Economics 120 Notes

ECON 120: INTRODUCTION TO MACROECONOMICS
LECTURE NOTES
TOPIC 1:
INTRODUCTION TO MACROECONOMICS
1.1 Definitions of Macroeconomics

1.1.1 Definitions
Macroeconomics is derived from “makros” which is Greek for
large/aggregate/summation. Macro economics is the study of the whole economy. It
looks at ‘aggregate’ variables, such as aggregate demand, national output and inflation. It
looks at how the economic activities and interactions of individuals and particular
organizations join together to create an overall economic environment at the national, and
often the global levels.
Macroeconomics is the field of economics that studies the behavior of the economy as a
whole and not just on specific companies, but entire industries and economies. This looks
at economy-wide phenomena, such as Gross National Product (GDP) and how it is
affected by changes in unemployment, national income, rate of growth, and price levels
(e.g. how an increase/decrease in net exports affects a nation's capital account or how
GDP is affected by unemployment rate)
Macroeconomics examines the economy as a whole and answers questions such as:
o What causes the economy to grow over time?
o What causes short-run fluctuations in the economy?
o What influences the values various economic indicators and how do those
indicators affect economic performance?
o What effect does interest rates have on whole economy?
o What causes inflation and unemployment?
o Economic Growth
o International trade and globalization
o Reasons for differences in living standards and economic growth between countries
o Government borrowing
WordReference.com:
 The branch of economics concerned with aggregates, such as national income,
consumption, and investment ".
The Economist's Dictionary of Economics:
 The study of whole economic systems aggregating over the functioning of individual
economic units
The website Tutor2U:
Macroeconomics considers the performance of the economy as a whole
When we study macroeconomics we are looking at topics such as economic growth;
inflation; changes in employment and unemployment, our trade performance with other
countries (i.e. the balance of payments) and the relative success or failure of government
economic policies
Econ 120-Introduction to Macroeconomics- Lihanda-0707253198; [email protected] Page 1

Macroeconomics is primarily concerned with variables which follow systematic and
predictable paths of behavior and can be analyzed independently of the decisions of the
many agents who determine their level.
More specifically, it is a study of national economies and the determination of national
income
1.2 Microeconomics versus Macroeconomics

Microeconomics is the study of particular markets, and segments of the economy. It
looks at issues such as consumer behavior, individual labor markets, and the theory of
firms.
Although it is convenient to split up economics into two branches – microeconomics and
macroeconomics, it is to some extent an artificial divide.
1.2.1 Micro principles used in macro economics. If you study impact of devaluation,
you are likely to use same economic principles, such as the elasticity of demand to
changes in price.
1.2.2 Micro effects macro economics and vice versa. If we see a rise in oil prices, this
will have a significant impact on cost-push inflation. If technology reduces costs, this
enables faster economic growth.
1.2.3 Blurring of distinction:- If house prices rise, this is a micro economic effect for
housing market. But, housing market is so influential that it could also be considered a
macro-economic variable, and will influence monetary policy.
1.2.4 There have been efforts to use computer models of household behavior to predict
impact on macro economy.
1.3 Central issues in macroeconomics

Unemployment rates, and price indices, national income, output, consumption,
unemployment, inflation, savings, investment, international trade and international
finance, and "crowding out" of the private sector
Monetary policy rules, such as keeping the rate of growth of the money supply constant
over time Government fiscal policy
1.4 Macroeconomic targets

There are four major macroeconomic targets, namely full employment, inflation control,
balance of payments equilibrium and economic growth
The role of government is also important since inevitably the direction of the economy
will to a considerable degree be dependent on government policies
1.4.1 Full Employment

The dominant economic and social objective of government is to achieve full
employment.

It has been defined as a situation where work is available for all those willing and able to
work at the going wage rate
To achieve this objective then the problem of unemployment must be tackled.
There are five main types of unemployment:
i. Structural Unemployment
Structural unemployment is where the structure of the economy changes. Employment in
some industries may expand while in others is contracts. This can be caused by a change
in the pattern of demand such as the demand for coal.
A second reason could be a change in the methods of production (i.e. technological
unemployment where new technology leads to redundancies)
ii. Cyclical Unemployment
Cyclical unemployment is also known as demand deficient unemployment and is
associated with economic recessions. As the economy moves into recession consumer
demand falls and in due course production will be reduced leading to laying off of
workers. As the economy picks up on its path through the trade cycle, production
increases and demand for labor increases (hence the reference to cyclical unemployment
iii. Underemployment (disguised unemployment)
Underemployment occurs when an individual is working below full capacity; e.g. where
a worker is employed for only part of a week but his addition to total production (MPP) is
very low, or a university graduate with a first class honors degree is delivering goods for
the local supermarket to earn a living)
iv. Frictional Unemployment (Search Unemployment)
Frictional unemployment occurs when there may be, say, 100 carpenters unemployed in
Nairobi while at the same time Turskys supermarket in Nakuru needs 100 carpenters.
Here the carpenters are searching for work and Turskys supermarket is searching for
workers.
v. Institutional unemployment
This occurs where obstacles to the mobility of labor or the removal of the incentive to
work such as in the following situations
o A "Close Shop" exists creating a situation where non-union members are refused
entry to the workplace
o There is a shortage of housing in areas where jobs are available.
o The gap between take home pay and social welfare is so narrow people decide it is
better to opt out of the workforce
vi. Seasonal Unemployment
Certain industries have greater demand for labor at different times of the year. The
tourism industry is a good example. During the winter many people here will little
opportunity to gain employment.
1.4.2 Inflation control

Keeping prices under control is a major concern in any economy. Some governments,
such as the Thatcher governments of the 1980s, could be regarded as considering
achievement of low levels of inflation as the prime macroeconomic target.
There are two main forms of Inflation; demand-pull and cost push
Demand pull arises where aggregate demand is greater than aggregate supply

Cost push is a consequence of increasing costs such as wages and taxes pushing prices
up. There are a number of deflationary measures which can be adopted in order to
counter inflation.
 Cutting government expenditure controls demand pull inflation
 Increase direct taxation (income tax) to reduce aggregate demand
 Reduce the money supply to control demand pull inflation through diminished
aggregate demand
 The government, together with the social partners, can establish control over
excessive wage increases which lead to higher prices. This can encourage
moderation by both workers in their wage demands and producers in their pricing
policies. This can act as defence against cost push inflation
1.4.3 The Balance of Payments (BoP)

In an open economy where there is a high level of dependency on foreign trade the
authorities must maintain vigilance over their foreign trade because of the consequences
in other areas.
One important point for observation is the annual Balance of Payments statistics. The
balance of payments is a record of a country’s financial transactions with the rest of the
world. In the current account it records the movements of exports and imports of both
visible and invisible while the capital account movements of capital in and out of the
country are recorded.
If a deficit on current account is recorded it is evidence that there has been an excess of
imports of goods and services over exports of goods and services. The prime
consequence of this is that there will be fall in demand for the national currency. (This
should now be read in the EMU context). If there is a decline in demand for the currency
the value could fall if the ECB does not take action to maintain its value. This could lead
to other consequences such as increases in interest rates to protect the outflow of capital
which will follow.
In summary, it is imperative that great vigilance should be maintained over our
international trading position and every effort should be brought to bear to strengthen the
system because of the consequences in other spheres.
1.4.4 Economic Growth

Economic growth involves a change in Gross National Product with no change in the
structure of society.
The achievement of substantial levels of growth is an aspiration of most policy options.
1.4.5 Overcoming the Macroeconomic Challenges

The above indicated macroeconomic challenges can be overcome through a combination
of the following ways:
 Exceptionally high domestic saving and investment rates; and ability to tap
successfully additional foreign savings to complement domestic effort
 Financial policies oriented toward macro-stability help to keep inflation low and
external imbalances under control.
 Creation of market-friendly and outward-oriented policies, with liberal external
regimes to maintain competitiveness
 Government interventions in a number of areas (e.g. anti-poverty programs; through
increased government spending, especially on education and health; productivity
and growth that helps ensure both economic and political sustainability
 The willingness to adjust policies flexibly and quickly in response to changing
economic circumstances and challenges to allow a rapid transformation of the
economic structure while maintaining intact strong macroeconomic fundamentals
 Stabilization policy: -using both monetary and fiscal policies to smooth out
fluctuations in output and employment and to keep prices as stable as possible

TOPIC TWO: MEANING AND MEASUREMENT OF NATIONAL
INCOME
2.1 Definitions
National Income is the total economic activity (production of finished goods and services
calculated in monetary value) within the economic territory of a country by its residents
during the year of accounting. In other words National Income of a country is the Net
National Product at factor cost.
While the flow of goods and service available to a country during a year is called national
product, the money value of the goods and services produced in a country during a year is
called national income.
Three popular definitions of national income include:
 Alfred Marshall
“The labor and capital a country acting upon natural resources produce annually, a
certain net aggregate of commodities material immaterial including service of all kinds.
This is the net annual income or revenue of country or the national dividend".
“The aggregate net product of and the sole source of payment for all the agents of
production”
 A.C. Pigou
"The national dividend is that part of the objective income of the community including of
course, income dividend from aboard, which can be measured in money”.
 Irving fisher
“The true national income is that part of annual net produce which is directly consumed
during that year".
Note:
The definition Marshall and Piguo are based on production. On the other hand, the
definition of Fisher is based on consumption. It is practically difficult to measure national
income on the basic of the definition based on consumption. Hence, the product-based
definition of Marshall and Piguo are regarded as being more acceptable.
Alfred Marshall’s definition of national income (as “The aggregate net product of and
the sole source of payment for all the agents of production”) can be disaggregated as:
Agents of production: the factors which create and then enjoy the national income
Aggregate net product Agents of production are producing a total (aggregate;
of: collection of goods and services), which cannot all be enjoyed
as income because in creating them depreciation has been
suffered on the capital assets of the nation e.g. wear and tear
of machines, buildings grow older, transport facilities suffer
wear and tear
Sole source of payment o Land owners - rent
for: o Laborers – wages
o Investors – interest, profit
The money value of the total flow of goods and services produced by the nationals or
citizens of a country over a period of one year; this flow of income includes goods as
well as services.

National income is the measure of money value of goods and services (commodities)
which arise from the productive activities of a country within a specified period of time,
usually one year.
However, not all productive economic activities that occur in a country belong to that
country; and also some productive economic activities of a country occur outside its
geographical boundaries.
This leads to the following definitions of the components of national income.
2.2 Concepts Associated with National Output
2.2.1 Gross Domestic Product (GDP)

GDP is the basic social accounting measure of total (aggregate) output or aggregate
supply of goods and services
GDP: – the total value of all final goods and services produced within the geographical
boundary of a country in a year.
Note:
 GDP is a monetary measure only
 Only final goods should be included in annual output (i.e. final goods are those that
are purchased for final use and not for resale or further processing; intermediate
goods are those that are produced for further processing)
 The sale of intermediate goods is excluded GDP since the value of the final goods
already includes the value of intermediate goods
 In calculating GDP, the value of the following production is included:
 Total agricultural production
 Total mineral production
 Total industrial production
 Total miscellaneous production of services (e.g. doctors, advocates, bankers
and insurers)
GDP is, therefore, a measure of the market value of all final goods and services produced
in a country during a year
 Nominal GDP – measured in actual market prices
 Real GDP – Calculated at constant (invariant/base year) prices
 Potential GDP –represents the maximum amount of goods and services that the
economy can produce while maintaining reasonable price stability. Potential output
is also referred to as high-employment level of output
2.2.2 Gross National Product (GNP)

Market value of goods and services which generate income in any country
GNP takes into consideration the net income from abroad
GNP = GDP + Net factor income (NFI)
NFI = (Income accruing to domestic residents arising from productive activities outside
the country) – (income earned within the domestic economy accruing to non-
residents).
Productive activities in a domestic country may be carried out by foreign factors/citizens
Citizens of a country can also be engaged in productive activities in other countries.

Countries which allow high levels of foreign investment and do not themselves invest
heavily outside will experience a big difference between GDP and GNP. Less Developed
countries (LDCs) happen to fall in this trap with high levels of investment being
undertaken by MNCs without corresponding significant investments outside.
2.2.3 Net National Product (NNP)

In the production of GNP, we consume or use some capital (i.e. equipment, machinery
and buildings).
Capital goods wear out or depreciate in value as a result of their consumption (i.e. they
are used up in the production process)
The consumption of fixed capital (fall in value of capital) due to the wear and tear is
called “depreciation”.
Depreciation allowance is the amount which is kept as reserve to keep the capital goods
in working condition.
NNP = GNP – Depreciation allowance
NNP provides for capital consumption (i.e. the replacement value of capital) used in the
production process.
Capital consumption (depreciation) recognizes the reduction in the value of assets which
generally arises from wear and tear.
2.2.4 Net National Product at factor prices

In estimating national income, the market prices are used to aggregate the value of
outputs. Under normal circumstances, market prices include indirect taxes and subsidies.
Thus, the value of output will not be equal to the value of incomes paid to the factors of
production because it is the revenue received by firms after indirect taxes which is
distributed as factor incomes.
Therefore, the value of incomes paid to factors of production must be net of indirect taxes
and plus subsidies.
Thus,
NNP at factor cost = NNP at market prices – indirect prices + subsidies
2.2.5 National Disposable Income

National Disposable Income (NDI) = National income (plus, minus) net transfer
receipts/payments
This concept becomes useful where a country receives substantial transfers from abroad
either to the government or to individual residents or, alternatively, where the residents of
a given country send out substantial remittances.
2.2.6 Nominal national income versus Real national income

For uniformity purposes, national income is measured in monetarily. However, a change
in the value of money can arise due to changes in either quantity or price.
2.2.6.1 Nominal National Income

This refers to the measurement of total output in current prices
The money values of total output, total factor incomes and total expenditure.
The actual dollar amount that the person receives as income and has not been adjusted for
the inflation rate (i.e. inflation is the increase in the general price level which means that
if your income is the same and the price level goes up then you will be able to buy lesser
in that income because now the products will be expensive. For example if a person is
given a salary of $2500 then it generally refers to the nominal income as it does not
account for inflation.
Nominal national income is the aggregate income within a country, expressed in currency
terms, that does not account for diminished purchasing power because of inflation or
outstanding debt.
2.2.6.2 Real National Income

This is the value of total output measured in “constant prices” (base year prices).
The general rate of inflation is deducted to record the purchasing power over resources.
Real income is adjusted for this increase in prices and represents a realistic picture and
shows how much a person is left with when the increase in prices is deducted from
nominal income. It shows the purchasing power of the person by relating the income to
the goods or services that can bought with it instead of just the dollar amount.
2.2.7 Per Capita Income

National income divided by the total population of the country. That is, the average
income of the people in a given year.
Per capita income = Net National income
Total population
2.3 Importance of Measuring National Output

2.3.1 To measure the extent of economic activity in the economy (i.e. the level of the
overall economic performance or growth of the economy) so that we can be able
to state that over a given period of time, economic growth rate is a certain figure.
2.3.2 To enable policymakers to determine whether the economy is contracting or
expanding and whether a severe recession or inflation threatens.
2.3.3 To measure the standard of living (material well being or welfare) in a country
Limitations of this measure:

 Ignores other forms of wealth e.g. property, houses, stocks and shares
 Inflation - a rise in GNP may be accompanied by a fall in real terms – i.e.
how many goods and services can be purchased?
 Population – countries may have similar levels of GNP but considerably
different levels of per capita income
 Income distribution – per capita income presupposes income equality
 Producer versus consumer goods – an increase in national income brought
about by an increase in the production of producer goods or investment does
not increase present welfare
 Working hours – an increase in national income may be due to longer
working hours and inferior working conditions
 Government expenditure – if government expenditure increases ten times,
welfare does not necessarily increase tenfold (expenditure might be on
armaments, increased salaries for politicians, white elephant projects, etc)

 Social costs and benefits – national income figures are based on private
costs and benefits (excludes social costs; e.g. an increase in mineral
production may be achieved at the expense of degrading the landscape or
increased incidence of malaria)
 Levels of accuracy – subsistence sector, population estimates, and estimates
of depreciation are rarely accurate. Inaccuracy of data may lead to wrong
conclusions being drawn about standard of living
2.3.4 To compare the standards of living in different countries
Limitations of such comparisons:
 Different currencies
 Differences in the definition of national income ; particularly on the
commodities to include
 Differences in tastes and preferences
 Differences in price structure and valuation systems
 Some countries have social security while others do not have
 Different levels of unemployment
2.3.5 To assess the rate at which an economy is growing.
Economic growth: - an increase in a nation’s productive capacity identified by a
sustained increase in real national income over a period of time
Economic development: - associated with a rise in national income accompanied
by structural changes (e.g. shift from agriculture to manufacturing)
Limitation: Inflation
2.3.6 To compare the economic performance or the economic growth among different
countries.
2.3.7 To assist the government in planning the economy
 National income assists the government to check on whether its economic
objectives are being achieved;
 National income figures assist the government to assess what policy
measures to take in order to correct adverse trends e.g. low investment
 National income figures are very useful in preparing the budget so as to
determine expenditure in appropriate sectors and to formulate sectoral
policies
 National income facilitates the redistribution of income to reduce
inequalities
2.3.8 National income figures assist in the forecasting of future trends
2.3.9 National income figures assist the business community to understand the
economy before committing resources to investment
2.4 Problems of Measuring National Income

2.4.1 Arbitrary definitions have to be made; for example production includes goods and
services paid for but excludes work done by individuals themselves e.g. parental
care, home gardening, and house repairs, even though such work may improve
peoples’ standards of living
2.4.2 Sources of data for national income may not be wholly reliable; e.g. income tax
data excludes that black economy, whose earnings are not declared to the tax
authorities

2.4.3 Value of leisure is not fully taken into account - to produce higher levels of
income requires that leisure be forfeited; yet leisure enhances the standards of
living. Between any given two time periods, changes in national income may be
influenced by the number of hours worked. Comparisons of standards of living
should include a measure of the increased value of leisure
2.4.4 Income distribution is not taken into account
2.4.5 “Black economy” activities are unrecorded; a considerable “black economy” will
cast aspersions on the credibility of official statistics
2.4.6 Government services- public services are valued at resource cost (e.g. security,
medical services). Since such services are not provided through the market
system, their true value to consumers is not really measured.
2.4.7 Manpower constraints make it difficult to get accurate and reliable data
2.4.8 Transfer payments- unemployment benefits, old age insurance, government
subsidies
2.4.9 National income calculation does not take into consideration capital gains and
capital losses; depreciation
2.4.10 Economic developments which enhance national income may have been
implemented at the expense of social costs vis-à-vis pollution, loss of places of
natural beauty, increased traffic congestion, and environmental degradation
2.5 The Circular Flow of Income

Insert definition, diagram and explanation
2.6 Measures of National Income
2.6.1 The output approach

The output approach focuses on finding the total output of a nation by directly finding the
total value of all goods and services a nation produces.
Because of the complication of the multiple stages in the production of a good or service,
only the final value of a good or service is included in the total output. This avoids an
issue often called 'double counting', wherein the total value of a good is included several
times in national output, by counting it repeatedly in several stages of production. In the
example of meat production, the value of the good from the farm may be $10, then $30
from the butchers, and then $60 from the supermarket. The value that should be included
in final national output should be $60, not the sum of all those numbers, $90. The values
added at each stage of production over the previous stage are respectively $10, $20, and
$30. Their sum gives an alternative way of calculating the value of final output.
Formulae:
GDP (Gross Domestic Product) at market price = value of output in an economy in the
particular year - intermediate consumption
NNP at factor cost = GDP at market price - depreciation + NFIA (net factor income from
abroad) - net indirect taxes

2.6.2 The Income Approach
The income approach equates the total output of a nation to the total factor income
received by residents or citizens of the nation. The main types of factor income are:
 Employee compensation (cost of fringe benefits, including unemployment, health,
and retirement benefits);
 Interest received net of interest paid;
 Rental income (mainly for the use of real estate) net of expenses of landlords;
 Royalties paid for the use of intellectual property and extractable natural resources.
All remaining value added generated by firms is called the residual or profit. If a firm has
stockholders, they own the residual, some of which they receive as dividends. Profit
includes the income of the entrepreneur - the businessman who combines factor inputs to
produce a good or service.
Formulae:
NDP at factor cost = Compensation of employees + Net interest + Rental & royalty
income + Profit of incorporated and unincorporated NDP at factor cost
2.6.3 The Expenditure Approach

The expenditure approach is basically an output accounting method. It focuses on finding
the total output of a nation by finding the total amount of money spent. This is
acceptable, because like income, the total value of all goods is equal to the total amount
of money spent on goods. The basic formula for domestic output takes all the different
areas in which money is spent within the region, and then combines them to find the total
output.
GDP = C + I + G + (X –M)
Where:
C  Household consumption expenditures / personal consumption expenditures
I  Gross private domestic investment
G  Government consumption and gross investment expenditures
X  Gross exports of goods and services
M  Gross imports of goods and services
Note: (X - M) is often written as XN, which stands for "net exports"
2.7 National income versus Welfare/Standard of Living

TOPIC THREE: THE CONSUMPTION FUNCTION
3.0 Introduction
In macroeconomics, the total spending, by individuals or a nation, on consumer goods
during a given period, is referred to as consumption. Strictly speaking, consumption
should apply only to those goods totally used, enjoyed, or “eaten up” within a given
period. In practice, consumption expenditures include all consumer goods bought, many
of which last well beyond the period in question, e.g. furniture, clothing and automobiles.
The consumption function shows the relationship between the level of consumption
expenditures and the level of personal disposable income.
The consumption function was introduced by John Maynard Keynes, based on the
hypothesis that there is a relationship between consumption and income.
To Keynes, employment depends on effective demand, which in turn consists of
consumption and investment.
Therefore, changes in consumer spending are important in determining the level of
employment. According to Keynes, income was the most important determinant of
consumption.
However, according to the Classical economists the decision by people to consume more
and save less, and vice versa, was influenced by changes in the interest rates. For
example, high interest rates induce consumers to save more (postpone consumption), and
vice versa.
High interest rates reduce aggregate consumption due to increased savings. Thu,
consumption is regarded as a negative function of interest rates.
Keynes view about income- consumption relationship can thus be summarized as Keynes
Psychological Law, which states that:
“Men are disposed, as a rule and on the average, to increase their consumption as
their income increases, but not as the increase in their income”
In the long run, as a rule, a greater proportion of income will be saved as real income
increases.
3.1 Definition of Consumption Function

A schedule relating total consumption to personal disposable income
The relationship between consumption and disposable income is expressed as a
consumption function.
C = f(Y)
Keynes formulated a law based on the analysis of consumption function. This law is
called the fundamental law of consumption (Keynes’ Psychological Law of
consumption), consists of inter-related propositions:
i. When aggregate income increases, consumption expenditure will also increase less
proportionately. That is, as income increases, more and more wants are satisfied,
hence not as much is again spent on consumption as income increases
ii. As income increases, the increment of income will be divided in some proportion
between saving and consumption. Some of the extra income is spent while the rest is
saved
In other words, as income increases, consumption also increases. However, the increase
in consumption is not as high as the increase in income. Some of the increase in income
goes out of the circular flow into saving,
The aggregate level of consumer spending in an economy is the total of the consumer
spending for every household in the economy. It is reasonable to assume that the
consumer spending of a household is divided two parts:
a) A fixed level of expenditure, which does not vary with the level of income of a
household, and
b) A proportion of total income which rises with increases in income
Consumption is often expressed in the following identity:
C = a + bY
Where:
C = Consumption of all households
a = fixed proportion (autonomous consumption)
b = Proportion of total income (Marginal propensity to consume; MPC)
Y = Disposable income
MPC- the proportion of extra income received that would be spent; that is, the proportion
of any increment in income that is devoted to consumption
3.2 Factors influencing MPC

MPC is influenced by several factors:
 Taste: if a household considers saving as a virtue, it will increase its savings
If the economy believes in thrift, MPC will be low
Nowadays the prestige attached to the possession of consumer goods may have
overcome the admiration for thrift, thus increasing MPC
 Attractiveness of savings i.e. if interest rates are high, households will wish to
save more of their income
 Credit- if interest rates are high, there is no incentive to borrow and thus a lower
tendency to consume
 The value of MPC may be affected by the value of autonomous consumption (a).
That is, if the cost of essential commodities rises relative to all other
commodities, the value of MPC rises - since a greater proportion of household
income becomes fixed and less of the income is available for variable
consumption bY; a rise in “a” causes “b” to fall
Apart from income, consumption is determined by various factors:
i. Expectations about future prices – stockpiling incase people anticipate price
increases; incase they anticipate price reductions they will postpone current
consumption until at a future time
ii. Income distribution – if income is redistributed from the rich to then poor, we
expect consumption to rise
iii. Advertisements, social/peer pressure
iv. Government policies
 Taxation- affects disposable income/purchasing power [Yd = Y-T]; high
taxes reduce disposable income/purchasing power while reductions in taxes
increase purchasing power by raising Yd
 Subsidies increase consumption

 Reduced interest rates increase borrowing, reduce savings and increase
consumption
 Injections into the circular flow of income
 Increased government expenditure
 Increased investment by firms
 -Increase in exports
Since national income eventually passes in the hands of households, a rise in national
income leads to a corresponding rise in the incomes of households, leading to an increase
in consumption
v. Changes in the distribution of national income- households with higher incomes
tend to have smaller MPC and higher MPS; a redistribution of wealth from high-
income households to low-income households will raise overall consumption
vi. Changes in price expectations – anticipated price increases will tend to make
households bring forward expenditure, thus reducing saving; expectations of being
declared redundant soon will reduce consumption and increase savings.
3.3 Average Propensity to Consume (APC)

The Average propensity to consume measures the ratio of total consumption to income.
APC= Total consumption =C

Total income Y
3.4 Marginal Propensity to Consume (MPC)

The concept of margin is very important in economics. It measures the response of one
variable to a small change in another variable.
The marginal propensity to consume (MPC) measures the change in consumption (∆C)
due to change in income (∆Y).
Therefore, MPC = ∆C
∆Y
3.5 THE SAVINGS FUNCTION

Individuals decide how much to consume and how much to save. It is a single decision
how to divide disposable income between consumption and saving.
Technically, saving is a function of income. It is the difference between consumption and
income.
S=Y-C
The relationship between saving and income is termed the saving function.
Saving is determined by two factors:
i. Power to save
The power to save depends on several factors, including the level of income, market
rate of interest, banking system, peace and security

ii. Will to save
The will to save depends on subjective factors of the consumption function. These
include the psychological characteristics of the individual and social practices and
institutions.
The saving function (propensity to save) is explained in the following two forms:
a) Average propensity to save (APS), and
b) Marginal propensity to save (MPS)
3.6 The Average propensity to save (APS)

The APS is a ratio between total saving and total income
APS = S
Y
3.7 The Marginal propensity to save (MPS)

The MPS is a relationship between change in saving and change in income.
MPS = ∆S
∆Y
3.8 Mathematical presentation of the Savings function
S = f (Y); savings is a function of income
Since Y = C + S, consumption and savings are counterparts of one another

Y = C + S ………………………………………………….(i)
S = Y – C ……………………………………………………(ii)
C = a + bY
Substituting C in (ii) above
S = Y – (a + bY)
S = -a + (1- b) Y ……………………………………….(iii)
Equation (iii) gives the saving function in which (1 –b) is the marginal propensity to save
(MPS)
Note:
MPC + MPS = 1
Thus,
1 – MPC = MPS
Since MPC = b in the consumption function C = a + bY

C = MPC = b
Y
Since Y = C + S
Y = C + S
Dividing both sides by Y
Y = C + S
Y Y Y
S = 1 - C
…………………………………………………………………………………………(iv)
Y Y
Since C = b, we substitute in equation (iv)

Y
S = 1 – b
Y
Numerical example:
The consumption function is given by:
C = 100 + 0.75Y
Y=C+S
S=Y–C
S = Y – (100 + 0.75Y)
S = Y – 100 – 0.75Y
= -100 + (1-0.75) Y
= -100 + 0.25Y
Graphing the consumption and saving functions together

The 45 line shows income consumption relation with Y = C at all levels of income
C = 100 + 0.75Y gives the income consumption relationship with consumption being a
linear function of income
S = - 100 + 0.25Y is the saving schedule derived from the consumption schedule
Diagram

The formal model of income determination
AD = AS
C+I =C+S
Since C is common to both the sides, the equilibrium conditions can also be stated as:
I=S
The income expenditure approach (aggregate demand)

C+I =C+S
Since C + S = Y, the national income equilibrium condition can also be restated as:
Y=C+I
At equilibrium C = a + bY
Substituting, we get the equilibrium national income as:

Y = a + bY + I
Y – bY = a + I
Y (1-b) = a + I
Therefore,
Y=1 (a + I)
1 –b
Empirical example:
Assume the consumption function is given by
C = 100 + 0.75Y, and
I = 100
Then
Y = 100 + 0.75Y + 100
Y = 200 + 0.75Y
Y – 0.75Y = 200
Y (1-0.75) = 200
0.25Y = 200
Y = 200/0.25 = 800
3.9 The Multiplier and Keynesian Economics

The concept of the multiplier process became important in the 1930s when J. M. Keynes
suggested it as a tool to help governments to achieve full employment.
This macroeconomic “demand-management approach”, designed to help overcome a
shortage of business capital investment, measured the amount of government spending
needed to reach a level of national income that would prevent unemployment.
The multiplier is a measure of the response/effect on the national income from a unit of
initial change in the component of aggregate demand that brings about the change in
income.
It is the impact of a unit change in any one of the components of aggregate demand
expenditures on total income (output).
It is calculated as a ratio of the change in income to the changes in expenditure that
brings it about.
These components of aggregate demand are injections into the system, namely:
 Investment,
 Government expenditure, and
 Exports
We know that:
Y = I + G + X which means that changes in each one of these will have an effect on
change on income, leading to the following individual multipliers:
a) Investment multiplier = Eventual change in national income

Initial change in investment spending
b) Government spending multiplier = Eventual change in national income

Initial change in government spending
c) Export multiplier = Eventual change in national income

Initial change in investment spending
Example of the investment multiplier

Given C = a + bY (i)
Y=C+I (ii)
Substituting (i) in (ii)
Y = a + bY + I
Y - bY = a + I
Y (1 – b) = a + I
Y=1 . (a + I)
(1 – b)
Assume that income changes to a new level Y*due to a change in investment to I*
Y* a + I*
We can compute the multiplier as:

Y* - Y = 1 . (a + I*) - 1 . (a + I)
(1 – b) (1 – b)
Y* - Y = 1 . (a – a + I* - I)
(1 – b)
Y* - Y = 1 . (I* - I)
(1 – b)
Y* - Y = Y
I* - I = I
Substituting:
Y* - Y = 1 . (I* - I)
(1 – b)
Y = 1 . I

(1 – b)
Note:
MPC + MPS = 1
MPS = 1 – MPC (in the above equation b = MPC)
Therefore:
Y = 1 . I OR Y = 1
(1 – MPC) MPS
The multiplier is denoted by k
Y = k. I
OR
Y = k
I
The higher is the propensity to consume domestically produced goods and services, the
greater is the multiplier effect.
The government can influence the size of the multiplier through changes in direct taxes.
For example, a cut in the basic rate of income tax will increase the amount of extra
income that can be spent on further goods and services.
Another factor affecting the size of the multiplier effect is the propensity to purchase
imports. If, out of extra income, people spend money on imports, this demand is not
passed on in the form of extra spending on domestically produced output. It leaks away
from the circular flow of income and spending.
The multiplier process also requires that there is sufficient spare capacity in the economy
for extra output to be produced. If short-run aggregate supply is inelastic, the full
multiplier effect is unlikely to occur, because increases in AD will lead to higher prices
rather than a full increase in real national output. In contrast, when SRAS is perfectly
elastic a rise in aggregate demand causes a large increase in national output.

Therefore:
The central prediction of national income determination theory by the Keynesian model
is that an increase in expenditure (injection), whatever its source, will cause an increase
in national income that is greater than the initial increase in expenditure by the effect of
the multiplier.
The multiplier really means that if there has been a change by increase in a given
autonomous expenditure, there will be a multiplication effect in the economy to the
extent that national income will increase by the multiples of the increase of the
autonomous expenditure.
Example:
An investment multiplier means that there will be an increase in investment as an
injection in the economy.
Effect:

This will have an effect of increasing incomes, which are, in turn, spent on commodities
in the economy.
Producers will also have an increase in their incomes, which they will also spend on, say,
factor services
At least every stage or sector of the economy will have some effect of the initial increase
in investment with some income being passed on at each stage.
The extent of the eventual increase in income will be determined by how income is
passed on at each stage, which is determined by the size of the multiplier.
The size of the multiplier is determined by the marginal propensity to consume (MPC)
and is given by the formula:
1
1 – MPC
A simple multiplier is given by a reciprocal of MPS (1 –MPC = MPS)
Therefore, the multiplier is equal to
1 where MPS is the marginal propensity to save
MPS
Example:
If the MPC in an economy is 0.6, then the multiplier will be given by
1 = 1 = 2.5
1 – 0.6 0.4
The higher the MPC, the higher the multiplier and the multiplier effects in the economy
This means that the higher the propensity to withdrawal from the system, the lower the
multiplier; and the higher the injections the higher the multiplier.
Note:
 Withdrawals cause contractionary effects
 Injections cause expansionary effects

TOPIC FOUR: INVESTMENT
Definition
Motives for investment
Investment, income and interest rates

TOPIC FIVE: GAP ANALYSIS
5.1 Definitions of Aggregate Demand (AD)
 In macroeconomics, aggregate demand (AD) is the total demand for final goods and
services in the economy (Y) at a given time and price level. It is the amount of
goods and services in the economy that will be purchased at all possible price
levels.
 The total demand of all potential buyers of a commodity or service. Includes all
individuals and organizations that have the ability, willingness, and authority to
purchase such products.
 The total demand for a country's output, including demands for consumption,
investment, government purchases, and net exports.
Y=C+I+G+X–M
 Aggregate demand is the demand for the gross domestic product (GDP) of a
country, and is represented by this formula:
Aggregate Demand (AD) = C + I + G (X-M) C = Consumers' expenditures on
goods and services. I = Investment spending by companies on capital goods. G =
Government expenditures on publicly provided goods and services. X = Exports of
goods and services. M = Imports of goods and services. Gross domestic product as
measured by the sum of final expenditure on goods and services produced, plus
exports minus imports
 Total spending on domestic output at a given price level, over a given time period,
usually one year
The total amount of goods and services demanded in the economy at a given overall
price level and in a given time period. It is represented by the aggregate-demand
curve, which describes the relationship between price levels and the quantity of
output that firms are willing to provide. Normally there is a negative relationship
between aggregate demand and the price level; also known as "total spending".
Diagram
5.2 Explaining the Shape of AD Curve

The three effects that explain the shape of AD curve include:

5.2.1 Wealth effect (real balances effect)
As the price level rises, the real value—the purchasing power—of money and other
accumulated financial assets (bonds, for instance) will decrease. People will therefore
become poorer in real terms and decrease the quantity demanded of real output.
5.2.2 Interest rate effect

We assume the supply of money to be fixed. When the price level increases, more money
is needed to make purchases and pay for inputs. With the money supply fixed, the
increased demand for it will drive up its price, the rate of interest. These higher rates will
decrease the buying of goods with borrowed money, thus decreasing the amount of real
output demanded.
5.2.3 Net exports effect

As Kenya’s price level rises relative to other countries, Kenyans will buy more abroad
(they will import more) in preference to their own domestically produced output. At the
same time foreigners, finding Kenyans goods and services relatively more expensive will
decrease their buying of Kenyan exports. Thus, with increased imports and decreased
exports, Kenya’s net exports decrease and so, therefore, does the quantity demanded of
Kenya’s real output.
5.3 Definition of Aggregate Supply (AS)

5.3.1 Definitions
 The total supply of goods and services produced by a national economy during a
specific time period. It is the total amount of goods and services in the economy.
 The total supply of a country's output, usually assumed to be an increasing
function of its price level in the short run but independent of the price level in the
long run.
 Gross domestic product as measured by the value of goods and services produced,
less the cost of production.
 The amount of total goods and services supplied at a given price level.
 The total output domestic producers are willing and able to produce at a given
price level, over a given time period, usually one year.
 It reflects the amount of output produced at different price levels.
The total supply of goods and services produced within an economy at a given overall
price level in a given time period. It is represented by the aggregate-supply curve, which
describes the relationship between price levels and the quantity of output that firms are
willing to provide. Normally, there is a positive relationship between aggregate supply
and the price level. Rising prices are usually signals for businesses to expand production
to meet a higher level of aggregate demand.
Diagram

5.3.2 Explaining the Shape of AS curve
Diagram
 Explain the concept of full employment (potential output or optimal output)
 Explain the Keynesian range, the Intermediate range and the Classical ranges of
the AS curve
There are two main reasons why quantity (output) might rise as price rises (that is, it
explains why the AS curve is upward sloping).
Aggregate supply is usually inadequate to supply ample opportunity. Usually this is fixed
capital equipment. The AS curve is drawn given some nominal variable, such as the
nominal wage rate.
In the short run, the nominal wage rate is taken as fixed.
Thus, rising prices imply higher profits that justify expansion of output.
In the neoclassical long run, on the other hand, the nominal wage rate varies with
economic conditions. (High unemployment leads to falling nominal wages -- and vice-
versa.)
An alternative model starts with the notion that any economy involves a large number of
heterogeneous types of inputs, including both fixed capital equipment and labor. Both
main types of inputs can be unemployed. The upward-sloping AS curve arises because:
i) Some nominal input prices are fixed in the short run (as in the neo-classical theory) and
ii) As output rises, more and more production processes encounter constraints. At low
levels of demand, there are large numbers of production processes that do not use their
fixed capital equipment fully. Thus, production can be increased without much in the way
of diminishing returns and the average price level need not rise much (if at all) to justify
increased production (thus, the AS curve is flat). On the other hand, when demand is
high, few production processes have unemployed fixed inputs. Thus, constraints are
general. Any increase in demand and production induces increases in prices. Thus, the
AS curve is steep or vertical.
5.4.1 The Keynesian range

The horizontal segment of the Keynesian aggregate supply curve that reflects rigid prices
and wages; shifts of the aggregate demand curve in this range lead to changes in the
aggregate output, but not changes in price level
5.4.2 The Intermediate range

The positively-sloped segment of the Keynesian aggregate supply curve, which reflects
the trade-off between aggregate output and the price level
Shifts of the aggregate demand curve in this range lead to changes in both aggregate
output and the in price level
5.4.3 The Classical range

The vertical segment of the Keynesian aggregate supply curve that reflects the
independence of full-employment aggregate output (or Gross Domestic Product) to the
price level
Shifts of the aggregate demand curve in this range lead to changes in the price level, but
not changes in aggregate output
5.5 Macroeconomic Equilibrium (AD = AS)

When aggregate demand equal aggregate supply with no tendency for output or the price
level to change
A state of national economic activity wherein aggregate demand is met by aggregate
supply
Meeting aggregate demand with aggregate supply as a national economic conditional
activity
Significant movement on either side will affect prices, employment and resources.
Diagram
5.6 Demand-deficiency and Excess Demand
5.7 Equilibrium level of employment
5.8 Inflationary and Deflationary gaps
5.9 Solutions to Deflationary gap and Inflationary Gap

TOPIC SIX: FOREIGN TRADE
6.1 Why Countries Trade
6.2 Gains from Trade
6.3 Specialization
6.4 Comparative Advantage
6.5 Terms of Trade
6.6 Balance of Payments
6.7 Protection versus Liberalization

TOPIC SEVEN: MONEY
7.1 Definitions of Money and Earlier Forms of Money

Definitions
 Anything that is generally acceptable as a means of payment in the settlement of all
transactions, including debt.
 Any generally accepted medium of exchange, i.e. it will be accepted by virtually
everyone in exchange for goods and services
 It is the commonly-used medium of exchange or means of transferring purchasing
power.
 Money is a highly liquid financial asset that is generally accepted inn exchange for
other goods and is used as a reference in valuing other goods.
The uniqueness of money is its general acceptability as a means of payment
Money is highly liquid- i.e. it does not need to be converted into something else before it
can be spent or used for the settlement of debt.
Money is money because of the belief by everyone that it will be accepted as such by all
others in the economy (The American dollar: “In God we trust”)
Earlier forms of money

Cowrie shells, goats, cows, cigarettes, rice, silver, gold pieces and coins, paper currency
notes and demand deposits (cheques).
Barter Trade
If there were no money, goods would have to be exchanged by barter; one good being
swapped directly for another.
Barter system is cumbersome since it entails double coincidence of wants.
The use of money as a medium of exchange has several advantages:
o It removes the problem of double coincidence of wants
As a medium of exchange it allows people to specialize; and with specialization in the
direction of one’s natural talents and abilities, there comes a greater increase in
the production of all commodities.
7.2 Characteristics of Money

If money is to serve as an efficient medium of exchange it must meet the following:
 Acceptability
 Uniformity
 Limited supply
 High value for its weight
 Divisibility
 Portability
 Not readily counterfeitable
 Durability
 Cognizability
7.3 Functions of Money

Money serves the following functions:

7.3.1 Medium of Exchange
It is this function alone which can help identify money as money. All the other attributes
of money are derived from this primary function.
The use of money as a common medium of exchange has greatly facilitated exchange.
Without money, exchange would involve a direct barter of goods and services.
However, most of the time, for such exchange to take place there must be double
coincidence of wants. That is, each party of the exchange must have precisely what the
other party requires, and in appropriate quantity and at the time required
Speaking dramatically, hungry weavers have to search for naked farmers and vice versa
to exchange their surplus cloth with farmers’ surplus food.
This would involve tremendous waste of time and resources in search efforts and making
bargains. Alternatively, barter would involve a series of transactions in completing the
desired exchange.
The use of money as a medium of exchange avoids waste of time and resources by
economizing on the use of scarce resources in carrying out exchanges. That is, it
promotes transactions efficiency in exchange.
The use of money also promotes allocational efficiency by making it possible to exploit
potential gains from specialization in trade and production and emergence of specialized
markets (dealers) in every type of goods and services.
7.3.2 Unit of account

Money customarily serves as a common unit of account or measure of value in terms of
which the values of all goods and services are expressed; which makes possible
meaningful accounting systems by adding up the values of a wide variety of goods and
services whose physical quantities are measured in different units.
Important examples of value totals are the national income estimates of a country, total
money costs of a project, and total sales proceeds of a multi-product firm.
This makes comparisons of various kinds across time and across regions (even countries
with different national monies but at given exchange rates among them) possible.
It has been possible for economics to grow as a science because it analyses social
behavior concerned with the production, exchange, distribution and consumption of
goods and services whose values can be measured in a common unit, money.
These prices, measured in a common unit, can be compared with each other and the ratio
of exchange between any pair of goods easily computed.
As a measure of value, money may not be perfect because of fluctuations in value. The
value of money is not constant. This is unlike, for example, physical measures such as
measures of distance (meter), weight (kilogram), time (an hour). These measures stay
invariant over time and across regions/countries.
7.3.3 Standard of Deferred Payment

Money serves as a unit or standard I terms of which deferred or future payments are
stated. This applies to payments of interest, rents, salaries, pensions, insurance premiums,
among others.
7.3.4 Store of Value

Members of the public can hold their wealth in terms of money.
Medium of exchange also serves as a store of value.
7.4 Demand fro Money (Liquidity Preference Theory)

According to Keynes, demand for liquidity is determined by three motives:
7.4.1 Transaction Motive

The transactions motive for money demand results from the need for liquidity for day-to-
day transactions in the near future; this need arises when income is received only
occasionally (say once per month) in discrete amounts but expenditures occur
continuously.
People prefer to have liquidity to assure basic transactions, for their income is not
constantly available. The amount of liquidity demanded is determined by the level of
income: the higher the income, the more money demanded for carrying out increased
spending.
Diagram:
7.4.2 Precautionary Motive

People prefer to have liquidity in the case of social unexpected problems that need
unusual costs. The amount of money demanded for this purpose increases as income
increases.
Diagram:
7. 4.3 Speculative Motive

John Maynard Keynes, in laying out speculative reasons for holding money, stressed the
choice between money and bonds. If agents expect the future nominal interest rate (the
return on bonds) to be lower than the current rate they will then reduce their holdings of
money and increase their holdings of bonds.
If the future interest rate does fall, then the price of bonds will increase and the agents
will have realized a capital gain on the bonds they purchased. This means that the
demand for money in any period will depend on both the current nominal interest rate
and the expected future interest rate (in addition to the transaction motives which depend
on income). People retain liquidity to speculate that bond prices will fall. When the
interest rate decreases people demand more money to hold until the interest rate
increases, which would drive down the price of an existing bond to keep its yield in line
with the interest rate. Thus, the lower the interest rate, the more money demanded (and
vice versa).
Diagram:
7.5 Central Bank and Monetary Policy

7.5.1 Introduction
As the undisputed leader of the money market, the Central Bank (CB) occupies a pivotal
position in monetary and banking structure of many countries. The CB is a financial
institution whose aim is to control the quantity and use of money so as to facilitate the
implementation of monetary policy.

Broad outlines of economic and monetary policies are the prerogative of the state or
government. However, monetary policy may be developed either by the Central Bank
itself or imposed on the bank by the government.
The CB controls and regulates the activities of the commercial banks affiliated to it
7.5.2 Definitions of Central Bank

Author Definition Comments
Kisch and The essential function of central bank is The Central Bank exercises
Elkin the maintenance of the stability of the complete control over the
country’s monetary standard monetary system of the
country
Hawtrey, R.G The essential characteristic of a Central The bank can not perform
Bank is its function as the lender of last this function well unless it
resort has the right of note-issue
Shaw, W.A The one true, but at the same time, all-
sufficing function of a Central Bank is a
banking system in which a single-bank
has either a complete or a residuary
monopoly in the note-issue
A bank in any country to which has
been entrusted the duty of regulating the
volume of currency and credit in that
country
The highest monetary institution in the
country charged with the duty and
responsibility of carrying out monetary
policy formulated by the government.

7.5.3 Need for Central Bank
 Control of credit
 Issuing of paper currency
 Economic help to the commercial banks
 Implementation of government monetary policies
7.5.4 Principles of Central Banking

7.5.4.1 In working for the interest of public welfare, the Central Bank:
 Is always inspired by the spirit of national welfare; as opposed to the
commercial banks which are inspired by the profit motive.
 Must always be guided by the public interest and must never be swayed by
the profit motive.
 Aims at safeguarding the stability of the monetary system
7.5.4.2 Monetary and fiscal stability

It has the right to issue notes and currency and be a banker to the
government It maintains custody of the government’s funds, float its loans,
pay interest on loans, repays the principal on maturity and grant temporary
advances to the government
 It acts as a lender of the last resort and stand behind the banks during
periods of strain or crisis
 It acts as a clearing house for all commercial banks; which settle their
indebtedness among themselves through the Central Bank
 It has the obligation to maintain stability of the internal and external value of
the currency and price stability
7.5.4.3 Freedom from political Interference (patronage)
 It is independent of the government; it is in a position to offer disinterested
advice to the government on all important economic and financial matters
Note:
Although parliamentary legislation for the independence of the Central Bank is a
necessary condition, it is not sufficient for the realization of the independence of a
Central Bank in actual practice.
The rate of the turnover of the Central Bank governors and the machinery for the
resolution of conflicts and differences between the Central Bank and the Ministry of
Finance on monetary and other policies of interest to the bank should be taken into
account.
The statutory provision for a Central Bank and the discretionary powers available to the
Governor to control government borrowing are among the factors which determine the
independence of a Central Bank from executive branch of government.
7.5.4.4 No competition with member banks

As a holder of the balances of the banks, the Central Bank must avoid competition with
banks. Therefore, it must not undertake any ordinary banking business such as the
acceptance of interest-bearing deposits or the grant of loans and advances to private
customers.

7.6 Functions of the Central Bank
7.6.1 Monopoly of note-issue; whose advantages include:
 Uniformity in the monetary system
 Greater public confidence
 Control of credit creation
7.6.2 Control of Money Supply
7.6.2.1 Direct controls

o Each bank is informed the maximum amount of deposits that it can take from
the public
o Limits are set on the banks’ lending and their hold of assets as well. Lending
ceilings are set, where each bank is allowed to increase its total lending
outstanding by a specified percentage over a given period
o The advantage of direct controls is that their effect on lending is fairly
predictable; banks will follow the instructions of the Central Bank.
7.6.2.2 Interest rate controls

The interest rate influences the demand for credit. The amount of bank lending that
individuals and firms will demand depends on, like the demand for other goods and
services, on the price charged. The higher the interest rate, the less will be the demand for
credit and the less the banks will lend
7.6.2.3 Monetary base control

The Central Bank closely regulates the commercial banks’ deposits (balances) with itself
Banks need to hold balances at the Central Bank since it is by transferring these balances
that the banks make payments between themselves and the also to the government. It is
also by drawing on these balances that the banks can obtain more cash to meet
withdrawals of cash by their customers.
As the banks need to hold balances with the Central Bank, it may be possible to control
the growth of the banks’ lending and deposits by limiting the amount of these balances
that are available to the banks.
7.7 Functions of the Central Bank may be grouped into the following broad
categories
7.7.1 Regulatory or Stabilization Function

Through its bank rate policy, the Central Bank regulates the rates of interest, which
commercial banks have to follow
The Central Bank is the financial advisor to the government
Through open market operations (OMOs) the Central Bank can reduce or increase the
volume of money in the economy.
The regulatory function includes:
 Regulation of money supply,
 Keeping the economy on an even keel,
 Maintenance of price stability, and

 Stabilization of the internal and external value of the currency
7.7.2 Control Function

The CB controls the mode of acquiring and use of foreign exchange for the country as a
whole. Through import quotas, export subsidies and foreign exchange control, the CB is
able to acquire and ration the use of limited foreign exchange available in the country.
The Central Bank also controls commercial banks through persuasion, guidance,
directives, inspection and indirect control, in order to ensure that its monetary and
economic policy is followed by the commercial banks to make advances to certain
priority sectors, or not to make advances to other sectors as determined by itself in
collaboration with the government.
Through the system of variable reserve ratios the Central Bank can effectively control the
volume of credit that the commercial banks offer to the public
By applying its monetary tools or weapons, the Central Bank is enabled to operate on the
general credit situation, to tighten or relax liquidity position of commercial banks and
other financial institutions
7.7.3 Financing Function

The CB is the lender of last resort (that is, if credit cannot be obtained from the
commercial banks).
The CB is a bank of issue- it issues currency notes and coins on behalf of the
government.
Financing functions include:
 Advising the government on monetary and financial matters
 Acting as lender of first and last resort
 Re-discounting of trade or commercial bills
7.7.4 Banking Function

The CB is the banker to the government, but not to individuals. It is the bankers’ bank, in
that every commercial bank is bound by law to keep a certain percentage of its liabilities
with the Central Bank which determines the percentage from time to time.
The liabilities of the commercial banks required to be maintained with the Central Bank
constitute what is referred to as the reserve ratio, which is utilized by the Central Bank to
control expansion and credit creation capacity of the commercial banks.
Thus, banking functions include:
 Maintenance of foreign exchange reserves
 Acting as banker to the government and to the commercial banks.

TOPIC EIGHT: UNEMPLOYMENT AND INFLATION
8.1 Definitions of Unemployment and Consequences of Unemployment
8.1.1 Definitions
Unemployment refers to the situation where factors of production are willing and capable
of being employed at the ruling wage rates but are involuntarily utilized or underutilized.
Unemployment occurs when a person who is actively searching for employment is unable
to find work.
Unemployment is often used as a measure of the health of the economy. The most
frequently cited measure of unemployment is the unemployment rate (the number of
unemployed persons divided by the number of people in the labor force)
Rate of unemployment = Number of unemployed persons
Number of people in the labor force
8.2 Reasons for concern about unemployment, Causes of unemployment and

Types of Unemployment and Solutions to the Unemployment Problem
8.2.1 Reasons for concern about unemployment

8.2.1.1 Unemployment represents a waste of potentially productive human resources.
When labor is unemployed this implies that the economy is not producing as
much as it could. This in turn signifies that national income is lower than it
could be and, therefore, national welfare is lower where unemployment is high.
8.2.1.2 Greater unemployment means a higher dependency ratio since the few
employed have to support a large number of dependants.
8.2.1.3 An increase in social problems like crime. Unemployment also contributes to
the social problems of personal suffering and distress which can lead to a rising
incident of mental disorders.
8.2.1.4 Overcrowding in urban areas resulting from urban unemployment. This is
prevalent in urban areas with high rates of rural-urban migration.
8.2.1.5 Unemployment represents a loss of human capital since the unemployed labor
will gradually lose its skills. This is because skills can only be maintained by
constant work and practice.
8.2.1.6 In order to maintain the unemployed, the government may be forced to increase
its expenditure on social amenities. This constitutes a drain on its expenditure
which could be used for other development projects.
8.2.2 Causes of unemployment in developing countries

In a modern economy unemployment has a variety of causes. Some of them relate to the
general level of economic activity, others are the result of a failure of the labor market in
an economy to work optimally.
The following are the main causes of unemployment in developing countries:
8.2.2.1 Lack of co-operating factors of production

These are other essential factors, which are combined with labor in production process. A
firm can only employ additional labor if it has more of cooperating factors like capital
and land. Developing countries, however, lack these factors especially capital and foreign
exchange.

8.2.2.2 Rapid population growth
The problem is that in many developing countries, population grows faster than the
overall rate of growth of the economy. This implies that the labor force entering the labor
market expands faster than the absorption capacity of the economy.
8.2.2.3 The use of inappropriate technology
Technology is said to be inappropriate in relation to the resource base in a given country.
In developing countries, technology is often labor saving or capital-intensive which is
inappropriate since most developing countries are labor surplus economies. A high
capital-labor ratio implies less labor is absorbed in production processes thereby causing
unemployment.
8.2.2.4 Distortion of relative factor prices
Following the principle of economy, producers are assumed to face a given set of relative
factor prices and to utilize the combination of labor and capital that minimizes the cost of
producing a given level of output. In many developing countries governments distort
prices making capital relatively cheaper than labor through, for example, various public
policies such as investment incentives, tax allowances, subsidized interest rates and low
tariffs on capital imports. On the other hand, labor is made artificially expensive through
minimum wage laws and trade unions.
8.2.2.5 The nature of the education system
Education systems in many developing countries were adopted from developed countries
and are geared to white collar jobs, which do not conform to the realities of the labor
market. The rate of job creation in the formal sector in developing countries where white
collar jobs are found is much lower than the number of people entering the labor force.
Consequently white collar jobs are increasingly hard to come by.
8.2.2.6 Seasonality in production
This factor is especially important in developing countries where the agricultural sector is
predominant. Changes in weather lead to seasonality in agricultural production and hence
seasonality in employment Seasonal unemployment is also prevalent in the tourism sector
where tourists prefer to travel during certain times of the year.
8.2.2.7 Limited products markets
This is especially relevant where production is for export and where primary products
constitute an important proportion of exports. Primary products have low price and
income inelasticities of demand. This implies that the expansion of output in the primary
products sector is low and the potential for employment creation is limited.
8.2.2.8 Massive rural to urban migration
This results in urban unemployment owing to insufficient urban job creation capacity.
Rural to urban migration is the physical movement of people from rural to urban centers
of a country. High rural to urban migration can be explained by the following factors:
• The perception of the existence of income differentials between the two areas. This
explains the standard “push" from subsistence agriculture and "pull" of relatively
high urban wages.
• The migrants perceive high chances of getting jobs in the urban centers partly because
of the concentration of industrial production in urban centers.
• The non-availability of social amenities in rural areas.
• Pressure on limited land in rural areas.
• Social factors including the desire of migrants to break away from the traditional
constraints of social organizations.
• Physical factors including climate and meteorological disasters like droughts and
floods which tend to be more prevalent in the rural areas.
• Demographic factors including a fall in mortality rates and consequent high rates of
rural population growth.
• Communication factors such as improved transportation, urban-oriented educational
systems and the "modernizing" effect of the introduction of radio, television and
cinema.
8.2.2.9 The adverse effects of economic reform programs
Many developing countries are undertaking economic reform programs which entail the
liberalization of certain key sectors, for example, textiles. Such liberalization may
contribute to domestic unemployment if domestically produced commodities are, for
example, unable to compete with cheaper foreign substitutes. This is because some
domestically owned firms may be forced to shut down their operations and consequently
lay off may workers. In addition, economic reform programs may have a component of
Civil Sector Reform which may lead to the retrenchment of many workers in the civil
service with consequent rising unemployment.
8.2.3 Types of Unemployment

The following are the main types of unemployment:
8.2.3.1 Open (Involuntary) Unemployment

This occurs when a person is willing to work at the ruling wage rate but is not able to
secure a job.
When a person willing to work but cannot find work and especially if this is visible to
others it is called open unemployment.
8.2.3.2 Real wage (classical) Unemployment

Real wage unemployment is a form of disequilibrium unemployment that occurs when
real wages for jobs are forced above the market clearing level.
Traditionally, trade unions are seen as the institutions causing this type of unemployment.
Classical unemployment is thought to be the result of real wages being above their
market clearing level leading to an excess supply of labor.
8.2.3.3 Cyclical (Demand-deficient) Unemployment

Cyclical unemployment is involuntary unemployment due to a lack of aggregate demand
for goods and services. This is also known as Keynesian "demand deficient"
unemployment and is associated with the transition of the economy through the business
cycle. When there is an economic recession we expect to see a rising level of
unemployment because of plant closures and worker lay-offs. This is due to a fall in
demand leading to a contraction in output across many industries.
The Glossary of Economics terms defines cyclical unemployment as:
"Cyclical unemployment occurs when the unemployment rate moves in the opposite
direction as the GDP growth rate. So when GDP growth is small (or negative)
unemployment is high."
Although demand deficient unemployment is usually associated with economic
recessions it can also exist in the long run when the economy is constantly run below

capacity. As the economy recovers from a downturn, we expect to see the problem of
cyclical unemployment decline.
8.2.3.4 Seasonal Unemployment

Seasonal unemployment is unemployment due to changes in the season - such as a lack
of demand for department store Santa Clauses in January. Seasonal unemployment is a
form of structural unemployment, as the structure of the economy changes from month to
month.
8.2.3.5 Frictional (Search) Unemployment

Frictional unemployment is unemployment that comes from people moving between
jobs, careers, and locations.
The Glossary of Economics Terms defines frictional unemployment as:
"Frictional unemployment is unemployment that comes from people moving between
jobs, careers, and locations."
Sources of frictional unemployment include:
 People entering the workforce from school
 People re-entering the workforce after raising children
 People changing employers due to quitting or being fired (for reasons beyond
structural ones)
 People changing careers due to changing interests
 People moving to a new city (for non-structural reasons) and being unemployed
when they arrive
Frictional unemployment is transitional unemployment due to people moving between
jobs: For example, newly redundant workers or workers entering the labor market (such
as university graduates) may take time to find appropriate jobs at wage rates they are
prepared to accept. Many are unemployed for a short time whilst involved in job search.
Imperfect information in the labor market may make frictional unemployment worse if
the jobless are unaware of the available employment opportunities.
Some of the frictionally unemployed may opt not to accept jobs if they believe the tax
and benefit system will reduce significantly the net increase in income from taking paid
work. When this happens there are disincentives for the unemployed to accept work.
8.2.3.6 Structural (Technological) Unemployment

Structural unemployment is the unemployment that comes from there being an absence of
demand for the workers that are available.
Structural unemployment occurs when people are made unemployed because of capital-
labor substitution (which reduces the demand for labor) or when there is a long run
decline in demand in their particular industry.
Structural unemployment exists where there is a mismatch between their skills and the
requirements of the new job opportunities. Many of the unemployed from heavy
manufacturing industry (e.g. in coal, steel and heavy engineering) have found it difficult
to gain re-employment without an investment in re-training. This problem is one of
occupational immobility.
The major reasons that cause an absence of demand for workers in a particular industry
include:

i. Changes in Technology
As personal computers replaced typewriters, typewriter factories shut down. Workers in
typewriter factories because unemployed and had to find other industries to be employed
in.
ii. Changes in Tastes
If bagpipes become unpopular, bagpipe companies will go bankrupt and their workers
will be unemployed.
8.2.3.7 Disguised (Hidden) Unemployment

Disguised unemployment exists where part of the labor force is either left without work
or is working in a redundant manner where worker productivity is essentially zero. An
economy demonstrates disguised unemployment where productivity is low and where too
many workers are filling too few jobs.
Disguised unemployment exists frequently in developing countries whose large
populations create a surplus in the labor force. Where more people are working than is
necessary, the overall productivity of each individual drops. Disguised unemployment is
characterized by low productivity
When more people are engaged in some activity than the number of person required for
that, this is called disguised unemployment.
For example: An agricultural field requires 4 laborers but 6 people are engaged in this
activity; then the unemployment for the 2 units of labor is called disguised
unemployment
8.2.3.8 Hardcore Unemployment

Hard-core unemployment is the unemployment of people that are unable to get jobs due
to severe disabilities or other problems that are unable to be corrected.
An example would be a blind, mute and mentally impaired man unable to find a job,
having to rely on government welfare. It can be seen, that although this man might be
interested in seeking a job and thus classified as "unemployed", there is no possibility of
him finding a job.
8.3 Policies to Combat Unemployment in Developing Countries

Government policies to influence employment may either aim to reduce the total number
of unemployed people or to increase the level of job creation. Policies to reduce
unemployment are linked to the causes of unemployment. These polices may take the
following forms of supply side and demand side policies:
8.3.1 Increasing employment creation in the private sector

Although the public sector in many developing countries is the largest employer, the
potential for employment creation for this sector is limited. Government policy can
support private sector development by creating an enabling environment for private
sector development. Reduced budget deficits will have the effects of lowering interest
rates and facilitating private sector development. Reduced budget deficits will have the
effect of lowering interest rates and facilitating private sector investments. The
government can also provide incentives to microfinance institutions which provide
capital to small and medium enterprises. Of particular importance in employment
creation is the informal (Jua kali) sector given that possibilities for employment creation
in the formal sector is limited. The availability of cheap finance can help firms to acquire
co-operating factors of production and hence reduce levels of unemployment.
8.3.2 Pricing policies that encourage the use of appropriate technology

Pricing policies can play a leading role in guiding investment towards labor-intensive
technologies in different sectors which are appropriate to the labor surplus economies in
many developing countries. Government policies should aim at lowering the relative
price of labor to create greater employment. The impact of removing factor price
distortions on employment creation will depend on the degree of sustainability of labor
for capital in the production processes of various sectors of the economy.
8.3.3 Adoption of relevant education systems

The education systems adopted in developing countries should emphasize skills required
by the labor market. Indiscriminate education expansion contributes to the
unemployment. Education expansion should, for example, balance the need to provide
general education and professional skills since the latter are often more readily
marketable.
8.3.4 Diversification of economic activities

This can be quite instrumental in reducing seasonal unemployment. For example, regions
that depend on tourism for employment can introduce alternative activities such as labor-
intensive manufacturing during the off-peak season. Seasonal unemployment in
agriculture can also be reduced by engaging in industrial activities, where possible.
8.3.5 Diversification of product and markets

Unemployment resulting from limited product markets can be reduced by diversifying
from primary products into other lines of production where demand is more price and
income elastic. This could partly include further processing of primary products to add
value to them. However, such diversification should still utilize labor-intensive
technology for substantial employment creation to take place. Firms should also seek new
markets for their products if current markets are unlikely to expand substantially. Since
the demand for labor is a derived demand, it will increase if the demand for the
commodities produced by labor increases.
8.3.6 Intensive rural development

The long-term way to combat rural-urban migration is by emphasizing rural
development. This can be done by the government providing incentives for industries to
locate in the rural areas thereby increasing employment and standards of living in rural
areas. Social amenities in rural areas should also be improved. In this way, the incentives
to migrate to urban areas will be reduced with a consequent decrease in both urban and
rural unemployment.
8.3.7 Encouragement of foreign direct investment (FDI)

Developing countries should aim to make the political and economic environment
conducive to the inflow of foreign capital. This is because such foreign capital can
contribute considerably to enhancing domestic employment opportunities. This is

especially so where the foreign firms use technology which tends to create greater
employment.
8.3.8 Encouraging the use of domestic resources

Developing countries should promote domestic resource use whenever possible because
this tends to create employment domestically. Considerable use of foreign inputs should
be reduced, where possible, since such usage generates employment abroad.
TOPIC NINE: DEVELOPMENT AND GROWTH

Definitions of economic development and growth; sources of growth; from growth to
development

Economics 120 Notes

Uploaded by

Copyright:

Available Formats

Economics 120 Notes

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Economics 120 Notes

Uploaded by

Copyright:

Available Formats

ECON 120: INTRODUCTION TO MACROECONOMICS

1.1 Definitions of Macroeconomics

Econ 120-Introduction to Macroeconomics- Lihanda-0707253198; [email protected] Page 1

1.2 Microeconomics versus Macroeconomics

1.3 Central issues in macroeconomics

1.4 Macroeconomic targets

1.4.1 Full Employment

Econ 120-Introduction to Macroeconomics- Lihanda-0707253198; [email protected] Page 2

1.4.2 Inflation control

Econ 120-Introduction to Macroeconomics- Lihanda-0707253198; [email protected] Page 3

1.4.3 The Balance of Payments (BoP)

1.4.4 Economic Growth

1.4.5 Overcoming the Macroeconomic Challenges

Econ 120-Introduction to Macroeconomics- Lihanda-0707253198; [email protected] Page 5

Econ 120-Introduction to Macroeconomics- Lihanda-0707253198; [email protected] Page 6

2.2 Concepts Associated with National Output

2.2.1 Gross Domestic Product (GDP)

2.2.2 Gross National Product (GNP)

Econ 120-Introduction to Macroeconomics- Lihanda-0707253198; [email protected] Page 7

2.2.3 Net National Product (NNP)

2.2.4 Net National Product at factor prices

2.2.5 National Disposable Income

2.2.6 Nominal national income versus Real national income

2.2.6.1 Nominal National Income

2.2.6.2 Real National Income

2.2.7 Per Capita Income

2.3 Importance of Measuring National Output

Limitations of this measure:

Econ 120-Introduction to Macroeconomics- Lihanda-0707253198; [email protected] Page 9

2.4 Problems of Measuring National Income

Econ 120-Introduction to Macroeconomics- Lihanda-0707253198; [email protected] Page 10

2.5 The Circular Flow of Income

2.6 Measures of National Income

2.6.1 The output approach

Econ 120-Introduction to Macroeconomics- Lihanda-0707253198; [email protected] Page 11

2.6.3 The Expenditure Approach

2.7 National income versus Welfare/Standard of Living

Econ 120-Introduction to Macroeconomics- Lihanda-0707253198; [email protected] Page 12

3.1 Definition of Consumption Function

3.2 Factors influencing MPC

Econ 120-Introduction to Macroeconomics- Lihanda-0707253198; [email protected] Page 14

3.3 Average Propensity to Consume (APC)

APC= Total consumption =C

3.4 Marginal Propensity to Consume (MPC)

3.5 THE SAVINGS FUNCTION

Econ 120-Introduction to Macroeconomics- Lihanda-0707253198; [email protected] Page 15

3.6 The Average propensity to save (APS)

3.7 The Marginal propensity to save (MPS)

3.8 Mathematical presentation of the Savings function

S = f (Y); savings is a function of income

Since Y = C + S, consumption and savings are counterparts of one another

Substituting C in (ii) above

Since MPC = b in the consumption function C = a + bY

Since C = b, we substitute in equation (iv)

Graphing the consumption and saving functions together

Econ 120-Introduction to Macroeconomics- Lihanda-0707253198; [email protected] Page 17

The income expenditure approach (aggregate demand)

Substituting, we get the equilibrium national income as:

3.9 The Multiplier and Keynesian Economics