete ban on imports.
76
Other Protection Techniques
1. Administrative practices can discriminate against imports through customs delays or setting
specifications met by domestic, but not foreign, producers.

2. Exchange controls (currency restrictions) prevent domestic residents from acquiring

sufficient foreign currency to pay for imports.

3. Prior to imports deposits. Before you import you are supposed to put aside an import value.
This reduces the amount of import.

4. Technical specifications on imported goods. The government put standards on the goods
imported causing rejection of some.

77
CHAPTER SEVEN
BALANCE OF PAYMENTS

Definition of the Balance of Payments

1. Is a systematic record of the economic transactions between residents of the exporting country
and residents of the foreign countries during a certain period of time or

2. Is the difference between the total earnings on both invisible and visible items and total
expenses. In order to know the position as regards international payments, government compile
records of transactions. This record of transactions is thus called the Balance of Payments (BOP).

3 The balance of payments is a record of one country's trade dealings with the rest of the world.
Any transaction involving Zimbabwean and foreign citizens is calculated in dollars

Dealings which result in money entering the country are credit (plus) items while transactions
which lead to money leaving the country are debit (minus) items.

Components of the Balance Of Payments

The balance of payments can be split up into three sections:

1. the current account which deal with international trade in goods and services;

2. transactions in assets and liabilities which deals with overseas flows of money from
international investments and loans;

3. Monetary Account which deals with foreign currency reserves and transactions with
multilateral bodies.

Current Account

The current account consists of international dealings in goods (visible trade) and services
(invisible trade). It records all transactions in goods and services, ie. visibles and invisibles.
Receipt of interest , profits and dividends on loans and investments in foreign countries; earnings
from tourism and transportation and remittances home of income earned by nationals working
abroad are included in this account as invisibles.

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Example of current account 1985

Debits $m Credits $m Balance £m

Visible imports 80 140 Visible exports 78 072 -2 068
Invisible imports 75 007 Invisible exports 80 027 5020
By referring to above table you can see that in 1985:

 Zimbabwe bought $80 140 million worth of goods made overseas.

 Zimbabwe sold $78 072 million worth of goods overseas.

 The difference between visible exports and imports is known as the balance of trade or
visible balance. The amounted to -$2 068 million.

 Zimbabwe bought $75 007 million worth of foreign-produced services.

 Zimbabwe sold $80 027 million worth of services overseas.

 The difference between invisible exports and imports is called the invisible balance. This
amounted to $5 020 million.

Adding the balance of trade and balance on invisibles together gives the balance on the current
account. A deficit on the current account means that more goods and services have been
imported into the country than have been sold abroad. A surplus on the current account means
more goods and services have been exported than imported.

Transactions in Assets and Liabilities/ Capital account

The transactions in assets and liabilities section of the balance of payments shows all movements
of money in and out of the country for investment. This may be direct investment - investment in
productive capacity (when firms invest in other countries to increase capital in these countries),
or portfolio investment - investment in shares ,bonds or other assets in foreign countries. Changes
in assets will be outflows from Zimbabwe, as Zimbabwean investors invest money overseas.
These flows will be debits to the Zimbabwe’s Balance of Payments. Changes in liabilities will be
credits to the Zimbabwean Balance of Payments as overseas investors invest money into the
country (Zimbabwe)

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Monetary Account
This is also called the official financing account. It records changes in the country’s official
foreign currency/exchange reserves (consisting usually of a mixture of gold and foreign
currencies) plus transactions with the IMF and other financial institutions.

Balance of Payments Problems

Balance of payments deficit

This is of concern especially in developing countries because it affects the ability of those
countries to trade with other countries. A balance of payments deficit is a major problem if it is
persistent. This can be the result of excessive purchases of foreign goods and services or
excessive Zimbabwean investment overseas. Faced with existing or projected balance of
payments deficits on the combined current and capital accounts a variety of policy options are
available:

Correcting a Balance of Payments Deficit

1. Long term capital from the rest of the world. This has the disadvantage of external
indebtedness.

2. Using foreign currency reserves- this is a short term measure because most non-oil producing
developing countries have very few months in which to exhaust this.

3. Attracting additional inflows of short-term capital by raising interest rates. Lack of stability in
developing countries means that there is no guarantee funds will remain in the countries, i.e.
there is capital flight.

4. Import substitution- this is the local production of previously imported goods. This requires
the importation of capital equipment and protection of the infant industry by imposing tariffs or
bans on imported goods.

5. Exchange control – this is designed to control foreign currency reserves. The foreign currency
is rationed so that the most pressing needs of the country will be given top priority when the
funds are allocated., eg. capital goods and essential raw materials. Measures also include import
licensing as well as creating a state monopoly tasked to import essentials.

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6. Use of multiple exchange rates- different rates for currencies/ transactions. Essentials such as
exports, tourism and essential inputs for industry would have a separate rate(s) of exchange to
encourage them while for nonessentials they would be discriminatory . In other words there is a
multi-tiered market for foreign exchange.

7. Disguised depreciation- this is a policy whereby there is a deliberate effort by government to

make imports more expensive. This includes raising import duties, taxing invisibles, taxing
remittances abroad, subsidise exports, charging high fees on sales of foreign currency. This
policy is deflationary and also has loopholes.

8. Devaluation- reducing the external value of a currency. This increases the volume of sales
abroad.

9. Promoting ting export expansion- drawbacks of duty, export incentive schemes.

10. Encouraging more private investment and seeking more foreign assistance. Much of the
foreign aid comes in the form of loans which have to serviced. Interest has to be paid on the
loans. The principal has also to be repaid in future.

Balance of Payments Surplus

This is also a cause for concern because if it is persistent, partners may retaliate by introducing
import controls etc. A surplus implies an overvaluation of currency and this leads to exports
becoming less competitive on the world market. It could also be inflationary because , it is
argued by monetarists that it leads to an increase in money supply. A persistent surplus could
mean a depression of domestic living standards.

Correcting a Balance of Payments Surplus

An unwanted balance of payments surplus can be the result of excessive foreign investment in
Zimbabwe. This will place a future strain on the invisible balance. A reduction in interest rates
( an outflow of funds on the capital account) or the scrapping of protectionist measures
(restrictive exchange controls) will correct the surplus.

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CHAPTER EIGHT
ECONOMIC GROWTH

Definition

Economic growth refers to an increase in a country's ability to produce goods and services. The
advantage of economic growth is that an increase in real national income allows more goods for
consumption or for investment.

It is also defined as “a long term rise in capacity to supply increasingly diverse economic goods
to its population, this growing capacity based on advancing technology and the institutional and
ideological adjustments that it demands.” by Professor Kuznets. From this definition advancing
technology provides the basis or preconditions for continuous economic growth.

Measurement of Economic Growth

It can be measured by the change in GDP or GNP over time. It can be measured at current prices,
also called nominal GDP (GNP). Real GDP is at constant prices. The best indicator of growth is
real GDP per capita.

Factors affecting Economic growth

4. Capital accumulation i.e. Accumulation of machinery, equipment and tools etc. These lead to
increased capacity of plants. Capital accumulation also includes investment in human
resources.

5. Population and labour force growth- a larger labourforce means more productive manpower
while a larger overall population increases the potential size of domestic markets. The
growing supply will have a positive impact if the economic system can absorb and
productively employ these added workers.

6. Technological progress- this is the most important source of economic growth. In its simplest
form technological progress can be said to result from new and improved ways of
accomplishing traditional tasks. The productive resources, if used efficiently can increase
economic growth.

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7. Weather. Because of the importance of rain-fed agriculture and agro-industry in certain
countries such as Zimbabwe, weather is also an important determinant of economic growth in
the medium term.

Developing Countries

A developing country or less developed country (LDC) is one that is not yet fully industrialised
and tends to have the following features:

 Agriculture is more important than manufacturing.

 There is limited specialisation and exchange.

 There are not enough savings to finance investment.

 Population is expanding too rapidly for available resources. Population growth is equal to
or more than the rate of GNP growth in some countries. There are high and rising levels of
unemployment and underemployment.

 There are low incomes. In the income distribution, the gap between the rich and poor is
generally greater in less developed than in developed countries.

 Inadequate housing.

 There are low levels of productivity. This may be due to the absence or severe lack of
complementary factor inputs such as physical capital and or experienced management.

 In education there are low levels of literacy, significant school dropout rates, inadequate
and often irrelevant curricula and facilities.

 There is poor health. Most LDC people suffer from malnutrition and ill-health and high
infant mortality and have a lower life expectancy than in developed countries (DCs)

 A low standard of living. A large portion of the population is living below the Poverty
Datum Line.

A developed country is more fully industrialised and has a high standard of living.

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Barriers to Economic Growth

A country can increase production if it increases the amount of resources used or makes better
use of existing factors. Economic growth is more difficult if:

 A country lacks the infrastructure (underlying capital) to produce goods more efficiently.
There are three types of infrastructure:

1. basic including electricity, road and telephone networks;

2. social including schools, hospitals and housing;

3. industrial including factories and offices.

 A country lacks the machines or skilled labour needed to manufacture modern goods or
services.

 A country lacks the technical knowledge.

 Workers are not prepared to accept specialisation and the division of labour.

 Population growth is too rapid.

 A country has too large a foreign debt.

Disadvantages of Economic Growth

 Increased noise, congestion and pollution.

 Towns and cities may become overcrowded.

 Extra machines can be produced only by using resources currently involved in making
consumer goods.

 A traditional way of life may be lost.

 People may experience increased anxiety and stress.

ECONOMIC DEVELOPMENT
“is a multidimensional process involving the reorganization and reorientation of the entire
economic and social systems. In addition to improvements in incomes and output, it typically
involves radical changes in institutional, social and administrative structures as well as in popular
attitudes and sometimes even customs and beliefs” (Michael Todaro- Economics for a
Developing world.)
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Economic development is also defined in terms of the reduction or elimination of poverty,
inequality and unemployment within the context of a growing economy.
Development must have the objectives of -: increasing the availability and wider distribution of
basic- food, shelter, health and protection; raising the levels of living (higher incomes, higher
employment, better education and increased attention to cultural values).

Indicators of Economic Development.

The traditional view of economic development is GNP is an index of development. Another
common economic index of development is the use of rates of growth of per capita GNP. Rapid
industrialization was viewed as a way of having an increasing GNP, this often at the expense of
agriculture and rural areas – these were to benefit through the “trickle down effect”.

Obstacles to Economic Development in developing countries

 Overpopulation- high population growth.
 Low savings rate- has hampered industrial development.
 Limited range of exports.
 Urbanization- this compounds population problems through congestion. Overcrowding
promotes pollution, unemployment, disease and food shortages.
 Lack of an infrastructure. Because LDCs generally do not have infrastructures, industrial
firms will not normally locate plants there. Products manufactured for mass consumption
simply cannot be distributed and used without transportation and communication facilities-
few schools, roads, dams and bridges.

Solutions for Economic Underdevelopment

 Foreign aid
 Exportation of a major resource e.g. oil.
 Industrialization and protective tariffs and quotas.
 Industrialization and the export of manufactured goods.

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