KENYA METHODIST UNIVERSITY

Distance Learning Material

SCHOOL OF BUSINESS

DEPARTMENT OF BUSINESS ADMINISTRATION

ECON 102

PRINCIPLES OF MACROECONOMICS

By

JOSEPH MWANGI

Published by Kenya Methodist University

P.O. Box 267 – 60200, Meru
Tel: 254 – 064 – 30301, 31146

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 TABLE OF CONTENTS

Course Overview ............................................................................................................................ 3

Course Objective............................................................................................................................. 4
Course Outline ................................................................................................................................ 5

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Course Overview

This course is a comprehensive introduction to economics. Emphasis is placed on inculcating

economic principals which are vital for the success of day-to-day affairs. Significant
consideration is also given to macroeconomics.

The primary goal of the course is to develop and enhance your knowledge and understanding of
concepts and techniques of economic reasoning in order to achieve important objectives in
making decisions and policies.

The instructional format and schedule for the course closely follows the organization of the
course outline. The course combines macroeconomic theory and research with the practical
knowledge and methods of experts in the essential categories of macroeconomics.

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Course Objective

At the end of this course, the students should have an understanding of the following:
i. The field of economics
ii. The value of economic principles and reasoning
iii. Economizing problems, specific economic issues and policy alternatives
iv. Macroeconomic measurements and macroeconomic policy practice
v. National income estimation, public expenditure management significance, money and
banking analysis, employment and inflation concepts in a country and the dynamics of
growth and development
vi. How monetary policy and fiscal policy tools can be used bring changes in the economic
arena.

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Course Outline

WEEK TOPIC LECTURE

1, 2 and 3 Measuring  National income accounting, potential, actual, real

National and nominal national income, problems of
Output measuring national income
 Circular flow of income in two sector and four
sector economy. Equilibrium national income
determination
4&5 Money and  Functions and characteristics of money
Banking  Non-Banking Financial Institutions- NBFI`s
 Money supply and demand of money
 Keynesian and classical quantity theory
 Commercial banks: Functions and role in economic
growth
 Central bank: Functions and monetary policy
 Credit creation in commercial banks
6&7 Public Finance  Sources of government revenue
 Principals of good taxation system
 The government and fiscal policies
 Expenditure and public debt
8 Unemployment  Definition of unemployment
 Types and causes of unemployment
 Problems of unemployment
 Measures to curb unemployment, fiscal measures
and monetary policy measures
9 Inflation  Inflation and measures to control it
 Types and causes of inflation
 Measuring and combating inflation
10 & 11 International  Theory of absolute and comparative advantage
Trade  Merits and demerits of international trade
 Protection, methods, reasons, advantage and
disadvantages
 Balance of payments, exchange rates
 Economic integration
12 Economic  Definition, determinants, benefits and costs
Growth and  Theories of economic growth and development
Development

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TOPIC 1, 2 & 3
Measuring National Output

Objectives
By the end of this lecture, you should be able to:
i. Explain how GDP is measured
ii. Describe the importance and limitations of GDP
iii. Explain why GNP is a better measure of the total income than GDP
iv. Understand methods of measuring national income and national income equilibrium.

National Income
Just as you are conscious about the level of your income, it is imperative for a country to
comprehend its income to facilitate national planning and to improve and maintain an
exemplary standard of living.

In the yester years, African people would state their income and hence wealth by counting the
number of domestic animals owned and the expansiveness of their land. In the modern world,
economic worth is estimated with the amount of income you earn. Your capacity to engage in
more resourceful activities (borrow loans, attain higher education, travel abroad etc) in the
economy is determined by your personal income. In the same vein, the country cannot progress
without knowing its national income. It will only borrow from donors, attract investment, and
spend well on public goods when its can estimate its income.

Can you imagine existing without knowing your state or level of wealth? What would happen?

Let’s analyze the concept of national income and its importance.

National Income is a measure of the total monetary value of final goods and services arising
from productive activities of a nation in any one year. But how do we explain the concept of
national income? Let’s look at various concepts used.

Gross Domestic Product (GDP)

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This is the first and most widely used measurement of national income.

Gross Domestic Product is the total monetary value of all final goods and services produced
within the geographical boundaries of a country. Therefore GDP of Kenya includes incomes
earned from goods and services from citizens in Kenya and all foreigners living in Kenya only.

Gross National Product (GNP)

It is thought to be a more accurate measure of national income than GDP. Gross National
Product (GNP) is an expression of the total monetary value of all goods and services produced
by the nationals or citizens of a given country. You can for instance say its goods and services
produced by citizens in Kenya and Kenyans living abroad. GNP focuses only on output produced
by a citizen of a country who lives within and outside the country. We can also have a more
accurate estimation of national income by reducing and adding other factors that distort the
correct estimations.

We have to consider that GNP figure does not consider that some goods depreciate due to wear
and tear. To have an accurate estimate, we need to reduce depreciation to get a realistic national
income. It is also crucial to consider that GNP is arrived by multiplying price and quantity of
goods and services generated by Kenyans in Kenya and outside Kenya. The prices usually
incorporate indirect taxes (customs duty, VAT, etc). Therefore we can say that prices are slightly
higher due to taxes, hence if we reduce them we can get more realistic prices and GNP will be
more accurate.

Sometimes the government may give some form of assistance to producers in terms of inputs,
cash etc. Farmers are usually subsidized through fertilizers, pesticides etc, but subsidies are not
paid back. They are free and not included in the prices since producers need not to repay them.
Therefore we need to add them in GNP figure to make it more realistic as they facilitate
production of goods and services.

The labour used to produce goods and services is also usually taxed through direct taxes such as
PAYE. These taxes are costs that are passed on through prices. Therefore, if direct taxes were

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not there, then prices would be much less. Hence, we need to reduce direct taxes to get a more
accurate figure of the national income.

In many countries we have persons who receive incomes from the Kenyans working outside
Kenya-net transfer receipts. No goods or services have been produced in Kenya to come up with
such incomes. They could also be going to the government, hence should be deducted. The net
figure after all the additions and subtractions should give us the national disposable income.

Per Capita Income

Now you have seen how we can conceptualize national income from various perspectives. After
estimating national income, we can also tell the average income of all citizens in a country by
deriving the Per Capita Income amount. Per Capita Income is the national income divided by the
total population of the country. It represents the average income of the people in a given year
income per head.

Importance of National Income Statistics

When we want to have a nutshell of wellbeing in a country, we use national income statistics as
our easiest parameter. By understanding the highest and the lowest national income statistics, we
are able to have a figment of imagination about the state of well being in a country. They serve
as primary indicators of the material well being of the people.

Activity
Consider the GDP of your country for the last 10 years. What can you say about the standards
of living? Do you think standards of living have improved? If not why?

You may have heard people complain that the GDP is increasing but the actual standards of
living do not reflect the GDP increase. Let’s explore some limitations of the national income
concept to answer this question.

Limitations of National Income Statistics

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1. Consider Illegal Activities
Activities such as drug trafficking, human trafficking, production of counterfeits generate
enormous amounts of money. However, they are not captured when calculating national income
because criminals do not want to be known and the chances of paying taxes or registering their
businesses are remote.

2. Domestic Services
Domestic services such as house help services, lawn mower activities etc are usually not well
registered with government authorities yet they generate income and livelihoods for many thus
not captured in national income estimation.

3. Level of Accuracy
Estimates of the value of the informal sector, population and depreciation are rarely accurate.

What other limitations do you think exist in the national income concept in trying to serve as an
indicator of standards of living?

National Equilibrium Concept

Let’s now examine the concept of equilibrium level of national income. National equilibrium is
not really a necessity to strive for but it helps us to understand the dynamics of output in the
economy.

Equilibrium level of national income is the level of national income which exhibits no tendency
to change.

How do we reflect on this concept?

We can say aggregate demand in the economy consists of household consumption(C), private
sector investment (I), government spending (G), and export(X) minus imports (I). Hence,
(AD=C+I+G +X-M). It is a representation of goods and services needed to satisfy wants in the
economy.

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On the other hand, the total value of goods and services is measured by national income. Income
by citizens received is spent either on consumer goods or withdrawn in terms of savings and
taxes. Hence, (Y=C+S+T).

You can logically conclude that in an ideal situation, all incomes earned in the economy will be
spent on all goods and services produces. Therefore at equilibrium, we can say;

Since at equilibrium level of national income Y=AD (E) i.e. Aggregate demand = national
income
Then, C+ I+ G +X – M = C+ S + T
C+ I+ G +X – M = C+ S + T
The C cancels out. Hence,
= I + G + X=S+T+M
Investment, government spending and exports are known as Injections into flow of national
income. Savings, taxes and imports are withdrawals into flow of national income. At
equilibrium, withdrawals should be equal to injections. Equilibrium income occurs when
desired aggregate expenditure equals to output and withdraws being equal to injections.

The Sectors of an Economy

An economy can by analyzed from various perspectives. One of them is dividing it into sectors
i.e.,
C + 1 are known as the frugal economy (2 sector economy).
C + 1 + G are known as Governed economy (3 sector economy).
C + 1 +G +(X-M) are known as open economy (4 sector economy).

Determination of Equilibrium Level of National Equilibrium in Open Economy

At equilibrium, total withdrawals =total injections in an open economy.
I+ C+X= S+T+M
J (Injections) =W (withdrawals)
Equilibrium location is E where withdrawal function (W) crosses injection (I).

Figure 1: Open Economy

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 W=T+S+M

E (Expenditure)
E
+ J=C+1+X

0 Y (Income)

Methods of Measuring National Income (NI)

Each time a commodity is produced and sold we can say that
1. The value of the commodity = purchasers expenditure on it
2. Producers will receive the same money as income
3. The value of the commodity is equal to the value added in its successive stages.

Basis of Measuring National Income

Income method - In this methodology we consider the total of all incomes earned by labour in
an economy. We can therefore easily estimate national income by considering all incomes of a
population in a given period. Incomes range from personal income to gross trading profits of
companies to informal sector incomes.
Measurement by the product or value added approach – It is important to consider the value
addition in each stage of production which should be equal to the final price of the final good in
an ideal situation.
Expenditure method of measurement approach - If we assume that all incomes earned are
spend in the economy-we assume no savings, no taxes and no other deductions .Thus we can say
that by estimating total expenditure in the economy will give us the national income.

Activity
What problems would you envisage when estimating national income using each of the three
methods?

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Circular Flow of Income and Expenditure
It depicts movement of resources between producers and consumers. On one side of the circle we
have firms and on the other we have households. Households give labour services to firms so as
to produce goods. They also give most of their income to firms when they buy goods and
services.

On the other hand, households receive goods and services manufactured by firms and they also
receive money flows when they lend services to firms. We can say that there are four flows in
the circle. But it is not as perfect as it flows. We have leakages of incomes earned-savings, taxes-
and we have injections in the flow-investments, government expenditure and exports.

Activity
Draw a diagram of the circular flow and illustrate the four flows in such a way that the circle is
informed.

REVIEW
Key Terms
Gross Domestic Product (GDP)
Per capita income
Standard of living
Health of a nation
Equilibrium level of national income
Injections
Withdrawals
Marginal propensity to consume
Circular flow
Income method
Value added approach
Expenditure method

Applying Economic Concepts

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1. Explain why GDP goes down when you quit your job to pursue college studies?
2. Describe how GDP is measured

Critical Thinking
1. In what situations may a country benefit from low GDP?

Self Assessment
1. What is Gross Domestic Product (GDP)?
2. State equilibrium level of national income?
3. Define marginal propensity to consume?
4. Discuss the circular flow?
5. Discuss the measurement of national income by the product or value added approach?

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 TOPIC 4 & 5
Money and Banking

Objectives
By the end of this lecture, you should be able to:
i. Explains the functions of money
ii. Describe the characteristics of money
iii. Bring out the functions of commercial banks and Central Bank
iv. Explain how monetary policy affects interest rates in the long run and in the short-run
v. Describe major tools of monetary policy.

Activity
Compare early forms of money such as Phoenician coin, Folded tobacco, shelled corn and
compressed tea leaves with modern forms of money such as cheques, e-money, traveller’s
cheques, and money orders.

Functions and Characteristics of Money

Money is any substance that functions as a medium of exchange, a measure of value and a store
of value. Why do you think money is a medium of exchange? It is because money is acceptable
in payments of goods and services.

Consider measuring the value of goods without money today. It would probably be a hard task.
Therefore, money expresses worth in terms that most individuals can understand. Money also
serves as a store of value in that goods and services can be converted into money, which is easily
stored until some future time.

Just imagine how difficult it would be to conduct creditor-debtor relationship without money.
Money is the standard of deferred payment. It allows a person, in form of credit, to obtain goods
and services before getting ownership.

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Characteristic of Money
To be successful as a medium of exchange, money must be:-
1. Portable - it can easily be transferred from one person to another e.g., cheque books
2. Durability- it must be reasonably durable when handled. Coins last for long checks and
cheques do not in comparison to coins.
3. Divisible- money should be easily divisible into smaller units, so that people use only as
much as they need and in any transaction.
4. Stability of value- money must be available but in limited supply.

Activity
Explain the relationship between the Kenya shilling, the Cuban peso and the Japanese
yen?

Non-Banking Financial Institution (NBF1)

For a long time in the financial markets, NBFI have co-existed with commercial banks
effectively as they complement each other in products and services. Commercial banks obtain
funds when members make regular deposits.NBF1 obtains funds and functions in a different
manner. They involve:

Finance companies
They make loans directly to consumers and specialize in buying installment contracts from
merchants. In additions, they change higher interest rates for loans taken since they deal with
high risk customers.

Life insurance companies

The primary function is to provide financial protection of survivors of the insured. This is
because they collect cash on regular basis in form of premiums and make loans to banks in form
of large certificate of deposit.

Mutual funds

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These are companies that sell stocks in their name to individual investors and then invest the
money received in stocks and bonds. They buy from a more diversified set of assets due to the
large quantities of funds they have. They are therefore able to spread the risks.

Pension funds
It is a fund set up to collect income and disburses payments to those persons eligible for
retirement, old age or disability benefits. The money is also invested in corporate stocks and
bonds.

Demand for Money

To understand the demand of money, we need to examine the following factors;
 Factors which influence demand for money
 How economy reacts to changes in supply of money

Economists are interested in understanding demand and supply of money since a societies ability
to purchase goods and services may be affected. Changes in money supply may inject inflation
and a degree of instability into the economy. Lets the examine the effects of changes in the stock
money i.e. demand and supply of money through the prism of Quantity theory of money and
Keynesian theory of money.

Quantity Theory of Money

Quantity theory of money is defined by the formula, MV=PT. It states that the average price of
transactions in an economy is proportional to the nominal quantity of money in circulation
M- Is the stock of money in circulation?
V- Number of times the given quantity of money changes hands in transactions.
P- Average price of all transactions.
T- The number of transactions during a period of time and so must be identified.
MV and PT measure the total value of transactions during a certain period and so the values
of MV must be equal to PT. Thus the total amount of money handed over in transactions is equal
to the value of what is sold.

Keynesian Theory of Money

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Keynes divided the demand for money into three. If you add up the three demands and supply of
money, you arrive at the total the supply or demand of money.
 The transactions demand – this is money meant to finance day-to-day transactions e.g.,
water, electricity, etc
 Precautionary demand –it arises out of uncertainty and desire to care for contingency needs
or emergencies e.g., vehicle mechanical breakdown, sickness etc
 Speculative demand- demand for money so as to meet investment and asset acquisition e.g.,
savings, buying shares etc

Total Demand
This entails adding together the transaction, precautionary and speculative demands.

Commercial Banks
We have previously mentioned Commercial banks when comparing them to Non-Banking
Financial Institution. Lets now examine how they function and how useful are they to the
economy.

Commercial banks are deposit taking institutions. In addition:

 They profit by lending at a higher interest as compared to the deposit rate
 They channel funds from those who have excess money to those in need through loans.
 They provide safety for our money.
 Deposits are insured and you also earn interest.
 They provide cheque accounts where by cheques are used as a medium to buy longer and medium
purchase.
 Provide safe deposit boxes to keep valuables.
 They sell money orders and travelers cheques.

Commercial banks decide on the desired cash ratio, the ratio of cash to deposit liabilities at
which it wishes to operate. A cash ratio should help the bank meet cash requirements of the
depositors. Banks must balance cash requirement of depositors with the desire to hold a spectrum
of profit earning assets.

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Activity
What other financial services do banks offer other than those mentioned above?

Credit Creation
Let’s look at the principal of credit creation. Now you are familiar with how a bank manages its
depositor’s money i.e. through the cash ratio. A big amount of depositor’s money goes to loans
and investment. Assume we have a closed economy, a single monopoly bank which observes
minimum cash ratio. Suppose the bank maintains 10% of its total deposit in cash to be able to
meet the day to day demand its customers:
Liabilities Ksh Assets Ksh
Deposit 20,000 Cash 2,000
______ Loans 18,000
20,000 20,000

The bank total deposit amounts to Ksh.20, 000 and maintains its 10% cash ratio by holding in its
till Ksh. 2,000 in cash.

If customer deposits an extra 2,000 in cash, the new balance sheet is

Liabilities Ksh Assets Ksh
Deposit 22,000 Cash 4,000
_____ Loans & Investments 18,000
22,000 22,000

Note:
The cash ratio is no longer 10%. To maintain a cash ratio of 10% and to be able to maximize its
profit, the bank will need to increase total deposits to Ksh 40,000 so as to restore the desired
ratio. By doing this, the bank grants new loans amounts to Ksh 36,000.
Liabilities Ksh Assets Ksh
Deposit 40,000 Cash 4,000
_____ Loans & Investment 36,000
40,000 40,000

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Therefore, the cash deposit of Kshs 2,000 increased in loans and investments of Kshs 36,000
thus the total deposit rose by Ksh 38,000 i.e. 19 times the amount of cash adjustment. This is an
example of a credit multiplier. This means that for every Ksh 1 held by the bank, its capable of
supporting total adjusts by Ksh.19. Credit creation operates within efficient clearing system.

Central Bank
You are now familiar with the Non-Banking Finance Institutions and Commercial banks. Have
you ever imagined if these banks are not watched by another regulator what they would do?
Most likely some directors and managers would use them for personal gain to get credit and
other services and even to help their friends. Have you ever thought of who regulates these
institutions as to comply with the best banking practices? The Central bank does this. What is it
and what does it do?

The Central bank ensures the smooth running of banking sector and other financial institutions. It
also works closely with government and public interest.

Functions
1. It is the Government bank since it looks after finances of the central government.
2. Central bank is the bankers’ bank as it holds bankers deposit which clears banks.
3. It holds the nations gold and foreign currency reserves which the bank uses to intervene in
foreign exchange markets and influence the exchange rate.
4. Issuing notes and coins.
5. Implementation of monetary policy
6. Lender of last resort.
Central bank is the ultimate source of cash. Commercial banks can also borrow and lend at inter-
bank market. However, if not possible, this could be as a result of liquidity problems in
commercial banks and the last resort becomes the Central bank.
7. Responsibility of a financial stability.
Financial stability role is to detect and limit systematic financial clash.
Systematic risk arises when banking financial crisis spreads to other financial institutions.

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Functions of Monetary Policy
Most often, you have heard an outcry about inflation all over the world. Some countries have
had hyper inflation. Inflation is a woeful event as it brings down the standard of living. Have you
ever thought of how inflation is controlled? Who is really responsible in this complex issue? Why
can the responsible institutions declare a wholesale price reduction to bring price levels down?

Objective of monetary policy is to maintain price stability i.e. control of inflation. It works
through the effects of interest rates on aggregate spending. Interest rates changes have an effect
on consumer spending. A rise in interest rates reduces some components of spending .There is a
negative relationship between interest rates and aggregate spending.

REVIEW
Key Terms
Money
Non-Banking Financial Institution
Demand for money
Quantity theory of money
Keynesian theory of money
Transaction demand
Precautionary demand
Liquidity and profitability
Speculative demand
Credit creation
Central bank
Monetary policy

Applying Economic Concepts

1. We sometimes hear of rumors about changing our currency to a different color, shape or size. Explain
how these changes would not affect the role played by money.

Critical Thinking
1. Evaluate modern money as a medium of exchange.

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2. Discuss other forms of near money e.g. savings account, fixed deposit account, shares,
Treasury bills etc. Why do we call them near money?

Self Assessment
1. Explain money as a standard of deferred payment
2. Discuss what we mean by mutual funds
3. State the quantity theory of money
4. Define cash ratio
5. Explain the term lender of last resort
6. What is the objective of monetary policy?
It is to maintain price stability i.e. control of inflation. It works through the effects of
interest rates on aggregate spending and the monetary authorities can set any short-term
interest rate that they desire

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 TOPIC 6 & 7
Public Finance

Objectives
By the end of this lecture, you should be able to:
i. State the principles of taxation and why taxation is important
ii. Describe the composition of public expenditure and public revenue
iii. Explain public debt and its effect on the society
iv. Understand fiscal policy
v. Describe balanced budget changes.

Taxation
Imagine if you never paid taxes to care for collective wants such as roads, hospitals, public
toilets, airports. It means all public goods and services would be provided by private
individuals and the corporate world. Imagine how life would be. Life would probably be
chaotic and miserable. Public finance deals with sourcing and using finances to cater for public
wants.

Public finance is concerned with major sources of the public sector revenues. Revenues meet
public expenditure needs and assist in redistribution function.

Taxes are compulsory transfers of money from individuals, groups, or institutions to the
Government. They can be:
1. Proportional taxes (As income rises, amount paid in tax is constant).
2. Progressive taxes are observed when income rises, amount of tax paid rises too.
3. Regressive taxes are observed when income increases, the amount paid in tax decreases.

Activity
What is the difference between direct taxes and indirect taxes? Give examples.

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Principles of Taxation
All taxation systems are based on some ideas which have been accepted widely as the basis of
taxation. These are:
1. People should pay taxes according to their abilities.
2. Payment of taxes should be clear and certain.
3. The method, manner and time of payment should be convenient to the taxpayer.
4. The cost of collection in relation to tax should be minimal.

Activity
Write a short essay on how taxation can help achieve equity in an economy.

Some Desirable Characteristics of the Modern Tax System

1. Taxes should not discriminate between different income groups.
2. Taxes should have built-in flexibility or automatic adjustments.

The benefit principle - explains taxation as a concept which should be imposed on the basis of
tax payers receiving benefits which are almost equal or related to the amount taxed.
The ability to pay principle - states that taxes should be imposed on people according to how
much each individual can afford to pay. This principle facilitates redistribution function.
Public expenditure - represents the cost to society of satisfying collective wants, such as those
for defense, education and health.

Composition of Public Expenditure

1. Expenditures on goods and services e.g. spending on the wages and salaries of the armed
forces, the police, teachers and civil servants, supply provisions to the armed forces, schools
and hospitals
2. Capital expenditure - This includes spending on roads, bridges, hospitals, and school
buildings.
3. Subsidies - This represents unrequited payments by both the central bank and local
government.

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4. Grants to personal sector - They include pensions, unemployment benefits, student grants and
other social security payments.
5. Debt interests - They represent payment of interest on the national debt, including interest.

Composition of Public Sectors Revenue

These include:
1. Tax on incomes
2. Taxes on capital
3. Taxes on expenditure
4. Rates/community charge
5. Social security contributions
6. Other incomes to the state
7. Financial receipts

Activity
Explain how and why government expenditures have grown since 1960`s.

We have seen what public expenditure is. Let’s examine why it keeps on growing every year. If
it was $1billion dollars this year it will be more and not less next year. Why not less?

Causes of Long-term Growth of Public Expenditure

1. Growth in per capita incomes. As an economy grows, the incomes of the population also
grows and therefore public needs.
2. Population growth - This leads to growth of infrastructure such as schools, hospitals and
persons.
3. High unit labor cost - This is the rise in labour costs - a rise in the cost of supplying the same
level of public service.

Fiscal Policy
Taxation is an important concept and tool to achieve microeconomic objectives. Let’s see how
we can achieve and control national objectives by using the taxation concept. Fiscal policy

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involves the use of government spending and tax policies to influence the total desired
spending in order to achieve any specific goal set by the government.

You can now understand how fiscal policy works by using taxation and government spending as
techniques to achieve microeconomic objectives. Let’s try to understand how the government can
use taxation spending as instruments to push the economy towards that target.

Taxation spending can achieve economic targets through various methodologies. For instance,
When an economy is in recession:
 The government would like to increase GDP
 Appropriate fiscal tools are used to raise spending and lower tax rates

You are now familiar with the idea that when tax is collected, it needs to be spent. Where we
have tax revenue we also have tax expenditure. What would happen if tax collected is more than
tax spent? What if tax spent is more than tax collected? We can understand the impact of the
two when we understand a balanced position of tax revenue is equal to tax expenditure.

Balanced budget change – it is the increase in government spending which has a mild
expansionary effect on GDP and a balanced budget decrease which have a mild contractionary
effect.

Public debt -is the means of financing government revenue. It occurs when expenditure exceeds
receipts. The government has to pay interest and principal to the public.

Why do we need a public debt?

 To finance a deficit budget
 To finance an internal war or external war
 To fund economic development
 To manage natural calamities
 To reinstate economic stability e.g., during inflation.

Redemption of Public Debt

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Some of the most popular methods of paying back public debts include:
1. Revenues through surplus budgets.
2. Creating a “sinking fund”.

REVIEW
Key Terms
Taxes
The benefit principle
Ability to pay principle
Fiscal policy
Public expenditure
Public sectors revenue
Balanced budget change
National debt
Public debt
Redemption of public debt

Applying Economic Concepts

1. Paying back public debt comes with a burden to public. What burdens would you expect
from domestic and external debt?
2. What is crowding-out effect?

Critical Thinking
1. Make a list of five ways that you or your families benefit from government spending?
2. Do you think that money is a means to an end?

Self Assessment
1. Explain what are taxes?
Taxes are compulsory transfers of money from individuals, groups, or institutions to the
Government
2. State desirable characteristics of the modern tax system?

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  The Finance minister should be able to estimate the yield of individual taxes
accurately.
 Finance minister should be able to estimate the distribution of the tax burden.
 Taxes should not discriminate between different income groups.
 Taxes should have built-in flexibility or automatic adjustments, as income rises taxes
increase more than proportionately
3. Explain the benefit principle
The principle calls for the taxation which people pay should be related to the benefits they
derive from public spending/government expenditure
4. Discuss why do we need a public debt?
 To finance a deficit budget
 To finance a war
 Economic development
 Natural calamities management
 Public enterprises management
 Economic stability

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 TOPIC 8
Unemployment

Objectives
By the end of this lecture, you should be able to:
i. Explain how the government labour statistics office determines if a person is unemployed
ii. Describe five types of unemployment
iii. State causes of unemployment
iv. Understand policies to combat unemployment in developing countries.

Unemployment
You can define unemployment as a situation where factors of production are involuntary
underutilized though they can be utilized well.

Unemployment is expresses as a percentage. Hence, it’s calculated using the formula below;

Unemployment = Number of unemployed x 100

Total workforce
Activity
Discuss how your government could be collecting monthly data of unemployment.

Measurement of Unemployment
Claimant Account
In most developed countries, the unemployed persons are usually registered for benefits. This
recorded data is composed of persons claiming for state support or any other non state support.
Hence, the term claimant account. It is usually a very accurate measurement and the time period
required to get the figures is very short.

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For those who do not claim the benefits and yet they are unemployed do so because they are well
supported by family members or family enterprises. This methodology certainly fails to capture
them.

We also have those who are not employed yet are registered for benefits but they work using
identities of absent friends and relatives. They receive benefits yet they earn an income thus
leading to distortion of figures.

Activity
What is your understanding of the category of unemployed referred to as Economically
Active?

Types of Unemployment
Disguised or hidden unemployment - Consider that in your office you have 30 workers and 5
are retrenched without any effect on production of goods and services. These five people were
actually not engaged fully and therefore hidden unemployment was existing.

General unemployment - imagine one of those islands in the Indian ocean that depends almost
entirely on tourism would be affected by bad publicity worldwide due to a very serious
pandemic. Their country would be avoided by other countries in the globe and nobody would
want to visit. Most industries in the private, public, rural, urban, white-collar, Blue-collar,
informal and formal sectors would reduce the workforce laundering about 70-80% of the
population unemployed. This would be widespread unemployment.

Structural unemployment - If we would automate tea harvesting in Kenya, we would have

unemployment in tea growing regions and among tea workers. Therefore, new technology is
affecting particular regions or categories of labour.

Seasonal unemployment - If there is a serious effect of Coffee Belly Disease in this year`s cold
season in coffee growing areas, coffee would not be harvested. This would mean that most
coffee farmers will be left jobless.

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 Frictional unemployment -When you change jobs from one company to another, you might
have some time in between at home trying to plan for your new job. This transitional
unemployment can be classified as frictional unemployment.

Activity
What would you refer to as demand sufficient or cyclical unemployment?

Unemployment
Causes of Unemployment
 Rapid population growth could lead to labour supply that is greater than absorption rate.
 An irrelevant education system e.g. one that seeks to produce white-collar jobs instead
of blue-collar jobs in a region dominated by high populations and traditional agriculture
production.
 Seasonality in production of goods and services.
 Massive rural urban migration

Activity
Try to imagine the number of unemployed young people in your village or town estate. How can
solve unemployment problem there?

Some policies to combat unemployment in developing countries

a. Increasing employment creation in the private sector
b. Diversification of products and materials
c. Intensive rural development
d. Encouragement of conducive political and economic environment.

Activity
Identify the level of employment that most economist today classifies as full employment.

REVIEW

Key Terms
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Unemployment
Claimant account
(ILO) Unemployment
Open involuntary unemployment
Structural unemployment
Frictional unemployment
Demand sufficient or cyclical unemployment

Applying Economic Concepts

1. Examine the similarities and differences between structural and technological
unemployment. Give an example of each. Why are these kinds of unemployment serious
problems for an economy?
Critical Thinking
1. Can a government statistic about the number of employed people be misleading?

Self Assessment
1. Explain why claimant account is a better calculation of unemployment?
Accurate measure of those claiming benefits gives an accurate picture of benefit claimants at
national and local level. The time period required to get the figure is quite short
2. Discuss structural type of unemployment?
This is unemployment which affects particular regions or categories of labour. This is due to
imbalance between the supply of a particular group of workers and demand of their services
when technology makes a product obsolete.
3. State reasons of concern about unemployment
 Unemployment represents a waste of potentially productive human resources.
 It leads to higher dependency ratio in the society.
 It also leads to increase in social problems like suffering, mental disorders.
 Overcrowding in urban areas.
 It causes loss of human capital and loss of skills over time.
 The Government may increase its expenditure on social amenities.

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 TOPIC 9
Inflation

Objectives
By the end of this lecture, you should be able to:
i. Explain how inflation is measured
ii. Discus the causes of inflation
iii. State causes types of inflation
iv. Describe how CPI is used to compute inflation rate
v. Understand how to combat inflation.

Inflation
Inflation is simply persistent rise in general price level.
Do you think there is a difference between inflation and price level?

Types of Inflation
Inflation types can be categorized as;
1. Creeping inflation is where price level increases between1-6
2. Hyper inflation is the extreme with three digit level.

Causes of Inflation
1. Costs push inflation. For instance, the cost of raw materials such as crude oil increases;
it pushes the cost of transport, energy, etc. This also increases the general level of prices.
2. Demand pulls inflation. If there is an oil shortage across the country petrol stations, the
acute demand increases the current oil prices, hence demand related inflation since many
sectors are dependent on oil.
3. Measurement of inflation
- Consumer Price Index (CPI) is an index number that measures relative changes in the
price of specified goods which are bought by an average household on regular basis.

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 - A Produce Price Index (PPI) measures prices that business organization pay in large
volume wholesale markets.
Activity
Do you think inflation can destabilize an economy?

Effects of Inflation
 It deters economic growth because it discourages savings.
 It makes exports expensive and non-competitive effective balance of payments.
 It leads to arbitrary redistribution of income. Debtors gain and creditors lose.
 Due to hyper inflation the public may lose confidence in domestic currency and hold assets in other
currencies or engage in barter trade.

Combating Inflation
For demand-pull inflation, we can apply the following policies:

Monetary Policy
This can take the form of contractionary monetary policy aimed at regulating or controlling the
money supply and excess credit expansion.

The tools of monetary policy include:

 Special deposits (used in the past) - The deposits were usually frozen at the Central bank
and banks had no access to them. This reduced operational deposits and therefore reduced
lending.
 Credit ceilings - They are aimed at limiting growth of bank lending.
 Reserve requirements - They impose restrictions on the form on which banks must hold
their assets.
 Interest rate. Changes in money supply affect the interest rate and therefore credit banks
are willing to make themselves available to borrowers.

Activity
Discuss the following tools of monetary policy:Open market operations; Reserve ratio and Discount

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 rate

Tight monetary policy – it is the action by the Central bank to decrease the monetary base or
growth. It is aimed at preventing the economy on overheating.

Activity
What do we mean by loose monetary?

REVIEW
Key Terms
Creeping inflation
Hyper inflation
Suppressed inflation
Cost push inflation
Demand pull inflation
Consumer Price Index (CPI)
Produce Price Index (PPI)
Contractionary monetary policy
Contractionary fiscal policy

Applying Economic Concepts

1. What does hyper inflation mean to an economy?
Critical Thinking
2. Explain the effect inflation has on financial positions of borrowers and lenders.

Self Assessment
1. Explain contractionary fiscal policy?
It involves raising taxes to cut consumers income and hence level of spending.
2. Describe the concept of reserve requirements
They impose restrictions on the form on which banks must hold their assets.
3. State effects of inflation

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  Mild – demand pull inflation can lead to higher investment and higher employment.
 It deters economic growth because it discourages savings.
 It makes exports expensive and non competitive effective balance of payments.
 It leads to arbitrary redistribution of income. Debtors gain and creditors lose.
 Due to hyper inflation the public may lose confidence in domestic currency and may hold assets
in other currencies or engage in barter trade.
4. Discuss the concept of Consumer Price Index (CPI)?
This is an index number of the price commodities which measures relative changes in the
price of specified goods which are bought by average households on regular basis – food
beverages, housing, transport, medical care.
5. Explain what is suppressed inflation?
It refers to where demand exceeds supply but the effect in prizes is minimal through the use
of instruments, price controls and rationing.

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 TOPIC 10 & 11
International Trade

Objectives
By the end of this lecture, you should be able to:
i. Compare and contrast the Theory of Absolute Advantage and Comparative Advantage
ii. Discuss the concept of protectionism
iii. Understand the dimensions of Balance of Payments
iv. Describe economic integration aspects
v. Understand why exchange rates are important.

Is international trade important to you? On average Americans are thought to spend over $2000
per year on imported goods and services. Look at the label on your computer, shoes, on food
products or even on the vehicles that are on our roads and you will realize international trade is
important to all.

International Trade
Let’s examine the concept of international trade which could be familiar to your ears from a
general perspective. International trade involves exchange of goods and services between one
country to another. It enables the principal of division of labor to develop in the international
sphere.

International trade arises due to:

a) The need for resources in different proportions.
b) Economic resources being unevenly distributed.
c) International mobility of resources being extremely limited.

To appreciate international trade we need to understand the following advantages:

a) It fosters better standards of living.
b) It helps countries earn foreign exchange.
c) It encourages efficiency.

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 d) It promotes peace and security.
However, to understand International trade we need to know how it comes about. We can now
look at the theories explaining the genesis of international trade.

The Concept of Absolute Advantage

A country is said to have Absolute Advantage in the production of a particular commodity if it
can produce more of a given commodity than any other country using the same resources.

The Concept of Comparative Advantage

A country has a comparative advantage over another if in producing a commodity it can do so at
a relatively lower opportunity cost in terms of forgone alternative commodities that could be
produced.

Activity
Why is international trade crucial to your country today?

Protectionism
We are now going to see how countries act against excessive imports of goods and services to
protect their interests and especially their industries.

Forms of Protectionism
Tariffs- They artificially raise the price of imports that enter a country.

Non-tariff barriers -These are measures meant to restrict imports or artificially boost exports.
They include;
a) Quotas - are quantitative limits on imported goods and services.
b) Bureaucratic export procedures - involves imposition of complex and time consuming
procedures on imports.
c) Product standard specifications -Safety regulations can raise the exporter’s costs.
d) Subsidies -The measure reduces the price of domestic product since some inputs or
production capital is provided free-of-charge.

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Arguments for Protection
The revenue argument
Protection earns the government revenue and therefore the need for protection of local industries
from imports.
The infant industry argument
Protection is used to shield industries not yet developed to a size so that they can survive initial
competition in the short-term.
Declining industry argument
Industries that are vulnerable, those that can decline and are close need protection. This prevents
industry collapse and mass unemployment.
The dumping argument
Dumping is selling a commodity outside Kenya at a lower price as compared to that charged in
Kenya in order to kill the local industries in the importing country.
Balance of payment argument
Protectionism may restrict imports to make them more proportional with exports. This improves
the balance of payments position.
The strategic industry argument
Production in a given industry may be relatively inefficient but important for immediate access
to goods and services during crises e.g. armament industries.

The Balance of Payments

This refers to a systematic record of the economic transactions between the residents of the
country and the rest of the world over a period of time. It includes:
 Current account
 Capital account
 Monetary or international finance accounts

Current Account
This deals with goods and services and unilateral transfer- payments and receipts relating to
gifts, grants and reparations to a country.

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Current account deficit
This occurs when a country persistently imports more than it exports e.g., in developing
countries they occur because of exporting primary products of low price and while developed
export goods and services with value addition. A persistent current account deficit means that
a. It may lead to import controls
b. Depleted foreign currency reserves
c. Over reliance on imports by both producers and consumers in the country. Hence domestic
industries do not grow.
d. Lack of competitiveness and failure in a country’s export trade.

Current account surplus

a. A surplus indicates success in trading.
b. It strengthens domestic currency.
c. Persistent surpluses could contribute to inflationary pressures by an increase of money
supply. In addition, they could contribute to appreciation of exchange rate, making exports
relatively expensive and imports relatively cheaper.

Capital Account
This account involves amount of capital that is borrowed or rent out, the repayments of capital,
the sale and purchase of assets to and from foreign countries.

The International Official Financing Account or Monetary Account

It records net changes in foreign exchange reserves. It deals with widely accepted means of
settling international obligations.

Overall Balance of Payments - It reflects the sum of the current and capital account balances. It
is the summing up of transactions of a given country with the rest of the world. It is always
balancing. Disequilibrium is adjusted through official financing –by using reserves and loans.

Balance of Trade – It is the difference between the value of goods and services sold by residents
to foreigners and value of goods and services purchased from foreigners.

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Activity
Do you think citizens of your country depend too much or too little on international trade
today?

Policy Measures and Dealing with Balance of Payment Deficit

A fundamental issue is whether the deficit is short term or long-term. Short terms deficits are
addressed by using the foreign exchange reserves or borrowing from abroad.

When deficit is long-term, measures taken include:

a) Deflationary measures - Involves restricting the demand for imports by restraining the
aggregate demand through raising taxes and interest rates and selling more government
securities.
b) Devaluation - This lowers the value of the domestic currency in terms of foreign currencies.
It makes exports cheaper and imports more expensive.
c) Export – Oriented industrialization - Its a long-term policy that focuses on increasing the
exports of given goods rather than attempting to reduce imports.

Exchange rates
This is the price of one currency in terms of another. The two most popular exchange rates are
a) Fixed rate systems - the rate of domestic currency exchanges for foreign currency is
determined by the control rate of a country.
b) Floating exchange rate systems - The rate is determined by interaction of forces of demand
and supply.

Activity
What are the advantages of fixed systems in comparison to floating exchange rate
system?

What determines demand and supply of a currency?

a) Balance of payments
b) The level of inflation
c) Government policy
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d) The political atmosphere

Activity
How does a weak local currency in your country affect you as a consumer?

Economic Integration
This refers to the action of a group of nations towards realizing free trade.

Levels of Economic Integration

a. Free trade – it is a form of integration where member countries agree to reduce the barriers
to trade among themselves but each is free to pursue its own trade policy.
b. Custom union - Member countries remove all trade barriers among themselves and have
common tariff for non-members.
c. The common market is an economic arrangement which has the requirements of custom
union and free movement of factors of production between members.
d. In an Economic Union, we have joint economic institutions among member countries to
coordinate economic policy e.g., European Union.

Advantages of Economic Integration

 It facilitates specialization in goods and services
 There are economies of scale in production
 Promotes competition and economic efficiency
 There is reduced unemployment due to free movement of labour.

Disadvantages of Economic Integration

 Inefficient industries may be terminated by imports
 Loss of revenue from tariffs
 Political instabilities among members reduce benefit of integration.

Activity
Where can you fit COMESA {Common Market of East and Southern Africa.), East African

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 Community, ECOWAS in the above levels of economic integration?

Activity
Compare the functions of International Monetary Fund with those of World Bank.

REVIEW
Key Terms
International trade
Absolute advantage
The concept of comparative advantage
Protectionism
Dumping
Balance of payments
Current account
Balance of payment
Exchange rate systems
Economic integration

Applying Economic Concepts

1. Explain why world output is larger when international trade is based on comparative
advantage.
Critical Thinking
1. Are products produced in your country based on Comparative Advantage or Absolute
Advantage?
Self Assessment
1. Define international trade?
It involves exchange of goods and services between one country and another. This has
enabled the principal of division of labor to develop in the international sphere.
2. State the concept of absolute advantage?
A country is said to have absolute advantage in the production of a particular commodity
if with a given quantity of resources it can produce more of that commodity than can any
other country using the same resources

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3. Can you explain exchange control mechanism?
This refers to a state exercising control over some or all transactions in foreign
currencies undertaken by its nationals.
4. Describe dumping concept?
Dumping is selling a commodity abroad at a lower price than that charged for the same
product in the domestic product. In the long-term it reduces output and employment in
the importing country.
5. Explain free trade concept
It is a form of integration where member countries agree to reduce the barriers to trade
among themselves but each is free to pursue its own trade policy. Removal of trade
barriers may be on specified commodities.

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 TOPIC 12
Economic Growth and Development

Objectives
By the end of this lecture, you should be able to:
i. Compare and contrast economic growth and development
ii. Discuss theories of economical growth and development
iii. State obstacles to economic development
iv. Understand measures of economic development
v. Describe the cost of economic growth.

Economic Growth and Development

Economic growth refers to an increase in a country productive capacity which is marked by
sustained increase production of goods and services.

Economic development refers to an increase in per capital income associated with an

improvement in the indicators of the quality of life. It is marked by a decline in the agriculture
sector and corresponding increase in value of manufacturing and service sector.

Economic growth means more increase in production output and changes in technical and
institutional arrangements by which output is produced and distributed. Thus development is
more comprehensive than economic growth.

Benefits of economic growth can be described as;

a) Contribution to higher standard of living.
b) Economic growth can help reduce poverty.

The cost of economic growth

a) Faster use and depletion of natural resources e.g., oil.
b) Technological unemployment due to adoption of more productive techniques.
c) It’s associated with negative externalities such as pollution and noise.

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Activity
What has contributed to rapid economic growth of Tunisia in recent past?

Economic Developments
We can now go further and examine measures of economic development. These are
 IMF bank divides countries to developed, developing and transitional economies.
 United Nations and World Bank categorizes countries into high income, middle-income
and low-income countries (based on measure of income per capital).

Let’s look at some of the profound obstacles to economic development

a) Vicious circle of poverty – e.g. (Low income) leads to low savings and in turn leads to
lack of capital and eventually to low productivity)
b) Lack of research skills and knowledge needed for development
c) Low level of capital formation due to poor saving attitudes and incentives
d) Social cultural constants e.g., witchcraft etc
e) Lack of entrepreneur skills
f) Corruption and mismanagement
g) Vulnerability to health epidemics.

Activity
What are the major obstacles in economic growth in Russia after the fall of communism?

Theories of Economical Growth and Developing

Let’s consider some plausible explanation of growth and development from a scholar’s
perspective.

Activity
Compare and contrast classical growth theory and modern growth theory.

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REVIEW

Key Terms
Economic growth
Economic development
Actual economic growth
Potential economic growth
Vicious circle of poverty
The cost of economic growth
Classical growth theory
Modern growth theories

Critical Thinking
1. What hindrance do African governments encounter in cultivating sustained economic
growth?

Self Assessment
1. Define economic growth
It means more output and economy development suggesting both an increase in output
and changes in technical and institutional arrangements by which output is produced and
distributed.
2. What is potential economic growth?
It is the rate at which the economy would grow if all the resources were fully utilized.
3. Describe five negative externalities of economic development?
Pollution, noise, crime, sedentary oriented diseases and family break-ups.
4. Explain the vicious circle of poverty?
These are certain factors that exist which perpetuate poverty e.g. (Low income leads to
low savings and in turn lead to lack of capital and eventually to low productivity)

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Further Reading
Attfield,C.L, Demery,D. and Duck,N.W.(1985), Rational Expectations in Macroeconomics: An
Introduction to Theory and Evidence, Blackwell Publishers.
Pierce,D & Tysome,P.(1985),Monetary Economics,2nd edition, Butterworths.
Abel,Andrew;Breanne,Ben (2005),Macroeconomics,5th edition, Pearson.
Any well detailed microeconomics text book.

References
1. Taylor, John; Hall, Robert Ernest (1993), Macroeconomics, New York: W. W. Norton
2. Caster Stephen D. (1992.). Introduction to Economics. NY: Harper Collins
3. Lubou,Andrew.1990.Taxes and Government Spending; Lerner publishing,
4. Campbell, Colin,et al. (1988) Money, Banking and Monetary Policy. Hinsdale,il: Drysden press

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 Sample Exam
UNIT TITLE: MACROCONOMICS.
UNIT CODE: BUS 115

Section A
Answer any three questions in section A. Time 2hrs

Question 1
Write short notes on all of the following (30 marks)
1. Customer price index (CPI).
2. Structural unemployment, give examples.
3. International Monetary Fund (IMF) lending.
4. Balance of payments and balance of trade.

Section B
Answer any two questions in section B (40 marks)
Question 2
Explain why countries are usually concerned about the level of their budget deficits.
Question 3
Give reasons why industrialized countries are concerned about problems of developing countries
Question 4
The table below represents economic transaction for a country MNZ in billions of shillings.
Total output Intermediate purchase
Agriculture 50 10
Manufacturing 80 55
Services 60 20
i. Calculate the Gross National product of this economy. Using the value added approach.
ii. What problems are associated with value added approach of measuring national income?

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