MACROECONOMICS

NOTES

NATIONAL INCOME
______________________________________________________________________________________________

After studying this chapter, the students should be able to:

 Describe the national income of a country

 Explain the relationship between output, income and expenditure using the circular flow of
income
 Explain the measurement of the national income
 Discuss the problems associated with the measurement of national income
 Appreciate the uses of national income figures
 Explain the factors that determine a country’s national income
_______________________________________________________________________________

1.0 Introduction

Measures of national income and output are used in Economics to estimate the value of goods
and services produced in an economy. They use a system of national accounts or national
accounting first developed during the 1940s. Some of the more common measures are Gross
National Product (GNP), Gross Domestic Product (GDP), Gross National Income (GNI), Net
National Product (NNP), and Net National Income (NNI).

There are at least three different ways of calculating these numbers. The expenditure approach
determines aggregate demand, or Gross National Expenditure, by summing consumption,
investment, government expenditure and net exports. On the other hand, the income approach and
the closely related output approach can be seen as the summation of consumption, savings and
taxation. The three methods must yield the same results because the total expenditures on goods
and services (GNE) must by definition be equal to the value of the goods and services produced
(GNP) which must be equal to the total income paid to the factors that produced these goods and
services (GNI).

In practice, there are minor differences in the results obtained from the various methods due to
changes in inventory levels. This is because goods in inventory have been produced (and therefore
included in GDP), but not yet sold (and therefore not yet included in GNE). Similar timing issues
can also cause a slight discrepancy between the value of goods produced (GDP) and the payments
to the factors that produced the goods, particularly if inputs are purchased on credit.

Gross National Product

Gross National Product (GNP) is the total value of final goods and services produced in a year
by a country's nationals (including profits from capital held abroad).
Gross Domestic Product

Gross Domestic Product (GDP) is the total value of final goods and services produced within a
country's borders in a year.

To convert from GNP to GDP you must subtract factor income receipts from foreigners that
correspond to goods and services produced abroad using factor inputs supplied by domestic
sources. To convert from GDP to GNP you must add factor input payments to foreigners that
correspond to goods and services produced in the domestic country using the factor inputs supplied
by foreigners.

GDP is a better measure of the state of production in the short term. GNP is better when analysing
sources and uses of income

Real and nominal values

Nominal GNP measures the value of output during a given year using the prices prevailing during
that year. Over time, the general level of prices rises due to inflation, leading to an increase in
nominal GNP even if the volume of goods and services produced is unchanged.

The national income of any country is important because it helps to assess the performance of a
country over a period of time, usually in a year.

National income accounting is much like the accounting carried out by the individual firms to
detect growth or decline in the profitability of a company. The national income figure that is
calculated is used to compare the performance of the country in the previous years as well as the
performance of that country with other countries.

In theory, the three methods of measuring the national income should provide the same figure as
illustrated by the circular flow of income.

1.1 The circular flow of income

The circular flow of income describes how money moves between the different sectors in the
economy. The expenditure of one sector is the income of another sector.

For a closed simple economy where there are only two sectors, firms and households, firms
employ labour to produce goods and services. Firms spend on labour since households receive
income for providing labour. Household income is spent on goods and services from firms.
HOUSEHOLDS

Consumption
Factor Goods
Markets Market
Income

FIRMS
1.2 THE NATIONAL OUTPUT OR THE VALUE ADDED METHOD

This is the total of consumer goods and services investment goods (including additions to stocks)
produced by the country during the year. The production of goods and services in different sectors
of the economy is added together. For example what is produced in the agriculture and fisheries,
forestry, manufacturing, hotels, banking, national defence, education, health sectors etc, is all
added together to arrive at the national income using the output method.
It can be measured by

- Totaling the value of the final goods and services and produced or
- Totaling the value added to the goods and services by each firm, including the government.
This is done to avoid double counting and in order to use this method, a detailed knowledge
of pricing is required. This explains why the output method is also known as the value
added method.

The usefulness of this method is that it shows the changing shares of the industrial sectors in an
economy, that is a sector which is expanding or falling it its contributions to the national income.

1.3 NATIONAL INCOME

Using this approach, the total factor incomes received by persons and firms for the provision of
factors of production, is added. Income from employment, trading profits, rent and interest are all
added together to arrive at the national income using the income method.

When using this method:

- Transfer payments or transfer incomes are excluded because the people receiving them do
not produce anything. It includes private money gifts, sale of second hand goods such as a
house, a car etc.
- Stock appreciation is deducted from the total because when inflation makes existing unsold
stocks more valuable, production has not increased.
- Residual error (statistical discrepancy) is added to make statistics from each method
balance.

1.4 NATIONAL EXPENDITURE

This involves adding together all total amounts spent on final goods and services by households,
central and local government, including what is spent by firms on the net additions to capital goods
and stocks in the course of the year.

The calculation of the national income using the expenditure method is what is known as the
aggregate demand. This total spending is made up of consumption expenditure, plus investment
expenditure, plus government expenditure, plus net exports (that is exports minus imports).
Adjustments have to be made for taxes and subsidies as they distort market prices, the idea
is to measure the national expenditure, which corresponds to the cost of the factors of
production used in producing the national product, which is known as national expenditure
at factor cost.

The usefulness of this method is in detecting changing trends in consumption and investment,
although this is the most widely used method, it trends to over estimate national output.

GROSS DOMESTIC PRODUCT (GDP)

The GDP is the first value arrived at in the national income calculations, before any adjustments
are made. This is often referred to as the value of the output produced in the country during one
year and if it increases in real terms, then it is a sign that the economy has grown. The GDP is
calculated at market prices, but after taxes are deducted and subsidies are added, the GDP is at
factor cost.

GROSS NATIONAL PRODUCT (GNP)

This refers to the value of the output produced by residents of a country in a year. It is arrived at
after including the output produced by companies and individuals of a country but they are based
abroad. In addition, output produced by foreigners and overseas companies in that country is
deducted. This is summarized as net property income from abroad, which maybe positive or
negative.

CAPITAL CONSUMPTION

Capital assets suffer wear and tear as such depreciation, termed capital consumption is deducted
from GNP to arrive at the Net National Product or the National Income is short.

In summary

GDP at market Prices

- indirect taxes
+ Subsidies

= GDP at Factor cost

+ Net property income from abroad

= GNP
- Depreciation

=NI
1.5 ZAMBIA’S GROSS DOMESTIC PRODUCT BY KIND OF ECONOMIC ACTIVITY
AT CURRENT PRICES (K'BILLION), 2003 – 2005 USING THE VALUE ADDED
(OUTPUT) METHOD

KIND OF ECONOMIC ACTIVITY 2003 2004 2005*

Agriculture, Forestry and Fishing 4,244.6 5,568.2 6,856.6
Agriculture 1,008.2 1,249.5 1,526.0
Forestry 2,960.3 3,998.5 4,953.6
Fishing 276.1 320.2 377.0
Mining and Quarrying 564.8 809.6 980.5
Metal Mining 558.2 798.3 960.4
Other Mining and Quarrying 6.6 11.3 20.0
PRIMARY SECTOR 4,809.4 6,377.7 7,837.0
Manufacturing 2,241.0 2,827.7 3,458.1
Food, Beverages and Tobacco 1,397.2 1,726.6 2,145.5
Textile, and Leather Industries 352.9 450.7 491.2
Wood and Wood Products 164.7 222.2 283.7
Paper and Paper products 93.1 123.6 161.0
Chemicals, rubber and plastic products 178.9 231.7 286.3
Non-metallic mineral products 30.0 41.0 51.6
Basic metal products 3.1 4.0 4.6
Fabricated metal products 21.0 27.7 34.2
Electricity, Gas and Water 595.1 694.7 922.7
Construction 1,590.0 2,402.1 3,689.8
SECONDARY SECTOR 4,426.1 5,924.5 8,070.6
Wholesale and Retail trade 3,873.8 4,843.7 6,079.7
Restaurants, Bars and Hotels 527.7 670.9 895.9
Transport, Storage and Communications 1,058.2 1,252.3 1,408.3
Rail Transport 89.5 100.8 99.9
Road Transport 393.9 464.0 546.7
Air Transport 152.7 203.0 246.7
Communications 422.1 484.6 515.0
Financial Intermediaries and Insurance 1,847.7 2,282.7 2,776.9
Real Estate and Business services 1,341.2 1,691.8 2,105.8
Community, Social and Personal Services 1,757.0 2,046.5 2,529.1
Public Administration and Defence 683.0 723.9 869.4
Education 688.6 867.7 1,127.1
Health 252.4 292.8 329.1
Recreation, Religious, Culture 26.4 28.8 36.1
Personal services 106.6 133.3 167.3
TERTIARY SECTOR 10,405.6 12,787.9 15,795.8
Less: FISIM (1,061.8) (1,311.8) (1,595.8)
TOTAL GROSS VALUE ADDED 18,579.3 23,778.3 30,107.6

Taxes on Products 1,899.9 2,219.1 2,541.1

TOTAL GDP. AT MARKET PRICES 20,479.2 25,997.4 32,648.6
Growth Rates in GDP 25.97 29.95 25.58
Current GDP per Capita (Current Prices) 1,852,017.00 2,317,860.00 2,909,857.00
Source: Central Statistical Office

1.6 Zambia’s GDP by expenditure method, in Kwacha (bn) at current prices

1990 1991 1992 1993 1994 1995 1996 1997

Total consumption 95 200 574 1316 1980 2779 3608 4752

Government consumption 17 35 102 192 313 489 714 857
Private consumption 78 165 472 1124 1667 2290 2894 3895
Total investment 20 24 68 223 284 394 582 701
Gross fixed capital formation 19 25 65 217 276 385 566 681
Public fixed capital formation 8 13 23 50 235 198 239 278
Private fixed capital formation 11 12 42 167 41 187 327 403
Changes in stock 1 -1 3 6 9 9 16 23
Net exports -1 -6 -72 -57 -23 -175 -246 -284
Exports of goods and services 41 76 210 498 785 1109 1344 1715
Exports of goods 38 70 195 454 714 1027 1200 1565
Imports of goods and services -41 -81 -282 -555 -809 -1284 -1590 -2000
Imports of goods -33 -62 -233 -465 -671 -1034 -1275 -1601
Total GDP 113 218 570 1482 2241 2998 3945 5169
Source: Internet

2.0 USES OF NATIONAL INCOME FIGURES

 - The main use is to assess the performance of an economy over a year. It is used as an
indicator of a growing or a contracting economy, Economic growth or lack of it is
assessed using the national income figures.
- The figures are used to indicate the overall standard of living, especially after dividing by
the total population in a country to calculate the per capital income.
- This enables comparisons to be made between different countries. To ascertain which are
rich and which ones are poor countries.
- To assist the government in managing the economy, using Keynesian demand
management.
- The trade or Economic cycles depend on the national income figures. The figures are also
used to estimate future movements.

2.1 LIMITATIONS IN NATIONAL INCOME CALCULATIONS

1. There are differences in the accuracy of the figures. Different countries collect and invest in
data collection differently.

2. Economic welfare affected by medical and educational facilities per head. There is need to
know what proportion of the national income is spent on the provision of better social sector
facilities and not on defence! As with all mathematical averages, per capita income data does
not take into account how the GDP is distributed amongst the population. If the income is
unevenly distributed, then increases in the GDP per capita may disproportionately benefit a
small group of high income earners and have little impact on reducing poverty. If GDP per
capita data is to be used then its distribution must also be taken into account.

3. Arbitrary definitions, for example when calculating the national income, only those goods and
services that are paid for, are normally included. Do it yourself jobs, such as gardening,
repairing one’s own car, housework etc, are excluded, and their exclusion distort the national
income figure. These unpaid services, which are normally provided by housewives, are
included in the calculation of the national income when done by someone else. If an
individual lives a in a house for which he pays rent to the landlord, this will be treated
differently from owning a house for which he no longer pays rent

4. Incomplete information, which can be attributed to, the high levels of subsistence sector,
barter and black economies that are more pronounced in developing countries.

5. Danger of double counting, for example, the cost of raw materials and that of finished goods
should not both be counted, this difficult to avoid when using the output method of calculating
the national income.

6. Using any monetary data, such as GDP per capita over time, must recognise that output and
incomes measures can increase for many reasons other than the country producing more
goods.

It is an increase in goods and services that is necessary if poverty is to be alleviated or

peoples’ livings standards rose. Output and incomes measures may increase because the rate
of inflation has simply increased the money value of goods and service produced rather than
 their real value. Real GDP per capital would be a better indicator, as this is a measure of the
physical value of goods and services produced. Real GDP is equal to the nominal GDP
adjusted for price changes, (minus inflation).

The different rates of inflation and the constant variations in the exchange rate within and in
different countries make comparisons difficult.

7. The national income measures the standard of living. This has to relate to the size of the
population. Some countries have a high-income figure and a correspondingly high population.

8. Some countries have high national income figure but are paying a high penalty for living
beyond their means and borrowing heavily.

9. It should be remembered that GDP only includes output that involves a financial transaction
i.e. is marketable. A considerable amount of Zambia's agricultural output is produced on
small-scale communal farms for subsistence purposes. It is currently estimated that only 25%
of production on communally owned land involves monetary transactions. The rest is not
included in any national income calculations. Likewise the output of the informal sector will
not be included.

10. Increasing national income and growth may occur at the expense of the environment rapidly
growing economies may result in negative externalities. An agricultural sector that increases
productivity by intensive use of pesticides and fertilisers or deforestation. may reduce future
land fertility and worsen the level of poverty for future generations

2.2 FACTORS DETERMINING A COUNTRY’S NATIONAL INCOME

Income is not evenly distributed, and the factors determining a country’s national income can be
classified as internal and external, the latter resulting from a country’s relationships with the rest of
the world.

The most important internal factors are

Original Natural Resources

Natural resources are nature-given, such as mineral deposits, sources of fuel and power, climate
soil fertility, fisheries, navigable rivers, lakes that help communications etc. New techniques allow
national resources to be exploited while the exhaustion of minerals resources reduces national
income. Some countries are well endowed by nature, and if the resources were well managed, then
the national income would be high.

Where a country’s economy is predominantly agricultural, variations in weather may cause

national income or output to fluctuate from year to year, this happens to be the problem with most
developing countries.

The nature of the people, particularly of the labour force

This includes the quantity of the labour force, the higher the proportion of workers to the total
population and the longer their working hours, the greater s the national income figure.

Another factor is the quality of the labour force, their health, nutrition, energy, inventiveness,
judgment and ability to organize them to cooperate in production, the climate, working conditions,
peace of mind as well as education and training.

Capital Equipment

Productivity or labour will be increased if the quality of the other factors is high, for example, the
more fertile the land, the greater is the output per man.

In addition, the quality of the capital equipment employed is the most important factor, the output
of workers varies almost in direct proportion to the capital equipment, and the single most
important material progress is investment in capital.

Consider the output per man where the majority of the farmers are using a hoe and an axe, while in
advanced countries, farmers use tractors and combine harvesters!

Knowledge of techniques

This is acquired through the development of Research and inventions. The government can
encourage this by financing research schemes. Alternatively the government can go into
partnership with the private sector or offer incentives such as tax rebates to companies that are
spending a lot on research and development. New inventions can bring in more income into the
economy.

The organization of resources

One of the known factors that can improve production and therefore national income in most of the
developing countries is the organization and the management of resources.

The leaders of any economy should have a vision for their countries. They have to be focused, set
goals and objectives, have the right people and the right resources in order to achieve those
objectives.

Political stability

A country has to be politically stable in order to produce. If the resources are being used on
warfare, very little production of goods and services takes place. This again is a common problem
in developing countries. Even if some are well endowed, they are not politically stable and the
organization of resources is poor.

The external factors are

Foreign loans and investments

These are an injection of funds that lead to an addition of stock, adding to the national income.

Related to the above, gifts or handouts from abroad for the purposes of Economic development
and defence improve the national income of the receiving countries.

Terms of trade

This is the rate at which one country’s exports exchange with another country’s imports. The terms
of trade is not constant, it changes as export and import prices change.

Developing countries generally deal in the primary sectors and not in the secondary sectors in
production. They export goods at low prices in their raw form, but import goods at relatively high
prices as these are finished goods.

3.0 CHAPTER SUMMARY

The national income of any country is simply the total value of goods and services its people
produce during the year. The national income can be measured in three different ways, the value
added (output) method, the income method and the expenditure method. In theory, all the three
methods should provide the same national income figure, based on the circular flow of income. A
simple model of the circular flow of income assumes a two-sector economy of firms and
households.

Factors of production move from households to firms, for the production of goods and services.
Firms pay factor incomes, such as wages and salaries to households in exchange for the factors.
The income earned by households is spent on goods and services produced by firms.

Calculation of the national income is very important in every economy as the figure has a number
of uses. It is used to assess the performance of the economy over the years, to indicate the overall
standard of living, and to enable comparisons to be made, from one year to the next, as well as
comparisons between countries.

Unfortunately, there are a number of difficulties that are encountered in measuring national
income, which provides unreliable testimony as to how the real welfare of the people has changed,
and when making comparisons.

The national income, and therefore Economic growth depends on the natural resources of a
country, the quality of the labour force and its participation rate, the capital equipment being used
etc.
NATIONAL INCOME DETERMINATION
______________________________________________________________________________________________

After studying this chapter, the students should be able to:

 Explain the relationship between national income, consumption expenditure, savings and
investment
 Discuss the factors that determine consumption, savings and investment
 Explain how the multiplier and the accelerator works
 Explain what the circular flow of income for an open (complex) economy is
 Discuss Economic or business cycles and their characteristic features
_______________________________________________________________________________

1.0 Introduction
In macroeconomics, there are mainly theories of two schools of thought. The monetarists, the
famous one being Milton Friedman, their arguments are mostly on the money supply and the
effects of changes in the money supply.

The Keynesians, advocates of Sir John Maynard Keynes. Keynes wrote a book entitled General
Theory of Employment, Interest and Money, published in 1936. His work was at the time of the
great depression.

1.1 CONSUMPTION EXPENDITURE

From the circular flow of income, spending by households is termed consumption

expenditure. It is an endogenous part of the circular flow of income.

Consumption expenditure depends on an individual’s income, it is therefore a function of income.

C = F (Y).

As Y increases the level of consumption also increases but Lord Keynes maintained that each
successive increment to real income is marched by a smaller increment to consumption
expenditure, the rest is saved.
Consumption
and
Savings
AS (Y)

Savings
S
Dissavings

a 450
Disposable income

The extent to which consumption changes with income is termed the marginal propensity to
consume (MPC). The marginal propensity to consume is the proportion of each extra kwacha of
disposable income spent by households. That proportion of each extra kwacha of disposable
income not spent by households is known as the marginal propensity to save (MPS).

If out of the extra kwacha increase, eighty ngwee is consumed, then the marginal propensity to
consume is 80% or 0.8, and the marginal propensity to save is 20% or 0.2.

Therefore the MPC is the ratio at which the extra income earned is consumed, and it is denoted by
the formula:

MPC = C, and it depends on the slope of C.

Y the steeper the slope, the larger is MPC

MPC depends on the slope of the consumption function, the steeper the slope, and the larger the
MPC, which implies a small MPS.

The nature of the relationship between consumption and income is given by the straight-line
equation:

C = a + by

Where
C = consumption
a = C when an individual is not working and income from employment is zero, it is also known as
autonomous consumption.
 b = MPC
y = income,

For example, assume K650 000 is required for a family of three people to survive, whether the
head of the family is working or not. The K650 000 has to be found for the family to stay alive; it
can come from social security, dissavings, begging, borrowing etc.

When in employment, for every extra kwacha earned, 80 ngwee is consumed. The equation
becomes
C = 650,000 + 0.8Y.

Factors influencing consumption are income, interest rates, government policy such as taxation,
which reduces the disposable income, hire purchase and other credit facilities, and invention of
new consumer goods, which are later, introduced on the market.

Note that in any economy households, firms and government undertake consumption of goods and
services

2.0 SAVINGS

Savings is defined as the part of income not spent, it is a withdrawal or a leakage from the
circulation flow of income.

Y=C+S

S=Y–C

Therefore consumption and savings are two sides of the same coin and the consumption function
tells us not only how much households consume, but also how they save. The factors that influence
consumption naturally affect savings.

MPS is denoted by the formula = S

Y where  is change.

Since any increment in income must be either spent or saved, MPC + MPS = 1

3.0 INVESTMENT EXPENDITURE

Investment is spent on the production of capital goods (houses, factories, machinery, etc) or on net
additions to stocks such as raw materials, consumer goods in shops, etc.

In national income analysis, investment takes place only when there is an actual net addition to
capital goods or stocks.
Investment is a major injection into the circular flow of income and affects national income and
aggregate demand. Investment through the multiplier is needed to achieve Economic recovery.
Investment is very dynamic, it determines future shape and pattern of Economic recovery.

Economic growth determined by technological progress, increase in size and quality of labour and
the rate at which capital stock is increased replaced. Addition to stock should be greater than stock
depreciation.

Investment therefore determines long-term growth, and both the private and the public sector can
carry it out. If it is undertaken by the private sector, the government is expected to provide an
enabling environment by stimulating business confidence by providing a stable Economic climate.
Setting and achieving macroeconomic targets like low levels of inflation, controlling the money
supply and therefore controlling the interest rates and consumption. The government can offer tax
concessions or finance research schemes, sometimes in conjunction with the private sector.

Keynesian demand management emphasizes the importance of the role, which the government
plays to influence investment.

4.0 KEYNESIAN DEMAND MANAGEMENT

National income determination is a Keynesian concept. Keynes emphasized the importance of

aggregate demand in the economy. The national economy could be managed by taking appropriate
measures to influence aggregate demand up or down depending on whether there was a
deflationary or an inflationary gap in the economy.

The aggregate demand (AD) is the total demand for goods and services in the economy. Aggregate
demand is made up of consumption expenditure (C), government expenditure (G), investment
expenditure (I) and exports (X) minus imports (M), that is AD = C + G + I + (X – M).
The aggregate supply curve (AS) is the total supply of goods and services in the economy, and a
typical Keynesian aggregate supply curve is an inverse “L”. The explanation is that the AS curve
becomes vertical when all the resources are fully employed.Keynes concentrated on shifting the
AD, hence the name Keynesian demand management, and it involves manipulating national
income by influencing C, I, G, or (X – M). According to Keynes, the equilibrium is where the
AD is equal to AS at the full employment level. This is the ‘ideal’ position where all the
resources are fully employed.

Prices
AS
AD
 0 (Real national income)
Output, employment and Income

Suppose the economy is in a recessionary stage, and there is underemployment of resources, it

means there is a deflationary gap.

Prices AD AS

P
D
P1

O Y YFE (Real national income)

Output, employment and Income

Where D is the deflationary gap, this is the extent to which the government needs to increase AD
to shift it to the right or upward to reach the ‘ideal’ full employment level in the economy.

Alternatively, the economy maybe experiencing inflationary pressures if AD is above the ‘ideal’
full employment position. The resources cannot be increased any further and this puts pressure on
the prices of goods and services.

Prices
AD AS

AD1
P
I

P1

(Real national income)

Output, employment and Income

Where I is the inflationary gap, the extent to which the government needs to reduce AD to shift the
curve from AD to AD1, back to the equilibrium level.
4.1 THE MULTIPLIER PRINCIPLE

Keynesian demand management involves manipulating national income by influencing C, I, G, or

X – M, while C is an endogenous part of circular flow of income, the others are injections into the
circular flow. Any injection into the circular flow of income of a country starts a snowball effect.

If the government decides to build a big hospital in Zambezi district costing K10 billion, the
increase in government expenditure through the construction of the hospital provides incomes to
the factors of production employed in the construction of the hospital. Part of the K10 billion goes
to the contractor as profits, part of it goes to the workers as wages and part of it is used for the
purchase of building materials. The three groups who will earn the income will spend it.

Any expenditure becomes someone else’s income, which is then in turn spent, generating a whole
series of rounds of additional spending and income generation, the snowball effect. However, not
all the income earned is consumed, some of it is saved. Savings is a leakage from the circular flow,
other leakages from the circular flow of income are imports and taxes. The total amount leaked out
is known as the marginal rate of leakages.

The effect on total national income of a unit change any of the injections into the circular flow
income can be measured, it is called the multiplier.

The investment, government or export multiplier = Eventual change in NI

Initial change in I, G spending or X

The multiplier is denoted by the symbol K, and can be re-written as

K = Total increase in NI
Initial increase in NI

The shortcut method is to take into account the leakages, therefore

K = 1
Marginal rate of leakages

Numerical example in a simple closed economy starts with the assumption that income is either
consumed or saved. Suppose the MPC in the example above where there is an injection of K10
billion is 80% (0.8). & income increases by £200
 Increase in Increase in
Expenditure Savings
(K’billion) (K’billion)
Stage

1 Income increase 10 -
2 80% consumed 8 2
3 A further 80% is
consumed 6.4 1.6
4 A further 80% is
consumed, etc 5.12 1.28

It works out to be K=1= 1 = 1 = 5 times

1 – MPC MPS 0.2

This translates to 5 times the initial investment of K10 billion, meaning that the eventual change in
national income is K50 billion! If the marginal propensity to consume were much higher than
80%, then the multiplier effects would be much higher and vice versa.

Multiplier in a complex, open economy would be lower because all the leakages or withdrawals
from the circular flow of income would be taken into account.

THE CIRCULAR FLOW OF INCOME FOR AN OPEN (COMPLEX) ECONOMY

SAVINGS

TAXATION
WITHDRAWALS/
IMPORTS
LEAKAGES
HOUSEHOLDS

Consumpt
iiiiion
Factor Goods
Market Market
s Income

FIRMS INVESTMENT
GOVERNMENT
INJECTIONS EXPORTS
4.2 Accelerator theory

The accelerator relates to a small change in the output of consumer goods, which is said to result in
a greater change in the output of capital equipment. This change in the production of capital
equipment depends on the capital-output ratio.
The accelerator theory suggests that the level of net investment will be determined by the rate of
change of national income. If national income is growing at an increasing rate then net investment
will also grow, but when the rate of growth slows net investment will fall. There will then be an
interaction between the multiplier and the accelerator that may cause larger fluctuations in the
trade cycle.

In the multiplier principle, an increase in investment affects income and consumption, while under
the accelerator, consumption affects investment. When the economy is expanding, and income as
well as consumption is high, then the business sector is encouraged to produce more goods. Thus
investment increases. The increase in investment leads to an increase in income and consumption,
and so on.

The combined effect of both the multiplier and the accelerator results in the sequence of rapid
growth in the national income followed by a slow growth, the business or trade cycles. These are
made up of four phases namely, the recession, depression, recovery and boom.

GROWTH (%)
Boom

Recession
s
Recovery

Depression

TIME

When aggregate demand falls, businesses are discouraged, and both employment and production
fall this is the recession stage. If this continues, then a full depression sets in.While a recession is
quicker, recovery is slower because of lack of business confidence. Once recovery starts it is
likely to quicken as business confidence returns. As output, employment and income increase,
there is even more investment because of business expectations until a ‘business boom’ is reached.

4.3 THE PARADOX OF THRIFT

In theory, investment depends on savings. In order to increase savings, consumption must reduce
because income is either consumed or saved.

Unfortunately, a reduction in consumption reduces business expectations, and the business sector
reduces investment. A reduction in investment causes greater reductions in income. When income
reduces, savings also reduces.
The paradox of thrift explains the working of the ‘demultiplier’.

5.0 CHAPTER SUMMARY

The level of national income of any country is determined by the relationship between decisions by
households to spend and save and decisions by the business community to invest.

The consumption function is C = a + bY. Where b is the marginal propensity to consume, this is
the proportion of an increase in income, which is spent (consumed).

Therefore, the most important determinant of the level of consumption is income.

Savings is that amount of income not spent, and therefore, it also depends on income. However,
there are other factors that influence consumption and savings, such as interest rates, inflation,
levels of taxation, existence of financial institutions etc.

In theory, the national income remains the same from one period to the next if people decide to
save an equal amount as the one, which business houses decide to invest.

Investment is the actual increase in stocks, the creating or buying capital equipment, not goods
which are for immediate consumption. Investment depends mostly on the expected returns.
When national income is at its full employment level, and the total spending, commonly known as
aggregate demand, is less than this figure, the deficiency is known as a deflationary gap.

If, on the other hand, at full employment, aggregate demand is in excess of the full employment
national income, then an inflationary gap occurs.

An increase in aggregate demand gives rise to additional income due to the workings of the
‘multiplier’, but a reduction in aggregate demand gives rise to multiple reductions in income,
called the de-multiplier.

The ‘accelerator’ theory links consumption expenditure to investment decisions. An increase in

consumption expenditure results in more investments in capital goods in order to increase output to
satisfy customers.

The combined effect of both the multiplier and the accelerator results in the business or trade
cycles. A business cycle consists of simultaneous expansion in many fields of business activity,
followed by widespread contraction.

The ‘paradox of thrift’ reflects the fact that a decision to increase the rate of savings may result in a
decline in income.

Note the fact that the theory of income determination is developed on simplified models whose
application in practice may be limited. However, Keynesian demand management is important
because governments intervene in order to stabilize their national economies, and even if their
interventions may not be fully successful, they do influence the level of Economic activity.

MONEY AND INTEREST RATES

______________________________________________________________________________________________

After studying this chapter, the students should be able to:

 Define and differentiate forms of money

 Describe the basic characteristics of money
 Appreciate the functions of money in the economy
 Explain the demand for money
 Explain how the money supply is defined
 Explain how Interest rate is determined
 Discuss the Economic effects of interest rate changes
______________________________________________________________________________

1.0 INTRODUCTION

Money is defined as anything that is generally acceptable in repayment of a debt. It is a medium of

exchange, a legal tender.

The early forms of money where items that were in common use and generally acceptable, such as
cattle, hides, furs, tea, salt, shells, cigarettes, etc.

These early forms of money had a lot of limitations, some items like cigarettes are not generally
acceptable to be used by all to settle debts. Other early forms of money like cattle were not easy to
carry around, and therefore not convenient. Some were perishable products like hides and as they
were deteriorating with frequent handling.

In addition, there was no homogeneity in terms of size, colour and weight. The money that is used
now such as the one, ten or fifty kwacha bank notes are similar and they are easily recognizable.,

Therefore, a good monetary medium must be:-

- Generally acceptable
- Fairly durable
- Capable of being divided into small units
- Easy to carry (portable)
- Should be relatively scarce
- Should be uniform in quality

1.1 The Origin of Money

Money came into use due to the abundance of some things, after producing in greater quantities
than what is required for immediate consumption. There was need to exchange the surplus with
another person for some other commodity. Initially, it was mostly the exchange of goods for
goods, the barter system.

This method had a lot of limitations and inconveniences such as the ‘double coincidence of wants’.
Finding a person who had an item or service you wanted and in return you also have an item,
which is wanted by that person, before any, exchange can take place.

There was also the problem of the rate of exchange. That is, how much of item X has to be given
for item Y. Related to this was issue of one party to a transaction having only a large commodity to
offer, but requires a small item in exchange.

The barter system is still being practiced among some people but to a very small extent.

Given the shortcomings of the barter system it is easy to appreciate and understand the functions
that money performs in modern economies.

1.2 Functions of money

Money performs four main functions:

 A Medium of Exchange

This is its earliest function and the most important one. Money facilitates the exchange of goods,
buyers and sellers meet and trade easily without the inconveniences of the barter system. This in
turn promotes specialization, productivity, efficiency and wealth creation. Money is considered to
be the ‘oil, which allows the machinery of modern buying and selling to run smoothly’.

 A Unit of Account and a Measure of Value

Another drawback of the barter system is the difficulty of determining a rate of exchange between
different kinds of goods especially large indivisible articles. Money acts as a common measure or
standard value of the unit account of goods and services.

The value of goods and services is reduced to a single unit of account, and therefore the process of
exchange is greatly simplified.

Money makes possible the operation of a price system and automatically providing the basis of
keeping accounting records, calculating the profit and loss accounts the balance sheet etc.

 A Store of Value

Money is the most convenient way of keeping any income, which is surplus to immediate
requirement. It makes possible a build up of stores of many things for future use, a store of wealth.
Money can also be stored in the form of other assets such as houses, but money is a preferred
because it is a liquid store of wealth. This means that money can be converted almost immediately
into a medium of exchange without ‘loss of face value’. Assuming that money is stable in value!
 A standard for Deferred Payments

Use of money makes it possible for payments to be deferred from the present to some future date.
Borrowing and lending are greatly simplified, loans are taken and repaid in the form of money.
Credit transactions cannot easily be carried out unless money is used. Given the assumed stability
in its value, future contracts are fixed.

Credit transactions cannot easily be carried out unless money is used.

1.3 The Demand For Money

Demand for money means the desire to hold money, as distinct from investing it. This
desire to hold liquid reserves is known as liquidity preference. According to Lord Keynes there
are three motives for holding money.

 The transactions motive

Both consumers and businessmen hold money to facilitate current transactions. A certain amount
of money is needed for every day requirements, the purchase of food, clothing, to pay casual
workers etc.

 The Precautionary Motive

Most people like to keep money in reserve, in case an unexpected payment has to be made, e.g.
illness, funeral, accident, car defects, household appliance defects, etc.

‘Active’ balances, depends any, fairly inelastic, less inelastic in the 2nd and elastic in the 3rd known
as ‘idle’ balances.

 The Speculative Motive

This is for the purpose of accumulating more, since holding money in active balances does not
yield any interest.

Speculation depends on the expectation of the future tend in securities e.g. attractive shares and
govt. stock, this generally moves in the opposite direction with interest rates if interest rates go up
i.e. people think the price of stocks will go down in the future they will hold money …

2.0 THE SUPPLY OF MONEY

Money supply in any economy is a very important part of government policy. Money supply has
to be monitored as a guide to Economic policy.
The argument of the monetarists is based mostly on the money supply. However both the
Keynesians and monetarists accept the importance of money supply.

The money supply is the stock of money existing at any particular point in time. It is basically
made up of coins and notes in circulation as well as bank deposits. Coins and notes make up
approximately only one fifth of the total money supply while bank deposits make up four fifth.
This is because commercial banks ‘create’ money through the creation of credit and the creation of
deposits.

2.1 MONETARY AGGREGATES

The definition of the money supply is carried out in order to measure monetary aggregates. In
practice, money is measured either narrowly or broadly, with a very thin dividing line between the
two.

 Narrow Money

This is money that is available to finance current spending, money that is held for transaction
purposes, it highlights the function of money as a medium of exchange. Narrow money is
designed in different ways, the narrow measure of money starts from MO (Pronounced as ‘m
nought’), is the narrowest definition of narrow money. It comprises mostly notes and coins in
circulation, plus commercial banks operational deposits held by the bank of Zambia.

 Broad Money

This is narrow money plus balances held as savings, that is the function of money as a medium of
exchange and as a store of value. Therefore, broad money is money held for transactions purposes
and money held as a form of saving.

Broad money includes assets, which are liquid but not as liquid as assets under narrow money.
Broad money is also defined in different ways. The first broad definition of money is M4, and
when foreign currency deposits are included, the definition is M3.

3.0 INTEREST RATE DETERMINATION

Interest is the price of money, and in the credit market, it is determined by the market conditions of
demand for and supply of money. According to the Keynesians, the demand for money, liquidity
preference is partly depend on the rate of interest. The supply of money is perfectly inelastic, the
supply might increase or decrease depending on the government policy.

The equilibrium market rate of interest is determined at the point where the supply of money
equals the demand for money
 Interest
Rate MS

LP = d

O m Quantity of money

As in other markets, changes in either demand or supply conditions lead to a change in interest
rates. In the Keynesian model, an increase in the money supply is associated with a fall in interest
rates and vice versa.

Interest
Rate MS MS1

r1
LP = d

O m m1 Quantity of money

If the money supply increases from MS to MS1, the equilibrium rate of interest reduces from or to
Or1.

3.1 THE MONETARISTS VIEW

Monetarists ensure that there are no three motives for holding money. Monetarists hold the view
that money is held mostly for transactions purposes and enjoyment, and that demand for money is
interest rate inelastic. As a result, any slight change in money supply leads to a big change in the
rate of interest. This explains the need to maintain stability in the money supply in order to
maintain stable interest rates.
Interest D MS Interest MS MS1
Rate rates D

r
r

D r1

O m Quantity of money O m m1 Quantity

of money

Another argument by the monetarist is the microEconomic view known as the loanable funds
theory (explained under factor markets).

3.2 EFFECTS OF INTEREST RATE CHANGES

Stable interest rates are important in any economy, if there is a large increase in the rate of interest,
then the economy is affected in a number of ways.

- The cost of credit increases borrowing reduces and investment expenditure reduces.

- Spending by households also reduces savings is encouraged, since income is either consumed
or saved, an increase in savings reduces consumption expenditure.

- Investment and consumption expenditure are components of aggregate demand, if spending by

both households and firms reduces, then inflation is likely to be lowered. Low prices and less
borrowing is a sign of less Economic activity.

- The foreign flow of funds increase financial speculators with ‘hot money’ are likely to be
attracted to the high rates of interest.

- An increased flow of foreign funds puts pressure on the exchange rate. The high demand for
the kwacha causes the kwacha to appreciate in value.

- A strong kwacha makes exports less attractive on the international market, reducing the
demand for exports. Some workers are likely to be laid off, this reduces the level of
Economic activity furthers.
- The business sector is also affected by the likely impact on profitability and investment
projects that are appraised. High costs of borrowing compared to reduced cash flows due to a
reduction in consumption expenditure.
3.3 VARIATIONS IN THE INTEREST RATES

Interest rates are determined by the market forces supply of and demand for money. In practice,
there are several variations of interest rates that financial intermediaries apply, financial
institutions do not give or charge exactly the same interest rates.

Finance bank, Indo-Zambia bank, Zambia National Commercial Bank etc all have their own rates
that they offer to customers.

‘Lending rates’ given to surplus units (the depositors/savers who supply funds) and ‘borrowing
rates’ charged to deficit units are different.

An individual bank can give or charge different rates to customers depending on estimated
compensation for trying up the money, perceived ‘risk’ of the customer, amount and period of the
loan etc.

In addition, there is the real rate of interest, which is the nominal rate of interest adjusted for
inflation. The nominal rates of interest are the expressed rates, in monetary terms, hence they are
also known as the money rate of interest.

The relationship between the inflation rates, the real rate of interest and the money rate of interest
are:

(1 + real rate of interest) x (1 + inflation rate) = 1 + money rate of interest. This is usually
approximated as real rate of interest + inflation rate = money rate of interest (nominal interest
rate).

5.0 CHAPTER SUMMARY

Money is a medium of exchange, anything that is generally acceptable in the settlement of a debt.
Early forms of money were items in common use, but had a number of limitations, hence a good
monetary medium has a number of characteristics.

Money performs a number of functions in the economy, it is a medium of exchange, unit of

account and measure of value, and it is a store of value and a standard for deferred payments.

The demand for money, according to Keynes, is the desire to hold money, and it is held as active
balances, for the transactions and precautions motive, this depends on an individual’s income and
it is interest rate inelastic. Money is also held as idle balances for speculative reasons, and this
depend on the rate of interest.
The money supply in any economy is simply made up of notes coins and bank deposits; however,
money supply is a very important part of government policy, and it can be measured both narrowly
and broadly.

Generally, the market forces of supply and demand determine interest rates. Interest rates should
have some degree of stability, as they are very important in Economics and in the business
environment.

In practice, there are variations in the rate of interest, which affect savings and loan repayments.

INFLATION AND UNEMPLOYMENT

______________________________________________________________________________________________

After studying this chapter, the students should be able to:

 Define and explain causes of inflation

 Understand how to measure changes in the value of money
 Identify the negative effects of inflation
 Explain the measures used to control inflation
 Define and explain types of unemployment
 Understand how to measure changes in unemployment levels
 Identify the negative effects of unemployment
 Explain the relationship between inflation and unemployment
 Appreciate the supply-side policies
_______________________________________________________________________________

1.0 INTRODUCTION

In any economy, the government can follow expansionary or contractionary monetary or fiscal
policies by either increasing the money supply and increasing aggregate demand or reducing the
money supply and reducing the aggregate demand respectively. Unless the ‘supply side policies’
are put into effect, a government cannot easily control both inflation and unemployment at the
same time. One Economic ‘evil’ has to be ‘traded off’ for the other.

2.0 INFLATION

Inflation is a sustained rise in the general price level of goods and services. It is
measured using price indices.

Inflation can be classified between two extremes depending on the speed at which prices are
changing. Creeping inflation is when there are small price increases while hyperinflation is the
worst case of inflation. The prices of goods and services change very rapidly.

2.1 CAUSES OF INFLATION

There are three main causes of inflation, one view from the Monetarists, and two views from the
Keynesians. Demand-pull and cost-push are essentially Keynesian explanations of inflation.
Monetarists reject these and believe that inflation is caused by an increase in the money supply.
Keynesians on their part do not accept that an increase in the money
Supply actually causes inflation.

They believe that an increase in the money supply is an indication that there is inflation in an
Economy. It is not a cause of inflation.
2.2 MONETARISTS VIEW AND THE QUANTITY THEORY OF MONEY

Monetarists consider the increase in the money supply as the only cause of inflation. The
argument of the monetarists is based on the quantity theory of money. The theory is summarized as
the fisher equation, Irving Fisher developed the Fisher equation of exchange. It appears in various
guises, the most common is:

MV = PT
where:

M is the amount of money in circulation

V is the velocity of circulation of that money
P is the average price level and
T is the number of transactions taking place

MV = PT states that money supply multiplied by the velocity of circulation equals the price level
multiplied by total transactions. This equation is true by definition since receipts are equal to
expenditure. PT can therefore be thought of as equivalent to National Expenditure.

Assuming that V is constant in the short run as it is determined by the money supply, and T is also
fixed in the short run. Then, an increase in the money supply would lead to an increase in the
general price level.

2.3 COST-PUSH INFLATION

This inflation is caused by an autonomous increase in the costs of production, considered as cost-
push factors. These may then cause cost-push inflation. Cost-push factors may be changes in
wages, changes in the exchange rate, which change the price of, imported raw materials or perhaps
changes in indirect taxation. Cost-push inflation occurs when a company's costs rise and to
compensate, a firm has to put prices up. Cost increases may happen because wages have gone up
or because raw material prices have increased. The increase in the costs, with aggregated demand
remaining uncharged, causes the aggregate supply curve to shift to the left from AS to AS 1, and
price increases from OP to OP1.
Prices
AS

AD

P1
AS
1

P AS

0 Y National output, employment and income

Cost-push factors that can contribute to the increase in the cost of production include:

- Strong, powerful trade viewers who force employers to concede high wage increases, costs
then rise and these are later passed on to consumers in the form of price increases. This
situation is worse during periods of low unemployment.
- Import cost inflation, especially for a country which depends on one or more of the
- Imported raw materials or other imported inputs
- Imported finished products, capital equipment and more especially the ever
- Increasing price of imported fuel.
- High indirect taxes such as when there is an increase in value added tax or excise duties,
consumers simply notice an increase in prices.

2.4 DEMAND-PULL INFLATION

If there is an excess level of demand in the economy, this will tend to cause prices to rise. This
type of inflation is called demand-pull inflation and is argued by Keynesians to be one of the main
causes of inflation. Inflation occurs when increases in aggregate demand pull up prices, with
aggregate supply remaining constant.

The aggregate demand is the total demand in an economy, made up of government expenditure,
consumption expenditure, investment expenditure and exports minus imports. Any increase in one
or more of these components of aggregate demand can put pressure on prices. As demand
increases from AD to AD1 there is increasing inflationary pressure on prices. This is demand-pull
inflation - "too much money chasing too few goods."

Price
level AS
AD1

AD

P1

O Y YFE (Real
national income)
Output, employment and Income

Increase in demand can be caused by either expansionary monetary or fiscal policies. If there is a
high public sector net cash requirement, then total demand in the economy is stimulated.

The Keynesian original aggregate supply curve is an inverse “L”. According to them, the pressure
on prices is when aggregate demand expands after the full employment of resources, before that
point, an increase in aggregate demand acts as an incentive for firms to increase output.

When the resources are fully employed, the aggregate supply curve becomes vertical, and if
aggregate demand increases beyond this point, an inflationary gap is created.

Price AD AS
Inflationary
gap

Output/employment/income

2.5 ANTI INFLATIONARY MEASURES

To control inflation, first, it is necessary to know the cause. Unfortunately, this is difficult to do
because inflation tends to feed on itself and there is the price wage spiral.

Suppose the prevailing inflation is demand driven, then, measures to reduce aggregate demand
should be put in place; such as tight fiscal and monetary policies like increasing direct taxes and
interest rates to reduce consumption expenditure and investment expenditure respectively.
Government expenditure should also be reduced. This means that the government must aim for a
budget surplus, by increasing its income through increased taxes, but reduce government spending,
the excess money should be kept frozen at the central bank.

If the inflation is due to an increase in the money supply then the government should attempt to
reduce the money supply by reducing commercial bank lending using the instruments mentioned
under the control of the money supply. These are open market operations, increasing interest rates
and asset ratios to discourage lending. Directing commercial banks to reduce their lending and
requesting them to make special deposits at the central bank.

If the source of inflation is an autonomous increase in the cost of production, then measures should
be taken to stop the wage-price spiral, reducing the power of trade unions or match the increased
costs with increased productivity.

A country’s currency can be allowed to depreciate in order to discourage imports, while

encouraging exports, this means increased production. An increase in supply lowers the price.

Prices and incomes policy that is wage and price controls can also be instituted to control inflation.
This means freezing prices and incomes. This may not work well in a liberalized market economy.
It also means controlling the consequence and not the cause of inflation!

2.6 ECONOMIC CONSEQUENCES OF INFLATION

A little inflation is considered to be good for any economy as it provides an impetus for firms to
increase output. High prices are a sign that there is a high demand for goods and services and there
is a prospect of higher profits.
Generally, the negative effects of inflation are as follows:

- Inflation redistributes income

- Retired people who are on fixed incomes suffer a lot from inflation. Some people earn K20,
000 per month as pension. At the time of retirement, they were able to purchase a lot of goods
and services from that amount, but due to inflation their purchasing power and standards of
living falls.
- Inflation distorts consumer bahaviour. Consumers purchase a lot of goods because of expected
future price increases. They hoard goods hoping to ‘beat’ inflation and in the process create
shortages.
- Inflation undermines business confidence. Businesses are unable to make concrete future
plans because of uncertainty in price fluctuation in addition, they have to change the price tags
on products on a regular basis and this can be so costly and time consuming.
- Inflation and interest rate and savings. The real rate of interest, which is the money rate of
interest after making an allowance for inflation, is reduced. Lenders demand for high money
rates to compensate for lower real values.
- Lower real interest rates discourage savings and encourage spending. This may have a long-
term effect on long-term finance for investment.
- Inflation reduces a country’s international competitiveness.
- High prices make products (exports) unattractive on the international market, consumers are
likely to prefer cheaper imports to locally produced products. This affects the balance of
payments. A country has an adverse balance of payments when exports are lower than
imports.
- Inflation causes the currency to depreciate when there is a low demand for exports, therefore,
the demand for the currency is low compared to its supply, and the currency depreciates in
value.
- Inflation redistributes wealth, it causes borrowers to gain at the expense of lenders as it
reduces the value of the debt. The lenders receive less relative to what they had lent. This is
related to the time value of money.
- Inflation leads to uncertainty in price forecasting, both at central government level and at
corporate business level.
- Money is unable to perform its functions properly.
 Inflation has little impact on money’s function as a medium of exchange. Money is still
used to purchase goods and services.
 The use of money as a means of deferred payment is rendered less effective by inflation.
Credit is granted but payment is deferred. This leads to redistribution of wealth where
borrowers or those who purchase goods on credit gain but lenders lose.
 The greatest effect of inflation on the functions of money is the function of money as a
store of value. The value of money is measured indirectly through prices when prices rise,
it is a sign that the value of money has fallen since few items can be brought from the
same amount of money. Money becomes an ineffective store of value. Interest rates paid
are supposed to compensate, and this is one of the explanations why interest rates rise
during periods of inflation.
  Money is used as a unit of account and as a measure of value. This function is also
hampered by inflation as the relative values of things being compared keep on changing
in monetary terms.

3.0 UNEMPLOYMENT

Unemployment simply means people do not have jobs. It occurs when people capable of and
willing to work are unable to find suitable paid employment.

Unemployment is measured as # of unemployed x 100

Total workforce

Full employment is when there are more jobs than people. The number of unfilled vacancies is
equal to the number of people out of work. It is the level of national income at which everyone
who wants to work is able to do so, in other words, there is sufficient demand to employ everyone.
Classical economists argued that the economy would automatically tend to this equilibrium, due to
the market forces of supply and demand. Keynesians maintain that it is the role of government,
using policy instruments at their disposal, to ensure that there s full employment in an economy.

3.1 CAUSES OF UNEMPLOYMENT

In some books the words ‘causes’ and ‘types’ are used interchangeably. However there is a
distinction.

Type is the label given to describe the main common characteristic of some unemployment, while
Cause is more analytical, an attempt is made to explain how some unemployment has arisen.

Causes of unemployment can be broadly divided into demand and supply factors:

- Demand deficiency unemployment is caused by lack of demand for goods and services, and as
a result, firms lay off workers. This is usually when the economy is in the recession stage of
the economic or trade cycle and there is little economic activity.

Keynesians argue that a shortage of aggregate demand is one of the key causes of
unemployment.

- Monetarists view Supply side factors such as strong trade unions demanding for high wages as
causes of unemployment as firms employ less labour while the supply of labour increases, as
shown below:

Price
D S
 W1

S D

O Q1 Q Q2 Number of workers
At a high wage rate of OW1, the demands for labour by firms reduces to OQ1, supply naturally
increases to OQ2, because individuals who were unwilling to work at wage rate OW are now
encouraged by the high wage rate. The difference between OQ 1 and OQ2 is unemployment caused
by the activities of trade unions.

- Firms lay off workers if import prices are too high, like the high price of oil, which reduces a
firms’ competitiveness, and loss of customers.

- State benefits tend to encourage ‘voluntary unemployment’. When the benefits are higher than
the market wage, as in the diagram above, a person feels ‘better off’ being unemployed
earning OW1 than earning a low wage (OW) while in employment.

3.2 TYPES OF UNEMPLOYMENT

- Seasonal unemployment is considered to be temporal and occurs in certain industries where

Economic activity is in specific periods or seasons, examples are tourism, agriculture and
construction industries. There is a high demand for labour during certain periods of the year,
and then most of the workers are laid off during off peak periods.

- Frictional unemployment is of a short-term duration. It refers to secondary school or college

graduates who are searching for jobs, as well as individuals who are in between jobs, the
transitional period between workers leaving one job and starting another. Frictional
unemployment is also an indication of imperfections in the market such as lack of knowledge,
the geographical immobility of labour or a mismatch between the requirements of the
employers and the available skills of the unemployed.

The more efficiently the job market is matching people to jobs, the lower this form of
unemployment will be. However, as long as there is imperfect information and people don't
get to hear of jobs available that may suit them then frictional unemployment is likely to be
high.

- Structural unemployment refers to long-term changes in the pattern of demand and supply in
an economy. On the demand side, a firm may fail to compete with rival firms, demand for the
company’s product declines and the firm is likely to lay off workers and close the business.

Changes in the supply of a product, for a example if the product like copper ore is getting
depleted, there is no need to employ miners and this can also lead to unemployment in the
Copperbelt. It may also result from changes in the production methods labour is replaced by
 machines or capital equipment, termed technological unemployment. Structural
unemployment also includes regional unemployment, some regions in a country may have
higher unemployment levels compared to other regions because of different regional
economic performances.

Unemployment results because individuals do not respond quickly to the new job
opportunities, they find themselves with no readily marketable talents. Their skills and
experiences are unwanted, as they have become obsolete.

- Cyclical unemployment is the same as deficiency in demand unemployment. It is

characterized by fluctuations in economic growth, characterized by booms and recessions, the
trade cycles. During the recession phase, there are high levels of unemployment.

- Voluntary unemployment is a relatively new concept, defined by the monetarists as being due
mostly to high state benefits, either unemployment benefits or being on welfare. This causes
people to be unwilling to work at existing low wage rates. They realize that they are “better
off” not working and receiving state benefits.

Voluntary unemployment also includes individuals who simply do not want to work!

3.3 NEGATIVE EFFECTS OF UNEMPLOYMENT

The Economic consequences of unemployment are classified as Economic, financial, social or

political costs:

 Labour is a factor of production, and due to unemployment, the Economic resource is not being
utilized, this is at a cost, the opportunity cost of goods and services not produced, quality of
workforce diminishes as idleness causes labour to be less efficient, this in turn increases the cost
of retraining it.

 Government revenue is mostly from taxes, unemployment results in a loss of government

revenue, as the unemployed do not pay any tax, in some rich countries they receive state
benefits, which means that unemployment is a financial cost to the government.

 Unemployment may lead to social undesirable behaviour like theft, vandalism, riots or general
discontent. The mental and physical health of the unemployed tends to deteriorate, the
unemployed are more prone to commit suicide. This is considered to be a social cost.

 Whenever there are high levels of unemployment in the country, the political party that forms
the government, is likely to lose popularity, this is a political cost to the government.

4.0 THE PHILLIPS CURVE

It shows the relationship between inflation and unemployment. In 1958, Professor A. W. Phillips
found a statistical relationship between unemployment and money wage inflation. Inflation and
unemployment are two sides of the same coin. If the rate of inflation falls, unemployment rises and
vice versa.

Zambia under the United National Independence party (UNIP), was experiencing high levels of
inflation, up to three digit figures, but the levels of unemployment were relatively low. Under the
Movement for Multiparty Democracy (MMD), the country has experienced low levels of inflation
but very high levels of unemployment.

The Phillips Curve explains the “trade off” between inflation and unemployment; it is a graphical
illustration of the inverse relationship between inflation and unemployment. It shows that the
lower the rate of inflation the higher the rate of unemployment.

Inflation rate

0
Unemployment rate

High inflation is associated with low unemployment. Note that the curve crosses the horizontal
axis at a positive value for the unemployment. It is not possible to have both zero inflation and
zero unemployment, zero inflation is associated with some unemployment.

The above means that the government cannot achieve two of its macroEconomic objectives of low
rates of inflation or stableness and low rates of unemployment at the same time. The two are
mutually exclusive. The government can only achieve one objective at the expense of the other.

4.1 STAGFLATION

Once in a while, in any country the “trade off” does not apply, as both inflation and unemployment

move in the same direction. This situation is known as stagflation.

Stagflation is a term coined by economists in the 1970s to describe the unprecedented combination
of slow Economic growth and rising prices. The Phillips curve does not apply, there is no “trade
off”, and instead, there are unacceptably high levels of both inflation and unemployment. This
means a country can be experiencing stagnation, the recession phase of the trade cycle and very
high levels of price increases.
The a above maybe as a result of high costs of production, especially the price of crude oil, which
may cause the supply curve to shift to the left. This causes the price to increase from 0P to 0P1 and
output, employment and income reduces from 0Q to 0Q1

Price D S1

P1 S

P
S1 D

0 Y1 Y Output, Employment, Income

5.0 SUPPLY-SIDE POLICIES

Monetarists believe that stagflation is as a result of ignoring the aggregate supply side of the
equation on supply and demand analysis. Keynesians believe in manipulating aggregate demand in
order to manage the national economy, and monetarists argue that Keynesian demand management
is inflationary, the solution is to put in place measures to improve the supply of goods and services,
known as supply side policies.
Supply-side policies can be used to reduce market imperfections. This should have the effect of
increasing the capacity of the economy to produce, that is increase output, employment and
income and reducing prices at the same time. It is without doubt the only non-inflationary way to
get increases in output.

Price D S

P S1

P1 S
 D

0 Y Y1 Output, Employment, Income

The idea is to increase aggregate supply from SS to S1S1 in order to increase output to Y1 and at the
same time reduce prices from 0P to 0P1.
The above is an indication of the need to shift both Economic and government policy towards
supply side policies. The long run Economic growth and standard of living are both functions of
both production and supply. The low prices from increased supply imply that a country can
compete with the low cost producing countries of South East Asia.
In general, supply side policies aim to remove market imperfections and encourage individualism
in order to increase efficiency and raise competitiveness. They are micro orientation, unlike
Keynesian policies that are macro.

Some of the best-known supply side policies are:

 Lower income taxes. High direct taxes are a disincentive to enterprise and hard work, more
especially overtime. There is need to encourage individuals and firms to be more enterprising,
and to increase production.
 Privatization and deregulation, since government intervention and regulation weakens a
country’s ability to make the economy dynamic and self regulating, Adam Smith’s ‘invisible
hand’ in the market. Public provision of services, government grants and subsidies encourage
inefficiencies, and state owned industries are not competitive.
 Strong trade unions and employment legislation lead to unemployment and encourage over
manning. There is need to have weak trade unions and workers who will accept ‘flexible’
wages.
D S

W1

0
Q1 Q2 Q3 Number of workers
Strong trade unions can successfully bargain for high wage rates (0W1), which results in few
workers (0Q1) being employed, while the supply is high at 0Q3. By accepting lower wages (0W),
more workers would be in employment (0Q2). The inflexibility in the labour market creates
unemployment.
 Related to the above, are wage controls, wage regulations and employment legislation which
all contribute to inflexibility, workers ‘pricing themselves’ out of the market and ultimately
unemployment. According to the supply side policies, these should be abolished.
 Better information on job opportunities and adequate training is what is required for the
aggregate supply curve to shift to the right.

6.0 CHAPTER SUMMARY

Inflation to a layman is simply a sustained increase in the price of goods and services. Inflation is
measured as a percentage change, and the two extremes are creeping inflation to hyperinflation.
Inflation can be caused by demand factors, supply factors, or according to the monetarists, any
change in the money supply is inflationary.

There are several reasons why inflation is considered to be economically undesirable, it affects
planning both at central government and at corporate business level and it also undermines
business confidence. Inflation reduces a country’s international competitiveness and causes the
currency to depreciate given a low demand for exports. Inflation discourages savings, and
ultimately, investment. It also distorts consumer behaviour, consumers purchase a lot of goods in
the hope of ‘beating’ inflation. More importantly, inflation has a big impact on people who are on
fixed incomes, their purchasing power and standard of living falls, and money is unable to perform
its functions properly.

Unemployment simply means people do not have jobs. The words ‘types’ and ‘causes’ of
unemployment are usually interchanged, but generally, unemployment is categorized as cyclical,
structural, seasonal, frictional and voluntary. Unemployment also has a number of negative
consequences, classified as Economic, financial, social or political.

A government can control both inflation and unemployment using either fiscal or monetary
policies, or both. Unfortunately, there is a negative relationship between inflation and
unemployment, which is illustrated by the Phillip’s curve. The government has to ‘trade off’
inflation for unemployment or vice versa. Sometimes, there is an increase in inflation and
unemployment, a situation known as stagflation.

An effort to ‘cure’ both inflation and unemployment is explained by the monetarists using the
supply-side policies. These policy measures are intended to free up the supply of goods and
services in all markets, eliminating market distortions, increasing production, the ‘supply’ side of
the equation, through deregulation. The government has to reduce taxes, privatize, allow the labour
supply to move freely, weaken trade unions, etc.
 EXCHANGE RATES

3.0 EXCHANGE RATES

Exchange rates are the price of a currency expressed in terms of another currency. An exchange
rate is the price for obtaining one unit of a foreign currency. The exchange rate refers to the value
of one currency (e.g. the Kwacha) in terms of currency (e.g. the United States Dollar).

3.1 DETERMINATION OF EXCHANGE RATES

The basic forces behind the determination of exchange rates are those of supply and demand.
Taking exchange rate for the kwacha against other currencies as an example, the exchange rate set
in the market will be affected by supply of and demand for Kwacha.

3.2 DEMAND

People and firms want the Kwacha for various reasons:

a) To pay for Zambian exports.
b) Investors based abroad wanting to invest in Zambia.
c) Speculation. Speculators will buy the Kwacha at the current exchange rate, if they think it
going to appreciate in the near future. They want to sell the Kwacha at a higher exchange rate
in future.
d) The central bank may want to buy Kwacha to push up its value on the foreign exchange
market.

3.3 SUPPLY

Supplies of Kwacha arise when people buy foreign currency in exchange for Kwacha. The factors
affecting supply are as follow:

a) Zambian residents wishing to buy imports will require foreign currency, so they need the
Kwacha to acquire foreign currency.
b) Zambian residents investing abroad will sell the Kwacha and buy foreign currency.
c) If speculators think that the Kwacha is about to depreciate they sell it.
d) The central bank may sell the Kwacha to manipulate its value.

3.4 FIXED EXCHANGE RATES

This is where the government keeps the exchange rate at a fixed level, but if it cannot control
inflation, the real value of the currency will not remain fixed.

3.4.1 ADVANTAGES OF FIXED EXCHANGE RATES

a) They make international trade more stable because of the certainty to traders.
b) They make it possible for importers and exporters to predict profits.
c) They make investors more confident about investing in other countries.
d) Importers and exports can agree prices for future delivery without having to worry about
potential losses through exchange rate movements.

3.4.2 DISADVANTAGES

a) They require substantial official reserves. The Central Bank requires a large pool of foreign
currency to enable a prolonged period of intervention to support the exchange rate.

b) They complicate Economic co-operation among countries with different Economic objectives
and policies

c) Fixed exchange rates can lead to capital flight or outflows of capital if interest rates are
attractive in other countries.

3.5 FLOATING EXCHANGE RATES

Floating exchange rates are exchange rates that are determined by the market forces of supply and
demand. Under the Floating exchange rate system, the government does not intervene in the
foreign exchange market. A system under which exchange rates are not fixed by government
policy but are allowed to float up or down in accordance with supply and demand.

3.5.1 ADVANTAGES

a) The nation’s exchange rate will adjust automatically in the foreign exchange market to correct
any balance of payments deficits or surplus.

b) The central bank does not need to large reserves maintain a certain exchange rate.

c) Monetary policy will be more effective.

d) There is no need to work out the new exchange rate because market forces of supply and
demand will determine it.

3.5.2 DISADVANTAGES

a) Floating exchange rates lead to uncertainty in international trade and this may hinder trade
with other countries.

b) Floating exchange rates encourages speculation, which in turn leads to increased volatility of
the exchange rates.

c) Fiscal policy will be less effective.

3.6 Note the following in relation to exchange rates: In markets where exchange rates float,
an increase in the external value of a currency is referred to as an appreciation and
a decrease in the external value is referred to as a depreciation of the currency.

In markets where exchange rates are fixed, when authorities raise the external value of the
currency to a higher fixed parity, this is referred to as a revaluation and a change to a
lower parity is referred to as a devaluation of the currency.

3.7 MANAGED FLEXIBILITY OR DIRTY FLOATING EXCHANGE RATES

The system that exists in practice is a compromise between fixed and floating rates.

The market forces now play a more important role in the determination of exchange rates, but the
authorities often intervene to neutralise short run pressure on exchange rates, to ensure that it
remains fixed within a certain zone of flexibility. This system is known as a managed float.
A central bank, on behalf of the government, buys and sells currency to stabilize the exchange rate.
When one reads in the newspapers that the Bank of Zambia has offloaded foreign currency (from
its reserves) to buy the Kwacha on the foreign exchange market, the bank wants to artificially
stimulate demand, and make the Kwacha appreciate in value, and vice versa.

However, because authorities do not always make it clear that they are using the reserves to
support a currency’s external value, and maintain an exchange rate target, which is usually
unofficial, the term dirty float is used.

4.0 CHAPTER SUMMARY

A balance of payments surplus can be adjusted by revaluation, and other measures to encourage
imports. Exchange rates are a ‘price’ of one unit of a currency expressed in terms of another
currency.

There are two basic exchange rate systems, the flexible or the floating and the fixed exchange rate
systems, in practice, most exchange rates fall in between these two extremes. A ‘dirty’ or managed
exchange rate is when the central bank intervenes in order to stabilize the exchange rate.

The market forces of supply and demand for a currency determine the floating exchange rate, and
the central authorities determine the fixed exchange rate system. Both systems have advantages
and disadvantages. When there is a high demand for a currency due to an increase in exports or
other factors, the currency appreciates in value and vice versa.