MAIN TOPIC: MACRO ECONOMICS – PAPER 1

TOPIC 1: CIRCULAR FLOW MODEL

SUBTOPICS:

1.1 The open eocnomy circular flow model.

• Equation
• Markets

1.2 National account aggregates

• NationaL account conversions

1.3 The multiplier

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1.1 The open economy circular-flow model

CONCEPTS related to the circular flow:

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Description / Definition

• The circular-flow model of the economy is a simplification showing how the

economy works and the relationship between income, production and spending
in the economy as a whole.
• The circular-flow model of an open economy shows the workings of an
economy that is open to foreign trade.
• It is different to a closed economy because it includes the foreign sector.

Diagram

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Participants:
Households
• There is a flow of money and goods and services between the household
sector and business sector.
• Households are the owners of the services of factors of production and they
place their factors of production on the market so that it can be bought.
• Households earn income in the form of wages by selling their factors of
production to business.

Business Sector
• Business uses factors of production to produce goods and services on which
the household sector spends their income
• Businesses place goods and services on the product market which is bought by
households to satisfy their needs
• Business receives an income.
• State / Government

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 • There is a flow of money and goods and services between the household
sector and State.
• Household sector provides the state with labour and receive income.
• The state provides the household with public goods and services
• (e.g.) parks, hospitals
• Households pay taxes to the state.
• This is income for the state.

• There is a flow of money and goods and services between the business sector
and State.
• The business sector provides the state with goods and services for which the
state pays.
• The state provides the business sector with public goods and services
• E.g. Roads, Electricity, harbours, etc.
• Business pay taxes to the state.

Foreign Sector
• There is a flow of goods (imports) to the business from the foreign sector
• Businesses that import these goods, pays for it.
• This will be regarded as expenditure for the business

• There is also a flow of goods (exports) from the business in the country to the
foreign sector.
• Businesses export their goods and services to other countries and earn money
for it.
• This will be income for the business.

The relationship of the financial sector in the circular flow

• The financial sector consists of banks, insurance companies and pension
funds.
• They act as a link between households and firms who have surplus money and
others in the economy who require funds.
• The money which households and firms provide to the financial sector is known
as savings.
• Businesses can Borrow money from the financial institutions and use it to
purchase capital goods.
• This spending on capital equipment by firms is regarded as investment.

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Real flow and Money flow

• Transactions takes place on markets.

• The exchange process has two components, namely

1 Real flow: Goods and services and Factors of production.

2 Money flow: The earning of money (income) and payments that is made.

Real flow
➢ Consumers render production factors to producers and government via the factor
market.
➢ Goods and services are supplied by producers via the product market to
government and consumers.
➢ Government provides public goods and services to consumers and producers.
➢ Producers receive goods and services (imports) form and deliver goods and
services (exports) to the foreign sector.

Money Flow
➢ Consumers earn an income for their production factors via factors market from
businesses.
➢ Business sector earn an income for goods and services via the product market
from consumers and government.
➢ Government earn an income consumers and businesses
➢ Businesses earn an income for exports from the foreign sector and make
payments to the foreign sector for imports.

EQUATIONS

Leakages
• A leakage represents the withdrawal of money from the economic cycle (local
economy)
• It does not give rise to a further round of income.
• Domestic purchases on goods and services decrease.
• In an open economy, the leakages are taxes (T), the expenditure on imports
(M) and savings (S).

In other words:

L = S + T + M
Leakages = Savings + Taxes + Import expenditure

Injections
• Injections represents the injection of money into the economic cycle (local
economy)
• It refers to the flow of any spending which is not derived from income (Y)
• Additional money enters the economy and it increases income
• Domestic purchases on goods and services increase

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 • In an open economy, injections are government spending (G), the revenue
earned from exports (X) and investment spending (I).

In other words:

J = I + G + X
Injections = Investments + Government expenditure + Export
Income

Equilibrium

• The economy is in equilibrium when leakages are equal to Injections.

• In other words
L=J

S+T+M = G+I+X

Disequilibrium

• The economy is in disequilibrium when:

1 Leakages are more than Injections (L > J).

2 Injections are more than Leakages (J > L).

Restoring the equilibrium causes changes to national income.

1. National Income increase when Injections are more than Leakages.

J>L

G+I+X >S+T+M

• The amounts of injections which exceed leakages contribute to additional demand.

• This additional demand must be satisfied.
• This causes in increase in the production of goods and services.

2. National Income decrease when Injections are less than Leakages.

J < L

I+G+X < S+T+M

• The amount with which leakages exceeds the injections contribute to a decreased
demand.
• Demand for goods and services drop.
• Less goods and services are produced.

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• Less income for participants.
DIAGRAM: participants, financial sector and flows

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Mathematical and Graph Presentation

• Income (Y) is equal to Expenditure (E)

In other words:

• Y=E

Y = C + G + I + (X-M) = E = C + G + I + (X-M)

Mathematical Calculation

Imports (M) R40 million

Investment Spending (I) R180 million
Consumption Spending (C) R 110 million
Exports (X) R 25 million
Government Spending (G) R110 million

Calculation of the aggregate Income in the economy.

Y = C + I + G + (X-M)

Y = R110 million + R180 million + R110 million + (R25 million – R40 million)

Y = R385 million

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Graphical Presentation

Y=E

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• Expenditure is (E) and it is shown on the vertical axis.

• Income is (Y) and it is shown on the horizontal axis.
• E = Y and it is separated by scale line.
• It halves the 900 angle into two equal portions of 450

• Aggregate Expenditure (AE) = C + I + G + (X-M)

• This curve shows the amount which consumers, producers, government and
foreign sector plans to spend at every level of income.
• It also equals aggregate demand.

• The curve slope upwards and to the right.

• At an income of Y, the AE intersects the vertical axis at E.
• If planned AE increase to E1
• This means more money is injected into the economy than what are leak out.
• This cause an increase of Y to Y1.

MARKETS

INTRODUCTION
The circular flow model is a simplified representation of the interaction between the
participants of the economy.
Markets coordinate economic activities and determine prices for goods and services

MAIN PART
Goods/Product/Output markets
These are markets for consumer goods and services
In economics a distinction is made between goods and services:
Goods are defined as any tangible items such as food, clothing and cars that satisfy
some human wants or need
Buying and selling of goods that are produced in markets
e.g. - Capital goods market for trading of buildings and machinery
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 - Consumer goods market for trading of durable consumer goods, semi-durable
consumer goods and non-durable consumer goods
- Services are defined as non-tangible actions and includes wholesale and retail,
transport and financial markets

Factors/Resources/Input markets
Households sell factors of production on the markets: rent for natural resources,
wages for labour, interest for capital and profit for entrepreneurship
The factor market includes the labour, property and financial markets

Financial markets:
They are not directly involved in production of goods and services, but act as a link
between households, the business sector and other participants with surplus funds
E.g. banks, insurance companies and pension funds

Money markets
In the money market, short term loans and very short term funds are saved and
borrowed by consumers and business enterprises
Products sold in this market are bank debentures, treasury bills and government
bonds
The SARB is the key institution in the money market

Capital markets
In the capital market long term funds are borrowed and saved by consumers and
business enterprises The Johannesburg Security Exchange is a key institution in the
capital market
Products sold in this market are mortgage bonds and shares

Foreign exchange markets

On the foreign exchange market businesses buy/sell foreign currencies to pay for
imported goods and services
These transactions occur in banks and consists of an electronic money transfer from
one account to another
The most important foreign exchange markets are in London/New York/Tokyo
The S.A Rand is traded freely in these markets
e.g. when a person buys travellers cheques to travel abroad

Flows
Flows of private and public goods and services are real flows and they are
accompanied by counter flows of expenditures and taxes on the product market
Factor services are real flows and they are accompanied by counter flows of income
on the factor market
Imports and exports are real flows and they are accompanied by counter flows of
expenditure and revenue on the foreign exchange market

National Accounts
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The aim of National accounts

• It is to provide a systematic and comprehensive record of national economic

activities.

• National income figures are NOT 100% accurate.

• There are many shortcomings or problems when we calculate or determine
national income figures.
• Irrespective of all these problems and shortcomings, it still remains important
economic statistics.

• South Africa uses the System of National accounts (SNA) - as suggested by

the United Nations (UN)

COMPOSITION OF NATIONAL ACCOUNT

• GDP is total value of final goods and services, produced within the
boundaries/borders of a country for a specified period.
• GNP is total value of final goods and services produced by the permanent
residents of a country for a specific period.

• Another name for GDP is: Gross Value Added

THREE METHODS THAT IS USED TO CALCULATE GDP

• Production method - GDP (P)

• Expenditure method - GDP (E)
• Income method - GDP (I)

1. THE PRODUCTION METHOD (VALUE ADDED APPROACH / METHOD)

• When using this method, the GDP is determined by calculating the sum of the
value added at each stage of the production process.
• This method yields GDP at basic prices.
• It is the quantity multiplied with the market or production price.
• To avoid double counting, only added values are taken.
• The value of intermediate goods and services are not included in the
calculation.

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 Production method R
Billions
Primary Sector 129
Secondary Sector 316
Tertiary sector 908
Gross value added at basic prices 1 353
Plus: Taxes on production 174
Less: Subsidies on products 4
Gross domestic product at market prices 1 523

2. EXPENDITURE METHOD (APPROACH)

• When using this method, the GDP measure the total value of expenditure
(spending) on final goods and services, at market prices, within the
geographical borders of the country in a specific period of time.
• The spending of the four spenders in the economy is added together.
• That is spending by households, business enterprises and stat, on consumer
goods, services and capital goods.

Expenditure method R
Billions
Final consumer spending on goods and services 968
Final consumer spending by the general government 307
Gross capital formation 278
Residual items 8
Gross domestic expenditure 1 545
Exports of goods and services 413
Less: Imports of goods and services 435
Expenditure on GDP at market prices 1 523

3. INCOME METHOD (APPROACH)

• When using this method, GDP measure the total remuneration earned by the
owners of factors of production within the geographical borders of a the country
for their services of their factors in the production process over a period of time
(year).
• It is based on factor cost.

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 Income method R
Billions
Compensation of employees 680
Net operating surplus 454
Consumption of fixed capital 190
Gross value added at factor cost 1 324
Other taxes on production 34
Less other subsidies production 5
Gross value added at basic prices 1 353
Taxes on products 174
Less subsidies on products 4
Gross domestic product at market prices 1 523

➢ Net operating surplus include the total value of goods and services less the costs.

Costs consist of:

1 Intermediate goods and services

2 The cost of compensation of workers
3 The cost of capital consumption.

NATIONAL ACCOUNT CONVERSIONS

➢ All countries use national account figures

➢ South Africa uses the SYSTEM OF NATIONAL ACCOUNTS (SNA) prescribed
by the United Nations.
➢ GDP, GDE, and GDI has a great deal to do with the prices we use such as nominal
and real prices, prices before or after taxes.
➢ Indirect taxes and subsidies are the most important determinants of the end values
of the circular flow aggregates.

Basic Prices
➢ Indirect prices and subsidies are related to production process and not individual
products.
➢ With the production method, taxes on production is subtracted as a cost and
subsidies on production are added as an income.
➢ Taxes on production are payroll taxes (SITE and PAYE), recurring taxes on land &
buildings, Business licenses.
➢ Subsidies on production include employment subsidies and subsidies paid to
prevent pollution.
Factor Cost
➢ GDP at basic prices – other taxes on production + other subsidies on production =
GDP at factor cost (factor income).

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Market prices
➢ Conversion of values form:

➢ Basic prices to market prices:

GDP ate basic prices + Taxes on products – subsidies on products = GDP at
market prices.

➢ Factor cost to market prices:

GDP at factor cost + other taxes on production – subsidies on production = GDP at
basic prices + taxes on products – subsidies on products = GDP at market
prices.

Net figures
Net operating surplus = surplus after taxes
Net income = income after taxes
Net fixed capital formation = After consumption of fixed capital (depreciation)
Net exports = exports – imports

Conversion of Domestic to National figures

Domestic figures relate to the income and production happening within the borders of
the country.
National figures relate to the income or production by the citizens of the country.

E.g.

R
Billions
GDP at market prices 1 523
Plus: Factor income earned abroad by South Africans 29
Less: Factor income earned in South Africa by foreigners 60
GNI at market prices 1 492

Nominal figures vs Real figures

Nominal figures
 It is also known as nominal or money value.
 It is also known as national product at current price.
 Production is calculated by multiplying the volume of the final goods and services
by their prices.
 Inflation has not yet been taken into consideration.

Real figures
 It is also known as national product at constant prices.
 The rate of inflation as expressed by the consumer price index (CPI) has been
taken into account.
 Real values of production are the nominal values of national product adjusted for
price increase.
 Real national product is the national product express in prices which applied in a
certain base year.
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The Multiplier

Definition
The multiplier shows how an increase in spending (injection) produces a more than
proportional increase in national income.

• The multiplier must always be more than 1.

• The multiplier works in opposite directions.

THE MULTIPLIER IN A TWO SECTOR MODEL

1 The multiplier derived from the marginal propensity to consume (mpc)

➢ The size of the multiplier depends on the proportion of any increase in income
that is spent.
➢ The larger the mpc the bigger the multiplier and the smaller the mpc the smaller
the multiplier.
➢ It is the money that stays in the economy.

E.g.
Y = R100 000
S = R 40 000 = 40% 0,4
C = R 60 000 = 60% 0,6

➢ marginal propensity to consume (mpc) = 0,6

➢ marginal propensity to save (mps) = 0,4

Please note:
• mpc + mps is always = 1
• mps = 1 – mpc
• mpc = 1 - mps

FORMULAE to calculate the multiplier:

Formula 1:

__1 __
α= 1 – mpc

__1__ = 1 = 1 = 2,5
α = 1 – mpc 1 – 0,6 0,4

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Formula 2:
__1 __
α= mps

__1__ = 2,5
α= 0,4

Formula 3:
∆Y
K = ∆E

• I = R40 000 m and it increase to R50 000 m

• ∆ I = R10 000 m: in other word investment in infrastructure and development
and building of houses

• Y = R100 000 m increase to R125 000 m

• ∆Y = R25 000 m

∆Y
K= ∆I

R25 000
R10 000 = 2.5 = 2½

THE MULTIPLIER IN A GRAPH

(Add steps in drawing the graph)

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➢ In the above sketch: PLEASE CHECK THIS SECTION!

➢ E = Original equilibrium.
➢ Y = Original income.
➢ AE = Aggregate Demand is illustrated by C + I + G
➢ ∆I=∆G
➢ Investment spending (I) is added.
➢ Total spending at each level of income (Y) increase with the amount of Investment.
➢ Government Investment increase
➢ The AE curve shifts to AE1
➢ The multiplier causes that Y increase to Y1
➢ The AE curve (Aggregate demand) shift upwards to AE1
➢ Planned spending determines aggregate demand.

Explain the Multiplier effect

• The multiplier relates to how much national income changes as a result of an

injection or withdrawal such as an investment.
• Initially there is an increase in injections into the economy (investment,
government spending or export), which would lead to a proportionate increase
in national income.
• The extra spending would have knock-on effect and create even more
spending
• The size of the multiplier will depend on the level of leakages.
• (E.g.) assume firms increase investment spending by R1000. This is done by
ordering capital goods from domestic firms to the value of R1000.
• Total spending has increased by R1000. Total production has increased by
R1000, which also leads to an increase in R1000 in income. The increase in
spending = the increase in production which = an increase in income.
• When households earn income (R1000) leakages can occur, through income
tax, savings and spending on imports.
• If this amounts to R300, then spending on domestic goods will increase by
R700. At this stage the multiplier starts to kick in.

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TOPIC 2: BUSINESS CYCLES

Subtopics:
2.1 Composition and features of business cycles
2.2 Explanations / Causes
2.3 Government policy
2.4 The new economic paradigm (smoothing of cycles)
2.5 Features underpinning forecasting

2.1 Composition and features of business cycles

Concepts

Definition: Business Cycles

• It refers to the phenomenon of successive periods of increasing and decreasing
economic activity.
OR

• A business cycle is defined as the recurrent but not periodic pattern of

expansion and contraction in the level of economic activity that occurs within a
country.

Nature of business cycles

Changes in economic activity are recurring but never exactly the same or of the same
magnitude.
Different circumstances and expectations cause consumers and producers to respond
differently to initiating forces.
The duration and amplitude of every business cycle will be different.
Business cycles are recognised by the following:
–– Two periods namely contraction and expansion;
–– Two turning points namely trough and peak;
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–– Four phases, namely recovery, prosperity, recession and depression.

Typical business cycle

• Economic activity clearly shows periods of contractions (Recession /

Depression) and periods of expansions (Recovery / Prosperity) in the
economy.
• It is shown by the upward and downward movements of the curve.
• A period where there is a general increase in economic activity is known as
UPSWING.
• A period of general decline in the economic activity is called a DOWNSWING.
• The business cycle oscillates between the upper (Peak) and lower (Trough)
turning points.
• The length of the business cycle is measured from Peak to Peak or from
Trough to Trough.
• The entire period from the Peak to the Trough is known as the Downswing.
• The entire period from the Trough to the Peak is known as the Upswing.
• The period immediately before and through the upper turning point of the cycle
is called the BOOM.
• The period immediately before and through the lower turning point is known as
the SLUMP.

PHASES OF BUSINESS CYCLES

Recovery phase
• There is a greater demand for goods and services
• This lead to an increase in Production
• More jobs are created
• Business confidence rises and there is increased spending by firms
• There is increased economic activity and the country enters into a period
of prosperity

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Expansion phase
• There is a great degree of optimism in the economy
• Entrepreneurs borrow more money to buy machines and equipment
(Investment)
• Employment levels rise, and this give rise to a rise in salaries and wages and
spending increases
• A peak is reached
• There is a larger amount of money in circulation and this leads to an inflationary
situation in the economy and lead to a recession.

Recession phase
• A recession phase is when there is negative economic growth rate for two
consecutive quarters.
• It is introduced by a decrease in profits of businesses that is the result of
inflation and over production
• There is a decrease in production that lead to a drop in employment
• Unemployment increase and this give rise to a feeling of pessimism
• There is a decrease in economic activity, and the economy slows down

Depression phase
• During a depression money is in short supply, leading to a further decline in
spending
• There is a negative impact on investment spending
• Economic activity is at its lowest, and a trough is reached
• Cost of production decreases
• This encourages foreign trade and leads to a recovery.

REAL (ACTUAL) BUSINESS CYCLE

An actual business cycle is obtained when the effects of irregular events, seasons and
long-term growth trend are removed from the time series data.
Figure 2.2 shows the real GDP of South Africa over a 12-year period displayed in a
jagged diagram.
The length or duration of the cycle is measured from trough to trough or peak to peak.
The distance of the peaks and troughs from the trend line is known as the amplitude
and shows the severity of cyclical fluctuations.

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2.2 EXPLANATIONS / CAUSES

EXOGENOUS EXPLANATION (MONETARIST EXPLANATION / REASONS)

• It is also called the sunspot theory / exogenous approach

• Believe markets are inherently stable.
• Departures from the equilibrium state are caused by exogenous factors (factors
outside of the market system).
• When disequilibrium exist in the economy, Market forces (supply and demand)
kick in and bring the economy back to its natural state or equilibrium route.
• Government interferences are not part of the normal forces operating in the
market.
• Governments should not interfere in the markets.

• The straight bold line indicates the natural growth of the economy.

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Causes of economic fluctuations
1. are inappropriate government policies
2. undesirable increases and decreases in money supply
3. weather conditions
4. shocks (September 11) severe increases in the price of fuel and wars
5. structural changes

ENDOGENOUS EXPLANATION (KEYNESIAN EXPLANATION)

• Also known as the Keynesian Approach or Interventionists

• Hold the view that markets are inherently unstable
• Level of economic activity constantly tend to be continually above or below its
potential
• Price mechanism fails to co-ordinate demand and supply in markets
• Prices are not flexible enough e.g. wages
• Business cycle is an inherent feature of market economy
• The potential growth path is indicated by the thin black line.
• The cyclical bold line around the thin black line indicates the real path of the
economy.
• Governments must intervene in the economy processes to smoothen the peaks
and the troughs as far as possible.

TYPES OF BUSINESS CYCLES

TYPES OF BUSINESS DESCRIPTION

CYCLE
In South Africa ±60 months.
Business Cycles There are clear expansions and contraction periods.
During these periods the major sectors of the
economy move up and down more or less together.
There duration is not fixed.

They last between 3 to 5 years.

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 Kitchin Cycles This happen because businesses adapt their
inventory levels.

They last 7 to 11 years

Jugler Cycles Are caused by changes in net investments by
business and the government.

They last 15 to 20 years.

Kuznets Cycles They are caused by changes in the building and
construction industries.
They are also called building cycles.
Kontratieff Cycles They last 50 years and longer.
They are caused by technological innovation, wars,
and discoveries of new deposits, e.g. gold.

2.3 GOVERNMENT POLICY

• Government must intervene in the economy with policies to smooth out peaks
and troughs.
• Higher peaks lead to Inflation.
• Lower troughs lead to Unemployment.

• The new economic paradigm, results in the state using monetary policy and
fiscal policy to smooth out the business cycle

FISCAL POLICY

• It has been successfully used to stimulate a depressed economy

Stimulate Private sector demand / Private sector demand can becomes too low
(at E)

➢ An increase in unemployment is the indicator.

➢ The government has THREE choices that can lead to an increase in Total
Spending and therefore an increase in Demand.

1. Decrease Taxation (T)

• Households and producers have more disposable income in their pockets

which they can spent on goods and services.
• There is an increases consumption spending which lead to an increase in
demand.
• The economy is stimulated and it leads to Employment.

2. Increase Government Spending (G)

• Achieved with borrowed money

• Reason: as a result of the deficit on the budget

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 • Total spending increase
• Demand increase
• The economy is stimulated and employment increase.

3. Increased government spending and simultaneously decreasing taxes.

➢ This will have a double strength effect.
➢ Government spending increase.
➢ Consumers and producers have more money in their pockets to spend on goods
and services.
➢ Demand increase.
➢ Employment increase.

Reduce private sector demand / Private sector demand can become too high at
(E)

➢ Inflation is the indicator.

➢ The government has THREE choices that can lead to an decrease in Total
Spending and therefore an decrease in Demand.

1.1 Reduced Government spending (G)

➢ Unspent money is preserved (Frozen)
➢ Total spending decrease.
➢ Demand decrease.
➢ Inflation will decrease.

1.2 Increased Taxation

➢ Tax income is preserved (frozen).
➢ Consumers and producers have less money in their pockets to spend on goods
and services.
➢ Demand decrease.
➢ Inflation decrease.

1.3 Reduced Government spending and simultaneously increasing taxation

➢ This will have a double strong effect.
➢ Government spending decrease.
➢ Consumers and producers have less money to spend on goods and services.
➢ Demand decrease.
➢ Inflation decrease.

MONETARY POLICY

• Monetary policy uses Interest rates and Money supply too expands or
contract aggregate demand.
• Large increases in money supply lead to inflation
• Monetary policy can be utilised more effectively to dampen an overheated
economy with severe inflationary pressures.

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Monetary policy instruments:

1. Interest Rates
2. Cash reserve requirements
3. Open market transactions
4. Moral Persuasion
5. Exchange rates

1. Interest Rates

Overheated economy / Boom – Increase interest rates

Decrease Money supply
• This will make credit more expensive and reduce and discourage consumer
credit.
• Demand will decrease.

Recession / Slump - Decrease Interest Rates

Increase Money supply
• This will make credit cheaper and it will increase and promote consumer credit.
• Consumer Demand will increase.
• Stimulate the economy

2. Cash reserve requirements

• Banks are required by law to keep cash reserves at the SARB.

• SARB can increase or decrease these cash requirements.

Overheated economy / Boom

• An increase in the cash reserve requirements - Decrease the supply of capital
to commercial banks, so that banks have less money to lend to consumers.
• Demand will decrease.

Recession / Slump
• A decrease in the cash reserve requirements – Increase in the supply of capital
to commercial banks, so that banks have more money to lend to consumers.
• Demand will increase.

3. Open market transactions

• The SARB can directly increase or decrease the amount of money in the
economy.

Overheated Economy / Boom

• If they want to reduce the supply of money in the economy, they can sell
government bonds / securities on the open market.

Recession / Slump
• If they want to increase the supply of money in the economy, they buy
government bonds / securities on the open market.
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 4. Moral persuasion
• The SARB can enter into discussion with banks, to
• Morally persuade them to limit credit and increase the cooperation to fight
inflation

5. Exchange rate policy

➢ Central banks (SARB) can use the following ways to stabilize exchange rates.

i. Free floating
ii. Control (Managed) floating

Free floating
1. Demand and supply determine the price of foreign currency.

2. Controlled (Managed) floating

3. The central bank interferes in the foreign exchange markets by buying and selling
the currency in order to stabilize it.

THE NEW ECONOMIC PARADIGM (SMOOTHING OF CYCLES)

➢ In real life circumstances, governments must strive towards economic growth.

➢ They must do it irrespective if markets are inherent stable or inherent unstable.

➢ Governments learned to be pragmatic.

➢ They apply policies that are not extreme but it must be transparent.

➢ Economists are convinced that it is possible for production output to rise at a high
rate for an extended period of time, without being tripped by supply constraints and
without the pressure of inflation.
➢ This paradigm lies in demand-side and supply-side policies.

(A) DEMAND SIDE POLICY

➢ Monetary policy and Fiscal policy focus on Aggregate Demand.

➢ Demand side policy is relying on Aggregate Demand only.
➢ Demand side policy does not render ideal results on its own.
➢ Growth is often cut short because of all sorts of bottle necks that develop in the
economy.
➢ Bottle necks such as, inflation, balance of payment s deficits, and shortages of
skilled labour, etc.

➢ It is clear that Aggregate Supply also needed to be managed.

➢ It the cost of increasing production is flexible; a greater real production output can
be supplied at any given price level.

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 1 Inflation

• Aggregate Demand (AD) is the total spending on goods and services in the
economy.
AD = C+I+G+(X-M).

• Aggregate Supply (AS) is the total quantity of goods and services supplied at
every price level.
• It is the total value of goods and services produced in the economy in a given
period.

• At Point C, Aggregate Demand (AD) and Aggregate Supply (AS) are in

equilibrium.
• When Aggregate Demand (AD) increases in the economy, it shifts the Aggregate
Demand (AD) to the right AD1.
• If the Aggregate Supply curve responds promptly and increase, the Aggregate
Supply (AS) shifts to the right to AS1.

• At Point E the new equilibrium is formed – The new AD1 and AS1 intersect at Point
E.
• At this point a larger production output becomes available (Q – Q1), without any
price increases.
• This occurs over the long-term – because aggregate Supply adjust easier over
long-term.

• Supply does not adjust easy over the short term.

• Over the short-term:
• When Aggregate Demand (AD) increase, it shifts to the right (AD1) and when
Aggregate Supply (AS) remains unchanged, the AD1 intersect the AS at point F.
• At Point F a new equilibrium is formed.

• At Point F real production increase but the price also increases.

• Inflation increase.
• To solve this problem, a situation must be created where supply is more flexible.
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2 Unemployment

➢ Unemployment is illustrated by the Philips Curve (PK-curve)

➢ The Philips curve illustrates the relationship between Unemployment and
Inflation.
➢ As unemployment decrease, Inflation Increased and vice versa.

• PK-curves indicate the original situation.

• At Point A the PK-curve intersects the x-axis.
• This indicates the Natural unemployment rate, 14%.

• Point A indicates the natural employment level.

• At this point unemployment is 14% with no inflation pressures (0% inflation)

• A movement left from Point A to Point B will cause a decrease in

unemployment (increase in employment) and an increase in inflation.

• At Point B
• If economic growth occurs and it causes a decrease in unemployment to 10%,
it means the more people will get a job.
• Wages increase (people have more money) and this will lead to an increase in
inflation up to 2%.

• At Point C
• If unemployment decreases to 8% - this will lead to an increase in inflation to
6%.
• This increase in inflation is caused by an increase in wages of people because
they have more purchasing power.

• If unemployment decrease, then inflation will increase

• The government decides the amount of unemployment they will accept for less
inflation.

• Supply side measures can be used to shift the PK curve to PK1.

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➢ Supply side measures are:

1 Improved education
2 Effective training
3 Fewer restrictions on migration of skilled labour.

• If the PK curve shifts to the left (PK1), the natural level of unemployment will
decrease from 14% to 9%.
• It means that unemployment is lower at 9% and the inflation rate is 0%.

(B) SUPPLY SIDE POLICY

1 Reduction of cost
➢ Infrastructure services: Are supplied by the government. It contributes
substantially to the cost of businesses.

➢ Administrative cost: Inspections, reports on the implementation of laws,

Regulations, all contribute to increased costs and expenditure of businesses.

➢ Cash incentives: Subsidies can be given to businesses when they want to

establish their business in neglected areas where unemployment is high.

2 Improving the efficiency of inputs.

➢ Tax rates: High personal income tax is disincentives to work. Higher company
taxes are disincentives to investment.

➢ Capital consumption: Replacing of capital goods create opportunities to keep up

with technology and to compete with their competitors.

➢ Human Resources: The quality of labour of people increased the efficiency of

businesses. The quality human resources are created by improving health care,
education, Training schemes, etc.

➢ Free advisory services: These are services that promote exports. E.g. Research,
agricultural services, Statistical information, etc.

3 Improving the efficiency in markets

➢ Deregulation: It is the removal of laws and regulations and all other forms of
government control to make the markets freer.

➢ Competition: It creates the establishment of new businesses. It also attracts

foreign investment.

➢ Leveling of the playing fields: Private sector businesses cannot compete with
the public sector.
Public enterprises have legislative protection and they are supported by the
government.
Privatisation are important.

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Effect of demand-side and supply-side policies using a graph (aggregate
demand and aggregate supply)

2.5 FEATURES UNDERPINNING FORECASTING BUSINESS CYCLES

Definition of Forecasting
Forecasting is the process of making predictions about changing conditions and
future events that may significantly affects the economy.

1. INDICATORS
Leading economic indicators
• These are indicators that change before the economy changes
• They give consumers, business leaders and policy makers a glimpse of where
the economy might be heading
• When these indicators rise, the level of economic activities will also rise in a few
months’ time.
• E.g. job advertising space/inventory/sales ratio

Lagging economic indicators

• They do not change direction until after the business cycle has changed its
direction.
• They serve to confirm the behaviour of co-incident indicators.
• E.g. the value of wholesalers’ sales of machinery if the business cycle reaches
a peak and begins to decline then we are able to predict the value of new
machinery sold

Co-incidental economic indicators

• They simply move at the same time as the economy moves
• It indicates the actual state of the economy.

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 • E.g. value of retail sales.
• If the business cycle reaches a peak and then begins to decline, then the value
of retail sales will reach a peak and then begin to decline at same time

Composite indicators
• It is a grouping of various indicators of the same type into a single value.
• The single figure forms the norm for a country’s economic performance.

2. LENGTH of a cycle
• It is measured from peak to peak or from trough to trough.
• It is the number of years it takes for the economy to get from one peak to the
next.
• It is useful to know the length of the cycle because the length tends to remain
relatively constant over time.
• If a business cycle has the length of 10 years it can be predicted that 10 years
will pass between successive peaks or troughs in the economy.
• Longer cycles show strength and shorter cycles show weakness
• Cycles can overshoot

3. AMPLITUDE
• The amplitude refers to the vertical difference between a trough and the next
peak of a cycle.
• The larger the amplitude the more extreme changes may occur
• e.g. during an upswing unemployment may decrease from 20% to 10 %
• (i.e. 50 % decrease)
• A large amplitude during an upswing indicates strong underlying forces – which
result in longer cycles

4. TREND LINE
• It represents the average position of a cycle.
• Indicates the general direction in which the economy is moving.
• An upward trend suggests that the economy is growing.
• Trend line usually has a positive slope, because production capacity increases
over time.

5. EXTRAPOLATION
• It is when forecasters use past data e.g. trends and by assuming that this trend
will continue, and then they make predictions about the future
• E.g. if it becomes clear that the business cycle has passed through a trough
and has entered into a boom phase, forecasters might predict that the economy
will grow in the months that follow
• It’s also used to make economic predictions in other settings e.g. prediction of
future share prices

6. MOVING AVERAGE
• It is a statistical analytical tool that is used to analyse the changes that occur in
a series of data over a certain period of time
• E.g. the moving average could be calculated for the past three months in order
to smooth out any minor fluctuations

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