Notesale: Turn your study into money

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Course Code:

BCM 123

Course Title:

Macro-Economics

Year:

2021

Contact Hours:

0707 497 776

Lecturer:

ENOCK RUTO

Contacts:

+254707 497 776 and enockruto02@gmail
...
0

Purpose of the Course

This course is an introduction to the fundamentals of Macroeconomics
...
The focus of the course is to look at long-run economic growth
first and then at short-run business cycle fluctuations
...

2
...
Identify macroeconomic issues at the intermediate level;
ii
...
relate the importance of macroeconomic analysis approach to the study of contemporary
and historical economic problems; and,
iv
...

3
...

4
...
0 COURSE ASSESSMENT
-

Continuous Assessment Test

15%

-

Work Based Assessment

15%

-

Final Examination

70%

Total

100%

7
...
R, Sweeney, D
...
A, Martin, R
...
(2011)
...
E
...
Management Decision Making: Spreadsheet modeling, analysis,
and applications, University of Illinois at Urbana-Champaign

Recommended Reference Material
-

Hillier, F & Lieberman, G J (2004)
...
Operations Research: An introduction, Prentice Hall, New Jersey

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Winston, W L (2004)
...


Reference Journal
- Journal of International Business Studies by division of Macmillan Publishers Limited
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Journal of Marketing by American Marketing Association

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Colorado Springs Business Journal by Colorado Springs

8
...
National income: accounting, determination, uses
and limitations
...
Public finance: taxation and fiscal policies,
Role of government in economic growth
...


Page 3 of 50

CHAPTER ONE
1
...
It looks at a national or
international economy as a whole, e
...
Total Output, Income and Expenditure, Unemployment,
Inflation Interest Rates and Balance of International Trade, etc and what economic policies a
government can pursue to influence the conditions of the national economy
...
1 Importance of Macroeconomics
...
It is important for understanding the macroeconomic issues
...
These are some of the problems that
determine the wellbeing of the people
...

2
...


Macroeconomics explains the causes of such

important problems and help in formulating economic policies to tackle them
...
Accelerating Economic Growth- Macroeconomics explains the factors which determine
economic growth and brings out, what causes slow-down in productivity growth
...
Higher rate of economic growth helps in solving the
problem of poverty and unemployment in developing countries like Kenya
...
g
...
Macroeconomic provides us with knowledge as to how to
achieve a self-sustained economic growth
...
Understanding Business Cycles- Business cycles have been considered the biggest
alignment of market economies
...
It is through the understanding of
business cycles that has led to adopt proper fiscal and monetary policies
...

5
...


When governments understand the

inflation and unemployment then they formulate policies to tackle them
...
Individual decision-making- The understanding about the working of the economy as a
whole helps the individuals to take better decisions
...
g
...
Macroeconomics helps an individual to assess an economic situation for example
inflation rate increasing and get away to get it
...
g
...
Importance of Business Decisions- The understanding of macroeconomics also helps a
good deal to businesses or their managers who are faced with various decision making
problems
...
g
...
e
...
These aggregates of the economy make up overall business
environment which affects decisions of managers
...
2 National Income
...
It can also be defined as the total money value of all final goods
and services produced by the nationals of a country during some specific period of time – usually
a year
1
...
Gross Domestic Product- The money value of all goods and services produced within the
country but excluding net income from abroad
...
Gross National Product- The sum of the values of all final goods and services produced by
the nationals or citizens of a country during the year, both within and outside the country
...
Net National Product- The money value of the total volume of production (that is, the gross
national product) after allowance has been made for depreciation (capital consumption
allowance)
...
Nominal Gross National Product- The value, at current market prices, of all final goods
and services produced within some period by a nation without any deduction for depreciation
of capital goods
...
Real Gross National Product- This is the national output valued at the prices during some
base year or nominal GNP corrected for inflation
...
National Income Accounting- This refers to the measuring of the total flow of output
(goods and services) and of the total flow of inputs (factors of production) that pass through
all of the markets in the economy during the same period
...

Economic Models are a simplification of a real world or a practical situation aimed at
explaining that situation within a set of assumptions
Page 6 of 50

APPROACHES TO MEASURING NATIONAL INCOME
There three different ways of measuring national income, each way being based on a different
aspect
...
The national output: - The creation of wealth by the nation‟s industries
...

b
...

c
...
Put in its simplest form we can express this as an identity: National
output ≡ National Income ≡ National Expenditure
...


Using Total Expenditure for Calculating National Income

The expenditure approach measures national income as total spending on final goods and
services produced within a nation during an year
...
Total aggregate final expenditure on
final output thus is the sum of four broad categories of expenditures;
1
...

2
...

3
...

4
...



Consumption expenditure
...
It includes expenditure on all goods and services produced and sold
to the final consumer during the year
...
Investment expenditure is expenditure
Page 7 of 50

incurred on by business firms on (a) new plants, (b) adding to the stock of inventories
and (c) on newly constructed houses
...
This is the second largest component of national income
...
It excludes transfer
payments while computing national income
...
Net exports are defined as total exports minus total imports
...

NI = C + 1 +G + (X – M)

ii
...
This is because each time something is produced and sold
someone obtains income from producing it
...
The test for incomes inclusion in the
national income calculation is that there should be a “quid pro quo” that the money should
have been paid against the exchange of a good or service
...
The sum of these incomes gives gross domestic
product GDP
...


Incomes excluded in calculating NI using the Income Approach
...

They include;

Page 8 of 50

1
...

2
...

3
...
is not be included in the estimation of
national income
...
Receipts from the sale of financial assets such as shares, bonds should not be included
in measuring national income as they are not related to generation of income in the
current year production of goods
...


Using the National Output for Calculating National Income
A final method which is more direct is the “output method” or the value added approach
...

“Value Added” is the value added by each industry to the raw materials or processed
products that it has bought from other industries before passing on the product to the next
stage in the production process
...
Final
products will include capital goods as well as consumer goods since while intermediate
goods are used up during the period in producing other goods, capital goods are not used up
(apart from “wear and tear” or depreciation) during the period and may be thought of as
consumer goods “stored up” for future periods
...

Because subsistence output is not sold in the market, some assumption has to be made to
value them at some price
...

However, since state education and other governmental services are not sold on the market
we shall not have market prices at which to value them
...

Page 9 of 50

Precautions for the Product Method approach
...
These in brief are:
1
...
When we add up the value of output of various sectors, we
should be careful to avoid double counting
...

2
...
While calculating national income, the values of
goods added in the particular year in question are added up
...
GDP
thus includes only those goods and services that are newly produced within the current
period
...
Stock appreciation
...
This
is necessary as there Production for self-consumption
...
In this method,
the production of goods for self-consumption should be valued at the prevailing market
prices
...
What goods and services to include
...
For example, unpaid services such as those
performed by a housewife are not included but the same services if provided by a paid
housekeeper would be
...
An imputed value is usually assigned to this income
...
It would be impossible to estimate this
value and hence these goods are included when they are first bought and subsequent services
ignored
...
All these provide a service
and are included in the national income at cost
...

2
...
The problem of double counting arises because of the interrelationships between industries and sectors
...
If the values of the outputs of all the sectors were added, some would be
added more than once, giving an erroneously large figure of national income
...
Some incomes such as social
security benefits are received without any corresponding contribution to production
...
Taxes and
subsidies on goods will distort the true value of goods
...

3
...
The sources from which information is obtained are not designed
specifically to enable national income to be calculated
...
There are also some incomes that have to be estimated
...
Also information on foreign payments or receipts
may not all be recorded
...
There is a shortage of trained staff which may collect the
statistics about the national product
...
Some people do not keep any proper account
about their business income, so their income is not included in the national income
...
Non-availability of statistical material
...
, do
some job in their spare time and receive income
...
This income which, should have been added to:
the national income is not recorded due to lack of full information of statistics material
...
Non-marketed services
...
The unpaid services, or non-marketed services are excluded
from the national income
...
Difficulty in assessing the depreciation allowance
...
it requires high degree of judgment to assess the depreciation allowance and
other charges
...
Self-consumed production
...
It is either consumed directly by producers or bartered
for other goods
...

8
...
National income is measured in money terms
...
This means that national income can change without any
change in output
...

The national income in under-developed countries like Pakistan cannot be accurately measured
due to the following reasons:


Self-consumed-bartered consumption
...
The statisticians
...

Page 12 of 50



No systematic accounts maintained
...
This makes the task of national income still more
complicated
...
There is no occupational specialization in the underdeveloped countries
...
One person
sometimes works as carpenter and at another time as mason
...




Unreliable data
...
They also do not take much pains for getting the reliable data
...


USES OF NATIONAL INCOME FIGURES
1
...

2
...
Comparing the standards of living between countries
...
National Income Statistics provide information on the stability of performance of the
economy over time e
...
a steadily increasing income would be indicative of increasing
national income
...
By assessing exports and imports as a percentage of Gross national Product i
...
using
national statistics, it is possible to determine the extent to which a country depends on
external trade
...
National Income Statistics also help in estimating the saving potential and hence investment
potential of a country
...
A nation will be rich if its endowments of natural resources are large, its people are
skilled, and it has a useful accumulation of capital assets
...
Natural Resources- These include the minerals of the earth; the timber, shrubs and
pasturage available; the agricultural potential (fertile soil, regular rainfall, temperature or
tropical climate); the fauna and flora; the fish and crustacea of the rivers and sea; the energy
resources, including oil, gas, hydro-electric, geothermal, wind and wave power
...
Human Resources- A country is likely to prosper if it has a large population; literate and
numerate sophisticated and knowledgeable about wealth creating processes
...
It should show enterprise,
being inventive, energetic and determined in the pursuit of a better standard of living
...
Capital Resources - A nation must create and then conserve capital resources
...
Transport creates
the utility of space
...

iv
...
If the majority of the enterprises are foreign –owned there will be a
withdrawal of wealth in the form of profits or goods transferred to the investing nation
...
8 Real Vs
...
Therefore, nominal GDP will include
all of the changes in market prices that have occurred during the current year due
to inflation or deflation
...
In order to abstract from changes in the overall price
level, another measure of GDP called real GDP is often used
...
For example, if 1990 were
chosen as the base year, then real GDP for 1995 is calculated by taking the quantities of all
goods and services purchased in 1995 and multiplying them by their 1990 prices
...
Using the statistics on real GDP and nominal GDP, one can calculate an
implicit index of the price level for the year
...
Note that in the base year, real GDP is by definition equal to nominal GDP so that the
GDP deflator in the base year is always equal to 100
...
The percentage change in the GDP deflator from the previous
(base) year is obtained using the same formula used to calculate the growth rate of GDP
...
Another way of describing this
finding would be to say that the inflation rate in the year following the base year was 10%
...
If the percentage change in the GDP
deflator over some period is a negative X%, then the rate of deflation over that period is X%
...
The GDP deflator is not the only index measure of the price level
...
The CPI differs from the GDP deflator in two important ways
...
Second,

Page 15 of 50

the CPI uses base year quantities rather than current year quantities in calculating the price level
index value
...

Standard of living refers to the quantity of goods and services enjoyed by a person
...
It also includes the less easily quantifiable aspects of living such as terms and
conditions of employment and general living environment
...
This is done by working out the per capita income of the country
...
Per capita
income is obtained by dividing the National Income by the Total population
...

Problems of using per capita income to compare standard of living over time
1
...
e
...
more
defense-related goods may be produced and less spent on social services, more producer
goods may be made and less consumer goods, and there may be a surplus of exports over
imports representing investment overseas
...

2
...

3
...
A small group may be much better off
...


Page 16 of 50

4
...
Working conditions may have deteriorated
...
These non-monetary aspects
are not taken into account in the estimates of the GNP
...
Increase in National Income- Finally the national income increases when people pay for
services which they previously carried out themselves
...
Similarly a reduction in national income would occur if a man painted his
house rather than paying a professional painter to do the same
...


Page 17 of 50

CHAPTER THREE
ANALYSIS OF CONSUMPTION, SAVING AND INVESTMENT AND THEIR
INTERACTION IN A SIMPLE ECONOMIC METHOD
Aggregate demand refers to the total planned or desired spending in the economy as a whole in
a given period
...

CONSUMPTION
The consumption function is the relationship [expressed in mathematical or diagrammatic form]
between planned consumption and other independent variables, particularly income
...

Consumption is the largest single component of aggregate expenditure and if we are to predict
the effects of income and employment of variations in private investment and in government
spending, we must know how consumption varies in response to changes in income
...

Other Determinants
1
...
Relative Prices Influences the aggregate consumption
...
Capital Gains- Keynes observed that there is a possibility of windfall gains or losses
influencing consumption
...
This is
true of the stock minded speculative economy
...
Wealth- The possession of liquid assets influences the amount that you have to save
...
The larger the stock of wealth, the
lower its Marginal Utility and consequently the weaker the desire to add to future wealth by
Page 18 of 50

curtailing present consumption
...

5
...

6
...

7
...
The expectations attained by the consumer about income
increases will affect the consumer behaviour
...
N
...
These things might
be true of an individual, but not the [aggregate] society
...
The money Illusion- Some people look at money at the face value
...
The phenomenon of Money illusion
occurs when despite proportional changes in the prices of goods and services and then their
money incomes which keeps real incomes unchanged, consumers make a change in their
real consumption pattern
...
With a
change in nominal income, people behave in the same way as though their real income has
gone up
...

9
...

10
...

THE KEYNESIAN THEORY OF CONSUMPTION FUNCTION
The theory was developed during the Great Depression which plagued Europe and America
...
e
...
The determination of aggregate demand,
then, was of crucial significance in Keynes analysis
...


Average Propensity to Consume: The average Propensity to Consume [APC] is defined
as the fraction of aggregate national income which is devoted to consumption
...
The Average
Propensity to Consume decreases in Keynes model as income increases
...


Average Propensity to save- The Average Propensity to Save [APS] is defined as the
fraction of aggregate national income which is devoted to savings
...
In a closed ungoverned economy, where income is spent or
saved, APC = APS = 1

iii
...
Thus, if S denoted changes in savings, and Y change in
income, then, MPC = ΔC/Δ y
...
Thus
Dividing through by ΔY, we get Δc/ΔY + ΔS/ΔY = 1
Therefore, ΔC + ΔS = 1, and S = 1 – CΔC + ΔS = ΔY

INVESTMENT
Investment is the process of increasing the productive capital stock of a country, or can be
defined as the production of goods not for immediate consumption
...

Definitions
1
...

Page 20 of 50

2
...
For instance,
in the simple theory of the determination of national income, investment is assumed to vary
directly with national income
...
Actual income and Full employment income: Full employment income (Also called
Potential National) is the national income that could be produced when the country‟s factors
of production are fully employed
...
Actual national
income, symbolized by Y, can be below or equal to YF and, by working resources overtime
and otherwise harder than normal, it can occasionally rise above YF
...
Intended or planned Investment: Expenditure on investment depends on business
expectations on the chance of making profits and on the availability of funds for the purchase
of producer goods
...

5
...
Both
households and firms can save
...
Firms save when they elect not to
pay out to their owners some of the profits that they have earned
...

6
...
All such goods a are called investment goods
...
Most investment is done by firms, and
firms can invest either in capital goods, such as plant and equipment, or inventories
...
The amount
Page 21 of 50

necessary for replacement is called the Capital consumption Allowance and is often loosely
referred to as Depreciation
...

7
...
First, there are consumption goods and services actually sold to households
...
The symbols C and I can be used to stand
for currently produced consumption goods and currently produced investment goods
respectively
...
In an economy that uses capital goods, as does the Frugal economy, it is helpful to
distinguish between two concepts of National Income (or National Product)
...
GROSS NATIONAL INCOME (or Gross National Product, GNP); It is the sum of the
values of all final goods produced for consumption and investment, and thus it is also the
sum of all Firms factor incomes earned in the process of producing the National output
...
NET NATIONAL INCOME (or Net National Product, NNP) is GNP minus the capital
consumption allowance
...


Page 22 of 50

CHAPTER FOUR
MONEY AND BANKING
MONEY
The Nature and Functions of Money
The development of money was necessitated by specialization and exchange
...

Disadvantages of Barter Trade
i
...
This is
called double coincidence of wants and is difficult to fulfill in practice
...


Even when each party wants what the other has, it does not follow they can agree on a
fair exchange
...


iii
...
For instance if a cow is worth two
sacks of wheat, what is one sack of wheat worth? Once again we may need to carry over
part of the transaction to a later period of time
...


It is possible to confuse the use value and exchange value of goods and services in a
barter economy
...


v
...
If such goods are perishable by nature, then the system will break down
...


The development of industrial economies usually depends on a division of labour,
specialization and allocation of resources on the basis of choices and preferences
...

Without a common medium of exchange and a common unit of account which is acceptable to
both consumers and producers, it is very difficult to achieve an efficient allocation of resources
to satisfy consumer preferences
...
For such peoples a
money system is essential
...

The Historical development of money
For the early forms of money, the intrinsic value of the commodities provided the basis for
general acceptability: For instance, corn, salt, tobacco, or cloth were widely used because they
had obvious value themselves
...

Commodity money had uses other than as a medium of exchange (e
...
salt could be used to
preserve meat, as well as in exchange)
...
Some were difficult to transport, some deteriorated overtime, and some
could not be easily divided and some were valued differently by different cultures
...
These had the advantage of being easily recognizable,
portable, indestructible and scarce (which meant it preserved its value over time)
...
Thus each time a transaction was made, the metal
was weighed and payment made
...
The state took over the minting of coins
by stamping each as being a particular weight and purity (e
...
one pound of silver)
...
It became readily apparent, however, that what was important was
public confidence in the “currency” of money, its ability to run from hand to hand and circulate
freely, rather than its intrinsic value
...

Any person receiving such a coin could afford not to mind, so long as he was confident that
anyone to whom he passed on the coin would also “not mind”
...
e
...

Functions of Money
1
...
This is its most important role
...
If I had fish but wanted bread, I would need to find someone who was in the
precise opposite situation
...
Money solves what is called the double
coincidence of wants
...
A unit of Account
...
Without money, prices must be expressed in units of other
goods and comparing prices are more difficult
...
Finding the cheapest grilled
chicken is not easy
...
Store of Value
...
Money, on the other hand,
stores well
...

Characteristics of Money
1
...
It is necessary for money to be easily transported so that people can carry it
around with them on a daily basis
...

2
...
Depending on the different types of currency that are available, money
within that specific currency must look the same
...


Page 25 of 50

3
...
In terms of a form of currency being accepted within society, money
must be accepted by everyone in the economy
...

4
...
This relates to money being easily divided into smaller denominations for
transactional purposes
...

5
...
This simply refers to the physical wear and use of money over a period of
time
...
Yet, money is made from a paper source, so some wear and
tear must be expected
...
Limited supply
...
The more money that is in circulation the less it is valued by the economy
...

Money has evolved to take different forms, and the way that monetary payments are made
continue to evolve at a rapid rate
...
A brief discussion of the various forms of money is
discussed below
...
Commodity Money
...

For example, a cigarette in prisons is commodity money because it is used to buy services
or food from other prisoners
...
Fiat Money
...
It is not backed by
gold or any other substance of real value
...

3
...
Electronic money also known as electronic cash or digital cash is a
term that is still fairly vague and undefined
...
Electronic
money may be either debit or credit
...
Debit Cards
...
This removes the need for bank
clients to go to the bank to remove cash from their account as they can now just go to an
ATM or pay electronically at merchant locations
...

5
...
Credit cards charge interest and are primarily used for shortterm financing
...

6
...
Because the check is in an
electronic format, it can be processed in fewer steps and has more security features than a
standard paper check
...

The Determination of the Value Money
Since money is primarily a medium of exchange, the value of money means what money will
buy
...
Since money itself is used as unit of account and a means
of measuring the “value” of other things, its own value can be seen only through the prices of
other things
...

DEMAND AND SUPPLY OF MONEY
1
...
Holding money therefore involves
Page 27 of 50

a loss of the interest it might otherwise have earned
...

These will be discussed later
...
Saving is simply that part of
income which is not spent
...
Liquidity preference is concerned
with the form in which that wealth is held
...

2
...
Narrow money supply consists of all the purchasing power that is
immediately available for spending
...

a
...

b
...
Also in the M2 definition are the other interestbearing retail deposits of building societies
...
Since all this money is readily available for spending
it is sometimes referred to as the “transaction balance”
...

The broad measure of the money supply includes most of bank deposits (both sight and
time), most building society deposits and some money-market deposits such as CDs
(certificates of deposit)
...

THEORIES OF DEMAND FOR MONEY
THE QUANTITY THEORY
In the 17th Century it was noticed that there was a connection between the quantity of money
and the general level of prices, and this led to the formulation of the Quantity Theory of Money
...
If the quantity of money was doubled, prices would double and so on
...
This theory was later improved by Professor Irving Fisher, who
took into account the volume of transactions, that is to say, the amount of “work” that the money
supply had to do as a medium of exchange
...
Money circulated
from hand to hand
...
As modified by Irving Fisher, the
quantity theory came to be expressed by the equation of exchange
...
The symbol V represents the velocity of circulation, i
...
the number of times during the
period each unit of money passes from hand to hand in order to affect a transaction
...
The symbol T is the
total of all transactions that have taken place for money during the year
...
the rate at which money circulates, and
b
...


Thus, prices may rise without any change taking place in the quantity of money if a rise occurred
in the velocity of circulation
...
Period each unit of money passes from hand to hand in order to affect a transaction
...
In the theory, he stated that the rate of interest is determined by the supply of
money and the desire to hold money
...

Keynes formulated derived from three motives for holding money, namely:
•

Transactions;

•

Precautionary; and

•

Speculative
...

i
...
People holding money as assets could also buy
Government bonds to earn interest
...
Consumers need money to purchase goods and services and firms need money to
purchase raw materials and hire factor services
...
People receive income either on
monthly, weekly, or yearly basis but spend daily, therefore money is needed to bridge the
time interval between receipt of income and its disbursement over time
...
Therefore holding habit and Interval
Constant, the higher the income level the more the money you hold for transactions
...

ii
...
Money demanded for these two motives is called
active balances, because it is demanded to be put to specific purposes
...
Hence the demand curve for active balances is
perfectly inelastic
...
Speculative Demand for Money- Finally, money is demanded for speculative motives
...
e
...
Keynes thus explained the Speculative motive in
terms of the buying and selling of Government Securities or Treasury Bills on which the
government pays a fixed rate of interest
...
It can be higher or lower than the face
value depending on the level of demand for securities
...
e
...
They are sometimes known as Joint
Stock Banks
...
They provide a safe deposit for money and other valuables
...
They lend money to borrowers partly because they charge interest on the loans, which is
a source of income for them, and partly because they usually lend to commercial
enterprises and help in bringing about development
...
They provide safe and non-inflationary means for debt settlements through the use of
cheques, in that no cash is actually handled
...

d
...

e
...

Some commercial banks offer insurance services to their customers eg
...
Some
commercial banks issue local travellers‟ cheques, e
...
ABSA Bank previously known as
Barclays Bank (Kenya)
...
These also safe if large amounts of money involved
...
The main element of
the Banking System is the Commercial Bank (in Kenya)
...
It’s the government‟s bank that
controls the monetary and fiscal policies in an economy
...
Government’s banker: Government‟s need to hold their funds in an account into which
they can make deposits and against which they can draw cheques
...
Banker’s Bank: Commercial banks need a place to deposit their funds; they need to be
able to transfer their funds among themselves; and they need to be able to borrow money
when they are short of cash
...
Consider any two
banks A and B
...

If the person paying and the person being paid bank with the same bank, there will be a
transfer of money from the account or deposit of the payee
...
In such cases, they cancel
each other out
...
Thus the central bank acts
as the Clearing House of commercial banks
...
Issue of notes and coins: In most countries the central bank has the sole power to issue
and control notes and coins
...

4
...
If all other sources failed, the central bank
would lend money to commercial banks with good investments but in temporary need of
cash
...
For this reason, commercial banks borrow from the
central bank as the lender of the last resort
...
Managing national debt: It is responsible for the sale of Government Securities or
Treasury Bills, the payment of interests on them and their redeeming when they mature
...
Banking supervision: In liberalized economy, central banks usually have a major role to
play in policing the economy
...

1
...

2
...

3
...
This type of inflation can, therefore, be described as
persistent/creeping inflation
...
Finally inflation can also mean runaway inflation or hyper-inflation or galloping inflation
where a persistent inflation gets out of control and the value of money declines rapidly to
a tiny fraction of its former value and eventually to almost nothing, so that a new
currency has to be adopted
...
The excess demand of goods and services cannot be met in
real terms and therefore is met by rises in the prices of goods
...

Cost-push inflation occurs when the increasing costs of production push up the general level of
prices
...
It occurs as a result of
increase in:
Page 35 of 50

a
...
Since wages are usually one of the most important costs of
production, this has an important effect upon the price
...

b
...


c
...

d
...
This
makes prices more sensitive to supply than to demand influences and can mean that they
tend to go up automatically with rising costs, whatever the state of economy
...
Structural rigidity: The theory assumes that resources do not move quickly from one
use to another and that wages and prices can increase but not decrease
...

THE EFFECTS OF INFLATION
Inflation has different effects on different economic activities on both micro and macro levels
...
During inflation money loses value
...
Cost of capital/credit will increase and the demand for funds is
discouraged in the economy, limiting the availability of investable funds
...
It‟s also impossible the diversion of investment portfolio into speculative
activities away from directly productive ventures
...
Other things constant, during inflation more disposable incomes will be allocated to
consumption since prices will be high and real incomes very low
...
This hinders the
process of capital formation and thus the economic prosperity to the country
...
The effects of inflation on economic growth have inconclusive evidence
...
Such kind of inflation if mild,
will act as an incentive to producers to expand output and if the reverse happened, there
will be a fall in production resulting into stagflation i
...
a situation where there is
inflation and stagnation in production activities
...
When inflation imply that domestic commodity prices are higher than the world market
prices, a country‟s exports fall while the import bill expands
...
The effect is a deficit in international trade account causing
balance of payment problems for the country that suffers inflation
...
During inflation, income distribution in a country worsens
...
In fact such persistence accelerates the loss of purchasing power and the
vicious cycle of poverty
...
Increased production-It is argued that if inflation is of the demand-pull type, this can lead
to increased production if the high demand stimulates further investment
...

7
...


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8
...
e
...

Measures to control inflation
An inflationary situation can effectively be addressed/ tackled if the cause is first and foremost
identified
...
The government could attempt to influence one of
the components C + I + G (X – M) of the aggregate demand by reducing government
expenditure and raising taxes
...




Monetary Policy: For many years monetary policy was seen as only supplementary to
fiscal policy
...
This could be achieved through what is known s medium term financial
strategy (MTFs) which aims to gradually reducing the growth of money in line with the
growth of real economy – the use of monetary policy instruments such as the bank rate,
open market operations (OMO) and variable reserve requirement (cash & liquidity ratios)
...
Nevertheless, these policies become
successful for a short period as they end up storing trouble further, once relaxed will lead to
frequent price rises and wage fluctuations
...


Definition of Unemployment
Page 38 of 50

Total number of able men and women of working age seeking paid work
...
Traditional methods for collecting unemployment data are based, typically, on
sampling or the number of unemployment benefit requests
...

Types and Causes of Unemployment
I
...
The main reason for this type of unemployment are:


Turnover unemployment: Some individuals leave their present jobs and make
efforts to secure better ones and in this way, they remain unemployed for some time
...
E
...
shipping or
building construction workers
...
The workers of such industries remain unemployed for that time e
...
ice
factories may remain closed during winter
...


Structural unemployment: Caused by structural changes such that there exist:


Cyclical unemployment: During depression, prices are too low and profit margins
remain distinctively low
...




Technological unemployment: Due to inappropriate technology
...
In most
developing countries, most production structures tend to be labour saving (capitalPage 39 of 50

intensive), which is not appropriate as these countries experience high labour supply
...



Industrial change: The establishment of new industries decreases the demand for the
products of existing industries e
...
the rapid increase in the demand for Japanese
industrial products is one reason for greater unemployment in some European
countries
...
If effective
demand is less, production of goods and services will fall which will further result in
the unemployment of labour
...




Urban unemployment: Due to availability of more facilities in urban areas, more and
more people tend to move to these areas
...
This kind of
unemployment is therefore due to rural-urban migration
...
In most
developing countries this type of unemployment is estimated at 20 to 30% and
measures should be taken to employ such people in other sectors of the economy
...


Insufficient Capital: Shortage of capital is a hindrance in the establishment of more
industries and other productive installations, and due to this reason, more employment
opportunities are not created
...


Nature of education system: Education systems for most developing countries are whitecollar oriented, yet the nature of productive capacities of these economies are not
Page 40 of 50

sufficiently supportive
...

V
...


Thus in summary, of the causes of unemployment in developing countries can be said to
include:


Rapidly increasing population



Inappropriate technology



Insufficient capital base



Demand deficiency/structural changes



Presence of expatriates



Education Systems – white-collar orientation



Rural-urban migration



One person for more than one job



Corruption and general mismanagement



Inadequate knowledge on market opportunities

Page 41 of 50

CHAPTER SIX
INTERNATIONAL TRADE AND FINANCE
Definition of International Trade
It is the exchange of goods and services between one country and another
...
g
...

Reasons for the Development of International Trade
a
...
The country may simply not possess
the raw materials that it requires; thus it has to buy them from other countries
...

b
...
In many cases, a country could
produce a particular good, but it would be much less efficient at it than another country
...
It may be better for the country to give up the production of a good (and import it instead) in
order to specialize in something else
...

d
...
A foreign good
may be more to his or her liking
...

e
...
In such a situation, imports tend to be bought to overcome the shortage
...
For instance, if we take a situation in which each country in a
simple two country model has an absolute advantage in producing either fruits or beef but is able
to produce the other commodity only if required (for simplicity we assume constant returns to
Page 42 of 50

scale and full utilization of resources)
...
Country X has an absolute advantage
in citrus fruit production and Y has an absolute advantage in beef production
...

THEORY OF COMPARATIVE ADVANTAGE
In his theory put forward in a book published in 1817, David Ricardo argued that what was
needed for two countries to engage in international trade was comparative advantage
...
Using the Labour Theory Value, Ricardo‟s contribution was to show that
a sufficient basis for trade was a difference, not in absolute costs
...

COUNTRY

COST OF PRODUCING ONE UNIT (In Man-hours)
A

B

I

8

9

II

12

10
Page 43 of 50

We can observe that country I has complete absolute advantage in the production of both
commodities since it can produce them with a lower level of resources
...

Ricardo believed that even then there could still be a basis for trade, so long as country II is not
equally less productive, in all lines of production
...
What is
important is the Comparative Advantage
...
(The Law of Comparative Advantage states that a nation should specialize in
producing and exporting those commodities which it can produce at relatively lower costs, and
that it should import those goods in which it is a relatively high cost producer)
...

The opportunity Cost of good A is the amount of other goods which have to be given up in
order to produce one unit of the good
...
It is thus more expensive to
produce good B then A
...
One unit of B is equal to 9/8 units of A
...

Therefore he felt that: Opportunity cost of producing one unit of:
COUNTRY

A

B

I

9/8 (1
...
89) A

II

10/12 (0
...
2) A

B is cheaper to produce in country II in terms of resources as opposed to producing it in country
I
...
Consider commodity A
valued in terms of B
...

Page 44 of 50

A country has comparative advantage in producing commodity if the opportunity cost of
producing it is lower than in other counties
...
In country I, they
should specialize in the production of A and Import B
...
Unfortunately, world markets and their prices are largely inefficient showing
influences of trade barriers, discrimination and market distortions
...
By pursuing gains from trade in the short run young nations may
jeopardize long term development prospects because:
i
...


Concentrating on short term comparative advantage may lead to internalizing wrong
externalities e
...
promoting use of illiterate peasants and primary sector production;

iii
...


PROTECTION OF INTERNATINAL TRADE
Despite the arguments of the “classical” theory of free trade, the twentieth century has seen the
gradual movement away from free trade, with governments increasingly imposing restrictions on
trade and capital flows
...

Page 45 of 50

Reasons for Protection


Cheap Labour- It is often argued that the economy must be protected from imports which
are produced with cheap, or „sweated”, labour
...




Infant Industry Argument- Advocates of this maintain that if an industry is just
developing, with a good chance of success once it is established and reaping economies of
scale, then is it necessary to protect it from competition temporarily until it reaches levels
of production and cost which allow it to compete with established industries elsewhere,
until it can “stand on its own feet”
...




Structural Unemployment- The decline of the highly localized industry due to
international trade causes great problems of regional (structural) unemployment
...




Dumping- If goods are sold on a foreign market below their cost of production this is
referred to as dumping
...
Countries in which
such products are “dumped” feel justified in protecting themselves
...


Page 46 of 50



Balance of Payments- Perhaps the most immediate reason for bringing in protection is a
balance of payment deficit
...
A country may not wish to abandon production of certain key
commodities even though the foreign product is more competitive, because it is then too
dependent on imports of that good
...
It is for
this reason that countries wish to remain largely self-sufficient in food
...
Such over
specialization may make sense now, but in the future, demand may fall and the country will
suffer disproportionally
...




Strategic Reasons- For political or strategic reasons, a country may not wish to be
dependent upon imports and so may protect a home industry even if it is inefficient
...
The steel industry, energy industries,
shipping, agriculture and others have used this strategic defense argument
...


Ways of Restricting International Trade
The most common means of restricting international trade is through import restrictions
...
Tariffs- This is a tax on each unit imported
...

Page 47 of 50

Such a tax may be ad valorem, representing a certain percentage of the import price, or
specific that is, an absolute charge on the physical amount imported as, for example, five
shillings a ton
...
Quotas- The most direct way of offering protection is by limiting the physical quantity of a
good which may be imported
...

The quota may be imposed in terms of physical quantities or in terms of the value of
foreign currency, so that a maximum of so many “shillings-worth” may be imported
...
Foreign exchange restriction- Exchange controls work much the same way as physical
controls
...
It can be severely
restricted to whatever the government decides it wants to see imported
...
This makes all imports dearer and thus
gives protection “across the board” to all domestic production for the home market
...
Procurement policies by government- The government itself, together with state
corporations, is an important purchaser of goods; in its “procurement” policies, therefore, it
can either buy goods from the cheapest source, whether domestic or foreign, or it can give
preference to domestic producers
...

5
...
Also where the country has state import agencies
they can choose not to import as much as their citizens would require
...

Arguments against protectionism
Page 48 of 50

Most of the arguments for protectionism may be met with counter arguments, but underlying the
economic arguments as opposed to the social, moral, political, strategic, etc, is the free trade
argument
...
Free trade argument- This, in brief, maintains that free trade allows all countries to
specialize in producing commodities in which they have a comparative advantage
...
By implication, any quotas, tariffs, other forms of import control and/or
export subsidies all interfere with the overall advantages from free trade and so make less
efficient use of world resources than would otherwise be the case
...
Reduced output argument- It has been said that import controls will protect jobs initially,
but not in the longer run
...
This will lead to a decline in sales
and a loss of jobs in export industries
...
The net result will be that total employment is
unchanged but total output is reduced
...
The infant industries seldom grow up- The infant industry argument is sometimes met with
the claim that infant industries seldom admit to growing up and cling to their protection when
they are fully grown up
...

4
...
It is true as noted above that the payment of low
wages will allow a country to export their goods cheaply and so possibly undercut those of
high wage countries
...
This
again is another use of the comparative advantage argument
...
No Validity in economics- The other arguments such as the need to avoid over dependence
on particular industries and the defense argument are really strategic arguments which are
valid in their own terms and for which economic science is largely irrelevant
...
Retaliation- Advocates of free trade also believe that if one country imposes import
restrictions, then those countries adversely affected will impose retaliatory restrictions on its
exports, so it will not end up any better off
...

7
...

8
...


Page 50 of 50



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