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Economics 1B notes and exercises

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 Production creates income and this income is then spent to purchase
products
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 One problem is how the income is distributed among the various
participants in the economy
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 Stock variable – can only be measured at a particular point in time and
has no time dimension (wealth, assets, liabilities, capital, population, and
balance on savings account)
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 In mixed economy households, firms, government and foreign sector are
all participants
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1
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 Can be an individual, whole family
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 Consumption – the act of using or consuming goods and services
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In a market economy it is the households or consumers that largely
determine what should be produced
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Households sell their factors of production to firms that convert them into
goods and services
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 Different types of firms are – individuals or sole proprietorship, cc,
companies, partnerships
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 Investment or capital formation = the act of purchasing capital goods
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Goods market – in macroeconomics we treat the goods market as if there were
only one market for all goods and services
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Circular flow of goods and services – the households offer factors of
production for sale on the factor market where these factors are purchased by
the firms
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o These goods and services are offered for sale on the goods market where
they are purchased by the households
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o Firms purchase the factors of production in the factor market
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o The households in turn spend their income by purchasing goods and
services in the goods market
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Government
 Includes all aspects of local, regional, provincial and national government
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 Government includes all politicians, civil servants, government agencies
and other bodies belonging to or under the control of government
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 Government spending is an injection to the circular flow
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 Exports are an injection (sell)
 Imports are a withdrawal (buy)
Symbols
C – Consumer spending -injection
I – Investment
-injection
G – Government spending -injection
X – Exports
-injection
S – Savings
-leakage
T – Taxes
-leakage
Z – Imports
-leakage
Total expenditure = C + I+G+(X-Z)

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4
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 S
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 Balance of payments = various flows between S
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Exports = X, injection into economy, are goods produced within the
country and sold outside the country
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Financial institutions in the circular flow of income and spending – surplus units
= individuals are in a position to save because they spend less (savings is a
withdrawal), deficit units = individuals that spend more than they earn
(investment is a leakage
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2 basic participants are households and firms
Stock variable – eg balance in a savings account on a particular day
Consumption is a flow variable
Capital a stock variable
Members of a household are called consumers
Consumers are rational in other words they will always try to maximize
their satisfaction given the means at their disposal
Households responsible for the spending on consumer goods
Capital goods are purchased by firms
2 sets of markets in the economy – goods markets (market for tomatoes)
and factor markets (labour market)
Firms purchase in the factor markets and sell in the goods market
Households sell in the factor markets and purchase in the goods markets
Major flows associated with the government are – government spending ,
taxes and transfer payments
Taxes = leakage from circular flow of income and spending
Government spending = injection into the circular flow of income
The foreign sector is linked to the domestic flow of income and spending
through imports and exports
Savings , imports , taxes = withdrawal
Investment , exports ,government spending = injection
C = spending by households on consumer goods and services
I = spending by firms on capital goods
G = spending by government on goods and services
X = Spending by foreigners on SA goods and services - (minus) S
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THE MONETARY SECTOR
 Money can be defined as anything that is generally accepted as payment
of goods and services or that is accepted in settlement of debt
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 Barter economy is an economy that operates without money where goods
are exchanges for other goods
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Medium of exchange - Money serves as a lubricant or intermediary to
smooth the process of exchange and to make it more efficient
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Money as a unit of account – is an agreed measure for stating the prices
of goods and services
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Money as a store of value – most common for holding wealth is money
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Most liquid form in which wealth can be kept
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Legal tender – means that old notes or coins cannot be refused if they are
tendered as payment
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M3 = M2 – plus all long term deposits of the domestic private sector with
monetary institutions
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A are – South African Reserve Bank
 Demand deposits – are deposits that can be withdrawn immediately by
means of cheque
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South African Reserve Bank (SARB)
 It is most important financial institution
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 Must also perform its function independently and without fear, favour or
prejudice but there must be regular consultation between the bank and the
cabinet member responsible for national financial matters
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formulation and implementation of monetary policy – repo rate tender
system is the main instrument
2
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3
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maintaining financial stability – (bank supervision , the national payment
system , banker to other banks , banknotes and coins)

The reserve asset position and the credit multiplier
 Each bank has to ensure that it always has sufficient cash reserves
available to provide for cash withdrawals, must provide for the claims of
other banks, which may exceed its own claims
...

 To maintain confidence in the banking system, the monetary authorities
lay down legal requirements stipulating the amount of cash reserves to be
held against the total liabilities of a bank
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R = cash reserves
D = demand deposits
Any increase in demand deposits will raise the required minimum cash
reserves
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 Any increase in demand deposits as a result of an increase in the
provision or use of overdraft facilities forces banks to acquire additional
reserves which have to be borrowed from the SARB at the repo rate
...
As the credit falls so too will the size
of M1
...
Payments for
exports will have a negative impact on the quantity of money
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o The demand for money – is the amount that the various
participants in the economy plan to hold in the form of
money balances
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o 2 basic components of the demand for money are – (a)
the transaction of demand for money which arises from the
medium of exchange function,(b) demand for money as an
asset which arises from the store of value function
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Reasons for holding money are:
(a) Transaction motive – all participants in a money economy hold money as
a medium of exchange
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(b) Precautionary motive (for unforeseen expenditure)
(c) Speculative motive - inverse relationship between the quantities of money
demanded for speculation purposes and the level of the interest rate
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(e) Passive balance = speculative motive
Demand for money or liquidity preference - L = f (Y, i)
I – interest rate
L = quantity of money demanded

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Y = national income
Interest rate – generally described as the price of loanable funds
...

Demand for money is a function of income and the rate of
interest
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Main features of SA monetary policy:
(a) ultimate objective is balanced and sustainable economic growth
(b) intermediate objective is a pre-announced inflation target
(c) operational variable – is short term interest rates , which are governed by
changes in the repo rate
(d) Monetary control system is a classical cash reserve system
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5% of their total liabilities
to the public in the form of cash
...
(mainly government bills and
government bonds)
(c) Other instruments - public debt management, intervention in foreign
markets
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5 percent above liabilities
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(a) cash reserve deposits with SARB
(b) banknotes and coins
(c) gold coin and bullion

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(d) short term treasury bills
(e) short term land bank bills
(f) securities of the reserve bank
(g) government bonds

MULTIPLE CHOICE
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Barter economy – is an economy that goods are exchanged for other
goods
The use of money eliminates the need for a double coincidence of wants
associated with a barter economy
The essential function of money is that it serves as a medium of exchange
When inflation is experienced , money loses some of its usefulness as a
store of value
Money is a financial asset
During inflation it is often more advantageous to keep certain assets than
to keep only money
Demand deposits can be withdrawn immediately by writing a cheque and
therefore demand deposits form part of the quantity of money
3 measures of quantity of money are = M1, M2 & M3
M1 = narrowest measure of money = coins notes and demand deposits
Cash reserve of any S
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An increase in income will result in an increase in the quantity of money
demanded at each interest rate , which can be illustrated by a rightward
shift of the money demanded curve
Monetary policy can be defined as the measures taken by the monetary
authorities to influence the quantity of money or the rate of interest with a
view to achieving stable prices, full employment and economic growth
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5 reasons for market failure:
(a) Monopoly and imperfect competition – options are – do nothing, impose
price controls, tax the full excess profits, and regulate monopoly through
competition policy
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A good is rivalrous in consumption if no two persons
can consume the same unit of a good and is non-rivalrous in consumption
if its consumption by one person does not reduce its consumption by
others
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Normal goods or pure private goods (fruit,
shirts, computers) = rivalrous and excludable
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mixed goods (museums , cinemas)= excludable & non-rivalrous , public
goods (street lights , basic research)= non rivalrous and non-excludable
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(d) Asymmetric information – to make informed choices the households and
firms must have all information
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(e) Common property resources – belong to no one and no one can be
excluded from using them, however one person’s use of them reduces the
availability to other persons
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FURTHER REASONS FOR GOVERNMENT INTERVENTION:
(a) income distribution – free markets tend to generate unequal income
distribution
(b) macroeconomic growth and stability – free markets tend to fall short of
achieving rapid economic growth , full employment and price stability and
therefore government intervention in needed
(c) merit goods – can be defined as goods that are regarded as so beneficial
to society that everyone should be in a position irrespective of their
income to receive or consume them
(d) allocative function – achieving more efficient allocation of resources
(e) stabilization function – measure taken by government to promote
macroeconomic stability
(f) distributive function – steps taken by government to achieve a more
equitable or socially acceptable distribution of income than that generated
by market forces
HOW DOES THE GOVERNMENT INTERVENE?
(a) Public provision – of goods and services
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(c) Government spending – government makes transfer payments – this is
payment for which it receives nothing
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GOVERNMENT FAILURE:
Governments also fail with their intervention

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