MACROECONOMICS

MODULE EC104

Written by Giya.G, Abel.S and substantially revised and edited by Ndlovu.E DEPARTMENT OF ECONOMICSMIDLANDS STATE UNIVERSITY

©2005

CHAPTER ONE

INTRODUCTION

Macroeconomics

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

concerned with the study of economy wide aggregates, such as the analysis of total

output and employment, total consumption, total investment and national product.

(Vaish,1995). It is concerned with the behaviour of the economy as a whole- with booms

and recessions, the economy’s total output of goods and services and growth of out[put,

the rates of inflation and unemployment, balance of payments, exchange rates etc.

Because it is closely related to real world issues, macroeconomics also involves many

non-economic factors such as political, historic, cultural and sociological factors.

(Dornbusch et al, 1998).

Macroeconomic ProblemsThese arise when the economy suffers from high unemployment, inflation, or a balance

of payments deficit. Therefore the government sets itself certain macroeconomic

objectives:

Low unemployment

Low inflation

A balance of payments surplus

Economic growth

Macroeconomics and Microeconomics

The line between macroeconomics and microeconomics is less sharp than it used to be,

but it is still there.

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What makes this module different is that we focus on the economy as a whole.

        Instead of talking about the demand and supply of (say) pizza, we talk about the demand and supply of output.

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

BUSINESS CYCLE

Business Cycles (or trade cycle)A business cycle is the more or less regular pattern of expansion (recovery) and

contraction (recession) in economic activity around a growth trend (Dornbusch et al,

1998). Business cycles can also be described as the periodic booms and slumps in

economic activities. The ups and downs in the economy are reflected by the fluctuations

in aggregate economic magnitudes, such as, production, investment, employment, prices,

wages, bank credits etc. The upward and downward movements in these magnitudes

show different phases of a business cycle (Dwivedi, 1996). Basically there are only two

phases in a cycle, namely prosperity and depression. Considering the intermediate stages

between prosperity and depression, the various phases of trade cycle may be enumerated

as follows:

1) Expansion 2) Peak 3) Recession; 4) Trough5) Recovery and expansion

Phase of Business Cycles line of cycle

Peak steady growth line Growth Rates prosperity depression expansion trough peak recovery trough Time

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Expansion or prosperity (or boom)This boom is characterised by increase in output, employment, investment, aggregate

demand, sales, profits, bank credits, wholesale and retail prices per capita output and a

rise in standard of living. The growth rate eventually slows down and reaches the peak.

However:

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

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

Peak This is characterized by slacking in the expansion rate, the highest level of

prosperity, and downward slide in the economic activities from the peak.

RecessionThe phase begins when the downward slide in the growth rate becomes rapid and steady.

Output, employment, prices, etc. register a rapid decline, though the realised growth rate

may still remain above the steady growth line. So long as growth rate exceeds or equals

the expected steady growth rate, the economy enjoys the period of prosperity, high and

low. When the growth rate goes below the steady growth rate, it marks the beginning of

depression in the economy. Depression begins when growth rate is less than zero i.e. the

total output, employment, prices, bank advances etc. decline during the subsequent

periods. In other words there is a slump in the economy. [A slump reduces spending on

imports, thus improving the balance of payments. Reduced total spending lowers

inflationary pressure.] The span of depression spreads over the period growth rate stays

below the secular growth rate or zero growth rate in a stagnated economy.

TroughThis is the phase during which the downtrend in the economy slows down and eventually

stops and the economic activities once again register an upward movement. Trough is the

period of most severe strain on the economy.

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RecoveryWhen the economy registers a continuous and rapid upward trend in output, employment,

etc, it enters the phase of recovery though the growth rate. When it exceeds this rate, the

economy once again enters the phase of expansion and prosperity. If economic

fluctuations are not controlled by the government, the business cycles continue to recur as

stated above.

Why worry about business cycles?Business cycles, cause not only harm to business but also misery to human beings by

creating unemployment and poverty. Governments in many countries assume the role of

a key player in employment and stabilization. Stabilization broadly means preventing the

extremes of ups and downs or booms and depression in the economy without preventing

factors of economic growth to operate.

Trade Cycles or business cycles- simplified diagram

Government Macroeconomic Policies

Macroeconomic Policy Objectives

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

(a) Full employment of labour force.

(b) A stable price level.

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

(d) A satisfactory rate of economic growth.

On full employment, of labour force it is not possible to achieve this in the strictest sense.

The use of official unemployment statistics as basis for setting policy objectives is also

suspect. The list by government includes those defined as being unemployed by

government rather than those who would be willing to take up paid employment should it

become available. Some people on the register may be unemployable-aged, disabled,

criminals and those not intending to work.

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

Policy Description

Fiscal Changes in government expenditure and taxation

Monetary Changes in the money supply and interest rates

Prices and incomes Legal or voluntary limits on price and wage increases

Regional Measures to help depressed areas

Industrial Government planning of industry

Commercial Quotas, tariffs, exchange controls or free trade

Exchange rate Encouraging a depreciation or appreciation of sterling

Problems of Policy Timing

The timing of policy events may be crucial to the efficiency and effectiveness of policies.

There are basically three forms of time lag to consider in relation to the behaviour of

policy makers and operation of the economy.

(a) Recognition lag- authorities perceive problems after some time.

(b) Administration lag- it takes time to set up the necessary administrative machinery in

motion. For example Parliament approves income tax measures after debate but

monetary policy options take days or hours to implement.

(c) Implementation lag- by the time the policy is implemented, new issues have arisen

hence new policies have to be implemented/formulated or adapt the policy

instruments introduced.

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Chief Instruments of Economic Policy

The two important subdivisions of economic policy are the monetary policy and the fiscal

policy. These two policies are applied as mutually complementary policies to serve as

instruments of government’s economic policy which is applied to achieve certain social

goals. Often the two overlap, because it is almost impossible to envisage any major fiscal

or monetary measure which does not affect the other.

A. Fiscal Policy. This is the policy of government with regard to level of government

spending and tax structure. Government expenditure includes transfer payments,

government current expenditures and budgetary balance (extent of borrowing).

Taxation (i) provides the funds to finance expenditure. (ii) Can also be used for

income redistribution. Taxes are subdivided into direct and indirect. (i) Direct taxes –

these are levied directly on persons / corporates and include income tax, corporate

tax, poll tax and inheritance taxes, import duties. Typical uses for this instrument are

a reduction in income inequalities, regulate aggregate demand, protection of domestic

producers, reduce poverty, and provision of infrastructure and to adjust balance

between aggregate demand and supply. Import duties are important sources of

revenue in many African countries. Countries impose import tariffs for some or all of

the following reasons: (a) Revenue, protection to local producers, (b) discriminate

between essential and non-essential goods and (c) B.O.P purposes. (ii)Indirect tax is

levied on a thing and is paid by an individual by virtue of association with that thing,

e.g. local rates on property, sales taxes and excise duties. Tax structure can be

regressive proportional or progressive. Tax incentives may be given - investment

allowances, tax holidays, accelerated depreciation allowances, duty-free imports; no-

tax concessions may be given by government for e.g. provision of roads, water and

power. In some African countries rural taxation- was used e.g. Cameroon, Mali and

Sudan.

Problems of Fiscal Administration

(a) Tax evasion

(b) Shortage of trained and experienced staff.

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(c) Corruption.

(d) attitudes towards payment of taxes.

(e) poor co-ordination of budgets with development plans.

B. Monetary Policy- the manipulation of the volume of credit, interest rates and other

monetary variables. Monetary policy is a policy which employs central bank’s control

over the supply, cost and use of money as an instrument for achieving certain given

objectives of economic policy. The policy is used to improve credit and saving

facilities and to regulate macroeconomic balance of the economy. All governments

run deficits in that their total spending exceeds the value of their tax and other current

receipts. The deficit is financed by long-term borrowing from abroad and from local

residents. Sometimes the long-term borrowings will not cover the gap which means it

has to be financed by other means. Government usually fills the gap by short-term

borrowing from the central and commercial banks. This borrowing from the banking

system (deficit financing) usually has highly expansionary effects on money supply.

In other words it increases the money supply by the amount of the deficit but is likely

also to result in secondary increases in money supply by increasing the cash base of

the banking system and hence its ability to lend more to private borrowers. (N.B.

Expansionary does not mean inflationary). Monetary policy can be used for anti-

inflationary purposes. Much industrial and commercial expansion is financed by bank

credit (especially for working capital) so to restrict bank lending is liable to place a

brake on new investment and economic expansion. It is possible for credit restrictions

to be pushed to the extent of forcing a deflation on the economy, with serious

avoidable loses of output and employment. Some economists have argued in favour

of the use of high interest rates to curb aggregate demand. The effect of a move along

these lines is to encourage the holding of larger money balances, reducing the

pressure of demand for commodities.

Critique of the interest rate Reservations to the interest rate issue have been raised:

(a) Higher interest rates may discourage investment and thus impede the development

of the economy. It can be counter argued that higher interest rates will raise the

productivity of new investments because now only projects which promise large

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returns will be undertaken. Hence it may be possible to sustain the overall rate of

economy growth even from a reduced volume of investment.

(b) A successful induction of people to substantially increase their money holdings

may due to the withdrawal of purchasing power from commodity markets may be

deflationary.

(c) Several studies have found the elasticity of demand for money with respect to the

cost of holding it to be rather small. If this is the case, it would take a very large

rise in interest rates to affect a significant increase in the demand for money.

Limitations of the state in achieving Macroeconomic Policy Objectives

(i) too many ministries, often with competing interests, too many public

corporations and too many boards of one kind or another.

(ii) Too much corruption of civil service, civil servants badly motivated.

(iii) Too much red tape.

(iv) Too much political instability with governments often changed by military

coups and other unconstitutional means. Governments are therefore

preoccupied with tasks of maintaining their own popularity, authority and

power.

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CHAPTER TWO

NATIONAL INCOME ACCOUNTING National Income is the outcome or the end result of all economic activities. Economic

activities generate two kinds of flows (i) money flows- these are in exchange for services

of factors of production in the form of flows- these are in exchange for services of factors

of production in the form of wages, rent, interest and profits (i.e factor earnings) (ii)

Product flows, are flows of consumer goods and services and productive assets. All

human activities which create goods and services that can be valued at market price are

broadly the economic activities.

Macroeconomics deals with a number of large totals or aggregates, which are used to

conceptualize and measure key components of the economy. The most fundamental of

these is the total output of goods and services, conventionally referred to as the national

income. (Official data in most countries is now actually reported on a "domestic" rather

than a "national" basis. The distinction, which is unimportant for most purposes, relates

to the treatment of investment income received from non-residents and paid to non-

residents. "Domestic income" is that produced within a country by all producers

operating there, whether foreign or not. "National income" is that produced only by

"nationals" of that country, whether they are producing it there or elsewhere.) 

There is nothing inconsistent in referring to total output as income. Although what is

earned as income can be measured separately from what is produced, the two aggregates

are necessarily the same in amount. Before going on to see why, note that in either case

such large totals can be expressed only in terms of money, not physical products as such.

It is impractical to try to measure output or income in real, physical terms, simply

because it is impossible to sum apples and oranges or any of the millions of goods and

services which are produced and received as income in a modern economy. Instead,

physical quantities must be converted to a common measure and the measure used for

this purpose is the national unit of account, the dollar, pound, or other currency. 

The value of total output or income in an economy during some accounting period,

usually a year or quarter of a year, is a significant statistic. It is generally used as an

indicator of the economy’s performance. Because a larger output or income is equated

with a rise in the economic well being of a country’s population, a higher output or

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income is considered desirable and a lower one undesirable. The economy’s overall

performance is tracked by the changing value of the total output or income statistic.

Similarly, comparisons of relative well-being among different countries are based on

these statistics and a host of political and social as well as economic implications flow

from their behaviour over time.

The Circular Flow

A modern economy can be simply modeled in the aggregate by thinking of it as

comprising two key sectors, households which consume produced goods and services and

which supply labour and other productive services to firms, which use the labour and

other productive services supplied by households to produce the goods and services the

households consume. Households supply the services of productive factors (land, labour,

capital, etc.) and the firms convert these inputs into produced goods and services which

return to the households. Owners of firms are, of course, also part of the household sector

where they function in their other capacity as consumers of goods and services. 

The real flows of productive services and produced outputs have corresponding flows of

money payments associated with them. Firms pay out wages and salaries in return for

labour services, rents to owners of land and other natural resource inputs, and interest and

profits to suppliers of capital and entrepreneurial inputs. Householders consequently have

money income with which to pay for the produced goods and services that flow to them

from firms. Thus, there are money flows corresponding to the real flows, but they move,

of course, in the opposite direction.

Circular Flow of Income

Services of factors of Production

Goods and services

Spending

Incomes

H/HOLDS FIRMS

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Because the flows of payments for produced goods and services and payments for factor

inputs are continuous, aggregate income/output in this simple model could be measured

at any point, metering the flow anywhere in the circuit. If measured in terms of spending

on produced goods and services, it would be natural to call this a measure of total

spending or total expenditure. If measured in terms of outlays made for the services of

productive factor inputs, it would be total income (from the point of view of the owners

of those factor inputs). Obviously the two totals would have to be the same.

This is a greatly simplified model. One thing missing is the possibility of saving. If

households do not spend all their income on produced goods and services, but hold some

of it back as savings, every time income flows into the household sector the flow of

payments made to producers will diminish. This is a "leakage" of income/spending from

the system and the volume of the flow would diminish—the level of national income

would fall. But if there are savings, there could also be new investment. If businesses

borrowed income saved by households and used it to finance the building of new plant or

for other business purposes, it would be injected back into the income stream (in the form

of payments to workers and other factor owners who supplied the necessary real inputs

needed to produce the new capital). Banks and other financial intermediaries serve as the

nexus through which savings are converted into investment spending and returned to the

income stream.

In the simple economy above we can write the identity of output produced and output

sold as Y ≡ C+I. That is all output produced is either consumed or invested. The

corresponding identity for the disposition of personal income is that the income is

allocated on C (Consumption) and part is saved (S). This implies that Y ≡ C+S. It also

flows that C+I ≡ Y ≡ C + S. Subtracting C from both sides gives I ≡ Y - C ≡ S which

shows that saving is also income less consumption and also investment is identically

equal to saving.

If another complication, government, is added to the simple model, another potential for a

leakage of income from the system is introduced. Governments impose taxes (T) on

households (and firms) and this results in a diversion of income from the private sector to

government. This is another leakage and it too has a corresponding potential for injecting

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such income back into the stream, this time in the form of government spending on

produced goods and services. Taxation reduces disposable income. Disposable income is

given by Yd ≡ Y-T and also Yd ≡ C+S. Thus C+S ≡ Yd ≡ Y-T

Finally, most real world economies are not closed loops. Instead they are "open" to the

rest of the world, with leakages from domestic income/expenditure flows in the form of

payments made for goods and services produced abroad ( imports, M) and injections of

income back into the domestic flows as a result of sales of goods by domestic firms to

consumers abroad (exports, X). As already seen, there can also be important flows of

savings and investment between one country and the rest of the world.

Circular Flow of Income

Services of factors of Production

Goods and services

Spending

Incomes

LEAKAGES/WITHDRAWALS INJECTIONSSavings InvestmentsTaxation Government ExpenditureImports Exports

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

The important ideas to understand at this point are that national income or expenditure

can be thought of as a continuous flow which can be measured in different ways

( Product ≡ income ≡ expenditure on the product) and that this simple process is

complicated by the possibilities of leakages and injections arising from private saving and

investing; government taxation and spending; and foreign trade and capital movements.

THE NATIONAL ACCOUNTS

H/HOLDS FIRMS

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All the economies today measure the volume of aggregate income, usually defined as

Gross Domestic Product, in much the same way.

Gross Domestic Product (GDP)

Refers to the total monetary value of all goods and services produced within the

geographic boundaries of a nation during a given year. The word “domestic” implies that

only the income produced in that country is accounted for. The income that arises from

investments and possessions owned abroad is thus not included in the GDP estimates.

Calculation of GDP

-calculated simply by valuing the outputs of all “final” goods and services at “market”

prices ( i.e. actual prices at which they are bought and sold) and then adding the total.

N.B. The market value of all intermediate products- those used to produce the final

output is excluded from the calculation of GDP since the values of intermediate goods are

already implicitly included in the market prices of the final goods. “Gross” implies not all

output was available for private/public consumption and investment, part went to replace

or maintain worn out capital equipment.

Nominal and Real GDP

Two measures of GDP are given: nominal GDP (also called current dollar GDP) and real

(constant dollar) GDP. Nominal GDP measures the value of output at the prices

prevailing at the time of production, while real GDP measures the output produced in any

one period at the prices of some base year. The growth rate of the economy is usually

taken to be the rate at which real GDP is increasing.

Whatever their minor differences, all national accounting conventions follow the basic

pattern identified in the preceding discussion of the circular flow of income and

expenditure. There are always at least two main calculations, one which sums total

expenditures on goods and services produced, the other of total income received as a

result of producing those same goods and services. Because both are measures of the

same thing they must, by definition, yield the same total. 

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

production and income. Product ≡ Income ≡ Expenditure on the product

Why two measures if the total must be the same? One reason is that two estimates

provide a check on one another with respect to accuracy. Another is that the two

measures break down into different components, some of which are more useful for

certain purposes than others.

GROSS NATIONAL PRODUCT (GNP)

This is the most important and widely used measure of national income. It is the most

comprehensive measure of a nation’s productive activities. It is defined as the value of all

final goods and services produced during a specific period, usually one year (Dwivedi,

1996). In other words it refers to that part of the GDP that is actually produced and

earned by or transferred to resident nationals of that country. Earnings of foreigners

which arise out of their domestic economic activities are thus excluded. For

Zimbabweans working abroad their income is included in the GNP of Zimbabwe. Where

there is substantial foreign participation in the economy and a large part of total domestic

income is earned and repatriated by foreigners and foreign companies as in many LDCs,

GDP will be much larger than GNP. As a result statistics of GDP growth may give a false

impression of the economic performance of a particular developing nation. GNP is

therefore a more appropriate measure of national income.

NET NATIONAL PRODUCT (NET NATIONAL PRODUCT)

Net National Product = Gross National Product– Depreciation. Net National Product

(NNP) is calculated by deducting from GNP the depreciation of existing capital stock

over the course of the period. The production of GNP causes wear and tear to the existing

capital stock, for example, machines wear out as they are used. It is a more accurate

measure of national product but in real life GNP is mostly because net investment (Gross

Investment – Depreciation) is difficult to measure especially as rate of depreciation is not

known (straight line, declining or reducing balance?) or may be quite inaccurate.

Depreciation estimates may also not be quickly available.

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MEASUREMENT OF NATIONAL INCOME

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

1). Expenditure

2). Income method

3). Value Added or Output approach

A. The Expenditure Approach

Measuring total output by the expenditure method involves breaking down total spending

on all goods and services produced into four categories: (a) Expenditures by consumers

on goods and services (abbreviated simply to the letter C); (b)Expenditures by businesses

on capital goods (total investment spending, I); (c) Expenditure by government on goods

and services, G); and (d) Net exports (the total value of exports minus the total value of

imports, X-M). Because all spending done in the country falls into one or other of these

four categories, we can say that total expenditure is the sum of C+I+G+(X-M). We now

examine each of these four main components of total spending. 

Consumption (C)

Consumption spending is the total of all outlays made by households on final goods and

services. In all countries it is by far the largest component of total spending. It covers

spending on an enormous range of items, including durable goods like television sets and

cars, non-durable goods like food and clothing, and personal services such as legal

advice, hairdressing, and dental care. But it usually excludes spending on houses, which

is customarily (and arbitrarily) treated as investment expenditure. C also excludes

purchases of second-hand goods that were produced in some earlier accounting period so

as not to double count the value of such output.

Government Expenditure on Goods and Services (G)

All governments payments to factors of production in return for factor services rendered

are counted as part of the GDP. Much of the spending done by governments in the

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developed countries today takes the form of simple transfers of income from taxpayers to

those eligible for the wide range of income supplements available to assist the elderly, the

sick and the unemployed, or as payments of interest to holders of the public debt. Such

transfer payments do not represent spending on current production and consequently, are

not counted in national income determination. What is counted is government spending

on goods and services, many of which are bought by the government on behalf of the

public and which are ultimately "consumed" by households: education, health care

services, national defence, roads, water and sewage systems, postal services. Because so

many of these goods and services are provided "free" or in other ways that bypass

markets, it is difficult to determine their value in the same way that the value of the other

items entering into C would be determined. Consequently, national income accountants

value government spending on the basis of what the government pays for the goods and

services it requires.

Another complication with government spending on goods and services is that such

spending is often done on things like highways which are themselves capable of being

used to assist in the production of other goods. Logically, such spending should be

thought of as investment spending and included in the next category to be discussed.

Some countries produce their accounts in such a form that government spending can be

separated into two categories, current spending on goods and services, and investment

spending, but if the main concern is to understand the causes of year-to-year cyclical

fluctuations in the level of national income rather than the causes of its longer term

growth (which may be strongly affected by the level of investment as opposed to current

spending) it is convenient to stick with the traditional categories of spending which

emphasize the different motivations driving the spending decisions of ordinary

consumers, private investors and governments. Here, investment spending refers to

private investment spending unless otherwise stated.

Investment (I)

Investment is the production of goods that are not for immediate consumption. The goods

are called investment goods (inventories and capital goods including residential housing)

The total investment in an economy is called Gross Investment.

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We count the construction of new houses as part of GDP, but we do not add trade in

existing houses. We do however, count the value of the estate agents commission in the

sale of existing houses as part of GDP. The estate agent provides a current service in

bringing buyer and seller together, and that is appropriately part of current output.

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

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

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

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

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

may be considered voluntary. But business conditions are uncertain and so firms

may also find themselves holding stocks because they miscalculated demand. In

either case, firms are considered to be investing when they accumulate

inventories. On the other hand, if their inventories decrease they are

"disinvesting." Inventory investment is highly volatile, changing greatly in

amount and composition from year to year.

Gross investment, then, is the total amount of (usually private) spending during the

accounting period on capital goods (defined as structures, machinery and equipment, and

inventories). Because capital by its nature consists of things that are used in the

production of other goods and services, it is inevitable that it will wear out or

"depreciate." The amount necessary for replacement is called Depreciation or capital

consumption allowance. Gross Investment – Depreciation = Net Investment. Unless it is

continually renewed, the stock of capital in the economy will gradually be depleted.

Handling depreciation is one of the more difficult parts of national income accounting.

Again, the best treatment depends on what the data are meant to be used for. If the

concern is with the long-term growth of the economy, net investment (total investment

during the accounting period minus depreciation) is the important concept because it

measures the growth of the economy’s capital stock over time. But if the purpose is to

understand short term, annual fluctuations in the level of total spending it is better to

work with gross investment. 

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Net Exports (X-M)

A significant part of total spending in most countries goes toward the purchase of goods

produced abroad rather than domestically. As noted in discussing the circular flow, such

outlays represent spending which leaks from the domestic economy to the rest of the

world and is consequently treated as a negative entry in measures of total domestic

spending. But it is offset to a greater or lesser degree by the spending of non-residents on

goods produced and exported to international markets. It is often convenient, therefore, to

take domestic spending on imports and foreign spending on exports as a combined value,

usually called net exports, a value which may be positive or negative in any accounting

period depending on which component, exports or imports, is larger.

Summing these four expenditure components, C+I+G+(X-M), gives a single figure, the

total amount of spending done in the economy during the accounting period. It should be

possible to arrive at exactly the same figure by summing all income received in the

economy during the accounting period. (GDP = Y = C+I+G+(X-M),

B. Measuring Total Output by the Income Method

As seen in discussing the circular flow, what the firms producing the national output see

as costs of production, owners of productive factors see as income. Factor costs and

factor incomes are consequently the same thing viewed from different perspectives.

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

Quantitatively, by far the most important and certainly the simplest factor costs to

measure are the payments made by employers for labour services. These payments are

usually reported in the official statistics under a heading such as "Wages, salaries, and

supplementary labour income," with the latter term referring to employee benefits such as

pensions, workers’ compensation benefits, and employer contributions to unemployment

insurance funds or other worker social security schemes. Most other factor payments,

however, are much more difficult to track. Consider a farming operation. How should any

net income derived from farming be classified? Part of it must be a return to the services

of land the farmer is using ( rent). Part must be a return to the farmer’s own input of

labour (wages). Part might be considered a return to setting up and operating the

business(profit). These are difficult to separate. Because of such problems, the national

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accounts typically use definitions of factor payments which owe more to convenience

than to the logic of factor classification: net income of farm operators, corporation

profits, net income of unincorporated business, and interest and other investment income.

Summing all these items yields the total amount received during the accounting period by

the owners of productive factors. But if this figure for factor costs or income is compared

with the total arrived at by the expenditure method, it falls considerably short of the

amount expected.

Indirect taxes and subsidies result in a discrepancy between the market price and the

factor cost of goods and services. The market price of most goods and services includes

indirect taxes, such as general sales tax, value- added tax and excise taxes with the result

that the market price is greater than the price the seller of the good or service receives. On

the other hand, subsidies paid to producers to keep the market price of certain goods and

services lower than it would otherwise be, result in the producers’ income being greater

than the market price. To calculate the GDP at factor cost, i.e. the amount received by the

factors of production that produced the goods and services concerned, we therefore have

to deduct indirect taxes from the GDP at market prices and add back subsidies. Thus:

factor cost ≡ market price – indirect taxes + subsidies. This point becomes important

when relate GDP to the incomes received by the factors of production.

C. Output Approach or the Value Added Method

A third method is available for estimating the total output of the economy and it is called

the "value added method" because it simply sums the net value of the output produced by

all the firms in the economy. GDP is the value of final goods and services produced. The

insistence on final goods is simply to make sure that we do not double count This

approach measures GDP in terms of values added by each of the sectors of the economy.

This is conceptually simple, but in practice complex because of the need to avoid double

counting. There are many interactions among firms in a modern economy. Many produce

goods that are sold not to final users as consumer goods, but to other firms. Consider a

firm producing power supply devices for computers. It buys components from suppliers,

assembles them, and sells the finished product to another firm which incorporates it into a

computer. If the value of the power supplies was measured when they were produced and

again as part of the price of the finished computer, total output would obviously be

19

exaggerated. Dealing with this requires that the value of each firm’s output be reduced by

the amount of all payments made by that firm to obtain inputs. This involves considerable

work, but the resulting data are often very useful because they yield a breakdown of

national output on an industry-by-industry basis. In formula terms:

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

If we follow the course of this process, we will see that the sum of values added at each

stage of process is equal to the final value of the item sold. Value added is also the basis

for the Value added Tax (VAT).

A problem associated with the value added approach is valuation of inventories of goods

produced but unsold. Unsold inventories are valued at market prices yet profits ( or

losses) have not been realised; prices may fall or rise; goods may not be sold. This means

that a rise in market prices causes a rise in value of the existing inventories. To avoid this

distortion a correction is made to eliminate changes in the value of inventories due to

price changes; that is stock appreciation should be deducted from the value.

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

Net factorpayments

Depreciation

Indirect taxesGDP at GNP less market at market subsidiesprices prices NNP at

market National Various*prices Income items

at factor Personal Personalcost Income Tax

PersonalDisposable income

* includes income that does not accrue to personal sector e.g. corporate taxation and corporate saving

20

Uses of National Income Accounting

1. Assists government in planning the economy. The accounts will show growth or

stagnation in the economy, alerting policymakers to the sort of action which ought to

be taken. Since national income accounts break the performance of the economy

down into its component parts, they provide policymakers with specific information

regarding the formulation and application of economic policy.

2. Permits us to measure the level of production in the economy over a given period of

time and to explain the immediate causes of that level of performance.

3. By comparing the national income accounts over a period of time, the long-run course

which the economy has been following can be plotted.

4. To compare standards of living of different countries- the problem is the countries

being compared use different currencies. The simplest means of dealing with the

problem is to use the Exchange rates between countries to convert the GNP of each

nation to a common currency e.g. US$. Most international comparisons use this

method. The second method used is Purchasing Power Parity. (a) Exchange rate

conversion- the method is simple and straightforward but this does not meet our

needs fully. We are seeking to measure differences in standard of living among areas,

but exchange rate reflects purchasing power of currencies for goods traded in

international markets. Goods and services not traded on international market may not

be correctly taken into account. (b) Purchasing power parity- the method involves

determination of the relative purchasing power of each currency by comparing the

amount of each currency required to purchase a common bundle of goods and

services in the domestic market of the currency’s country of origin. This information

is then used to convert the GNP of each nation to a common monetary unit. Estimates

using Purchasing Power Parity method are a more accurate indicator of international

differences in per capita GNP than exchange rate conversion method.

5. As a measure of welfare and national development, GNP per capita may be rising

over a period of time implying a rise in economic welfare and economic

development. Criticisms include the following- output of weaponry may rise, crime

21

may rise (use of more police), motor vehicle production (more pollution) may also

rise (showing increasing GNP) yet in terms the people are not better off or even

worse off. Output may also have been of capital goods. GNP per capita gives no

indication of how national income is actually distributed and who is benefiting from

growth of production. A rising level of absolute and per capita GNP may obscure the

reality that the poor are no better off than before. As an index of improved economic

welfare GNP growth rates are inadequate for the generality. Despite its shortcomings,

GNP provides a useful measure especially if it is accompanied by indicators like life

expectancy, infant mortality rates, education, literacy and income distribution.

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

7. National income and product estimates by sector of origin of national product reveal

contributions made by different sectors of the economy.

PROBLEMS OF GDP MEASUREMENTGDP data are far from perfect measures of either economic output or welfare. Problems

of GDP measurement are:

(1) Badly measured outputs-some outputs do not go through the market, e.g. government

output (such as defence) is not sold in the market. Also there is nothing comparable

available that would make it possible to estimate the value of government output. It is

therefore valued at cost. Other non-market activities, including do -it- yourself work

and volunteer activities, are also excluded from GDP.

(2) Unrecorded economy- many transactions that go through the market escape

measurement. e.g. payment for a handyman’s services is not recorded in the GDP

data as it is unlikely to be declared, illegal traffic in drugs. The main problem is that

the relative importance of such activities may have been changing. If such activities

become more important over time , then measured real GDP will understate the rate

of growth of total economic activity. Why there might have been an increase in

unrecorded transactions (i) rising tax rates (which make it more tempting not to

declare sales or income,) and the growing importance of the so called informal

activities outside the modern sector of the economy.

22

(3) Data revisions- when they first appear, GDP data are not firm estimates. The reason is

that many of the data are not measured directly, but are based on surveys and guesses.

Considering the GDP is supposed to measure the value of all production of goods and

services in the economy, it is not surprising that not all the data are available within a

few weeks after the period of production. The data are revised as new figures come

in, as the CSO and RBZ improve their data collection methods and estimates.

Adjusting National Income Data to Allow for Price Changes

One difficulty with using money values to express national accounting magnitudes is that

the value of money may change over time. If there is a general rise in all prices, or a fall

in all prices, the monetary unit either decreases or increases in value. Trying to measure

distance with a ruler that shrank or expanded significantly between measurements would

obviously be a frustrating and not very useful activity. Inflation, defined as a general rise

in the price level, or deflation, a general fall in the price level, are common enough to

make it necessary to adjust national income data to remove the effect of changes in the

purchasing power of the dollar or other monetary unit being used to measure the value of

total output. This is done by developing indexes which show how the prices of the goods

and services produced in any one year have changed relative to the prices of those goods

and services in some other year. Setting up these indexes of prices is not difficult in

principle, although it can be an expensive, time-consuming task in practice. Consider a

simple example in which only a single commodity is the subject of interest, men’s shoes.

In the following table the price of men’s shoes in each year is compared with the price

prevailing in one particular year. The base year in the example is year 2000, (this can be

written as 2000=100) although it could have been any one of the five years. The price in

any particular year is then divided by the price in the base year to get the ratio of prices

shown in the third column. Because these ratios are usually expressed as percentages,

they are then multiplied by 100 to obtain the price index numbers shown in the last

column.

Year 1999 2000 2001 2002 2003

23

Price($) 20 40 50 60 80

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

Price Index 50 100 125 150 200

 

These index numbers can now be used to adjust the data on the value of men’s shoes

produced in each year, thereby eliminating the effect of price changes from the series.

Suppose the following production information is available.

 

 

Year 1999 2000 2001 2002 2003

Output in Current

$

5 20 30 50 90

Output in

Constant$

10 20 24 33.3 45

The current dollar values shown in the second column turn out to be quite misleading as

an indicator of the real changes in output. Because prices were lower in Year 1999 than

in the base year (Year 2000), the output in Year 1999 was understated, whereas, because

prices in Years 2000, 2001, and 2003 were higher than in the base year, the current dollar

production values overstated the volume of output. The conversion to (Year 2000)

constant dollars in the third column was done by dividing the current dollar values of

output for each year by the relevant index number (expressed as a percentage).

Men’s shoes are only one of thousands of commodities which are included in the total

national income and, in practice, it is not feasible to develop price indexes for each item

24

in this way. Instead, price indexes are built up for groups of commodities which are often

defined in terms of who buys them. For example, a commonly used index measures

changes in the amounts households spend on a selected bundle of goods and services.

One of the problems with this kind of index is that it is very costly to determine which

goods should be included in such a bundle. Surveys must be made of household buying

habits to determine which goods households are buying in significant quantities and the

relative importance of various goods in typical household budgets. Because of this, years

may elapse between redefinitions of the goods which are included in the index which

makes the information the index provides of dubious value toward the end of the

redefinition cycle. 

When constructing large price indexes for adjusting national income data, most statistical

agencies build up a general index from a large number of specific commodity group

indexes, so that changes in expenditure patterns within the component groups will not

seriously affect the outcome. This composite index is known as a gross domestic product

deflator. It can be used to convert any current dollar value of gross domestic product to a

constant dollar basis using the relation: 

Nominal GDP/Real GDP x 100 = GDP Deflator

GDP price deflator is an index calculated from nominal and real GDP. Thus, if the

deflator is known to have a value of 125 and nominal (current dollar) gross domestic

income is 50 billion dollars, real gross domestic income is $40 billion.

The measurement of per capita incomeAll countries have adopted the conventions (the United Nations Standard National

Accounts) for the calculations of Gross National Product (GNP) and Gross Domestic

Product (GDP), and GNP or GDP per capita is the commonest indicator of the level of

development. Economic growth refers to an increase in either of these indicators. There

are however well known problems associated with the calculation of national income in

poor countries and its use as an indicator of development:

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

25

2. The accounting conventions are not necessarily appropriate; the services of

women working in the household are excluded from national statistics yet in

many poor countries, especially in sub – Saharan Africa, women are often

responsible for running the family farm as well as working in the household.

3. In most poor countries, there is a large subsistence sector – that is, farmers may

well consume all or large proportion of what they produce, rather than sending it

to the market where it would be counted for the purposes of calculating national

income. Statisticians make an allowance for this non- marketed component of

output, and for rural capital formation that may not enter the national accounts –

house building, irrigation ditches – but it is generally accepted that the value of

the activities is underestimated, thus biasing downwards the national income

figures for poor countries.

4. Income may be overstated for developed economies because a number of items

that are included as income might better be seen as costs and hence excluded from

income- the cost of travelling to work, for example, or the cost of heating the

home in temperate climates.

5. Per capita (average) incomes tell us nothing about the distribution of income. Two

countries with similar per capita income distributions, with important implications

for the welfare of their populations and the nature and characteristics of the

development process.

Significant problems arise when international comparisons of income levels are made.

Income data measured in national currencies have to be converted into a common

currency, usually the US dollar, and an exchange rate must be chosen. If poor countries

artificially maintain overvalued exchange rates (that is, the price of foreign currencies in

terms of their domestic currency is too low), this will overstate the income of the country

expressed in US dollars. Offsetting this, however, is the fact that many goods and

services in poor countries are not traded and hence have no impact on the exchange rate.

Many of these necessities of life in poor countries – basic foodstuffs for example- are

very low priced in dollar terms, and a haircut in Zimbabwe will cost less than one in Paris

or London.

26

According to World Bank data:

Mozambique with an estimated GNP per capita of US 60 in 1992 was the poorest

country in the world;

Switzerland, with a GNP per capita of US$36080, was the richest

Is the average Swiss citizen 600 times better off than the average Mozambican? To put

that question slightly differently, does it make sense to state that in Mozambique, on

average, people live on 16 cents a day?

Clearly nobody in a developed economy could survive on such a low income. Given that

the majority of Mozambicans do survive, it must be the case that the necessities essential

for survival cost less in Mozambique than for example in Switzerland, and/ or $60 is not

a meaningful estimate of per capita income in Mozambique. This is not to deny that a

huge gap exists between the average incomes of very rich and very poor countries, nor

should it lessen our concern with such inequalities. But it does mean that the gap on

average is not as great as the statistics would suggest and a number of attempts have been

made to compute more meaningful comparisons.

Measurement of the Standard of LivingThe value of this year's national income is a useful measure of how well-off a country is

in material terms. However, inflation increases the money value of national income but

does not provide us with any more goods to consume. Real national income is found by

applying the equation:

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

The standard of living refers to the amount of goods and services consumed by

households in one year and is found

(i) by applying the equation:

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

27

A high standard of living means households consume a large number of goods and

services. Or

(ii) by counting the percentage of people owning consumer durables such as cars,

televisions, etc. An increase in ownership indicates an improved standard of living. Or

(iii) by noting how long an average person has to work to earn enough money to buy

certain goods. If people have to work less time to buy goods, then there has been an

increase in the standard of living.

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

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

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

Leisure time is reduced to achieve the production increase.

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

Common Misunderstanding

1. The various measures of the national product give us a tally of the nation’s income for a year. However this does not measure the nation’s wealth .The nation has great stock of capital goods .The stock of national capital is the sum total of everything that has been preserved from all that has been produced throughout our economic history. Interestingly, perhaps the greatest asset of modern economies is the skill and education of the workforce. This is called ‘human capital’ but is not included in measures of net capital stock owing to difficulty of measurement.

2. If we are assessing someone’s wealth, one of the first things we would look at is

how much money they had and whether they owned stock and shares. However

these are excluded from the calculation of national wealth. Why? The answer is

because we have already counted them in the form of real wealth such as buildings

and machines. Money and other financial assets are only claims upon wealth and

hence are simply paper certificates of ownership. Similarly, varying the amount of

money in the economy does not directly make it any richer or poorer.

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DETERMINATION OF EQUILIBRIUM NATIONAL INCOME

Equilibrium is that position in which the opposing forces of change are in balance. In a

two sector income equilibrium equation is Y = C + I where C = a + bY e.g. 50 + 0.75Y

According to Keynesian theory of income and employment, national income depends

upon the aggregate effective demand. If aggregated effective demand falls short of the

output at which all those able and willing to work are employed, unemployment in the

economy will result. Consequently there will be a gap between economy’s actual and

optimum potential output. On the contrary if the aggregate effective demand exceeds the

economy’s full employment output inflation will result.

Equilibrium aggregate income and output is determined at that point at which total

expenditure or aggregate demand function C + I + G + (X - M) cuts the 450 equality line

(Expenditure = Income). N.B. Equilibrium does not mean full employment output.

MULTIPLIERS

When there is an increase in the level of injections, part of it will be received by a

household as extra income. The households will probably act so that part of this extra

income is then spent and part is saved. This extra consumer spending then gives rise to a

series of further incomes and expenditures. The overall increase in spending is much

higher than the initial injection. This effect is known as the multiplier effect. The greater

the proportion of the extra income that is spent (the Marginal Propensity to Consume),

the bigger the multiplier effect will be. The multiplier is defined as the ratio of the change

in national income to the change in expenditure that brought it about. The change in

expenditure might come from for example private investment (investment multiplier) or

government expenditure (government expenditure multiplier) or exports (exports

multiplier). If we let k be the multiplier;

29

Investment Multiplier

Investment Multiplier ki

To clarify the investment multiplier supposing there is an injection of $120m to build

factories and other capital goods. The impact of this investment will be more than the

$120m initially invested. The $120m spent is thus income to those who supplied the

equipment, resources etc. How much of this $120m which has been received as income

will be spent depends on the keenness of the recipients to spend it, in other words their

marginal propensity to consume. Marginal Propensity to consume (MPC) would thus be

the fraction of the income likely to be spent. Of all income earned part will be spent, part

will be consumed, ie. Y = C + S

Consumption/ Income earned = MPC = Marginal Propensity to Consume

Amount Saved or Amount earned or income = MPS (Marginal Propensity to Save) and

therefore MPC + MPS = 1. Assuming a marginal propensity of 2/3, then $80m of the

$120m will be spent in the next stage. In the next stage of the $80m income, $53m will

be consumed. The greater the MPC the greater the income that is consumed hence the

greater the amount spent at subsequent stages. To calculate the multiplier

ki = 1/(1-MPC) = 1/MPS. From the example above ki = 1/(1-2/3) = 1/ (1/3)= 3. The

greater the MPC the greater the multiplier. This means that the total increase in the

national product brought about by the investment of an initial sum of $120m is $360m.

This analysis assumes away taxation and also price increases due to high demand for

goods and services. Imports have also not been taken into account. In reality once

demand increases prices may stabilize for a short while if factories have been operating at

less than full capacity but when that happens, i.e. full capacity is reached prices start to

30

rise. The rise will also depend on whether the economy is inward looking or outward

looking in terms of raw material inputs. If inputs are imported this pushes up prices of the

inputs and as a result increase in national output of $360m will not be realized because of

the leakages. Increase in demand for finished products also causes a derived demand for

material inputs hence cost of finished goods and ancillary services will rise. On the whole

there would be a decline in the quantities that would be purchased, due to increases in

prices. Anticipated expenditure is thus not equal to actual expenditure realized. The tax

structure may be increased especially as the tax base has been widened. Once the rate of

tax has increased then disposable income diminishes hence this affects the amount of

purchases vis-à-vis savings.

Simple Investment Multiplier

Importance of the multiplier for economic policy purposes stems from the assumption

that a given initial change in autonomous investment spending causes a magnified change

in the equilibrium income in the economy. Multiplier theory states that the increase in

total income occasioned by any given increase in autonomous investment (or

consumption) outlay is a certain multiple of the original increase in autonomous

expenditure and the magnitude of the increase in total income depends upon the value of

the MPC. The investment multiplier Ki and MPC are related in such a manner that the

higher the MPC the higher the investment multiplier and vice versa.

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

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

Y = a +bY + Ī

Y(1-b) = a + Ī

31

Ki = 1/MPS MPS = 1 – MPC

The operation of the simple investment multiplier in the economy is thwarted by many

leakages. Consequently the actual income generated consequent upon any given increase

in autonomous investment expenditure will be less than the product of the investment

multiplier Ki and the given increase in autonomous investment ΔI. In other words

ΔY < ΔĪ. Ki . Examples of a leakages (imports); inflation (increased money spending

fails to increase real consumption); savings (higher MPS lowers the multiplier while a

lower MPS raises the multiplier. Regressive tax policy and other fiscal measures

involving redistribution of income in favour of the richer sections of the economy also

reduce the size of the multiplier as do paying off debts, or if the increase is invested in

securities.

So far we focused on the simple investment multiplier where investment was treated as

autonomous, i.e. not related to income changes. In reality increases in income also causes

increases in investment. Thus like consumption the changes in investment in the

economy are induced by change in the level of income. Induced investment is positively

related to the level of income such that an increase in income induces an increase in

investment and net investment in any given time period will be equal to the increase in

aggregate demand. It is therefore more realistic to treat total investment as being

composed partly of the autonomous investment and partly of induced investment.

Investment demand function in the form I =. IA + eY where ĪA is autonomous investment

and eY is the induced investment 0<e<1.

DerivationY=C+I and C= a + bY; and I =. IA + eY substituting gives

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

value of the investment multiplier.

32

Paradox of Thrift

The inclusion of the induced investment in the model shows the interesting phenomenon

of the “paradox of thrift” which reveals that an attempt on the part of the community to

save more out of any given income will lead to an actual decrease in the amount it will

succeed in saving. In short, the attempt to save more will be self-defeating. In fact the

community may paradoxically end up with reduced total saving.

Government Expenditure Multiplier

From the definition this multiplier is kg

Government expenditure can influence economic activity in a country. It can influence

national output and employment levels to name a few. The multiplier applies equally to

government expenditure as it does to investment. In a simple model on the determination

of national income or output, aggregate demand is given by the formula Y=C+I+G, that

is aggregate demand = Y = Consumption + Investment + Government Expenditure. If

MPC =2/3 as before the change in national will be $360m. This implies that an increase

in employment for the factors used to produce that much in output will result.

Knowledge of government expenditure multiplier would help the government in deciding

on what expenditure level would be necessary to reach the full employment level.

E=Y E=Y AD2

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

Recessionary gap ∆G Full employment Full employment

700 1000 700 1000 National Product National Product

33

In the diagrams, assuming that MPC=2/3, the multiplier is 3 an the present equilibrium is

such that the national product (aggregate demand) is at $700m and the full employment

level is at $1000m then the government can increase its expenditure to wipe the

recessionary gap by spending only $100m.

Government Spending-Investment Multiplier

When investment (I) varies as income varies, then a change in government spending

leads to a modified multiplier – the government spending – investment multiplier, kgi

where MPI = marginal propensity to invest out of income. If MPC =2/3 and MPI =1/6

(MPS = 1 – 2/3=1/3)

From this a change in government expenditure, hence aggregate demand of $120m leads

to a magnified change in income of $720m because of the multiplier factor.

∆Y = kgi ∆G = 6 x $120 = $720m.

Government Expenditure Multiplier in a closed economy, with taxes

If we assume a closed economy

1. - Government expenditure is exogenous

2. - The tax (T) depends on the tax rate (t), which is the function of incomeBudget Surplus or Deficit = G – T; G is Government expenditure; T is Taxation

If G>T there will be a budget deficit.

If G<T there will be a budget surplus.

3. where is disposable income

4. Disposable income equals total income less taxation.

=

34

5. Investment is exogenous (independent of income)

Expenditure (E) = Income (Y)

Government multiplier

Alternative approach1. 2. 3. 4. 5.

The higher the MPS and taxes the lower the amount consumed. The lower the MPS and

taxes the higher the expenditure rate and figure.

Government Expenditure Multiplier in an open economy, with taxes

35

1. 2. 3. 4. 5. M=M0 +M1Y M = import function M1 = marginal propensity to import M0 = autonomous imports6. 7. exports are exogenous because imports depend on the exchange rate. It also depends on the world price. The marginal propensity to import depends on the exchange rate. ( . Exports are exogenous in a small country because they are determined by other countries.

8.

injections = leakages

Government purchases of goods and services when added to the level of private

consumption and business investment demand cause an increase in the equilibrium

income in the economy. This is so because government purchases of goods and services

not financed by an increase in taxes, increase the aggregate effective demand and

consequently increase the equilibrium income in the same manner in which an increase in

consumption and/or investment outlay raises the equilibrium income.

Taxes on the other hand have the same impact on the economy as saving. An increase in

government taxes will, ceteris paribus, decrease the equilibrium income. Government

purchases involve government expenditure on goods and services. Total government

expenditure can be separated into government purchases of goods and services (G) and

36

government transfer payments (R). Their impact on the economy is different. While G

involve direct consumption of the purchased goods and services by government and

therefore raise aggregate demand by the full amount of government expenditure. In the

case of transfer payments (R), government pays money to individuals in the form of old

age insurance, unemployment dole payments, etc. After including government sector in a

3 sector closed economy, equilibrium aggregate income will be Y = C + I + G with no

increase in the government taxes and autonomous investment, the government purchases

multiplier will be equal to the simple investment multiplier.

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

is autonomous investment. G = Go= autonomous government expenditure.

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

Government transfer multiplier. A government transfer multiplier operates like the

simple multiplier except that its value is generally smaller than the value of the simple

multiplier for either government purchases or investment. Normally different transfer

payments would have different multipliers. For example, the transfer multiplier for

interest payments would be smaller than that for the unemployment compensation

payments since interest payments are mostly received by high income families owning

government bonds. These families’ MPC is low while the unemployment compensation

payments are received by the low income and poor families whose MPC is generally

high.

37

Tax Multiplier. The tax multiplier would be negative because a tax would cause a

negative change in the disposable personal income of the community. The disposable

personal income

Yd = Y –T+R where R is transfers. (It is assumed that T and R are autonomously

determined.) C = a + bYd and therefore ΔC= bΔYd

ΔC= bΔ (Y –T+R) and ΔC= bΔY –bΔT+bΔR)

The impact of taxes on consumption and therefore, on income is negative. Derivation is

Y = C + I + G

Substituting for Yd gives

for the transfers multiplier.

Lump sum tax multiplier

Lumpsum tax is tax that is a fixed amount. The lumpsum tax multiplier

ktx= - MPC/MPS. This has a negative sign because as tax increases consumption falls. If

MPC = ¾; MPS = ¼, then ktx= - MPC/MPS.= -(3/4)/ (1/4) = -3.

If MPC = 2/3 ; MPS = 1/3 then ktx= - MPC/MPS = -(2/3)/ (1/3)= -2.

∆Y = ktx.∆T T = Tax.

With a tax cut of say $10m

∆Y = ktx.∆T=-2 (-10) = $20m.

Balanced Budget multiplier

38

When a budget is balanced G=T hence ∆G = ∆T. If both G and T increase by $10m,

income increases by $10m. The multiplier for a balanced budget kBB.=1 ;

∆Y = kBB.x ∆G = 1 x ($10m) = $10m this would be an expansionary budget. If there is a

cut of say $10m , ∆Y= kBB.x ∆G= 1 x (-10) = -$10m and this is a contractionary budget.

Foreign trade multiplier. For an open economy, income and output will increase from

one period to the next as total exports increase or its total imports decrease because as a

result of both these changes the economy’s net exports expand. Conversely, domestic

economy’s income and output will fall over time as its total exports decline or total

imports rise as both these changes will tend to cause a fall in net exports. From this it

follows that the effect of imports and exports on economy’s equilibrium income and

output originates from those factors that determine the economy’s imports and exports.

Generally, a country’s total exports depend on the price of goods in the country relative

to their prices in other countries, tariff and trade policies prevalent in the country and

availability of foreign currencies in the foreign exchange markets, income in other

countries, own imports of the country, etc. Some of the more important factors that

determine a country’s exports are not directly related to conditions within that country.

Consequently, it is assumed that gross exports of a country are autonomously determined,

i.e. exports are determined by the external factors. The volume of imports is determined

by similar factors. However many of these factors are influenced by conditions within

the country. Ceteris paribus, a country’s total imports are determined by the level of

national income. In other words assuming given international price differences and

unchanging tariff, trade and foreign exchange restrictions a country’s imports are

functionally related to her national income.

Assuming a linear relationship between national income and imports of the following

form which defines the import function as M = Ma + mY, where Ma is the autonomous

spending on imports and m is the marginal propensity to import (MPM).

In the four sector open economy the equilibrium income is given by the equation Y = C +

I +G + (X-M) or by the equation S +T + M = I + G + X. Since our consumption is

39

defined by the equation of the consumption function C = a + b(Y-T) and imports are

defined by the import function equation M = Ma + mY, by substituting for the terms C

and M the above equilibrium income can be written as

Y = a + b(Y-T) + I + G +X – (Ma + mY). This can be rewritten as

Where 1/ (1-b+m) is the foreign trade multiplier for the economy in which exports are

wholly autonomously determined while both consumption spending and import

expenditure are linear functions of the level of national income. If taxes are assumed to

be functionally related to the level of income so that the total tax function is T = d + tY,

the equilibrium national income would then be

Where 1/(1-b+bt+m) is the foreign trade multiplier for the system in which

consumption, imports and taxes are all linear functions of the level of domestic income.

Furthermore if we treat investment spending also linearly related to the level of income

so that the investment demand function can be written as I = Ia + eY, the equation for the

equilibrium aggregate income will become

in which consumption, investment, imports and taxes are all linear functions of the level

of national income. The foreign trade multiplier, also called the export multiplier,

operates in exactly the same manner, as does the ordinary investment multiplier. An

increase in country’s exports causes an increase in the incomes of the exporters and

factors employed in the export industries that in turn spend a part of their increased

incomes on domestic goods. In short, the larger the marginal propensities to save and

import, smaller will be the value of the foreign trade multiplier and vice versa.

40

is the foreign trade multiplier for the economy in which the consumption, investment,

imports and taxes are all linear functions of the level of national income. A look at the

multiplier brings home the fact that ceteris paribus the value of the foreign trade

multiplier is inversely related to the value of the marginal propensity to import m such

that higher m is associated with lower foreign trade multiplier and vice versa.

Criticisms of the Multiplier Analysis

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

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

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

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

41

CHAPTER THREE

MONEY AND BANKING THEORY

Origins of MoneyThe earliest method of exchange was barter in which goods were exchanged directly for

other goods. Problems arose when either someone did not want what was being offered in

exchange for the other good, or if no agreement could be reached over how much one

good was worth in terms of the other.

Valuable metals such as gold and silver began acting as a medium of exchange.

Governments then decided to melt down these metals into coins.

By the seventeenth century people were leaving gold with the local goldsmith for safe

keeping. Receipts of £1 and £5 were issued which could then be converted back into gold

at any time. Soon these receipts were recognized as being 'as good as gold' and were

readily taken in exchange for goods. Goldsmiths became the first specialist bankers and

their receipts began to circulate as banknotes.

Only the Reserve Bank of Zimbabwe can issue banknotes in Zimbabwe. However, notes

are not usually used to buy expensive items such as cars. The buyer is more likely to

write out a cheque, which instructs his bank to transfer money from his account into the

account of the seller. Hence bank deposits act as money.

Functions of Money

Money is something which people generally accept in exchange for a good or a service.

Money performs four main functions:

a medium of exchange for buying goods and services;

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

a store of value when saving;

a standard for deferred payment when calculating loans.

42

Properties or Characteristics of Money

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

acceptable to people as payment;

scarce and in controlled supply

stable and able to keep its value

divisible without any loss of value

portable and not too heavy to carry.

Gresham’s Law- ‘ bad money drives out good money’If there are two types of money, and one is more valuable than the other , the inferior

money gets used/ circulated and it drives the valuable / superior money out of

circulation. People will hoard the good money and spend it.

MONEY SUPPLY

Definition

The money supply is the total amount of assets in circulation, which are acceptable in

exchange for goods. In modern economies people accept either notes and coins or an

increase in their current account as payment. Hence the money supply is made up of cash

and bank deposits.

Credit Creation

Some customers leave money in the bank earning interest. A bank can use these idle

deposits to make loans to people who then buy goods. Shopkeepers receive extra money,

which they redeposit with the bank. Some of this redeposited money is left to earn

interest and can be re-lent. The bank has therefore created money. If all customers were

to try to cash their deposits at once, there would not be sufficient cash. The amount of

43

money the bank can create therefore depends on the ratio of cash to liabilities that they

hold. The higher this cash ratio the less money the bank can re-lend or create.

How do banks create money?

Assume a single bank, Barclays bank

Mr. Moyo deposits $20000 cash in the bank.

By depositing $20000 in the bank, money changes its form from cash to deposit.

Mrs. Maphosa wants to borrow money for business.

Barclays Bank can lend because it knows Mr. Moyo will not withdraw all at once.

But it knows it must keep some cash as a reserve say 10% therefore Barclays

lends $18000 to Mrs. Maphosa.

By lending money to Mrs. Maphosa, the bank increases money supply to $38000

from just $20000. The bank is able to create money because people have

confidence that the cheques signed by the bank are honoured.

If the reserve ratio is r then the basic definition of money multiplier (m)

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

When r = 0.1 and deposit = 20000, then

The change in total deposits = D=

From this calculation changes in deposits can be as high as $200000 from an initial

deposit of $20000. If the reserve ratio increases, it limits the change in deposits

because most of the deposits are kept as reserves and not lent.

Limits to banks to create money will depend on:

Amount of reserves (liquid) assets

Reserve asset ratio

Willingness of people to borrow

Desire of people to hold cash.

44

What is regarded as reserve asset must be defined by law. The following assets

can however be regarded as reserve assets:

Cash balance with central bank

Foreign exchange

Treasury bills

Gold etc.

Definitions of money

1. = It is also called high powered

money.

2. Demand deposits notes and coins in circulation with public.

It is sometimes referred to as ‘narrow money’

3. Savings deposits with banks. It is sometimes referred to as broad money.

4. Other savings deposits etc.

Determining Money Supply

1.

2.

Where - reserve ratio

- Reserve assets

- Demand deposits

- Currency ratio

- Notes and coins in circulation

in countries like Zimbabwe, the currency ratio is very high because many people keep

notes and coins at home. This is because the banking system can at times be

inconvenient.

45

3.

4.

Where

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

- the reserve ratio can be separated into required reserve ratio and excess

reserve ratio

- Banks hold excess reserve ratio because

1. Most banks are prudent (prudential banks ) and sensible to see whether lending is

profitable.

2. Limited liability of banks to create since people may not be willing to

borrow due to high interest rates.

46

DEMAND FOR MONEY

- refers to the amount of money held by the general public in an economy.

- The main reasons for holding money are:

1. Transactional reason/ motive

2. Speculative motive

3. Precautionary motive.

MONETARY POLICY

What is Monetary Policy?

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

such as :

Inflation

Economic growth

Investment

Interest rates

Balance of payments

Objective of monetary policy

In general monetary policy has two major objectives:

1. To reduce inflation (stability objective)

2. To boost economic growth (growth objective)

Instruments / Measures/tools of monetary policy

47

Monetary policy measures are used to increase or decrease the amount of

money, depending on the situation prevailing.

Each instrument can be used in 2ways, either to increase or decrease the

amount of money in circulation

The following are some of common instruments:

1. Bank rate

2. Open market operations

3. Rediscount rate

4. Repurchase Agreement

5. Selective credit controls

6. Moral Suasion

7. Reserve requirements

These instruments can be classified into the general or quantitative instruments and the

selective or qualitative instruments.

General or quantitative instruments

These include open market operations, changes in the minimum legal cash reserve ratio

and changes in the bank or discount rate. These instruments influence the credit creating

capacity of the commercial banks in the economy by operating directly or indirectly on

their excess cash reserves.

Selective or qualitative instruments

The instruments affect the types of credit extended by the banks. They affect the

composition rather than the size of the loan portfolios of the commercial banks. The

immediate object of imposing the selective credit controls is to regulate both the amount

and the terms on which credit is extended by the banks for selected purposes. The

48

selective credit control instruments enable the central bank to restrict unhealthy

expansion of credit for specific purposes; without at the same time airing credit

expansion in general.

Use of the Instruments/ Measures /Tools

The instruments are contractionary or expansionary, depending on the liquidity situation.

When there is too much money, monetary tools are used in contractionary way. When

there is less money, monetary tools are used in an expansionary way.

Bank Rate/ Rediscount Rate

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

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

rates.

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

It is a benchmark for commercial bank lending rates.

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

money.

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

money.

Open market operations

This is buying and selling of government securities e.g. bonds (TBs). When there is too

much money, the government sells securities. The government takes the money and the

public holds securities. To reduce money supply, the government sells bonds to the

public and pays with currency (notes + coins in circulation). This reduces money

available for spending. The success of the instrument depends on whether the public

wants to buy bonds or not. To persuade people to buy bonds, the government raises

interest.

49

When there is inadequate money, the government buys securities. The government takes

the securities and the public holds money. Money is injected into the economy.

Selective credit controls

When there are liquidity problems, the central bank and even banks have preferential

treatment of clients. Credit is allocated to some selected sectors. For example, credit can

be allocated to export or productive sectors. Rationing of credit- this involves imposing a

ceiling upon its (Central Bank’s) discounts for any one bank or rejecting a proportion of

each discount application whenever total demand for loans exceeds the amount the

central bank is prepared to discount on any one day.

Regulation of consumer credit

The regulation of consumer credit is employed to regulate the terms and conditions under

which bank credit repayable in installments could be extended for purchasing or carrying

the consumer durable goods. The regulation of consumer credit is quite important in

combating inflation by restricting the aggregate consumer demand for those goods which

are in short supply in industrially developed countries where consumer credit is largely

used to finance domestic purchases. In countries where there is no consumer credit and

the banks do not participate in financing the purchase of consumer durables to any

significant degree, the method cannot be effective in curbing the inflationary pressures in

the economy.

Moral Suasion

It involves direct solicit with the Central Bank. The central bank persuades financial

institutions to be supportive of the prevailing monetary policy stance. When there is too

much liquidity, institutions are persuaded to tighten their credit allocation systems. When

there is a shortage of liquidity, institutions are persuaded to loosen their credit allocation

systems. This measure is not mandatory but persuasive and as a result it is difficult to

influence the currency ratio c/D and consequently money supply.

The instrument would succeed only if the commercial banks follow scrupulously the

leadership of the central bank. This will however depend on the strength of the central

50

bank and the prestige enjoyed by it among the member banks. In countries with highly

liquid monetary conditions and where the central bank cannot undertake open market

operations on a massive scale to counteract the high bank liquidity, it is advisable for the

central bank to use moral suasion.

Reserve Requirements

When bank deposits are made, part of the money is kept as bank reserves and the rest

is lent out as loans. The reserve requirement is the amount of money that is kept as

reserves. The percentage of money kept as reserves is called the reserve requirements

ratio. When there is too much money, the reserve ratio is increased to reduce credit

creation. When there is a shortage the reserve ratio is reduced to increase credit

creation so as to increase money supply. The government can regulate the required

reserve ratio .

Increasing required reserve ratio reduces the lending base. The instrument is not

without its limitations: If their cash reserves are swollen, commercial banks will not

care at all for the increase in the minimum legal cash reserves ratio requirement

unless the increase is very high. They might also conduct their operations with a

lower cash reserves ratio if they are optimistic about the future, while a fall in the

minimum legal reserves ratio may fail to induce them to lend in depression. A

counteracting force may arise from a change in the banking practices. If percentages

of minimum legal cash reserves required to be kept with reserve banks differ for

different kinds of deposits held by banks e.g. with a minimum legal cash reserves

ratio of 10% against the demand deposits and of 3% against the time deposits, a

transfer of bank funds from the former to the latter would enable the banks to expand

credit and to that extent would induce them to disregard the credit restriction policy

enforced by the central bank.

Publicity

Central banks may employ the instrument of publicity in order to publicise the economic

facts in the weekly statements of their assets and liabilities, monthly bulletins containing

review of credit and business condition, and detailed annual reports stating their

operations and activities, the state of affairs of the money market and banking system and

51

general review of the trade, industry, agriculture, etc. in the country. By resorting to

publicity, the central bank enlists public opinion in favour of its monetary policy and

thereby combats opposition to its policies among political, financial and business

interests. However the method of publicity has the scope of useful application in

industrially advanced countries where public opinion is enlightened. In the developing

countries where people are mostly less educated and even those who are educated are not

acquainted with the technique of banking the method of publicity is of little use in

controlling credit.

52

CHAPTER FOUR

UNEMPLOYMENT

What is unemployment?

Definition

Unemployment is the pool of people above a specified age who are without work, are

currently available for work and are seeking work during a period of reference.

Unemployment results when the available workplaces cannot adapt to the job seekers.

When the number of persons, who offer their working capacities, exceeds the number of

available workplaces, this leads to a lack in workplaces.

Unemployment has become a serious economic problem. Majority of people can only

make living by working for others. Many millions of people are both able and willing to

work, but simply cannot find a job. Unemployment is an overwhelming concern of

policymakers and the general public. Unemployment often implies a waste of human

resources that could otherwise be producing goods and services to satisfy the needs of

society. At the same time, it can mean extreme personal hardship for the Unemployed,

and therefore it is an important social concern. Unemployment rate fluctuates widely over

time within a given country, in line with the business cycle. Unemployment increases

during recession and declines during booms.

Measurement of Unemployment

When calculating the level of unemployment the government only counts those people

who register as unemployed and claim benefit. A large number of people seeking work

either do not register or do not claim benefit and are now excluded from official figures.

Unemployment rate is the number of unemployed people as a proportion of the labour

force. The labour force is all those with work or all those seeking work.

The unemployment rate is the percentage of the labour force officially jobless. Full

employment occurs when the number of notified job vacancies exceeds the number of

registered people unemployed.

Unemployment Trends

53

Unemployment is a flow and not a stock. There are always inflows onto the

unemployment register, and there are outflows off the register as people get jobs or join

training schemes.

If all inflows rise and all outflows except training fall then overall unemployment will

rise. Young people, women, the over-fifties and ethnic minorities tend to be the hardest

hit. Inner cities and manufacturing areas also tend to have above-average unemployment.

Natural rate of unemployment

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

inflation is equal to its actual level. It is that rate of unemployment to which the economy

will return after a cyclical, recession or boom.

The natural rate of unemployment is sometimes called the “the full employment” rate of

unemployment conveying the sense that unemployment is excessive only when actual

unemployment exceeds the natural level.

We generally refer to the gap between actual unemployment and the natural rate as

cyclical unemployment. In other words, cyclical unemployment is the amount of

unemployment that can be reduced by expansionary macroeconomic policies without

setting off an endless rise in the rate of inflation.

Types of unemployment

We have to differentiate between a few types of unemployment:

1. Cyclical unemployment: if a country has an economical boom then people have jobs,

if there is an economic recession people lose jobs. Cyclical unemployment is

unemployment above the natural rate.

2. Frictional unemployment: This arises because people are always flowing into and out

of unemployment. New workers are constantly entering the labour force, and existing

workers frequently leave one job and look for another. During these transitions they

spend time on their job searches e.g. you stop working in December and start your new

work in March, these period between these months is called frictional unemployment

54

3. Structural unemployment: Structural unemployment can occur in factories when too

old machines, cannot produce enough, sell less products, cannot pay their staff, more

unemployed people. It is unemployment that exists when the economy is operating at the

natural rate. The natural rate of unemployment (Un) reflects many different phenomena

and forces such as union power, which raises real wages above full employment real

wages.

4. Hidden unemployment: dismissed people don’t ask for a new job, they also don’t

register for unemployment benefits, e.g. women after their maternity leave often stay at

home with their children. It can also include the discouraged, those nominally having

jobs for which they are paid but in fact doing nothing; and those who can be withdrawn

from rural areas because of their zero marginal product.

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

sector. In the rural areas or farming areas, everyone is fully employed during the rain

season and harvesting periods but thereafter demand for labour is very low. The

unemployment is mostly where there is single cropping

6. Structural Unemployment. This occurs when economic readjustments are not fast

enough during economic growth, so that severe pockets of unemployment occur in areas,

industries and occupations in which the demand for factors of production is falling faster

than is the supply. Policies that discourage movement among regions, industries and

occupations can raise structural unemployment.

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

Why unemployment is studied

1. The income aspect- income can mostly be earned if one is employed. Most economies

gain from employment of their nationals.

55

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

unemployed there is a waste of productive resources.

3. Recognition aspect- the type of employment determines social status and self-esteem.

Studies found that people who had been unemployed for two or more years had self-

esteem.

Causes of Unemployment

1. Rapid growth of labour forces due to high population growth rate in developing

countries. Fast growth of labour force places a strain on the ability of the economy to

generate new work opportunities on a sufficient scale to absorb rising numbers (economic

dualism and rural- urban migration).

2. Education system also contributes – the size of the educated labour force is growing

more rapidly than the economy can absorb.

3. Shortage of saving and investment- investment per worker in developing countries is

often less than that in developed countries.

4. Inefficient land tenure systems in many developing countries cause them not to be able

to utilise their expanding labour resources.

5. Inappropriate developmemnt strategies they pursued and technologies adopted. They

engaged in import substitution strategies hence limited jobs.

6. Engineering bias, minimum wage laws, government salary structures, influence of

trade unions, pay policies of multinational corporations all help to raise the urban wages

well above competitive market clearing levels.

7. Laws and conventions holding down interest rates, tax concessions for foreign

investors similarly hold the price of capital well below levels which would reflect their

scarcity in the economy.

56

Consequences of unemployment /Costs of Unemployment

Lost OutputThe opportunity cost of each unemployed person is their foregone output. Increased Benefit PaymentsEach extra person who becomes unemployed stops paying tax ( perhaps $4000) and starts

receiving benefit (upwards of $5000). The government therefore has to raise a additional

funds to finance unemployment benefits for unemployed. As the figure falls the

government pays out less unemployment benefits and receives more in tax. The savings

to the exchequer from this will be considerable.

Lost Tax Revenue

Growing unemployment means less direct and indirect tax revenue. When people lose

their jobs they will stop paying income tax, and their spending will fall considerably

reducing government receipts from VAT and other indirect taxes.

Human Costs of Unemployment

The long-term and youth unemployed feel increasingly isolated and removed (alienated)

from society. There will also be increased NHS costs as people's health often suffers

when they are unemployed, and there will be increased costs to society in terms of crime.

In our society where money means success the unemployed feel useless and consider

themselves a failure. Studies have shown that people who have been unemployed for

some time develop a low self esteem.They are dissatisfied and depressed and this may

lead to alcoholism drug problems and homelessness and even to crime.

Especially for families it’s difficult because they do not have enough money to afford

their basics of life. So because of that that government has to help financially, but this

causes high costs for working people who have to support the unemployed.

High risk groups

There are some high-risk groups, for example youths, women with little children after

their maternity leave or elderly people aged 50 and over. Lots of those people cannot find

a (good) job.

57

Young people are part of the high-risk group because in most cases they do not have any

practical experience and there are lots of young people searching for the same few jobs.

That is why there is a high selection rate on the job market. Firms want to employ young

people with lots of experience who want to work almost 24 hours a day and earn just a

little pocket money.

Women in general, but especially women with little children who want to work again

after their maternity leave are another high-risk group. Their problem is that the

probability of their needing time off to nurse sick children is very high, especially if they

have little kids. Another problem is that those women have not worked for the time of

their child nursing and there might be new trends, new developments or things like that.

The last high-risk group is the large group of over 50 year old people. Their problem is

that they cost too much. If a firm employs younger workers they do not have to pay as

much as they would for an older person. That is why they are fired. And it is almost

impossible for those people to find a new work place.

Solution of unemployment

Possible solutions:

Early retirement

Job-sharing

New jobs (new economy)

A general reduction of working hours

Reduction of overtime

It is very hard to find good solutions in the long run. Some ideas such as job-sharing or

early retirement are in discussion. But my opinion on that is that both, job-sharing and

early retirement are not the right way because if you share your job you won't earn

enough money to afford the basics of life for your family.

Early retirement sounds nice but it means a huge amount of costs for all the other

working people who have to pay for that. So this cannot be the right way, I suppose.

58

A good solution would be the attendance of further training courses, so that unemployed

people are trained to find a new job and learn new skills. The only problem about that are

the costs, which are very high and the question is who is going to pay them.

Population control- if there is population restraint the growth of developing country

labour force will be in check.

Overhaul of the education systems to change from their present academic, elitist, white-

collar job orientation to vocational and technical training systems to produce artisans and

technicians the countries desperately need.

Sectoral priorities which particularly favour the development of small-scale agriculture

and the informal sector. Small-scale agriculture and the informal sector are labour

intensive, so their development will both generate more employment and raise

productivities of those already working in them.

Incomes policies designed to prevent formal sector wage levels from being raised by

institutional factors to levels well above the true economic value of unskilled labour. This

involves attention to the government‘s own pay policies, its policies towards the trade

unions, towards multinational firms and towards minimum wage legislation.

Rural development and decentralisation- this involves coordination of programmes for

the improvement of agriculture, water, transport; access to goods and services and

appropriate land tenure- aim is to reduce rural- urban migration.

Informal Sector:The development of the sector is attractive because it does not require

complex and expensive infrastructure and has high potential for creating jobs. It uses

mostly locally produced resources or raw materials. It can be a major source of income

generation both for rural and nonagricultural informal sections of the economy. It creates

a platform for the exchange of locally produced goods and services. It provides strong

base for local entrepreneurs. It is also a source of government revenue when these

sectors grow and become registered.

Problems of the informal sector in Zimbabwe

Procedures to be followed in obtaining licences and project approval are discouraging

and they (operatives in the sector) pay high rentals to landlords.

59

Because of the high corporate tax, they would rather remain unregistered. If they are

taxed they face financial problems and hence cannot pay minimum wages.

Lack of adequate transport and infrastructure to facilitate delivery of produce to the

target market.

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

Lack of project planning and implementation.

Inability to obtain loan and credit facilities hence due to lack of collateral security,

90% of microenterprises are automatically eliminated from getting financial

assistance.

However it must be pointed out that the development path whereby there is heavy

emphasis on iunformal sector enterprise and small business development has limitations,

although it provides employment and income. The disadvantage of informal enterprise is

it does not lead to development of high technology non traditional export.It does not

invest in new technique, generate new skills and develop new products.

Types, Causes, and Remedies for Unemployment

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

unemployment.

The average length of time workers remain unemployed is a critical measure of the

seriousness of the unemployment figures. If the average length of unemployment is short

then the economy will be healthier and people will not lose their skills from long periods

without work.

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

Scheme Description

Restart Programme Interviews and training for the long-term unemployed

Community

Programme

Local projects for the long-term unemployed

New Workers

Scheme

A subsidy to employers taking on youth unemployed

Job Search Scheme Return fare and allowances for job interviews

60

Job Release Scheme Older workers retire early with an allowance and are replaced by an

unemployed person

Job Splitting Scheme A subsidy to employers who encourage job sharing

Youth Training

Scheme

Two-year work experience and training for school leavers

Job Training Scheme Retraining scheme for unemployed adults

Causes and remedies of unemployment

Type Description Cause Remedy

Frictional Workers temporarily

between jobs

Delays in applying

interviewing and

accepting jobs

Improve job

information, eg

computerised job

centres

Structural Workers have the

wrong skills in the

wrong place

Declining industries

and the immobility of

labour

Subsidies and improve

the mobility of labour

Cyclical All firms need fewer

workers

Low total demand in

the economy

Increased government

spending or lower taxes

Technological Firms replace workers

with machines

Automation and

information

technology

Retraining

International Overseas firms replace

UK producers

High-priced/low-

quality UK goods

Tariffs quotas or

sterling depreciation

Regional High unemployment in

one area

Local concentration of

declining industries

Regional aid, eg

relocation grants

Seasonal Unemployment for part

of the year

Seasonal variation in

demand

Retraining

Voluntary Workers choose to

remain unemployed

More money 'on the

dole' than from

working

Remove the low-paid

from the liability to pay

income tax

CHAPTER FIVE

61

INFLATION

DEFINITIONS

There are several definitions:

(a)This is a persistent rise in the general level of prices or a persistent fall in the

purchasing power of money. The value or purchasing power of money refers to the

amount of goods or services a unit of money can buy. It should be noted that the

definition implies that an increase in some particular price is not inflationary if

compensated by falls in other prices.

(b) Inflation is the general and prolonged rise in the price level.

(c) Inflation can also be defined as to the continual increase in prices.

Inflation means the value of money is falling because prices keep rising.

MEASURES OF INFLATION

(1) Cost of living Index (*COLI)-

also called the retail price index or consumer price index. This is the most frequently

used measure and is based on observations of prices of a ‘basket’ of goods selected as

a representative of the spending patterns of consumers within some specified range of

incomes.

(2) Wholesale price index-

is the index which measures prices of commodities commonly bought and sold by

wholesalers. This index has an advantage over the consumer price index in that it

gives an earlier warning of an upsurge in prices than a retail index. It takes time for a

rise to work its way through to the shops and markets.

(3) The GNP deflator-

This is derived from comparisons of GNP estimates in current prices and in constant

prices. Prices of consumer goods, capital goods etc. are taken into consideration when

compiling this.

Calculating the Retail Price Index

62

The retail price index (RPI) can be used to measure inflation. The retail price index (RPI)

is a monthly survey carried out by the government which measures price changes. The

following procedure is used:

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

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

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

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

Price relative = Current price/Base price x 100

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

The new RPI is found using the equation:

RPI = Total weightings x Price relative/Total weightings

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

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

Calculation of the retail price index

Basket Weighting Price relative Weightings x price relative

Food 60 125 7500

Housing 30 120 3600

Transport 10 100 1000

Total 100 12100

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The rate of inflation is the percentage change in the RPI over the last twelve months and

is calculated using the equation:

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

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

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

Problems in Using the Retail Price Index The RPI is narrow.

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

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

Not all regions in the country experience identical price changes.

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

Advantages and Effects of Inflation

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

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

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

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

Disadvantages of Inflation

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

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

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

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

CAUSES OF INFLATION

Supply oriented Explanations

These explanations concentrate on the cost push and structuralist theories.

Cost-push InflationCost Push Theory- this ascribes inflation to increases in cost, which are independent of

the state of aggregate demand. For most manufacturers in developing countries, the cost

of imported goods is continuously rising because of world inflation. This both directly

raises the cost of living through higher prices for finished goods imports and indirectly

through more costly imported materials used by domestic producers. In addition, trade

unions may force wages up more rapidly than increases in productivity, raising unit

labour costs. Other groups e.g farmers organizations, may also be strong enough to

prevent their own position from being eroded, and the generally low degree of

competition in modern industrial sector allows manufacturers to pass cost increases on to

consumers perhaps adding an enlarged profit margin for themselves.

Cost-push Inflation occurs when a firm passes on an increase in production costs to the

consumer. The inflationary effect of increased costs can be the result of:

Increased wages, leading to

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

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

Increased import prices which can be the result of:

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

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2. a depreciation of the domestic currency.

Increased indirect taxation

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

Pure cost inflation- aggregate demand held constant

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

S3 S2

Px S1

Py

D Qx Qy

Cost Push with Demand Adjustments

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

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S3

Pz S2

price S1

D3

Py D2

D1

Qx

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

Structuralist Theory of Inflation

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

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

Export earnings lag behind import needs because of the slow expansion of world demand for primary products exported by less developed countries. Artificial barriers of

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developed countries make matters worse. Official aid flows fall far short of filling the gap between export earnings and import requirements.

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

Demand-pull Inflation

Demand-pull inflation occurs when there is 'too much money chasing too few goods'

because the demand for current output exceeds supply.

Demand inflation is caused by an excess of aggregate demand for goods and services

over available supplies at a given level of prices. The natural market response to such a

situation is a rise in prices towards a market clearing equilibrium in which once more

D=S. A new equilibrium may not be achieved because of propagating forces which raise

both demand and costs and thus push prices ever higher.

Inflation is not an inevitable outcome of an increase in demand. It all depends on the

price elasticity of supply. If the elasticity is large, a small price increase may call forth a

large increase in output so that the inflation impact is slight.

In the short run, the main determinants of the supply elasticity will be the extent to which

suppliers are operating below productive capacity and the availability of foreign

exchange. If there is much surplus capacity, the principal effect of an increase in demand

will be to induce greater output, rather than to initiate an inflationary spiral. Similarly, if

there is surplus foreign exchange, the effect will be to induce a larger volume of imports.

For the economy as a whole, a large danger of demand inflation is when there is a foreign

exchange constraint and the economy is operating at near full capacity. The possibility of

demand inflation is greater the nearer the economy is to being on its production

possibility frontier.

The monetarist school of inflation (led by Milton Friedman) tries to explain the origins of

demand inflation.. The essence of the monetarist position is that inflation is always and

everywhere a monetary phenomenon. The greater the monetization of the economy the

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greater the inflation. People whose economic lives are entirely monetized will be more

strongly affected by inflation than those who still meet many of their needs for

themselves.

The consequence of an increase in the supply of money greater than an increase in the

demand for money will be a rise in the demand for products and hence will tend to cause

inflation. People desire the convenience of holding money balance but if they6 desire

they will spend the surplus on goods and services.

Assuming the supply of money is under the control of the state and the demand for

money is a function of the level of real income, the extent of monetization of economic

activity and the net utility of holding money, there will be an increase in demand if real

income goes up. There will be a larger transactions demand for money. Barter

transactions or subsistence production become monetised. The demand for money will

also rise if interest rates on bank deposits go up or if the people expect slower inflation.

NB. Monetarists are not contending that any increase that any increase in the supply of

money is inflationary.

An economy can increase the quantity of money without inflation to extent that it is

growing in real terms, that economic activity is becoming monetised and that the net

utility of money is going up. In particular a rapidly developing economy can absorb more

non-inflationary money supply increases than a stagnant one. As long as money supply is

expanded to meet non-inflationary needs, monetary stringency may retard the pace of

development.

The figure below shows increased demand and increased prices as consumers compete to

buy up goods still available.

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A major source of inflationary pressure is the government which can print money to buy

goods. The monetarist view of inflation can be stated in the equation:

MV = PT

Where M = the money supply,

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

P - the average price of goods, and

T = the number of goods bought (transactions).

Monetarists believe that the values of V and T are fixed so that any increase in the money

supply , must raise the level of prices (P), and this is inflationary. There is

always an associated price increase with money supply to balance the 2 sides of the

equation.

Remedies of Inflation

There are many ways for businesses, consumers and government to halt or control

inflation. The traditional Keynesian approach is to categorise inflation as being either

demand pull or cost push in nature.

Cost-push Remedies

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

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

Encourage an appreciation of domestic currency.

Reduce indirect taxation.

Demand-pull Remedies

For the Keynesians, where inflation is demand pull, they advocate demand management

policies:

Reduce government spending ( G).

Increase income tax (T) to reduce consumer spending.

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

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

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

Construction should be postponed in so far as feasible because this reduces investment in buildings, machinery and inventories. This reduces aggregate demand.

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Production should also be geared towards reasonable demand and unnecessary stockpiling of raw materials and semi-finished products should be avoided.

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

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

Some undesirable effects of Inflation

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

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

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

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

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

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

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Inflation-does anyone gain?

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

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

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

Inflation- The losers

1. Creditors.

2. With a fixed exchange rate domestic producers of exports and of imports substitutes will be losers.

4. Consumers of farmers products.

5. Economically inactive groups e.g. housewives.

6. Modern sector wage labour force.

7. Pensioners and others on fixed income.

CAUSES FOR AND AGAINST INFLATION

PROINFLATION CASE

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

Government also gains from inflation, it is argued, because of inflation tax on money balance, i.e. on everyone. The public has to forego expenditure on goods and services.

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The reduction in spending releases real resources in the economy which can then be used for investment.

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

ANTIGROWTH WITH INFLATION ARGUMENTS

It is argued that inflation penalizes saving because it reduces the purchasing power of income set aside. There is also a high propensity to borrow, as repayments are cheaper.

Investment/planning decisions are difficult under uncertainty, due to inflation. Inflation may lure firms into unproductive investment decisions because their accounts will most probably mislead them about their current profitability. Because depreciation of capital equipment is mainly based on historical costs, during inflationary times, firms tend to underestimate the depreciation and overestimate company profit. Many profits of manufacturing and trading companies in times of rapid inflation are often the result of stock appreciation hence the swollen profits are therefore illusory.

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

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CHAPTER SIX

INTERNATIONAL TRADE

Introduction

Basic condition of the world community is one of mutual interdependence. All countries

of the world rely for their national well being on international trade and payments.

Foreign currency or foreign exchange is used for effecting payments. The rate at which

one country’s currency is exchanged for another. for example Z$1800 / 1Rand is the

exchange.

Exchange Rates

An exchange rate is the price of one currency in terms of another. For Zimbabwe, the

dollar exchange rate means the number of pounds (£) can one dollar ($) buy. The

exchange rate is determined by the supply and demand for dollars) and is $2 per pound in

the diagram below:

Demand for dollars

British want to exchange pounds for dollars for two reasons:

1. To buy Zimbabwean goods and services;

2. To lend or invest in Zimbabwe.

The diagram above shows the number of dollars demanded at each and every exchange

rate. This is the D curve.

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Supply of DollarsZimbabweans want to exchange dollars for pounds for two reasons:

1. to buy British goods and services;

2. to lend or invest in Britain.

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

exchange rate.

Changes in the Exchange Rate (flexible exchange rate)

A fall in the value of the dollar (depreciation) means one dollar now buys fewer pounds.

The dollar depreciates if Britons demand fewer dollars (shown in the diagram below) or

if Zimbabweans offer more dollars. Zimbabwean exports become cheaper and its imports

become dearer. Hence, a dollar depreciation improves the balance of payments.

A rise in the value of the dollar (appreciation) means one dollar now buys more pounds.

Zimbabwean exports become dearer and its imports become cheaper. Hence a dollar

appreciation worsens the balance of payments.

Benefits of Trade

Participation in the international economy can improve living standards and the rate of

economic development. This is in 3 ways:

1. Trade provides countries with an escape from confines of their national

economies. It creates more profitable investment opportunities and this leads to

accelerated growth.

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2. By giving access to the products of other nations, it avoids the need to strive for

self sufficiency within national boundaries- technology developed elsewhere is

available.

3. Capital flows, an integral feature of world trade and payments give developing

countries access to the savings of richer nations, to augment their own. Capital is

obtainable from private sources as well as from ‘aid’ from foreign governments

and agencies eg. World Bank.

Reasons for Trade

Domestic Non-availability

International trade is the exchange of goods and services between countries. An import is

the Zimbabwean purchase of a good or service made overseas. An export is the sale of a

Zimbabwean-made good or service overseas.

A nation trades because it lacks the raw materials, climate, specialist labour, capital or

technology needed to manufacture a particular good. Trade allows a greater variety of

goods and services.

Principle of Comparative Advantage

The principle of comparative advantage states that countries will benefit by

concentrating on the production of those goods in which they have a relative advantage.

For instance, France has the climate and the expertise to produce better wine than Brazil.

Brazil is better able to produce coffee than France. Each country benefits by specialising

in the good it is most suited to making.

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

Protectionism

Advantages of Protectionism

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

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

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

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

Strategic industries. To protect the manufacture of essential goods.

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

Disadvantages of Protectionism

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

Invites retaliation from foreign governments.

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

Protection Methods

Methods of trade restriction

TariffsFor every unit of import a charge is put and this fixed amount for every unit of import is

the tariff. Tariffs (import duties) are surcharges on the price of imports. The diagram

below uses a supply-and-demand graph to illustrate the effect of a tariff.

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Note that the tariff

raises the price of the import;

reduces the demand for imports;

encourages demand for home-produced substitutes;

raises revenue for the government.

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

Quotas

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

raises the price of imports;

reduces the volume of imports;

encourages demand for domestically made substitutes.

A quota is a non tariff restriction. Another example of a non tariff restriction is an embargo. An embargo is a complete ban on imports.

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Other Protection Techniques

1. Administrative practices can discriminate against imports through customs delays or setting specifications met by domestic, but not foreign, producers.

2. Exchange controls (currency restrictions) prevent domestic residents from acquiring sufficient foreign currency to pay for imports.

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

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

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CHAPTER SEVEN

BALANCE OF PAYMENTS

Definition of the Balance of Payments

1. Is a systematic record of the economic transactions between residents of the exporting

country and residents of the foreign countries during a certain period of time or

2. Is the difference between the total earnings on both invisible and visible items and total

expenses. In order to know the position as regards international payments, government

compile records of transactions. This record of transactions is thus called the Balance of

Payments (BOP).

3 The balance of payments is a record of one country's trade dealings with the rest of the

world. Any transaction involving Zimbabwean and foreign citizens is calculated in

dollars

Dealings which result in money entering the country are credit (plus) items while

transactions which lead to money leaving the country are debit (minus) items.

Components of the Balance Of Payments

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

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

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

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

Current Account

The current account consists of international dealings in goods (visible trade) and

services (invisible trade). It records all transactions in goods and services, ie. visibles and

invisibles. Receipt of interest , profits and dividends on loans and investments in foreign

countries; earnings from tourism and transportation and remittances home of income

earned by nationals working abroad are included in this account as invisibles.

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Example of current account 1985

Debits $m Credits $m Balance £m

Visible imports 80 140 Visible exports 78 072 -2 068

Invisible imports 75 007 Invisible exports 80 027 5020

By referring to above table you can see that in 1985:

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

Zimbabwe sold $78 072 million worth of goods overseas.

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

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

Zimbabwe sold $80 027 million worth of services overseas.

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

Adding the balance of trade and balance on invisibles together gives the balance on the

current account. A deficit on the current account means that more goods and services

have been imported into the country than have been sold abroad. A surplus on the current

account means more goods and services have been exported than imported.

Transactions in Assets and Liabilities/ Capital account

The transactions in assets and liabilities section of the balance of payments shows all

movements of money in and out of the country for investment. This may be direct

investment - investment in productive capacity (when firms invest in other countries to

increase capital in these countries), or portfolio investment - investment in shares ,bonds

or other assets in foreign countries. Changes in assets will be outflows from Zimbabwe,

as Zimbabwean investors invest money overseas. These flows will be debits to the

Zimbabwe’s Balance of Payments. Changes in liabilities will be credits to the

Zimbabwean Balance of Payments as overseas investors invest money into the country

(Zimbabwe)

Monetary Account

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This is also called the official financing account. It records changes in the country’s

official foreign currency/exchange reserves (consisting usually of a mixture of gold and

foreign currencies) plus transactions with the IMF and other financial institutions.

Balance of Payments Problems

Balance of payments deficit

This is of concern especially in developing countries because it affects the ability of those

countries to trade with other countries. A balance of payments deficit is a major problem

if it is persistent. This can be the result of excessive purchases of foreign goods and

services or excessive Zimbabwean investment overseas. Faced with existing or projected

balance of payments deficits on the combined current and capital accounts a variety of

policy options are available:

Correcting a Balance of Payments Deficit

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

indebtedness.

2. Using foreign currency reserves- this is a short term measure because most non-oil

producing developing countries have very few months in which to exhaust this.

3. Attracting additional inflows of short-term capital by raising interest rates. Lack of

stability in developing countries means that there is no guarantee funds will remain in the

countries, i.e. there is capital flight.

4. Import substitution- this is the local production of previously imported goods. This

requires the importation of capital equipment and protection of the infant industry by

imposing tariffs or bans on imported goods.

5. Exchange control – this is designed to control foreign currency reserves. The foreign

currency is rationed so that the most pressing needs of the country will be given top

priority when the funds are allocated., eg. capital goods and essential raw materials.

Measures also include import licensing as well as creating a state monopoly tasked to

import essentials.

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6. Use of multiple exchange rates- different rates for currencies/ transactions. Essentials

such as exports, tourism and essential inputs for industry would have a separate rate(s) of

exchange to encourage them while for nonessentials they would be discriminatory . In

other words there is a multi-tiered market for foreign exchange.

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

government to make imports more expensive. This includes raising import duties, taxing

invisibles, taxing remittances abroad, subsidise exports, charging high fees on sales of

foreign currency. This policy is deflationary and also has loopholes.

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

sales abroad.

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

10. Encouraging more private investment and seeking more foreign assistance. Much of

the foreign aid comes in the form of loans which have to serviced. Interest has to be

paid on the loans. The principal has also to be repaid in future.

Balance of Payments Surplus

This is also a cause for concern because if it is persistent, partners may retaliate by

introducing import controls etc. A surplus implies an overvaluation of currency and this

leads to exports becoming less competitive on the world market. It could also be

inflationary because , it is argued by monetarists that it leads to an increase in money

supply. A persistent surplus could mean a depression of domestic living standards.

Correcting a Balance of Payments Surplus

An unwanted balance of payments surplus can be the result of excessive foreign

investment in Zimbabwe. This will place a future strain on the invisible balance. A

reduction in interest rates ( an outflow of funds on the capital account) or the scrapping of

protectionist measures (restrictive exchange controls) will correct the surplus.

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CHAPTER EIGHT

ECONOMIC GROWTH

Definition

Economic growth refers to an increase in a country's ability to produce goods and

services. The advantage of economic growth is that an increase in real national income

allows more goods for consumption or for investment.

It is also defined as “a long term rise in capacity to supply increasingly diverse economic

goods to its population, this growing capacity based on advancing technology and the

institutional and ideological adjustments that it demands.” by Professor Kuznets. From

this definition advancing technology provides the basis or preconditions for continuous

economic growth.

Measurement of Economic Growth

It can be measured by the change in GDP or GNP over time. It can be measured at

current prices, also called nominal GDP (GNP). Real GDP is at constant prices. The best

indicator of growth is real GDP per capita.

Factors affecting Economic growth

1. Capital accumulation i.e. Accumulation of machinery, equipment and

tools etc. These lead to increased capacity of plants. Capital accumulation

also includes investment in human resources.

2. Population and labour force growth- a larger labourforce means more

productive manpower while a larger overall population increases the

potential size of domestic markets. The growing supply will have a

positive impact if the economic system can absorb and productively

employ these added workers.

3. Technological progress- this is the most important source of economic

growth. In its simplest form technological progress can be said to result

from new and improved ways of accomplishing traditional tasks. The

productive resources, if used efficiently can increase economic growth.

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4. Weather. Because of the importance of rain-fed agriculture and agro-

industry in certain countries such as Zimbabwe, weather is also an

important determinant of economic growth in the medium term.

Developing Countries

A developing country or less developed country (LDC) is one that is not yet fully

industrialised and tends to have the following features:

Agriculture is more important than manufacturing.

There is limited specialisation and exchange.

There are not enough savings to finance investment.

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

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

Inadequate housing.

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

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

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

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

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

Barriers to Economic Growth

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A country can increase production if it increases the amount of resources used or makes

better use of existing factors. Economic growth is more difficult if:

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

1. basic including electricity, road and telephone networks;

2. social including schools, hospitals and housing;

3. industrial including factories and offices.

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

A country lacks the technical knowledge.

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

Population growth is too rapid.

A country has too large a foreign debt.

Disadvantages of Economic Growth

Increased noise, congestion and pollution.

Towns and cities may become overcrowded.

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

A traditional way of life may be lost.

People may experience increased anxiety and stress.

ECONOMIC DEVELOPMENT“is a multidimensional process involving the reorganization and reorientation of the

entire economic and social systems. In addition to improvements in incomes and output,

it typically involves radical changes in institutional, social and administrative structures

as well as in popular attitudes and sometimes even customs and beliefs” (Michael

Todaro- Economics for a Developing world.)

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Economic development is also defined in terms of the reduction or elimination of

poverty, inequality and unemployment within the context of a growing economy.

Development must have the objectives of -: increasing the availability and wider

distribution of basic- food, shelter, health and protection; raising the levels of living

(higher incomes, higher employment, better education and increased attention to cultural

values).

Indicators of Economic Development.

The traditional view of economic development is GNP is an index of development.

Another common economic index of development is the use of rates of growth of per

capita GNP. Rapid industrialization was viewed as a way of having an increasing GNP,

this often at the expense of agriculture and rural areas – these were to benefit through the

“trickle down effect”.

Obstacles to Economic Development in developing countries

Overpopulation- high population growth.

Low savings rate- has hampered industrial development.

Limited range of exports.

Urbanization- this compounds population problems through congestion.

Overcrowding promotes pollution, unemployment, disease and food shortages.

Lack of an infrastructure. Because LDCs generally do not have infrastructures,

industrial firms will not normally locate plants there. Products manufactured for mass

consumption simply cannot be distributed and used without transportation and

communication facilities- few schools, roads, dams and bridges.

Solutions for Economic Underdevelopment

Foreign aid

Exportation of a major resource e.g. oil.

Industrialization and protective tariffs and quotas.

Industrialization and the export of manufactured goods.

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