Economics 2 Educor ©

BCOM IN MARKETING AND BUSINESS MANAGEMENT

MODULE: ECONOMICS 2B
MODULE CODE: ECO 220

STUDY GUIDE
2023

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COPYRIGHT © EDUCOR, 2023

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TABLE OF CONTENTS

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1. DAMELIN

Damelin knows that you have dreams and ambitions. You’re thinking about the future, and how the next
chapter of your life is going to play out. Living the career you’ve always dreamed of takes some planning and
a little bit of elbow grease, but the good news is that Damelin will be there with you every step of the way.

We’ve been helping young people to turn their dreams into reality for over 70 years, so rest assured, you
have our support.

As South Africa’s premier education institution, we’re dedicated to giving you the education experience you
need and have proven our commitment in this regard with a legacy of academic excellence that’s produced
over 500 000 world – class graduates! Damelin alumni are redefining industry in fields ranging from Media to
Accounting and Business, from Community Service to Sound Engineering. We invite you to join this storied
legacy and write your own chapter in Damelin’s history of excellence in achievement.

A Higher Education and Training (HET) qualification provides you with the necessary step in the right direction
towards excellence in education and professional development.

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2. OUR TEACHING AND LEARNING METHODOLOGY

Damelin strives to promote a learning-centred and knowledge-based teaching and learning environment.
Teaching and learning activities primarilytake place within academic programmes and guide students to
attain specific outcomes.

a) A learning-centred approach is one in which not only lecturers and students, but all sections and
activities ofthe institution work together in establishing a learning community that promotes a
deepening of insight and a broadening of perspective with regard to learning and the application
thereof.

b) An outcomes-oriented approach implies that the following categories of outcomes are embodied
in the academic programmes:

c) Culminating outcomes that are generic with specific reference to the critical cross-field outcomes
including problem identification and problem-solving, co-operation, self-organisation and self-
management, research skills, communication skills, entrepreneurship and the application of
science and technology.

d) Empowering outcomes that are specific, i.e. the context specific competencies students must
master within specific learning areas and at specific levels before they exit or move to a next
level.

e) Discrete outcomes of community service learning to cultivate discipline-appropriate

competencies.

Damelin actively strives to promote a research culture within which a critical-analytical approach and
competencies can be developed in students at undergraduate level. Damelin accepts that students’
learning is influenced by a number of factors, including their previous educational experience, their
cultural background, their perceptions of particular learning tasks and assessments, as well as discipline
contexts.

Students learn better when they are actively engaged in their learning rather than when they are passive
recipients oftransmitted information and/or knowledge. A learning-oriented culture that acknowledges
individual student learning styles and diversity and focuses on active learning and student engagement,
withthe objective of achieving deep learning outcomes and preparing students for lifelong learning, is
seen as the ideal. These principles are supported through the use of an engaged learning approach that
involves interactive, reflective, cooperative, experiential, creative or constructive learning, as well as
conceptual learning via online-based tools.

Effective teaching-learning approaches are supported by:

a) Well-designed and active learning tasks or opportunities to encourage a deep rather than a
surface approach to learning.

b) Content integration that entails the construction, contextualization and application of

knowledge, principles and theories rather than the memorisation and reproduction of
information.

c) Learning that involves students building knowledge by constructing meaning for themselves.

d) The ability to apply what has been learnt in one context to another context or problem.

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e) Knowledge acquisition at a higher level that requires self-insight, self-regulation and self-
evaluation during the learning process.
f) Collaborative learning in which students work together to reach a shared goal and contributeto
one another’s learning at a distance.

g) Community service learning that leads to collaborative and mutual acquisition of competencies in
order to ensure cross cultural interaction and societal development.

h) Provision of resources such as informationtechnology and digital library facilities of a high quality
to support an engaged teaching-learning approach.

i) A commitmentto give effect teaching-learning in innovative ways and the fostering of digital
literacy.

j) Establishing a culture of learning as an overarching and cohesive factor within institutional

diversity.

k) Teaching and learning that reflect the reality of diversity.

l) Taking multi culturality into account in a responsible manner that seeks to foster an appreciation
of diversity, build mutual respect and promote cross-cultural learning experiences that
encourage students to display insight into and appreciation of differences.

2.1.1. Icons
The icons blow act as markers, that will help you make your way through the study guide.

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Additional information
Find the recommended information listed.

Case study/Caselet
Apply what you have learnt to the case study presented.

Example
Examples of how to perform a calculation or activity with the solution /
appropriate response.

Practice
Practice the skills you have learned.

Reading
Read the section(s) of the prescribed text listed.

Revision questions
Complete the compulsory revision questions atthe end of each unit.

Self-check activity
Check your progress by completing the self-check activity.

Study group / Online forum discussion

Discuss the topic in your study group or online forum.

Think point
Reflect, analyse and discuss, journal or blog about the idea(s).

Vocabulary
Learn and apply these terms.

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3. INTRODUCTION TO THE MODULE

Welcome to Economics 2B.

Students very often do not understand the relevance of macroeconomics to marketing management. To
some it is additional burden and to others a misplacement of resources. The combination of economics and
marketing management are inevitably important to the success of the organisation, corporation,
company and the economy.

While economics as asocial science studies resources allocation, the distribution and consumption; capital and
investment, management studies the sustainable process of managing the resources to satisfy human wants.
Combining the economics and management in a business as a strategy brings about success.

unemployment.

3.1. MODULE INFORMATION

Qualification title Bachelor of Commerce in Marketing and Business Management
Module Title Economics 2B
NQF Level 6
Credits 10
Notional hours 100

3.1.1. MODULE PURPOSE

This module covers the main topics and components of macroeconomics at a second-year level.
It assumes prior knowledge of the fundamentals such as policy issues regarding the balance of
payments, unemployment and inflation that were introduced to you in your first year. The module
will continue this focus on main macro-economics topics this time deepening the understanding
of the interrelationship, while concentrating on the problems of unemployment and inflation
which are very pertinent in the development of the economy and decision making of the state.

Further, this module focuses on the Keynesian model and builds on those principles you have
become familiar with. These theoretical insights should always be rooted in an intuitive
understanding of economic behaviour because without the ability to situate theoretical insights the
theory becomes sterile. The knowledge of this module suggests how the state may adjust its policy
to combat job losses and income during the COVID19 pandemic.

The overall performance of the economy in terms of national income, the distribution of income
among different groups of people in the economy and the knowledge of how fiscal and monetary
policies work together to combat economic problems that might have been caused by the micro
section amongst others are also illustrated in the module. Macro. The national income data helps
in anticipating the level of fiscal activity and understanding.

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3.1.2. OUTCOMES
At the end of this module learners should be able to:
a) Demonstrate an understanding and application of the basic Keynesian model.
b) Demonstrate an ability to critically understand the deriving and functioning ofthe IS and LM
models.
c) Demonstrate an ability to critically understand and be able to derive the AD model from the IS-
LM model
d) Demonstrate a sound knowledge ofthe difference between the LRAS and the SRAS
e) Demonstrate an understanding of the role that various macroeconomic variables play in our
economy.
f) Understand the practical operation of financial markets.
g) Understand the system of National Accounts.
h) Be able to cite real, monetary and foreign sector relationships.

3.1.3. ASSESSMENT
You will be required to complete both formative and summative assessment activities.

Formative assessment:
These are activities you will do as you make your way through the course. They are designed to help you
learn about the concepts, theories and models in this module. This could be through case studies,
practice activities, self-check activities, study group / online forum discussions and think points.

You may also be asked to blog / post your responses online.

Summative assessment:
You are required to do one test and one assignment. For online students, the tests are made up of the
revision questions atthe end of each unit. A minimum of five revision questions will be selected to
contributetowards your test mark.

Mark allocation
The marks are derived as follows for this module:
Test 20%
Assignment 20%
Exam 60%
TOTAL 100%

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3.1.4. LESSON PLAN

The table below will give you an indication of which topics you need to prepare for class.
Week Class 1 Class 2 Class 3
1 The Basic Model: Consumer, The Basic Model: Consumer, The Basic Model: Consumer,
Producer & Government Producer & Government Producer & Government

2 The Basic Model: Consumer, The Basic Model: Consumer, The Basic Model: Consumer,
Producer & Government Producer & Government Producer & Government
3 The Basic Model: Consumer, The Basic Model: Consumer, The Basic Model: Consumer,
Producer & Government Producer & Government Producer & Government
4 Basic Model II: Financial Basic Model II: Financial Basic Model II: Financial
Institutions, Money & Interest Institutions, Money & Interest Institutions, Money & Interest
Rates Rates Rates
5 Basic Model II: Financial Basic Model II: Financial Basic Model II: Financial
Institutions, Money & Interest Institutions, Money & Interest Institutions, Money & Interest
Rates Rates Rates
6 Basic Model II: Financial Basic Model II: Financial Basic Model II: Financial
Institutions, Money & Interest Institutions, Money & Interest Institutions, Money & Interest
Rates Rates Rates
7 Basic Model III: The Foreign Basic Model III: The Foreign Basic Model III: The Foreign
Sector Sector Sector
8 Basic Model III: The Foreign Basic Model III: The Foreign Basic Model III: The Foreign
Sector Sector Sector
9 National Accounting Identities National Accounting Identities National Accounting Identities
and Macroeconomic Analysis: and Macroeconomic Analysis: and Macroeconomic Analysis:
Uses & Abuses Uses & Abuses Uses & Abuses
10 A Model For An Inflationary A Model For An Inflationary A Model For An Inflationary
Economy: Aggregate Demand & Economy: Aggregate Demand & Economy: Aggregate Demand
Supply Supply & Supply
11 Monetary Policy: The Role ofthe Monetary Policy: The Role of the Monetary Policy: The Role of
Reserve Bank Reserve Bank the Reserve Bank
12 Fiscal Policy: The Role of the Fiscal Policy: The Role of the Fiscal Policy: The Role of the
Government Government Government
13 Policy Problems: Coordination, Policy Problems: Coordination, Policy Problems:
Lags and Schools of Thoughts Lags and Schools of Thoughts Coordination, Lags and
Schools of Thoughts

3.1.5. PLANNING YOUR STUDIES

You will have registered for one or more modules in the qualification and it is important that you plan
your time. To do this look at the modules and credits and units in each module.

Create atime table / diagram that will allow you to get through the course content, complete the
activities, and prepare for your tests, assignments and exams. Use the information provided above (How
long will it take me?) to do this.

What equipment will I need? Access to a personal computer and internet.

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This module will take you approximately 100 hours to complete. The following table will give you an
indication of how long each module will take you.

Unit Number Hours

1 20
2 20
3 10
4 10
5 10
6 10
7 10
8 10

4. PRESCRIBED READING

Mohr, P. and Fourie, L. 2015. Economics for South African students. Fifth edition. Pretoria: Van
Schaik Publishers.

4.1.1. RECOMMENDED ARTICLES

Afonso, O., Monteiro, S. and Thompson, M. 2014. Innovation economy, productive public
expenditure and economic growth. Metroeconomica, 65(4): 671-689.
Doroftei, I.M. and Paun, C. 2013. The choice of monetary policy and its relevance for economic
performance: Empirical evidence from a global perspective. Romanian Journal of Political Science, 13(1):
76-100.
Plante, M. 2014. How should monetary policy respond to changes in the relative price of oil?
Considering supply and demand shocks. Journal of Economic Dynamics and Control, 44(1): 1-19.
Toka, S. 2014. A method for calculating export supply and import demand elasticities. Journal of
International Trade and Economic Development, 23(7): 1059-1097.

4.1.2. RECOMMENDED MULTIMEDIA

Websites:

[Link]
[Link]

Video /Audio

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5. MODULE CONTENT

You are now ready to start your module! The following diagram indicates the topics that will be covered.
These topics will guide you in achieving the outcomes and the purpose of this module.

Please make sure you complete the assessments as they are specifically designed to build you in your
learning.

Unit 1: An introduction to economics

Unit 2: The major sectors, markets and flows in the economy

Unit 3: Measuring economic performance

Unit 4: The South African economy

Unit 5: Demand, supply and prices

Unit 6: Elasticity

Unit 7: The labour market

Unit 8: The monetary sector

Unit 9: The public sector

Unit 10: The foreign sector

Unit 11: Inflation and its effects

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5.1. UNIT 1: THE BASIC MODEL I: CONSUMERS, PRODUCERS &

GOVERNMENT
By the end of this unit, you will be able to:
Have reviewed the basic model of production and income
determination.
To answer the question ‘why total income in the economy fluctuate
using models.
Understand and interpret the main components of expenditure in an
open economy, i.e. consumption, investment, government
Specific Learning expenditure, imports and exports.
Outcomes
Know how to use chain reactions (or ‘chain reasoning’) to analyse the
way changes in economic variables (taxation, interest rates, imports,
and so forth) or external disturbances work dynamically through the
economy
Be able to use graphical aids to support and check your economic
reasoning

It will take you 15 hours to make your way through this unit.
Time
Complements Refer to goods that can be used jointly.
Demand Refers to the quantities of a good or service that potential
buyers are willing and able to buy.
Important terms Law of Other things remaining the same (ceteris paribus), the
and definitions demand higher the price of a good, the smaller is the quantity
demanded.
Law of supply Other things remaining the same (ceteris paribus), the
higher the price of a good, the greater is the quantity
supplied.
Substitutes Refer to goods that can be used in place of another to
satisfy the same need.
Supply Refers to quantities of a good or service that producers
plan to sell at each price during a specific period.

5.1.1. INTRODUCTION
The most basic players, who are the core players in a closed economy are the consumers, producers as
well as the government. There is no any economy that may function without the consumers. The main
focus of any economic system lies on the consumers, who constitute the majority of the electorate. The
power to elect a government of their choice helps them steer economic choices in their favour. These
consumers do not exist in a vacuum, but rather in an interdependent network with producers and the
government. These three players dearly depend on each other in the network.

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5.1.2. WHAT MACROECONOMICS IS ALL ABOUT?

Macroeconomics deals with the functioning of an economy as a whole and is usually concerned with
aggregate variables such as growth, employment, price stability and external transactions.
Macroeconomics seeks to explain the determinants of these variables in terms of trends and variations in the
short - and long-run, and debates the appropriateness of policy actions in response to apparent or
perceived macroeconomic instability (Blanchard & Johnson, 2013).

Unemployment, inflation, interest rates, exchange rates, the balance of payment, the gold price, the
budget, public debt, taxation, Reserve Bank policy – these issues are what macroeconomics is all about.

They deeply affect all our lives whether as a student, household consumer, investor, business manager,
employee, labour union member or government official. As a first step towards understanding the
operation of the economy we consider, in this chapter, the simple Keynesian theory of income
determination. This theory was designed originally to explain recessions and periods of sustained
unemployment, and emphasises the causes of fluctuations in real national income and employment. It
helps in understanding the nature and causes of short-run changes in income and employment.

• Short run period: Is thought to span for a period of up to 3 years.

• Medium term period: A time frame between 3 to 7 years. 2
• Long run period: A time frame that is usually in decades.

The simple model focuses on the so-called real sector ofthe economy, where real economic activities like
production, consumption, saving, investment, imports and exports occur. The theory can, therefore, help
us understand the course of the South African economy, especially the course of gross domestic product
(GDP). The price level, which is essential for an analysis of inflation, isa prominentvariable in more modern
version of Keynesian theory. This difference will bring in the concept of nominal and real values. Nominal
GDP is the total value of productivity measured at current market prices whereas real GDP is the value of
total output that is expressed at base year prices (constant prices). In the simple Keynesian model we
assume, for the time being, that the average price level remains constant. While obviously unrealistic, it
does not affect the results ofthe analysis materially.

In this unit wefocus, therefore onthe determination oftotal production and income inthe real sector. This
is measured in terms of GDP. Changes in GDP are reflected in the business cycle (upswings and downswings
in the economy), as well as changes in the rate of economic growth (the growth in GDP over the longer
term). Except where explicitly indicated otherwise, we will be concerned with real GDP and real national
income.

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5.1.3. THE BASIC FRAMEWORK REVIEWED

The crux of the Keynesian approach is that the explanation of changes in production and income is to be
found in fluctuations in total expenditure in the economy. Total expenditure in the economy is at the centre
of the action. If that can be explained, the decision that lead to (or are reflected in) the macroeconomics
state of the economy can be understood. Therefore, the basic Keynesian model is an expenditure- or
demand-determined model. The idea of an income-expenditure circular flow isvery useful to illustrate the
Keynesian approach. It shows the circular flow of expenditure and income between two key groups of role
players in a simple economy: households (consumers) and business enterprises (producers). In a more
complete diagram one will also indicate a public sector (state), a monetary sector and foreign sector.

Three types of transactions that occur in this sector are:

1 The goods market transaction- where producers sell their goods in the goods market in exchange for
income.

2 The labour market transactions – where labour is employed by firms and gets income for its services.
Financial market transaction – deficit spending units (firms) access loans from savings by surplus
spending units (households)

5.1.4. BASIC CIRCULAR FLOW

Our main concern is the amount of income that ends up in the pockets of households and individuals in
the bottom half ofthe circle. The volume of income flowing in the bottom half ofthe circular ‘tube’ depends
on the volume of expenditure in the top half. If the flow expenditure increases, for example, it is likely to
induce decisions to increase production to meet the increased expenditure. This implies a corresponding
adjusted level of sales and real income Y. Figure 1.1 shows the circular flow of income and expenditure
between firms and households.

Figure 1.1 Circular Flow of Income and Spending

This reasoning provides us with the first and basic chain reaction: changes in expenditure cause
adjustments in production and income. When production has adjusted fully to a change in total

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expenditure, a situation of macroeconomic equilibrium occurs. At such an equilibrium, the following

condition is satisfied:

Total expenditure =Total production

In Keynesian theory fluctuations and trends in real national income Y basically are interpreted as shifts in this
equilibrium, or at least movements towards a new equilibrium point. Therefore, it is an equilibrium approach.
Changes in the equilibrium level of income are caused and explained by changes total expenditure.

A more complete chain reaction would run as follows:

Suppose total expenditure increases. At existing production levels, production

is less than the new level ofexpenditure. This will be apparent in a decrease in
thestocks of producers. This is a sign and inducement for producers to decide
to adjust their production levels to the new expenditure levels. When (and if)
they decide to do so, total production will increase (as measured in terms of
real GDP) and so will employment. The income from the increased sales flows
to the different factors of production – managers, workers, landowners,

shareholders, other input suppliers, etc – and national income Y increases

correspondingly. This increase is bound to continue until production is equal
to the new, higher level of total expenditure – i.e. until a new and higher
equilibrium level of income Y is reached. An economic upswing occurs.

In brief:
Total Expenditure↑ → stocks are depleted → production↑ → Real GDP and Real Y↑

The entire Keynesian approach centres on this fundamental chain reaction. It enables one to
identify the likely causes of fluctuations in income Y, or the likely consequences of
fluctuationinexpenditure. Inthis way one can gain some insight intothe causes of upswings
or downswings in the economy, or of increases or decreases in the real economic growth
rate.

The rest of the theory consists of a refined focus on expenditure. It focuses on two aspects:

(a) To understand and explain trends and fluctuations in expenditure as such, and
(b) To relate and translate all other disturbances and shocks in the economy – changes in
interest rates, the money supply, taxation, VAT, the gold price, the exchange rate, the
balance of payments (BoP), etc – into one or another impact on expenditure.
The well-known income-expenditure diagram or ‘45° diagram’ is the basic graphical aid of the
simple Keynesian approach.

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Figure 1.2 Income Determination in the Keynesian Model

This shows the real sector of the economy, and illustrates the interaction between total
expenditure (E) and total production to determine the equilibrium level of real income Y. The
graphical indication of this level is where the total expenditure line intersects the 45°
line. Only at that level of Y (Y◦) will total production (measured horizontally) be equal to
total expenditure (measured vertically). Any other Y level is a disequilibrium level, since
production can be seen to be either higher or lower than expenditure.
In others words, only at Y◦is the condition for macroeconomic equilibrium satisfied:
Total expenditure = Total production

5.1.5. The Real Sector

The basic thrust of the Keynesian approach is to understand, explain and anticipate the behaviour of total
expenditure. This is done by dividing total expenditure into different components of expenditure. Each of
these components can then be analysed as indicated in (a) and (b) above.
The main components or types of expenditure are consumption expenditure (C), capital formation (or
investment) (I), government expenditure (G), and net exports, i.e. exports (X) less imports (M). Therefore:

Total expenditure = C + I+ G + (X – M)
Consumption: a summary
Consumption (C) pertains to expenditure by households on consumable items and services such as clothing,
food, sport, movies, transport, medical services, books, pencils, computers, fridges, lawnmowers and vehicles.
Expenditure on imported items is included in total consumption expenditure.
It includes anything from spending on refrigerators to medical services to movie tickets to food. In the national
accounts of South Africa, final consumption expenditure by households is classified in terms of durable goods,
semi-durable goods, non-durable goods and services. Ifyou would like to know more about how South
African households spend their income, you will find valuable information in the Quarterly Bulletin of
the South African Reserve Bank on

[Link]).

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Total consumption expenditure usually is avery stable component of aggregate expenditure.

Consumption C depends on (or, is a function of) real disposable income (YD), wealth, the average price
level, expectations, habits, etc.
C =f (real disposable income (YD); wealth; expectations; habits; demographic factors, etc)
This means that the decisions to spend income on consumption goods largely are determined (or
caused) by these factors. Some of these factors have a positive impact on consumption
expenditure, others a negative impact.
Of all these factors the most important is the level of real disposable income (YD). Disposable income
is the part of income Y that remains after taxation T has been paid or subtracted (YD = Y – T). This
indicates the importance of the government when it comes to determine the level of consumption
in an economy. If taxation is reduced, this can be seen as expansionary fiscal policy as households
will have more disposable income to spend leading to a growth in national income. On the other
hand, an increase in taxation will be considered as a contractionary fiscal policy because it
diminishes the level of consumption.
If real disposable income increases, individuals and households are likely to increase their
consumption spending.
The part of disposable income that is not spent on consumption is saved. (Therefore saving also
depends on disposable income.)
The essence of the relationship between real consumption and real disposable income can be found
in the marginal propensity to consume (MPC).
Atax increase will decrease disposable or after-tax income, which should discourage consumption
spending. Here one finds a negative or inverse relationship between taxes and consumption.
If levels of wealth increase, people are better off, this will encourage consumption spending. It is
reasonable to expect a positive relationship between wealth and consumption. A prominent
example is the positive effect of rising stock market prices on wealth and thus on consumption.
In chapter 5 we shall encounter arguments that consumption is also determined by the average price
level. Ifthe average price level increases, the real value ofassets will decrease. This decreases the
wealth of people and discourages consumption. In this way the average price level can have a
negative impact on consumption.

The consumption function

The relationship between consumption and real income, i.e. the consumption function, can be expressed
in mathematical term as:

C = a + bY + ….
• a represents autonomous consumption
• b is the marginal propensity to consume (MPC)
• Y is the disposable income

This function can be depicted graphically on the income-expenditure diagram. The consumption line
shows, for each level of Y (real income), the corresponding level of real consumption expenditure in the
country (e.g. Y1 and C1). It depicts the overall behaviour of consumers and largely explains the level of
consumption in terms of real income. Figure 1.3 shows the Keynesian Consumption function

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The positive slope indicate the positive relationship between consumption and real income: as income Y
increase, an increase in consumption C is induced. When income decreases, consumption should decrease.
• The slope of the consumption function is directly related to the marginal propensity to
consume. (How?)
• Graphically, any change in consumption due to a change in Y is indicated by a movement on
or along the line.
• A change in one of the other factors that determines consumption implies, graphically, a
shiftofthe C line. Ifwealth levels increase, for example, the C line is shifted upwards. If taxation is
increased, the C line is shifted down.
• After Keynes, a number of economists have suggested more complex relationships
between income and consumption.
• Relative income: Consumption is not determined by absolute income but by relative
income (that of friends and neighbours). Households do not necessarily reduce consumption when their
income increases.
• Permanent income: Household consumption not determined by current income but by
whatthey expect to earn normally.
• Life-cycle income: Spending by households is planned according to what they expect to
earn over their lifetime.
• The distribution income: Compares consumption patterns between the rich and the poor.
The mpc (marginal propensity to consume) is higher for the poor with a lower (Marginal Propensity
to Save) mps, whereas the rich have a lower mpc but their mps is high.

Real Investment (capital formation): a summary

Investment (I) is the purchase of production or capital goods, for example factories or machinery – real
assets on which a return is expected from the sales of production. (Expenditure on imported capital goods,
e.g. machinery, is included in total investment)
Typically, investment is avery unstable element in the economy.
In the national accounts investment is called ‘capital formation’. These two terms are synonymous
and are interchangeably in this book.
More specifically, what is of concern here is fixed investment: gross fixed capital formation comprises the
following components: residential buildings, non-residential buildings, construction, transport equipment,
machinery and other equipment. The other (non-fixed) part of gross investment is inventory investment.
This merely is unplanned and unsold inventory of produced goods due to an imbalance between total
production and total expenditure.
The importance of investment
If you peruse through South African Quarterly Bulletin, you will notice that investment spending ranges
between 20% and 25% of total spending and, if you compare changes in it with changes in consumption
spending and government spending, it is indeed very volatile.

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Before we proceed with a discussion of investment spending we need to distinguish between real
investment and financial investment in order to avoid confusion.
The difference between real investment and financial investment
Investment or real investment is spending on additions to the capital stock (machinery, structures,
inventories, etc.). Such investment is undertaken in order to make profits in the future. This is an
important definition and should not be confused with the definition of financial investment.
Financial investment is investment in shares and other financial instruments. When people put
money on deposit with a bank or buy bonds or shares, they are making a financial investment, on
which they will earn a return. Financial investment in shares and other financial instruments is
obviously crucial in the economy, but does not directly create production capacity. When an
economist refers to investment, he or she usually means real investment. Throughout this module
we follow this convention.
Importance of investment
Investment is important for the following two reasons:
Firstly, it creates production capacity and therefore makes higher levels of production possible. The more
machines, factories and tools we have, the more goods and services we can produce. This leads to
economic.
For our purpose it is the fact that investment creates a demand for consumer goods and services that is
[Link] follow this argument we need to go back to consumption spending by households.
From the consumption function we have learned that households do not spend all their income on
consumption. They save some part of it. This behaviour of households might result in insufficient demand
to take up the goods and services produced.

Imagine the following:

The level oftotal production in the economy is R100 million, which also represents the income households
receive. If households spend only 90% of this income, the consumer demand for goods and services will only
be R90 million. There is thus a shortfall of R10 million in spending (or demand). Firms will be left with

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unsold goods and services and start to cut back on their production. As production declines, income starts
to decline, followed by a decline in consumption, and ultimately a downward spiral.
According to Keynes (1936) additional spending is needed to make sure that there is a sufficient demand for
goods to ensure that the total production of society is taken up. The nature of this additional spending in a
closed economy can be in the form of investment spending and government spending.
Investment is one way of providing this additional spending that is needed to take up the production of
society. When a capital good such as a machine is produced, factors of production are employed to create
this capital good, and since households are the owners ofthe factors of production, their income increases,
which makes higher consumer spending possible inthe economy and additional spending is created to take up
the "overproduction". The "overproduction" is the R10 million in the above example.
Keynes (1936:27) wrote the following about this issue:
"... to justify any given amount of employment there must be an amount of current investment sufficient to
absorb the excess of total output over what the community chooses to consume when employment is at a
given level".
Determinants of investment
Investment usually requires a substantial capital outlay, and a lot of thinking and planning goes into the
decision whether or not to invest. A guideline used in this decision-making process is to compare the
internal rate of return of the project with the market interest rate. If the internal rate of return is higher
than the market interest rate, it would be profitableto undertake the investment. If, however, the internal
rate of return is lower than the market interest rate, it would be better not to undertake investment. The
calculation of the internal rate of return is complicated by the fact that the income from the sales of the
products, produced by the capital goods, lies in an uncertain future. In calculating this internal rate of
return, firms have to take this uncertainty into account, together with the initial cost and depreciation of
the capital good in question.
Keynes (1936:149-150) aptly explains this asfollows:
"Ifwespeakfrankly we have to admit that our basis for knowledge for estimating the yield ten years hence of
a railway, a copper mine, a textile factory, the goodwill of patent medicine, an Atlantic liner, a buildingin
the City of London, amounts to very little and sometimes to nothing".
It is therefore not surprising that investment is so volatile since we are dealing with a fundamentally
uncertain environment.
The decisions of private business enterprises to invest largely depend on and are strongly influences by,
the following factors and variables:
Investment =f (interest rates; expectations; business confidence; regulations)
interest rates – a higher interest rate decreases investment
expectations – improved expectations about the future increase investment
business confidence – higher business confidence increases investment
regulations – a more investment-friendly environment increases investment
Investment and the interest rate have an inverse or negative relationship: an increase in the interest rate is
likely to discourage capital formation, while a decreased interest rate is likely to stimulate capital
formation. This is so because the interest rate is the opportunity cost of capital formation.
The investment-interest rate relationship can be depicted as follows:

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The inverse economic relationship between investment I and the interest rate r is graphically reflected in
the negative slope. Changes in the interest rate will influence and determine the level of investment
(graphically this amounts to a movement along the investment curve or function).
Note that private investment (capital formation) in South Africa often does not react strongly to
changes in interest rates. Factors such as tax incentives and depreciation allowances, or
decentralisation incentives, are often more important, if not decisive, in the determination of
investment in South Africa.
Graphically, changes in these factors will shift the investment curve. (Why?)
Changes in confidence and expectations will shift the curve in the diagram
The potent influence of expectations and psychological factors is one reason why investment can
fluctuate wildly attimes.
A factor that often influences expectations is the exchange rate (How? Why?)

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In the income-expenditure diagram (the 45° diagram, which does not have the interest rate on one of its
axes), investment is depicted as a horizontal line at the level of investment determined in the above
diagram. Inthis way we are provided with a channel for interest rates to influence total expenditure in the
45° diagram.
Any change in the level of investment, due to either an interest rate change or some other relevant factor,
implies a parallel shift of the I line in the 45° diagram.
Investment and savings
An unresolved issue in macroeconomics is the issue of whether savings causes investment or if it is
investment which causes savings.
In the list of factors given for the determinants of investment, you might have noticed that savings by
households were not listed as one of the determinants. In the Keynesian view of the world, this is an
important point. While it is true that in order for investment to occur, savings are needed and that, in
equilibrium, savings equal investment, it does notfollow that the decision to save and the decision to invest
are two sides of the same coin. In other words, an increase in savings does not automatically lead to an
increase in investment. However, in this model, an increase in investment does lead to an increase in
savings.
The argument is that the decision to save is taken by households on the basis of their income, and the
decision to invest by firms on the basis of the factors listed above – and there is no mechanism present in
this model to ensure that these decisions correspond to each other. It is quite possible that households might
decide to save more, while atthe same time, firms decide to invest less. This combined effect might have
disastrous consequences for the level of output in the economy.
In the Keynesian world it is investment that creates savings.
Briefly, the argument is as follows: An increase in investment causes an increase in the demand for goods
and consequently output and income increases. As income increases, savings increase since savings are a
positive function of income.
The statement “do not worry about savings since investment will create its own savings” is sometimes made
in this regard.

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5.1.6. Macroeconomic equilibrium: the basic idea

The basic concept of equilibrium between total expenditure and total production, and the corresponding
graphical analysis of equilibrium in the 45° diagram, was explained above. If one assumes, for a moment,
that consumption and investment are the only kinds of expenditure in the economy, together they
constitute total expenditure.
At the equilibrium
Total expenditure =Total production
Or, for this simple case with only consumption and investment expenditure

C + I = Total production
Since production must be identical to income - all revenue from production sold must flow to some
production factor in the form of income – one can also write:
C+ I=Y
This statement describes the equilibrium for this simple, illustrative case (see the section for the general case.)
At the same time it is an equilibrium condition – it is the requirement or prerequisite for equilibrium in the
real sector.

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The basic tools to analyse changes in the economy are available now. Although the model still is very
simple, one can already construct much more comprehensive macroeconomic chain reactions. For
example:

“Suppose interest rates fall. (The next chapter will explain why that can happen.) This decreases the
opportunity cost of investment. More planned investment projects become potentially profitable
and viable. Therefore, investment is encouraged. If investment does increase, total expenditure and
sales increase. This will cause adecline in inventories, which is a sign and an incentive for producers
to decide to increase production. When (and if) they do increase production to match the higher
level of expenditure, GDP and real income will increase. The economy experiences an upswing. In
brief:”
i↓→I↑→Total Expenditure↑→Production↑→Y↑

The expenditure multiplier

The core of the idea of the multiplier is that any change in expenditure (∆Exp) – i.e. an injection of expenditure into,or
leakage from the circular flow – will eventually lead to a change in equilibrium income (∆Y) significantly larger than the
original injection (or leakage).
The size of the multiplier K is the ration between the eventual, cumulative change in Y (∆Y) and the original ∆
expenditure that caused it, i.e.

Therefore, the value of the multiplier shows the extent to which an expenditure injection (or leakage) is amplified or
multiplied.

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It can be mathematically shown that:

Government expenditure, taxation and equilibrium

Government expenditure concerns the purchase of goods and services by the general government. This may vary from
pencils to roads to policing services to army tasks. A large portion of government spending goes towards the payment
of wages and salaries of public servants.

In macroeconomic reasoning we often ignore all these institutional and definition problems and broadly
treatthe general government in terms oftotal government expenditure (G) and total taxation (T).
Government expenditure and taxation are the main elements of so-called fiscal policy. Government
borrowing to finance budget deficits is athird important element of fiscal policy.
In macroeconomic reasoning one usually regards government expenditure and taxation decisions as
exogenous or autonomous, i.e. as political decisions under full control of the government. These decisions are
taken ‘outside’ the economy (therefore exogenous).
Government expenditure (G) is adirect component oftotal expenditure and influences it directly and fully.
In the 45° diagram G is show as a horizontal line, at the level of government expenditure. It is then
simply added, vertically, to the C and I lines to get the total expenditure line.
Any increase in G has the same direct impact as any other direct increase in expenditure. Graphically the
expenditure line is shifted upwards by the exact amount of such an increase.
The expenditure multiplier KE also applies to changes in G: the eventual change in Y exceeds the
initial change in G by afactor equal to the multiplier.
Taxation has an indirect effect on equilibrium income, i.e. via its impact on disposable income and, in that
way, on consumption. Graphically the consumption function is shifted up or down as a result of tax
changes.
Since a tax increase is partly financed by the individual or households consuming less and saving
less.

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Therefore, the tax multiplier (KT) is smaller than the expenditure multiplier by afactor equal to the
marginal propensity to consume (MPG):
KT = MPC X KE
This means that a R1 million increase in government expenditure, for example, will not have the same
impact on equilibrium income Y as a R1 million reduction in total taxation. The former has a larger
impact.
A balanced increase in the budget – equal increases ingovernment expenditure and taxation – will
therefore have a positive net impact on Y. (This is the ‘balanced budget multiplier’ result.)

Remarks
1. An increase in G and a reduction in T are both examples of expansionary fiscal policy (and vice
versa for restrictive policy).
2. In any discussion of the consequences of a change in government expenditure (G), one should
analytically handle them in isolation, i.e. one should not automatically assume that taxation (T) will
be increased to finance the higher level of spending.
3. In practice, a large portion of taxation is in the form of income taxation. This implies that the tax
revenue of government is a function of total income: if income Y increases during an upswing,
income tax revenue ofthe Treasury will also increase.
4. The graphical analysis of a change in taxation is complicated by the difference between types of
taxation.
Exports, imports and equilibrium (introductory)

The South African economy is ‘open’: a large part of total production is exported, and a large part of total
expenditure is spent on the purchase of imported items. Therefore international trade affects the pattern of
expenditure and production decisively. It is therefore essential to understand fully the macroeconomic effect
of foreign trade transactions.
To arrive atthe total demand that South African producers experience, one must:
Add spending in foreign countries on South African goods to domestic expenditure, and
Deduct local spending on imported goods, since this spending merely flows to producers in other
countries.

Gross domestic expenditure is the sum of consumption, private investment and government expenditure, i.e.
GDE = C + I + G
However, this is not equivalent to the total spending that is effectively felt by domestic producers. The latter
magnitude – the total demand for domestic production – is indicated by the term expenditure on gross
domestic product = C + I + G + (X – M).
Therefore:
Total expenditure E = C + I + G + (X – M)
For this, the complete open economy case, macroeconomic equilibrium will be atthat level of real income
Y where
Total expenditure =Total production
Or
C + I + G + (X - M) = Total production

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Since production is identical to income, one can equivalently write the equilibrium condition as:
C + I + G + (X - M) = Y

Graphically one merely adds net exports to the total expenditure line. Any increase in net exports istreated
like any other expenditure injection (and is subject to the same multiplier process):
(X – M)↑→ Total Expenditure↑→Production↑→GDP↑→Y↑

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5.2. UNIT 2: BASIC MODEL II: FINANCIAL INSTITUTIONS, MONEY &

INTEREST RATES
By the end of this unit, you will be able to:
• Understand the everyday, practical operation of financial
markets;
• Determine the impact ofdemand and supply forces on interest
Specific Learning rates.
Outcomes • Be able to analyse movements in interest rates;
• Understand the interaction between the financial world – the
monetary sector – and the real economy (as discussed in chapter 1);
• Understand where monetary policy fits in, including the role
of the Reserve Bank

It will take you 15 hours to make your way through this unit.
Time

5.2.1. INTRODUCTION
In the previous study unit, you studied about the functioning of the real sector, also known as the goods
market. Despite the magnitude, any dynamics in the real sector can be felt by an ordinary man in the street.
For instance, taxes are in the real sector. Recently, with effect from the 1st of April 2018, VAT increased
from 14% to 15%. This is indicated as an increase in taxes in the Keynesian model. The increase in taxes
was felt by everyone in the economy – from motorists, investors, business owners, to students.

The question that follows is, what backs up the functioning ofthe real sector? It is the monetary sector. In
this study we present a brief debate concerning the understanding of the Basic Model II: Financial
institutions, Money & Interest Rates.

5.2.2. LINK BETWEEN REAL AND MONETARY SECTOR ON THE ECONOMY

Financial institutions and markets are integral parts of the economy. Real activities like consumption
invariably imply financial transactions which involve bank accounts and, often, bank credit to consumers.
The same is true for international financial flows deriving from foreign trade or foreign investment.
• The monetary sector can be seen to handle the ‘oil’ (money, credit and financial
transactions) necessary for the smooth functioning of the ‘wheels’ of real activities (production,
employment, consumption, investment, etc.) in the real sector.
Real sector changes have monetary impacts, and monetary disturbances can have real impacts.
• While not a separate sector, the activities and institutions in the monetary sector are
sufficiently different from those in the real sector to distinguish it analytically.

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5.2.3. THE MONETARY SECTOR AND INTEREST RATES

Interest rates are analysed at two levels: first, in terms of the practical, everyday operation of money
markets, and, secondly, more formally in terms ofthe behavioural relationships that lie behind and explain
this everyday operation – the supply of money (Ms) and the demand for money (MD).

The practical determination of interest rates in the money market

Although one is used to thinking of interest rates in the context of, for example, savings accounts or,
especially, interest rates on loans or on an overdraft, the main interest rates are those determined in the
money market.
Where is the money market?
The money market does not exist in a physical location or building. It is constituted by a large number of
financial institutions, especially commercial banks and other kinds of banks (e.g. merchant banks) that are
continually in contact with each other via telephone, video and computer links. These institutions have
‘dealer rooms’ where dealers handle large amounts of money, buying and selling in the money market.

Money market dealers trade, on behalf of clients, in short-term financial instruments or financial paper.
The purpose of the trade is to connect lenders (financial investors) and borrowers; in other words, the
money market channels funds.
The capital market
The financial market is arbitrarily divided into the money market and the capital market:
• The money market handles instruments/assets with a term or ‘maturity’ of up to 1 year
(‘short term’). Associated with these are short-terminterest rates.
• ransactions in financial instruments with aterm of more than one year (‘long term’) occur in
the capital market, which is organised in exactly the same fashion as the money markets. In this
market one finds long-term interest rates.
Various kinds of money market paper exist, each with its own interest rate. Each transaction determines a
price for the paper at that moment, which implies a certain interest rate for that transaction (and type of
paper or asset).

Main Types Of Money Market Papers

1. Treasury bills (TBs): are issued by treasury/government when it borrows money from the private sector.
The central bank also uses TBs to control market liquidity via OMO. TBs usually mature between 91
to 182/273 days. TBs can be sold in the secondary market.
2. Negotiable certificates of deposit (NCDs): Are issued by banks when they are facing liquidity
challenges. It is common with investors because it attracts higher levels of interest rates. They are also
traded on the secondary market.
3. Banker’s acceptances (BAs): are bills of exchange guaranteed by the banks. They are similar to the
concept of post-dated cheque where a producer uses Bas to buy inputs with the bank’s guarantee thatthe
payment will be made on the maturity date of the BA.

Link between financial papers and the demand for and supply of money
• If people or institutionshold more money (e.g. cash) than they really want intheir portfolio
– i.e. there is a surplus of money holdings – they are likely to buy financial paper (as a short-term
financial investment)

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• Ifthere isashortage of money – i.e. people want to improve their cash position -they tend to
sell financial paper. The increased supply of paper on the market causes a decrease in price, and the
interest rate increases.
In other words, interest rates depend on the trade in money market instruments, and this trade is
determined by the demand for, and supply of money.
Money or income?
When one speaks of ‘money’ in macroeconomics it is important to distinguish it from the everyday usage
of the term. The latter usage – as in ‘Do you have enough money to buy a car?’ – Actually concerns income
or wealth rather than money. The decision to buy something or not depends on whether you have earned
or saved enough income with which to buy it.

[Link]. THE DEMAND FOR MONEY

The aggregate demand for money inthe economy depends mainly onthe amount of money people require
for transactions. Therefore, the total money value, or nominal value, of transactions (in a year, say) in the
country is decisive. This in turn depends on the total volume of goods that is to be exchanged, i.e. the total
volume of goods produced, as measured by real GDP (or Y).

• This means that, if Y increase (the economy is in an upswing and economic activity
increases), the demand for money typically increases.
• This suggests that there is an endogenous or built-in effect of the business cycle on the
demand for money, and hence on interest rates.
In addition to the volume of (real) production, the nominal value of transactions also depends on the
average price level (P) [Nominal GDP = PxY]. Accordingly, an increase in the average price level (as
experienced when inflation occurs) also increases the demand for money. There is a direct or positive
relationship between P and MD.
A final important factor determining the demand for money is the interest rate (i). The demand for money
depends on the amount of money people want to hold at one time (instead of going to the bank to get
money for each transaction).
The higher the rate of interest, the less willing people will be to hold significant amounts of money/ cash. That
is, a higher rate of interest will decrease the demand for money; a lower interest rate is likely to increase
the demand for money. There is an inverse or negative relationship between iand MD.
Therefore the money demand relationship is as follows:
MD = f (i; Y; P)
▪+ +
The sign below the equation indicate the kind of relationship between the left -hand variable (MD) and the
corresponding right-hand variable:
+ indicates a direct or positive relationship;
- indicates an inverse or negative relationship.
Graphically, the demand for money relationship can be depicted as follows:

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money demand curve.

[Link]. THE MONEY SUPPLY (MS)

The money supply is the total amount of money that is present in the economy at a particular moment.
The stock of money can be defined as the sum of all deposits at banks plus all cash (notes and coins) held
by the public. Other names for money supply are the ‘monetary base’ or the ‘high-powered money’.
There are 4 different definitions of money supply;
M1A: Notes, coins, cheques and transmission deposits ofthe private sector
M1: M1A plus short term demand deposits
M2: M1 plus medium-term deposits
M3:M2 plus long term deposits

Money creation does not occur via the printing of notes but, rather, via the extension of credit (loans) by
banks.
• Banks lend money that has been deposited by clients, e.g. in cheque accounts, to other
persons.
• There are a number of rounds of lending and relending, with deposits being created and
recreated all the time.
• The extent of the money creation process, i.e. the value of the credit multiplier, depends on
how much is relent in each round.
• The higher this percentage leakage, the smaller the portion that can be lent each round.
Therefore the maximum scope of the money creation process is inversely proportional to the
minimum reserve requirement (the leakage rate).
• This means that the value of the credit multiplier is 1/R, where R = reserve requirement (e.g.
0,03).
It is importantto note that the reasoning here concerns the maximum scope ofthe money creation process.
Banks can choose voluntarily to hold higher reserves (so-called excess reserves), thereby restraining the process.

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The role of the Reserve Bank in the money supply process

In addition to the minimum reserve requirement, the Reserve Bank can use two other instruments of
monetary policy to influence the money supply:

• The Repo rate- the rate atwhich banks borrowto support their created creation but should
not be confused with the prime overdraftfacility where the central bank act as the lender of last
resort.
• Open market operations (OMOs): Is the buying and selling of treasury bills by the central
bank in order to determine or control the amount of liquidity in the market.
The money supply function
The instruments of monetary policy are among the main determinants ofthe supply of money. The supply of
money (Ms) is mainly a function of exogenous policy factors under the control of the monetary
authorities. In simple theory this is as far as one would go. It implies a vertical money supply curve that is
shifted left or right by contractions orexpansions ofthe money supply as aconsequence of monetary policy
steps.
Why would a bank hold excess reserves, and how does that affect the money supply function?
• In a period of uncertainty excess reserves provide security.
• Excess reserves also provide a ‘buffer’ to protect a bank against unexpected, large
withdrawals of cash by its clients.
Holding excess reserves is not without cost, however, if a bank holds excess reserves, it forfeits the interest
it could have earned by putting the funds out as loans: the interest rate is the opportunity cost of holding
excess reserves. High interest rates are likely to discourage the holding of excess reserves and encourage
maximum lending. Lower interest rates can induce not to lend to the fullest extent.
This suggests the possibility of a positive relationship between the interest rate and credit/moneycreation.
This positive relationship can be valid only up to the point where banks are fully loaned up. Then money
creation in the banking system reaches a ceiling. Exactly where this ceiling is will depend onthe exogenous
policy factors analysed above.
The money supply can therefore be depicted in two ways:

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Figure 2.2 Two depictions of real money supply (Source: Fourie, 2015)
Is money supply exogenous or endogenous?
In the policy debate this is a major point of dispute between Keynesian and Monetarists.

• Ifa portion ofthe money supply curve is interest elastic (i.e. non-vertical graphically), then the
money supply is partially endogenous (= dependent on factors within the economy) and reacts
spontaneously to changes in the economy.
• If policy makers respond to problems such as unemployment by allowing the money supply to
grow, then this money supply growth is (partially) an endogenous result or symptom of events in
the economy.

[Link]. SUPPLY AND DEMAND INTERACTION: EQUILIBRIUM IN THE

MONETARY SECTOR

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Figure 2.3 Money Market Equilibrium (Source: Fourie, 2015)

Graphically, it is simple to indicate that the equilibrium between the demand for and the supply of money
is determined by the intersection of the MD and Ms curves which determines an equilibrium interest rate
as well as an equilibrium quantity of money. An increase in the money demand (e.g. due to an increase in
Y) will lead to a rate increase. Likewise, an expansion of the money supply should result in downward
pressure on the rate of interest.
For example, suppose (due to some change in the economy) the demand for money were to increase (MD
shifts right graphically). The following chain of events would occur in the money market:
At the initial interest rate level there will be an excess demand for money. This implies that the public
requires more money (not income) for transactions than what they currently have in their portfolios. One
way to get hold of money is to sell some of their financial instruments/assets. The sale of financial paper
implies an increased supply of, for example, BAs on the money market. This causes downward pressure on
the prices of Bas, which is equivalent to upward pressure on the BA rate.
Remarks
In practice, quite a number of different short-term rates of interest exist (compare the interest rate
information in the Quarterly Bulletin ofthe Reserve Bank).
1. The relationship between these different rates of interest is called the ‘term structure of interest rates’
or the ‘yield curve’. It indicates the relationship between short – and long-term rates.
2. Note that neither the government nor the Reserve Bank sets interest rates in the sense of a legal
prescription or decree. The Reserve Bank influences, managers or controls interest rates via the
money market by influencing the money supply.
3. Inthe analysis above wesaw how open market operations (OMOs) can change the supply of money in
the market, thereafter leading to a change in the rate of interest. In practice the sale of, for example,
government stock in OMOs usually has an immediate effect on interest rates, since each transaction
carries a certain price and thus a corresponding rate of interest.
4. The daily news reports often note that the ‘money market shortage’ is so many million rand. This
simply means that the money market frequently is not in actual equilibrium: interest rates are
below or above the equilibrium level.
5. In published official date there are three different definitions of money or the money stock. Whileit
is important to be aware of these, they to not change the essential logic ofthe reasoning applied
above:

5.2.4. LINKAGES BETWEEN THE MONETARY AND THE REAL SECTORS

At this point we can combine the elements of the model encountered so far: the monetary sector and the
real sector. Together the two sectors constitute a coherent model of the economy (temporarily excluding
the external sector variables and the price level). Different chain reactions can now be linked together to
explain most macroeconomic changes in these two sectors. The three diagrams involved can be juxtaposed
to illustrate the linkages between the two sectors.
The Keynesian transmission mechanism
The first important linkage is from the monetary sector (or money market) to the real sector (or goods
market). Changes in the monetary sector cause changes in the rate of interest that, via the impact on
investment (capital formation), influence aggregate expenditure and consequently real GDP.
Suppose the bank rate (or repo rate) is increased by the Reserve Bank. This discourages the lending and
money creation capacity of banks. The money supply (Ms) contracts. This is likely to cause excess demand

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in the money market. Sales of money market instruments (to increase money holdings) cause downward
pressure on their prices, and thus upward pressure on interest rates (towards a new money market
equilibrium). The higher interest rates discourage investment. (Why?) The likely decrease in investment
expenditure (I) decreases aggregate expenditure (C + I + G + X – M). Accumulating stocks discourage
production. If and when production decreases, real GDP and thus real income Ydecrease. The 27

level of economic activity declines and the economy experiences a downswing or cooling down period. In
brief:

Repo rate↑ → MS↓ → i↑→I↓→Total Expenditure↓→Production↓→GDP

and Y↓ Graphically, the following figure explains this.

Figure 2.4 Keynesian Transmission Mechanism (Source: Fourie, 2015)

To summarise:

1. The implications of money market conditions or events are not limited to the monetary sector
of the economy. They are also transmitted to the real sector. In this transmission the link between
the rate of interest and investment is decisive.
2. The main significance of monetary disturbances and events is the consequences for real GDP
and employment.
3. The direct causes of, for example, a downswing inthe economy can be found in reductions
in one or more of the components of aggregate expenditure (e.g. G or X), but may actually lie further
back in money market conditions. The reverse is true for an upswing.

Secondary effects and ‘crowding unit’

There is a second linkage between the two sectors. This one operates in the opposite direction, i.e. from
the real to the monetary sector: any change in real income Y has an effect on the monetary sector (via Md).
Suppose government tries to stimulate the economy by increasing government expenditure (G). The
subsequent chain reaction exhibits two distinct effects:
Primary effect: G↑→TE↑→Production↑→GDP & Y↑ 28
Secondary effect:
GDP↑→Transactions↑→MD↑→i↑→I↓→TE↓→Production↓→GDP&Y↓ In words:
As GDP increases, so does the volume of goods to be traded
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→Total value of transactions increases →transactionary demand for money increases, i.e. Md increases
(graphically, MD shifts right); this puts upward pressure on interest rates (why?); increasing interest rates,
in turn, discourage private investment (why?)total→ expenditure declines→ production discouraged→
real GDP and Ydecline.
Note that the secondary, feedback effect via the money market runs counter to the initial increase in Y.
However, the secondary impact on Y, being a side effect, is smaller and weaker than the primary impact.
• The net impact on Y will still be in the direction ofthe primary effect (in the example above
there still would be a positive impact on Y).
• In practice the two effects are not neatly separated in time as an increase in Y followed by
a distinct (smaller) decline.
The pointisthatmonetary feedback effects maynoticeably reduce the income boosting effect of anincrease
in expenditure. The growth in income is gradually restrained or choked by the interest rate rise.
• Since private investment (capital formation) is depressed by the higher interest rates that
result fro the increase in government expenditure, the process is called the ‘crowding out’ of
private investment by government expenditure

A term often heard is the ‘crowding-in’ effect of government expenditure. What does this indicate?

▪ It indicates the stimulation of private investment that may result from government investment in, for
example, infrastructure. This is due to the opportunities that the stimulation of the economy creates for priavte
economis activity in gerneral, or specifically for the private sector to supply inputs to government projects.
These backward and forward linkages with government investment can serve to create more room for
private investment, hence the idea of crowding in.
The strength of the crowding-out effect is one of the major disputes in the debate on the potency of fiscal
policy.
Financing the budget deficit
The foremost method of financing government expenditure is taxation. In the case of a budget deficit – when
total tax revenue falls short oftotal government expenditure – the shortfall must be finances in some way or
another. Since borrowing is the main form of deficit financing, the deficit is often called the ‘deficit before
borrowing’.
There are three main methods of financing a budget deficit: domestic borrowing from the private non- bank
sector; borrowing from the Reverse Bank; and foreign loans. Our concern here is the different
macroeconomic consequences of the three options.
• Domestic borrowing from the private non-bank sector
• Borrowing from the Reserve Bank
• Foreign loans

5.2.5. THE IS-LM MODEL AS AN ALTERNATIVE DIAGRAMMATICAL AID

What is the IS-LM model?
The IS-LM model is an alternative way of depicting these relationships diagrammatically. It is a diagram
which summarises these three diagram into one, some- what complex, diagram.

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Source: (Blanchard, 2013)

It is a more abstract diagram in that it derives ‘equilibrium curves’ from the various behavioural
relationships. These curves do not permit the direct type of behavioural interpretation possible in the diagram
encountered so far, e.g. a consumption function which directly shows consumption behaviour. The IS-LM
curves are indirect, derived curves.
Essentials of the model: an intuitive introduction
The IS-LM model integrates the real and the monetary sectors and shows their interrelatedness and
interaction inone diagram. It offers aone-diagram summary ofthe traditionalthree diagrams inthe simple two-
sector Keynesian 45° diagram model. The model depicts the key macroeconomic relationships in a diagram
with real income (Y) and the interest rate (i) on the two axes. As the name indicates, the IS-LMmodel
comprises two curves: the IS curve and the LM curve.

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Figure 2.0.3 IS-LM Model (Source: Fourie, 2015)

The IS curve is a summary curve which depicts the real sector – i.e. the two diagrams shown in study unit 1,
containing the interest rate, investment, consumption, government expenditure, net exports and
aggregate expenditure – in a single diagram.
▪ The IS curve shows combinations of the interest rate (i) and real income (Y) that are consistent with
equilibrium in the real sector.

The LM curve is a summary curve that depicts the monetary sector - i.e. the demand for money and the
supply of money – on the same axes as the IS curve.
▪ The LM curve shows combinations of the interest rate (i) and real income (Y) that are consistent with
equilibrium in the money market.

The intersection of the two curves indicates an overall macroeconomic equilibrium – simultaneous
equilibrium in the real sector and monetary sector (money market).

Which is which?
How does one remember which curve is the IS and which the LM? Try the following association:
▪ IS: Investment, Savings and other real sector variables.

▪ LM: Liquidity, Money and other monetary sector variables.

Using the model: the basics
Macroeconomic shocks translate into a shift in either the IS or the LM curves, or both, resulting in a new
intersection point. This indicates a change in the equilibrium values of Y and i.
To use the model, one must be able to translate economic disturbances or policy steps into shifts in the
curves:
Shifts of the IS curve
Any exogenous change in expenditure – in C, I, G or X – M– that boosts expenditure and thus Y would shift
the IS curve towards the right. Any exogenous decrease in expenditure shifts the IS curve towards the left.

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▪ If G is increased, the IS curve shifts to the right.

▪ If G declines, the IS curve would shift to the left.
▪ If exports fall, the IS curve would shift to the left.

▪ It taxes are reduced, this would lead an exogenous boost in consumption, and the IS curve would shift to
the right.
▪ If restrictions are placed on imports, an exogenous drop in imports would result, X – M would increase,
and the IS curve would shift to the right.
▪ If investment falls due to a drop in investor confidence (i.e. at the prevailing interest rate level), it would
shiftthe IS curve to the left.
Shifts of the LM curve
The primary reason for a shift in the LM curve is an exogenous or policy change in the money supply Ms.
▪ If the money supply expands, the LM curve shifts to the right.
▪ If the money supply contracts, the LM curve shifts to the left.

5.2.6. FORMAL DERIVATION AND PROPERTIES OF THE IS – LM MODEL

Deriving the IS curve

Figure 2.4 Derivation of the IS Curve (Source: Fourie, 2015)

Derivation ofthe IS can be summarised by the following chain of events:
r↑→I↓→E↓→Y↓
The IS curve alone cannot be used to analyse sequences of events in the economy. It summarises only one part
ofthe economy, i.e. relationships and changes inthe real sector. The addition of LM curve is necessary to
incorporate monetary effect and to complete the model.
▪ Diagrammatically: to determine the actual equilibrium point and value of Y, a specific point among the
series of potential equilibrium points on the IS curve must be selected. This will depend on the LM curve.

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Formal rule for shifting vs moving along a curve

The shifting of the two curves is the most important aspect of the IS – LM model for rudimentary analysis
and reasoning about economic events. It is essential to master this part of the theory.
• A curve shifts if a relevant variable not on one of the axes ofthe diagram changes.
• If one ofthe variable on the axes changes, there is a movement along the curve.

The sequence starting with an interest rate change illustrates an important characteristic ofthe IS curve. ▪
If the interest changes, the change in Y from one equilibrium to the next is depicted as a move along the
IS curve form one point to another.

Figure 2.7 Derivation of the LM curve (Source: Fourie, 2015)

The following chain of events explains the derivation of the LM Curve:
Y↑→MD↑→r↑
Whereas the IS curve summarises economic relationships and equilbria in the real sector of the economy,
the LM curve summarizes relationships an equilibria in the monetary sector. More specifically, the LM
curve summarises the money market derived in the first section of this chapter.
The LM curve shows combinations of the interest rate (i) and real income (Y) that are consistent with
equilibrium in the money market. The LM curve is derived directly from the money market diagram.
The essential linkage between the money market and real income lies in the demand for money
relationship MD:
MD = f (i; Y; P; expectations)
-++
Money demand and money supply together determine the equilibrium interest rate in the money market.
For a given money supply Ms, each different MD curve would imply a different equilibrium interest rate.
To derive this in the diagram, do the following:

• The starting point for this derivation is an equilibrium in the money market, for a given
money supply, this shows an equilibrium interest rate which is compatible with the prevailing
position of MD, which in turn depends on the prevailing level of Y.
• Suppose Y isat adifferent, higher level. This would imply a higher level of MD, or a position
more to the right.

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In general, each equilibrium level of the interest rate i has a specific, corresponding income level Y as its
counterpart. Stated differently, each point of equilibrium in the monetary sector has two sides: a specific
level of i and a corresponding level of Y.

• In this way one can derive, from the money market diagram and the 45° diagram, many such
pairings of Y and i that satisfy the conditions for equilibrium in the money market (monetary sector).
• Ifthese (Y; i) pairs are plotted on a diagram with these two variables onthe axes the result
is the LM curve.

Formally, the LM curve can be defined as follows:

The LM curve shows all combinations of real income Y and the interest rate i that are consistent with the
conditions for equilibrium in the monetary sector, for agiven, constant money supply.
The LM curve as asummary curve
Whereas the money market diagram can be used to analyse the relationship between the money market
and real income, the LM curve is a handy, concise summary curve which depicts the string of points along
which the money market can settle following a change in real income Y.
Properties of the LM curve
Moving along the LM curve, shifting the LM curve
If Y changes, the change in i from one equilibrium to the next is depicted as a move along the LM curve.
A shift in the LM curve would occur if the equilibrium interest rate were to change for a reason other than
a change in Y.

Three factors can shift the LM curve: changes in the price P, an exogenous increase in the demand for
money MD, and a change in the money supply Ms.
1. Suppose the price level increases
2. Suppose the demand for money increases
3. Suppose the money supply is increased.
To summarise
• If the money supply is increased, it will shift the LM curve to the right. If the money supply
contracts, it will shift the LM curve to the left.
• Ifthe price level increases, the LM curve shifts up (left). Ifthe price level decreases, the LM
curve shifts down (right).
• If money demand increases for an exogenous reason the LM curve shifts up/left. If it
decreases for some reason, the LM curve shifts down/right.
IS and LM together: simultaneous equilibrium in the real and monetary sectors
Shifts in either curve would lead to a new equilibrium level of GDP and the interest rate. Graphically, this
new equilibrium was to be found at the intersection point of the two curves.
It was noted that the intersection between the two curves isthe only point among the two sets of potential
equilibrium points (denoted by the two curves) that produces equilibrium in both sectors. The question is why
the economy would be at, orwould gravitate to, the point of intersection or simultaneous equilibrium. The
reason is that at any point otherthan the intersection; forces would exist that would push the economy
towards the intersection.

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5.2.7. THE ‘LIQUIDITY TRAP’

An extreme case is that a completely horizontal LM curve. In such a case a monetary stimulus would have
no effect whatsoever on income or the interest rate. All extra liquidity would be absorbed (‘trapped’) in
portfolios without any impact on interest rates – there is an infinite demand for money (a horizontal MD curve).
Ifthis situation were to occur, monetary policy would be entirely impotent. (In the 1940s and 1950s
some economists believed that this condition prevailed at low interest rates.
A liquidity trap is characterised by:
• a. Extremely low levels of interest rates
• b. The low levels of interest rates is consist with extremely high prices of bonds
• c. Financial market participants have an infinitely high preference for money over bonds, such that
any changes in the rates of interest do not affect the quantity of money demanded in the
economy.
• d. Monetary policy is impotent (ineffective, useless or bears no outcome)
There is a consensus among renowned economists such as Krugman (2015), and reports among a number
of papers by Vonstâncio (2015) and (Minerd, 2016) to name afew, that Europe iscurrently under a liquidity
trap. This is evidenced by the extremely low levels of interest rates and impotence of monetary policy in
Europe.
This led to the introduction of quantitative easing, in Europe and Japan.
The opposite extreme, equally odd, is the case of a vertical LM curve. Any monetary stimulus would have
a maximum impact on real income. Therefore, monetary policy would be very potent in stimulating the
economy.
The vertical LM curve is called the Classical case, mainly because it seems to suggest preference for
monetary policy rather than fiscal policy.
The slope ofthe IS curve is also relevant. The impact of a given monetary policy stimulus on real income is
larger if the IS curve is somewhat flatter. This is especially true when:
• The interest elasticity of investment is high – investment will react strongly to the policy-
induced drop in interest rates;
• The expenditure multiplier is large – the increase in investment has a strong multiplier
effect on real income Y.

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Case Study: The global liquidity trap turns more treacherous

For the first time since the Great Depression, the world is in a global liquidity trap. The
unintended consequence of many central banks pushing negative interest rate policy is
conjuring deflationary headwinds, stronger currencies, and slower growth — the exact
opposite of what struggling economies need. But when monetary policy is the only game in
town, negative rates are likely to beget even more negative rates, creating a perverse cycle
with important implications for investors.

When central banks reduce policy rates, their objective is to stimulate growth. Lower rates
are designed to spur savers to spend, redirect capital into higher-return (ie riskier)
investments, and drive down borrowing costs for businesses and consumers.

Additionally, lower real interest rates are associated with a weaker currency, which
stimulates growth by making exports more competitive. In short, central banks reduce
borrowing costs to kindle reflationary behaviour that helps growth. But does this work
when monetary policy is driven through the proverbial looking glass of negative rates?

There is a strong argument that when rates go negative it squeezes the speed at which
money circulates through the economy, commonly referred to by economists as the
velocity of money.

We are already seeing this happen in Japan where citizens are clamouring for 10,000-yen
bills (and home safes to store them in). People are taking their money out of the banking
system to stuff it under their metaphorical mattresses. This may sound extreme, but
whether paper money is stashed in home safes or moved into transaction substitutes or
other stores of value like gold, the point is it’s not circulating in the economy.

The empirical data support this view — the velocity of money has declined precipitously as
policymakers have moved aggressively to reduce rates.

A decline in the velocity of money increases deflationary pressure. Each dollar (or yen or
euro) generates less and less economic activity, so policymakers must pump more money
intothe system to generate growth.

As consumers watch prices decline, they defer purchases, reducing consumption and
slowing growth. Deflation also lifts real interest rates, which drives currency values higher.
In today’s mercantilist, beggar-thy-neighbour world of global trade, a strong currency is a
headwind to exports.

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Obviously, this is not the desired outcome of policymakers. But as central banks grasp for
new, stimulative tools, they end up pushing on an ever-lengthening piece of string. The Bank
of Japan and the European Central Bank are already executing massive quantitative easing
programmes, but as their balance sheets expand, assets available to purchase shrink.

The BoJ now buys virtually all ofthe Japanese government bonds that are issued every year,
and has resorted to buying exchange traded funds to expand its balance sheet.

The ECB continues to grow the definition of assets that qualify for purchase as sovereign debt
alone cannot satisfy its appetite for QE. As options for further QE diminish, negative rates
have become the shiny new tool kit of monetary policy orthodoxy.

It would not be a surprise to see the overnight rates in Europe and Japan go to negative 1 per
cent or lower, which will in turn pull down other rates along their respective yield curves.

Negative rates at these levels would make US Treasuries much more attractive on a relative
basis, driving yields even lower than they are today.

If the European overnight rate were cut to minus 1 per cent from its current level of negative
40 basis points, German 10-year Bunds would be dragged into negative territory and we
could see 10-year Treasuries yielding 1 per cent or less.

This experiment with negative interest rates on a global scale is unprecedented. While there
may not yet be enough data to draw the final conclusion about the efficacy of negative
interest rate regimes, I have little confidence this will work.

Monetary policy primarily addresses cyclical economic problems, not structural ones. Fiscal
and regulatory policies are doing little to support growth and in most cases are restraining it.
Combined with negative interest rates, the current policy prescriptions are a perilous mix
that is deepening the global liquidity trap.

Questions

1. From the case study above, identify the characteristics that are consistent with a liquidity
trap in Europe.

2. What is quantitative easing, and discuss how is it implemented in Europe

3. Explain the effect of the liquidity trap in Europe on the South African economy?

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5.2.8. SELF-ASSESSMENT

Answer the following questions to check whether you have achieved all the set outcomes:
1. What is the repo rate and how high is it in this moment?
2. How does the existence of monetary feedback effects affect the size of the expenditure multiplier?
3. What are the factors that affect money demand?
4. Define the following;
• Treasury bill
• NCDs
• BAs
5. Use the IS-LM models to demonstrate the following;
(a) Suppose taxes are increased

(b) Suppose the cash reserve requirement is increased.

(c) Suppose exports are increased

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5.3. UNIT 3: BASIC MODEL III: THE FOREIGN SECTOR

By the end of this unit, you will be able to:
• Be able to explain the main foreign economic links,
international trade in goods and services (i.e. imports and exports), and
• The relationship between foreign interest rates, the price of
gold and the value of the rand
• Foreign investment and lending (international capital flows) and
their impact on the national economy
Specific Learning
• Understand the role and importance of the balance of
Outcomes payments, the current account, the financial or capital account and
foreign reserves.
• Understand movements in exchange rates, including the
practical, everyday determination of these rates in foreign exchange
markets.

It will take you 15 hours to make your way through this unit.
Time

5.3.1. INTRODUCTION
Is South Africa better off isolated or integrated with the rest of the international market? If its borders are
sealed off from the movement of goods, services and factors of production, will she perform better off?
The answer is adefinite No! South Africa does not have everything – petroleum, for example. Inthis study,
we present a brief debate concerning the understanding ofthe Basic Model III: The Foreign Sector.

5.3.2. BACKGROUND: WHY TRADE INTERNATIONALLY?

The prime reason for engaging in international trade is explained by differences in resource endowments
and differences in prices among different countries. South Africa’s main trading partners, outside Africa
are Germany, China, USA, UK, India and Saudi Arabia (CIA, 2017). Within Africa, South Africa’s main trading
partners are Botswana, Namibia, Mozambique, Zambia and Zimbabwe (StatsSA, 2016).

5.3.3. IMPORTS, EXPORTS AND CAPITAL FLOWS

As indicated in study unit 1, imports and exports are important for the macro economy since they impact
directly on total expenditure.
Exports (X) imply an injection of expenditure (by foreigners) into the domestic expenditure flow,
and imports (M) imply a leakage from the expenditure flow to the rest of the world.
Net exports (X – M) – the net injection – are a direct component of total expenditure = C + I +G +
(X – M).

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Imports (M)
Imports concern the purchase of foreign products (both consumer goods and capital goods). The major
share of South African imports comprises machinery and capital items; oil is also an important item.
Expenditure on imports by all participants is included: households, business enterprises, the government
sector, parastatal institutions, etc.
Which factors determine imports?

M = f (YDSA; PSA/PForeign; rand; …)

+ + +
A part of import expenditure involves the purchase of imported consumer goods. Therefore, like
consumption (C), it depends positively on disposable income (YD) and thus on total income (Y).
This suggests the concept of marginal import propensity (m) (defined as . . .?). One can write the import
function as:

M = ma + mY + . . .

A second factor influencing the decision to import is the price of imported goods relative to the price of
locally produced goods.
The exchange rate is a third important factor determining imports. This follows from the fact that the
exchange rate determines the price of an imported product in South African rands.
The M function can be depicted in the 45° income-expenditure diagram as a positively sloped line/curve.
If Y increases, the ensuing increase in M will be apparent as a move along the M curve. Changes in
determinants such as the price ratio or the exchange rate imply shifts in the import line. The same applies to
trade policies, e.g. import sanctions.
The import function

Figure 3.1 Import Function (Source: Fourie, 2015)

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Exports (X)
The explanation of exports is relatively simple, since South African exports are actually imports by other
countries from South Africa. Accordingly, South African exports are determined by factors similar to those
concerning imports.
Which factors determine exports?
Exports depend not only on foreign income levels (Yforeign), but also on the rice ratio (terms
of trade) and the exchange rate. Thus:
PsA ; rand; …)
X = f (Yforeign; PForeign

Capital flows
Capital inflows are all inflows of foreign funds for the purpose of fixed investment (in fixed assets), as well
as financial investment (for the purchase of financial assets). Capital inflows include foreign loans by either
the private sector or the public sector (e.g. for infrastructural projects or for financing a budget deficit).

Which factors determine capital inflows?

Capital flows across international borders because capital owners are seeking the highest possible rates of return
on investments (real or financial). Therefore the main factors that determine the inflow of capital into a
country are relative interest rates (on financial investments), relative rates of return (on real investment),
the exchange rate, ³ and economic and political expectations. Accordingly:
K-inflow=f (Foreign SAP P ; relative SA rates of return; rand; expectations)
+ + - ?
How doforeignflows affect the economy?
The analysis of the short-term macroeconomic impact of foreign capital inflows is quite complex. To
understand this, one must clearly distinguish between possible real and monetary effects.
Interest rates in SA are always higher than that of developed countries but capital does not always flow into
SA because investors look at real interest rates and other factors such as political stability and the macro-
economic outlook.

5.3.4. THE BALANCE OF PAYMENTS AND EXCHANGE RATES

The balance of payment (BoP)
The balance of payments (BoP) is an accounting record of a country’s involvements in international trade
(exports and imports) and international capital flows. The former category of transactions is indicated on
the current account of the balance of payments and the latter on the financial (or capital) account.
In accounting terms the balance of payments (BoP) is the sum ofthe balances on the current and financial
accounts:
BoP = Current account balance + Financial account balance

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What determines the balance of payments position?

The BoP position depends on all the factors that determine the flow of goods and capital: domestic and
foreign income levels, interest rates, rates of return, borrowing activities, price levels and exchange rates,
as well as expectations, perceptions of risk, political events, and so forth. A change in one or more of these
factors simply has to be translated into a subsequent change in imports, exports or capital inflow. From
this flows the net impact on the BoP.

Chain reaction example:

Suppose YForeign increases → XSA increases→ current account improves BoP→ improves (a
surplus develops or the deficit shrinks).

What are the consequences of a BoP disequilibrium?

A surplus on the balance of payments (BoP>0) implies a net inflow of payments (for whatever purpose). A
deficit (BoP<0) implies a net outflow of funds, i.e. outflows exceed inflows (in a given period).
The BoP has a direct impact on three key variables:
1. The foreign reserves;
2. The money supply (monetary liquidity), and
3. The exchange rate.
Impact onforeign reserves
A surplus on the BOP will boost foreign currency reserves, since there is a net inflow of foreign currency.
Likewise, a BOP deficit will create a net outflow of foreign currency leading to a depletion of foreign
currency reserves.

Impact on money supply

A BOP surplus creates an increase in money supply whereas a BOP deficit will cause
money supply to drop.

Impact on the exchange rate

When there is a BOP surplus, the South African rand will tend to appreciate in value and when the BOP is
in a deficit position, the South African rand will depreciate against world currencies.

Exchange rates
What is the exchange rate?
An exchange rate is the price of one currency in terms of another, e.g. $1 = R7,00 or ₤1 = R10,00. This is
also called the nominal exchange rate.

Where and by whom are exchange rates determined?

As with interest rates, exchange rates are not fixed or set by law or decree by some or other authority or
governmental body – and specifically not by the Reserve Bank. Exchange rates are determined, on a daily basis,
in the so-called foreign exchange (‘forex’) market. (Foreign exchange = currencies of other countries.)

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Which factors determine exchange rate movements?

The inflow and outflow offunds – either for import and export payments or for capital flows)
– determines the intensity and extent of forex buying and selling transactions, i.e. the demand and supply
for foreign exchange.
Each outflow of funds from the country implies a demand for foreign exchange -which is mirrored
by an exactly equivalent supply of rands.
Each inflow offunds into South Africa implies ademand for rands (i.e. asupply offoreign currency).
If the inflow exceeds the outflow of funds, there is an excess demand for rands. That should
translate into upward pressure on the external value of the rand.
• Likewise, a net outflow offunds leads to an excess supply of rands onforex markets, and downward
pressure on the rand.

Inflation differentials
In some of the examples above it was demonstrated that, if South African inflation is higher than that in
other countries (especially its main trading partners), it would discourage exports and encourage imports.
International competitiveness ornon-competitiveness
This is another important factor determining trade patterns and therefore the current account.
Competitiveness depends on factors as productivity, input cost tendencies, labour force skills, innovative
management and marketing, technological developments, natural resources development, human
development, and so on.
The BoP and exchange rates: a restatement and summary
The basic linkages between internal economic variables and different external sector variables are complex
but fascinating, and can be summarised as follows:

• The exchange rate is determined by the net inflow or outflow of funds. Thus the BoP position is a
decisive factor. In turn the BoP position is determined (caused) by changes in exports and imports
(current account) and in capital inflows (financial account).
• The current account (X-M) influences total expenditure (C + I + G + X – M) – and thus also
production GDP and Y – directly.
• The financial account on its own has no direct short-term effect on expenditure.
• In other words, the real sector is influenced, in the first instance, by the current account, since it
affects expenditure directly.
• The monetary sector is influenced by the current account and financial accounts together, i.e. by the
BoP, and not by the financial account as such. (Of course, this effect on the monetary sector will
subsequently impact on the real sector.)

5.3.5. THE BOP ADJUSTMENT PROCESS

The crux of the idea of a BoP adjustment process is that a BoP disequilibrium activates forces that tend to
eliminate the disequilibrium. These forces operate via the above-mentioned effects of the BoP on the
money supply and the exchange rate. Suppose there is a BoP surplus (BoP>0). One can then expect the
followingtwo adjustments effects:
1. Short-term effect: via the money supply (while the exchange rate still is relatively passive or rigid).
2. Medium-term effect: via the exchange rate (when the exchange rate starts to adjust).
BOP>0 – (i) inflow of foreign exchange→Ms↑→i↓→I↑→E↑→Y↑→M↑→Current Account↓

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(ii) inflow of foreign exchange→excess demand for rand→rand↑→X↓and M↑→ current

account↓ Both effects will cause the current account to deteriorate. Hence they will reduce the
BoP surplus.
Bothe these adjustments effects will continue as long as BoP ≠0, and hence continues to push the BoP
towards equilibrium. When and if BoP equilibrium is reached, the process stops.
In practice, the process will seldom reach equilibrium so smoothly, moreover, it rarely happens that the
adjustment process proceeds uninterrupted to the end. New disturbances may interfere. What is
important, is the basic direction of the adjustment effects via the money supply and the exchange rate.

5.3.6. THE COMPLETE MODEL: THE BOP, THE EXCHANGE RATE AND THE
DOMESTIC ECONOMY
Our model has been developed sufficiently to analyse the expected consequences of any internal or external
disturbance (as reflected in changes in foreign trade or in capital flows). It is illustrated with some examples,
followed by an exposition of a general method.
At the same time, we consider the impact of the exchange rate and BoP adjustment on the effectiveness
of fiscal and monetary policy steps.
• Monetary policy steps: consequences and effectiveness
• Fiscal policy steps: consequences and effectiveness
• External disturbances
• Analysing internal and external disturbances: a general method
• Chain reactions in reverse: the likely causes of events
• Thirteen open economy puzzles

5.3.7. CONFLICT BETWEEN INTERNAL AND EXTERNAL CONSIDERATIONS

The previous discussion demonstrates the existence of important linkage between the internal economic
variables (e.g. interest rates, GDP, unemployment, the budget deficit) and external variables (e.g. the
exchange rate, the BoP). It is important to note that desirable changes in internal variables do not
necessarily augur wellfor external variables – and vice versa. For example, whereas high interest rates may
be ‘good’ for the capital account and foreign reserves, they are detrimental to investment (and home-
owners, due to high bond rates).

5.3.8. THE IS-LM MODEL AS AN ALTERNATIVE DIAGRAMMATICAL AID

The IS curve in the open economy
For the open-economy IS curve, aggregate expenditure must be defined to include net exports (X-M).
Actually this is how the IS curve was defined and derived previous. Hence we do not have to add anything
to that analysis. However, it is useful to highlight certain open-economy aspects of the IS curve.
Shifts ofthe IS curve
Changes in exports or imports caused by factors other than Y or i– e.g. changes in exchange rates orforeign
economic conditions – would shift the IS curve.

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The LM curve in the open economy

The LM curve was defined in the previous chapter in terms of aggregate monetary demand and aggregate
money supply (liquidity) in the economy. That derivation allowed for foreign sector influences in the
monetary sphere. It is worth highlighting some of these.
The slope of the LM curve, which depends mainly on the domestic demand for money, is not markedly
different in an open economy.
Using the model for an open economy: disturbances and policy effectiveness
The consequences of three types of disturbances were analysed: a monetary policy step, a fiscal policy
step, and an increase in exports. It is worth revisiting those examples in terms of the IS-LM model for an
open economy. Whilst this will necessarily be fairly mechanical, it adds significantly to our understanding
of the processes, notably the BoP adjustment process.

5.3.9. THE IS-LM-BP MODEL

The main external sector results have now been analysed in two frameworks: the simple, largely intuitive,
Keynesian 45° model, and the more formalised IS-LM model. The final step inthis progression is the IS-LM-
BP model, in which another curve – the BP curve (or BoP curve) – is added to the IS and LM curves. This
section redoes much of the material in this technically more sophisticated framework, therefore it can be
treated as optional.

Figure 3.2 IS-LM-BP Model

The BP curve shows all combinations of real income Y and the interest rate r that are consistent with the
conditions for BOP equilibrium.
• What does the BP curve add?
• Using the IS-LM-BP model: the basics
• A complete example: a disturbance followed by a BoP adjustment
• The formal derivation ofthe BP curve
• Formal properties of the BP curve.

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5.3.10. SELF-ASSESSMENT

1. What isthe likely effect of high South African inflation (relative to its main trading partners)
on the external value ofthe rand?

2. What does BP curve add?

3. Discuss the difference between depreciation and devaluation.
4. What is the difference between appreciation and revaluation?

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5.4. UNIT 4: NATIONAL ACCOUNTING IDENTITIES AND

MACROECONOMIC ANALYSIS: USES & ABUSES
By the end of this unit, you will be able to:
• Understand the System of National Accounts (SNS) and the
different sub-accounts;
• Be able to analyse the different national accounting identities;
Specific Learning
Outcomes • Know how these can be used, not only to measure the
economy, but as an analytical tool to better understand the way an
economy works;
• Be able to apply the macroeconomic constraints implied by
these identities
It will take you 15 hours to make your way through this unit.
Time

5.4.1. INTRODUCTION
The system of National Accounts (or SNA) is the primary date system in macroeconomics. It was developed
by the United Nations to promote and standardise systematic economic measurements. The system
prescribes, firstly, the correct methods to collect, measure and process the data. It is the basic
measurement system for macroeconomics in a country.
Secondly, it offers a complete system of definitions of macroeconomic aggregates/variables such as
consumption, investment, imports and exports – the well-known variables encountered in microeconomic
theory and in the circular flow. The definitions are very important once one starts working with published
figures. Thirdly, it offers an accounting framework within which all these figures can be placed to provide
and ensure a consistent set of data. In this study we present a brief debate concerning the understanding
of National Accounting Identities: Uses & Abuses.

5.4.2. FROM EQUILIBRIUM CONDITIONS TO IDENTITIES

Aggregate Planned Expenditure > Production→Change in Inventories is negative (I↓)
C + I + G + (X – M) > Y→Inventory investment figure is negative
OR
C + I + G + (X – M) < Y →Inventory investment figure is positive
Both these inequalities can be changes into equalities by adding the inventory investment Ii to the left-
hand side of the expression:
C + I + G + (X – M) + Ii = Y
OR
C + (I + Ii) + G + (X – M) = Y
OR
C + I* + G + (X – M) =Y … (1)

Where I* denotes investment redefined to include unplanned inventory investment.

This I* constitutes gross domestic investment (fixed and non-fixed).

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• Recall from chapter 1 that published national accounts data include government
investments in domestic investment. The latter is not a part of G.
• In addition, G is only the consumption expenditure of government, not all current
expenditure.
A more complete version of the national income identity, which corresponds to published tables, also shows
‘net current transfers received from the rest of the world’ (TR):
C + I* + G + (X + TR – M) =Y + TR … (1a)

5.4.3. THE INTERPRETATION OF IDENTITIES USES AND ABUSES

The national income identity can be interpreted in several important ways. With some simple
mathematical manipulation it can also be converted into different formats, which provide yet more
insights.
Broadly speaking, the meaning of these identities is that they indicate certain accounting constraints on
macroeconomic variables – as defined and measured in the system of national accounts. All changes in
variables that occur in the course of a macroeconomic chain reaction must and always will ‘obey’ these
identities.

5.4.4. EXPENDITURE, PRODUCTION AND CURRENT ACCOUNT DEFICITS

One can rewrite the complete, open economy national income identity as
(X +TR – M) = Y + TR – (C + I* + G) …(2)
This form of the identity has a very powerful interpretation. It shows that the extent to which aggregate
national expenditure (GDE =C + I* + G) exceeds aggregate national production (GNP) is directly and
identically reflected in net exports, and therefore in the current account (X + TR – M). Leaving aside the
complication of net international transfers (TR), one can state the following:
• A current account surplus means that GDE is less than total national income or GNP.
• A current account deficit means that GDE exceeds total national income or GNP.
OR
• If GDE is less than total national income or GNP, it implies a current account surplus.
• If GDE is exceeds total national income or GNP, it implies a current account deficit.

Therefore, an external disequilibrium (current account deficit or surplus) always has an internal
macroeconomic counterpart (production is < or > expenditure). Therefore, the removal of a current
account disequilibrium must always include the restoration of internal balance between expenditure and
production (income). Likewise, restoring internal equilibrium between expenditure and production always
will and must reflect in the establishment of external (current account) equilibrium.

5.4.5. THE SECTORAL BALANCE IDENTITIES

Let T = current revenue of government, i.e. taxes and other revenue. Ifone adds and immediately subtracts
T on the right-hand side of equation (2) it produces:
(X +TR – M) = (Y + TR – T) - (C + I* + G - T) …(3)
Moving terms around produces:
(Y + TR – T) = C + I* + (G - T) + (X +TR – M) …(4)
Since Y + TR – T = disposable income (YD) of residents, the following can be derived with some substitution
of terms:

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YD = C + I* + (G - T) + (X + TR – M) …(5)
Furthermore, savings is that part of the disposable income that is not spent on consumption: S = YD – C,
hence YD = S + C. Substituting this in equation 5, whilst collecting terms, produces:
(S - I*) + (T – G) = (X + TR – M) … (6)

5.4.6. SELF-ASSESSMENT

Answer the following questions to check whether you have achieved all the set outcomes:
1. Differentiate between domestic and national measures
2. What is value added?
3. What is the relationship between GDE and the current account position?
4. Given that (T- G) ≡ (I –S) + (X +TR – M), what could be the implications of a fiscal deficit?

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5.5. UNIT 5: A MODEL FOR AN INFLATIONARY ECONOMY: AGGREGATE

DEMAND & SUPPLY
By the end of this unit, you will be able to:
• Have reviewed the basics of the aggregate demand (AD) and
aggregate supply (AS) model, including the way these two
relationships interact to determine real GDP and the average price
level;
Specific Learning • Understand the aggregate supply adjustment process towards
Outcomes a long-run AS curve, as well as the role of structural unemployment in
determining the position of this long-run equilibrium; and
• Be able to situate real, monetary and foreign sector
relationships inthe context of an economy with achanging price level,
and to develop complex chain reactions which include effects on the
price level

It will take you 15 hours to make your way through this unit.
Time

5.5.1. INTRODUCTION
In study units 1 to 4, we studied functioning of real as well as financial markets. In these markets, there is
one variable that was rarely mentioned – price. The original and relatively simple Keynesian model paid scant
attention to the average price level and inflation – the price level was assumed to remain constant. The focus
was on real income and unemployment.
The reason for this is that Keynesian theory (and macroeconomic theory as such) was developed in
response to high and sustained unemployment during the Great Depression.
The experience of the 1970s, with high or rising inflation occurring simultaneously with high or rising
unemployment (i.e. stagflation), placed a serious question mark over the traditional Keynesian theory. As
a result, it was adapted in order to try to find an explanation for the phenomenon ofstagflation. And hence
the study of the AD-AS model.

5.5.2. ESSENTIALS OF THE AD-AS MODEL

The AD-AS model is a powerful analytical tool to focus on the price level, whilst retaining the important focus
on real income Y. The basic purpose of the aggregate demand-and-supply model is to recast the analysis
ofthe real and monetary sectors in one diagram that explicitly isolates the average price level P as a variable
on one axis. Real income Y appears on the other axis.
The AD-AS model therefore summarises the traditional theory in one diagram. However, it also expands
thattheory to incorporate the explanation ofthe average price level, thereby overcoming one ofthe major
weaknesses ofthe traditional Keynesian model in an inflationarycontext.

In essence, the entire of the traditional ‘demand-side’ model – the 45° diagram threesome (or the IS-LM
diagram) – is collapsed into one curve, the aggregate demand (AD) curve. The AD curve has a negative
slope, as shown in the diagram below. Together the AS and AD curves simultaneously determine the
equilibrium levels of real income Y and the average price level P. this equilibrium is at the intersection of
the two curves.

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5.5.3. AGGREGATE DEMAND (AD)

Aggregate demand depicts the total quantity of goods and services demanded in the economy at each
price level. In other words, it shows all quantities of real income and average price level consistent with
real and monetary sectors equilibrium.
Derivation of the AD Curve
a) Derivation from the Real Sector b). Derivation from the IS/LM Model

Figure 5.1 Derivation of the AD Curve (Source: Fourie, 2015)

Derivation from the Real Sector
Assume a given level of price level (P0) and national income (Y0). This is consistent with equilibrium level
0. Assuming an increase in prices to P1, this results in higher rates of inflation. Increase in inflation
increases speculation atthe expense of investment and
a) Derivation from the Real Sector
b) Derivation from the IS/LM Model

In turn, consumption and investment spending decreases in the economy. This consequently results in
lower total expenditure, hence downward shift of total expenditure curve. Level of output and income
decreases to Y1.
Derivation from the IS-LM Model

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The following chain explains the derivation ofthe AD curve:

P↓→M/P↓→i↑→I↓→E↓→Y↓

5.5.4. SLOPE OF THE AGGREGATE DEMAND CURVE

AD is negatively sloped, depicting an inverse relationship between national income and the price level.
This relationship is due to;
a) The interest rate effect: High prices will drop real money supply, which will increase interest
rates, reducing investment and total expenditure.
b) The wealth effect: Higher price level reduces the value of assets, making consumers feel poorer
and hence reduce expenditure.
c) The foreign trade effect: The higher the relative price, the lower the amount of exports and
hence reduced aggregate expenditure.
d) The tax effect: Inflationary times (higher prices) leads to more bargains which push consumers
into higher tax brackets (bracket creeping), reducing their levels of expenditure.

5.5.5. SHIFT OF THE AD CURVE

It is essential for you to be able to distinguish clearly between a movement along the AD curve and a shift
of the AD curve. A movement along the AD curve is caused by a change in the price level, while a shift in
the AD curve is caused by a change in any of the autonomous (or exogenous) variables, such as taxes,
government spending or the nominal money supply. Remember that exogenous variables include factors
such as autonomous consumption and autonomous investment.

Movement along Rightward shift Leftward shift

a change in the price level (Δ in increase in autonomous decrease in autonomous

P) government spending (G) government spending (G)

P↑: upwards decrease in autonomous increase in autonomous

taxation (T) taxation (T)

P↓: downwards increase in the nominal money decrease in the nominal money
supply (M) supply (M)

Table 5.1 Shift of the AD

5.5.6. AGGREGATE SUPPLY (AS)

The AS curve shows, for each price level P, the aggregate level of real output that producers are willing or
able to supply.
As will be explained below, the AS curve can be interpreted as a set of attainable combinations of P and
Y, given supply-side conditions.

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Factors determining aggregate supply

The theory of aggregate supply is much less developed that the theory of aggregate demand, and there
still are many unresolved problems. Nevertheless, one can gain a reasonable idea of a possible aggregate
supply relationship. The factors determining, in the aggregate, an ability and/or willingness to produce
output actually are quite obvious:
• Aggregate labour force (population growth)
• Productivity of labour
• Labour skills levels
• Cost of labour (wages)
• Availability of raw materials
• Cost of raw materials
• Availability of capital goods
• Cost of capital goods
• Technology (productivity of capital goods)
• Cost of financial capital, i.e. interest rates, and
• The average price level (both actual and expected prices).
These factors are more or less similar to the factors of supply atthe micro-level as discussed in micro-
economics.

5.5.7. DERIVATION OF THE AS – THE LABOUR MARKET

It is important to establish how producers arrive atthe output they are willing to supply in both the
short-run and the long-run period. It is known that producers profit motivated hence the need to
understand the relationship between the production costs and the selling price.
Price setting
()
(1)
QN
W

P ,Where P=Price, μ=mark up, W=wage level, Q=labour productivity and

N= employment rate.
• When W is higher, then per unit production cost is higher, leading to a higher price P.
• Higher labour productivity (Q) will reduce per unit production cost which should
• cause price P to fall.
• In cases where producers have more market power, then the mark-up (μ) will be higher
or if non-labour input costs are higher or if corporate tax is higher, leadingto a higher price.
Wage setting
Wages are not only determined by pure forces of demand and supply but also by labour
unions, monopolistic behaviour and government minimum wage laws.
Wage setting ) ; ( . ZNf PW e
All the factors have a direct relationship with the wage rate, any increase in these factors will push the
wage rate up.

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Where W is the nominal wage, Pe is the expected price level, N is the employment level and Z represents
institutional factors.

• A higher level of employment N means employers will compete for skills leading to higher
wages. If employment levels are low, labour competes for jobs and employers will get labour at a
bargain.
• Expected price level is an indicator ofthe cost of living. High cost of living will lead to
bargains for higher nominal wages.
• Institutional factors comprise labour unions, employer organisations, efficient wages and
minimum wage legislation
• Expected price levels and aggregate supply have a negative relationship. Why?

5.5.8. AGGREGATE DEMAND AND SUPPLY TOGETHER: MACROECONOMIC

EQUILIBRIUM

Figure 5.2 Short-Run Equilibrium

macroeconomic equilibrium is reached at a point where AD intersects with the AS. Economically
speaking, this is the point where aggregate expenditure in the economy is equal to aggregate production
of goods and services.

5.5.9. USE OF STABILISATION POLICIES ON THE AD-AS MODEL

Should the authorities adjust tools of monetary and fiscal policy, it influences the aggregate demand of
goods in the economy. The AD curve shifts. For instances, suppose there is high unemployment in the
economy, the government may increase government spending through engaging in public spending
policies. This results in an increase in aggregate demand for goods. The AD shifts to the right. The level of
output and income will consequently rise. An increase in the level of output and production results in an
increase transactionary demand for money. Demand for money increase. This culminates into higher
rates of interest.
However, the increase in the level of output and income results in an increase in employment, and a
reduction in unemployment. A decrease in unemployment increases the bargaining power of workers,
and they will rally for a nominal wage increase. Faced with higher nominal wage bills, firms will cushion
this through an increase in the prices.
Can this theory explain the course of the South African economy?

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The Keynesian framework developed in these chapters can be used to try to explain different observed
patterns in the macro-economy. While this largely constitutes ‘enlightened guesswork’ in hindsight, one
can attempt to explain the course of the average price level P and real GDP (Y) in the South African
economy over the last decades.

5.5.10. SELF-ASSESSMENT
Answer the following questions to check whether you have achieved all the set outcomes:
1. What is the shape of the AS curve?
2. Explain three types of employment
3. What are efficient wages?
4. List the factors that determine wage setting.
5. What institutional factors exist in determining the wage rate.

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5.6. STUDY UNIT 6: MONETARY POLICY: THE ROLE OF THE RESERVE BANK
By the end of this unit, you will be able to:
• Know the main instruments of monetary policy, and
understand their impact on the economy;
• Be able to analyse the policy choices that the Reserve Bank has
to make in conducting monetary policy;
Specific Learning • Have a good intuitive grasp of the daily practice of monetary
Outcomes policy;
• Understand the role ofthe Reserve Bank with regard to public
debt, including its impact on fiscal policy;
• Appreciate the complexity of monetary policy in an open
economy, particularly for asmall economy such as that of South Africa.

It will take you 15 hours to make your way through this unit.
Time

5.6.1. INTRODUCTION
Monetary policy and fiscal policy are the two main components of macroeconomic policy. This chapter
considers the main features of monetary policy from a macroeconomic perspective. Monetary events and
variables (especially interest rates) are critically important for the business sector and for the state of the
economy. In particular, it is essential to understand, and to be able to evaluate, the policy steps of the
monetary authority (the Reserve Bank). Monetary policy documents can be accessed online onthe Reserve

Bank website:

5.6.2. DEFINITION AND INSTRUMENTS OF MONETARY POLICY

Monetary policy is defined as all deliberate steps of the monetary authority to affect monetary aggregates (the
money supply), the availability of credit, and interest rates in order to influence monetary demand, income,
production, prices and the balance of payments. In South Africa, the monetary authorities are the South African
Reserve Bank (SARB) and the National Treasury, with the Governor ofthe SARB and Minister of Finance as
the principal decision makers.

The basic monetary policy instruments

The cash reserve requirements (as well as liquid asset requirements); Banks are required to reserve 2.5%
of their clients’ deposits. If this rate is increased, then money supply will drop and a decrease in the
reserve ratio will increase money supply.

a) The bank rate/repo rate (as part of the Reserve Bank’s accommodation function): The central
bank uses the repo rate to show its intentions. The repo rate when increased cause banks to hold
excess reserves as a buffer. The impact will be to reduce money supply and increasing interest
rates causing a contraction to economic activities
b) Open market transactions: Involves the buying and selling of treasury bills in order to determine
the amount of liquidity in the market.
c) Direct measures, such as credit and interest rate ceilings, and moral suasion.
The macroeconomic impact of monetary policy instruments (summary)
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The theoretical analysis of the chain reactions following various monetary policy actions constitutes the core
of the theory of monetary policy (originally seen primarily as a tool of stabilisation policy). These
monetary policy steps have been encountered throughout chapter 2 to 5, and need not be repeated here.
It suffices to summarise the basic macroeconomic impact of monetary policy steps.

The cash reserve requirement

The bank rate (or repo rate)
Open market transactions.

5.6.3. MONETARY POLICY DESIGN: FIVE IMPORTANT CHOICES

Overarching policy objectives or mission
The mandate given to the central bank as specified by the constitution and the reserve bank Act is to defend
the value of the rand. Value of the rand can be defended by internally (inflation rate) and externally
(exchange rate). Defending the internal value of the rand is the primary objective of the monetary
authorities. This means that there is less attention on other macroeconomic matters such as income,
production, employment and the exchange rate. This created criticism from other sectors of the economy
which are ofthe view that unemployment isacrucial issue in South Africa and therefore requires attention.
If the reserve bank increases interest rates to control inflation, this will result in public debt ballooning.

Intermediate or final policy targets?

This relates to operational policy, whether to directly target inflation or focus on intermediate targets as
money stock and interest rate.

For inflation, final policy target will be stated as an inflation target range then interest rate and money stock
will be used to achieve the target.

Intermediate policy target- inflation target is stated and specific interest rate intervals and money stock is
stated.

1986 to 2000 – there was an official money supply targets (M3 was kept within guidelines)
In the year 2000, official inflation targeting was used – 3% to 6%.

Which intermediate policy variable: interest rates or the money stock?

The choice between the management of money stock or interest rate has to be made as the central bank
cannot manage both. An attempt to fix both will distort money market equilibrium creating arbitrage
opportunities for the emergence ofthe black market leading to financial disintermediation.

Which specific target values?

A choice of specific quantitative targets or guidelines is required for the chosen variable. For inflation
targeting, South Africa considered comparative inflation rates from its major trading partners. The rational
is that there is an inverse relationship between a country’s inflation rate and the level competitiveness of its
exports.

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5.6.4. INFLATION TARGETING IN SOUTH AFRICA

South Africa formally introduced inflation targeting in February 2000, after announcing the intention to
adopt the framework in August 1999. Prior to adopting the inflation-targeting framework, the Bank had
adopted a number of frameworks. Between 1960 and 1998, these included exchange-rate targeting,
discretionary monetary policy, monetary-aggregate targeting and an eclectic approach.

Inflation targeting isa monetary policy framework in which the central bank announces an explicit inflation
target and implements policy to achieve this target directly. One of the features of an inflation-targeting
framework is the greater degree oftransparency it brings to monetary policy. South Africa targets inflation
rates between 3 and 6%.

Inflation targeting has been adopted in a number of countries. The choice of the target varies across
countries. Some countries have opted for target ranges in specifying their inflation targets, while others
prefer a point target or a point target combined with a range. The trade-off in this regard is essentially
between the simplicity of a point target and the degree of flexibility for absorbing shocks outside the
control of the authorities which atarget range allows.

It is acknowledged that monetary policy cannot contribute directly to economic growth and employment
creation in the long run. However, by creating a stable financial environment, monetary policy fulfils an
important precondition for the attainment of economic development.

5.6.5. THE PRACTICE OF MONETARY POLICY

Monitoring the monetary policy environment
Any central bank must keep awatchful eye on a number of macro-economic and monetary sector variables.
Depending on its policy approach, e.g. whether it has adopted inflation targeting or money supply
targeting, the priorities given to different indicators will be different. In South Africa the change to inflation
targeting in 2000 caused such a change in priorities. Nevertheless, the basic of monetary policy monitoring
is unaffected and can be described as follows:

Monetary liquidity: Is monitored on daily, weekly and monthly bases both inthe money and capital
markets. Open market operations are used to regulate the amount of liquidity in the market
through buying and selling of treasury bills.
The inflation rate: It is monitored on a monthly and quarterly bases
Monitoring external variables: The reserve bank monitors the exchange rate, the BOP position,
international economic trends, trading partners inflation rates.

The operational procedures of the Reserve Bank

Public debt management: The interface between financial markets and fiscal and monetary policy

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Public debt, or government borrowing, is a complex policy area with both monetary and fiscal dimensions.
The thorny issues concerning the total debt are discussed in the context of fiscal policy. Here we consider
only the monetary impact of public debt. This derives from the impact of the borrowing activities of
government on the financial markets.

Public debt management can be defined as follows:

The decisions and actions of the monetary and fiscal authorities to attain certain objectives with regard to
the magnitude, composition (according to type of debt instrument), term structure and ownership
structure of public debt.

The move of the Treasury to play a more active role in public debt management was related to an intrinsic
tension between fiscal, monetary and refinancing considerations in the marketing of government bonds.
These are:

A fiscal consideration
A monetary consideration
A refinancing consideration

5.6.6. EXCHANGE RATE POLICY AND THE PROBLEMS OF MONETARY

POLICY IN AN OPEN ECONOMY
The first and most important choice concerning exchange rate policy is the exchange rate system to be
followed.
Such a system entails that the Reserve Bank intervenes in the forex market to stabilise the
external value ofthe rand – especially to moderate undesirable short-run fluctuations. The
Reserve Bank cannot contain a depreciation tendency indefinitely.
Specific exchange rate targets are not used. Nevertheless, dirty floating implies that the Reserve
Bank must continually take a view on the most desirable level ofthe rand, and act accordingly.
First, the linkages between domestic monetary liquidity, interest rates and exchange rates imply
that these variables cannot be determined or manipulates independently. Their level must be
compatible.
A particular decision on interest rates and money supply growth necessarily implies a
corresponding impact on, for example, capital inflows, which will affect the exchange rate. The
monetary policy decision determined the exchange rate possibilities (undesirably large
depreciations of the currency are often ascribed to bad monetary policy).
On the other hand, if a particular exchange rate level isto be sustained, it implies a constraint on
the interest rate and money supply levels that can be maintained. The exchange rate decision
effectively determines monetary policy’s room for manoeuvre.

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5.6.7. SELF-ASSESSMENT
Answer the following questions to check whether you have achieved all the set outcomes:
1. How does inflation targeting work?
2. Why the change in approach?
3. What is monetary liquidity?
4. Who is responsible for setting the goals of the reserve bank?
5. What do we mean when we say the reserve bank in instrument independent?
6. What is a contractionary monetary policy?

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5.7. UNIT 7: FISCAL POLICY: THE ROLE OF THE GOVERNMENT

By the end of this unit, you will be able to:
Know the main instruments of fiscal policy, and understand their
macroeconomic impact;
Have a good intuitive grasp of the practice of fiscal policy and the
budgetary cycle, including institutional dimensions;
Be able to analyse the policy choices that the fiscal authority (the
National Treasury) has to make in conducting fiscal policy and in
drawing up the annual government budget;
Understand the constraints on choices regarding main budget
aggregates; Understand the key issues regarding the budget deficit and
its financing;
Specific Learning
Have a good grasp of public debt issues, including the interaction
Outcomes between debt cost and monetary policy (the Reserve Bank);
Know how to apply appropriate deficit measures as fiscal criteria,
including the key nor of fiscal sustainability;
Appreciate the complexity of fiscal policy in a developing economy such
as that of South Africa;
Be able to select and interpret the appropriate figures to measure
government commitments in the macroeconomic and budgetary
context, and to avoid being misled by politicians in this regard

It will take you 15 hours to make your way through this unit.
Time

5.7.1. INTRODUCTION
This unit considers various dimensions of fiscal policy from a macroeconomic perspective. Fiscal policy is
generally known as the budget in the public sphere. The main budget of the national government, usually
presented in March, is one of the main dates on the calendar of every economist, business person and
taxpayer.

5.7.2. THE ROLE OF GOVERNMENT IN THE ECONOMY

Government, mainly offers three functions in the economy. The three functions are:

Allocative function. The government aims to correct market failures such as the market abuse by
monopolies and pollution. This role is in most cases delegated to subnational governments than
central governments.

Stabilisation function. Government also controls the instabilities in the economy such as inflation, low
economic growth and unemployment. It makes use of stabilisation policies such as fiscal and
monetary policies. This role is best performed by the central government than any other arm of the
public sector.

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Distributive function. The harsh past of South Africa culminated into extreme inequality that was
sustained through advancement of other races at the prejudice of others. The government
reverses this through the redistribution of income to achieve an equitable distribution of income.
Economists advise that this function should be performed by the central government to avoid
income inequality across provinces and regional areas. This will lead to spatial inequalities.

5.7.3. DEFINITION AND INSTRUMENTS OF FISCAL POLICY

In the context of the normal macroeconomic framework, fiscal policy can be defined as follows:

All deliberate efforts of government to use changes in government expenditure, taxation (including
transfers) and government borrowing to influence aggregate expenditure in order to influence income,
production, prices and the balance of payments.

5.7.4. THE BASIC INSTRUMENTS OF FISCAL POLICY

The main instruments of fiscal policy are:

1) Government expenditure – both the aggregate level and the composition of spending (e.g. current
versus capital expenditure, or spending on economic services versus social services).
2) Taxation. All the kinds of direct and indirect taxes such as personal income tax, corporate taxation,
value-added tax (VAT) and excise duties. (There also are different forms of transfers, e.g. pension
payments, which can be analysed as negative taxes).

3) Government borrowing, which is part of public debt management. The government can borrow from
different sources namely; the private sector, the central bank or the international capital markets.

Borrowing from the central bank and the international capital markets isvery unpopular because it creates an
increase in money supply. Foreign debt further exposes the tax payer to an exchange rate risk. For example
the current depreciation ofthe South African rand would mean that the government has to collect more tax
revenue to be able to service the debt plus its interest.

Domestic loans from private sector ↣ decrease in money supply ↣ interest rates↑ leading to a
contractionary impact.

Domestic loans from SARB ↣ monetary injection↣ money stock increase ↣ interest rates drop
↣expansionary effect.

Foreign loans↣monetary injection↣ money stock increase ↣ interest rates drop ↣expansionary effect.

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Who determines fiscal policy?

“The Expenditure Planning unit designs and manages the South African national budget process and plays a
central role in preparing and publishing the various budget documents. The budget decision-making process
is a matrix that requires coordination across the three spheres of government and involves
engagements with various committees, including Cabinet, to ensure that appropriate budgeting choices are
made. Extensive internal and external budget-related engagements by various National Treasury units require
planning, coordination and support, by managing different forums and types of data analysis. To assist with
budget preparation and the publication of documents, the unit prepares budget process and requirement
guidelines, which are issued to all government institutions”

([Link] accessed 14-May-2018)

The treasury department is the custodian of the nation’s financial resources, accountable to the nation to
discharge its responsibilities professionally, with the aim of promoting growth and prosperity for all.

The department strives to raise fiscal resources equitably and efficiently and to manage government’s
financial assets and liabilities soundly by promoting transparency and effective financial management.

The Finance minister is the political head of specialised public sector organisations in the areas of finance,
economics and accounting. South Africa continues to have the most transparent budget process when
measured against 94 countries, including developed economies. Notwithstanding this achievement,
National Treasury continues to improve the quality of information presented in the budget. This is meant
to help those entities responsible for oversight, to ensure better accountability by those who have been
entrusted with the responsibility of managing and spending public funds. The ministry provides analysis
and advice on fiscal policy and public finances, intergovernmental financial relations, and expenditure

planning and priorities. It manages the annual budget process and provides public finance management
support.

5.7.5. THE MACROECONOMIC IMPACT OF FISCAL POLICY INSTRUMENTS

(SUMMARY)
The theoretical analysis of the chain reactions following various fiscal policy actions constitutes the core of the
theory of fiscal policy (originally seen primarily as a tool of stabilization policy). These have been
encountered throughout chapters 1 to 5 and need not be repeated here. It suffices to summarise the basic
macroeconomic impact of fiscal policy steps.

Government expenditure
Taxation
Government borrowing

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5.7.6. THE CHOICE OF OVERARCHING POLICY OBJECTIVES

It is not easy to reduce the objectives ofthe fiscal authority to afew aims, since the budget displays a large
spectrum of dimensions. This includes typically macroeconomic aspects as well as all the complexities of
government services, economic infrastructure, social conditions, poverty and the development situation.
In addition, the budget constitutes the financial manifestations of the plans of the political authority for
the coming year. Therefore it concerns a variety of political objectives. (In this sense monetary policy
actually is fairly simple: it concerns a clearly defined area of responsibility and clearly specified objectives
and instruments. However, there is disagreement on the extent to which the Reserve Bank can or should
distance itself from social and political considerations).

The 2008 world financial crisis forced many governments to consider stabilisation policies in their
economies. USA was known for its minimal intervention in its markets, but afterthe crises, had to introduce
a policy of “quantitative easing” in order to stimulate its economy. For the PIGS countries (Portugal, Italy,
Greece & Spain), their levels of debt mounted significantly as a result of the financial crises. The fiscal
authorities were forced to engage in serious austerity measures.

5.7.7. CONSTRAINTS ON FISCAL POLICY CHOICES

Fiscal theory may give an inaccurate impression ofthe ease (or otherwise) with which the economy can be
manipulated to achieve specific objectives. In practice the fiscal authority faces many constraints. Some of
these derive from institutional rigidities, others from fixed financial commitments or from the inherent
nature of economic relationships and behaviour. First, the institutional context in which the budget is
drawn up and approved, eventually, does not promote quick and flexible policy behaviour. The entire
process of the long budget cycle, including the lengthy approval procedures in Parliament, implies that it
is quite difficult to turn the fiscal ship. Secondly, the nature of, for example, government expenditure
implies a limited ability to change fiscal variables in the short run. Even if the fiscal authority wishes to
pursue shortrun stabilisation objectives, it will face problems such as the following:

Government expenditure items are usually of such a nature – expenditure on wages and salaries, on
schools, hospitals, roads, etc. – that they cannot be increased or decreased readily in the short run
without severely disrupting the activities concerned or running up against contractual
commitments and legal obligations.

By contrast, taxation can be adjusted much more easily to pursue anticyclical or other short-run
objectives. However, as we will see below, such decisions can never be taken in isolation, which
implies another set of constraints.

The manner inwhich the budget deficit is financed can be used, at least to some extent, to address
cyclical concerns, i.e. by using contractionary or expansionary methods of financing.

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5.7.8. THE SECTORAL BALANCE IDENTITIES

From your study unit 4, the following identity was derived:

T – Gc = (I* - S) + (X + TR – M)

When the government is planning its current expenditure, it is important to consider on the savings and
investment gap or on the current account. If a current account deficit is not an option then a government
budget deficit can only be financed by having more private savings compared to private investment. This
will result in the growth of the public sector at the expense of the private sector. This will not be the case
if there is a current account surplus.

5.7.9. THE BUDGET IDENTITY

Budget deficit =Total government expenditure – total government revenue

This identity implies that the three elements cannot be manipulated independently of one other. If values for
two are chosen, the third is determined automatically. Therefore decisions on each element can never occur
in isolation:

If a smaller deficit is desired, it will require either expenditure cuts or increases in revenue
(taxation), or both.

If tax relief is a goal; one must be willing to accept either a larger deficit or a cut in government
expenditure, or both.
Fixed budgetary commitments

Three areas in which the government’s expenditure are fixed are

Payment of interest on government loans
Transfers to households
Remuneration ofgovernment employees

5.7.10. COMPONENTS OF GOVERNMENT EXPENDITURE

Total expenditure = Capital expenditure + Current expenditure Capital expenditure + [Interest on public debt
+ Non-interest current expenditure]

= Capital expenditure + Interest + [Current transfers to households + Subsidies + Transfers to rest of the
world+ Government consumption expenditure]

= Capital expenditure + Interest + Transfers to households + Subsidies + Transfers to foreign countries +

[Compensation of employees + Expenditure on goods and services]

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5.7.11. THE BUDGET DEFICIT AND THE BORROWING REQUIREMENT

Definition and interpretation

The relationship between total government expenditure and total revenue determines the budget balance
(deficit or surplus). If total planned expenditure exceeds projected total revenue, a deficit is budgeted for.

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There may be good reasons for a government not to plan a balanced budget (i.e. where expenditure =
revenue).

If it pursues an anti-cyclical policy, the desired macroeconomic effects usually require a budget
which deliberately in deficit or surplus, as the case may be.

Even if no active anti-cyclical policy is pursued, during a period of stagnation – which would cause
a natural drop in tax revenues – one has to budget for a deficit.

Deficit spending, i.e. spending financed by borrowing, is also warranted where government
investment which serves to underpin future economic growth is concerned.

Historically, in many countries extraordinary circumstances such as wars were addressed with
deficit spending. Peacetime prosperity normally allows debt reduction.

5.7.12. PUBLIC DEBT AND PUBLIC DEBT MANAGEMENT

Public debt is an important fiscal variable, especially because the interest cost of public debt is claiming a
growing portion of government expenditure in South Africa. There also is the fear of the country getting
caught in debt trap. Therefore it is important to be able to evaluate the size of the public debt and to
analyse its implications for future budgets and sound fiscal policy.

The size of public debt

Domestic versus foreign debt
Budget implications ofthe interest on public debt
The Reserve Bank, monetary policy and public debt

5.7.13. FISCAL DISCIPLINE AND FISCAL NORMS

Fiscal discipline has been a persistent theme in the policy debate during the past decade. At face value it
would seem to be a proper principle. However, it’s meaning in practice, and how should be measured and
monitored, it not so simple.

A variety of fiscal balances

The conventional deficit as fiscal norm?
The current deficit as fiscal norm?
The primary balance and sustainability
Recall the definition ofthe primary balance:

Primary balance =Total non-interest expenditure – aggregate revenue

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5.7.14. SELF-ASSESSMENT
Answer the following questions to check whether you have achieved all the set outcomes:

1. Explain public debt and public debt management

2. What is monetary and fiscal policy?
3. Define the public sector ( the government)
4. What fiscal instruments does the government use?
5. State the options available for government borrowing and discuss their impact on macroeconomic
stability.

6. What is government capital expenditure?

7. List the government fixed budgetary commitments

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5.8. UNIT 8: POLICY PROBLEMS: COORDINATION, LAGS AND SCHOOLS

OF THOUGHTS
By the end of this unit, you will be able to:
Understand the differences and interaction between fiscal policy and
monetary policy, and between the National Treasury and the Reserve
Bank;
Grasp the problems relating to time lags and uncertainties in practical
Specific Learning policy formulation and implementation;
Outcomes Appreciate problems posed by the existence of different schools of
thought with diverse views on economic theory and policy. In
particular, you should understand thoroughly the essential differences
between the Keynesians and the Monetarists, as this is crucial for
understanding the debate on unemployment and inflation.

It will take you 15 hours to make your way through this unit.
Time

5.9. INTRODUCTION
In your local community, there are problems and issues that are of concern to the local inhabitants. Does
the government know about this? Let us assume the government has identified these problems, how long
does it take for solutions to the problem to be approved? After approval, how long will it take for the
projects to take off? These delays are called ‘lags.’ In this study we present a brief debate concerning the
understanding of Policy Problems: Coordination, Lags & different Schools of Thought.

5.9.1. MONETARY VS FISCAL POLICY?

In contemplating policy steps to affect the standard macroeconomic variables, a basic consideration is the different
macroeconomic impacts and side effect of monetary and fiscal policy. A comparison of the basic
macroeconomic effects of fiscal and monetary policy yields contrasts such as the following:

Fiscal expansion via government expenditure can enlarge the share of the public sector in the
economy relative to that of the private sector, especially if crowding out occurs.

Expansionist monetary policy has a net downward effect on interest rates, which is likely to
stimulate capital formation (investment). However, it is inflationary. In designing a policy package,
macroeconomic policy makers have to balance these considerations carefully, taking prevailing
conditions and forces inthe economy into account. In practice, the real choice is not between using
eitherthe one or the other type of policy: both fiscal and monetary policy are applied regularly.

Monetary policy that supports fiscal policy directions is called accommodating monetary policy.
Some types of conflict between fiscal and monetary policy are intrinsic and unavoidable. The

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interaction between budget deficits and interest rates presents a particularly vexing source of
conflict.

As explained before, high budget deficits can lead to upward pressure on interest rates. This is due
to the demand for credit exerted by government in money markets. ▪On the other hand, high
interest rates due to restrictive monetary policy increase the cost of public debt, which then claims
a larger share of government expenditure.

High interest rates due to restrictive monetary policy can severely affect the sustainability of fiscal
policy.

5.9.2. POLICY PROBLEMS

The theory of macroeconomic policy – showing the impact of fiscal and monetary policy measures on
important macroeconomic variables such as Y, P, and so forth – seems to be clear-cut. However, the
effective manipulation/control/management of these variables in practice is not simple at all. The recurring
economic crises ofthe world attest to this.

Policy makers face a number of quite fundamental problems. While both fiscal and monetary policy are
problematic, the issue is complicated by the fact that the nature and extent of their respective problems
differ. In particular, they encounter difficulties in two areas:

1) Policy lags (both internal and external),Observation lags: The gap between occurrence of a
disturbance and its observation Internal policy lags: The time frame between the observation of an
event and institution of policy measures to address it. External policy lags: The timeframe it takes to
establish the impact of policy steps.

2) Uncertainty about the precise effect of policy measures.

5.9.3. THE LARGER PROBLEM: DIFFERENT VIEWS AND SCHOOLS OF

THOUGHT
(1) Background: the Classical model and the Quantity Theory of Money
Monetarism is the antithesis ofthe Keynesian approach. The Monetarist viewpoint cannot be understood
without a thorough understanding of the Classical model, in which the roots of Monetarism are to be
found.

The Classical intellectual framework

The Classical analytical framework can be traced to the works of John Locke, the English philosopher, and
Adam Smith, the Scottish economist. Both were exponents of Classical liberalism, the philosophy built on
the fundamental belief that individual freedom and liberty are the highest good, and which fundamentally
distrusts the state.

The Classical economics framework

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The economic dimension of this harmonious picture – which emerged in an era when the economy
primarily comprised a large number of one-person and small family enterprises (bakers, grocers,
carpenters, blacksmiths, etc.) – was that the unfettered interaction between demanders and suppliers in
free markets would lead spontaneously to economic equilibrium.

Classical macroeconomic theory

Classical macroeconomic view, the economy is inherently stable. As a result, unemployment is not a real
problem. No remedial steps are necessary to ensure full employment, least of all from government. It will
materialise spontaneously. Protracted periods of unemployment and recession are impossible.

More formally, the Classical model of the economy – in vogue up to 1930 or thereabouts – comprises four
main components, built on the fundamental assumption of a world of perfect competition:

1) Equilibrium in the labour market

2) Say’s law
3) A real interest theory
4) The quantity theory of money

Monetarism and the transmission mechanism

Classical roots
The demand side of the economy
The supply side: the real economy
The price level
(2) The policy debate between Monetarists and Keynesian
General approach
Monetary vs fiscal policy
Priorities of policy
Exchange rate policy
(3) The Rational Expectations School

The Rational Expectations School is a younger and more extreme mutation in the Classical-Monetarist
lineage. It also is called the New Classical School or Monetarism mark II.

The basic New Classical argument is that people, as rational beings use all available information in making
economic decisions. They do not act in ignorance, but learn from experience exactly how the economy
works.

(4) Supply-side economics

Supply-side economics is an approach that was invogue inthe United States atthe beginning ofthe Reagan era
(1980). It does not constitute athorough framework orfully expounded theory. Rather, it comprises a

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fewrather loosely formulated ideas onthe operation of a market economy. The basic inclination isstrongly
anti-fiscalist, i.e. it is against the entire Keynesian tradition of demand-oriented policy by the fiscal
authority. As such, it is closely related to the Classical free market way ofthinking.

Evolution of Schools of Thought: Timeline, Economists and Major Tenets

The following is a broad outline ofthe development of macroeconomic theory

5.9.4. THE PRE-KEYNESIAN PERIOD [1776 – 1936]

(1) The Classical Period

Classical economists emphasised the natural ability, or optimising power, of the market mechanism to
achieve and maintain full employment equilibrium. Hence interventionist economic policies were neither
needed nor desired.

Adam Smith; 1776: Wealth of Nations

David Ricardo; 1817: Principles of Political Economy
John Stuart Mill; 1848: Principles of Political Economy
(2) The Neoclassical Period

Support for the optimising power of the market mechanism continued, but underpinned by relevant
microeconomic analyses.

• Alfred Marshall; 1920: Principles of Economics

• A.C. Pigou; 1933: The Theory of Unemployment
THE KEYNESIAN REVOLUTION

Following the Great Depression of 1929-33 and its devastating impact on unemployment, Keynes and his
followers challenged the classical belief regarding the ability of the market to maintain full employment
equilibrium. The Keynesians considered the economy to be capable of being at less than full employment
equilibrium, that is, equilibrium associated with involuntary unemployment. Moreover such conditions
could persist over time, thereby necessitating interventionist economic policies.

(1) Keynes and his Interpreters. [1936 – 1950s]

Macroeconomics in terms of the Keynesian view regarding market failure and involuntary unemployment
conflicted with orthodox neoclassical microeconomics underpinned by Walrasian theory which asserted
general market-clearing equilibrium based on the assumptions of perfect competition, flexible prices, and
rational optimising agents.

(2) The Neoclassical Synthesis. [1950s – 1960s]

The attempt to reconcile Keynesian macroeconomics with orthodox neoclassical microeconomics had a
dominant influence on the evolution of macroeconomic theory in the 1950s and 1960s.
• John Maynard Keynes; 1936: The General Theory of Employment, Interest and Money.
• John Richard Hicks; 1937: Mr Keynes and the Classics.
• Franco Modigliani; 1944: Liquidity Preference and the Theory of Interest and Money.

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• D. Patinkin; 1956: Money, Interest and Prices: An Integration of Monetary and Value
Theory.
• James Tobin; 1958: Liquidity Preference as Behaviour towards risk.
• Paul Anthony Samuelson; 1948: Economics
(3) MONETARISM [late 1960s to mid-1970s]

During a period of both increasing inflation and unemployment (stagflation), the Keynesian view drew
serious challenge. The Monetarist School re-invoked the classical notion that capitalist economies are
inherently stable, that an economy will return swiftly to the natural level of output and employment
followinga disturbance. Hence, stabilisation policies were neither needed nor desirable. The monetarist
conclusions were largely based on the assumption of adaptive expectations. Monetarists advocated rules
as opposed to discretionary policy.

• Milton Friedman; 1953: Essays in Positive Economics 1956: The Quantity Theory of
Money, A Restatement.
• Others: David Laidler, Micheal Parkin, Harry Johnson, Karl Brunner, Alan Meltzer.
NEW CLASSICAL SCHOOL [Mid 1970s – 1980s]

Together with Monetarist school, the New Classical School also challenged the tradition Keynesian
approach and its support for aggregate demand management policies. This school favoured rules as
opposed to discretionary policy.

1. The Rational Expectations Approach

Based on the assumption of rational expectations, this branch of the New Classical School believed, that
apart from the effects of unanticipated monetary shocks (monetarysurprise), the economy is inherently
stable, in that following a disturbance it would return swiftly to the natural level of output and
employment.

Proponents include:

• Robert Lucas; 1972: Expectations and the Neutrality of Money

1973: Some International Evidence on Output – Inflation Trade-offs.
1976: Econometric Policy Evaluation: A Critique

• Others: Thomas Sargent, Neil Wallace, Robert Barro, Edward Prescott and Patric Minford.
2. The Real Business Cycle School

Real Business Cycle Theory, which may be regarded as the second phase of the New Classical School was
a shift from the monetary-surprise (demand-side) version, and placed emphasis on supply-side factors as
being the predominant cause of aggregate economic fluctuations. This School viewed aggregate
economic fluctuations as being a sign of Pareto-efficient responses to technological shocks to the
aggregate production function of an economy. Hence, it followed that fluctuations represented
variations in the natural rate of output itself, and notjust movements away from a smooth deterministic
trend. Stabilisation policy, would therefore not be successful in reducing instability, but may in fact lead
to a loss of welfare.

• Kydland and Prescott; 1982: Time to Build and Aggregate Fluctuations.

• Long and Plosser; 1983: Real Business Cycles

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3. SUPPLY-SIDE ECONOMICS [1980s – early 1990s]

A distinction may be drawn between ‘traditional supply-siders and the ‘New Supply-side Economics’.
Whilst invoking the analysis of the neoclassical thinking, traditional supply-siders place attention on
aspects such as the efficiency of markets, incentives for economic growth and government failure. The
new supply-siders, on the other hand, focus attention on the effect of tax cuts and deregulation on
economic growth.
• Vane (1987; 1992), Minford, et al (1985), Minford (1991)
4. NEW KEYNESIAN THEORY [late 1980s – early 1990s]

The New Keynesian School, which challenged the New Classical equilibrium approach, sought to adapt
micro to macro theory rather than the other way around. Whilst maintaining the rational expectations
hypothesis, the New Keynesian School argued that markets failed to clear due to microeconomic rigidities
resulting from wage and price stickiness. Hence there was a need for macroeconomic interventionist
policy since an economy is subject to both supply and demand shocks resulting in efficient fluctuations in
aggregate output and employment.

• George Akerlof, Janet Yellen, Olivier Blanchard, Gregory Mankiw, Edmund Phelps, David Romer, Joseph
Stiglitz and Ben Bernanke.
5. POST KEYNESIAN THEORY [late 1980s – early 1990s]

The Post Keynesian School departed from the rational expectations hypothesis, and emphasised
heterogeneous expectations associated with uncertainty. It placed much attention on the importance of
asymmetrical information, the element oftime in terms ofthe economy being an historical process, the
role of money as a link between the present and the future, the role of economic and political
institutions, the competition between government, labour and firms for a share of income generated in
the economy.

• Joan Robinson, Nicholas Kaldor, Michal Kalecki, George Shackle, Piero Sraffa, Jan Kregel, Victoria Chick,
Hyman Minsky, and Paul Davidson.

6. THE AUSTRIAN SCHOOL

The most recent school of thought. Still in its early stages. Refer to the Snowdon and Vane (2005) for
more information if desired

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5.9.5. SELF-ASSESSMENT
Answer the following questions to check whether you have achieved all the set outcomes:
1. Explain supply-side economics

2. Explain the policy debate between Monetarists and Keynesian

3. List and explain the different types of policy lags.

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5.10. BIBLIOGRAPHY

1. Blanchard, O. & Johnson, D., 2013. Macroeconomics. 6th ed. Boston: Pearson.

2. CIA, 2017. South African Economy. [Online] Available at:[Link]

3. Krugman, P., 2015. The Conscience of a liberal. [Online] Available at:

[Link] [Accessed 29 May 2018].

4. Minerd, S., 2016. The global liquidity trap turns more treacherous. [Online] Available at:

[Link] [Accessed 29 May 2018].

5. StatsSA, 2016. South Africa's African Trading Partners. [Online] Available at:[Link]

6. Vonstâncio, V., 2015. Monetary policy and the Euro area problem. [Online] Available at:

[Link] [Accessed 29 May

2018].

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