WOLAITA SODO UNIVERSITY

COLLEGE OF BUSINESS AND ECONOMICS

DEPARTMENT OF ECONOMICS

MODULE NAME
BASIC MACROECONOMICS
(MACROECONOMICS & DEVELOPMENT ECONOMICS)

Compiled By:
Afework Berhanu (Assistant Professor)
Birhanu Hankamo (Assistant Professor)

Wolaita Sodo, Ethiopia

March, 27/2023

Table of Contents

1
Chapter One...........................................................................................................................................5
Introduction to Macroeconomics.......................................................................................................5
1.2 The State of Macroeconomics: Evolution and Recent Developments.........................................5
Chapter- Two.........................................................................................................................................8
National Income Accounting.............................................................................................................8
Real GDP versus Nominal GDP....................................................................................................9
GDP Deflator.................................................................................................................................9
Other Measures of Income...........................................................................................................10
The Consumer Price Index (CPI).................................................................................................11
Measuring Joblessness: The Unemployment Rate.......................................................................12
The Business Cycle and the Output Gap......................................................................................13
CHAPTER THREE.............................................................................................................................15
AGGREGATE DEMAND IN THE CLOSED ECONOMY............................................................15
3.1 Foundations of the Theory of Aggregate Demand.................................................................15
The Money Market and the LM Curve........................................................................................20
The Theory of Liquidity Preference.............................................................................................21
Income, Money Demand, and the LM Curve...............................................................................22
CHAPTER- FOUR..............................................................................................................................24
AGGREGATE DEMAND IN THE OPEN ECONOMY.................................................................24
Exchange Rates...............................................................................................................................29
Exchange rate Determination/Fixed versus Flexible Exchange rate Regimes/.............................30
The Mundell-Fleming Model...........................................................................................................31
Small Open Economy with Perfect Capital Mobility...................................................................32
CHAPTER FIVE: AGGREGATE SUPPLY.......................................................................................37
The Long Run: the Vertical Aggregate Supply Curve.................................................................38
Course Title: Macroeconomics II........................................................................................................41
Chapter One.........................................................................................................................................41
Behavioural Foundations: Theories of Consumption.......................................................................41
John Maynard Keynes and the Consumption Function................................................................41
Secular Stagnation, Simon Kuznets, and the Consumption Puzzle..................................................43
Irving Fisher and Intertemporal Choice...........................................................................................44
Franco Modigliani and the life-cycle Hypothesis............................................................................47
Milton Friedman and the Permanent-Income Hypothesis................................................................48
Robert Hall and the Random-Walk Hypothesis...............................................................................49
CHAPTER TWO.................................................................................................................................49
INVESTMENT THEORY...............................................................................................................49

2
 Three types of Investment Spending............................................................................................49
Residential Investment.....................................................................................................................54
Chapter 3: Money Demand and Money Supply...................................................................................56
Chapter 4: The Labour Market............................................................................................................61
Neoclassical Microeconomics Model Of The Labour Market.........................................................61
The Neoclassical Theory of Labor Supply...................................................................................61
The Neoclassical Labor Market...................................................................................................64
Unemployment in the Neoclassical Model..................................................................................64
Keynesian views of the Labor Market.........................................................................................65
CHAPTER FIVE.............................................................................................................................68
Macroeconomic Policy Debates: Stabilization Policy.....................................................................68
Chapter Six..........................................................................................................................................71
Models of Macroeconomic Growth.................................................................................................71
The Harrod- Domar Growth Model.............................................................................................71
The Solow Neoclassical Growth Model.......................................................................................73
Growth in the Capital Stock and the Steady State........................................................................74
Endogenous Growth Theory........................................................................................................78
Chapter 7: Macroeconomic Theories and African Economies............................................................80
Macroeconomic Theories and African Economies: An overview....................................................80
DEVELOPMENT ECONOMICS MODULE......................................................................................82
DEVELOPMENT ECONOMICS I.....................................................................................................82
CHAPTER ONE..................................................................................................................................82
Economics of development: concepts and approaches.....................................................................82
Chapter two.........................................................................................................................................86
Structural features and common characteristics of developing countries.........................................86
The size of the country (geographic area, size of population, and income levels).......................86
Its historical and economical background........................................................................................87
It endowments of physical and unman resources.............................................................................87
Its ethnic and religious composition................................................................................................88
The relative importance of its public and private sector...............................................................88
The nature of its industrial structure............................................................................................89
Its degree of dependence on external economic and political forces............................................89
The distribution of power and the institutional and political structure within the nation.............90
Common Characteristics of Developing Countries..........................................................................90
Low levels of living, characterized by low income, inequality, poor health, and inadequate
education.....................................................................................................................................91

3
CHAPTER THREE.............................................................................................................................94
Growth Models and Theories of Development....................................................................................94
Growth Models................................................................................................................................95
The Harrod-Domar Growth Model..............................................................................................95
The Solow Model........................................................................................................................97
Theories of Development................................................................................................................98
Rostow’s Stage of Economic growth...........................................................................................98
CHAPTER FOUR.............................................................................................................................100
Historic Growth and Contemporary Development: Lesson and controversies...............................100
CHAPTER FIVE...............................................................................................................................105
INEQUALITY, POVERTY AND DEVELOPMENT...................................................................105
Inequality and Absolut Poverty.....................................................................................................108
DEVELOPMENT ECONOMICS-II..................................................................................................110
CHAPTER ONE................................................................................................................................110
Population Growth and the Quality of Life....................................................................................110
World Population Growth through History....................................................................................111
The Hidden Momentum of Population Growth.............................................................................112
The cause for high fertility in LDCs..............................................................................................112
Malthusian Population Trap.......................................................................................................112
The Microeconomic Household Theory of Fertility......................................................................112
UNIT TWO......................................................................................................................................114
Human Capital: Education and Health in Economic Development................................................114
Chapter three.....................................................................................................................................117
Rural-urban intersection, migration, and unemployment...............................................................117
The Urban Informal Sector............................................................................................................118
Urban Unemployment...................................................................................................................119
Migration and Development..........................................................................................................120
Toward an Economic Theory of Rural-Urban Migration...............................................................120
UNIT FOUR......................................................................................................................................122
AGRICULTURE AND ECONOMIC DEVELOPMENT..............................................................122
The Structure of Agrarian Systems in the Developing World....................................................123
The Economics of Agricultural Development............................................................................125
The Transition to Mixed and Diversified Farming.....................................................................125
From Divergence to Specialization: Modern Commercial Farming...........................................126
Toward a Strategy of Agricultural and Rural Development: Some Main Requirements................127
CHAPTER FIVE...............................................................................................................................128

4
 International trade and economic development: the trade policy debate and industrialization.......128
Trade Theory and Development Experience..................................................................................128
Importance of Exports to Different Developing Nations...............................................................129

Chapter One

Macroeconomics I & II

Introduction to Macroeconomics

1.1 What Macroeconomics is about?

 Economics is the study of the economy and the behavior of people in the economy.

5
  Traditionally, economics is divided into microeconomics & macroeconomics.
 Microeconomics, which studies the behavior of individuals and organizations
(consumers, firms and the like) at a disaggregated level, and
 Macroeconomics, which studies the overall or aggregate behavior of the economy.

Macroeconomics is concerned with the behavior of the economy as a whole-

 with booms and recessions, total output of goods and services, the growth of output, the
rate of inflation, unemployment, the balance of payments, exchange rates…
Macroeconomics focuses on the economic behavior and policies that affect:
 consumption and investment, trade balance, prices, monetary and fiscal policies, the
money stock, government budgetinterest rate, and national debt

1.2 The State of Macroeconomics: Evolution and Recent Developments

(Schools of thoughts in Macroeconomics)

 Classical (1776 – 1870)  1970s–present (the new

 Neo-classical (1870–1936) classical,new Keynesians,
 Keynesian (1936 – 1970s) Monetarism)

Classical (1776 – 1870)

 In this period the distinction between micro and macro was not clear. The classicals
have made an ample contribution to the development of economic science. With regard
to the labor market, they contend that labor demand and labor supply are brought into
equilibrium by the real wage. As a result there is no involuntary unemployment.
 With regard to the financial market, for classicals saving and investment are brought
into equilibrium by the interest rate and investment respond to the interest rate.
 In the money market, money demand is simply a transaction demand and money has
no any effect on the real economy and hence raising the money supply simply pushes up
prices (i.e. inflationary). The implication is that, government has no any role in the
economy through its monetary policy.To this end, the classical are the proponents of
laissez-faire (no government role). In general, for this school markets (be it,
commodity, factor, and money) works best if left to themselves.
Neo-classical (1870–1936)
 Basically the neoclassical school is not different from the classical school. The main
distinction is the tool of analysis, such as the marginal analysis.

6
 Keynesian (1936 – 1970s)
 The main thesis of the Keynesian stream is that the economy is subjected to failure so that
it may not achieve full employment level. Thus, government intervention is inevitable.
This school views the labor market in that workers and firms bargain for a money
(nominal) wage, not for real wage. Money wages adjust slowly and workers resist any
drop in the money wage. Unlike the classicals, for Keynesians saving and investment are
brought into equilibrium by changes in income. Investment is not influenced by a mere
change in interest rate; rather it is affected by expectations of the future, which is
uncertain.
 Money demand is affected by transactions, but also by other things, in particular fear,
which may lead to a “speculative demand” for high money balances.
1970s – Present. There is no dominant school of thought of macroeconomics. There have
been two main intellectual traditions in macroeconomics.
 One school of thought believes that government intervention can significantly improve
the operation of the economy. The other believes that markets work best if left to
themselves.In the 1960s, the debate on these questions involved Keynesians, including
Franco Modigliani and James Tobin, on one side, and monetarists, led by Milton
Friedman, on the other. In the 1970s, the debate on much the same issues brought to the
fore a new group- the new classical macroeconomists, who by and large replaced the
monetarists in keeping up the argument against using active government policies to try to
improve economic performance.
 On the other side are the new Keynesians; they may not share many of the detailed belief
of Keynesians three or four decades ago, except the belief that government policy can
help the economy perform better.
Keynes and Economic Policy-monetary expansion/ fiscal expansion
 For Keynes to do about recessions, the first and most obvious thing to do is to make it
possible for people to satisfy their demand for more cash without cutting their spending,
preventing the downward spiral of shrinking spending and shrinking income. The way to
do this is simple to print more money, and somehow get it into circulation. So the usual
and basic Keynesian answer to recessions is a monetary expansion.
 But Keynes worried that even this might sometimes not be enough, particularly if a
recession had been allowed to get out of hand and become a true depression. Once the
economy is deeply depressed, households and especially firms may be unwilling to

7
 increase spending no matter how much cash they have; they may simply add any
monetary expansion to their hoarding. Such a situation, in which monetary policy has
become ineffective, has come to be known as a “liquidity trap”.
 In such a case, the government has to do what the private sector will not: spend. When
monetary expansion is ineffective, fiscal expansion must take its place. Such a fiscal
expansion can break the vicious circle of low spending and low incomes and getting the
economy moving again. However, Keynesian macroeconomics was subject to ongoing
criticism.
 Monetarism, as advocates of free market, started challenging Keynes’s theory in the
1970s. Milton Friedman, the founder of monetarism, attacked Keynes idea of smoothing
business cycle on the ground that such active policy is not only unnecessary but actually
harmful, worsening the very economic instability that it is supposed to correct, and should
be replaced by simple, mechanical monetary rules. This is the doctrine that came to be
known as “monetarism.”
Policy Rule under Monetarism
 If economic slumps begin when people spontaneously decide to increase their money
holdings, then the monetary authority must monitor the economy and pump money in
when it finds a slump is imminent. If such slumps are always created by a fall in the
quantity of money, then the monetary authority need not monitor the economy; it need
only make sure that the quantity of money doesn’t slump.

 In other words, a straightforward rule- “Keep the money supply steady”- is good enough,
so that there is no need for a “discretionary” policy of the form, “Pump money in when
your economic advisers think a recession is imminent.”

The New Classical School

 The new classical macroeconomics remained influential in the 1980s. This school of
macroeconomics shares many policy views with Friedman. It sees the world as one in
which individuals act rationally in their self-interest in markets that adjust rapidly to
changing conditions. The government, it is claimed, is likely only to make things worse
by intervening.

The central working assumptions of the new classical school are three:

8
 Economic agents maximize. Households and firms make optimal decisions given all
available information in reaching decisions and that those decisions are the best.
 Expectations are rational,which means they are statistically the best predictions of the
future that can be made using the available information.
 Markets clear.There is no reason why firms or workers would not adjust wages or prices
if that would make them better off. Accordingly prices and wages adjust in order to
equate supply and demand; in other words, market clear.
The New Keynesians

 New Keynesian economics is the school of thought in modern macroeconomics that

evolved from the ideas of John Maynard Keynes. Keynes wrote The General Theory of
Employment, Interest, and Money in the thirties, and his influence among academics and
policymakers increased through the sixties.In the seventies, however, new classical
economists such as Robert Lucas, Thomas J. Sargent, and Robert Barro called into
question many of the precepts of the Keynesian revolution. The label "new Keynesian"
describes those economists who, in the eighties, responded to this new classical critique
with adjustments to the original Keynesian tenets. The new Keynesians argue that
markets sometimes do not clear even when individuals are looking out for their own
interests.

Much new Keynesian research attempts to remedy this omission:

 Menu Costs and Aggregate-  Coordination Failure

Demand Externalities  Efficiency Wages
 The Staggering of Prices

Chapter- Two

National Income Accounting

 Definition: National income accountingrefers to the accounting system used to measure
GDP and many relatedstatistics. This chapter focuses on the three statistics that
economists and policymakers use most often. Gross domestic product, or GDP, tells
us the nation’s total income and the total expenditure on its output of goods and services.
The consumerprice index, or CPI, measures the level of prices. The unemployment
rate tells us the fraction of workers who are unemployed.

9
 The single most important measure of overall economic performance is Gross Domestic
Product (GDP).The GDP is an attempt to summarize all economic activity over a period
of time in terms of a single number; it is a measure of the economy’s total output and of
total income. In other words GDP is the value of all final goods and services produced in
the economy in a given time period (note that GDP is a flow not a stock).
 There are two ways to view this statistic. One way to view GDP is as the total income of
everyone in the economy. Another way to view GDP is as the total expenditure on the
economy’s output of goods and services.  

Real GDP versus Nominal GDP

 Notice that GDP can increase either because prices rise or because quantities rise.

GDP= Q*P

 That is, this measure does not accurately reflect how well the economy can satisfy the
demands of households, firms, and the government. If all prices doubled without any
change in quantities, GDP would double. Yet it would be misleading to say that the
economy’s ability to satisfy demands has doubled, because the quantity of every good
produced remains the same. Economists call the value of goods and services measured at
current prices nominal GDP. Thus, it is important to correct for changes in prices. To do
this, economists value goods at the prices in some given year. This is known as real GDP.
Real GDP measures the output produced in any one period at the prices of some base
year.

GDP Deflator
 From nominal GDP and real GDP we can compute a third statistic: the GDP deflator. The
GDP deflator, also called the implicit price deflator for GDP, is defined as the ratio of
nominal GDP to real GDP:

Nominal GDP
◦ GDP Deflator=
Real GDP

 The GDP deflator reflects what’s happening to the overall level of prices in the economy.

◦ Nominal GDP = Real GDP * GDP Deflator.

Nominal GDP
◦ Real GDP=
GDP Deflator

Components of GDP

10
The national income accounts divide GDP into four broad categories of spending:

◦ Consumption (C) ◦ Government purchases (G)

◦ Investment (I ) ◦ Net exports (NX)
Thus, letting Y stand for GDP:

Y = C + I + G + NX

Other Measures of Income

 It is important to be aware of the various measures, because economists and the press
often refer to them.
 Gross national product (GNP): it is the value of final goods and services produced by
domestically owned factors of production within a given period. To obtain GNP, we add
receipts of factor income (wages, profit, and rent) from the rest of the world and subtract
payments of factor income to the rest of the world:
GNP = GDP + Factor payments from abroad - Factor payments to abroad.
 Whereas GDP measures the total income produced domestically, GNP measures the total
income earned by nationals (residents of a nation).Net national product (NNP):To obtain
net national product (NNP),we subtract the depreciation of capital- the amount of the
economy’s stock of plants, equipment, and residential structures that wears out during the
year:
 NNP = GNP - Depreciation.

 In the national income accounts, depreciation is called the consumption of fixed capital.

 National income (NI):

 National Income = NNP − Indirect Business Taxes

 National income measures how much everyone in the economy has earned.

 The national income accounts divide national income into five components, depending on
the way the income is earned.

Personal Income = National Income

(- Corporate Profits - Social Insurance Contributions- Net Interest + Dividends +

Government Transfers to Individual + Personal Interest Income)

Disposable Personal Income = Personal Income - Personal Tax and Nontax Payments.

11
 We are interested in disposable personal income because it is the amount households and
non-corporate businesses have available to spend after satisfying their tax obligations to
the government.

The Consumer Price Index (CPI)

 A dollar today doesn’t buy as much as it did 20 yrs ago. The cost of almost everything has
gone up. This increase in the overall level of prices is called inflation.The most
commonly used measure of the level of prices is the consumer price index (CPI).The CPI
turns the prices of many goods and services into a single index measuring the overall
level of prices. The CPI is the price of this basket of goods and services relative to the
price of the same basket in some base year.
Prices of ba sket of goods∧service∈current year
CPI=
prices of the same basket ∈thebase year
 The index tells us how much it costs now to buy a given basket relative to how much it
cost to buy the same basket in the base year.
The CPI and the GDP Deflator

 There are three key differences between the two measures.The first difference is that the
GDP deflator measures the prices of all goods and services produced. Whereas, the CPI
measures the prices of only the goods and services bought by consumers. Thus, an
increase in the price of goods bought by firms or the government will show up in the GDP
deflator but not in the CPI.The second difference is that the GDP deflator includes only
those goods produced domestically. Imported goods are not part of GDP and do not show
up in the GDP deflator.
 Hence, an increase in the price of a Toyota made in Japan and sold in this country affects
the CPI, because the Toyota is bought by consumers, but it does not affect the GDP
deflator.
 The third and most subtle difference results from the way the two measures aggregate the
many prices in the economy. The CPI assigns fixed weights to the prices of different
goods, whereas the GDP deflator assigns changing weights. In other words, the CPI is
computed using a fixed basket of goods, whereas the GDP deflator allows the basket of
goods to change over time as the composition of GDP changes. Economists call a price
index with a fixed basket of goods a Laspeyres index and a price index with a changing
basket a Paasche index.

12
Measuring Joblessness: The Unemployment Rate
 The unemployment rate is the statistic that measures the percentage of those people
wanting to work but who do not have jobs.
 A person is employed if he or she spent some of the previous week working at a paid job.
 A person is unemployed if he or she is not employed and has been looking for a job or is
on temporary layoff.
Categories of the population
 Employed : working at a paid job
 Unemployed : not employed but looking for a job
 Labor force: the amount of labor available for producing goods and services; all
employed plus unemployed persons (16-65)
 Not in the labor force: not employed, not looking for work (<16, >65)
i. Unemployment rate :percentage of the labor force that is unemployed

ii. labor force participation rate :the fraction of the adult population that
“participates” in the labor force

Computing labor statistics:

U.S. adult population by group, May 2009
Number employed = 140.57 million
Number unemployed = 14.51 million
Adult population = 235.45 million
Use the above data to calculate
 the labor force  the labor force participation rate
 the number of people not in the  the unemployment rate
labor force

Data: E = 140.57, U = 14.51, POP = 235.45

 labor force
L = E +U = 140.57 + 14.51 = 155.08
 not in labor force
NILF = POP – L = 235.45 – 155.08 = 80.37

13
  unemployment rate
U/L x 100% = (14.51/155.08) x 100% = 9.4%
 labor force participation rate
L/POP x 100% = (155.08/ 235.45) x 100% = 65.9%

The Business Cycle and the Output Gap

 The business cycle describes the ups and downs in a real GDP over time.

 Although no business cycles are identical, they all have four distinct phasepeak,
contraction or recession, trough, and expansion.

 Peak:
 Is the highest level of real GDP in the cycle
 End of economic expansion and beginning of recession
 Unemployment rate is relatively low
 Contraction/recession
 Output and employment decline/fall
 Unemployment level increases
 Rate of change is negative
Trough/depression
 Bottom level of the cycle
 lowest level of real GDP observed over the cycle
 Excessive amount of unemployment

14
  Expansion/recovery
 Output and employment grow
 Real GDP increases
 Unemployment level decline
 Rate of change is positive
 Inflation, growth, and unemployment are related through the business cycle. The
business cycle is the more or less regular pattern of expansion (recovery) and
contraction (recession) in economic activity around the path of trend growth. At a
cyclical peak, economic activity is high relative to trend; and at a cyclical trough, the
low point in economic activity is reached.
 The trend path of GDP is the path GDP would take if factors of production were fully
employed. Over time, real GDP changes for the two reasons.
 First, more resources become available which allows the economy to produce more
goods and services, resulting in a rising trend level of output. Second, factors are not
fully employed all the time. Thus, output can be increased by increasing capacity
utilization.Deviations of output from trend are referred to as the output gap.The
output gap measures the gap between actual output and the output the economy could
produce at full employment given the existing resources. Full employment output is
also called potential output.
 Output gap = potential output – actual output
Okun’s Law

 A relationship between real growth and changes in the unemployment rate is known
as Okun’s law, named after its discoverer, Arthur Okun.His law says that the
unemployment rate declines when growth is above the trend rate of 2.25 percent.
Specifically, for every percentage point of growth in real GDP above the trend rate is
sustained for a year, the unemployment rate declines by one-half percentage point.
 The relation is stated as:∆ U =−0.5 ¿). Where ∆U- is change in unemployment rate, y
is percentage growth rate.

Inflation –Unemployment Dynamics: The Phillips Curve

 The Phillips curve describes the empirical relationship between inflation and
unemployment:
 The higher the rate of unemployment, the lower the rate of inflation.

15
  The curve suggests that less unemployment can always be attained by
incurring more inflation and that the inflation rate can always be reduced by
incurring the costs of more unemployment.
 In other words the curve suggests there is a trade-off between inflation and
unemployment.

CHAPTER THREE

AGGREGATE DEMAND IN THE CLOSED ECONOMY

3.1 Foundations of the Theory of Aggregate Demand

• Of all the economic fluctuations in world history, the one that stands out as particularly
large, painful, and intellectually significant is the Great Depression of the 1930s. During
this time, the United States and many other countries experienced massive unemployment
and greatly reduced incomes. In the worst year, 1933, one-fourth of the U.S. labor force
was unemployed, and real GDP was 30 percent below its 1929 level. This devastating
episode caused many economists to question the validity of classical economic
theory.Classical theory seemed incapable of explaining the Depression.
• After the onset of the Depression, many economists believed that :
• A new model was needed to explain such a large &sudden economic downturn & to
suggest government policies that might reduce the economic hardship so many
people faced.
• In 1936 the British economist John Maynard Keynes revolutionized economics with his
book: The General Theory of Employment, Interest, and Money.Keynes proposed a new
way to analyze the economy, which he presented as an alternative to classical theory.
• Keynes proposed that low aggregate demand is responsible for the:
• low income and high unemployment that characterize economic downturns.

16
• He criticized classical theory for assuming that aggregate supply alone—capital, labor,
and technology—determines national income. Economists today reconcile these two
views with the model of aggregate demand and aggregate supply.
• In the long run, prices are flexible, and aggregate supply determines income- (classical
model). But in the short run, prices are sticky, so changes in aggregate demand influence
income- (Keynesian model). The model of aggregate demand developed in this chapter,
called the IS–LM model, the leading interpretation of Keynes’s theory. The goal of the
model is to show what determines national income for any given price level.
There are two ways to view this:
• We can view the IS–LM model as showing what causes income to change in the short
run when the price level is fixed. Or we can view the model as showing what causes the
aggregate demand curve to shift. The two parts of the IS–LM model are- the IS curve
and the LM curve.
• ISstands for “investment’’ and “saving,’’ and
• theIScurve represents what’s going on in the market for goods and services.
• LMstands for “liquidity’’ and “money,’’ and
• theLMcurve represents what is happening to the supply and demand for money.

The Goods Market and the IS Curve

• The IS curve plots the relationship between the interest rate and the level of income that
arises in the market for goods and services. To develop this relationship, we start with a
basic model called the Keynesian cross. This model is the simplest interpretation of
Keynes’s theory of national income and is a building block forthe more complex and
realistic IS–LM model.

The Keynesian Cross

• In his General Theory, Keynes proposed that an economy’s total income was, in the short
run, determined largely by the desire to spend by households, firms, and the
government. The more people want to spend, the more goods and services firms can sell.
• The more firms can sell, the more output they will choose to produce and the more
workers they will choose to hire. Thus, the problem during recessions and depressions,
according to Keynes, was inadequate spending.We begin our derivation of the Keynesian
cross by differentiating between actual and planned expenditure.
• Actual expenditureis the amount households, firms, and the government spend on goods
and services and it equals the economy’s gross domestic product (GDP).

17
• Planned expenditureis the amount households, firms, and the government would like to
spend on goods and services.
• Assuming the economy is closed, so that net exports are zero, we write planned
expenditure AD as the sum of consumption(C), investment (I) and government
purchase (G)
E = C + I + G………………………………………… (1)
• Consumption is a function of disposable income(Y-T)
C = C(Y - T)……………………………….………………… (2)
• This equation states that consumption depends on disposable income (Y - T), which is
total income Y minus taxes T.
• To keep things simple, for now we take planned investment as exogenously fixed:

………………………………………….…………… (3)
• we further assume that fiscal policy—the levels of government purchases and taxes—
is fixed:

…………………………….…………………………(4)
• Combining these four equations, we obtain:

• The figure above graphs planned expenditure as a function of the level of income.
• This line slopes upward because higher income leads to higher consumption and thus
higher planned expenditure. The slope of this line is the marginal propensity to
consume, the MPC: it shows how much planned expenditure increases when income
rises by $1. This planned-expenditure function is the first piece of the model called
the Keynesian cross.
The Economy in Equilibrium
• The economy is said to be in equilibrium when Actual expenditure is equal to planned
expenditure. This assumption is based on the idea that when people’s plans have been

18
 realized, they have no reason to change what they are doing. We can write the
equilibrium condition as:
Actual Expenditure = Planned Expenditure
Y = E

The Adjustment to Equilibrium

• In summary, the Keynesian cross shows how income Y is determined for given levels
of planned investment I and fiscal policy G and T. We can use this model to show
how income changes when one of these exogenous variables changes.
Fiscal Policy and the Multiplier: Government Purchases (Refer to the graph)
• The graph shows that, an increase in government purchase leads to an even greater
increase in income.
• That is, ΔY>ΔG. The ratio ΔY/ΔG is called the government purchases multiplier; it tells
us how much income rises in response to a $1 increase in government purchases.
• An implication of the Keynesian cross is that the government-purchases multiplier is
larger than one.
Why does fiscal policy have a multiplied effect on income?
• The reason is that, according to the consumption function C = C(Y - T), higher income
causes higher consumption. When an increase in government purchases raises income, it
also raises consumption, which further raises income, which further raises consumption,
and so on. Therefore, in this model, an increase in government purchases causes a greater
increase in income.

19
How big is the multiplier?
The total effect on income is
• Initial Change in Government Purchases = ΔG
• First Change in Consumption = MPC* ΔG
• Second Change in Consumption = MPC2* ΔG
• Third Change in Consumption = MPC3 * ΔG
.. ..
.. ..
• ΔY = ΔG (1 + MPC + MPC2 + MPC3 + . . .).
• The government-purchases multiplier is
ΔY/ΔG = 1 + MPC + MPC2 + MPC3 + . . .
• This expression for the multiplier is an example of an infinite geometric series. A
result from algebra allows us to write the multiplier as2
ΔY/ΔG = 1/ (1 - MPC).
• For example, if the marginal propensity to consume is 0.6, the multiplier is
ΔY/ΔG = 1 + 0.6 + 0.62 + 0.63 + . . .
= 1/ (1 - 0.6) = 2.5.
• In this case, a $1.00 increase in government purchases raises equilibrium income by
$2.50.
Fiscal Policy and the Multiplier: Taxes (Refer to the graph)
• Just as an increase in government purchases has a multiplied effect on income, so
does a decrease in taxes.
• As before, the initial change in expenditure, now MPC × ΔT, is multiplied by 1/ (1 −
MPC).The overall effect on income of the change in taxes is
ΔY/ΔT = −MPC/ (1 − MPC).
• This expression is the tax multiplier, the amount income changes in response to a $1
change in taxes. For example, if the marginal propensity to consume is 0.6, then the
tax multiplier is
ΔY/ΔT = −0.6/ (1 − 0.6) = −1.5.
• In this example, a $1.00 cut (decrease) in taxes raises equilibrium income by
$1.50.The multiplier implies that taxes and income are inversely related and a unit
decrease in taxes increase income by more than proportionately.
The Interest Rate, Investment, and the IS Curve
• The Keynesian cross is only a stepping stone on our path to the IS–LM model.
• Yet it makes the simplifying assumption that the level of planned investment I is
fixed.
• Here we set an important macroeconomic relationship between planned investment
and the interest rate r.If interest rate increases, planned investment falls, and so does
output. Thus higher levels of interest rate are associated with lower level of output.To
add this relationship between the interest rate and investment to our model, we write
the level of planned investment as, I = I(r).

20
 • In essence, the IS curve combines the interaction between r and I expressed by the
investment function and the interaction between I and Y demonstrated by the
Keynesian cross.
• Because an increase in the interest rate causes planned investment to fall, which in
turn causes income to fall, the IS curve slopes downward
How Fiscal Policy Shifts the IS Curve
• The IS curve is drawn for a given fiscal policy; that is, when we construct the IS
curve, we hold G and T fixed. When fiscal policy changes, the IS curve shifts. Figure
below uses the Keynesian cross to show how an increase in government purchases by
ΔG shifts the IS curve. This figure is drawn for a given (constant) interest rate and
thus for a given level of planned investment. The Keynesian cross shows that this
change in fiscal policy raises planned expenditure and thereby increases equilibrium
income from Y1 to Y2. Therefore, an increase in government purchases shifts the IS
curve outward. (Please, refer to the graph)
• In summary, the IS curve shows the combinations of the interest rate and the level of
income that are consistent with equilibrium in the market for goods and services.
• The IS curve is drawn for a given fiscal policy.
• Changes in fiscal policy that raise the demand for goods and services shift the IS
curve to the right. Changes in fiscal policy that reduce the demand for goods and
services shift the IS curve to the left.

The Money Market and the LM Curve

• The LM curve plots the relationship between the interest rate and the level of income that
arises in the market for money balances.

21
• To understand this relationship, we begin by looking at a theory of the interest rate, called
the theory of liquidity preference.

The Theory of Liquidity Preference

• This is a theory of interest rate determination in short run. It argues that interest tare, in
the short run, is determined in the money market, where the demand and supply of real
money balances intersect. Just as the Keynesian cross is a building block for the IS curve,
the theory of liquidity preference is a building block for the LM curve.
• To develop this theory, we begin with the supply of real money balances. If M stands for
the supply of money and P stands for the price level, then M/P is the supply of real money
balances. The theory of liquidity preference assumes there is a fixed supply of real money
balances.

That is,
• The money supply M is an exogenous policy variable chosen by a central bank, such as
the National Bank. The price level P is also an exogenous variable in this model (in the
short run when the price level is fixed.)
• These assumptions imply that the supply of real money balances is fixed and, in
particular, does not depend on the interest rate. Thus, when we plot the supply of real
money balances against the interest rate in figure below, we obtain a vertical supply
curve.Next, consider the demand for real money balances.
• The theory of liquidity preference posits that the interest rate is one determinant of how
much money people choose to hold. The reason is that the interest rate is the opportunity
cost of holding money: it is what you forgo by holding some of your assets as
money.When the interest rate rises, people want to hold less of their wealth in the form of
money.

We can write the demand for real money balances as,

22
• According to the theory of liquidity preference, the supply and demand for real money
balances determine what interest rate prevails in the economy. That is, the interest rate
adjusts to equilibrate the money market.(please refer to the graph)

Income, Money Demand, and the LM Curve

• So far we assumed that only interest rate determines the quantity of real money balances
demanded. But more, realistically, the level of income Y also affects money demand.
• When income is high, expenditure is high, so people engage in more transactions that
require the use of money. Thus, greater income implies greater money demand. We can
express these ideas by writing the money demand function as,

• The quantity of real money balances demanded is negatively related to the interest rate
and positively related to income.Using the theory of liquidity preference we can see what
happens to the interest rate when the level of income changes. For example, consider
what happens when income increases from Y1 to Y2.

• The LM curve plots this relationship between the level of income and the interest rate.
• The higher the level of income, the higher the demand for real money balances, and the
higher the equilibrium interest rate. For this reason, the LM curve slopes upward, as in
panel (b) of Figure above.
How Monetary Policy Shifts the LM Curve
• If real money balances change— for example, if the Fed alters the money supply-the LM
curve shifts.
• Suppose that the National Bank decreases the money supply from M1 to M2, which
causes the supply of real money balances to fall from M1/P to M2/P. Hence, a decrease in
the money supply shifts the LM curve upward.(please refer to the graph)

23
• In summary, the LM curve shows the combinations of the interest rate and the level of
income that are consistent with equilibrium in the market for real money balances. The
LM curve is drawn for a given supply of real money balances.
• Decreases in the supply of real money balances shift the LM curve upward.
• Increases in the supply of real money balances shift the LM curve downward.
The Short-Run Equilibrium

• The model takes fiscal policy, G and T, monetary policy M, and the price level P as
exogenous.
• Given these exogenous variables, the IS curve provides the combinations of r and Y
that satisfy the equation representing the goods market, and
• TheLM curve provides the combinations of r and Y that satisfy the equation
representing the money market.

From the IS-LM to Aggregate demand Curve

• We have been using the IS–LM model to explain national income in the short run when
the price level is fixed. To see how the IS–LM model fits into the model of aggregate
supply and aggregate demand, we now examine what happens in the IS–LM model if the
price level is allowed to change. For any given money supply M, a higher price level P
reduces the supply of real money balances M/P. A lower supply of real money balances
shifts the LM curve upward ( to the left), which raises the equilibrium interest rate and
lowers the equilibrium level of income, as shown in panel (a).
• Here the price level rises from P1 to P2, and income falls from Y1 to Y2.The aggregate
demand curve in panel (b) plots this negative relationship between national income and
the price level. In other words, the aggregate demand curve shows the set of equilibrium
points that arise in the IS–LM model as we vary the price level and see what happens to
income.

24
 CHAPTER- FOUR
AGGREGATE DEMAND IN THE OPEN ECONOMY
International Flows of Capital and Goods

• In the previous chapter, we simplified our analysis by assuming a closed economy.

• In actuality, however, most economies are open:
– they export goods and services abroad
– they import goods and services from abroad, and
– they borrow and lend in world financial markets.
Open Versus Closed Economies
• A closed economy is one that does not interact with other economies in the world.
 There are no exports, no imports, and no capital flows.
• An open economy is one that interacts freely with other economies around the
world.An open economy interacts with other countries in two ways:
 It buys and sells goods and services in world product markets.
 It buys and sells capital assets in world financial markets.
International Flows of Goods: (Exports, Imports, and Net Exports)
• Consider the expenditure on an open economy’s output of goods and services, which
can be divided into four components:
d
C , consumption of domestic goods and services,
d
I , investment in domestic goods and services,
d
G , government purchases of domestic goods and services,
EX, exports of domestic goods and services.
• The division of expenditure into these components is expressed in the identity,
d d d
Y =C + I + G + EX

25
 • Note that domestic spending on all goods and services is the sum of domestic
spending on domestic goods and services and on foreign goods and services.
Therefore,
C=C d +C f I=I d + I f
d f
G=G +G
• We substitute these three equations into the identity above: and rearranging
d d d
Y =C + I + G + EX ,

Y = ( C−C ) + ( I −I ) +G−G + EX
f f f
•

• Y =C + I + G+ EX −(C f + I f +G f )
• Y =C + I+ G+ EX −ℑ
The national income identity in an open economy is therefore:
Y =C + I+ G+ Nx
Or Nx=Y −(C+ I +G),
Net Exports = Output − Domestic Spending
• It shows that in an open economy, domestic spending need not equal the output of
goods and services.
• If output exceeds domestic spending (consumption), we export the difference: net
exports are positive.
• If output falls short of domestic spending (consumption), we import the difference: net
exports are negative.It shows that in an open economy, domestic spending need not
equal the output of goods and services.
• Exports: are domestically produced goods and services that are sold abroad.
• Imports: are foreign produced goods and services that are sold domestically.
• Net exports (NX):-also called the trade balance: refers to the values of a nation’s
exports minus the value of its imports.
International Capital Flows
• Net foreign investment/Net capital outflow/- refers to the purchase of foreign assets by
domestic residents minus the purchase of domestic assets by foreigners.
• For instance, the Ethiopian resident buys stock in the Chinese corporation and a Chinese
buys stock in the Ethiopian corporation.When Ethiopian resident buys stock in Telmex,
the Mexican phone company, the purchase raises the Ethiopian net foreign investment.
• When a Japanese resident buys a bond issued by the Ethiopian government, the
purchase reduces the Ethiopian net foreign investment.

26
• Financial/Capital markets and goods markets are closely related.
• Begin with the identity: Y =C + I + G+ NX .
Subtract C and G from both sides to obtain:
Y −C−G=I+ NX
Note: Y −C−G is national saving S, the sum of private saving, Y −T −C , and public
saving, T −G .
• Therefore, S=I + NX .
• Subtracting I from both sides of the equation, we can write the national income
accounts identity as
S−I =NX ⟹
( trade balance=net capital outflow )
• This identity shows that an economy’s net exports must always equal the difference
between its saving and its investment.
• S−I ,is termed as net capital outflow/net foreign investment (domestic saving less
domestic investment).
• If net capital outflow is positive, our saving exceeds our investment, and we are
lending the excess to foreigners /I.e., When S> I , the country is a net lender/
• If the net capital outflow is negative, our investment exceeds our saving, and we
are financing this extra investment by borrowing from abroad / I.e., When S< I ,
the country is a net borrower/.
• Thus, net capital out flow equals the amount that domestic residents are lending abroad
minus the amount that foreigners are lending to us.
• The national income accounts identity shows that the international flow of funds to
finance capital accumulation and the international flow of goods and services are two
sides of the same coin.
• On the one hand, if our saving exceeds our investment, the saving that is not invested
domestically is used to make loans to foreigners. Foreigners require these loans because
we are providing them with more goods and services than they are providing us. That is,
we are running a trade surplus.
• On the other hand, if our investment exceeds our saving, the extra investment must be
financed by borrowing from abroad. These foreign loans enable us to import more
goods and services than we export. That is, we are running a trade deficit.
Factors that Influence Net Foreign Investment:
• The real interest rates being paid on foreign assets.
27
 • The real interest rates being paid on domestic assets.
• The perceived economic and political risks of holding assets abroad.
• The government policies that affect foreign ownership of domestic assets.
Saving and investment in a small open economy
Basic Assumptions:
• Small open economy-it is to mean that the economy is a small part of the world market
and thus, by itself, can have only a negligible effect on the world interest rate.
• Perfect capital mobility- residents of the country have full access to world financial
markets. Meaning the government does not impede international borrowing / lending.
• Owing to the above assumptions, the interest rate r, must equal the world interest rate
r∗¿ (the real interest rate prevailing in world financial markets): r =r∗¿
• Residents of the small open economy need never borrow at any interest rate above r*,
because they can always get a loan at r* from abroad. Similarly, residents of this
economy need never lend at any interest rate below r * because they can always earn r *
by lending abroad. Thus, the world interest rate determines the interest rate in our small
open economy.
What determines the world real interest rate?
• The equilibrium of world saving and world investment determines the world interest
rate.
• Our small open economy has a negligible effect on the world real interest rate
because, being a small part of the world, it has a negligible effect on world saving and
world investment.
• Hence, our small open economy takes the world interest rate as exogenously given.
• The Model: To build the model of the small open economy, we make three
assumptions,
• Production function: Y =Y =F (K , L) : The economy’s output Y is fixed by the
factors of production.
Consumption function: C=C ( Y −T )
Investment function: I =I (r )
• We can now return to the accounting identity and write it as
Nx=( Y −C−G ) −I
Nx=S−I

28
 • Substituting our three assumptions and the condition that the interest rate equals the
world interest rate, we obtain
Nx=[Y −C (Y −T )−G]−I ¿
Nx=S−I ¿
• This equation shows what determines saving S and investment I, and thus the trade
balance−Nx .
• Saving depends on fiscal policy: lower government purchases G or higher taxes T raise
national saving. Investment depends on the world real interest rate r*: high interest
rates make some investment projects unprofitable. Therefore, the trade balance depends
on these variables as well.The trade balance is determined by the difference between
saving and investment at the world interest rate. (please refer to the graph)
• In a closed economy, the real interest rate adjusts to equilibrate saving and
investment.But, in a small open economy, the interest rate is determined in world
financial markets. The difference between saving and investment determines the trade
balance. Here there is a trade surplus, because at the world interest rate, saving exceeds
investment.
How Policies Influence the Trade Balance
• Suppose that the economy begins in a position of balanced trade. That is, at the world
interest rate, investment I equal saving, S , and net exports Nx equal zero. Let’s use our
model to predict the effects of government policies at home and abroad.
Fiscal Policy at Home:
• What happens to the small open economy if the government expands domestic spending
by increasing government purchases? The increase in G reduces national saving,
because S=Y −C−G . With an unchanged world real interest rate, investment remains
the same. Therefore, saving falls below investment, and some investment must now be
financed by borrowing from abroad. Because NX =S−I , the fall in S implies a fall in Nx
. The economy now runs a trade deficit. (please refer to the graph)
• Because Nx is the distance between the saving schedule and the investment schedule at
the world interest rate, this shift reduces Nx . Hence, starting from balanced trade, a
change in fiscal policy that reduces national saving leads to a trade deficit.
Fiscal Policy Abroad
• What happens to a small open economy when foreign governments increase their
government purchases? Assuming these foreign countries are a large part of the world

29
 economy, and thus their increase in government purchases reduces world saving and
causes the world interest rate to rise.
• The increase in the world interest rate raises the cost of borrowing and, thus, reduces
investment in our small open economy.

Shifts in Investment Demand

• What happens to our small open economy if its investment schedule shifts outward —
that is, if the demand for investment goods at every interest rate increases?
• An outward shift in the investment schedule from I(r1) to (I(r2) increases the amount of
investment at the world interest rate r*.
• As a result, investment now exceeds saving, which means the economy is borrowing
from abroad and running a trade deficit.

Exchange Rates
• Having examined the international flows of capital and of goods and services, we now
extend the analysis by considering the prices that apply to these transactions.The
exchange rate (E) is the rate at which one currency exchanges for another.
• One may view the exchange rate as indicative of the relative price of goods and services
denominated in the currencies of the two countries concerned. There are two conventions
for measuring the exchange rate, the distinction between which can be the source of
serious confusion:
1) Domestic currency units per unit of foreign currency
• For example, if the birr is the home currency and the dollar ($) is the foreign Currency,
and 20 birr exchanges for $1, then the exchange rate is 20. The domestic currency is on
the numerator of the ratio.
• Here, whenever E rises the home currency gets weaker; it depreciates.
• For example, a rise from 20 to 21 means that 21birr exchanged for $1, less than before.
• Conversely, when E falls, the domestic currency gets stronger, it appreciates.
2) Foreign currency units per unit of domestic currency

30
• This is exactly the converse of the first convention.
• The domestic currency is on the denominator. When 20 birr is exchanged for $1, the
exchange rate is 0.05.If E rises, the home currency gets stronger, and vice versa.
Real and Nominal Exchange Rates
• The Nominal Exchange Rate (e) is the relative price of the currency of two countries.
• For example, if the exchange rate between the Ethiopian birr and the U.S dollar is 20 birr
per dollar, then you can exchange one dollar for 20 birr in the world markets for foreign
currency.The Real Exchange Rate is the relative price of the goods of two countries.
• That is, the real exchange rate tells us the rate at which we can trade the goods of one
country for the goods of another.It measures a country’s competitiveness in the
international trade.
• The real exchange rate R, is usually defined as
f
R=e . P /P
• Where P and Pf are the price levels here and abroad, respectively and e is the birr price of
foreign exchange (the nominal exchange rate). The rate at which we exchange foreign and
domestic goods depends on the prices of the goods in the local currencies and on the rate
at which the currencies are exchanged.If the real exchange rate equals 1, currencies are at
purchasing power parity (PPP).A real exchange rate above 1 means, that goods abroad
are more expensive than goods at home.
• Other things equal, this implies that people- both at home and abroad- are likely to switch
some of their spending to goods produced at home. This is often described as an increase
in the competitiveness of our products. As long as R is greater than 1, we expect the
relative demand for domestically produced goods to rise.

Exchange rate Determination/Fixed versus Flexible Exchange rate Regimes/

Flexible Exchange Rates:
• Under this system the exchange rate is completely market- determined, without any
interference from government authorities (the central bank).
• The balance of payments balances: surpluses are eliminated via exchange rates
appreciation; deficits are cured by exchange rate depreciation.
• In other words, balance of payments disequilibria are self-correcting.
Fixed Exchange Rates:
• Here the rate of exchange is a policy parameter fixed by the authorities.

31
 • They have to meet excess demand for a foreign currency (not financed by sales in that
foreign country) from their reserves of foreign currency.
• Net inflows of foreign currency swell the domestic money supply, as private economic
agents who don’t use it to purchase goods abroad convert foreign currency to domestic
money at the fixed rate of exchange.
• There is no self-correcting mechanism to balance of payments disequilibria.Between
two extremes we have: Managed float (consider the Ethiopian case).
Depreciation versus Appreciations
• A currency is said to be depreciate when under floating rates it becomes less expensive
in terms of foreign currency. By contrast, currency appreciates when it becomes more
expensive in terms of foreign money.
Devaluation Versus Revaluation
• Devaluation takes place when the price of foreign currencies under fixed exchange rate
regime is increased by official. To promote exporters and discourage importers.
• Devaluation thus means that foreigners pay less for devalued currency and that residents
of the devaluing country pay more for foreign currencies. The opposite of devaluation is
revaluation.

The Mundell-Fleming Model

• The model developed in this chapter, called the Mundell–Fleming model, is an open-
economy version of the IS – LM model.This model owes its origins to papers
published by James Flemming (1962) and Robert Mundell (1962, 1963).
• Their major contribution was to incorporate international capital movements into
formal macroeconomic models based on the Keynesian IS-LM framework.
• Their papers led to some dramatic implications concerning the effectiveness of fiscal
and monetary policy on national income.
• The Mundell–Fleming model makes one important and extreme assumption: it
assumes that the economy being studied is a small open economy with perfect capital
mobility.
• That is, the economy can borrow or lend as much as it wants in world financial
markets and, as a result, the economy’s interest rate is determined by the world
interest rate.
• One virtue of this assumption is that it simplifies the analysis: once the interest rate is
determined, we can concentrate our attention on the role of the exchange rate.

32
 • In this section, we will build the Mundell –Fleming model, and use the model to
examine the impact of various policies to discern how the economy operates under
floating and fixed exchange rate regimes and notice whether a floating or fixed
exchange rate is better.

Small Open Economy with Perfect Capital Mobility

¿
• r is determined by the world interest rate r -the small open economy being under
consideration do not affect world interest rate. Mathematically: r =r∗¿
• The r =r∗¿ equation represents the assumption that the international flow of capital is
rapid enough to keep the domestic interest rate equal to the world interest rate.
• Since r is fixed, fiscal and monetary policies will affect the IS and LM curves through
the exchangerates.

The Goods Market and the IS* Curve

• The Mundell–Fleming model describes the market for goods and services much as the
IS–LM model does, but it adds a new term for net exports.
• In particular, the goods market is represented with the following equation:
Y =C (Y −T )+ I ¿
• The net exports depend on the real exchange rate.
• The Mundell-Fleming model, however, assumes that the price levels at home and
abroad are fixed, so the real and nominal exchange rates are proportional (R=e*pf/pd)
• When the nominal exchange rate appreciates foreign goods become cheaper
compared to domestic goods, and this causes exports to fall and imports to rise, and
lowers the aggregate income. (see figure below).
• The relation of the exchange rate and aggregate income is called the IS ¿curve.
Figure:The Net-Exports Function
An increase in the exchange rate from e 1to e 2 lowers net exports from Nx ( e 1 )to Nx ( e 2 )

How changes in the exchange rate do affect income?

Figure: The Keynesian Cross
(Please Refer to planned-expenditureFigure!)

33
 • A decrease in net exports from Nx(e1) to Nx(e2) shifts the planned-expenditure
schedule downward and reduces income from Y1 to Y2 as indicated above.
• The IS* curve summarizing this relationship between the exchange rate and income:
the higher the exchange rate, the lower the level of income.
Figure:The IS ¿ Curve

The Money Market and the LM* Curve

• LM curve is derived from M / P=L(r , Y )
• The model assumes M as fixed policy variable chosen by central banks and P is also
fixed in the short-run, and thus LM curve draws combinations of r and Y satisfying the
equation written above. Since r is fixed by the world interest rate in an open economy,
the equation finds a fixed amount of income Y, i.e. to say Y is not affected by the
exchange rate.
• Hence, the LM curve, which draws the relation of the exchange rate and aggregate
income, is vertical.
• (Please Refer to the LM Figure!)
The Equilibrium/Combining the IS* and LM* Curves

Monetary and Fiscal Policy Analysis in an Open Economy with Perfect Capital Mobility
The Small Open Economy under Floating Exchange Rates
 Fiscal Policy under Floating Exchange Rates
Suppose that the government stimulates domestic spending by increasing government
purchases or by cutting taxes. Because such expansionary fiscal policy increases planned
expenditure, it shifts the IS* curve to the right, as in Figure below. As a result, the exchange
rate appreciates, whereas the level of income remains the same.(Please Refer to the Figure!)
Note the mechanism:

34
 • When income rises in a small open economy, due to the fiscal expansion, the interest
rate tries to rise but capital inflows from abroad put downward pressure on the interest
rate. This inflow causes an increase in the demand for the domestic currency pushing up
its value (the currency appreciates). The appreciation of the exchange rate makes
domestic goods expensive for foreigners, and this reduces net exports.The fall in net
exports offsets the effects of the expansionary fiscal policy on income.
• An increase in government purchases or a decrease in taxes shifts the IS* curve to the
right. This raises the exchange rate but has no effect on income.(Fiscal policy in this
case is ineffective here)
A Fiscal Expansion Under Floating Exchange Rates(Please Refer to the Figure!)
Monetary Policy under Floating Exchange Rates
• Suppose now that the central bank increases the money supply.
• Because the price level is assumed to be fixed, the increase in the money supply
means an increase in real balances.
• The increase in real balances shifts the LM* curve to the right, as in Figure below.
• Hence, an increase in the money supply raises income and lowers the exchange rate.
• (Please Refer to the Figure!)

Note the mechanism:

• When increase in themoney supply puts down ward pressure on the domestic
interest rate. Hence, capital flows out of the economy as investors seek a higher
return elsewhere. This capital outflow prevents the domestic interest rate from
falling.
• In addition, because the capital outflow increases the supply of the domestic
currency in the market for foreign-currency exchange, the exchange rate
depreciates.
• The fall in the exchange rate makes domestic goods cheap relative to foreign
goods and, thereby, stimulates net exports.
• Hence, in a small open economy, monetary policy influences income by
altering the exchange rate.
• An increase in the money supply shifts the LM* curve to the right, lowering
the exchange rate and raising income. (MP is effective in this case).
The Small Open Economy under Fixed Exchange Rates

35
 • Under a fixed exchange rate, the central bank announces a value for the exchange rate
and stands ready to buy and sell the domestic currency at a predetermined price to
keep the exchange rate at its announced level.
• i.e., the sole objective of monetary policy is to keep the exchange rate at the
announced level.
How a Fixed-Exchange-Rate System Works
• Suppose that the Ethiopian national bank announces that it is going to fix the
exchange rate at 32 birr per dollar (I.e., $0.03125 per birr).
• It would then stand ready to give 32 birr in exchange for $1 or to give $1 in exchange
for 32 birr.
• Hence, the NB would need a reserve of birr (which it can print) and a reserve of
dollars (which must have been purchased previously)
• Suppose in the current equilibrium with the current money supply, the exchange rate
is 20 birr per dollar ($0.05 per birr) that is higher than 32 birr per dollar determined by
the central bank.
• Arbitrageurs use their birr to buy foreign currency in foreign-exchange markets and
sell it to the domestic national bank for a profit.
• This process automatically increases the money supply (the base money)-shifting the
LM ¿ curve to the right and lowers the exchange rate as the table below presents.
Figure: Whenthe equilibrium exchange rate is greater than the fixed exchange rate

(Reversing)
• Suppose the equilibrium exchange rate is lower than the fixed exchange rate.
• Arbitrageurs will buy birr in foreign-exchange markets and use them to buy foreign
currency from national bank of Ethiopia.
• This process automatically reduces the money supply, shifting the LM ¿ curve to the
left and raises the exchange rate as figure , presents.
When the equilibrium exchange rate is less than the fixed exchange rate
• (Please Refer to the Figure!)
Fiscal Policy under Fixed Exchange Rates

36
• Suppose that the government stimulates domestic spending by increasing government
purchases or by cutting taxes.
• This policy shifts the IS* curve to the right, as in Figure, putting upward pressure on
the exchange rate.
• But because the central bank stands ready to trade foreign and domestic currency at
the fixed exchange rate, arbitrageurs quickly respond to the rising exchange rate by
selling foreign currency to the central bank, leading to anautomatic monetary
¿
expansion.The rise in the money supply (in the base money) shifts the LM curve to
the right. Thus, under a fixed exchange rate, a fiscal expansion raises aggregate
income. (PF is effective in this case).

• A fiscal expansion shifts the IS* curve to the right.

• To maintain the fixed exchange rate, the central bank must increase the money
supply, thereby shifting the LM* curve to the right.
• Hence, in contrast to the case of floating exchange rates, under fixed exchange rates a
fiscal expansion raises income.
Monetary Policy under Fixed Exchange Rates
• Imagine that a central bank operating with a fixed exchange rate were to try toincrease
the money supply —for example, by buying bonds from the public. Whatwould
happen? The initial impact of this policy is to shift the LM* curve to theright,
lowering the exchange rate, as in Figure below.
• Hence, monetary policy is ineffectual under a fixed exchange rate. By agreeing to fix
the exchange rate, the central bank gives up its control over the money supply.
• (Please Refer to the Figure!)
• If the National bank tries to increase the money supply -for example, by buying bonds
from the public—it will put downward pressure on the exchange rate.
• To maintain the fixed exchange rate, the money supply and the LM* curve must return
to their initial positions. Hence, under fixed exchange rates, monetary policy is
ineffectual.

37
The Mundell-Fleming Model with a Changing Price Level
¿ ¿
• The IS −LM model is constructed for fixed price level.
• However, a change in the price level shifts the LM ¿ curve and changes the
equilibrium income.
• Consider reduction in the price level. When the price level falls, the LM* curve shifts
to the right. The equilibrium level of income rises.

The Short-Run and Long-Run

Equilibria in aSmall Open Economy
• Now let’s compare the short-run and the long-run equilibrium of the economy using
the IS ¿−LM ¿ and aggregate demand-aggregate supply models.
• Point K in both panels shows the equilibrium under the Keynesian assumption that the
price level is fixed at P1.
• Point C in both panels shows the equilibrium under the classical assumption that the
price level adjusts to maintain income at its natural rate Y .

CHAPTER FIVE: AGGREGATE SUPPLY

5.1 The Classical approach to aggregate supply
• In previous section we have analyzed the demand side of the economy taking the
price level p as exogenously determined. This section develops the supply side of
macro economy.
• By equating SS and DD in the economy we obtainendogenously determined
equilibrium values of output and the price level. we focus on different aggregate
supply models.
• Aggregate supply is the relationship between quantity of goods and services
supplied and the price level.
38
 • We need to discuss two different aggregate supply curves:
• long run aggregate supply curve LRAS (the classical supply curve) and
• short-run aggregate supply curve SRAS (the Keynesian supply curve)
• Finally an attempt will be made to present four prominent models of short-run
aggregate supply curve.

The Long Run: the Vertical Aggregate Supply Curve

 Classical model describes how the economy behaves in the long run;we derive the
long-run aggregate supply curve from the classical model.
 The classical aggregate supply curve is vertical,
 it is indicating that the same amount of goods will be supplied whatever the
price level or
 output does not depend on the price level
 The classical supply curve is based on the assumption
 labor market is in equilibrium with full employment of labor

 If the aggregate supply curve is vertical, then changes in aggregate demand affect
prices but not output. For example, if the money supply falls, the aggregate demand
curve shifts downwards. The economy moves from point A to point B.
 If it is an increase in money supply, the economy moves from A to C.The shift in
aggregate demand affects only prices.

39
 The classical model and the vertical aggregate supply curve apply only in the long run.
 In the short run, some prices are sticky and, therefore, do not adjust to changes in
demand.
 Because of this price stickiness, short run aggregate supply curve is not vertical
 This is what we call the Keynesian aggregate supply curve.
 In the extreme Keynesian case Aggregate supply curve is horizontal.

 The idea underlying the Keynesian aggregate supply curve is that because there is
unemployment, firms can obtain as much labor as they want at the current wage.
 Their average costs of production therefore are assumed not to change as their output
levels change. The short run equilibrium of the economy is obtained at the intersection
of the AD curve and the horizontal AS curve. Suppose central bank reduces the money
supply and aggregate demand curve shifts downward.
 In the short run, prices are sticky, so the economy moves from point A to point B.
 Output and employment fall below their natural levels, which means the economy, is
in recession. Over time, in response to the low demand, wages and prices fall.
 The gradual reduction in the price level moves the economy down ward along the
aggregate demand curve to pint C, which is the new long run equilibrium.

5.2 The Keynesian approach to aggregate supply

5.2.1 The Four Models of Aggregate Supply

40
  In the previous section the IS-LM model shows how changes in monetary and fiscal
policy to the money and goods market shift the aggregate demand curve.
 In the long run, prices are flexible, and the aggregate supply curve is vertical.
 When the aggregate supply curve is vertical, shifts in the aggregate demand curve
affects the price level, but output remains unchanged.
 In the short run, prices are sticky, and the aggregate supply curve is not vertical.
 In this case, shifts in the aggregate demand do cause fluctuations in output.
 In this section we study four models of short-run AS curve.
 Although these models differ in some significant details, but with common conclusion
that short-run aggregate supply curve is upward sloping.

Aggregate supply equation of the form:

 Where Y is output, is the natural rate of output, p is the price level, and pe is the
expected price level.
 This equation states that output deviates from its natural rate when the price level
deviates from the expected price level.
 The parameter α indicates how much output responds to unexpected changes in the
price level.
 Each of these models tells different story about what lies behind this short-run
aggregate supply equation.
 Different models of aggregate supply:
 The Sticky – Price Model  The Sticky- Wage Model
 The Imperfect Information  The workers-misperception
Model model

Course Title: Macroeconomics II

Course Code: Econ 1032
Course Objective:
This course has the objective of providing students with the basics of macroeconomic
analysis. The course is thus supposed to let students understand the fundamentals of the
interactions of economic agents at the aggregate level. With this perspective, students are
expected to acquire at least the framework to further analyze the aggregate interactions
among economic agents themselves and the outcomes that these interactions generate in the
economy at some level of aggregation. This is fundamentally based on the wealth of

41
macroeconomic theories that can be ascribed to the classical and Keynesian schools of
thought.

Chapter One

Behavioural Foundations: Theories of Consumption

Topics under discussion:
 John Maynard Keynes and the Consumption Function
 Irving Fisher and Intertemporal Choice
 Franco Modigliani and the life-cycle Hypothesis
 Milton Friedman and the Permanent-Income Hypothesis
 Robert Hall and the Random-Walk Hypothesis
This chapter presents the views of five prominent economists to show the diverse approaches
to explaining consumption.

John Maynard Keynes and the Consumption Function

The consumption function exhibits three properties that Keynes conjectured.
 The marginal propensity to consume c is between zero and one.
 b/c, when a person earns an extra dollar, he typically spends some of it and saves
some of it .
 The average propensity to consume falls as income rises.
 He believed that saving was a luxury, so he expected the rich to save a higher
proportion of their income than the poor
 Consumption is determined by current income.
 income is the primary determinant of consumption
Keynesian consumption function is often written as:

 whereC is consumption, Y is disposable income, C is a constant, and c is the marginal

propensity to consume.
 This consumption function, shown in Figure 1.1, is graphed as a straight line.
 Notice that this consumption function exhibits the three properties that Keynes
posited.
 It satisfies 1st property b/c the MPC is between zero and one,
 so that higher income leads to higher consumption and also to higher saving

42
  It satisfies 2nd property b/c the APC is

 As Y rises, C/Y falls, and so the APC i.e. C/Y falls. And
 Finally, this consumption function satisfies 3rd property b/c
 the interest rate is not included in this equation
The Early Empirical Successes
 Soon after Keynes economists began collecting and examining data to test his
conjectures.
 The earliest studies indicated that the Keynesian consumption function was a good
approximation of how consumers behave.
 They found that HHs with higher income consumed more, which confirms that the
MPC is greater than zero.
 They also found that HHs with higher income saved more, which confirms that
the MPC is less than one.
 In addition, they found that higher-income HHs saved a larger fraction of their
income, which confirms that the APC falls as income rises.
 Thus, these data verified Keynes’s conjectures about the marginal and average
propensities to consume.
 In other studies, researchers examined aggregate data on consumption and income for
the period between the two world wars.
 These data also supported the Keynesian consumption function.
 In years when income was unusually low, such as during the depths of the Great
Depression, both consumption and saving were low,
 indicating that the MPC is between zero and one.
 In addition, during those years of low income,
 the ratio of consumption to income was high, confirming 2nd
conjecture.
 Finally, because the correlation between income and consumption was so strong,
 no other variable appeared to be important for explaining consumption.
Therefore, it confirmed Keynes’s third conjecture that income is the primary determinant of
how much people choose to consume.

43
Secular Stagnation, Simon Kuznets, and the Consumption Puzzle
 Although the Keynesian consumption function met with early successes, two anomalies
soon arose.
 Both concern Keynes’s conjecture that the APC falls as income rises.
The first anomalysome economists made erroneous—prediction during World War II.
 They reasoned that:
 as incomes in the economy grew over time, households would consume a
smaller and smaller fraction of their incomes.
 They feared that there might not be enough profitable investment projects to
absorb all this saving.
 After the end of World War II incomes were much higher after the war than before,
these higher incomes did not lead to large increases in the rate of saving.
Keynes’s conjecture that the average propensity to consume would fall as income rose
appeared not to hold.
The second anomaly arose when economist Simon Kuznetdiscovered that the ratio of
consumption to income was remarkably stable from decade to decade, despite large increases
in income over the period he studied.
 Again, Keynes’s conjecture that the average propensity to consume would fall as
income rose appeared not to hold.
 The failure of the secular-stagnation hypothesis and the findings of Kuznets
 both indicated that the average propensity to consume is fairly constant over
long periods of time.
 Conclusion, two consumption functions:
 The short time-series, the Keynesian consumption function appeared to work well.
 Yet for the long time-series, the consumption function appeared to exhibit
a constant average propensity to consume.
 These two r/ps b/n consumption and income are called the short-run and long-run
consumption functions.
 Economists needed to explain how these two consumption functions could be
consistent with each other.
 In the 1950s, Franco Modigliani and Milton Friedman each proposed explanations of
these seemingly contradictory findings.

44
Irving Fisher and Intertemporal Choice
 The consumption function introduced by Keynes relatescurrent consumption to
current income.
 This relationship, however, is incomplete at best.
 When people decide how much to consume and how much to save, they consider
both the present and the future.
 The more consumption they enjoy today, the less they will be able to enjoy
tomorrow.
 In making this tradeoff, HHs must look ahead to the income they expect to receive
in the future and to the consumption of goods and services they hope to be able to
afford.
 The economist Irving Fisher developed the model with which economists analyze
how rational, forward-looking consumers make intertemporal choices— that is,
choices involving different periods of time.
Fisher’s model illuminates
 the constraints consumers face, the preferences they have, and how these
constraints and preferences together determine their choices about
consumption and saving
1.1.1 The Intertemporal Budget Constraint
 Most people would prefer to increase the quantity or quality of the goods and services
they consumeto wear nicer clothes, eat at better restaurants, or see more movies.
 The reason people consume less than they desire is thattheir consumption is
constrained by their income, called a budget constraint.
 Our first step in developing Fisher’s model is to examine this constraint in some
detail.
 To keep things simple, we examine the decision facing a consumer who lives for two
periods.
 Period one represents the consumer’s youth, and
 period two represents the consumer’s old age
 The consumer earns income Y1 and consumes C1 in period one, andearns income Y2
and consumes C2 in period two.
 (All variables are real—that is, adjusted for inflation.)

45
 Because the consumer has the opportunity to borrow and save, consumption in any
single period can be either greater or less than income in that period.
 Consider how the consumer’s income in the two periods constrains consumption in
the two periods.
 In the first period, saving equals income minus consumption. That is,

 whereS is saving. --------------------------1

 In the second period, consumption equals the accumulated saving, including the
interest earned on that saving, plus second-period income.

 That is, -----------------------2

 For example, if the real interest rate is 5 percent, then for every $1 of saving in period
one, the consumer enjoys an extra $1.05 of consumption in period two.
 Because there is no third period, the consumer does not save in the second period.
 Note that the variable S can represent either saving or borrowing.
 If first-period consumption is less than first-period income, the consumer is saving,
and S is greater than zero.
 If first-period consumption exceeds first-period income, the consumer is borrowing,
and S is less than zero.
 For simplicity, we assume that the interest rate for(borrowing = saving).
 To derive the budget constraint, combine the two equations.
 Substitute the 1st equation for S into the 2nd equation to obtain
C2 = (1 + r)(Y1 − C1) + Y2
 To make the equation easier to interpret, we must rearrange terms.
 To place all the consumption terms together, bring (1 + r)C1 from the right-hand side
to the left-hand side of the equation to obtain (1 + r)C1 + C2 = (1 + r)Y1 + Y2.
 Now divide both sides by 1 + r to obtain
 This equation relates consumption in the two periods to income in the two periods.
 It is the standard way of expressing the consumer’s intertemporal budget constraint.
1.3.2 Consumer Preferences
 The consumer’s preferences regarding consumption in the two periods can be
represented by indifference curves.

46
  An indifference curve shows the combinations of 1st-period and 2nd-period
consumption that make the consumer equally happy.
 The consumer is indifferent among combinations W, X, and Y, because they are all
on the same curve.
 if the consumer’s first-period consumption is reduced, say from point W to point X,
second-period consumption must increase to keep him equally happy.
 The consumer is equally happy at all points on a given indifference curve, but he
prefers some indifference curves to others.
 Because he prefers more consumption to less, he prefers higher indifference
curves to lower ones.
 The set of indifference curves gives a complete ranking of the consumer’s
preferences.
 It tells us that the consumer prefers point Z to point W, but that should be
obvious because point Z has more consumption in both periods.
1.1.2 Optimization
 The consumer would like to end up with the best possible combination of consumption in
the two periods—that is, on the highest possible indifference curve.
 The highest indifference curve that the consumer can obtain without violating the budget
constraint is the indifference curve that just barely touches the budget line, which is curve
IC3 in the figure.
 The point at which the curve and line touch—point O, for “optimum”—is the best
combination of consumption in the two periods that the consumer can afford.
 Notice that, at the optimum, the slope of the indifference curve equals the slope of the
budget line.
 The indifference curve is tangent to the budget line.
 The slope of the indifference curve is the marginal rate of substitution MRS, and the slope
of the budget line is 1 plus the real interest rate.
 We conclude that at point O MRS = 1 + r.
 The consumer chooses consumption in the two periods such that the marginal rate of
substitution equals 1 plus the real interest rate.

47
Franco Modigliani and the life-cycle Hypothesis
 In the 1950’s, Franco Modigliani, Ando and Brumberg used Fisher’s model of
consumer behavior to study the consumption function.
 One of their goals was to study the consumption puzzle.
 According to Fisher’s model, consumption depends on a person’s lifetime income.
 Modigliani emphasized thatincome varies systematically over people’s lives and
saving allows consumers to move income from those times in life when income is
high to those times when income is low.
The Hypothesis
 Most people plan to stop working at about age 65, and they expect their incomes to
fall when they retire, but don’t want a drop in standard of living characterized by
consumption.Suppose a consumer expects to live another T years, has wealth of W
and expects to earn income Y until she retires R years from now.
 What level of consumption will the consumer choose to have a smooth consumption
over her life?
The Life-cycle Consumption Function
 The Lifetime resources of consumer for T years are wealth W and lifetime earnings
of R x Y (assuming interest rate to be zero).
 To have smoothest consumption over lifetime, she divides such that
C = (W + RY) / T or
C = (1 / T)W + (R / T)Y
 If she expects T = 50 and R = 30, then the consumption function will be
C = 1 / 50W + 30/50Y or
C = 0.02W + 0.6Y
 This equation says that consumption depends on both income and wealth.
 An extra $1 of income per year raises consumption by $0.60 per year,
and an extra $1 of wealth raises consumption by $0.02 per year.
 Generalizing for Aggregate Consumption function of the economy:

48
 C = αW + βY
Where, α = MPC out of Wealth
β = MPC out of Income
 The life-cycle model says that consumption depends on wealth as well as income.
 As a result, the intercept of the consumption function αW depends on wealth.
 According to Life-cycle consumption function,
APC = C/Y = α(W/Y) + β
 Because, in short periods,wealth does not vary proportionately with incomes, High
incomes corresponds to Low APC.
 But over longer periods,wealth and incomes grow together, resulting in constant W/Y
ratio and hence a constant APC.

Milton Friedman and the Permanent-Income Hypothesis

 In 1957, Milton Friedman proposed the permanent-income hypothesis to explain
consumer behavior.
 Its essence is that current consumption is proportional to permanent income.
 Friedman’s permanent-income hypothesis complements Modigliani’s life-cycle
hypothesis:
 both use Fisher’s theory of consumption should not depend on current
income alone.
 But unlike the life-cycle hypothesis,
 which emphasizes that income follows a regular pattern over a person’s lifetime,
 permanent-income hypothesis emphasizes that people experience random and
temporary changes in their incomes from year to year.
 Friedman suggested that current income Y as the sum of two components, permanent
income YP and transitory income YT.
Y = Y P + YT
 Permanent Income is the part of income that people expect to persist in the future.
 Transitory income is the part of income that people do not expect to persist.
 Friedman reasoned that consumption should depend primarily on permanent income
 b/c consumers use savings and borrowings to smooth consumption in response to
transitory changes in income.
 Friedman approximation of consumption function is:
C = αYP

49
  While Average propensity to consume is:
APC = C/Y = αYP /Y, When Y > YP , APC Falls, When Y < YP , APC rises

Robert Hall and the Random-Walk Hypothesis

 Robert Hall was first to derive the implications of rational expectations for
consumption.
 He showed that if the permanent-income hypothesis is correct, and if consumers have
rational expectations, then changes in consumption over time should be unpredictable.
 When changes in a variable are unpredictable, the variable is said to follow a random
walk.
 According to Hall, the combination of the permanent-income hypothesis andrational
expectations implies that consumption follows a random walk.
CHAPTER TWO

INVESTMENT THEORY
 Investment is the most volatile component of GDP.
 When expenditure on goods and services fall during a recession, much of the decline
is usually due to a drop in investment spending.
 The models of GDP, such as IS-LM model, were based on a simple investment
function relating investment to real interest rate: I = I(r)
 That function states that an increase in the real interest rate reduces Investment.
 Here we look more closely at the theory behind this investment function.

Three types of Investment Spending

1) Business fixed investment: includes the equipment and structures that businesses buy
to use in production.
2) Residential investment: includes the new housing that people buy to live in and that
landlords buy to rent out.
3) Inventory investment: includes those goods that businesses put aside in storage,
including materials and supplies, work in progress, and finished goods.
 We shall build models of each type of investment to explain the fluctuations in the
economy.
 Also these models will shed light on the questions such as:
 Why investment is negatively related to the interest rate?
 What causes investment function to shift?

50
  Why does investment rise during booms and fall during recessions?
2.1.1Business Fixed Investment
 The largest piece of investment spending (about ¾ of total) is business fixed
investment.
 Business: these investment goods are bought by firms for use in future
production.
 Business Fixed investment includes everything from fax machines to factories,
computers to company cars.
 The standard model of business fixed investment is called the neoclassical model of
investment.
 It examines the benefits and costs of owning capital goods.
 Here are three variables that shift investment: or the level of investment/the
addition to the stock of capital related to:
 marginal product of capital
 interest rate
 tax rules affecting firms
 To develop the model, imagine that there are two kinds of firms in the economy:
 production firms that produce goods and services using the capital that they rent
 Rental firms that make all the investments in the economy. they buy capital and
rent it out to the production firms.
i. The Rental Price of Capital
 A typical production firm decides how much capital to rent by comparing the cost and
benefit of each unit of capital.
 The firm rents Capital at a rental rate R and sells its output at a price P
 The real cost of a unit of capital to the production firm is R/P
 The real benefit of a unit of capital is the marginal product of capital, MPK (the extra
output produced with one more unit of capital)
 MPK falls as the amount of capital rises.
 To maximize profit, the firm rents capital until the marginal product of capital falls to
equal the real rental price.(see figure below)
MPK = R/P
 Hence MPK determines the downward sloping demand curve for capital for a firm

51
 While at point in time, the amount of capital in an economy is fixed, so supply curve is
fixed.
 So, to maximize profit, the firm rents capital until the MPK falls to:
 The real rental price of capital adjusts to equilibrate the demand for capital
(determined by the marginal product of capital) and the fixed supply.
 The Cobb-Douglas production function serves as a good approximation of how the
actual economy turns capital and labor into goods and services

 The Cobb-Douglas production function is:

where
Y Þ is output, KÞ capital , L Þ labor
 A Þa parameter measuring the level of technology
 αÞ a parameter between 0 and 1 that measures capital’s share of output.
 The marginal product of capital (MPK) for the Cobb-Douglas production function is:
 MPK = αA(L/K)1-α
 Because the real rental price (R/P) equals MPK in equilibrium, we can write:
R/P = αA(L/K)1-α
 This expression identifies the variables that determine the real rental price. It shows the
following:
 The lower the stock of capital, the higher the real rental price of capital
 The greater the amount of labor employed, the higher the real rental price of capitals
 The better the technology, the higher the real rental price of capital.
 Events that reduce the capital stock, or raise employment, or improve the
technology,raise the equilibrium real rental price of capital.
i. The Cost of Capital
 The Rental firms, just like car rental firms merely buy capital goods and rent them out.
 Let’s consider the benefit and cost of owning capital.
 The benefit of owning capital is the real rental price of capital R/P for each unit of
capital it owns and rents out.
 For each period of time that a firm rents out a unit of capital, the rental firm bears three
costs:
 Interest on their loans, which equals the purchase price of a unit of capital PK times the
interest rate, i, so iPK

52
 The cost of the loss or gain on the price of capital denoted as -DPK
 The minus sign is here because we are measuring costs, not benefits.
 Depreciation d defined as the fraction of value lost per period because of the wear and
tear, so dPK
Total cost of capital = iPK - DPK + dPK
= PK (i - DPK/PK + d)
 The cost of capital depends upon the price of capital, the interest rate, rate of change of
capital prices and the depreciation rate.
 Example: A Car rental company
 Buys cars for $1,000,000 each and rents them out to other businesses
 If it faces an interest rate i of 10% per year, so the interest cost, iPk = $100,000 per
year for each car the company owns.
 Car prices are rising at 6% per year, so excluding maintenance costs the firm gets a
capital gain, DPk= $60,000 per year
 Cars depreciate at 20% per year so,loss due to wear and tear, dPk= $200,000
 So, Total cost of capital = iPK - DPK + dPK
= 100,000 – 60,000 +200,000
= $240,000
 The cost to the car-rental company of keeping a car in its capital stock is $2,400/ year.
 To make the expression for the cost of capital simpler and easier to interpret, we
assume that the price of capital goods rises with the prices of other goods.
 In this case, DPK/PK equals the overall rate of inflation p. Because i-π equals the real
interest rate r, we can write the cost of capital as
Cost of Capital = PK(r + d).
 This equation states that the cost of capital depends on the
 price of capital,
 the real interest rate, and
 the depreciation rate.
 Finally, we want to express the cost of capital relative to other goods in the economy.
 The real cost of capital—the cost of buying and renting out a unit of capital
measured in units of the economy’s output—is
 Real Cost of Capital = (PK/P)(r +d ).

53
 This equation states that the real cost of capital depends on the relative price of a
capital good PK/P, the real interest rate r, and the depreciation rate d.
The Determinants of Investment
 Now consider a rental firm’s decision about whether to increase or decrease its capital
stock.
 For each unit of capital, the firm earns real revenue R/P and bears the real cost (P K /P)
(r+d).
 The real profit per unit of capital is
Profit rate = Revenue – Cost = R/P - (PK /P) (r+d)
 Because real rental price equals the marginal product of capital, we can write the
profit rate as: Profit rate = MPK - (PK / P)(r + d)
 The change in the capital stock, called net investment depends on the difference
between the MPK and the cost of capital.
 If the MPK exceeds the cost of capital, firms will add to their capital stock.
 If the MPK falls short of the cost of capital, they let their capital stock shrink.
 Thus:
DK = In [MPK - (PK / P )(r + d)]
 where In ( ) is the function showing how much net investment responds to the
incentive to invest.
 We can now derive the investment function in the neoclassical model of investment.
 Total spending on business fixed investment is the sum of net investment and the
replacement of depreciated capital.

 This model shows why investment depends on the real interest rate.
 A decrease in the real interest rate lowers the cost of capital. It therefore raises the
amount of profit from owning the capital and increases the incentive to accumulate
more capital.

54
  Similarly an increase in real interest rate raises cost of capital and leads the firms to
reduce their investment.
The Stock Market and Tobin’s q
 The term stock refers to the shares in the ownership of corporations
 The stock market is the market in which these shares are traded.
 The Nobel-Prize-winning economist James Tobin proposed that firms base their
investment decisions on the following ratio, which is now called Tobin’s q:

 The numerator of Tobin’s q is the value of the economy’s capital as determined by the
stock market.
 The denominator is the price of capital as if it were purchased today.
 Tobin conveyed that net investment should depend on whether q is greater or less than 1.
 If q is greater than 1, then the stock market values installed capital at more than
its replacement cost, the firms raise the value of their stock by increasing capital.
 If q is less than 1, the stock market values capital at less than its replacement
cost. In this case, managers will not replace capital as it wears out.

Residential Investment
 We will now consider the determinants of residential investment by looking at a simple
model of the housing market.
 Residential investment includes the purchase of new housing both by people who plan to
live in it themselves and by landlords who plan to rent it to others.
 To keep things simple, we shall assume that all housing is owner-occupied.
 There are two parts to the model:
1) The market for the existing stock of houses determines the equilibrium housing price
2) The housing price determines the flow of residential investment
 The relative price of housing adjusts to equilibrate supply and demand for the existing
stock of housing capital.
 Construction firms buy materials and hire labor to build the houses and then sell them at
market price.
 Their costs depend on the overall price level P while their revenue depends on the price
of houses PH. The Higher the PH, the greater incentive to build house.

55
 This model of residential investment is much similar to q theory of business fixed
investment, which states that business fixed investment depends on the market price of
installed capital relative to its replacement cost, which in turn depends on expected
profits from owning installed capital
 The residential investment depends on the relative price of housing, which in turn
depends on demand for housing, depending on the imputed rent that individuals expect
to receive from their housing
 When the demand for housing shifts, the equilibrium price of housing changes, and this
change in turn affects residential investment. An increase in housing demand, perhaps
due to a fall in the interest rate, raises housing prices and residential investment.
2.3 Inventory Investment
• Inventory investment, the goods that businesses put aside in storage, is at the same
time negligible and of great significance.
• It is one of the smallest components of spending, yet its volatility makes it critical in
the study of economic fluctuations.
• In recession, firms stop replenishing their inventory as goods are sold, and inventory
investment becomes negative
Reasons for Holding Inventories
 production smoothing  stock-out avoidance
 inventories as a factor of  work in process
production
The Accelerator Model of Inventories
 The accelerator model assumes that firms hold a stock of inventories that is
proportional to the firm’s level of output.
 When output is high, manufacturing firms need more materials and supplies on hand,
and more goods in process of completion.
 When Economy is booming, retail firms want to have more merchandise on their
shelves to show customers.
 Thus, if N is the economy’s stock of inventories and Y is output, then
N = bY
 Where, b is a parameter reflecting how much inventory firms wish to hold as a
proportion of output.
 Inventory investment I is the change in the stock of inventories DN.

56
 Therefore,I = DN = b DY
 The accelerator model predicts that inventory investment is proportional to the change
in output
 When output rises, firms want to hold a larger stock of inventory, so inventory
investment is high
 When output falls, firms want to hold a smaller stock of inventory, so they allow their
inventory to run down, and inventory investment is negative.
 The model says that inventory investment depends on whether the economy is
speeding up or slowing down.
Chapter 3: Money Demand and Money Supply
3.1 Banks’ role in the Money Supply
 The money supply equals currency plus demand (checking account) deposits:
M= C + D
 Since the money supply includes demand deposits, the banking system plays an
important role.
A few preliminaries:
 Reserves (R): the portion of deposits that banks have not lent.
 A bank’s liabilities include deposits,assets include reserves and outstanding loans.
 100-percent-reserve banking: a system in which banks hold all deposits as reserves.
 Fractional-reserve banking:a system in which banks hold a fraction of their deposits
as reserves.
To understand the role of banks, we will consider three scenarios:
a) No banks
b) 100-percent reserve banking (banks hold all deposits as reserves)
c) Fractional-reserve banking (banks hold a fraction of deposits as reserves, use the rest
to make loans)
 In each scenario, we assume C = $1000.
SCENARIO 1: No banks with no banks, D = 0 and M = C = $1000.

57
58
59
Three instruments of monetary policy
1) Open-market operations
2) Reserve requirements
3) The discount rate
Open-market operations
 Definition:
The purchase or sale of government bonds by the Federal Reserve.
 how it works:
If Fed buys bonds from the public, it pays with new dollars, increasing B and
therefore M.
Reserve requirements
 Definition:
Fed regulations that require banks to hold a minimum reserve-deposit ratio.
 how it works:
Reserve requirements affect rr and m: If Fed reduces reserve requirements,
then banks can make more loans and “create” more money from each deposit.
The discount rate
 Definition:
The interest rate that the Fed charges on loans it makes to banks.
 how it works:
 When banks borrow from the Fed, their reserves increase, allowing them to make more
loans and “create” more money. The Fed can increase B by lowering the discount rate
to induce banks to borrow more reserves from the Fed.

60
Which instrument is used most often?
 Open-market operations:most frequently used.
 Changes in reserve requirements: least frequently used.
 Changes in the discount rate: largely symbolic.
The Fed is a “lender of last resort,” does not usually make loans to banks on demand.
New Instruments of Monetary Policy
 Financial Crisis led Fed to use New Tools
 Term Auction Facility:
 Allows banks to borrow reserves through an auction mechanism.
 Affects the monetary base just like borrowing through the discount
window.
 Paying Interest on Reserves:
 Higher interest rate on reserves held on deposit at the Fed leads banks to
hold more reserves.
 Affects the reserve-deposit ratio and, in turn, the money multiplier.
Money Demand
Two types of theories
 Portfolio theories
 emphasize “store of value” function
 relevant for M2, M3
 not relevant for M1. (As a store of value, M1 is dominated by other assets.)
 Transactions theories
 emphasize “medium of exchange” function
 also relevant for M1
A simple portfolio theory

where
rs = expected real return on stocks
rb = expected real return on bonds
πe = expected inflation rate
W= real wealth
The Baumol-Tobin Model
 a transactions theory of money demand

61
  notation:
Y= total spending, done gradually over the year
i= interest rate on savings account
N= number of trips consumer makes to the bank to withdraw money from savings account
F = cost of a trip to the bank (e.g., if a trip takes 15 minutes and consumer’s wage =$12/hour,
then F = $3).
Chapter 4: The Labour Market
Chapter Objectives:
At the end of this chapter you will be able to:
 Elaborate how people make choices between leisure and hours of work
 Identify the income and substitution effects of a wage increase on labour supply
 Mention and discuss the determinants of labour demand
 Show how the interaction b/n supply of and demand for labour determines wage rate
and employment in the neoclassical model of labour market
 Distinguish between the Neoclassical, Keynesian and New Keynesian view of the
labour market and their implications
 Mention and explain the causes of unemployment
 Discuss how government policy interventions & firms decision affects employment
4.1 Introduction
We have learnt about two major components of GDP, consumption and investment. We
discussed the exports, and imports in the first half of the course. Another way of
measuring GDP is through the income approach, which involves factors of production.
Labor market is where an important factor of production is traded with implications for
the level of output produced.
In this section, therefore, we will attempt to learn how the labor market works by looking
at neoclassical microeconomics model and the New Keynesian view of the labour market.

Neoclassical Microeconomics Model Of The Labour Market

The Neoclassical Theory of Labor Supply
To hold a paid job, you must first have decided to do so. This is the starting point of the so-
called ‘‘Neoclassical’’ theory of labour supply. It posits that each individual disposes of a
limited amount of time, which s/he chooses to allocate between paid work and leisure.
 As such, the Neoclassical theory of labour supply is based on a model of a consumer
making a choice between consuming goods and leisure.

62
 Choice Between Consumption and Leisure
It is assumed that consumer derives utility from two sources:
The quantity of consumer goods (aggregated to C with price normalized to unity)and the
amount of leisure(time devoted to other activities than work, denoted by L)
Two key assumptions used by the model:
i. People act to maximize their welfare, or utility (i.e. people do the best they can with what
they have).
ii. People experience diminishing marginal benefit to consuming extra consumption goods or
extra leisure (i.e. their welfare goes up but at a diminishing rate).
We assume that a worker wants to achieve the mix of real income and leisure that is most
satisfactory to him or her. To develop the labour supply model, we use the microeconomics
model of consumer behavior where the consumer maximizes utility subject to his/her budget
constraint.
A. Consumer’s Preferences
The trade-off b/n consumption and leisure can be depicted by the help of indifference curve
analysis of a utility function, U(C, L), where C and L designate, respectively the consumption
of goods and the consumption of leisure.
The slope of the indifference curve at a given point defines the marginal rate of substitution
b/n consumption and leisure ( MRS CL).
It represents the hours of leisure which a consumer must give up in exchange for an hour of
work or consumption goods, for his/her level of satisfaction to remain unchanged.
B. Consumer’s Budget Constraint
Now let’s consider all the resources available to a person. The consumer has non-labor
income (R) and 24 hours a day which s/he can use to work and get income (where wT is
the wage income from working all the possible hours available). People can then use this
income to buy consumption goods (C) or leisure hours ( wL ). This gives us a budget
constraint of the form:
C+ wL=wT + R
This equation states that a person can use his/her income to either buy consumption goods, or
to “buy” leisure time. Here the price of the leisure time we “buy” is the opportunity cost of
that time, which simply equals the wage income we did not earn, but could have.
C. Consumer’s Choice-Optimal Allocation Of Time b/n Work and Leisure

63
So far, we have developed the consumer’s consumption-leisure preference curve and the
Consumer’s Consumption-Leisure Budget Line. Now, let’s define consumer equilibrium.
D. Effect of Wage Increase on Labor Supply
Now consider what happens to labor supply when the wage rate rises. A change in Wage rate
causes two effects:
1. Substitution Effect—as the price of leisure increases, the amount of leisure consumed
goes down, and the amount of labor services supplied increases, holding utility constant.
2. Income Effect—as people’s income increases, the amount of leisure consumed
increases, and the amount of labor services supplied decreases. We can show these two
effects graphically as follow:
Summary: The net effects of a wage increase on labour supply:
Higher wage will increase labour supply (decrease demand for leisure) if substitution
effect is stronger than income effect:
Higher wage will decrease labour supply (increase demand for leisure) if income effect is
stronger than substitution effect:
i. Labor Demand in the Neoclassical Model
So far, we have considered the supply side of the labor market in the neoclassical context.
Now, let’s consider the other part of the labour market-(I.e., Labor demand) - to add to our
supply function of the labour market.
Two key assumptions used by the model:
1. Firms act to maximise their profits.
2. There exist diminishing marginal benefits to employing extra resources (i.e.
output goes up but at a diminishing rate).
 The problem thus facing firms is to decide how much of each input to employ to
maximize profits subject to the technologies they have and prices they face.
The demand for labour is a demand for factors of production derived from demand for
final goods. Firms in a perfectly competitive market use a short run production function
(with predetermined capital stock and given technology)to maximize profits:
Y = AF (L, K )
Where Y –real output, K –given capital stock, L –amount of labour employed, A –technology.
w=MP L
What Determines Labour Demand ( L D)?
From the above math expression we can claim that: L D ( ↑ ) =f [ w ( ↓ ) , A (↑ ) , K ( ↑ ) ].

64
i. An increase in real wage reduces demand for labour (Since F ¿ <0 ).
If the real wage rate increases then this means the MC to employing labour increases. If the
firm was in equilibrium before the wage increase, it will now be making losses on the last
units of labour it employs as their MB will be lower than their MC.
This tells us that there is a negative relationship b/n the real wage and the quantity of labour
employed and can be characterized as the normal downward sloping labour demand curve,
and in fact the labour demand curve is just the MP L.
a. An increase in capital stock increases demand for labour (Since F LK >0)
b. An improvement in technology increases demand for labour(Since F L > 0)
How changes in capital stock and technology affect demand for labour?
If k increases or production technology gets better then the MP L increases, that is, each unit
of labour employed becomes more productive. This is shown graphically by an outward shift
of the MP L schedule, (or equivalently, by outward shift of the labour demand curve).

The Neoclassical Labor Market

The demand for labour is a decreasing function of the real wage rate (indicating that it is
by reducing the real wage rate that more workers can be employed). Contrary to this, the
supply of labour is an increasing function of the real wage rate (showing that it is by
increasing the real wage rate that more workers can be employed).
In general, the forces in this market act to determine both the amount of labour traded and
the level of the real wage. It is also worth noting that there is no involuntary
unemployment in this model. People may be “unemployed”, but it is only because they
choose not to work at the going real wage.
According to this model, full employment is a normal situation and any deviation from
this regarded as something abnormal, and the tendency of the economic system is to
automatically provide full employment in the labor market.

Unemployment in the Neoclassical Model

Recall that Neoclassical labour market is characterized by:
o Perfect competition and Perfect information
o Market clearing, flexible wages
o Homogenous workers
o No involuntary unemployment
Is the Neoclassical model enough to explain the performance of the labor market today?
Possible Explanations for Unemployment

65
o If wages don’t clear the market, so that there exist unemployment, why don’t they fall?

 Wage rigidity (especially downward)–minimum wage legislation

 Efficiency wages–it may be profitable for firms to pay higher wage than market-
clearing wage.
 Bargaining power of labor unions
 Heterogeneity of workers and jobs–search for jobs and matching a worker with
suitable job is costly and takes time.
Unemployment may result from the rigidity in the wage structure and interference in the
working of free market system in the form of labor union, minimum wage legislation etc.

Keynesian views of the Labor Market

It was Keynes that first acknowledges the existence of disequilibria in the labor market. He
emphasizes the possibility of downward nominal wage stickiness. However, concerning the
capacity of nominal wages reductions in restoring full employment, Keynes did not believe
that nominal wage rigidity was the main source of unemployment. As a consequence, he
asserted that nominal wage cuts were not the proper cure for unemployment.
As a result, Keynes advocated the maintenance of a stable level of nominal wages and that
authorities/governments would take positive action in order to restore full employment.
The implication is that government through monetary and fiscal policies can alter
aggregate demand, and thereby employment.Consider the IS-LM model of Keynes to
understand how this works.
IS (Investment-Saving): Y =C (Y −T (↓))+ I (r (↓))(↑)+G(↑)
M (↑)
LM (Liquidity Preferences-Money Supply): =L(r ( ↓ ) ,Y )
P
Note: Arrows indicate expansionary policies.
Expansionary policies shifts IS and LM curves to the right what provokes a shift in the same
direction of the aggregate demand fixing a new and higher level of output and employment at
a given price level. The following diagram presents how expansionary policies influences
aggregate demand which then determines employment.
a. New Keynesian View of the Labor Market
New Keynesian Economists (NKE) which obtains their inspiration from Keynes accepted the
existence of wages and price rigidity. However, unlike Keynes, NKE argued that wage
rigidity can be the source of unemployment. As a result, for NKE flexible wages would allow
the economy to maintain full employment.

66
Thus, NKE attempts to provide micro foundations for the phenomena of wages and prices
sluggish adjustments. For instance, NKE developed efficiency wages and insider-outsider
theoriesto explain why firms do not cut wages when there are unemployed workers.
i. Efficiency wages: New Keynesian economists often turn to theories of what they call
efficiency wages to explain why labour market-clearing mechanism may fail. In an
asymmetric information framework, efficiency wage models describe several reasons for
which cutting a wage adversely affect the quality or productivity of labor and increase at
the end the firm’s cost.
These theories hold that high wages make workers more productive. Hence, the influence
of wages on worker efficiency may explain the failure of firms to cut wages despite an
excess supply of labor.
ii. Insider-Outsider Theory: in this theory, it is argued that the insiders (employed workers)
have some power in determining firm’s wage and employment decision due to the
presence of turnover costs. Since for a firm it is costly to exchange insiders for outsiders
(unemployed workers), the insiders can extract a share of the economic rent generated by
such turnover costs.
b. Labour-Market Search and Unemployment
Empirical evidence has shown that the labour market in many countries is characterized by
huge gross flows of workers leaving a job and entering unemployment and vice versa. In this
section, we develop asimple model of labor-force dynamics that shows what determines the
natural rate of unemployment.
Because everyworker is either employed or unemployed, the labor force is the sum of the
employed and the unemployed:
i.e., L=E+ U
3.5.Types and Causes of Unemployment
I. Job Search and Frictional Unemployment
One reason for unemployment is that it takes time to match workers and jobs.As a matter of
fact, workers have different preferences and abilities, and jobs have different attributes.
Furthermore, the flow of information about job candidates and job vacancies is imperfect,
and the geographic mobility of workers is not instantaneous.
The unemployment caused by the time it takes workers to search for a job is called frictional
unemployment.

67
Economists call a change in the composition of demand among industries or regions a
sectoral shift. Because sectoral shifts are always occurring, and because it takes time for
workers to change sectors, there is always frictional unemployment.
II. Cyclical Unemployment
It is the unemployment that accompanies fluctuations in real GDP and sometimes called
“Demand deficient unemployment”.
 Reflects business cycle conditions
 When there is a general downturn in business activity, cyclical unemployment rises.
III. Seasonal Unemployment
A product of regular, recurring changes in the hiring needs of certain industries on a
monthly or seasonal basis.
IV.Real-Wage Rigidity and Structural Unemployment
Wage rigidity refers to the failure of wages to adjust until labor supply equals labor demand.
The unemployment resulting from wage rigidity is called structural unemployment.
Minimum-Wage Laws
The government causes wage rigidity when it prevents wages from falling to equilibrium
levels. Minimum-wage laws set a legal minimum on the wages that firms pay their
employees. For most workers, this minimum wage is not binding, because they earn well
above the minimum. Yet for some workers, especially teenagers and unskilled
workers,minimum-wage laws have significant unemployment impacts since it raises their
wage above Policy Options to Solve Unemployment caused by Minimum wage Laws
i. Tax credits: Minimum wage increases are designed to help the working poor. However, it
causes unemployment.
ii. Subsidizing unskilled labor: the government by subsidizing unskilled labor could push
the labor demand up so that employment would be better.
iii. The government can directly employ some unskilled workers at the goingminimum
wage. Again, the demand for unskilled labor shifts to the right andunemployment is
reduced.
 N.B: For all the three options discussed above, there is a revenue requirement onthe
part of the government.
A. Provision of training to unskilled workers by the government: By making unskilled
labor more productive, it is possible to stimulate the demand for those workers and
employment.

68
B. Unions and Collective Bargaining
Another cause of wage rigidity is the monopoly power of unions. In Sweden 84 percent of
workers, and in the United States, only 18 percent of workers belong to unions. Often, union
contracts set wages above the equilibrium level and allow the firm to decide how many
workers to employ.
C. Efficiency Wages
Efficiency-wage theories propose a third cause of wage rigidity in addition to minimum-wage
laws and unionization. These theories hold that high wages make workers more productive.
The influence of wages on worker efficiency may explain the failure of firms to cut wages
despite an excess supply of labor. Even though a wage reduction would lower a firm’s wage
bill, it would also lower worker productivity and the firm’s profits.
 Economists have proposed various reasons to explain how wages affect worker
productivity
1. Wages influence nutrition (which is applied mostly to poorer countries)
2. High wages reduce labor turnover
3. The average quality of a firm’s workforce depends on the wage it pays its employees
4. High wage improves worker effort

CHAPTER FIVE

Macroeconomic Policy Debates: Stabilization Policy

 In this chapter we ask two questions that arise in this debate.
 First, should monetary and fiscal policy take an active role in trying to stabilize the
economy, or should policy remain passive?
 Second, should policymakers be free to use their discretion in responding to changing
economic conditions, or should they be committed to a fixed policy rule?
 Question 1: Should policy be active or passive?
Arguments for active policy
 Recessions cause economic hardship for millions of people.
 The model of aggregate demand and supply shows how fiscal and monetary policy
can respond to shocks and stabilize the economy.
 In the absence of an active government role in the economy, events like the
Great Depression could occur regularly.

69
  It also shows how monetary and fiscal policy can prevent recessions by responding to
these shocks.
Arguments against active policy
 Other economists critics argues that government should take a hands-off approach to
macroeconomic policy.
Policies act with long & variable lags, including:
 inside lag: the time between the shock and the policy response.
 takes time to recognize shock
 takes time to implement policy, especially fiscal policy
 outside lag: the time it takes for policy to affect economy. i.e Monetary
policy
 If conditions change before policy’s impact is felt, the policy may destabilize
the economy.
Automatic stabilizers
 Some policies, called automatic stabilizers, are designed to reduce the lags associated
with stabilization policy.
 Automatic stabilizers are policies that stimulate or depress the economy when necessary
without any deliberate policy change. Examples: income tax , unemployment
insurance / Welfare
 Why the income tax is an automatic stabilizer: Each person’s tax bill depends on her
income. In recession, average incomes fall, so the average person pays fewer taxes.
 Why unemployment insurance/welfare is an automatic stabilizer
Forecasting the macroeconomy
Because policies act with lags, policymakers must predict future conditions.
Two ways economists generate forecasts:
 Leading economic indicators: data series that fluctuate in advance of the
economy
 Macroeconometric models: Large-scale models with estimated parameters that
can be used to forecast the response of endogenous variables to shocks and
policies
The Lucas critique
 Due to Robert Lucas who won Nobel Prize in 1995 for rational expectations.

70
  Forecasting the effects of policy changes has often been done using models estimated
with historical data.
 Lucas pointed out that such predictions would not be valid if the policy change alters
expectations in a way that changes the fundamental relationships between variables.
An example of the Lucas critique
 Prediction (based on past experience):An increase in the money growth rate will reduce
unemployment.
 The Lucas critique points out that increasing the money growth rate may raise expected
inflation, in which case unemployment would not necessarily fall.
 An increase in money growth and inflation only reduces unemployment if expected
inflation remains unchanged. Perhaps that was the case in the past.
 But now, if the money growth increase causes people to raise their expectations of
inflation, then unemployment won’t fall.
Question 2: Should policy be conducted by rule or discretion?
Rules and discretion: Basic concepts
 Policy conducted by rule: Policymakers announce in advance how policy will respond
in various situations, and commit themselves to following through.
 Policy conducted by discretion: As events occur and circumstances change,
policymakers use their judgment and apply whatever policies seem appropriate at the
time.
Arguments for rules:
1. Distrust of policymakers and the political process
 misinformed politicians
 politicians’ interests sometimes not the same as the interests of society:
political business cycle?
2. The time inconsistency of discretionary policy
 Def: A scenario in which policymakers have an incentive to renege on a previously
announced policy once others have acted on that announcement.
 Destroys policymakers’ credibility, thereby reducing effectiveness of their policies.
Monetary policy rules
a.Constant money supply growth rate
b.Target growth rate of nominal GDP
 Automatically increase money growth whenever nominal GDP grows slower than
targeted.

71
  Decrease money growth when nominal GDP growth exceeds target.
c.Target the inflation rate
 Automatically reduce money growth whenever inflation rises above the target rate.
 Many countries’ central banks now practice inflation targeting, but allow themselves a
little discretion.
Central bank independence
 A policy rule announced by central bank will work only if the announcement is
credible. Credibility depends in part on degree of independence of central bank.
Chapter Six

Models of Macroeconomic Growth

 The neo-Keynesian Harrod–Domar model
 The Solow–Swan neoclassical model; and
 The Romer–Lucas-inspired endogenous growth models

The Harrod- Domar Growth Model

 Harrod (1939, 1948) and EvseyDomar (1946, 1947) independently developed theories
that relate an economy’s rate of growth to its capital stock.
 The model assumes:an exogenous rate of labour force growth (n) a given technology
exhibiting fixed factor proportions i.e. - constant capital–labour ratio, K/L) and a
fixed capital–output ratio (K/Y).
 Assuming a two-sector economy (households and firms)we can write the simple
national income equation as:
Yt = Ct + St -------------------------------------------6.1
whereYt = GDP, Ct = consumption and St = saving.
 Equilibrium in this simple economy requires:
It = St --------------------------------------------6.2
Substituting (6.2) into (6.1) yields (6.3):
Yt = Ct + It ----------------------------------------------------6.3
 Within the Harrod–Domar framework the growth of real GDP is assumed to be
proportional to the share of investment spending (I) in GDP and for an economy to
grow, net additions to the capital stock are required.
 The capital stock over time is given in equation as
Kt+1 = (1− δ)Kt + It ---------------------------------6.4
where δ is the rate of depreciation of the capital stock.

72
  The relationship between the size of the total capital stock (K) and total GDP (Y) is
known as the capital–output ratio (K/Y = v) and is assumed fixed.
 Given that we have defined v = K/Y, it also follows that v = ΔK/ΔY
 Assume that total saving is some proportion (s) of GDP (Y)
St = sYt ------------------------------------------------------------------6.5
 Since K = vY and It = St, it follows that we can rewrite equation (6.4) as equation
vYt+1 = (1− δ)vYt + sYt ----------------------------------------------------6.6
 Dividing by v, and subtractingYtfrom both sides of equation (6.6) yields equation
(6.7):Yt+1 − Yt = [s/v − δ]Yt -----------------------------------------------------------6.7
 Dividing through by Y t gives us equation :
[Yt+1 − Yt ]/Yt = (s/v) − δ--------------------------------------------------6.8
 Here [Yt + 1 – Yt]/Yt is the growth rate of GDP. Letting G = [Yt + 1 – Yt]/Yt,
 We can write the Harrod–Domar growth equation as:
G = s/v − δ -------------------------------------------------------------6.9
NB: This simply states that the growth rate (G) of GDP is jointly determined by
 the savings ratio (s) divided by the capital–output ratio (v)
 The higher the savings ratio and the lower the capital–output ratio and depreciation
rate, the faster will an economy grow.
 By ignoring depreciation rate Harrod–Domar model as
G = s/v -----------------------------------------------------------------6.10
 For example, if a developing country desired to achieve a growth rate of per capita
income of 2 per cent per annum and population is estimated to be growing at 2 per
cent, then economic planners would need to set a target rate of GDP growth (G*)
equal to 4 per cent.
G/ pop%= Percapita income
4%/2% = 2%
 If v = 4, this implies that G* can only be achieved with a desired savings ratio (s*) of
0.16, or 16 per cent of GDP.
 If s* > s, there is a ‘savings gap’, and planners needed to devise policies for plugging
this gap.
 Since the rate of growth in the Harrod–Domar model
 is positively related to the savings ratio
 If domestic sources of finance were inadequate to achieve the desired growth target,

73
  then foreign aid could fill the ‘savings gap’
Aid requirements (Ar) would simply be calculated as : s* – s = Ar

The Solow Neoclassical Growth Model

 In Solow model :capital, labor, and technology are key determinants of production of
goods &services.
 We developed the Solow model to show :how changes in capital (through S and I) &
changes in the labor force (pon growth) affect economy’s output
 We are now ready to add the third source of growthchanges in technology—to the mix.
 The Solow model does not explain technological progress but,
 instead, takes it as exogenously given and
 shows how it interacts with other variables in the process of economic growth
The Solow growth model is designed to show how growth in the capital stock, growth in the
labor force, and advances in technology -affect a nation’s total output of goods and services.
Our first step is to examine how the supply and demand for goods determines the
accumulation of capital.
 In this first step, we assume that(the labor force andtechnology are fixed).
 We then relax these assumptions by introducing changes in the labor force later in this
chapter and by introducing changes in technology in the next.
 The supply of goods in the Solow model is based on the production function,
 which states that output depends on capital stock and labor force:
Y = F(K, L)
 The Solow growth model assumes that the production function
 hasconstant returns to scale. zY = F(zK, zL)
 Production functions with constant returns to scale allow us to analyze all quantities
in the economy relative to the size of the labor force.
 To see that this is true, set z = 1/L in the preceding equation to obtain
Y/L = F(K/L, 1)
 This equation shows that the amount of output per worker Y/L
 is a function of the amount of capital per worker K/L.
 (The number 1 is constant and thus can be ignored.)
 The assumption of constant returns to scale implies that
 the size of the economy as measured by the number of workers does not affect
the relationship between output per worker and capital per worker

74
  y = Y/L is output per worker, and k = K/L is capital per worker.
 We can then write the production function as, y = f (k)
 the production function becomes flatter, indicating that the production function
exhibits diminishing marginal product of capital.
 When k is low, the average worker has only a little capital to work with, so an extra
unit of capital is very useful and produces a lot of additional output.
 When k is high, the average worker has a lot of capital already, so an extra unit
increases production only slightly. (Refer to the figure!)
The Demand for Goods and the Consumption Function
 The demand for goods in the Solow model comes from consumption and investment.
 In other words, output per worker y is divided betweenconsumption per worker c and
investment per worker i:y = c + i
 The Solow model assumes that each year people save a fraction s of their income
andconsume a fraction (1 – s)
 We can express this idea with the following consumption function:
c = (1 − s)ywhere s, the saving rate
 To see what this consumption function implies for investment,
 substitute (1 – s)y for c in the national income accounts identity:y = (1 − s)y + i
 Rearrange the terms to obtain i = sy
 For any given capital stock k, the production function y = f(k)
 determines how much output the economy produces, and
 The saving rate s determines the allocation of that output between consumption and
investment.

Growth in the Capital Stock and the Steady State

 At any moment, the capital stock is a key determinant of the economy’s output,but the
capital stock can change over time, and those changes can lead to economic growth
 In particular, two forces influence the capital stock: investment and depreciation.
 Investment is expenditure on new plant and equipment, and it causes the capital
stock to rise.
 Depreciation is the wearing out of old capital, and it causes the capital stock to fall.
 This equation relates the existing stock of capital k to the accumulation of new capital i.

75
 The production function f(k), and the allocation of that output between consumption and
savingwhich is determined by the saving rate s.
 To incorporate depreciation into the model, we assume that a certain fraction d of the
capital stock wears out each year.
 For example, if capital lasts an average of 25 years, then the depreciation rate is 4
percent per year (d = 0.04).
 The amount of capital that depreciates each year is dk.
Change in Capital Stock = Investment − Depreciation
Dk = i −dk
 whereDk is the change in the capital stock between one year and the next.
 Because investment i equals sf(k), we can write this as Dk = sf (k) − dk.
 Let’s consider each of these forces in turn. As we have already noted, investment per
worker iequals sy.
 By substituting the production function for y, we can express investment per worker
as a function of the capital stock per worker:i = sf(k).
 Regardless of the level of capital with which the economy begins, it ends up with the
steady-state level of capital.
 To see why an economy always ends up at the steady state,suppose that the economy
starts with less than the steady-state level of capital, such as level k1 in Figure 6.2.
 In this case, the level of investment exceeds the amount of depreciation.
 Over time, the capital stock will rise and will continue to rise- along with
output f(k)—until it approaches the steady state k*.
 Similarly, suppose that the economy starts with more than the steady-state level of
capital, such as level k2. In this case, investment is less than depreciation: capital is
wearing out faster than it is being replaced. The capital stock will fall, again
approaching the steady-state level.
 Once the capital stock reaches the steady state, investment equals depreciation, and
there is no pressure for the capital stock to either increase or decrease.
 The higher the capital stock, the greater the amounts of output and investment.
 Yet the higher the capital stock, the greater also the amount of depreciation.
 If the economy finds itself at this level of the capital stock, the capital stock will not
change because the two forces acting on itinvestment and depreciation-just balance.

76
 That is, at k*, Dk = 0, so the capital stock k and output f(k) are steady over time (rather
than growing or shrinking).
 We therefore call k* the steady-state level of capital.(Refer to Figure 6.2)
 The Solow model shows that the saving rate is a key determinant of the steady-state
capital stock.
 If the saving rate is high, the economy will have a large capital stock and a high level of
output in the steady state.
 If the saving rate is low, the economy will have a small capital stock and a low level of
output in the steady state.
The Golden Rule Level of Capital
 So far, we have used the Solow model to examine how an economy’s rate of saving and
investment determinesits steady-state levels of capital and income.
 Yet suppose a nation had a saving rate of 100 percent. That would lead to the
 largest possible capital stock and the largest possible income.
 But if all of this income is saved and none is ever consumed, what good is it?
 This section uses the Solow model to discuss the optimal amount of capital
accumulationfrom the standpoint of economic well-being.
 So, how do we find the sand k*that maximize c* ?
K*golden= the Golden Rule level of capital,the steady state value of kthat maximizes
consumption.
 To find it, first express c* in terms of k*:
c* = y*-i*
= f (k*) -i*
= f (k*) -dk*
 In general:
i = Dk + dk
 In the steady state:
i* = dk* because Dk = 0.
(Refer to the figure !)
Population Growth
 Assume that the population--and labor force-- grow at rate n. (n is exogenous)
 EX: SupposeL = 1000 in year 1 and the population is growing at 2%/year (n=0.02).
 Then DL = n L = 0.02 ´ 1000 = 20, so L = 1020 in year 2.
Break-even investment

77
  (d + n)k = break-even investment, the amount of investment necessary to keep k
constant.
 With population growth, the equation of motion for k is
Dk = s f(k)-(d+ n) k

Actual invesmentbreak even investment

The Effects of Population Growth
 An increase in n= break-even investment, leading to a lower steady-state level of k.
 Higher nÞlower k*. And since y = f(k) , lower k* Þ lower y* .
 Thus, Solow model predicts that countries with higher popn growth will have lower
levels of capital and income per worker in the long run.
(Refer to the figure!)
The Golden Rule with Population Growth
 To find the Golden Rule capital stock, we again express c* in terms of k*:
c*= y*-i*
= f(k* )-(d+ n) k*
c* is maximized when
MPK = d+ nor equivalently,MPK -d = n
Technological Progress in Solow Model
Previously, in the Solow modelthe production technology was held constantincome per capita
was constant in the steady state.
Tech. progress in the Solow model
 A new variable: E = labor efficiency
 Assume: Technological progress is labor-augmenting: it increases labor efficiency
at the exogenous rate g:
E
g 
E
 We now write the production function as
 where L´E = the number of effective workers
 Hence, increases in labor efficiency have the same effect on output as increases in the
labor force.
 Notation:
y = Y/LE = output per effective worker
k = K/LE = capital per effective worker
 Production function per effective worker:y = f(k)
 Saving and investment per effective worker:s y = s f(k)
(d + n + g)k = break-even investment:

78
  The amount of investment necessary to keep k constant. Consists of:
 dk to replace depreciating capital
 nk to provide capital for new workers
 gk to provide capital for the new “effective” workers created by technological
progress
Policies to promote growth
Four policy questions:
Are we saving enough? Too much? What policies might change the saving rate?How
should we allocate our investment between privately owned physical capital, public
infrastructure, and “human capital”?What policies might encourage faster technological
progress?
Evaluating the Rate of Saving
 Use the Golden Rule to determine whether our saving rate and capital stock are too high,
too low, or about right. To do this, we need to compare (MPK -d) to (n +g).
To estimate (MPK -d), we use three facts about an economy;
1. k = 2.5 y
The capital stock is about 2.5 times one year’s GDP.
2. dk = 0.1 y
About 10% of GDP is used to replace depreciating capital.
3. MPK ´k = 0.3 y
Capital income is about 30% of GDP
1. k = 2.5 y 2.d k = 0.1 y 3.MPK ´k = 0.3 y

To determine d, divided 2 by 1:


 To determine MPK, divided 3 by 1:

Hence, MPK -d = 0.12 - 0.04 = 0.08

 From the last slide: MPK -d = 0.08, Real GDP grows an average of 3%/year,
so n + g = 0.03. Thus, in this economy, MPK -d = 0.08 > 0.03 = n + g
Conclusion:
 The economy is below the Golden Rule steady state: if we increase saving rate of this
economy, the economy will have faster growth until it reaches to a new steady state with
higher consumption per capita.

Endogenous Growth Theory

 Solow model:
 Sustained growth in living standards is due to tech progress, the rate of tech
progress is exogenous.

79
 Endogenous growth theory:
 a set of models in which the growth rate of productivity and living standards is
endogenous
 A basic model
 Production function: Y = AK
 where , Y is Output , K is the capital stock, A measures the amount of
output produced for each unit of capital (A is exogenous & constant)
 Key difference between this model & Solow: MPK is constant here, diminishes in
Solow
 Investment: sY
 Depreciation: dK

80
  Equation of motion for total capital:
Δ K =s Y -dK
 Δ K = s Y -dK
 Divide through by K and use Y = AK , get:

Chapter 7: Macroeconomic Theories and African Economies

Macroeconomic Theories and African Economies: An overview

7.1 The Applicability of Conventional Theories to African Economies

7.1.1 Introduction
There were also much more debate on the applicability of conventional macro model to African
economies in particular and developing countries in general. But the major views can be
categorized into two:
a) The Orthodox View
According to this view such macro models are applicable elsewhere be it developed or
developing countries. The solution forwarded by this view is that to let the market to allocate
resources and limit government intervention. The guiding principle of economic decision is
“price and market system is right”.

b) The Structuralist View

The structuralist view can be classified as:

 Early View: it argues that the structure of developing countries is different from that of developed
countries. This school is the proponent of infant industry argument which focuses on protecting the
industries and on import substitution strategy.
 The Recent View: this view focuses on short term adjustments. For this school monetary and fiscal
policy prescriptions that may be applicable to developed countries are not relevant for developing
countries.
 Removing structural rigidities, creating well-functioning and integrated markets to eliminate supply
side rigidities should therefore be in the priorities of development strategies.
7.1.2 Characteristics of Developing Countries
These characteristics include the nature of openness to trade with the rest of the world in both
commodities and assets, the properties of the economy’s long-run and short-run supply functions, the
nature of financial markets, the characteristics of the government’s budget and their implication for fiscal
policy, etc.

81
 Developing countries tend to be more open and have little control over the prices of the goods they
export and import. Hence the conventional closed economy model is not applicable.
 In contrast to the major industrial countries, the vast majority of developing countries have not
adopted flexible exchange rates.
 Developing countries tend to be capital importers, and the servicing of external debt is a central
policy issue in many of them.
 The extent of external trade in assets tends to be more limited in developing countries than in
industrial ones.
 The aggregate demand curve is down ward sloping just like developed countries but much steeper.
7.1.3 Devaluation and Developing Countries
The difference between the MDC and LDC models are perhaps most evident when considering
devaluation. In the MDC, devaluation improves the balance of trade shifting the IS and the aggregate
demand curves (YD) to the right, resulting in an increase in both output and the price level; restrictive
monetary and fiscal policy are likely to be the appropriate stabilization policies to accompany
devaluation.
7.1.4 Restrictive Monetary policy and Developing Countries
An increase in the reserve ratio, reducing the money supply, has a large impact on the LM curve (for a
given price level) because of the interest elasticity of money demand. The decrease in the availability of
low interest commercial bank loans also reduces retained earning somewhat shifting the IS curve down.
 7.1.5 Restrictive Fiscal policy and Developing Countries
While restrictive monetary policy is likely to increase both unemployment and inflation in the LDC in the
short run, restrictive fiscal policy is likely to be more successful in reducing the price level without the
costs of a major recession.
 7.1.6 Income policy and Developing Countries
An income policy that lowers the nominal wage affects the standard LDC economies in a number of
ways.
 Shifts the IS curve to the left (since government spending is decreasing)
 The LM curve shifts to the right due to a decrease in money demand
 It decreases both wage and interest costs shifting aggregate supply down

END

82
 DEVELOPMENT ECONOMICS MODULE
DEVELOPMENT ECONOMICS I
CHAPTER ONE

Economics of development: concepts and approaches

Development economics deals with development problems of developing countries. In other
words, it is about the causes and cures of mass poverty in the less developed nations. At the
outset, therefore, we should be aware of the relevant concepts and measuring methods of
development devised by different institutions and persons. Thus, the discussion of the historical
evolution of the concept development and the methods employed in measuring development are
vital. Dear students, we will begin our discussion development economics by defining the
concepts of development and economic growth.

The meaning of economic growth is unambiguous. Almost all economists would accept the
increase in the output of goods and services of a country per unit time as its definition.
Output is measured by the gross national product (GNP) or gross domestic product (GDP).
Growth in GNP/GDP can be calculated either at market price or factor cost. In order to measure
the effect of growth on the standard of living of the population, the GNP/GDP per capital is
taken, which is also known as per capital income. Per capital income can be measured in terms
of home currency and for international comparisons in terms of US dollar. However, the US
dollar has different purchasing power in the market of different countries especially for non-
traded goods.

Other tried to explain development in terms of the process of structural transformation of the
economy. Thus it’s the planned alteration of the structure of production and employment. Later
on concern are accorded to poverty, unemployment, inequalities of income, and other economic,
institutional, social and political factors owing to the failure of developing countries to improve
the standard of living of the poor.

Dudley Seers argues on the need of looking on what has been happening to poverty,
unemployment, and inequality as a determinant of development rather than mere growth of per
capita income. After him In addition to these issues, development has to incorporate other

83
economic and non-economic factors. A concept of development in general is required which
embraces the major economic and social objectives and values that societies strive for.

Currently, by Podaro development is “conceived as a multi dimensional process involving

major changes in social structures, popular attitudes, and national institutions, as well as the
acceleration of economic growth, the reduction of inequality (and unemployment), and the
eradication of absolute poverty”. Denis Goulet distinguishes three basic components or core
values in this wider meaning of development. Life-sustenance: is concerned with the provision
of basic needs. No country can be regarded as fully developed if it cannot provide its entire
people with such basic needs as housing, clothing, food and minimum education. A major
objective of development must be to raise people out of primary poverty and to provide basic
needs simultaneously without which there is absolute under development. Hence, economic
development is a necessary condition (but not sufficient condition) for the improvement of the
quality of life in providing these life sustenance needs and bringing development.

Self-Esteem: self-esteem is concerned with the feeling of self-respect and independence. It

means to be a person, a sense of worth and self-respect, of not being used as a tool by others for
their own ends. Every society or individual strives towards self-esteem. Without development the
pride of the peoples of the developing countries on their cultural identity and dignity are being
eroded. No country can be regarded as fully developed if it is exploited by others and does not
have the power and influence to conduct relations on equal terms. Now days, economic wealth
and technological power have become almost universal measures of worth. Developing countries
seek development for self-esteem; to eradicate the feeling of dominance and dependence which
is associated with inferior economic status.

Freedom from servitude: Freedom is ability of people to determine their destiny. It involves an
expanded range of choices for societies and their members together with a minimization of
external constraints in the pursuit of devolvement. No man is free if s/he cannot choose; if s/he is
imprisoned by living on the margin of subsistence with no education and no skills.

Economic prosperity expands the range of choices that people may have. It enables to gain
greater control over nature and physical environment. It gives the freedom to choose greater
leisure, to have more goods and services or deny material wants. Therefore, development is
hardly possible without growth, but growth is possible without development. Different methods
of measuring development and making international comparisons have so far been devised.
Among these:-

84
 1.1. Conventional Measures of Development:

The dominant conventional measures of growth and development are the Gross National Product
(GNP) or Gross Domestic Product (GDP) and their corresponding per capital values. GNP is
calculated as the total domestic and foreign value added claimed by a country’s residents without
making deductions for depreciation of the domestic capital stock.

1.2. Alternative development indicators:

Aside from the aforementioned deficiencies encountered in measuring income itself, this search
has been prompted by the following considerations:

i. The failure of the GNP/GDP measures to reflect the impact of growth on the pattern of
income distribution
ii. The inability of the GNP/GDP measures to reflect the welfare impact of the goods and
services produced as well as the likely costs to society of certain patterns of growth.
iii. The invalidity of the GNP/GDP indicator as a measure of well being in situations where
growth has actually deepened poverty and income inequalities, increased unemployment
and affected the environment adversely.
Therefore, the most important factor influencing the search for alternative indictors has been the
marked shift in thinking among development economists, organizations and practitioners since
the beginning of the 1970s about the meaning of development and the processes leading to it.
Among the developed alternative indicators the major are the physical quality of life index
(PQLI) developed by Morris (1979), the Human Development Index (HDI) developed by UNDP,
and the Human Poverty Index. These are to be discussed one by one below:
PQLI = Life expec. index + infant mort. index + literacy index

The PQLI indirectly reflects the effects on human development of investment in health service,
water and sewage systems, quality of food and nutrition, education, housing, and changes in
income distribution. One positive aspect of the PQLI is, therefore, that it helped redirecting
attention away from growth, toward a broader concept of human development.

However, the PQLI has been criticized as an indicator of social development in relation to both
the choice of indicators as well as the weight assigned to the different indicators.

 It is handicapped by the limited data availability

85
  It gives disproportionate weight to longevity as two of the three indicators, infant
mortality and life expectancy are related to it.
 It gives equal weight to each indicator arbitrarily without obvious rationale
 It treats economic and social indictors separately, instead of combining them in a
composite index.
HDI is ranking various countries according to the relative success they have had with the human
development of their population. UNDP is offering the HDI as an alternative to the GNP for
measuring the relative socio-economic progress of nations. HDI has also attempted to take
account of some of the limitations of the PQLI. HDI is based on three variables:

 longevity:- as measured by life expectancy at birth

 educational attainment:- as measured by a condition of adult literacy (two third
weight) and a combined primary, secondary, and tertiary school enrollment ratios
(one third weight)
 Standard of living measured by real per capita income at PPP. The marginal value of
money income above the world average threshold of $5120 real GDP per capita is
assumed to be rapidly diminishing
For any component of the HDI, the individual indices can be computed according to the general
formula of:

Index = Actual value – Minimum value

Maximum value – Minimum value

 Life Expectancy Index =

 Education Index =

 Adult Literacy Index (ALI) =

 Gross Enrolment Index (GEI) =

 GDP Index =

Where: LE: Life expectance ALR: Adult literacy rate

CGER: Combined gross enrolment ratio GDPpc: GDP per capita at PPP in USD

86
The index thus ranges from 0 to 1. If the actual value is equal to maximum the index is one. The
HDI ranks countries into three groups: low human development (0.0 to 0.49), medium human
development (0.50 to 0.79) and high human development (0.80 to 1.00). For any given year,
HDI measures relative not absolute level of human development and that its focus is on the ends
of development (longevity, educational achievement and standard of living).

The United Nations has constructed human poverty indices for developing countries. The
composite measure focuses on dimensions of deprivations. The HPI for developing countries is
based on three main indices:

 The percentage of the population not expected to survive to the age of 40 (P1)
 The adult illiteracy rate (P2)
 A deprivation index based on an average of three variables: the percentage of the
population without access to safe water; the percentage of population without access to
health service; and the percentage of the underweight children under five years old (P3). The
formula is given by: HPI = [1/3(P13 + P23 + P33)] 1/3
Question1.1. Why is a strictly economic definition of development inadequate? Use empirical
evidences as examples of countries developing economically but are underdeveloped.

Chapter two

Structural features and common characteristics of developing countries

This chapter portrays the structural diversity of developing nations. With this intention we will
make an examination of eight critical components. These are:

The size of the country (geographic area, size of population, and income levels)
Evidently, economic potential of a country is significantly determined by its physical and
population size, and its level of national income per capita. These are also major factors
differentiating one developing country from another. This size provides both advantages and
disadvantages. Large size usually presents advantages of diverse resource endowment, large
potential markets, and lesser dependence on foreign sources of materials and products. But it
also creates problems of administrative control, national cohesion, and regional imbalances.

However, it is to be born that there is no necessary relationship among a country’s size, its level
of per capita income, and the degree of equality or inequality in the distribution of that income.

87
For example, as compared to Ethiopia, the neighboring country, Kenya is smaller in geographic
and population size. But Kenya has about 3 times the per capita income of Ethiopia at official
exchange rate. But Kenya has also lesser per capita income than Brazil and some other larger
developing countries.

Its historical and economical background

The other sources of diversity among the developing countries are their traditional and colonial
heritages. Apparently, countries have their own different cultural background accumulated in
their history making them to have different social and economic institutions. Moreover,
developing nations were at one time or other colonies of Western European countries. The
European colonial powers had a dramatic and long-lasting impact on the economies, political and
institutional structures of their African and Asian colonies. The economic structures of these
nations, as well as their educational and social institutions have typically been modeled on those
of their former economic rulers.
Hence, the diversity in colonial heritage together with the indigenous cultural differences have
resulted different structural problems in these countries. Depending on their colonial heritage
therefore the countries are required to take different measures. Countries like those in Africa that
only recently gained their independence are likely to be more concerned with consolidating and
evolving their own national economic and political structures than with simply promoting rapid
economic development.
Their policies may consequently, reflect a greater interest in these immediate political issues.
Latin American countries have a longer history of political independence plus a more shared
colonial heritage. Therefore, in spite of geographic and demographic diversity the countries
possess relatively similar economic, social, and cultural institutions and face similar problems.
In Asia, on the other hand, different colonial heritages and the diverse cultural traditions of the
indigenous peoples have combined to create different institutional and social patterns.

It endowments of physical and unman resources

Endowments of physical and human resources are other sources of disparities in economic
growth potential of the counties. If we start with the physical resource endowments, on the one
hand there are countries which are extremely and favorably endowed in resources such as
minerals, raw materials, and fertile land. On the other hand, there are also poorly endowed
nations where endowments of raw materials and minerals and even fertile land are relatively
minimal.

88
Moreover, geography and climate can also play an important role in the success or failure of
development efforts. Other things being equal, it is said that island economies seem to do better
than landlocked economies. With respect to climate also temperate zone countries do better than
tropical zone nations. Developing countries are also distinguished one from the other in their
human resource endowments. The human resource endowments includes not only the number of
people and their skill levels but so also their cultural outlooks, attitudes toward work, access to
information, willingness to innovate, and desire for self-improvement.

Its ethnic and religious composition

Ethnicity and religion often play a major role in the success or failure of development efforts.
Evidently, the greater the ethnic and religious diversity of a country the more likely it is that
there will be internal strife and political instability. There is also distinction in ethnic and
religious composition among nations.
Presently more than 40% of the world’s nations have more than five significant ethnic
populations. In most cases, one or more of these groups face serious problems of discrimination.
Over half of the world’s less developed countries have recently experienced some form of
interethnic conflict. Just in the first half of the 1990s, ethnic and religious conflicts leading to
wide spread death and distinction took place in many African countries and some countries of
other regions.
But neither overt physical conflict nor widespread violence is necessary to disrupt an economy or
cause political instability. If development is about improving human lives and providing a
widening range of choice to all peoples, racial, ethnic, or religious discriminations can be equally
destructive. For example throughout Latin America, indigenous populations have significantly
lagged behind other groups on almost every measure of economic and social progress. In these
countries, being indigenous makes it much more likely that an individual will be less educated,
in poorer health, and in a lower socio economic structure than other citizens. This is particularly
true for indigenous women. Ethnic and religious diversity need not, however, necessarily lead to
inequality, turmoil, or instability.

The relative importance of its public and private sector

Most developing countries have mixed economic systems, featuring both public and private
ownership and use of resources. The division between the two and their relative importance are
mostly determined by the historical and political circumstances of the countries. Thus, in
general, Latin American and South East Asian nations have larger private sectors than South
Asia and African nations.

89
The degree of foreign ownership on the private sector is another important variable to consider
when differentiating among less developed countries. A large foreign owned private sector
usually creates economic and political opportunities as well as problems not found in countries
where foreign investors are less prevalent.
Economic policies, such as those designed to promote more employment, will naturally be
different for countries with large public sectors and ones with sizeable private sectors. Direct
government investment projects and large rural work programs may take precedence in
economies dominated by the public sectors. In the private oriented economies, however, special
tax allowances designed to induce private businesses that can employ more workers might be
more common. Therefore, although the problem to be solved may be similar, the solution can
differ in countries with significant differences in the relative importance of the public and private
sectors.

The nature of its industrial structure

Developing countries are predominantly agrarian in economic, social, and cultural outlook.
Labour force in most of these countries is overwhelmingly engaged in agriculture. The
agricultural sector contributes significantly also to the GDP of many of the poor nations.
Farming is not merely an occupation but a way of life for most people in Asia, Africa, and Latin
America. Nevertheless, there are great differences between the structure of agrarian systems
and patterns of land ownership in Latin America and Africa. Asia agrarian systems are slightly
closer to those of Latin America in terms of patterns of land ownership. But even then the
similarities are lessened by substantial by cultural differences.
It is in the relative importance of both the manufacturing and service sectors that we find the
widest variation among developing nations. Most Latin American countries possess more
advanced industrial sectors. But in the 1970s and 1980s countries like Taiwan, South Korea, and
Singapore are rapidly becoming industrialized states.

Its degree of dependence on external economic and political forces

The degree to which a country is dependent on foreign economic, social, and political forces is
related to its size, resources endowment, and political history. For most developing countries,
this dependence is substantial. In some cases, it touches almost every facet of life. Most small
nations are highly dependent on foreign trade with the developed world. Almost all small
nations are dependent on the importation of foreign and often inappropriate technologies of
production. This fact alone exerts an extraordinary influence on the character of the growth
process in these dependent nations.

90
A country’s ability to chart its own economic and social destiny is significantly affected by its
degree of dependence on these and other external forces

The distribution of power and the institutional and political structure within the nation.
In the final analysis, it is often not the correctness of economic policies alone that determines the
outcome of national approaches to critical development problems. The political structure and the
vested interests and allegiances of ruling elites (e.g., large landowners, urban industrialists,
bankers, foreign manufacturers, the military, and trade unionists) will typically determine what
strategies are possible and where the main barriers to effective economic and social change may
lie.
The concentration of interests and power among different segments of the populations of most
developing countries is itself the result of their economic, social, and political histories and is
likely to differ from one country to the next. Nevertheless, whatever the specific distribution of
power among the military, the industrialists, and the large landowners of Latin America; the
politicians and high level civil servants in Africa; the oil Sheiks and financial moguls of the
Middle East; or the land lords, money lenders, and wealthy industrialists of Asia – most
developing countries are ruled directly or indirectly by small and powerful elites to a greater
extent than the developed nations are.
Effective social and economic changes thus require either that the support of elite groups be
enlisted or that the power of the elite be offset by more powerful democratic forces. Either way
economic and social development will often be impossible without corresponding changes in the
social, political, and economic institutions of a nation. Such institutional changes may include:
land tenure systems, forms of governance, educational structures, labour market relationships,
property rights, the distribution and control of physical financial asset, laws of taxation and
inheritance and provision of credit.

Common Characteristics of Developing Countries

The foregoing discussions have demonstrated why it is sometimes risky to generalize too much
about such a diverse set of nations. Nevertheless common economic features of developing
countries permit us to view them in a broadly similar framework.

This section portrays various dimensions of the development gap between rich and poor
countries and similarities of poor nations. These include level and growth rate of income,
unemployment and underemployment, population growth rate, economic structure, political and

91
institutional factors, and degree of dependence. For convenience, we can classify these common
characteristics into seven broad categories.

Low levels of living, characterized by low income, inequality, poor health, and inadequate
education
In developing nations, general levels of living tend to be very low for the vast majority of people.
This is true not only in relation to their counterparts in rich nations but often also in relation to
small elite groups within their own societies. These low levels of living are manifested
quantitatively and qualitatively in the form of low income (poverty), inadequate housing, poor
health, limited or no education, high infant mortality, low life and work expectancies, and in
many case a general sense of malaise and hopelessness.

Per Capita National Income: As you have seen it in chapter one, the GNP per capita is often
used as summary index of the relative economic well-being of people in different nations. One
common distinguishing feature of developing countries as compared to developed nations is the
extremely low level of income. The difference in income between rich and poor nations will be
apparent when one takes account of the distribution of world population. In these terms, this
means that almost 80% of the world’s income is produced in the economically developed regions
by 20% of the world’s people. Thus the remaining four-fifths of the world’s population is
producing only one-fifth of total world output.
Growth Rates of Income: Many developing countries not only have much lower levels of per
capita income but also have experience slower GNP growth than the developed nations
Distribution of National Income: the growing gap in per capita incomes between rich and poor
nations is not the only manifestation of the widening economic disparity between the world's rich
and poor. To appreciate the breadth and depth of Third World poverty, it is also necessary to
look at the growing gap between rich and poor within individual LDCs. All nations of the world
show some degree of income inequality. There are large disparities between the income of the
rich and of the poor in both developed and underdeveloped countries. Nevertheless, the gap
between rich and poor is generally greater in less developed nations than in developed nations.
Extent of Poverty: The magnitude and extent of poverty in any country depend on two factors:
the average level of national income and the degree of inequality in its distribution. But how is
one to measure poverty in any meaningful quantitative sense?
Health: in addition to struggling on low income, many people in developing nations fight a
constant battle against malnutrition, disease, and ill health.

In the mid-1970s, more than 1 billion people, almost half the population of the developing world

92
(excluding China), were living on diets deficient in essential calories. One-third of them were
children under 2 years of age. In both Asia and Africa, over 60% of the population barely met
minimum caloric requirements necessary to maintain adequate health. To make matters worse,
numbers of doctors, medical facilities are concentrated in urban areas where only 25% of the
population resides; the woefully inadequate provision of health care to the masses of poor people
becomes strikingly clear. Most probably these victims 66% of them were residing in Africa
while Asia and Latin America had 21% and 4.3% respectively.

Education: the spread of educational opportunities is the final indicator of the very low levels of
living that is pervasive in developing nations. The attempt to provide primary school educational
opportunities has probably been the most significant of all LDC development efforts. In most
countries, education takes significant share of the governments’ budget.

Yet in spite of some impressive quantitative advances in school enrollments, literacy levels
remain strikingly low compared with the developed nations. For example, among the least
developed countries, literacy rates average only 45% of the population.

Low level of productivity

In addition to low level of living, LDCs are characterized by relatively low level of labor
productivity. Since production function describes the way in which societies go about providing
for their material needs. Throughout the developing world, levels of labor productivity are
extremely low compared with those in developed countries. This can be explained by principle
of diminishing marginal productivity that if increasing amounts of a variable factor (labor) are
applied to fixed amounts of other factors (e.g., capital, land, materials), the extra or marginal
product of the variable factor declines beyond a certain number.

Low levels of labor productivity can therefore be explained by the absence or severe lack of
"complementary" factor inputs such as physical capital or experienced management. To raise
productivity, according to this argument, domestic savings and foreign finance must be
mobilized. This is to generate new investment in physical capital goods and build up the stock of
human capital (e.g., managerial skills) through investment in education and training.

Population Growth and Dependency Burdens

Statistics on demographic evolution by country show that the present rhythm of global
population growth is largely the result of the acceleration of growth in the developing regions.
The crude birthrate is probably one of the most efficient ways of distinguishing the less

93
developed from the developed countries. Death rates (the yearly number of deaths per 1,000
populations) in Third World countries are also high relative to the developed nations.

However, these poor nations have benefited from the progress of medicine for the masses and the
campaigns against endemic disease. This was followed by fall in mortality. Hence, the
differences in death rate between developing and developed countries are substantially smaller
than the corresponding differences in birthrates. Thus in most developing countries, the active
labor force has to support proportionally almost twice as many children as it does in richer
countries.

We may conclude, therefore, that not only are Third World countries characterized by higher
rates of population growth, but they must also contend with greater dependency burdens than
rich nations.

High Unemployment and Underemployment

One of the principal manifestations of and contributors to the low levels of living in developing
nations is their relatively inadequate or inefficient utilization of labor in comparison with the
developed nations. Unemployment increased as a result of the fact that employment has been
growing during the past at a rate which is much slower than the rate of growth of the labour
force; stagnating economic growth and also high rural to urban migration. The unemployed
exhibit two important characteristics, namely their youthfulness and their high level of education.
And also creeping up the education ladder

Substantial Dependence on Agricultural Production and Primary-Product Exports

The vast majorities of people in LDCs live and work in rural areas. Over 65% are rurally based,
compared to less than 27% in economically developed countries. Similarly, 58% of the labor
force is engaged in agriculture, compared to only 5% in developed nations. Agriculture
contributes about 14% of the GNP of developing nations but only 3% of the GNP of developed
nations.

There is striking difference between the proportionate size of the agricultural population in
Africa, which constitutes (68%) and South Asia (64%) versus North America (3%). But the
average productivity of agricultural labor is almost 35 times greater in North America than in
Asia and Africa combined. Agricultural productivity is low not only because of the large
numbers of people in relation to available land but also because LDC agriculture is often
characterized by primitive technologies, poor organization, and limited physical and human

94
capital inputs.

Most economies of less developed countries are oriented toward the production of primary
products. These primary commodities form their main exports. And also most poor countries
need to obtain foreign exchange in addition to domestic savings in order to finance priority
development projects.

Imperfect Markets and Incomplete Information

Starting from the 1980s almost every developing country is moving toward the establishment of
a market economy for many reasons. There seemed to be a growing consensus that there had
been too much government intervention in the workings of Third World economies. This
government intervention is sighted by many as the major cause of the problems in the poor
nations. Hence, free market and unfettered competition are considered as the key to rapid
economic growth.

Dominance, Dependence, and Vulnerability in International Relations

For many LDCs, a final significant factor contributing to the persistence of low levels of living,
rising unemployment, and growing income inequality is the highly unequal distribution of
economic and political power between rich and poor nations. These unequal strengths are
manifested economically and non-economic aspects of the relationship. Economically the
dominant powers of rich nations control the pattern of international trade. They have also the
ability to dictate the terms whereby technology, foreign aid, and private capital are transferred to
developing countries.

Finally, the penetration of rich-country attitudes, values, and standards also contributes to a
problem widely recognized and referred to as the international brain drain(migration of
professional and skilled personnel).

Question2.1. Discuss the characteristics of Ethiopia that make it to be categorized as

one of the developing countries by taking actual figures when appropriate.

CHAPTER THREE
Growth Models and Theories of Development
In the previous chapter, we have discussed the dimensions of the problems of developing
countries, which may be called their diversities and common characteristics. Generally, we
have tried to make an assessment of the factors that make these countries to be categorized

95
as poor countries. We have also assessed the differences among them that should be
observed in formulating development policies and strategies.
Now it is time to look at some of the available tools useful in explaining development
problems and formulating relevant development policies and strategies. These helpful
instruments are the growth models and development theories. There are different theories
explaining the diverse development problems of countries at different social, economic,
political, and institutional circumstances. Chapter divided in two major parts these are
growth model and development theories.

Growth Models
The Harrod-Domar Growth Model
The growth model that was particularly popular with economic planners just after World
War II came to be known as the Harrod-Domar model, since it was based on independently
published articles by Roy Harrod and Evsey Domar. The fact that the two authors
independently produced identical models was not surprising. Their models were simple
extensions of John Maynard Keynes’s well-known macroeconomic model, which dominated
economic thinking in the 1940s. The Harrod-Domar model makes similar assumptions to the
Keynesian macroeconomic model:

o Unlimited amount of unemployed labour, output can be increased without triggering

price increases.
o Due to first assumption marginal product of capital (capital output ratio).
o Due to second assumption output growth is directly proportional to new investment
in new capital.
o Productive investment is always equal to saving.
Harrods model dynamic extension of keynes' static equilibrium analysis. Firstly in Keyens'
General Theory, the condition for income and output to be in equilibrium (in a closed
economy) is that plans to invest equals plans to save. Hence, Harrod asked if changes in
income induce investment, what must be the rate of growth of income for plans to invest to
equal plans to save in order to ensure a moving equilibrium in a growing economy through
time?

Secondly, in static Keynesian theory, if equilibrium between saving and investment is disturbed,
the economy corrects itself and a new equilibrium is achieved via the multiplier process. Then

96
the second question is if growth equilibrium is disturbed, will it be self-correcting or self-
aggravating? And lastly, will this equilibrium rate be equal to the maximum rate of growth that
the economy is able to sustain given the rate of growth of productive capacity? If not what will
happen?

To explain this condition, Harrod distinguished three different growth rates. These are

Actual growth rate (g) defined as

G=s/c----------------------------------------------------------------1

Whereas s= the ratio of saving to income(S/Y), c=actual investment capital output ratio, that is
the ratio of extra capital accumulation or investment to the growth of output

(K/Y=I/Y)

g = s/c = (S/Y)/ (I/Y)

= (S/Y) (Y/I)

=Y/Y (rate of growth of output), given S=I

Warranted growth rate (gw): rate of growth which, if it occurs, will leave all parties satisfied. At
this rate producers have produced neither more nor less than the right amount. It is determined
as: plans to save at any time are given by the Keynesian saving function

S=sY-------------------------------------------------------------2

The demand for investment is given by the acceleration principle. This is where cr is the
accelerator coefficient measured as the required amount of extra capital or investment to produce
a unit flow of output at a given rate of interest, determined by technological condition. Thus

Cr = Kr/Y = I/Y

I = CrY ------------------------------------------------------------------------------------------3

For planned savings to equal planned investment therefore, we have

sY = CrY----------------------------------------------------------------------------------------4

And the required rate of growth for a moving equilibrium through time is

97
Y/Y= s/cr =gw -------------------------------------------------------------------------5

This is the warranted rate of growths (gw). For dynamic equilibrium, output must grow at this
rate. The condition for equilibrium is that

g=gw

From e5 and el, this means

gc = gwcr (g/gw = cr/c)

Suppose there is disequilibrium g>gw then c<cr implies investment fall below the level required
to meet the increase in output. There will be a shortage of equipment, a depletion of stocks and
an incentive to invest more. The actual growth rate will then depart even further from the
warranted rate. The rivers true for surplus of goods and investment will be discouraged, causing
the actual growth rate to fall even further below the equilibrium rate. Thus, as Harrod points out,
in the dynamic field we have a condition opposite to that in static field.

Natural growth rate (go): derived from the identity

Finally, there is no limit to how much growth can be had! Although the Harrod Domar model
was initially created to help analyze the business cycle, it was later adapted to explain economic
growth. Its implications were that growth depends on the quantity of labor and capital; more
investment leads to capital accumulation, which generates economic growth. The model also had
implication for less economically developed countries; labor is in plentiful supply in these
countries but physical capital is not, slowing economic progress. LDCS do not have sufficient
average incomes to enable high rates of saving, and therefore accumulation of the capital stock
through investment is low.

The Solow Model

The Solow model is built around two equations, a production function and a capital
accumulation equation. The production function describes how inputs are combined to produce
output. To simplify the model, we group these inputs into two categories, capital, K, and labour,
L, and denote output as Y. The production function is assumed to have the
Cobb-Douglas form and is given by

Y = F(K, L) = K α L1−α….…..(1)

98
where α is some number between 0 and 1. Notice that this production function exhibits constant
returns to scale: if all of the inputs are doubled, output will exactly double- i.e. a production
function has constant returns to scale if

zY = F(zK, zL)

for any positive number z. That is, if we multiply bothcapital and labour by z, we also multiply
the amount of output by z. In line with the above stylised facts, we are interested in explaining
output per worker or per capita output. With this interest in mind, we can rewrite the production
function in equation [1] in terms of output per worker, y ≡ Y/L, and capital per worker, k ≡ K/L -
i.e. setting z = 1/L
Y/L = F(K/L, 1)
y=f(k) where f(k) = F(k, 1)

Equation [1] can, thus, be written as

y = k
α
………..(2)

This production function is graphed below. With more capital per worker, firms produce more
output per worker. However, there are diminishing returns to capital per worker: each additional
unit of capital we give to a single worker increases the output of that worker by less and less.

Theories of Development
Rostow’s Stage of Economic growth
Walt W. Rostow uses the historical approach to explain the process of economic development.
Its essence is that logically and practically possible to identify stages of development and to
classify societies. According to him, there are five stages of economic growth;

The Traditional Society: the traditional society is defined as one whose structure is developed
within a limited production and backward technology. The “Pre-condition for Take-off”

He calls the stage between feudalism and take-off the transition stage. During the transition
period all the pre-conditions for sustained economic development are created. In this stage level
on economic front; investment raised, self-sustaining growth ensured, main direction of
investment build especially transportation and telecommunication, technological revolution in
agricultural sector, import expansion. On social front; new elite emerged, surplus channeled by

99
new elite from agriculture to industry. In addition, politically effective modern government is
vital.

Take-off: is defined by Rostow as “an industrial revolution tied directly to radical changes in the
methods of production having their impact over a short period of time which lasts for two
decades.” It has three necessary conditions: a rise in the rate of productive investment,
development of substantial manufacturing sector, and the existence of political, social, and
institutional framework in fostering economic development.

There are two approaches for take-off: Aggregate approach based on H-D model of growth and
leading sector approaches based on unbalanced growth theory. The take-off period is different
for different countries. The take-off stages for some of the developed countries are

Drive to maturity stage: a period when a society has effectively applied the range of modern
technology to develop the bulk of its resources. In this stage, three significant changes take
place: character of work force become skilled and organized), entrepreneurship,
industrialization. Age of High Mass Consumptions: during this stage, the balance of attention
of society is shifted from supply to demand for goods and services and from problems of
production to consumption and welfare.

Criticisms of Rostow’s model: too rigid, universal applicability claimed, linear conception of
history in the stages of growth is a-historical.

2.1.1. Surplus Labour Theory

Prof. Arthur Lewis has developed a very systematic theory of economic development with
unlimited supply of labour. Its focus was structural transformation of a primary subsistence
economy. The model starts with the assumption of a dual economy with a modern industrial
sector and a traditional subsistence sector.

2.1.2. Dualistic Theories

Dualism indicates a situation where types of parallel phenomena co-exist. It represents the
existence and persistence of increasing divergences between rich and poor nations and rich and
poor peoples on various levels. Specifically, the concept of dualism embraces four key elements
such as; superior and others inferior can co-exist in a given space, This co-existence is chronic
and not merely transitional, Not only do the degrees of superiority or inferiority fail to show any

100
sign of diminishing, but they even have an inherent tendency to increase and The interrelations
between the superior and inferior elements

Dualism has been perceived in different ways such as: social, technological (use of different
production functions in the advanced sector and the traditional sector of the economies of
underdeveloped countries), financial (co-existence of different interest rates in the organized
and unorganized money markets in the LDCs), and geographic dualism.

CHAPTER FOUR

Historic Growth and Contemporary Development: Lesson and controversies

Today, countries of the world are divided into rich (developed) countries and poor (developing)
countries. There is a wide gap between the rich and the poor countries. The statement that “the
rich nations get richer and the poor countries get poorer” has become popular in the literature in
world poverty. But what are the explanations for the poor performance of the developing
countries? There are two approaches to explain the determinants of economic development the
traditional approach and the institutional approach.

4.1 Traditional Approach (Economic Factors) to Development

The traditional approach to development assumes that economic development is determined by
economic factors, like natural resources, capital, technology, etc. Let’s see each of the major
economic factors

a) Natural Resources: The principals’ factor affecting the development of an economy is the
natural resources or land. “Land” as used in economic includes natural resources such as fertility
of land, its situation and composition, forest wealth, minerals, climate, water resources, sea
resources, geographical proximity with rich countries etc. For growth, the existence of natural
resources in abundance is essential. A country which is deficient in natural resources will not be
in a position to develop rapidly. As pointed out by Lewis, “Other things being equal, men can
make better use of rich resources than they can of poor.”

In LDCs natural resources are unutilized, underutilized or mutualized. These are one of the
reasons for their backwardness. The presence of natural resources is not sufficient for economic
growth. What is required is their proper exploitation.

101
It is often said that economic growth is possible even when an economic is deficient in natural
resources. As pointed out by Lewis, “A country which is considered to be poor in resources
today may be considered very rich in resources at some later time, not merely because unknown
resources are discovered, but equally because new uses are discovered for the known resources.”
Japan is one such country which is deficient in natural resources but it is one of the advanced
countries of the world because it has been able to discover new uses for limited resources.

b) Capital Accumulation
Capital means the stock of physical reproducible factors of production. When capital stock
increases with the passage of time, it is called capital accumulation or capital formation. Capital
formation is investment in capital goods that leads to increase in capital stock, national output
and income.

Capital formation is the key to economic development. On the one hand it reflects effective
demand and on the other hand, it creates productive efficiency for production. Capital formation
possesses special importance to LDCs. The process of capital formation leads to the increase in
national output in a number of ways. Capital formation is essential to meet the requirements of
an increasing population in such economies. Investment in capital goods not only raises
production but also employment opportunities. It is capital formation that leads to technological
progress. Technological in turn leads to specialization and the economies of large scale
production. The provision of social and economic over heads, like transport, power education
etc in a country is possible through capital formation. It is also capital formation that leads to the
exploitation of natural resources, industrialization and expansion of markets which are essential
for economic progress.

c) Organization

Organization is an important part of the growth process. It relates to the optimum use of factor
of production economic activities. Organization is complement to capital and labour and helps
in increasing their product activities. In modern economic growth, the entrepreneur has been
performing the task of an organizer and undertaking risks and uncertainties.

The underdeveloped countries lack entrepreneurial activity. Such factors as the small size of the
market, capital deficiency, absence of private property and contract, lack of skilled and trained
labour, non-availability of adequate raw materials and infrastructural facilities like transport,
power, etc increase risk and uncertainties. That is why such countries lack entrepreneurs.

102
d) Technological Progress: Technological charges are regarded as the most important factor in
the process of economic growth. They are related to changes in the methods of production
which are the result of some new techniques of research or innovation. Changes in Technology
lead to increase in productivity of labour, capital and other factors of production.

e) Division of labour and scale of production: Specialization and division of labour lead to
increase in productivity. They lead to economies of large scale production which further help in
industrial development. Adam Smith gave much importance to the division of labour in
economic development. Division of labour leads to improvement in the productive capacities of
labour. Every laborer becomes more efficient than before. S/he saves time. S/he is capable of
inventing new machines and process in production. Ultimately production increases manifold.
But division of labour depends upon the size of the market. The size of the market, in turn,
depends upon economic progress, i.e. the extent to which the size of demand, the general level of
production, the means of transport etc are developed. When the scale of production is large there
is greater specialization and division of labour. As a result production increases and the rate of
economic progress is accelerated.
Underdeveloped countries are unable to take advantage of the economics of division of labour
and large scale production due to the presence of market imperfections, which in turn keep the
size of the market small.

4.2 Institutional Approach to Development

The institutional approach to development is a recent phenomenon. It argues that explanations
of the poor economic development are found not only in economic factors but also non-
economic factors. In fact most of these factors are explained by non-economic factors or
institutional factors.

The institutional approach to development emphasizes importance of the institutional factors

more than the economic factors using the case of a metropolitan city. The central city in a
metropolitan area, while gaining some high-rise buildings, has a stagnant population and an
increasing proportion of poor people. On the other hand suburbs are prosperous and growing
rapidly. To a certain degree, modern economics is like such a metropolitan area. The traditional
economics is at the center of the city. At the same time, the suburbs of economics are expanding
rapidly in all directions.

The institution approach to development is a case in point. For example, consider shifting the
focus from capital and other resources toward the quality of governance. In the suburbs of

103
economics, governance is a focus, but not in the city center where capital is the focus. The
institutional factor further argues that most of the economic factors can be obtained in the
globalize market. For example, many MNCs are ready to invest a significant amount of capital if
conditions are favorable. Besides LDCs can also borrow technologies from DCS.

The institutional factors that determine economic performance include.

a) Type of Government
A country with a monarchy system is less likely to develop as compared with a country with a
democratic government. The nature of democracy depends on the level of education, discipline,
culture etc of the people. In maintaining rules, governments could be soft or strong. To maintain
rules and there by prepare the ground for development, governments need be strong. To provide
for the enforcement of contracts, the prevention of anarchy, and the provision of other public
good, the coercive power of government is necessary.
Good governance is another important factor which determinants economic performance of
countries. According to Olson M. “Governance is a decisive determinant of economic
performance and that with the right economic policy and institutions, poor countries can grow at
a very rapid rate.” Good governance is reflected by long tem vision, correct policies and
effective implementation. For example, in Japan the government decided what type of industries
to develop after World War II. It gave emphasis to textile, iron and steel, shipbuilding etc. In
recent years, the government shifted towards electronics in response to a change in world market.

Another aspect of good governance is the development of infrastructure. Countries like Hong
Kong, Singapore, Malaysia, etc develop infrastructure and attract foreign capital.

b)Institutions: Availability of technology like the capital good, complementary factors like
infrastructure, highly skilled labor, innovation etc are required for an economy to grow. To have
such technological changes requires a good institution. For example, in making innovations,
there could be resistance. To calm such resistance, government effort is required. Thus,
institutions that encourage technological innovation and suitability of institution for successful
adoption of new ideas is an important question. Political and cultural dynamism help in adoption
of new technology and the negative forces such as labour union orthodoxy should be managed
properly by good governance. Spread of education, scientific culture are necessary for adoption
of new technology

104
Reservation/Affirmative Action/. Social justice requires that if some sections of the society are
deprived, they must be given special attention i.e. reservation is needed. The supporters of
reservation justify its use in terms of social justice, equity and to rectify historical mistakes.
However, from the point of view of efficiency, it is not justified.

c) Social Structure of Population: In some countries, we get a homogenous type of population.

Homogeneity of the population leads to the development of national feelings, which is helpful
for economic development – for example China, Japan, Korea, Russia. On the other hand,
population of a country could also be heterogeneous - divided on the basis of language, religion,
ethnicity, caste etc. In such societies, some groups play entrepreneurial role. For example, the
Jews in USA.

d)Human Capital and Cultural Traits: The difference in per capita income among countries
could be explained by human capital and cultural traits. In the DCs, human capital and cultural
traits in the form of work culture, discipline, good entrepreneurship etc have played an important
role. Poor countries are poor because they lack these traits. The cultural traits that perpetuate
poverty are the result of centuries of social accumulation and they can’t be changed quickly.
Cultural advancement according to M. Olson results in two types of human capital:
a) Marketable human capital - these include more skill, propensity to work harder, more
entrepreneurial personality - these qualities result in increase in the quality and quantity
of productive outputs. These results in increase in income of persons, groups as well as
of nations.
b) Civic culture. A civic culture leads to the election of good government which adopts
good policy. It also results in a disciplined society. Corruption will be less. People pay
tax.
It is impossible to study the economic growth of the developing countries in modern times
without considering the mutual interactions between these economies and those of the
advanced countries. When Western European Capitalism began to expand its production and
trade on a world-wide scale, it awakened the less-developed areas of the world to modern
economic development. This article will take up the Asian afea, including Japan, as object
of examination. Economic growth in the Asian area was brought about by the eastward
advance of Western European capitalism. In this intermingling of Western European and
Asian economies the following historical stages can be observed.
The first stage is the period when native Asian industry developed as a result of the
exchange of native Asian products for Western European industrial products.

105
The second stage is the period when the native handicraft industry crumbled because
manufactured consumer goods flowed into the Asian area after the Industrial Revolution in
Western Europe. The third stage is the period when Western European capital and
techniques infiltrated the Asian area for the large-scale in consequence; there was a
conspicuous change from consumer goods to capital goods in the import structure.
The sixth stage is the period when manufactured goods in general began to be produced by
native industries, whether the raw materials were domestically available or not. The capital
goods required by these industries were imported at the expense of the induction of foreign
capital and of the export of primary products. The seventh stage is the period when the
industrialization of the developing countries became so advanced as to make possible the
export of manufactured consumer goods, and when the domestic production of some capital
goods gradually came to the fore.

CHAPTER FIVE

INEQUALITY, POVERTY AND DEVELOPMENT

The 1970, witnessed a remarkable change in public and private perceptions about the ultimate
nature of economic activity. In both rich and poor countries, there was a growing disillusionment
with the idea that relentless pursuit growth was the principal economic objective of society. In
the developed countries, the major emphasis seemed to shift toward more concern for the quality
of life, a concern manifested mainly in the environmental movement.

In this chapter, we will examine:-

 What is the extent of relative inequality in LDCs

 Who are the poor, and their economic characteristics?

 Hat determine the nature of economic growth, that is who benefits?

 Are rapid economic growth and more equitable distributions of income?

 What kinds of policies are required to reduce the magnitude and extent of absolute
poverty?

Income inequality

106
By pulling question 1and 2 together same recent evidence from variety of sources; we define the
dimensions of income distribution and poverty problems and identify some similar elements that
characterize the problem in many developing countries. Economists usually like to distinguish
between two principal measures of income distribution for both analytic and quantitative
purposes.

1. The personal or size distribution of income: is the measure most commonly used by
economists. It simply deals with individual persons or households and the total income they
receive. Economists and statisticians, therefore, like to arrange all individuals by ascending
personal incomes and then divided the total population in to distinct groups or sizes. A
common method is to divide the population in to successive quintiles (fifths) or deciles
(tenths) according to the ascending income levels and then determine what proportion of the
total national income is received by each income group.

Lorenz Curve: Another common way to a personal income statistics is to construct what is
known as a Lorenz curve. On the horizontal axis, the number of income recipients is plotted, not
in absolute terms but in cumulative percentages. The vertical axis shows the share of total
income received by each percentage of the population; it also is cumulative up to 100% meaning
that both axes are equally long. The entire figure is enclosed in a square and the curve shows the
actual quantitative relationship between the percentages of income recipients and the percentage
of the actual income they did in fact receive during, say, a given year.

The more the Lorenz line curves is away from the diagonal (perfect equality), the greater the
degree of inequality represented. The extreme case of perfect inequality ( i.e. a situation in which
one person receives all of the national income while ever body else receives nothing) would be
represented by the congruence of the Lorenz curve with the bottom horizontal and right hand
vertical axes.

107
Gini Coefficient or Gini concentration ratio: A final and very convenient short hand summary
measure of the relative degree of income inequality in a country can be obtained by calculating
the ratio of the area between the diagonal and the Lorenz curve divided by the total area of the
half square in which the curve lies. This is shown below.

Figure5.1: Gini coefficient curve

Gini Shaded Area A

Coefficient Total Area BCD

2. The functional or distributive factor share distribution of income:

The second common measure of income distribution used by economists, the functional or factor
share distributions of income, attempts to explain the share of total national income that each of
the factors of production (land, labour and capital) receives. Instead of looking at individuals as
separate entities, inquiries into the percentage that labour receives as a whole and compares this

108
with the percentages of total income distributed in the form of rent, interest, and profit (i.e. the
return to land and financial and physical capital).

Inequality and Absolut Poverty

Inequality: variations among countries

Question5.1 what is the relationship between levels of per capita income and degree of
inequality? Are higher incomes associated with greater or lesser inequality or can no definitive
statement be made?

Absolute poverty: Extent and magnitude

Now let's switch our attention from relative income shares of various percentile groups with in a
given population to the more significant question of the extent and magnitude of absolute
poverty in developing countries. Absolute poverty is meant to represent a specific minimum
level of income needed to satisfy the basic physical needs of food, clothing and shelter in order
to ensure continued survival extent of obsolete poverty is therefore the number of people who
are unable to command sufficient resources to satisfy basic needs.

A problem, however, arises when one recognizes that those minimum subsistence levels will
vary from country to country and region to region, reflecting different physiological as well as
social and economic requirements. Economists have therefore tended to make consultative
estimates of world poverty in order to avoid unsubstantiated exaggerations of the problem. Since
the international poverty line knows no boundaries, is independent of the level of national per
capita income, and takes into account differing price level by measuring poverty as any one
living on less than $1 a day in PPP dollars.

Question 5.2 let’s assume that the poverty line is set at $360. If two individuals A and B earn $
350 and $300 respectively, the two are below the poverty line Are two equally poor

Question5.3"Higher per capita incomes per se do not guarantee the absence of significant
numbers of absolute poor. It is possible for a country with a higher per capita income to have a
large percentage line and a larger poverty gap than a country with a lower per capita income
“Argue on this statement by relating your answers to question5.1

Why poverty persist in LDCs? The answer is basically because of large inequality level within a
nation and across countries. Consider the following facts: among four point four billion people
live in developing countries. Three-fifths lack basic sanitation, almost one third have no access to

109
clean water and quarter (25%) do not have adequate housing. Twenty percent have no access to
modern health services. In 1997 the richest fifth of the world’s population had 74 times the
income of the poorest fifth. The top three billionaires have assets greater than the combined
GNP of all least developed countries and their 600 million people.

Why should we be concerned with inequality among those above the poverty line? There are
three major answers to this question. First, extreme income inequality leads to economic
inefficiency. This disparity undermines social stability and solidarity. High inequality facilitates
rent seeking, including actions such as excessive lobbying and bribery. These can be generally
viewed as unfair. Generally, our assumption is that social welfare depends positively on the
level of income per capita but negatively on poverty and negatively on the level of inequality.

Factors Driving Higher Income Inequality

Technological change: eliminating many jobs through automation, financial development could
benefit the rich in the early stages of development, changes in labor market institutions (a decline
in trade union membership could reduce the relative bargaining power of labor), redistributive
policies, false Progressive taxation & social transfers.

Causes of poverty in third world countries (LDCs

Trade: third world countries lose out through unfair trade agreements, lack of technology and
investment, and rapidly changing prices for their goods.

Work and globalisation: Better communications and transport have led to a “globalised”
economy. Companies look for low-cost countries to invest in. This can mean that, though there
are jobs, they are low-paid.

War or conflict: When a country is at war (including civil war) basic services like education are
disrupted. People leave their homes as refugees. Crops are destroyed

Policy Option: Four broad areas of possible government policy intervention can be identified:

1) Altering the functional distribution through and changing relative factor prices.

It is argued that measures designed to reduce the price of labor relative to capital (e.g., through
public wage subsidies to employers) will cause employers to substitute labor for capital in their
production activities Such factor substitution increases the overall level of employment and
ultimately raises the incomes of the poor.

110
 2) Mitigating the size distribution: through progressive redistribution of asset ownership

3) Moderating (reducing) the size distribution at upper levels: through progressive taxation of
personal income and wealth. Progressive income tax is a tax whose rate increases with
increasing personal incomes. Such taxation increases government revenues that decrease
the share of disposable income of the very rich

4) Moderating (increasing) the size distribution at lower levels: through transfer payments
and public provision of goods and services.

DEVELOPMENT ECONOMICS-II
CHAPTER ONE

Population Growth and the Quality of Life

Every year approximately 80 million people are being added to the world’s population. Almost
all of this net population increase (97%) is in developing countries. Increases of such magnitude
are unprecedented. But the problem of population growth is not simply a problem of numbers. It
is a problem of human welfare and of development. Rapid population growth can have serious
consequences for the well-being of all of humanity. If development entails the improvement in
people’s levels of living, then the really important question about population growth is this: How
does the contemporary population situation in many developing countries contribute to or detract
from their chances of realizing the goals of development, not only for the current generation but
also for future generations? Conversely, how does development affect population growth?

Among the major issues relating to this basic question are the following: Will developing
countries be capable of improving the levels of living for their people with the current and
anticipated levels of population growth? To what extent does rapid population increase make it
more difficult to provide essential social services, including housing, transport, sanitation, and
security?

How will the developing countries be able to cope with the vast increases in their labor forces
over the coming decades? Will employment opportunities be plentiful, or will it be a major
achievement just to keep unemployment levels from rising? What are the implications of
higher population growth rates among the world’s poor for their chances of overcoming the
human misery of absolute poverty? Will world food supply and its distribution be sufficient
not only to meet the anticipated population increase in the coming decades but also to
improve nutritional levels to the point where all humans can have an adequate diet?

111
Given the anticipated population growth, will developing countries be able to extend the
coverage and improve the quality of their health and educational systems so that everyone
can at least have the chance to secure adequate health care and a basic education? To what
extent are low levels of living an important factor in limiting the freedom of parents to
choose a desired family size? Is there a relationship between poverty and family size?

To what extent is the governing affluence among the economically more developed nations
an important factor preventing poor nations from accommodating their growing populations?
Is the inevitable pursuit of increasing affluence among the rich more detrimental to the global
environment and to rising living standards among the poor than the absolute increase in their
numbers? We will try to explore and explain these and other problems in this course.

World Population Growth through History

Given current population growth rates in different parts of the world, the regional distribution of
the world’s population will inevitably change by 2050. By that time, it is likely that there will be
6.6 billion more people on the earth than in 1950 and 3.1 billion more than in 2000. Africa will
experience the largest percentage increase (184%), and its projected population of 2.1 billion
will be almost three times its 1998 population and almost 10 times its 1950 population.

Fertility and Mortality Trends: the rate of population increase is quantitatively measured as
the percentage yearly net relative increase in population size due to natural increase and net
international migration. Natural increase simply measures the excess of births over deaths or,
in more technical terms, the difference between fertility and mortality rates.

The difference between developing and developed nations in terms of rates of population
growth can be explained simply by the fact the birthrates (fertility rates) in developing
countries are generally much higher than in the rich nations. In Developing countries, death
rates (mortality rates) are also higher. However, these death rate differences are substantially
smaller than the differences in birthrates. Age Structure and dependency Burdens: World
population today is very youthful, particularly in the developing world. Children under the
age of 15 constitute more than 31% of the total population of developing countries but just
18% of developed nations.

112
The Hidden Momentum of Population Growth
Perhaps the least understood aspect of population growth is its tendency to continue even
after birthrates have declined substantially. Population growth has a built-in tendency to
continue, a powerful momentum that, like a speeding automobile when the brakes are
applied, tends to keep going for some time before coming to a stop. In the case of population
growth, this momentum can persist for decades after birthrates drop. There are two basic
reasons for this. First, high birthrates cannot be altered substantially overnight. The social,
economic, and institutional forces that have influenced fertility rates over the course of
centuries do not simply evaporate at the urging of national leaders. The second and less
obvious reason for the hidden momentum of population growth rate is related to the age
structure of LDC.

The cause for high fertility in LDCs

Malthusian Population Trap
Two centuries ago, the Reverend Thomas Malthus put forward a theory of the relationship
between population growth and economic development that still survives today. The
Malthusian population trap provides a theory of the relationship between population growth
and economic development. Unfortunately, it is based on a number of simplistic assumptions
and hypotheses that do not stand the test of empirical verification.
We can thus largely reject the Malthusian and neo-Malthusian theories as applied to
contemporary developing nations on the following grounds: first they do not take adequate
account of the role and impact of technological progress. Second they are based on a
hypothesis about a macro relationship between population growth and levels of per capita
income that does not stand up to empirical testing. Third they focus on the wrong variable,
per capita income, as the principal determinant of population growth rates. Thus, a much
better and more valid approach to the question of population and development centers on the
microeconomics of family size decision making in which individual, and not aggregate,
levels of living become the principal determinant of a family’s decision to have more or
fewer children.

The Microeconomic Household Theory of Fertility

In recent years, economists have begun to look more closely at the microeconomic
determinants of family fertility in an attempt to provide a better theoretical and empirical
explanation for the observed falling birthrates associated with stage 3 of the demographic

113
transition. In doing this, they have drawn on the traditional neoclassical theory of household
and consumer behavior for their basic analytical model and have used the principles of
economy and optimization to explain family size decisions. Specifically, birthrates among
the very poor are likely to fall where there is : An increase in the education of women and a
consequent change in their role and status.

An increase in female nonagricultural wage employment opportunities, which raises the price
or cost of their traditional child-rearing activities; a rise in family income levels through the
increased direct employment and earnings of a husband and wife or through the
redistribution of income and assets from rich to poor; a reduction in infant mortality through
expanded public-health programs and better nutritional status for both mother and child and
better medical care; the development of old-age and other social security systems outside the
extended family network to lessen the economic dependence of parents, especially women,
on their offspring and Expanded schooling opportunities so parents can better substitute child
“quality” for large numbers of children.

1.1.1. Some Policy Approaches

In view of these broad goals and objectives, what kinds of economic and social policies
might the developing country and developed-country governments and international
assistance agencies consider bringing about long-term reductions in the overall rate of world
population growth? Three areas of policy can have important direct and indirect influences
on the well-being of present and future world populations:

General and specific policies that LDC governments can initiate to influence and perhaps
even control their population growth and distribution. General and specific policies that
developed-country governments can initiate in their own countries to lessen their
disproportionate consumption of limited world resources and promote a more equitable
distribution of the benefits of global economic progress.

Certain development policies are particularly crucial in the transition from a high-growth to a
low-growth population. These policies aim at eliminating absolute poverty; lessening income
inequalities; expanding educational opportunities, especially for women; providing increased
job opportunities for both men and women; bringing the benefits of modern preventive
medicine and public-health programs, especially the provision of clean water and sanitation,
to the rural and urban poor; improving maternal and child health through more food, better

114
diets, and improved nutrition to lower infant mortality; and creating a more equitable
provision of other social services to wide segments of the population.

1.1.2. How Developed Countries Can Assist Developing Countries with Their Population
Programs

There are also a number of ways in which the governments of rich countries and
multilateral donor agencies can help the governments of developing countries achieve their
population policy objectives in shorter periods of time. The most important of these concerns the
willingness of rich countries to be of genuine assistance to poor countries in their development
efforts. Such genuine support would consist not only of expanded public and private financial
assistance but also of improved trade relations, such as tariff-and quota-free access to developed-
country markets, more appropriate technology transfers, and assistance in developing indigenous
scientific research capacities, better international commodity-pricing policies, and a more
equitable sharing of the world’s scarce natural resources.

There are two other activities more directly related to fertility moderation in which rich-country
governments, international donor agencies, and private non-governmental organizations (NGOs)
can play an important assisting role.

The first is the whole area of research into the technology of fertility control, the contraceptive
pill, modern intrauterine devices (IUDs), voluntary sterilization procedures, and, particularly for
Africa in the age of AIDs, effective barrier contraception.

The second area includes financial assistance from developed countries for family-planning
programs, public education, and national population policy research activities in the
developing countries. This has traditionally been the primary area of developed-country
assistance in the field of population.

UNIT TWO

Human Capital: Education and Health in Economic Development

In the third unit, we examine the roles of education and health in economic development.
These two human capital issues are treated together because of their close relationship. We
consider the relationships between income on the one hand and health and education on the
other.

115
 1.2. Education and Health as Joint Investments for
Development

Health and education are closely related in economic development. On the one hand, greater
health capital may improve the return to investment in education, in part because health is an
important factor in school attendance and in the formal learning process of a child. A longer
life raises the return to investments in education; better health at any point during working
life may in effect lower the rate of depreciation of education capital. On the other hand,
greater education capital may improve the return to investments in health, because many
health programs rely on basic skills often learned at school, including personal hygiene and
sanitation, not to mention basic literacy; education is also needed for the formation and
training of health personnel. Finally, an improvement in productive efficiency from
investments in education raises the return on a lifesaving investment in health.

Why Increasing Income Is Not Sufficient? Health and education levels are much higher in
high-income countries. There are good reasons to believe that the causality runs in both
directions: With higher in-come, people and governments can afford to spend more on
education and health; with greater health and education, higher productivity and incomes are
possible. Because of these relationships, development policy needs to focus on income,
health, and education simultaneously.

Child Labor: Child labor is a widespread problem in developing countries. When a child under
age 14 work, their labor time disrupts their schooling and in a majority of cases prevents them
from attending school. Compounding this, the health of child workers is significantly worse,
even accounting for their poverty status, than that of children who do not work; physical stunting
among child laborers is very common. In addition, a large fraction of laboring children is subject
to especially cruel and exploitative working conditions that will affect their health and their
productivity during their old age that will have direct impact on the development of the
developing courtiers.

There are four main approaches to child labor policy currently in development policy: The first
recognizes child labor as an expression of poverty and recommends an emphasis on eliminating

116
poverty rather than directly addressing child labor; this position is generally associated with the
World Bank.

The second approach emphasizes strategies to get more children into school, including expanded
school places, such as new village schools, and incentives to induce parents to send their children
to school. The third approach considers child labor inevitable, at least in the short run, and
stresses palliative measures such as regulating it to prevent abuse and to provide support services
for working children. The fourth approach favors banning child labor. If this is not possible,
however, and recognizing that child labor may not always result from multiple equilibria, this
approach favors banning child labor in its most abusive forms. The latter approach has received
much attention in recent years.

Finally, many activists in developed countries have proposed the imposition of trade sanctions
against countries that permit child labor or at least banning the goods on which children work.
This approach is well intentioned, but if the objective is the welfare of children, it needs to be
considered carefully, because if children cannot work in the export sector, they will almost
certainly be forced to work in the informal sector, where wages and other working conditions are
generally worse.

1.3. Policies for Health, Education, and Income

Generation

In the coming years, the clear evidence that health and education are joint in-vestments may
offer scope for a more integrated policy approach. It may be that one of the most effective
investments we can make in education quality is to improve child health. Similarly, one of
the most effective investments we could make in health may be to improve the quality of
education. In fact, a number of prominent poverty programs in developing countries now
explicitly integrate incentives for the development of health and education human capital
among low income families. Integrated strategies seek linking highly successful micro credit
systems with health and education.

Integrating program on education, health and nutrition is another good strategy to refer to. In
this integrated strategy, there is cash transfer to poor family, family clink visit, and other in
kind nutritional supplement, and other health benefits for pregnant and lactating women and
their children under a specified age. Some of the benefits can be made conditional on child’s

117
regular school attendance. In this manner it is possible to integrated health, education and
benefit packages to the households.

Chapter three

Rural-urban intersection, migration, and unemployment

After completing this unit, you will clearly understand the potential roles of cities to enhance
economic development in the contemporary developing economies you be familiar with the well-
known theoretical model of rural- urban migration( the Todaro Model of Migration) you will be
able examine the advantages and disadvantages of the informal sector in the modern cities of the
contemporary developing countries you will be able to evaluate different policy options that the
contemporary developing countries should pursue to solve problems associated with heavy in
flow of rural to urban migration

1.4. The role cities

What explains the strong association between urbanization and development? To a large degree,
cities are formed because they provide cost advantages to producers and consumers through what
are called agglomeration economies. Agglomeration economies come in two forms. Urbanization
economies are effects associated with the general growth of a concentrated geographic region.
Localization economies are effects captured by particular sectors of the economy, such as
finance or automobiles, as they grow within an area.

1.5. The Urban Giantism Problem

In the case of developing countries, the main transportation routes are often a legacy of
colonialism. Theorists of the dependency school have compared colonial transportation networks
to drainage systems, emphasizing ease of extraction of the country's natural resources. In many
cases, the capital city will be located near the outlet of this system on the sea cost. This type of
transportation system is also called a "hub-and-spoke system," which is especially visible when
the capital city is located in the interior of the country.

1.5.1. Causes of Urban Giantism

Why have first cities often swelled to such a large multiple of second cities in developing
countries? Overall, urban giantism probably results from a combination of a hub-and-spoke
transportation system and the location of the political capital in the largest city, thus combining

118
the effects of the urban hierarchy model with the differentiated plane model. This is further
reinforced by a political culture of rent seeking and the capital market failures that make the
creation of new urban centers a task that markets cannot complete.

The Urban Informal Sector

As discussed in module one, a major focus of development theory has been on the dualistic
nature of developing countries' national economies-the existence of a modern urban capitalist
sector geared toward capital-intensive, large-scale production and a traditional rural subsistence
sector geared toward labor-intensive, small-scale production. The informal sector continues to
play an important role in developing countries, despite decades of benign neglect at best and
outright hostility at worst. In many developing countries, about half of the employed urban
population works in the informal sector.

The informal sector is characterized by a large number of small-scale production and service
activities that are individually or family-owned and use simple, labor-intensive technology. They
tend to operate like monopolistically competitive firms with ease of entry, excess capacity, and
competition driving profits (incomes) down to the average supply price of labor of potential new
entrants.

Moreover, workers in the informal sector do not enjoy the measure of protection afforded by the
formal modern sector in terms of job security, decent working conditions, and old -age pensions.
Many workers entering this sector are recent migrants from rural areas unable to find
employment in the formal sector. Their motivation is often to obtain sufficient income for
survival, relying on their own indigenous resources to create work. Since many members of the
household as possible are involved in income-generating activities, including women and
children, and they often work very long hours.

A large fraction inhabit shacks that they themselves have built in slums and squatter settlements,
which generally lack minimal public services such as electricity, water, drainage, transportation,
and educational and health services. Others are even less fortunate. They find sporadic temporary
employment in the informal sector as day laborers and hawkers, but their incomes are
insufficient to provide even the most rudimentary shelter.

2.2.1. Arguments in favor of Urban Informal Sector

There are several arguments that are made in favor of promoting the informal sector:

119
First, scattered evidence indicates that the informal sector generates surpluses even under the
currently hostile policy environment, which denies it access to the advantages offered to the
formal sector, such as credit, foreign exchange, and tax concessions. Thus the informal sector's
surplus could provide an impetus to growth in the urban economy.

Second, as a result of its low capital intensity, only a fraction of the capital needed in the formal
sector is required to employ a worker in the informal sector, offering considerable savings to
developing countries so often plagued with capital shortages.

Third, by providing access to training and apprenticeships at substantially lower costs than that
provided by formal institutions and the formal sector; the informal sector can play an important
role in the formation of human capital.

Fourth, the informal sector generates demand for semiskilled and unskilled labor whose supply is
increasing in both relative and absolute terms and is unlikely to be absorbed by the formal sector
with its increasing demands for a skilled labor force.

Fifth, the informal sector is more likely to adopt appropriate technologies and make use of local
resources, allowing for a more efficient allocation of resources.

Sixth, the informal sector plays an important role in recycling waste materials, engaging in the
collection of goods ranging from scrap metals to cigarette butts, many of which find their way to
the industrial sector or provide basic commodities for the poor. Finally, promotion of the
informal sector would ensure an increased distribution of the benefits of development to the
poor, many of whom are concentrated in the informal sector. Promotion of the informal sector is
not, however, without its disadvantages.

Urban Unemployment
One of the major consequences of the rapid urbanization process has been the burgeoning supply
of job seekers into both the modern (formal) and informal sectors of the urban economy. In many
developing countries, the supply of workers far exceeds the demand, the result being extremely
high rates of unemployment and underemployment in urban areas. Because a major contributing
factor to both high rates of urban growth and high rates of unemployment and underemployment
is rural-urban migration, it is essential to investigate this issue in some detail.

120
Migration and Development
As we have seen earlier in the unit, rural-urban migration has been dramatic, and urban
development plays an important role in economic development. Rates of rural-urban migration in
developing countries have exceeded rates of urban job creation and thus surpassed greatly the
absorption capacity of both industry and urban social services. Migration today, particularly to
the largest LDC cities, must be seen as the major factor contributing to the ubiquitous
phenomenon of urban surplus labor, a force that continues to exacerbate already serious urban
unemployment problems.

Migration worsens rural-urban structural imbalances in two direct ways. First, on the supply side,
internal migration disproportionately increases the growth rate of urban job seekers relative to
urban population growth, which itself is at historically unprecedented levels, because of the high
proportion of well-educated young people in the migrant system. Their presence tends to swell
the urban labor supply while depleting the rural countryside of valuable human capital. Second,
on the demand side, urban job creation is generally more difficult and costly to accomplish than
rural job creation because of the need for substantial complementary resource inputs for most
jobs in the industrial sector. Moreover, the pressures of rising urban wages and compulsory
employee fringe benefits in combination with the unavailability of appropriate, more labor-
intensive production technologies means that a rising share of modern-sector output growth is
accounted for by increases in labor productivity. Together this rapid supply increase and lagging
demand growth tend to convert a short-run problem of resource imbalances into a long-run
situation of chronic and rising urban surplus labor

Toward an Economic Theory of Rural-Urban Migration

The economic development of Western Europe and the United States was closely associated with
the movement of labor from rural to urban areas. For the most part, with a rural sector dominated
by agricultural activities and an urban sector focusing on industrialization, overall economic
development in these countries was characterized by the gradual reallocation of labor out of
agriculture and into industry through rural-urban migration, both internal and international.
Urbanization and industrialization were in essence synonymous.

But the overwhelming evidence of the past several decades, when developing nations witnessed
a massive migration of their rural populations into urban areas despite rising levels of urban
unemployment and underemployment, lessens the validity of the Lewis two-sector model of

121
development. An explanation of the phenomenon, as well as policies to address the resulting
problems must be sought elsewhere. As a result the Todaro migration model was developed

2.2.2. Five Policy Implications of the Model

Although the Todaro theory might at first seem to devalue the critical importance of rural-urban
migration by portraying it as an adjustment mechanism by which workers allocate themselves
between rural and urban labor markets, it does have important policy implications for
development strategy with regard to wages and incomes, rural development, and
industrialization.

First, imbalances in urban-rural employment opportunities caused by the urban bias, particularly
first-city bias, of development strategies must be reduced. Because migrants are assumed to
respond to differentials in expected incomes, it is vitally important that imbalances between
economic opportunities in rural and urban sectors be minimized. Permitting urban wage rates to
rise at a greater pace than average rural incomes will stimulate further rural-urban migration in
spite of rising levels of urban unemployment. This heavy influx of people into urban areas not
only gives rise to socioeconomic problems in the cities but may also eventually create problems
of labor shortages in rural areas, especially during the busy seasons. These social costs may
exceed the private benefits of migration.

Second, urban job creation is an insufficient solution for the urban unemployment problem. For
every new job created, two or three migrants who were productively occupied in rural areas may
come to the city. Hence a policy designed to reduce urban unemployment may lead not only to
higher levels of urban unemployment but also to lower levels of agricultural output due to
induced migration. Third, indiscriminate educational expansion will lead to further migration and
unemployment. Fourth, wage subsidies and traditional scarcity factor pricing can be
counterproductive.

Policies of rural development are crucial to this aim. Many informed observers agree on the
central importance of rural and agricultural development if the urban unemployment problem is
to be solved. Most proposals call for the restoration of a proper balance between rural and urban
incomes and for changes in government policies that currently give development programs a
strong bias toward the urban industrial sector (e.g., policies in the provision of health, education,
and social services). Conceptually, it may be useful to think of cities and their surrounding rural

122
areas as integrated systems. There are significant complementarities between town and country.
Agricultural and raw materials grown and extracted in rural areas are inputs for urban industry.

All in all, the Todaro migration model has four basic characteristics:

Migration is stimulated primarily by rational economic considerations of relative benefits and

costs, mostly financial but also psychological.

The decision to migrate depends on expected rather than actual urban-rural real-wage
differentials where the expected differential is determined by the interaction of two variables, the
actual urban-rural wage differential and the probability of successfully obtaining employment in
the urban sector.

UNIT FOUR

AGRICULTURE AND ECONOMIC DEVELOPMENT

This unit is about agriculture and economic development. Agriculture and development of a
nation in general and rural development in particular are highly interconnected. Well over 3.3
billion people lived in rural areas in 2003. People living in the countryside comprise
considerably more than half the population of developing countries. In Africa, the ratios are
much higher, with most countries having rural dwellers in excess of three-quarters of the total
population. Over two-thirds of the world’s poorest people are also located in rural areas and
engaged primarily in subsistence agriculture. It is estimated that more than 800 million of these
people do not have enough food to meet their basic nutritional needs. Their behavior may have
often seemed irrational to many observers. If development is to take place and become self-
sustaining, it will have to include the rural area in general and the agricultural sector in
particular. Six main questions, therefore, need to be asked about agriculture and rural
development as it relates to overall national development:

1. How can total agricultural output and productivity per capita be increased in a
manner that will directly benefit the average small farmer and the landless rural
dwellers while providing a sufficient food surplus to support a growing urban,
industrial sector?
2. What is the process by which traditional low-productivity peasant farms are
transformed into high-productivity commercial enterprises?

123
3. When traditional family farmers and peasant cultivators resist change, is their
behavior stubborn and irrational, or are they acting rationally within the context of
their particular economic environment?
4. Are economic and price incentives sufficient to elicit output increases among
peasant agriculturalists, or are institutional and structural changes in rural farming
systems also required?
5. Is raising agricultural productivity sufficient to improve rural life, or must there
be concomitant off-farm employment creation along with improvements in
educational, medical, and other social services? In other words, what do we mean
by rural development, and how can it be achieved?

124
The Structure of Agrarian Systems in the Developing World
World agriculture comprises two distinct types of farming: (1) the highly efficient agriculture
of the developed countries, where substantial productive capacity and high output per worker
permit a very small number of farmers to feed entire nations, and (2) the inefficient and low-
productivity agriculture of developing countries, where in many instances the agricultural
sector can barely sustain the farm population, let alone the quickly increasing urban
population, even, at a minimum level of subsistence. The gap between the two types of
agriculture is immense.

4.1.1. The Structure of Agrarian Systems in Latin America and Asia:

Similarities and differences:

Both the Latin American and Asian peasant is a rural cultivator whose prime concern is
survival. Earns subsistence income by tilling inadequate piece of land rented from or pawned
to a landlord or moneylender, or by selling his labour for substandard wages to a commercial
agricultural enterprise. Employs techniques rationally scaled to his level of disposable
capital:
o human and animal power rather than mechanized equipment;

o excrement rather than chemical fertilizers;

o traditional crops and seeds rather than experimental cultivation

4.1.1.3 The Structure of Agrarian Systems in Africa

As in Asia and Latin America, subsistence farming on small plots of land is the way of life
for the vast majority of African people. However, the organization and structure of African
agricultural systems differ markedly from those found in contemporary Asia or Latin
America. The great majority of farm families in tropical Africa plan their output primarily for
their own subsistence. Since the basic variable input in African agriculture is farm family and
village labor, African agriculture systems are dominated by three major characteristics: (1)
the importance of subsistence farming in the village community; (2) the existence of some
(though rapidly diminishing) land in excess of immediate requirements, which permits a
general practice of shifting cultivation and reduces the value of land ownership as an
instrument of economic and political power; and (3) the rights of each family (both nuclear
and extended) in a village to have access to land and water in the immediate territorial
vicinity, excluding from such access use by families that do not belong to the community
even though they may be of the same tribe.

125
The low-productivity subsistence farming characteristic of most traditional African
agriculture results from a combination of three historical forces restricting the growth of
output:

1. In spite of the existence of some unused and potentially cultivable land, only small areas
can be planted and weeded by the farm family at a time when it uses only traditional
tools.

2. Given the limited amount of land that a farm family can cultivate in the context of a
traditional technology and the use of primitive tools, these small areas tend to be
intensively cultivated.

3. Labor is scarce during the busiest part of the growing season, planting and weeding
times. At other times, much of the labor is underemployed.

The net result of these three forces had been a relatively constant level of agricultural total output
and labor productivity throughout much of Africa. Of all the major regions of the world, Africa
has suffered the most from its inability to expand food production at a sufficient pace to keep up
with its rapid population growth.

The Economics of Agricultural Development

For expository convenience, we can identify three broad stages in the evolution of
agricultural production. The first and most primitive is the pure, low-productivity, mostly
subsistence-level peasant farm. The second stage is what might be called diversified or mixed
family agriculture, where part of the produce is grown for consumption and part for sale to
the commercial sector. The third stage represents the modern farm, exclusively engaged in
high-productivity specialized agriculture geared to the commercial market.

4.1.2. Subsistence Farming: Risk Aversion, Uncertainty, and Survival

On the classic peasant subsistence farm, most output is produced for family consumption, and a
few staple foods (usually including wheat, barley, sorghum, rice, or corn) are the chief sources of
nutrition. Output and productivity are low, and only the simplest traditional methods and tools
are used. Capital investment is minimal; land and labor are the principal factors of production.
The law of diminishing returns is in operation as more labor is applied to shrinking (or shifting)
parcels of land.

The failure of the rains, the appropriation of his land, and the appearance of the moneylender to
collect outstanding debts are the banes of the peasant's existence and cause him to fear for his
survival. Labor is underemployed for most of the year, although workers may be fully occupied

126
at seasonal peak periods such as planting and harvest. The peasant usually cultivates only as
much land as his family can manage without the need for hired labor, although many peasant
farmers intermittently employ one or two landless laborers.

The environment is harsh and static: Technological limitations, rigid social institutions, and
fragmented markets and communication networks between rural areas and urban centers tend to
discourage higher levels of production. Any cash income that is generated comes mostly from
non-farm wage labor.

The Transition to Mixed and Diversified Farming

It is neither realistic nor desirable to think of instantly transforming a traditional agrarian
system that has prevailed for many generations into a highly specialized commercial farming
system. Diversified or mixed farming therefore represents a logical intermediate step, in the
transition from subsistence to specialized production.

In this stage, the staple crop no longer dominates farm output, and new cash crops such as
fruits, vegetables, coffee, tea, and pyrethrum are established, together with simple animal
husbandry. These new activities can take up the normal slack in farm workloads, during
times of the year when disguised unemployment is prevalent. This is especially desirable in
many developing nations where rural labor is abundantly available for better and more
efficient use.

The success or failure of efforts to transform traditional agriculture will depend not only on
the farmer's ability and skill in raising his productivity but, even more important, on the
social, commercial, and institutional conditions under which he must function. If he can have
reasonable and reliable access to credit, fertilizer, water, crop information, and marketing
facilities; if he receives a fair market price for his output; and if he can feel secure that he and
his family will be the primary beneficiaries of any improvements, there is no reason to
assume that the traditional farmer will not respond to new opportunities to improve his
standard of living.

Evidence from such diverse countries as Colombia, Mexico, Nigeria, Ghana, Kenya, India,
Pakistan, Thailand, and the Philippines shows that under proper conditions, small farmers are
responsive to price incentives and economic opportunities and will make radical changes in
what they produce and how they produce it. Lack of innovation in agriculture, as we have
seen, is usually due not to poor motivation or fear of change but to inadequate or unprofitable
opportunities.

127
Throughout much of the developing world, agriculture is still in this subsistence stage. But in
spite of the relative backwardness of production technologies and the misguided convictions
of some foreigners who attribute the peasants' resistance to change as a sign of incompetence
or irrationality, the fact remains that given the static nature of the

From Divergence to Specialization: Modern Commercial Farming

The specialized farm represents the final and most advanced stage of individual holding in a
mixed market economy. It is the most prevalent type of farming in advanced industrial nations. It
has evolved in response to and parallel with development in other areas of the national economy.
General rises in living standards, biological and technical progress, and the expansion of national
and international markets have provided the main impetus for its emergence and growth.

In specialized farming, pure commercial profit becomes the criterion of success, and maximum
per-hectare yields derived from synthetic (irrigation, fertilizer, pesticides, hybrid seeds, etc.) and
natural resources become the object of farm activity. Production, in short, is entirely for the
market. Specialized farms vary in both size and function. They range from intensively cultivated
fruit and vegetable farms to the vast wheat and corn fields of North America. In most cases,
sophisticated laborsaving mechanical equipment, ranging from huge tractors and combine
harvesters to airborne spraying techniques, permits a single family to cultivate many thousands
of hectares of land.

The common features of all specialized farms, therefore, are their emphasis on the cultivation of
one particular crop, their use of capital-intensive and in many cases laborsaving techniques of
production, and their reliance on economies of scale to reduce unit costs and maximize profits.

Toward a Strategy of Agricultural and Rural Development: Some Main

Requirements
If the major objective of agricultural and rural development in developing nations is the
progressive improvement in rural levels of living achieved primarily through increases in
small-farm incomes, output, and productivity, it is important to identify the principal sources
of agricultural progress and the basic conditions essential to its achievement. These are
necessarily interrelated, but for purposes of description we may separate them and further
divide each into three components:

4.1.3. Sources of small-scale agricultural progress include:

128
Technological change and innovation appropriate government economic policies Supportive
social institutions Conditions for General Rural Advancement : Modernizing farm structures
to meet rising food demands creating an effective supporting system changing the rural
environment to improve levels of living. Let us look at each of these six interrelated
components.

4.2. Technology and Innovation

Two major sources of technological innovation can increase farm yields. Unfortunately, both
have somewhat problematic implications for LDC agricultural development. The first is the
introduction of mechanized agriculture to replace labor. The introduction of labor saving
machinery can have a dramatic effect on the volume of output per worker; especially where
land is extensively cultivated and labor is scarce. For example, one man operating a huge
combine harvester can accomplish in a single hour what would require hundreds of workers
using traditional methods.

But in the rural areas of most developing nations, where land parcels are small, capital is
scarce, and labor is abundant, the introduction of heavily mechanized techniques is not only
often ill-suited to the physical environment but, more important, often also has the effect of
creating more rural unemployment without necessarily lowering per-unit costs of food
production. The second major sources are biological (hybrid seeds), water control
(irrigation), and chemical (fertilizer, pesticides, insecticides, etc.) innovations. They are land-
augmenting;

CHAPTER FIVE

International trade and economic development: the trade policy debate and
industrialization
Over the past several decades, the economies of the world have become increasingly linked,
through expanded international trade in services as well as primary and manufactured goods,
through portfolio investments such as international loans and purchases of stock, and through
direct foreign investment, especially on the part of large multinational corporations. At the
same time, foreign aid has increased very little and indeed has become dwarfed by the now
much larger flows of private capital. These linkages have had a marked effect on the
developing world.

129
Trade Theory and Development Experience
Basic Questions about Trade and Development

Our objective in this section is to focus on traditional and more contemporary theories of
international trade in the context of five basic themes or questions of particular importance to
developing nations. (1)How does international trade affect the rate, structure, and character
of LDC’s economic growth? (2)How does trade alter the distribution of income and wealth
within a country and among different countries? (3) How are the gains and losses distributed,
and who benefits? (4)Under what conditions can trade help LDCs achieve their development
objectives? Can LDCs by their own actions determine how much they trade?

(5) In the light of past experience and prospective judgment, should LDCs adopt an
outward-looking policy (freer trade, expanded flows of capital and human resources, ideas
and technology, etc.) or an inward-looking one (protectionism in the interest of self-reliance),
or should they pursue some combination of both, for example, in the form of regional
economic cooperation? What are the arguments for and against these alternative trade
strategies for development? Thus, clearly the answers or suggested answers to these five
questions will not be uniform throughout the diverse economies of the developing world.

Importance of Exports to Different Developing Nations

Developing countries are generally more dependent on trade than developed countries are.
This is shown clearly in the case of traditionally export-oriented Japan, whose exports
amount to roughly 10% of GDP, whereas LDCs with somewhat larger populations such as
Indonesia, Bangladesh, and Nigeria export a far higher share of output.

While total exports and the share of manufactures in merchandise exports have been rising
for many developing countries, it is important to keep this rise in perspective. A few Newly
Industrialized Countries still command a dominant position in developing-country exports.
For example, in 2000, South Korea alone exported more than all of South Asia and sub-
Saharan Africa combined. And South Korea and Taiwan together exported more
manufactured goods in 2000 than the entire regions of Latin America, the Caribbean, the
Middle East, North Africa, South Asia, and sub-Saharan Africa combined.

2.1.3. The Traditional Theory of International Trade

What determines which goods are traded and why some countries produce some things while
others produce different things? The answer lies in the international differences in costs of

130
production and prices of different products. Thus, the concept of absolute and/or relative cost
and price differences is basic to the theory of international trade. The main idea of Absolute
& Comparative advantage lies on the notion of specialization and trade. If the country
produce a good for which it has an absolute and/or comparative advantage over another
country and trades it with the other country, the total potential consumption in both countries
can be increased beyond what is possible without trade.

The Smith’s theory stated that wealth of nations depend on the goods and services available
to their citizens, rather than their gold reserves.

Trade stimulates economic growth: It enlarges a country’s consumption capacities, increases

world output, and provides access to scarce resources. Trade promotes international and
domestic equality by equalizing factor prices, raising real incomes of trading countries, &
making efficient use of each nation’s resource endowments. E.g. By raising relative wages in
labor-abundant countries and lowering them in labor-scarce countries.

2.1.4. Balance of Payments & Macroeconomic stabilization

The balance of payments (BoP) is a summary statement in which, in principle, all the
economic transactions of the residents of a nation with the residents of all other nations are
recorded during a particular period of time, usually a calendar year. Thus, BoP is the flow of
goods, services, gifts, and assets between the residents of a nation and the residents of other
nations during a particular period of time, usually a calendar year. The techniques of
recording transactions under Debit and Credit in the balance of payment.

Any transaction that supplies the country’s currency in the foreign exchange market (the
market in which currencies of different countries are exchanged) is recorded as a debit. For
example, a U.S. retailer wants to buy Japanese television sets so that he can sell them in his
stores in the United States. He need to supply dollar to FX. Any transaction that creates a
demand for the country’s currency in the foreign exchange market is recorded as a credit.

International transactions are classified as credits or debits. Credit transactions are those that
involve the receipt of payments from foreigners. Debit transactions are those that involve the
making of payments to foreigners.

The BoP has three major accounts under which different transactions are recorded: 1)
Current Account (CA): has many components, such as trade in goods, trade in services, debt
service payments, income & net unilateral transfers. The balance of current account tells us if

131
a country has a deficit or a surplus. If there is deficit or surplus, does that mean the economy
is weak or strong? Not necessarily.

A trade deficit occurs when a country imports more than exports. This could be indication of
less revenue being generated and hence resulting in low standard of living in a given
economy. It could also be a sign of economic expansion. A trade surplus occurs when a
country sells more than it buys from foreign markets.

2) Capital Account: includes all payments related to the purchase and sale of assets and to
borrowing and lending activities. Its major components are outflow of domestic capital and
inflow of foreign capital. Capital account classified in to two capital outflow (domestic
purchases of foreign assets) and capital inflow (foreign purchase of domestic currency).

END

132