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MACROECONOMICS
ALI ANWERZADA
2023 Syllabus
CHAPTER 1

NATIONAL INCOME
INTRODUCTION
MICRO VS. MACRO
Macroeconomics examines issues relating to an economy
as a whole, such as unemployment, inflation, growth and
the balance of payments. This means that the focus of
macroeconomics is on aggregate economic variables.
Whereas microeconomics may be interested in explaining
why the price of corn is rising, macroeconomics
investigates why the average price level may be rising. In
microeconomics, the focus may be on how many workers a
firm will employ but macroeconomics examines the total
level of employment and unemployment in a country. In
other words, in macroeconomics we zoom out of individual
markets and firms and look at what is going on in the
country.

2
 CIRCULAR FLOW OF INCOME
The circular flow model is a simplified representation of
how the basic decision-making units of an economy
(households, firms, the government and in an ‘open’
economy the foreign sector) interact. It describes the flows
between these units. These flows can be real (flows of
factors of production, flows of goods and services) or
monetary (flows of expenditures on goods and services,
flows of incomes generated in the production process).

FIGURE 1.1 Circular flow of Income

3
Leakage or Withdrawal refer to those parts of national
income that are not used for consumption. A withdrawal
from the circular flow is therefore spending which does not
flow back from household to firms. Injections are
supplementary expenditure not originating from the
domestic households.

Withdrawals Injections

Saving Investment
Taxes Government Spending
Imports Exports

W=S+T+M

J=I+G+X

There are indirect links between saving and investment,

taxation and government expenditure, and imports and
exports, via financial institutions, the government (central
and local) and foreign countries respectively. If more money
is saved, there will be more available for banks and other
financial institutions to lend out. If tax receipts are higher,
the government may be keener to increase its expenditure.
Finally, if imports increase, incomes of people abroad will
increase, which will enable them to purchase more of our
exports.

4
Equilibrium in the circular flow: In equilibrium, injections
are equal to withdrawals. If for example, injections exceed
withdrawals, this will lead to a rise in national income. But
as national income rises, so households will not only spend
more on domestic goods (Cd), but also save more (S), pay
more taxes (T) and buy more imports (M). In other words,
withdrawals will rise. This will continue until they have risen
to equal injections. At that point, national income will stop
rising, and so will withdrawals. Equilibrium has been
reached.

5
CHAPTER 2

NATIONAL INCOME
DETERMINATION
In national income determination, we will start off by
building a macroeconomic model. The analysis is based on
the model developed by Keynesians, a macroeconomic
school of thought of the 20th century British economist
John Maynard Keynes.

The level of production in the economy depends on the

level of aggregate demand. If people buy more, firms will
produce more in response to this, given that they have
spare capacity. If people buy less, firms will cut down their
production and lay off workers. But just how much will
national income rise or fall as aggregate demand changes?
We will answer this as the chapter progresses.

AGGREGATE EXPENDITURE (AE):

FIGURE 2.1 Aggregate Expenditure

7
Looking at the diagram, the consumption of domestically
produced goods (Cd) and the three withdrawals (W) – net
saving (S), net taxes (T) and spending on imports (M) – all
depend on the level of national income (Y). In fact, in the
model, national income must always equal consumption of
domestic goods plus withdrawals: there is nothing else
people can do with their incomes!

Y ≡ Cd +W

Total spending in the economy on the goods and services

of domestic firms is defined as aggregate demand (AD) or
Aggregate Expenditure. Aggregate expenditure consists of
Cd plus the three injections (J): investment in the domestic
economy (I), government expenditure in the domestic
economy (G) and expenditure from abroad on the country’s
exports (X).

AD ≡ AE ≡ Cd + J

In equilibrium, withdrawals equal injections. Since national

income (Y) is simply withdrawals plus Cd, and aggregate
expenditure (E) is simply injections plus Cd, it follows that in
equilibrium national income must equal aggregate
expenditure. To summarize:

W= J

Therefore, Cd + W = Cd + J

Y = E (= AD)

8
In this model, it is assumed that the levels of consumption
and withdrawals are determined by the level of national
income. Since national income is part of the model, we say
that consumption and withdrawals are endogenous. This
means that they vary with income. Injections, however, are
assumed to be exogenous: they are determined
independently of what is going on in the model; they do
not depend on the level of national income.

2 SECTOR MODEL
AE = C + I

In a simple model, we will examine the determinants of

each component – consumption and investment – of
desired aggregate expenditure.

Consumption

Consumer spending is spending by households on goods

and services to satisfy current wants, e.g. spending on
food, clothes etc. Keynesians believe that consumption is
dependent on the level of current income where they
define consumption as:

C = a + bY

(Keynesian Consumption Function)

When income rises, total spending also rises (Y↑ C ↑).

9
FIGURE 2.2 Consumption function

As
can be seen in figure 2.2, the consumption function doesn’t
start from the origin. This implies that even when the
income level is zero, there will still be spending. This
spending is called autonomous spending or consumption.
How could households consume if they have no income?
This spending is not driven by income. This spending is
necessary consumption for which households have to
borrow money or draw their past savings.

Induced Spending: ‘bY’ is the income induced spending or

endogenous spending and suggests that as more and more
income increases, more and more consumption will also
increase. The extent to which consumption increases due to
increases in income is measured by the slope or gradient

10
‘b’ which is called the marginal propensity to consume
(MPC).

MPC = Δ C / Δ Y = Amount of every dollar earned that is

spent.

For the economy as a whole, the marginal propensity to

consume is likely to be positive and less than one. Any rise
in income will lead to more spending but also some saving
too.

While total spending rises with income, the proportion of

disposable income that is spent tends to fall. Economists
refer to this proportion as the average propensity to
consume (APC).

APC = Consumption / Income = C / Y

11
Graphical Representation of Consumption Function

We can define consumption function as:

AE = C = 100 + 0.8Y (Equation 1)

Where a = 100 and b = mpc = 0.8

FIGURE 2.3 Consumption function

Figure 2.3 contains the Y = AE line, where the desired

consumption expenditure is equal to the income. The line
is called 45˚ line or the income line as the line has a positive
slope of unity and forms an angle of 45˚ with the axes.

The point at which consumption function meets the 45˚ line

can be found by equating the two lines:

Y=E=C

12
 And C = 100 + 0.8 Y (Equation 2)

Therefore Y = C at the point where the two lines meet.

Putting Equation 1 in Equation 2: Y = 100 + 0.8 Y

0.2 Y = 100 or Y* = 500

Therefore when Y = 500, C = 100 + 0.8 Y

=100 + 0.8 (500)

=500

In other words, it is the breakeven point, where

consumption = income and APC = C / Y = 500/ 500 = 1

FIGURE 2.4 Savings and Borrowings

13
To the left of Y = 500, C > Y and clearly individuals will be
borrowing or drawing on their past savings. This situation is
called ‘dissavings.’

To the right of Y = 500, C < Y , clearly ‘savings’ are taking

place and are positive. We define savings as disposable
income minus consumption.

Yd = C + S

Therefore, S = Yd – C, and we can make the following

schedule:

Disposable Consumption
Savings (S)
Income (Yd) (C)
0 100 -100
100 180 -80
200 260 -60
300 340 -40
400 420 -20
500 500 0
600 580 20
700 660 40
800 740 60
900 820 80
1000 900 100

From this information, we can also make saving function

diagram.

14
FIGURE 2.5 Saving Function

The Saving function is the reverse of the consumption

function C = a + bY. It is:

S = - a + (1 – b) Y

Therefore S = -100 + (1 – 0.8) Y

S = - 100 + 0.2 Y

The gradient ‘1 – b’ is called the marginal propensity to

save (mps) and shows the proportion of extra income that is
saved.

15
MPS = Δ S / Δ Y = Amount of every dollar earned that is
saved.

MPC + MPS = 1, which clearly suggests that any

incremental income can either be saved or consumed.

Also, average propensity to save (APS) = savings / income

=S/Y

APS + APC = 1

Suggesting that income is either saved or spent.

When a person or country is poor, most of the disposable

income is spent to meet current needs. Such individuals
and countries will have a higher mpc as well as APC.

16
Factors affecting Consumption / Saving

1. Income: According to the Keynesian theory, income is

the most important determinant of planned current
consumption. Any changes in income will result in a
movement along the consumption function.

2. Wealth: Changes in wealth change consumption and

saving plans of household. Economists argue that
households save in order to accumulate wealth that they
can use during their retirement or pass on to their heir.
An increase in wealth results in more of current
disposable income to be spent on consumption and a
smaller fraction to be saved. Thus, it will shift the
consumption function upward and saving function
downwards.
An increase in the level of wealth raises desired
consumption at each level of disposable income, thus
shifting the consumption function line up from C0 to C1.
As a result, the breakeven level of income also rises.
Similarly, a fall in the wealth increases the incentive to
save in order to restore wealth. This shifts the
consumption function downward and the saving function
upward.

17
FIGURE 2.6 Shift of the consumption and saving function

3. Interest Rates: Increase in interest rates results in lower

consumer spending due to two reasons. First, higher
interest rates discourage borrowings, as the cost of credit
rises. This results in a reduction in consumption of
durables like cars etc. Second, higher interest rates
encourage savings, as the reward for savings are
increased. Taking both these effects into account, higher
interest rate discourages borrowing and encourages
savings resulting in lower consumption.

4. Distribution of income: If income becomes more evenly

distributed, due to, for instance, an increase in direct
taxes and state benefits, consumption is likely to rise.

18
 This is mainly because rich have lower MPC than the
poor. When rich lose income, they are unlikely to cut
back in their spending significantly, while the poor who
gain more income will spend most of the extra income.
Hence, the more even the distribution of income, the
higher will be the consumption.

5. Expectations: Expectation of better future economic

prospect, where people expect an increase in real
incomes will also tend to encourage households to
increase consumption now by borrowing more. Similarly,
pessimism about future results in people to reduce their
consumption now. Pessimism could be because of
increase in unemployment rates, rise in taxes or a fall in
real wages.

6. Inflation: Inflation is a rise in the general level of prices

and has two effects. First, if households expect prices to
be higher in the future, they will be tempted to bring
forward their purchases. Hence, expectation of inflation
increases current consumption and reduces savings.
However, inflation also affects wealth. Rising inflation
tends to erode real value of money wealth. Households
react to this by attempting to restore the real value of
their wealth (i.e. they save more). This reduces
consumption. Both effects work in opposite directions.
The final effect is determined by primarily knowing which
effect outweighs the other.

19
CHAPTER 3

INVESTMENT
 Investment to an economist is a precise term, which
involves the acquisitions of capital goods designed to
provide us with consumer goods and services in the future.
It is the second major component of aggregate
expenditure.

2-SECTOR NATIONAL INCOME EQUILIBRIUM

In a simple model of closed economy with no government:

AE = C + I,

where in a Keynesian model, investment is regarded as

autonomous – that is capital expenditure on produced
goods is independent of the level of national income.

FIGURE 3.1 Investment Function

21
 In our previous example: C=100+0.8Y

Now if I=250, AE=C+I

AE=100+0.8Y+250

AE=350+0.8Y

FIGURE 3.2 Aggregate Expenditure with Investment

22
 EQUILIBRIUM GDP
In equilibrium, AE=Y, where the 45° line intersects the
desired or planned aggregate expenditure

AE=350+0.8Y,

Y=350+0.8Y

0.2Y=350

Y=1,750

FIGURE 3.3 Increase in National Income with Investment

23
 WITHDRAWAL AND INJECTIONS APPROACH

FIGURE 3.4 Withdrawals and Injections

When savings are the only withdrawal and investments are

the only injections, the equilibrium Y1 is also the equilibrium
level of GDP at which:

S=I

-100 + 0.2Y = 250

Y = 1,750

24
Multiplier

An increase in investment results in a change in GDP of

greater magnitude due to the multiplier effect.

For example, AE0=350+0.8Y. If investment increases by

$100. Then AE1 = 350 + 0.8Y + 100

AE1 = 450 + 0.8Y

Y= AE1

Y = 450 + 0.8Y

Y = 2250

An increase in investment by $100 resulted in GDP to

increase by 5 times, to 500, due to the multiplier effect.

Assume an initial $100 million of autonomous investment.

The money will return to the households in terms of income
earned from the factors of production. It is assumed that
the mpc= 0.8, and so the mps=0.2.

Hence, households save 20% of the income. $20 million is

saved and the rest is spent on the goods and services
produced by the firms. The $80 million again returns to the
households in terms of factor incomes. 20% of this is saved
($16 million) leaving $64 million to be spent on goods and
services. This process keeps going on.

25
FIGURE 3.5 Multiplier Effect

The initial $100mln will multiply to give a final increase in

total income of much more than $100mln.

26
In a 2-Sector economy, the value of the multiplier is:

Therefore, total increase in national income = Initial

Injection * Multiplier

=100 * 5

=$500mln

27
 DETERMINANTS OF INVESTMENT
1. Interest Rates: Marginal efficiency of capital (MEC)
theory explains the relationship between level of interest
rates and investment in the economy. The rate of return
on an investment project is MEC. A profit maximizing
firm will invest in a project if the rate of return is greater
than or equal to the interest rate, which is the cost of
borrowing or the opportunity cost of investment.

Project Investment Return Rate of return

1 100 120 20%
2 100 115 15%
3 100 110 10%
4 100 105 5%

FIGURE 3.6 Demand for Investment

28
At lower rates of interest (i.e. r1 rather than r0) more capital
projects appear financially viable because the cost of
borrowing to finance projects is lower.
Example: Four investment opportunities each involving
spending $100 now and obtaining a single sum one year
later.

If the interest rate is 25%, none of the projects will be

undertaken. However, when interest rate reduces to 10%,
projects 1, 2 and 3 will be undertaken implying, a lower the
interest rate leads to a higher the level of investment. The
MEC Curve is therefore the demand for investment, where
the interest rate is the price of investment.

2. Cost of capital goods: A fall in the cost of capital goods

results in an increase of investment at all levels of interest
rates as it becomes cheaper to invest. The investment
schedule will shift to the right.

3. Technological Change: Advances in technology will raise

the productivity of capital goods and will stimulate more
investment. Planned investment will shift to the right at
all levels of interest rates.

4. Expectations: If firms are optimistic about the future in

terms of economic conditions, they will undertake more
projects as they expect higher returns in the future. This
will shift the planned investment curve outward.

29
PARADOX OF THRIFT
If people save more, they will increase their consumption
possibilities in the future. But if all the members in the
society decide to save, this may not be good. An increase
in savings by the society results in a simultaneous decrease
in consumption and aggregate expenditure, which via the
multiplier effect, leads to a more than proportionate
decrease in national income (S0↓from S0 to S1 leading Y ↓
from Y0 to Y1). However, lower consumption can also
discourage firms to invest. A reduction in investment (I↓
from I0 to I1) results in income to decrease further (Y↓ from
Y1 to Y2).

As can be seen in diagram 3.7, a rise in national savings

results in a fall in consumption, which can cause the
economy to fall into a recession, incomes will fall, and so
will savings, other things being equal. The phenomenon of
higher saving leading to lower national income is known as
‘the paradox of thrift’.

30
FIGURE 3.7 Paradox of Thrift

31
INVESTMENT AND THE ACCELERATOR THEORY
The accelerator theory of investment suggests that the
level of planned investment varies with the rate of change
of income or output rather than with the rate of interest. In
the Keynesian model, investment is taken as autonomous,
while the accelerator theory focuses on induced investment
– where investment depends on the rate of change in
income. The amount by which induced investment
depends on changes in national income is called the
accelerator co-efficient or the capital-output ratio i.e.

I = α∆Y, where α = accelerator coefficient

For example, if a $1 million increase in GDP causes induced

investment to be $3 million. The accelerator co-efficient or
α is equal to 3. If GDP is rising but at a constant rate,
induced investment will not change. This is because firms
can continue to buy the same number of machines each
year to expand capacity. However, a change in the rate of
growth of income can have an influence on investment.

If the accelerator co-efficient = 3, and an industry is

producing at full-capacity, an increase in rate of change of
output will result in an increase in investment or capital
stock.

32
As can be seen from the table, rising output induces
investment expenditure. In years where the change in Y is
zero, there is no change in investment or capital stock.

Annual Change in Required New

Year
Output (S) output (S) capital stock Investment
1 10 0 30 0
2 10 0 30 0
3 11 1 33 3
4 13 2 39 6
5 16 3 48 9
6 16 0 48 0

Limitations of the accelerator theory:

The accelerator theory is very simple. There are a number

of factors which limit the predictive power of the model.

1. An increase in income does not always result in a greater

percentage change in demand for capital goods, for
example, firms will not buy more capital goods if they
have spare capacity or if they do not expect a rise in
income to sustain.

2. The model assumes that the capital-output ratio is

constant over time. However, it can change over time as,
for example, new technology can make capital more
productive.

3. The model also ignores time lags, where changes in

investment are likely to respond to changes in income
over several time periods not just one.

33
CHAPTER 4

GOVERNMENT AND
TRADE
CLOSED ECONOMY WITH GOVERNMENT
Government Expenditure on goods and services like
education, hospitals etc. is financed through tax revenue. In
the Keynesian model, we treat government expenditure as
autonomous, that is, not dependent upon the level of
income. We also do not include transfer payments in ‘G’ –
the government expenditure.

Tax revenue: We define net taxes (tax revenue) to be total

tax revenue received by the government minus total
transfer payments made by the government. We denote it
by ‘T’.

Tax rate is taken as autonomous – the govt. sets its tax rate
and doesn’t vary it as GDP varies. This makes tax revenues
to be endogenous – as GDP rises with a given tax rate, the
tax revenue will also rise.

From here, we can find Budget Balance, which is T-G, that

is the difference between govt. revenue and govt.
expenditure where:

T - G > 0 Budget Surplus, where savings by the govt.,

public savings, are positive

T - G = 0 Balance Budget

T - G < 0 Budget Deficit, where public savings are negative

Example: tax rate = 10%, Govt. expenditure = 170, then

T - G = 0.1Y - 170

35
FIGURE 4.1 Government budget balance

The diagram also suggests that as tax revenue increases

due to an increase in national income, the govt. budget
surplus or public savings increases.

36
Changes in Tax rates on Consumption and Saving

Disposable income available to consumers falls at each

level of national income as tax rates increase. The higher
the proportion of national income taken in taxes, the lower
the income available to consume and save and therefore,
the lower will be the mpc and mps.

mpc after tax = mps after tax =

Tax rate (%)
mpc (1-t) mps(1-t)

0 0.8(1-0) = 0.8 0.2(1-0) = 0.2

10 0.8(1-0.1) = 0.72 0.2(1-0.1) = 0.18

25 0.8(1-0.25) = 0.6 0.2 (1-0.25) = 0.15

FIGURE 4.2 2 sector

37
 Figure 4.2 and 4.3 show tree diagrams that explain how an
extra $1 change in income, is spent in the 2 and in the 3
sector. In the 2 sector, mpc +mps =1, while in the three
sector mpc + mps + mpt =1.

FIGURE 4.3 3 sector

After tax, the disposable income (Yd) is 0.9, i.e. $0.9 of $1

extra income is left to be saved and consumed. As a result,
mpc and mps are now reduced to 0.72 and 0.18.

38
Equilibrium in the 3 Sector Model

AE = C+I+G

Where previously,

AE0 = C+I

C = 100+0.8Y

I = 250

AE0 = 350 + 0.8Y

However with the govt. and tax rate of 10%, mpc changes
and becomes 0.8(1-0.10) = 0.72

AE1 = C+I+G

C = 100 +0.72Y

I = 250

G= 170

AE1 = 100+ 0.72Y+250+170

AE1 = 520 + 0.72Y and equilibrium income where AE = Y is

at Y* = 1857

39
FIGURE 4.4 AE and NI in the 3 sector model

Because the slope changes due to the tax rate, there is a

non-parallel shift after the introduction of government
expenditure.

Also, S = -100 + 0.18Y, T = 0.1Y, making the withdrawal

function W = S+T = -100 + 0.28Y and injections are I + G =
250 + 170 = 420.

40
FIGURE 4.5 3 sector model

Multiplier in a 3-sector Model

In a 3-sector model, the multiplier becomes:

Where mps = marginal propensity to save and mrt =

marginal rate of taxation or tax rate and these are the two
withdrawals (W).

41
In our example, mpc before tax = 0.8, t = 10%,

With tax,

mpc after tax = 0.72, mrt = 0.1, mps after tax = 0.18

as now, mpc + mps + mrt =1,

Therefore:

For example, an increase in autonomous expenditure by

$100mln results in Y to increase by 3.57 X100 = $357mln.

With the injections and withdrawals approach, in a 3 sector

model, S+T = I+G

Where, S = -100 +0.18Y, T = 0.1Y, I = 250 and G=170

Therefore, -100+0.18Y+0.1Y = 250+170

0.28Y = 520, Y* = 1857

42
4-SECTOR MODEL – OPEN ECONOMY WITH GOVERNMENT
In an open economy, we bring in the foreign sector, i.e.
imports and exports. Exports depend on spending
decisions made by foreign consumers or overseas firms that
purchase domestic goods and services. We therefore
assume exports to be autonomous spending.

Imports, however, depend on the spending decisions of

domestic residents. Clearly, the increase in income (Y) will
also result in imports (M) of foreign produced consumption
goods to rise.

Let’s assume X = 540, M = 0.25Y

Factors which affect Net Exports:

1. Foreign GDP: An increase in foreign GDP results in an

increase in the quantity of domestic-produced goods by
foreign countries. Therefore, as X increases, (X-M)
function shifts upward. However, same amount is sold at
each level of domestic GDP as X is treated as
autonomous.

2. Relative International Prices: Any changes in the prices

of home produced goods relative to those of foreign
goods will cause both imports and exports to change.
Two factors that cause relative international prices to
change are:

a) International differences in inflation rates: If domestic

economy’s inflation rate is lower than inflation overseas,

43
 exports will appear cheaper. Therefore, X increases. Also, M
becomes expensive for domestic consumers and X – M ↑.

FIGURE 4.6 Imports and Exports

b) Changes in the exchange rate: Depreciation of

currency results in X to become cheaper for foreigners.
Therefore, X increases. Also, M becomes expensive for
domestic consumers and X – M ↑.

44
Equilibrium in the 4-sector model

In an open economy with government:

AE = C + I + G + X – M

With t = 10%,

C = 100 + 0.8(1-t)Y = 100 + 0.72Y

I = 250

G = 170

X – M = 540 – 0.25Y

At Equilibrium AE = Y and AE = C + I + G + X – M

AE = 100 + 0.72Y + 250 + 170 + 540 – 0.25Y

=> AE = 1060 + 0.47Y or

Replacing AE = Y, Y = 1060 +0.47Y

0.53Y = 1060 =>Y* = 2000

Also,

S+T+M = I+G+X

-100+0.28Y+0.25Y = 250+170+540

-100 + 0.53Y = 960

Y* = 1060/0.53 = 2000

45
FIGURE 4.7 4 sector

46
FIGURE 4.8 4 sector model

47
Multiplier in a 4-sector Model

With the govt and imports, the multiplier is now:

Where mpm = marginal propensity to import = the

proportion of extra income which is spent on imports

mpm = 0.25, mrt = 0.1, mps = 0.18

Hence, an increase of $100 in autonomous expenditure will

lead to a $182 increase in national income (Y).

Determination of the size of the Multiplier

The effect on national income of a change in an

autonomous expenditure depends on the size of the
multiplier, which in turn, depends on a number of factors:

1. Openness of the economy: The more open the

economy, the higher the marginal propensity to import,
the lower the mpc as consumers buy imports rather than
domestically produced goods and therefore the lower
the multiplier.

2. Interest Rates: Higher interest rates encourage savings.

Higher mps can in turn dilute the value of the multiplier.

48
3. Tax rates: Higher tax rates result in lower disposable
income to be available for consumption, thereby
reducing the size of the multiplier.

FULL EMPLOYMENT AND NATIONAL INCOME

Keynesian theory assumes that there is a maximum level of
national output, and hence real income, which can be
obtained at any one time. If the equilibrium is at this level,
there will be no deficiency of aggregate expenditure and
hence no disequilibrium unemployment. This level of
income is referred to as full employment level of national
income.

49
Deflationary gap

The full-employment level of national income ( Yf ) is

represented by the vertical line. The equilibrium level of
national income is Ye, where Y=AE. The deflationary gap is
a - b: namely the amount that the E line is below the 45
degree line at the full-employment level of income ( Yf ).

Inflationary Gap

If, at the full-employment level of income, aggregate

expenditure exceeds national income, there will be a
problem of excess demand. Ye will be above Yf. The
problem is that Yf represents a real ceiling to the output. In
the short run, real national income cannot expand beyond

50
this point. Ye cannot be reached. The result will be
therefore, demand pull inflation. The situation involves an
inflationary gap. This is the amount by which aggregate
expenditure exceeds national income or injections exceed
withdrawals at the full employment level of national
income. This is illustrated by the gap c - d in the diagram
below.

51
BALANCED BUDGET MULTIPLIER

Balanced Budget multiplier shows the effect on national

income of equal changes in government spending and
taxation. For example, if taxation increases by $100 million
and government injects $100 million as government
expenditure, the net effect of this equal increase in taxation
and government spending will not be zero but in fact equal
to the amount of the government injection.

1. An increase in government spending of $100 million

leading to a $500 million increase in national income.
(multiplier = 5)

52
2. An increase of Taxes of $100 million, leads to a fall in
disposable income by $100 million, and therefore a fall in
consumption by $80 million (mpc = 0.8) and a fall in
savings by $20 million (mps = 0.2). As a result, AE falls by
$80 million leading to a fall in Y by $400 million.

When autonomous taxes increase by $100 million, the AE

will decline by less than full $100 million because mpc is
less than one. For example, a fall in national income of
$100 million will result in consumption to fall by $80 million
and savings to fall by $20 million. As a result, AE falls by
$80 million. At the same time, a simultaneous increase in G
will result in AE to rise by full $100 million. Therefore, the
combination of increasing the autonomous level of G and T

53
by the same amount will actually lead to a net increase in
desired spending of $20 million, and an increase in
equilibrium level of GDP by $100 million, as the value of
multiplier is 5. A balanced budget increase in government
expenditure leads to a mild expansionary effect on GDP
equal to the size of the increase in G, suggesting the
balanced budget multiplier =1.

ACCELERATOR - MULTIPLIER INTERACTION

If there is an initial change in injections or withdrawals, then
theoretically this will set off a chain reaction between the
multiplier and the accelerator. For example, if there is a rise
in government spending, this will lead to a multiplied
increase in national income. But this rise in national income
will set off an accelerator effect: firms will respond to the
rise in income and the resulting rise in consumer demand
by investing more. But this rise in investment constitutes a
further rise in injections and therefore, will lead to a second
multiplied rise in in income. If this increase in income is
larger than the first, then there will be a second increase in
investment (the accelerator), which in turn will cause a third
rise in income (the multiplier). And so the process continues
indefinitely.

But does this lead to an exploding rise in national income?

Will a single rise in injections cause national income to go
on rising forever? The answer is no. In real terms, national
income cannot go on rising faster than the growth in

54
potential output. It will bump against the ceiling of full
employment, whether of labor or of other resources.

55
CHAPTER 5

MONEY AND BANKING

DEFINITION, FUNCTIONS AND CHARACTERISTICS OF MONEY
Money can be defined as anything which is generally
acceptable as a means of payment. Before the
development of money, barter was used. This involves the
direct exchange of goods and services without the use of
any monetary mechanism.

Barter had a number of distinct disadvantages:

1. It required a double coincidence of wants, i.e. one

person offering a good or service needs to find someone
who wants that good or service and that person also
needs to be offering something in exchange that the
seller wants.

2. It was often difficult to compare the value of different

goods and services.

3. The products may be indivisible, e.g. in the case of

animals.

4. The products may be difficult to store while a seller is

looking for an appropriate buyer.

These various disadvantages of barter meant that

economies moved towards the development of money
which would avoid the direct exchange of goods and
services.

Although money has largely replaced barter, it is still

necessary to establish what is, and what is not, money:

57
1. Cash: the most obvious form of money is cash, whether
in the form of notes or coins.

2. Legal tender: some money may only be acceptable in

transactions up to a certain amount and this is referred to
as legal tender; this means that it must be accepted
legally as a means of payment.

3. Bank deposits: much money is in the form of money

deposited in banks, building societies, credit unions and
other financial institutions; these monetary deposits can
be in current accounts or various forms of savings
account.

4. Near money: near money, or quasi money as it is

sometimes called, refers to an asset that is immediately
transferable into money and so can be used to settle
some, but not all, debts. Near money, therefore, is able
to fulfil some of the functions of money, but not all of
them. For example, it cannot be used as a medium of
exchange.

5. Liquidity: the ability to turn an asset into cash refers to its

liquidity. Cash is the most liquid form of asset. The more
liquid an asset, the easier it is to convert it into money.

6. Cheque: it is important to know not only what money is,

but also what it is not. For example, a cheque is
sometimes believed to be a form of money, but this is
incorrect as a cheque is simply a means of payment and
is not actually a form of money.

58
FUNCTIONS OF MONEY
Money is said to perform four essential functions in an
economy:

1. A medium of exchange. A very important function of

money is that it operates effectively as a means of
exchange. Money is generally accepted as a means of
payment for goods and services. This is the great
advantage of money over barter, i.e. it overcomes the
problems associated with the need to have a double
coincidence of wants between two people.

2. A measure of value or unit of account. This function of

money can either be described as a measure of value or
as a unit of account. This is the idea that money enables
the value of different goods and services to be
compared. The direct exchange of goods and services
in a barter system made it very difficult to give a
valuation of the different products being traded. This
function of money makes it possible to compare the
value of different goods and services.

3. A standard for deferred payment. Money enables

people to borrow money and pay it back at a later date.
This encourages the provision of credit and so acts as
an incentive to trade. Buyers are able to consume
goods and services immediately, but the payment can
be spread over a period of time. This was a major
limitation of the barter system.

59
4. A store of value or wealth. A final function of money
is that it enables wealth to be stored in the form of
money. Compared to the barter system, money
does not physically deteriorate and it is usually not
expensive to store it, although this function of
money does face the problem of a possible
deterioration in its value if there is a situation of
inflation in an economy as inflation erodes the value
or purchasing power of a given sum of money over a
period of time.

60
CHARACTERISTICS OF MONEY
Money has a number of distinctive characteristics and these
are outlined in Table below

DEFINITION OF MONEY SUPPLY

The money supply is the total amount of money in an
economy at any one time. It includes notes and coins and
also any deposits, such as current accounts in banks, which
can be quickly converted into cash.

Today more and more transactions are done using cheques,

debit cards, credit cards and electronic bank transfers. It is

61
usual, therefore, to distinguish between narrow money and
broad money although there is no completely agreed
definition of either between countries or economists.
Narrow money is sometimes referred to as M0 or M1 and
broad money as M3 or M4.

Narrow definitions of money include only items that can be

spent directly, such as cash and current accounts in banks
(since they can be spent directly by using cheques or debit
cards). Broad definitions of money also include various
items such as deposit and savings accounts in banks that
cannot be spent directly, but which can nevertheless be
readily converted into cash. Hence, broad measures may
include items that are not liquid. Liquidity refers to the ease
with which an asset can be spent. Cash is the most liquid
asset, as it can be used for transactions. However, if you are
holding funds in a savings account whereby you must either
give notice of withdrawal or forfeit some return to withdraw
it instantly, then such funds are regarded as being less
liquid, as they cannot costlessly or instantly be used for
transactions.

Narrow measures focus on items which are used primarily

as means of exchange while broad measures include items
which are used not only as a means of exchange but also as
a store of value.

62
SOURCES OF MONEY SUPPLY
1. An increase in commercial bank lending – credit
creation: Commercial banks, by lending to customers,
create money. Whenever a bank receives deposits, it
keeps a fraction of it as a reserve and loans out the rest.
By lending out, the bank creates more deposits and
increases money supply in the economy.
Example: If the bank receives $100, and the liquidity
reserve ratio is 10%, the bank will keep $10 and loan out
$90. The borrower can then use the $90 to buy
something from someone who then deposits the
currency. This process goes on and on. Each time money
is deposited and a bank loan is made, more money is
created.
How much money is created in the economy from $100?
Original deposit = $100
Bank 1 lending = $90 which is (0.9*100)
Bank 2 lending = $81
…
Total money supply = 1000
The amount of money the banking system generates with
each dollar of reserves is called the money multiplier
(Credit Multiplier).
Money Multiplier =1/Liquidity Ratio
With 10% liquidity or reserve ratio, for example, the
money multiplier becomes 100/10 = 10. Hence $100 of
initial deposit will result in money supply to grow to
$1000.

63
 Change in Money Supply = Initial Deposit x Money
Multiplier.
The lower the reserve ratio, the higher the amounts the
bank can lend, the higher will be the money supply.
Reserve ratios provided by the central bank are one of
the ways the government controls the money supply in
the economy.

2. Open Market Operations: Money supply can also be

changed through open market operations – which is
buying and selling of government securities. When the
government sells securities in the open market, it takes in
cash from the financial institutions purchasing the
government securities, thus reducing the cash in the
system. Vice versa, when government buys securities in
the open market, it gives in cash to the financial
institution selling the government securities, thus
increasing cash in the system.
The government uses government securities to borrow
money to finance a deficit. If the bonds are sold to the
central bank or the commercial banks, there will be a
multiplied effect on money stock. This is because when
the government undertakes its expenditure, this releases
new money into the system that then acts as an increase
in the base on which credit creation takes place. Selling
to the non-bank private sector does not have this effect,
because the public draw down their bank deposits in
order to pay for the bonds in the first place. Deficit

64
 financing by the government can thus have an impact on
the size of money stock.

3. Total Currency Flow: The total currency flow of the

balance of payments refers to the total outflow or inflow
of money resulting from international transactions. If
there is net inflow of money into a country, the excess
surplus currency will be converted into local currency,
thereby increasing the money supply of the country.

4. Quantitative easing:Since 2009, central banks have

purchased financial assets from banks and businesses
resulting in an increase in the money supply to expand
economic activity. It works by the central bank buying
large amounts of government bonds which then lowers
the interest rates on those bonds. This, in turn, pushes
down the interest rates offered on loans because rates on
government bonds tend to affect other interest rates in
the economy. This makes it cheaper for individuals and
businesses to borrow money, encouraging spending. In
addition, it can boost a wide range of financial asset
prices. By purchasing the government bonds, other
financial institutions have more money which they can
invest in other financial assets such as shares increasing
their price. This makes businesses and individuals
holding shares wealthier, making them more likely to
increase spending leading to more economic activity.

65
FUNCTIONS OF COMMERCIAL BANKS

Commercial banks are financial institutions which take

deposits from, and loan out money to individuals and firms.

Providing deposit accounts (demand deposit account,

savings account)

The most significant and traditional function of commercial

banks is accepting deposits from the public. Demand
deposit, or current, accounts usually do not have interest
paid on the money as it can be withdrawn at any time
either through taking notes and coins out or
by using cheques or through the use of bank cards. Saving
accounts do attract interest because although money can
normally be withdrawn from them at any time, the bank can
require notice of withdrawal. This is most likely if a very
large sum is required.

Lending money (overdrafts, loans)

Banks having accepted deposits, and paid interest on

some, need to lend money at higher interest rates in order
to pay their depositors. They can lend money in the form of
overdrafts or loans. Overdrafts are an arrangement by
which a person can borrow money they do not have
through their current account. Loans, however, are a sum of
money given by a bank to a borrower for a set period of
time where interest is paid on the whole of the loan.

66
Holding or providing cash, securities, loans, deposits,
equity

1. Cash is held by banks to provide depositors with the

money in their account. Banks in India hold about 4 per
cent of their deposits as cash.

2. Most loans are secured loans, in that the borrower has to

offer some way in which the bank could regain its money
if the loan was not repaid. If you borrow $20,000 to buy
a house, the bank may require you to give them the
deeds, or legal ownership, of the house. If you fail to
repay the loan the bank could then sell the house and
repay itself.

3. Making loans and taking deposits are the two major

functions of as commercial bank (see below).

4. Equity is the ownership of assets. In the case of banks,

other than the banks’ buildings, the main equity is the
money that a bank has obtained from its shareholders
and other investors and any profit that it has made and
not paid out.

Reserve ratio and capital ratio

The reserve ratio is the percentage of deposits which

commercial banks are required, by the country’s central
bank, to keep as cash. In the UK it is 12.5 per cent. The
reserve ratio is an important tool of monetary policy and
plays an essential role in regulating the money supply.

67
When the central bank wants to increase money supply in
the economy, it lowers the reserve ratio. As a result,
commercial banks have higher funds to disburse as loans,
thereby increasing the money supply in an economy. The
opposite is true when money supply needs to be reduced.

The capital ratio is the funds that a commercial bank has in

reserve measured against the total value of assets which are
a risk, that is might not be able to be repaid. This is an
attempt to prevent banks from not being able to meet their
liabilities. Since the financial crises of 2008, many central
banks now run “stress tests” to check whether banks have
enough capital to cope with a crisis.

Objectives of commercial banks: liquidity, security,

profitability

In order to survive and to be able to pay its liabilities,

mainly deposits, banks must ensure that they have sufficient
liquidity. Its most liquid asset is cash, but it also involves
how easily it can turn other assets into cash. It is an
important objective as the “stress test” will be testing it.

Security is another objective. Clearly banks need to ensure

that their customers’ money is kept safe. This has become
increasingly important with the use of online and similar
technological innovations. Cyber security is now essential
as otherwise criminals can gain access to large sums of
deposited money as well as private information.

68
The major objective, however, is probably profitability. Not
only will a bank go out of business if it is not profitable, but
both shareholders and depositors are likely to withdraw
their money if there is any sign of problems. The objective
is to make a profit by earning more from the interest
charged on loans than the interest paid to depositors. Profit
can also be made by providing services such as deposit
security, currency trading, business advice, cheque and
credit-card processing.

69
DEMAND FOR MONEY – LIQUIDITY PREFERENCE THEORY
Keynesians argue that rate of interest is determined by
demand and supply of money. It is assumed that the supply
of money is determined by the monetary authorities and is
fixed in the short-run.

The demand for money refers to the desire to hold money:

to keep your wealth in the form of money, rather than
spending it on goods and services or using it to purchase
financial assets such as bonds or shares. The opportunity
cost of holding any money balance is the extra interest that
could have been earned if the money had been used
instead to purchase bonds. It is usual to distinguish three
reasons why people want to hold their assets in the form of
money.

1. Transaction Motive: Since money is a medium of

exchange, it is required for conducting transactions.
However, people receive money only at intervals (e.g.
weekly or monthly) and not continuously, they need to
hold balances of money in cash or in current accounts.
The transaction demand for money relates directly with
real GDP. The higher the GDP, the higher will be the
money demand for transaction purposes.

2. Precautionary Motive: Firms and households also

demand money to meet any unexpected expenses and
take advantage of any unforeseen bargains.
Money held for transaction and precautionary motives

70
 are called active balances (LP1)– as they are likely to be
spent. Active balances are relatively interest inelastic,
which means a rise in interest rates will not result in
households and firms to significantly alter or cut back on
their holdings of money for transaction and precautionary
purposes.
FIGURE 5.1 Active and Idle Balances LP curve

3. Speculative Motive: Certain firms and individuals who

wish to purchase financial assets such as bonds, shares or
other securities, may prefer to wait if they feel that their
price is likely to fall. In the meantime, they will hold

71
 money balances instead. This speculative demand can be
quite high when the price of securities is considered
certain to fall. Money when used for this purpose is a
means of temporarily storing wealth.
Therefore, firms and households will hold money, which
are sometimes called idle balances (LP2), when they
believe that the returns from holding financial assets are
low. When interest rates are high, the opportunity cost of
holding money is high and idle balances will be low. Vice
versa, when interest rates are low, opportunity cost of
holding money is low, idle balances will be high. The idle
balances are therefore interest elastic – very responsive
to changes in interest rates.

FIGURE 5.2 Liquidity Preference Curve

72
 Liquidity Preference (LP) = Active Balances (LP1) + Idle
Balances (LP2)

Supply of Money

According to Keynesians, supply of money in the short-run

is fixed by the central bank and is vertical, which the
government can change through many methods described
earlier like changing the reserve ratio.

FIGURE 5.3 Money supply

73
 Equilibrium in the money market therefore occurs where
the demand for money (LP curve) equals the supply of
money (MS0). Any changes in the demand and supply of
money can change the equilibrium quantity of money and
the rate of interest.

FIGURE 5.4 Money market equilibrium

74
 Downward slope of Aggregate Demand and Interest
Rates

1. An increase in the price level results in

2. An increase in the demand for money

3. Which in turn results in interest rates to rise and

4. Consumption and investment to fall and ultimately results

in national income (Y) to fall

FIGURE 5.5 Interest rates and aggregate demand

75
Interest rates and the price of bonds

There exists an inverse relationship between interest rates

and the price of bonds or the government securities.

When a government issues a security it has a fixed dividend

rate, a face value and a tenor or duration for the bond. For
example, govt. can issue a bond for a tenor of 10 years with
the face value of $100 and fixed per annum return rate of
10%. The market value or price of the bond, however,
depends upon the interest rates determined by the market.

If the market interest rate rises to, for example 15%, the
value or price of the bond will fall, that yields a fixed return
of 10%. Similarly, when the market interest rate falls to, for
example 5%, the value of the bond and its price will be
higher and that yields a 10% return.

Money demand

From a speculator’s perspective, who buys low and sells

high, holding money is for speculative purposes. When the
interest rates are high, the price of the bonds are low, he
would buy bonds and hold less money balances. Similarly,
when the interest rates are low, the prices of bonds are high
and a speculator will hold more money balances and will be
selling bonds.

76
FIGURE 5.6 Money Demand

Liquidity Trap

According to Keynesians, the speculative demand for

money is highly responsive to changes in interest rates. If
people believe the rate of interest will rise, and thus the
price of bonds and other securities will fall, few people will
want to buy them. Instead there will be a very high demand
for liquid assets (money and near money). The demand for
money will therefore be very elastic in response to changes
in interest rates. The demand for money curve (the liquidity
preference curve, LP curve) will be shallow and may even
be infinitely elastic at some minimum interest rate. This is
the point where everyone believes interest rates will rise,

77
 and therefore no one wants to buy bonds. Everyone wants
to hold their assets in liquid form.

FIGURE 5.7 Liquidity Trap

With a very shallow LP curve, a rise in money supply from

MS to MS′ will lead to only a small fall in the rate of interest
from r1 to r2. Once people believe that the rate of interest
will not go any lower, any further rise in money supply will
have no effect on interest rates. The additional money will
be lost in what Keynes called the liquidity trap. People
simply hold the additional money as idle balances.

78
Keynes himself saw the liquidity trap as merely a special
case: the case where the economy is in deep recession. In
such a case, an expansion of money supply would have no
effect on the economy. In more normal times, an expansion
of money supply would be likely to have some effect on
interest rates. Nevertheless, the problem could be severe in
times of recession.

The Japanese economy suffered from a prolonged

recession (from the early 1990s to the early 2000s). The
government and central bank expanded the money supply,
but people seemed unwilling to spend. They preferred to
hold idle balances. What is more, with interest rates already
being virtually zero, there was little incentive to buy bonds
or other assets. Thus any extra money was simply kept in
idle balances – lost in the liquidity trap.

79
MONEY SUPPLY AND MONETARY TRANSMISSION
MECHANISM
Direct Transmission Mechanism

The direct transmission mechanism relates to an increase in

the money supply resulting in an increase in the AD directly.
This happens when money supply increases in an economy,
there is more money available than the amount people
require holding and the surplus will be spent thereby
increasing the AD.

MS↑→MS> MD → AD↑

Indirect Monetary Transmission

An increase in money supply results in changes in AD via

the interest rates and exchange rates indirectly.

1. Increase in Money Supply from MS0 to MS1

2. Results in Interest Rates to fall from r0 to r1

3. Hot money flows out and the demand for currency falls
while supply rises and ER depreciates from e0 to e1

4. AD rises as X-M rises (due to weaker ER) and even C and

I rise due to lower interest rates.

80
 FIGURE 5.9 Fall in interest Rates

FIGURE 5.8 Exchange rate depreciates

81
FIGURE 5.10 AD rises

82
EFFECTS OF MONEY SUPPLY ON THE ECONOMY
According to the Fisher equation

MV = PT

M= money supply

V= velocity of circulation (no. Of times money changes

hands)

P= Price level

T= Total output

Simple example: An economy produces pizzas only. If it

makes 100 pizzas and the price is for $10 and money
supply is $50.

T = 100 pizzas, P=$10, MS=$50

Velocity = 10*100/50 = 20

Money has to change hands 20 times in order for the 100

pizzas to be sold. The quantity theory of money states that
the value of total expenditure (MV) must equal to the value
of the output sold (PT). Changes in money supply and its
impact on the economy is a matter of dispute between the
Classical Economists and the Keynesians.

Monetarist View

Monetarists are of the view that changes in the money

supply can have a significant impact on the price level of
the economy.

83
Monetarist economists believe that in the short term
velocity (V) is fixed as it depends on the spending pattern,
which does not change over time. They also believe that
Output T is fixed by supply side factors, as the economy
operates under full-employment in the long run. Hence V
and T are constant and are determined independently of
the money supply. If there is a change in the money supply
then price level will rise, as T will quickly return to its long
run (natural) equilibrium. Note LRAS is inelastic in the
Classical economists model. Therefore an increase in the
money supply (M) faster than the growth of national income
will lead to an increase in (P) inflation.

Keynesian View

Keynesians dispute the validity of the theory. They argue

that a change in the money supply can affect any or all of
the other three variables so it is not possible to predict
what will happen when money supply changes. For
example, the Velocity of Circulation V is not stable, but can
change due to factors such as increase in the use of credit
cards. Keynesians also argue that the LRAS is not
necessarily inelastic; they argue that the economy can be
below full capacity for a long time.

Keynes also rejected the simple quantity theory of money.

Increases in money supply will not necessarily lead merely
to rises in prices. If there is a lot of slack in the economy,
with high unemployment, idle machines and idle resources,
an increased spending of money may lead to substantial

84
increases in real income (Y) and leave prices (P) relatively
unaffected.

Interest rate determination: loanable funds theory

An alternative approach to liquidity preference is that of
demand and supply of loanable funds.

The demand for loanable funds comes from two sources –

domestic investment and net foreign investments (NFI). Net
foreign investments are net of capital assets owned by
foreigners.

NFI = Foreign capital assets owned by domestic individuals

- domestic capital assets owned by foreigners.

Demand for loanable funds = I +NFI

Demand for loanable funds is downward sloping as an

increase in interest rates results in the cost of borrowing to
increase and discourages investment. In addition to this,
when interest rates increases, domestic residents will
reduce investments in foreign investments abroad and
foreigners will increase their investments in domestic assets
(hot money or short term investment), resulting in NFI to
decline.

The supply of loanable funds comes from the national

savings of an economy. National savings has two
components – private and public savings.

National savings= Private Savings + Public Savings

85
Private savings are the savings by the private sector, while
public savings are the savings by the govt.The supply of
loanable fund is upward sloping as higher interest rates
encourage people to save more and therefore raises the
quantity of loanable funds supplied.

Loanable funds bring together savers who are supplying

the funds and borrowers who are demanding funds. In this
case the rate of interest is determined by where the supply
of funds equals the demand for funds as shown in the
figure below.

86
When the government runs into a surplus, there will be an
increase in public savings and, as a result, the supply of
loanable funds increases. Similarly, when the government
runs into a deficit, there will be public borrowings and the
supply of loanable funds decrease. Bank lending can also
shift the supply of loanable funds. Higher the bank lending,
the more the supply of loanable funds at all levels of
interest rates.

87
POLICIES TO REDUCE INFLATION AND THEIR EFFECTIVENESS

For an economy that is in macroeconomic equilibrium,

there are two ways in which prices can begin to increase.
First, there could be a leftward shift in the aggregate supply
curve. Second, there could be a rightward shift in
aggregate demand.

Anti-inflationary policy

The appropriate policies to reduce inflation depend on the

type of inflation. Given that demand-pull inflation is due to
excess aggregate demand, then an appropriate policy
would be to reduce aggregate demand. Thus the
government could use deflationary fiscal policy (increase
taxes and lower government spending) and/or deflationary
monetary policy (raise interest rates and reduce the money
supply).

Evaluation of Anti-inflationary policies

1. From a political standpoint, such policies are highly

unpopular. Looking first at fiscal policy, a voting
population is unlikely to be happy to accept higher taxes
as it reduces disposable income and the level of
consumption. A reduction in government spending will
inevitably impact upon a variety of groups in the
economy and this may result in less support for the
government.

88
2. It takes a long time for a government to bring about a
change in its fiscal policy. Budgets are developed over a
long period and changes need to go through lengthy
legislative procedures where there may be great
opposition to any budget cuts. Therefore, there would
be a long time lag involved in using contractionary policy
to bring about a decrease in aggregate demand.

3. As far as monetary policy is concerned, higher interest

rates will also harm some people in the economy, most
obviously anybody who has taken a loan or mortgage.
Higher interest rates mean higher loan and mortgage
repayments and will therefore be unpopular. A
government that is concerned about being re-elected
will be reluctant to use these methods to fight inflation.

4. Nowadays, monetary policy is considered to be the most

effective way of managing aggregate demand in the
economy and changes in interest rates are considered
the best weapon in the fight against inflation. Fiscal
policy is not seen to be as effective as monetary policy in
battling inflation. It would be very difficult for
governments to reduce their spending because of their
commitments to the public. Moreover, even if
governments could reduce their spending, it would take
a long time for the cuts to have any effect on the price
level.

5. If inflation is of a cost-push nature, then deflationary

demand-side policies may bring down the price level,

89
 but they will result in lower national output and are likely
to cause unemployment to rise. Thus, demand-side
policies are ineffective and supply-side policies are the
appropriate policies to deal with cost-push inflation.
However, when inflation does occur, it is difficult to
distinguish the demand-pull from the cost-push factors
and so policy-makers are likely to use a mix of solutions.

6. A significant problem facing governments is the possible

trade-off between their different policy objectives. They
may want to fight inflation by bringing about a decrease
in aggregate demand, but this might result in a higher
level of unemployment. If they try to fight unemployment
and increase economic output (achieve economic
growth) by increasing aggregate demand, it might create
inflationary pressure.

90
CHAPTER 6

UNEMPLOYMENT AND
ECONOMIC GROWTH
The unemployed are The most usual definition that economists use for the
those who are of
number unemployed is: those of working age who are
working age, who are
without work, but without work, but who are available for work at current
who are available for wage rates. If the figure is to be expressed as a percentage,
work at current wage
then it is a percentage of the total labour force. The labour
rates.
force are those in employment plus those unemployed.
The labour force
is defined as: FIGURE 6.1 Labour Force of Pakistan 2010
those in
employment plus
those
unemployed.

Unemployment Rate = (Unemployed/ Total Labour Force)

x100= 2.42/49.98 x100 = 4.84

92
 AGGREGATE DEMAND AND SUPPLY OF LABOUR
FIGURE 6.2 Equilibrium

Figure 7.2 shows the aggregate demand and supply of

labor: that is, the total demand and supply of labor curve
(ASL) shows the number of workers willing to accept jobs at
each wage rate. The supply curve is inelastic, since the size
of labor force at any one time cannot change significantly. It
is not totally inelastic because (a) a higher wage rate will
encourage some people to enter the labor market and (b)
the unemployed will be more willing to accept job offers
rather than continuing to search for a better-paid job.

93
 The aggregate demand for labor curve (ADL) slopes
downward. The higher the wage rate, the more will firms
attempt to economize on labour. The labor market will be
at equilibrium where the demand for labor equals the
supply.

FIGURE 6.3 Natural Unemployment

Even when the labor market is in equilibrium, not everyone

looking for work will be employed. Some people will be
unemployed. For example, some people will hold out,
hoping to find a better job. The curve N shows the total
number in the labor force. The horizontal difference

94
between it and the aggregate supply of labor curve (ASL)
represents the excess of people looking for work over
those actually willing to accept jobs. QE represents the
equilibrium level of employment and the horizontal
distance D – E represents the equilibrium level of
unemployment. This is sometimes known as the natural
level of unemployment.

Note that the ASL curve gets closer to the N curve at higher
wages. The reason for this is that the unemployed will be
more willing to accept jobs, the higher the wages they are
offered. If the wage rate were above We, the labor market
would be in a state of disequilibrium. For example, at a
wage rate of W1, there is an excess supply of labor of A – B.
This is called disequilibrium unemployment.

95
 DISEQUILIBRIUM UNEMPLOYMENT
1. Real wage or classical unemployment: This is the
unemployment that is caused because the real wage rate
is higher than the equilibrium real wage rate.

FIGURE 6.4 Classical unemployment

Classical economists believe that the real wage and

quantity of labor is determined by the interaction of the
demand and supply curve of labor (WE and Qe). Market
imperfections like trade unions and government
intervention in terms of minimum wage can disrupt the
equilibrium and creates unemployment equal to Q2 – Q1.
Real wage is likely to be forced up above the equilibrium
real wage to W1 if the minimum wage is established

96
 above WE. The real wage unemployment will therefore
result in involuntary unemployment.

2. Demand deficient or cyclical unemployment:

Keynesians believe that unemployment was not a result
Labor is derived of the labor market equilibrium. Labor is derived
demand, derived
demand, derived from the demand for the good that is
from the demand for
the good that is produced. If there is a big fall in the demand for products
produced. in the goods market then the demand for labor will fall
causing unemployment. Keynesians argue that in times
of recession, the aggregate demand curve for the
economy as a whole will shift to the left. This will cause
the demand for labor to shift to the left as well (from AD1
to AD2). However, if the real wage stays at W1, there will
be involuntary unemployment equal to Q1 – Q2.
Keynesians believe that this will happen because wages
are ‘sticky’ downward. The downward stickiness in real
wage may be the result of unions seeking to protect the
living standards of their members or of firms worried
about the demotivating effects of cutting the real wages
of their workers.

97
FIGURE 6.5 Disequilibrium Unemployment

98
EQUILIBRIUM UNEMPLOYMENT (OR NATURAL
UNEMPLOYMENT)
The natural rate of unemployment is defined as the
equilibrium rate of unemployment i.e. the rate of
unemployment where real wages have found their free
market level and where the aggregate supply of labour is in
balance with the aggregate demand for labour. At the
natural rate, all those wanting to work at the prevailing real
wage rate have found employment and thus there is
assumed to be no involuntary unemployment. There
remains some voluntary unemployment as some people
remain out of a job searching for work offering higher real
wages or better conditions.

1. Frictional Unemployment: Frictional unemployment is a

voluntary form of unemployment for workers who are
looking for better jobs. Many qualified workers seeking
work are not able to find new jobs right away, usually
because of a lack of complete information about new job
openings. While it is likely that qualified workers will soon
be matched with new jobs, these workers are considered
frictionally unemployed during the time that they spend
searching for their new jobs. The bigger the
imperfections in the labor market, the longer will be this
period of ‘unemployment’ for each worker and the higher
will be the search costs for individuals.

2. Structural Unemployment: It is caused by changes in

the structure of the economy. A huge shift away from

99
 manufacturing to service sector in the recent times is one
reason of structural unemployment. Another example is
when demand switches away from domestic industries to
more competitive foreign industries. Structurally
unemployed workers are not qualified for the new job
openings that are available, mainly because they lack the
education or training needed for the new jobs.
Consequently, the structurally unemployed tend to be
out of work for long periods of time, usually until they
learn the skills needed for the new jobs or until they
decide to relocate.

3. Seasonal Unemployment: is when demand for workers

fluctuate according to the time of the year.

Full Employment is considered to be achieved when

unemployment falls to 2-3%. At any period of time, there
will be some people who may be experiencing a period of
unemployment as they move from one job to another
(frictional unemployment or voluntary unemployment).

Voluntary and involuntary unemployment

Voluntary unemployment occurs when someone who is

able to work is not willing to do so, even though suitable
work is available. Most frictional unemployment is
considered voluntary because one is looking for work rather
than taking any job available. Some economists claim that
structural unemployment can often be voluntary as those

100
with specific skills may not be willing to take lower-skilled
work.

Involuntary unemployment occurs when those who are able

and willing to work at the going wage rate cannot find
work. The main form of this is demand deficient or cyclical
unemployment which is linked to the trade cycle and the
lack of aggregate demand causing the supply of workers
wanting to work exceeding the demand for them. Some
structural, especially technological, unemployment may
also be involuntary.

Natural rate of unemployment

Definition

The natural rate of unemployment is the rate of

unemployment where real wages have found their free
market level and where the aggregate supply of labour is
equal to the aggregate demand for labour. At the natural
rate, all those wanting to work at the current real wage rate
are employed and there is no involuntary unemployment.
Some voluntary unemployment still exists due to frictional
and some structural unemployment.

Determinants

As the natural rate of unemployment is mainly composed of

frictional and structural unemployment, factors that affect
these types of unemployment will alter the natural rate.

101
Policy Implications

Demand-side policies have problems as there is a need to

measure aspects such as the output gap, but this has
proved difficult to do. There are also issues with the Phillips
curve.

The result is that supply-side policies have usually been

used to try to reduce or stabilise the natural rate. These
include:

1. Improved education and training to reduce occupational

immobility through new skills

2. greater availability of different kinds of housing to make

it easier for workers and firms to be relocated

102
3. making labour markets more flexible

103
MOBILITY OF LABOUR

Forms of labour mobility: geographical and occupational

1. Geographical mobility of labour is the ease or otherwise

with which individuals can move between geographical
areas, whether these are within a country or between
countries. It is affected by factors such as family ties,
transport networks, transferable qualifications, common
language and international relations and situations.

2. Occupational mobility of labour is the ease or otherwise

with which individuals can move between occupations.
The occupational mobility of labour depends on such
factors as the level of education, training and skills
required by the job, together with the length of training.
It is possible to distinguish between horizontal and
vertical labour mobility.

3. Horizontal mobility is a worker’s ability to move to

another job at a similar wage such as being a shop
assistant in one store to being a shop assistant in another
store. Vertical mobility is, however, the worker’s ability to
move up, and down, the employment hierarchy. A
teacher, for example, could move from a being a new
young recruit to being a headteacher.

104
Factors affecting labour mobility

Factors affecting geographical mobility include:

1. The cost and availability of suitable housing

2. Transportation

3. Immigration policies can both facilitate and hinder

mobility.

4. Migration, where unrest in one country encourages

people to move to another one both for better job
prospects, but also for greater safety.

5. Family ties often restrict geographical mobility. Many

people are reluctant to move far away from their family.

Increasingly, the most important factor affecting

occupational mobility is education and training. The ability
to gain relevant qualifications and skills not only at the start
of a career, but also throughout and the types of jobs
available, determine mobility. This means both vertical
mobility, but, also, moving to different types of occupation.

Both geographical and occupational mobility are affected

by factors such as: labour market regulations; types of work
contract – long term, short term, zero hours; the power of
trade unions; etc.

105
POLICIES TO CORRECT UNEMPLOYMENT
Unemployment has both demand and supply side causes.
Demand side causes are disequilibrium unemployment
leading to involuntary unemployment. While
unemployment equilibrium is associated with supply side
causes, which cause voluntary unemployment (natural rate
of unemployment).

1. Disequilibrium Unemployment: Fiscal and monetary

policies can be employed to increase the aggregate
demand in the economy, which in turn can increase the
demand for labour which is a derived demand.

2. Equilibrium unemployment: Supply side policies are

employed to tackle the voluntary or natural
unemployment.

Supply Side Policies

Supply side policies are government policies designed to

increase the rate of economic growth. Effective supply side
policies push the Long Run Aggregate Supply curve to the
right. This increases economic growth and reduces
inflationary pressure. It may also bring about a reduction in
unemployment and lead to higher exports and lower
imports.

106
FIGURE 6.6 LRAS shifts outwards due to supply side policies

Supply-side policies include encouraging education and

training, improving the flexibility with which markets
operate, trade union reforms and promoting competition
through privatization and deregulation.

Notice that it is quite difficult to quantify the effects of

these supply-side policies. In the case of education and
training, the idea is that by increasing education and
training, the human capital of the labour force is increased,
thus resulting in improvements in productivity, which enable
an increase in the overall productive capacity of the
economy – in other words, this will lead to a rightward shift
of the aggregate supply curve. However, some of the
effects of increased spending become evident only after
very long time lags.

107
FIGURE 6.7 Relation between unemployment and Inflation

108
In the case of competition policy, again, it is not easy
to identify the effects on productive capacity, although it
is argued that the use of competition policy will provide
incentives for firms to be more productively efficient, and
will reduce the loss of allocative inefficiency through the
abuse of market power.

It is particularly difficult to isolate the impact of these

policies when so much else in the economy is changing
through time. Nonetheless, these policies do have the
effect of stimulating economic growth without inflationary
pressure.

Another example that is important to examine is the effect

of changing the rate of income tax. When people face high
marginal rates of income tax, there is a disincentive to offer
additional labour hours, or even to participate in the labour
force at all. A reduction in income tax rates would therefore
provide an incentive for people to work more hours or to
participate in the labour force. This would then lead to
higher employment, and a higher potential capacity output
for the economy as a whole.

Such high marginal tax rates are normally found at the

high end of the income distribution, but there may also be
disincentive effects to consider at low incomes. These
effects may arise where unemployment benefits are set at
such a level that individuals would be little better off if they
accepted a low- paid job – a situation sometimes known as
the ‘unemployment trap’. This effect may be reinforced if

109
the search costs for jobs are relatively high – for example, if
the jobs available are not in areas where unemployment is
high. There may then be people who do not find it worth
their while undertaking a costly search for jobs, especially if
the wage they could command would be only marginally
better than the benefits that they can receive.

110
THE PHILLIPS CURVE – RELATIONSHIP BETWEEN
INFLATION AND UNEMPLOYMENT
In 1958, an economist Bill Phillips showed a negative
correlation b/w the rate of unemployment and the rate of
inflation by using historical data on these two variables.

AD/AS And the Phillips Curve

If the government, for example, decides to cut

unemployment through an expansionary fiscal or monetary
policy, the resulting shift in the AD curve would increase
output (AD0 to AD1 and Y0 to Y1) and result in more
employment. Money wages have to be raised to attract
new workers (who were voluntarily unemployed at the
lower wage rate). This, in turn would cause an inflationary
rise in the price level. So, unemployment will fall, but
inflation will rise.

At AD0, the economy is at point A, which corresponds to

output level of Y0, where the price level is P0 and
unemployment rate is 7%.

At AD1, the economy is at point B, which corresponds to

the output level of Y1, the price level of P1 and
unemployment rate of 4%. The Phillips curve therefore
suggests that there exists a tradeoff between inflation and
unemployment at any point in time for the economy.

111
 Monetarist view

Monetarists are of the view that this tradeoff may be there

in short-run but not in the long-run. In other words,
expansionary fiscal and monetary policy will have no impact
on unemployment but it may end up in raising the inflation
rate. Monetarists come up with long-run Phillips curve
(expectation-augmented Phillips curve) – which is a vertical
line.

FIGURE 6.8 Long Run Phillips Curve

112
 Expectation-Augmented Phillips curve

Assume that the economy begins at A in figure 8.9, with

0% inflation at the rate of unemployment to be 8%. Now
assume that the government expands aggregate demand
in order to reduce unemployment. Unemployment falls to
6%. The economy moves to point B along curve SRPC0.
Inflation has risen to 4 per cent, but people, basing their
expectations of inflation on year 1, still expect a zero
inflation. Therefore, there is no shift as yet in the Phillips
curve. SRPC0 corresponds to an expected rate of inflation
of zero.

FIGURE 6.9 Expectation augmented Phillips Curve

113
The increased money wages forces the inflation rate up to
4%. The new workers did not realize this straight away.
They initially suffer from “money illusion” as they thought
that their real wages have increased. At lower real wages
and augmented expectation of inflation, the workers will
withdraw their labor services and become unemployed
again. The economy moves from point B to point C,
unemployment is back at 8%, but inflation stays where it is
because money wages have not fallen back to their original
level. The economy is now on a different short-run Phillips
curve (SRPC1) with expected inflation equal to 4%.

If the government tries to reduce unemployment again, the

same thing will happen. The economy will move from point
C to D and then to E. In other words, every time the
government tries to reduce unemployment below 8%, it
manages to do it in the short-run, but as the workers come
out of the money illusion, the economy goes back to the
level of unemployment 8% but at a higher and permanent
level of inflation. Hence the long-run Phillips curve is
vertical.

To conclude, in the short run, higher aggregate demand

will reduce unemployment below the natural level, but in
the long run, once expectations have adjusted, all the extra
demand is absorbed in higher inflation. Unemployment
thus rises back to the natural rate.

If unemployment is to be reduced in the long run,

therefore, this vertical Phillips curve must be shifted to the

114
left. This will be achieved by a reduction in the natural
(equilibrium) rate of unemployment, not by an increase in
demand. To reduce the natural rate, argued the
monetarists, supply-side policies would be needed.

NAIRU

The level of unemployment U* is often called the non-

accelerating inflation rate of unemployment (NAIRU)
because at U*, inflation is non-accelerating. If
unemployment is below U*, then inflation accelerates.

115
ECONOMIC GROWTH
Actual versus Potential Growth in National Output

Potential GDP is the level of real GDP that the economy

would produce if it were at full employment. When real
GDP falls short of potential GDP, the economy is not at full
employment. When the economy is at full employment real
GDP equals potential GDP. Real GDP can exceed potential
GDP only temporarily as it approaches and then recedes
from a business cycle peak.

An increase in the annual percentage increase in real GDP

is called actual growth. This would result in the economy to
reach towards its full employment level or potential output.
Any shift of the AD curve to the right towards the full
employment level results in an economy to achieve actual
growth as the economy would be utilizing its resources fully
and efficiently.

116
Potential growth is the growth in the productive potential
of the country. It is associated with the shift of the LRAS to
the right or the PPC curve to the right. An improvement in
the quantity and quality of factors of production is potential
growth of the economy.

BUSINESS (TRADE) CYCLE

The business cycle is the way in which economic growth
fluctuates over a period of time.

Phases of the cycle

The process of actual economic growth is not always

smooth, as real GDP tends to be subject to fluctuations
over time. The fluctuation of real GDP around an
underlying trend is usually known as the business cycle, and

117
Lorem ipsum do lor sometimes known as the trade cycle. At any point in time,
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GDP may be below or above its trend value.
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Morbi com modo,
Fluctuations in economic activity can arise for a variety of
ipsum magna sed
phar etra gravida, reasons. For example, suppose that there is a technological
orci magna rhon cus break-through that leads to investment by firms and a surge
neque, id pulvinar
in demand from consumers. This could initiate an
odio lorem non
turpis. expansion in the economy (a ‘boom’). As time goes by,
demand may begin to tail off and the economy may move
closer to its capacity, at which point the economy is likely to
slow down. If expectations of firms and consumers become
pessimistic at this point, GDP could begin to fall (a
recession sets in). Governments may intervene at this point
to initiate a recovery, and firms may begin to increase
investment, reinforced by multiplier effects. The cycle
begins again.

Consider an economy at point A in the figure below. At this

stage in the cycle, the economy is entering a period of
recession, in which GDP is falling. This continues until point
B, the trough of the cycle, at which point GDP stops falling
and begins to grow again. At point C, the economy is
showing growth in actual GDP – it is still below its trend
value, but recovery has set in; only at point D does the
economy hit the trend. In other words, between points A
and D, the output gap is negative. Beyond point D the
economy moves into a boom period (as at point E), where
GDP grows more rapidly than its trend value, and the level
of GDP is above its trend value. At point F, the cycle

118
reaches its peak and stops increasing; beyond this point
actual GDP again begins to fall in the slowdown phase, and
then the story repeats.

From a policy perspective, it is important to know at what

stage of the business cycle the economy is. When the
output gap is negative, and the level of output is below
trend, it may be tempting for policy-makers to try to ‘fill the
gap’ by stimulating aggregate demand. However, this
would be dangerous when the output gap is positive, as
the effect would be to put upward pressure on the price
level.

Automatic stabilizers

Some items of government expenditure and receipts vary

automatically with the business cycle. They are known as
automatic stabilizers. For example, if the economy enters a
period of recession with a negative output gap,

119
government expenditure will rise because of the increased
payments of unemployment and other social security
benefits, and revenues will fall because fewer people are
paying income tax, and because receipts from sales taxes
are falling. This helps to offset the recession without any
active intervention from the government.

Similarly, if there is a positive output gap, government

expenditure will tend to fall and tax revenues will increase.
This will result in a fall in aggregate demand, which will
help to speed the adjustment back to equilibrium.

An advantage of these automatic stabilizers is that they

need no conscious intervention by the government, so they
come into play at minimal administrative cost. Furthermore,
they come into effect more rapidly than any policy
introduced by government, which can only happen after
delays, caused by the time it takes to realize that action is
needed, and further time for a policy change to take effect.

Policies to promote economic growth and their effectiveness

These policies can be grouped under demand-side, fiscal
and monetary, and supply-side.

Demand-side

1. Expansionary fiscal policy involves cutting tax and

increasing government spending. Lower income tax will
increase disposable income and encourage consumer
spending. Higher government spending will create jobs

120
and provide a boost demand. It works well if consumption
is falling and savings rising as it can increase demand
without causing crowding out.

The problem is that it leads to an increase in government

borrowing. To finance this extra spending, governments
borrow from the private sector. If the economy is already
growing, then this can result in crowding out.

2. Lower interest rates reduce the cost of borrowing,

encouraging investment and consumer spending. Lower
interest rates also reduce the incentive to save, making
spending more attractive instead. Lower interest rates will
also reduce mortgage interest payments, increasing
disposable income for consumers.

Lower interest rates may not always boost spending as

consumers may lack confidence and/or banks have liquidity
shortages. In addition, cutting interest rates very low could
distort future economic activity by, for example, leading to
future overheating in terms of housing and other assets.

3. Quantitative easing (QE) has been introduced to try to

overcome the failure of low interest rates to boost demand.
This increases the money supply. The problem is that this
could possibly cause inflation. Evidence from when it has
been used shows that the inflationary impact was minimal
and did not itself stimulate a recovery. Probably, however,
without QE a recession would be deeper.

121
If there is spare capacity (negative output gap) then
demand-side policies can help, see the figure below, to
increase the rate of economic growth.

If, however, the economy is already close to full capacity, a

further increase in AD will mainly cause inflation.
Nevertheless, managing AD to avoid boom and bust cycles
can help provide longer periods of economic expansion.

122
Supply-side

Supply-side policies attempt to increase productivity and

efficiency of the economy. They include: privatization,
deregulation, tax cuts, education and training, and better
infrastructure. These are all long-run policies. Their effect
can be seen in the figure below where real output/national
income increases and the price level is reduced.

Supply-side policies can take a considerable time to act in

terms of AD growth. Investing in better education and
training would take many years to give higher labour
productivity. In a recession, supply-side policies are not
going to solve the lack of sufficient aggregate demand.
Without demand, firms will be unwilling to expand their
output.

123
INCLUSIVE ECONOMIC GROWTH
Definition of inclusive economic growth

Inclusive economic growth is economic growth that is

distributed fairly across society and creates opportunities
for all.

Impact of economic growth on equity and equality

There is no certain impact of economic growth on equity

and equality. Some countries in the latter half of the
twentieth century, for example, Indonesia, Malaysia and
Singapore managed to achieve rapid growth and relatively
low inequality. On the other hand, the majority of the
members of the OECD saw inequality increase with
economic growth.

The case for economic growth reducing inequality and

boosting equity can be seen in the Kuznets curve, which
shows that as an economy develops, initially inequality
increases, but then decreases.

Policies to promote inclusive growth

Some policies have contributed to narrower inequality by

delivering stronger income gains for households at the
bottom of the distribution compared with the average
household. Such is the case, for instance,
of reducing regulatory barriers to domestic competition,
trade and inward foreign direct investment, as well as

124
improving job-search support and programs to increase
economic activity including improved skills training.

In addition, some policies have had a positive effect on all

income groups. Investment in information and
communications technology, raising the average level of
education in the working age population and reductions in
marginal income taxes for wage earners have had this
effect.

SUSTAINABLE ECONOMIC GROWTH

Sustainable economic growth means a rate of growth which
can be maintained over the long run without creating
significant costs on future generations.

Sustainable growth involves both environmentally

sustainable growth, by not exhausting scarce resources,
and, also, growth in terms of low inflation and a balanced
economy.

Impact of economic growth on the environment and

climate change

There is a trade-off between rapid economic growth today,

and growth in the future. Rapid growth today may exhaust
resources and create environmental problems for future
generations, including the depletion of raw materials and
global warming.

Economic growth today must not, therefore, use up raw

materials and destroy the environment so as to reduce the

125
quality of life available in the future. This means that there
is pressure on countries to ensure that growth does not
needlessly waste resources and that it improves not only
living standards, but also the quality of life. There are many
ways that can be tried to do this including recycling of used
materials and reduction of pollution.

The International Resource Panel has stated that there is a

need to break the link between economic growth and ever
greater use of resources and environmental degradation.
While economic growth has resulted in hundreds of millions
of people being no longer in poverty, unsustainable
production and consumption patterns have resulted,
among other problems, in a quarter of the earth’s land area
being highly degraded, millions of hectares of forests lost
every year, rivers and lakes drying up and widespread
overfishing.

Climate change with warmer temperatures, rising sea levels

and more extreme weather patterns has already affected
many countries. In the future it will lead to: greater damage
to property and infrastructure, decline in agriculture,
forestry, fisheries and tourism; decline in productivity;
negatively affecting sectors such as agriculture, forestry,
fisheries and tourism; and increasing demand for energy as
power generation becomes less reliable. In addition it may
disrupt global trade and supply chains. It has been
estimated that without major changes the GDP per capita

126
of countries will fall, for example, the US by 10.5 per cent
and China by 4.3 per cent by 2100.

Policies to mitigate the impact of economic growth on

the environment and climate change

Policies roughly divide into market-based ones and

regulations. The market based ones include pollution
permits and emission taxes.

There are a wide range of regulatory policies that have

been proposed or have started to be implemented.

1. Use of renewable energy sources. The adoption of these

energy sources also reduces the environmental damage
from coal, gas and oil extraction.

2. Use of sustainable transport including bus rapid transit,

electric vehicles, and hydrogen-powered vehicles. These
would reduce climate pollution and also use of oil.

3. Using natural barriers especially in coastal areas where

land has been drained causing environmental damage.

127
CHAPTER 7

MACROECONOMIC
POLICY
GOVERNMENT MACROECONOMIC POLICY OBJECTIVES
Inflation

Although inflation is seen as inevitable, and normal, all

governments are concerned to try to achieve stable prices,
or at least ones which only rise at a slow rate. If prices are
continually rising at high rates then investors are reluctant
to invest in new machinery, factories and products because
they cannot calculate the outcome of their investments.
Rising inflation leads to menu costs such as revising price
lists. Similarly, those who are on fixed incomes, usually the
economically inactive, such as those relying on state
benefits, suffer as any increases lag well behind price rises.

In addition, inflation is likely to lead to other

macroeconomic problems.

Balance of Payment

The ideal situation is for the balance of payments to be in

equilibrium i.e. the inflows of money equal the outflows
across the whole account. Countries are usually concerned
about their current accounts. If there is a persistent deficit
then a country could face severe economic and financial
problems such as depreciating exchange rate, inability to
pay its debts and in extreme circumstances bankruptcy.

Unemployment

Governments aim to achieve full employment. It is difficult

to know what this means as not only are there different

129
definitions of full employment, but there is no agreement
on what percentage of unemployment would indicate that
full employment had been reached. All governments,
however, aim for this objective.

Economic growth

Governments aim to achieve sustainable economic growth.

High growth rates may be very good for developing
countries, but if they are achieved by depletion and
exhaustion of scarce natural resources or by too much
pollution, leading to climate change, then the high rates
will not be sustainable.

Development

The need for development is to raise the standard of living

of the country as a whole and of the poorest groups in
particular. This includes: higher incomes; more jobs to
reduce unemployment; better, and more, food, housing,
etc; greater availability of, and higher quality, education
and health facilities.

Sustainability

The idea is to develop growth which is lasting and makes a

real difference to individuals. It recognizes that everybody
has the right to a healthy, clean and safe environment. In
2015 the United Nations passed a resolution called Agenda
2030. This set out 17 Sustainable Development Goals

130
(SDGs), sometimes called Global Goals as a “blueprint to
achieve a better and more sustainable future for all”.

Redistribution of income and wealth

Governments aim to reduce inequalities of income and

wealth through taxation and expenditure. This is done by
imposing taxes on the rich and spending more on the
welfare of the poor. It will reduce income of the rich and
raise standard of living of the poor, thus reducing
inequalities in the distribution of income. Wealth can be
redistributed through taxes such as capital gains,
inheritance and wealth.

Inequality is much higher in developing than in advanced

economies. This is often because many developing nations
lack the resources and fiscal policy structures to make much
difference.

LINKS BETWEEN MACROECONOMIC PROBLEMS AND

THEIR INTERRELATEDNESS
Economic problems such as how to achieve low inflation
and full employment do not exist in isolation, but are
interconnected. Any action to try to achieve one economic
aim, see above, may well result in adverse effects on other
aims. Below a number of the main ones are considered.

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Relationship between the internal value of money and
the external value of money

The internal value of money is how much a unit of money

can buy i.e. its internal purchasing power or the real value
of money, while the external value is the value of a currency
as measured in foreign currency. A direct comparison is
with purchasing power parity.

A fall in the internal value of money is a result of inflation. A

country with an inflation rate higher than that of other
countries will find that people lose confidence in holding its
currency so its foreign exchange rate depreciates. This
means that less can be bought in terms of purchasing
power parity. If, however, a country has a lower rate of
inflation than its main trading partners then, although the
internal value of money is falling, the external value will
rise. This is partly because the country’s goods will appear
cheaper on world markets than its competitors and partly
because foreign holders of money would prefer to hold
that country’s currency.

132
MONETARY POLICY
Monetary policy is the attempt by the government or its
central bank to manipulate monetary variables such as the
rate of interest or the money supply to achieve policy
goals. The four main macro-economic goals are price
stability, low unemployment, high economic growth and
balance of payment equilibrium.

Instruments of Monetary Policy

Government can increase or decrease money supply by

some of the following instruments:

1. Monetary Base Control: The monetary base includes

cash in circulation outside the central bank. By changing
the reserve ratio, the government can change the money
supply in the economy.
Reserve Ratio ↑ → MS ↓
Reserve Ratio ↓ → MS ↑

2. Open Market Operations: The sale and purchase of

government securities in the open market can influence
the money supply.
Buy Gov. Securities → MS↑
Sell Gov. Securities → MS↓
The government public-sector borrowing financed by
borrowing from the banking sector can result in money
supply to rise.

3. Discount Rate: The discount rate is the interest rate the

Central Bank charges banks that need to borrow reserves

133
 in order to meet reserve requirements. From time to
time, unanticipated withdrawals leave banks with
insufficient reserves. Banks can make up for deficiencies
in their required reserves by borrowing from the Central
Bank at the discount rate. If the Central Bank sets the
discount rate high relative to market interest rates, it
becomes more costly for banks to fall below reserve
requirements. Accordingly, banks will hold more excess
reserves, which tend to reduce the multiple expansion of
deposits and the supply of money. Similarly, when the
discount rate is low relative to market interest rates,
banks tend to hold fewer excess reserves, allowing for
greater deposit expansion and an increase in the supply
of money.

4. Rules and Regulations: The central bank may impose

rules and regulations on banks whose deposits make up
most of broad money. For instance, a central bank may
impose financial penalties on banks, which increase their
deposits (and therefore lending) by more than a certain
percentage over a period.

134
 MONETARY POLICY AT WORK

1) Increase in Money Supply (MS0 to MS1)

2) Interest rates to fall (r0 to r1)

FIGURE 7.1 Increase in money supply

3) ER to depreciate as hot money flows out (e0 to e1)

135
FIGURE 7.2 Hot money flows out

4) C↑, I↑, X-M↑ (as ER↓) →AD shifts to the right

136
 Limitations of Monetary Policy

1. Demand for money: The effectiveness of monetary

policy is also dependent upon how elastic the demand
for money is to a change in the interest rates. According
to the Keynesians, the demand for money is very elastic.
If this is the case, then any rise in money supply will not
change interest rates by that much. Once people believe
that the rate of interest will not go any lower, any further
rise in money supply will have no effect on interest rates.
The additional money will be lost in what Keynes called
the liquidity trap. People simply hold the additional
money as idle balances.

FIGURE 7.3 Liquidity Trap

137
 2. Interest rates and Investment: Keynesians argue that
investment is relatively unresponsive to changes in
interest rates (interest inelastic demand for investment).
Business people are much more likely to be affected by
the state of the market for their product rather than by
interest rates. Hence, the lower interest rates that result
from an expansionary monetary policy need not induce
an increase in aggregate investment and consumption
expenditures because firms' and households' demands
for investment and consumption goods may not be
sensitive to the lower interest rates.

FIGURE 7.4 Interest Inelastic Demand for Investment

138
3. Time lags: Economists argue that there is a time lag with
monetary policy. When interest rates fall, people do not
immediately cut their savings. Only after households
adjust their consumption patterns, do firms react by
changing output. This may take a long time for changes
in interest rates to change AD of the economy.

4. Mobility of financial capital: With increasing mobility of

financial capital, it can be difficult for a country to have
an interest rate that is significantly different from other
countries. A rise in interest rates, for example, can lead
hot money to flow into the country and exchange rate to
appreciate and a country’s trade position to get affected.

139
FISCAL POLICY
Keynesians argue that AD fluctuates largely because of
irrational waves of pessimism and optimism. They use the
term ‘animal spirit’ to refer to these arbitrary changes in
attitude. When pessimism reigns, households reduce
consumption spending, and firms reduce investment
spending. The result is reduced AD, lower production, and
higher unemployment.

Conversely, when optimism reigns, households and firms

increase spending. The result is higher AD, higher
production and inflationary pressure.

Keynesians therefore claim that government should actively

stabilize AD to remove any severe deflationary or
inflationary gaps. Expansionary fiscal policy could be used
to prevent an economy experiencing a severe or prolonged
recession, such as that experienced in the Great Depression
of the 1930s. Likewise, deflationary fiscal policy could be
used to prevent rampant inflation.

Increase in government spending or decrease in taxation

can result in AD to shift from AD0 to AD1 and make the
economy come back to the full employment level.

140
FIGURE 7.5 Expansionary fiscal policy

Between changing taxation and government spending,

Keynesians favor raising government spending because
they believe this will have a bigger multiplier effect.
Increase in government expenditure, especially if it is on
benefits given to the poor, who have high propensity to
consume, can raise national income by much more than tax
cuts.

Fiscal Policy can take the form of either discretionary fiscal

policy or automatic stabilizer. Discretionary fiscal policy is a
deliberate government policy with regards to taxation and
spending that aims to alter the level of AD and real national
income.

141
Automatic stabilizers are forms of government spending
and taxation, which change without any deliberate
government action to offset fluctuations in GDP. When the
economy goes into recession there is a reduction in the
amount of taxes collected by the government automatically
as all taxes are tied to economic activity. Also, tax rates fall
if the taxation system is progressive. As recession would
lead to falling earnings, incomes and profits there would be
a reduction in taxes. This automatic tax cut stimulates AD
and thereby reduces the magnitude of economic
fluctuations.

Government spending on unemployment benefits also act

as automatic stabilizers. As the economy goes into
recession workers are laid off, more employment benefits
and income support is given resulting in AD to rise and
economy to recover.

In short, as Y falls, G rises and T falls resulting in AD to rise

and economy to recover itself from a recession. Similarly, as
Y rises, G falls and T rises resulting in AD to fall and
economy to recover from inflation.

Limitations of fiscal policy

1. The problem of ‘fiscal drag’: Automatic stabilizers have

the obvious advantage that they act instantly as soon as
AD fluctuates. However, they also reduce the size of the
multiplier, reducing both upward and downward
movements of national income. Thus, in theory, the

142
 business cycle should be dampened by such built-in
stabilizers. In times of recession, however, if the economy
began to recover, the automatic stabilizers will reduce
the size of the multiplier and reduce the magnitude of
the recovery, as they act as a ‘drag’ on discretionary
policy. The more powerful the automatic stabilizers are,
the bigger the change in G or T that would be necessary
to achieve a change in national income.

2. Time lags: If the government plans to increase spending

this can take a long time to filter into the economy and it
may be too late to have the desired effect. Any changes
in government spending have political process and
implications to it. Alterations in government spending
and direct taxes take longer to implement (negotiations,
passing and implementing of policy) and work their way
through the economy. Such lags suggest that the
economy’s condition might have changed already and
the policy may result in undesirable effects.

3. Poor Information: To predict future inflation and growth

is not easy, therefore it may be difficult to know how
much to increase or decrease AD. For example, for fiscal
policy to be effective it is important that the government
can estimate accurately the impact that changes in
government spending and taxation will have on the
economy. To do this, they have to have a good idea of
the value of the multiplier and awareness of the possible
side effects of policy measures. If the government

143
 underestimates the value of the multiplier, it may inject
too much extra spending and thereby generate inflation
and balance of payment problems.

4. Adverse supply side effects: Fiscal policy of increasing

taxation may have disincentive effects on efforts and
initiatives. The higher the tax rates, the more likely taxes
create disincentive to work and to invest. If this occurs
there will be a fall in productivity and aggregate supply in
the economy, causing unemployment and fall in output.

5. Crowding out effect: Crowding out can take place in the

form of financial and resource crowding out.

a. Resource crowding out: When the government uses

resources such as labour and raw materials that would
otherwise be used by the private sector, it results in the
price of these resources to rise. Also, less of it will be
available for the private sector to now use.

b. Financial crowding out: An increase in government

expenditure results in an increase in AD, which in turn
results in a rise in interest rates. A rise in interest rates can
cause AD to shift to the left, thereby reducing the effect on
initial rise in AD due to expansionary fiscal policy.

Keynesian view: Keynesians reject this and they argue the

economy can be below full capacity for a long time,
therefore there will not be any crowding out because the
government will be using unused resources. Therefore in a

144
recession, expansionary fiscal policy can play an important
role in increasing real GDP.

Crowding out

1. G↑ →AD↑
2. This results in P↑
3. LP to shift out as transaction demand for money ↑
4. Interest rates to rise and
5. C, I and X-M to fall causing AD to fall and outweigh or
reduce the multiplier effect

145
FIGURE 7.6 Crowding Out

146
CHAPTER 8

INTERNATIONAL
ECONOMIC
ISSUES
POLICIES TO CORRECT DISEQUILIBRIUM IN THE BALANCE
OF PAYMENTS
Components of the balance of payments accounts

The International Monetary Fund (IMF) has a recommended

method for the presentation of a nations’ balance of
payments accounts to enable international comparisons to
be made.

In order to explain the main components of a country’s

balance of payments accounts, reference will be made to
the UK accounts for 2019. These are summarised in Table
below:

The balance of payments account is a systematic record of

all economic transactions between a particular country and
the rest of the world.

148
The balance of payments accounts are divided into three
sections:

1. current account

2. capital account

3. financial account

In all cases, credit items bringing money into the UK are

represented by a plus (+) sign and debit items taking
money out of the country by a negative (−) sign.

In addition, because the balance of payments is an account

it must balance i.e. the inflows of money must equal the
outflows. As the figures are collected by many different
government departments the account often does not
balance. To correct the problem a net errors and omissions
figure is included.

The capital account is the part of the balance of payments

which shows the changes in a country’s asset ownership as
a result of both public and private investment inflows and
outflows. Capital transfers are those involving transfers of
ownership of fixed assets, except land, and transfers of
funds linked to the acquisition or disposal of fixed assets or
cancellation of liabilities by creditors.

The financial account records an economy’s transaction in

external financial assets and liabilities, e.g. investment-
owned assets such as foreign reserves, gold, etc. Assets
owned by foreigners, those private and official, are also

149
recorded in the financial account. These assets are both
fixed (e.g. the opening of mines or pharmaceutical
production plants in Indonesia), often referred to as foreign
direct investment, and portfolio investments such as shares
as well as non-financial (e.g. the buying or selling of land). It
also includes short-term monetary flows, so-called “hot
money”, where investors move their money to where they
can get the best return often because of a change in
interest rates.

Effect of fiscal, monetary, supply-side, protectionist and

exchange rate policies on the balance of payments

Fiscal and monetary policies

Demand-side policies will directly affect the trade in goods

and services. Reductions in government spending, and
higher taxes, fiscal, or higher interest rates and reducing
the availability of credit, monetary, could all have the effect
of dampening consumer demand and reducing the
demand for imports. This is an example of expenditure
reduction, see next section. This process can also lead to
an increase in spare productive capacity which can then be
used to increase exports. It is difficult, however, to predict
the precise effect of a fall in spending on imports, which
requires an accurate calculation of the marginal propensity
to import.

150
Supply-side policies

Supply-side policies focus on improving the supply-side

performance of the economy in order to increase
competitiveness. As seen before when looking at these
policies, this is inevitably a long-run solution, unlike
demand-side policies. Some of these policies are set out in
below.

Protectionist policies

Protectionist policies are all designed to reduce imports of

goods and services. This initially has a positive effect on the
current account, assuming that domestic industries can
provide acceptable substitutes. Other countries, however,
may retaliate by imposing their own protectionist measures
on the country’s exports. A more subtle policy is that of
“red tape”. In the case of Brexit, UK exporters have
complained that, although there is a free trade agreement

151
between the UK and the European Union (EU), they find the
amount of paperwork required for goods to enter the EU a
real barrier.

Exchange rate policies

The exchange rate may fall either because of a current

account deficit or because of other policies such as
lowering interest rates, see above. Allowing it to fall should
improve the balance of payments especially the trade in
goods and services part of the current account. Export
prices fall while import prices rise. Given a favorable
Marshall– Lerner effect, the value of exports increase, while
the value of imports fall.

A fall in the exchange rate has the effect of increasing the

value of profits and income for a country’s businesses with
investments overseas and thus improving the financial
account. All of this works so long as capital is not free to
move from one economy to another. If an economy is
growing and there is a rise in consumer expenditure then
investors and speculators may buy the currency even if the
current account deficit is increasing as they think that the
economy is improving.

152
Difference between expenditure-switching and
expenditure-reducing policies

Expenditure-switching policies try to shift expenditure from

imported to domestically produced goods. This can be
done in three ways, as explained above.

Expenditure-reducing policies are aimed at trying to reduce

excess demand which has led to high levels of imports (see
fiscal and monetary policies above).

153
EXCHANGE RATES
Measurement of exchange rates

Distinction between nominal and real exchange rates

Exchange rates can be measured in terms of nominal value,

real value and trade-weighted value.

The nominal exchange rate is the one which is usually

quoted e.g. if you go to a bank or look at the rate on the
internet then you will see this rate. The real exchange rate
is what the currency will buy in terms of other currencies.
This is often referred to as purchasing power parity.

Trade-weighted exchange rates

The trade-weighted exchange rate is the measurement, in

terms of an index, of changes in a country’s currency
against a basket of other currencies. These are weighted to
reflect the relative importance of trade for the country of
the currencies in the basket. If, for example, the UK does
five times more trade with the EU as it does with Japan
then the euro will b e given five times the weight
of the yen.

Determination of exchange rates under fixed and

managed systems

A fixed exchange rate is one where little or no change is

possible from the agreed rate. In practice, a small variation
of around two per cent is usually allowed, but the central

154
bank of the country is committed to maintain the value by
buying its own currency, to prevent the price falling, or to
sell its currency to stop it rising. In practice, countries often
have to either revalue or devalue (see next section) their
rates from time to time to allow for differences in economic
growth.

Many developing countries use fixed or pegged exchange

rates for their currencies (Figure below). A pegged
exchange rate is where a country sets a specific fixed
exchange rate for its currency with a specific foreign
currency, or basket of currencies. This provides these
countries with more stability.

155
Where governments Governments can try to manage their currency by
deliberately set their
intervening in the market to influence its price. This is
currency at a lower
rate than the market called a managed float. The purpose is to try to prevent
would under a wild fluctuations in the value of the currency, one cause of
floating system in
which is speculation. Where governments use this idea to
order to gain a
trading advantage, deliberately set their currency at a lower rate than the
this is called a “dirty market would under a floating system in order to gain a
float”
trading advantage, this is called a “dirty float”. Japan was
accused of this in the 1960s and 1970s while China has
more recently faced similar accusations.

Distinction between revaluation and devaluation of a

fixed exchange rate

Unlike floating exchange rates, fixed exchange rates can

only change their value if the government decides that this
is necessary. A lowering of the exchange rate, i.e. a fall in
the value, is a devaluation, while a raising of the exchange
rate, i.e. it goes up in value, is a revaluation.

Changes in the exchange rate under different exchange

rate systems

Floating exchange rates can either depreciate, i.e. fall in

value, or appreciate, i.e. rise in value. As can be seen in the
figure below an increase in demand for the currency, from
DD to D1D1, leads to a rise in the currency’s value, an
appreciation, whereas a fall in demand leads to the
opposite effect, a devaluation.

156
Figure below shows the effects of revaluation and
devaluation. If the original fixed value was‘P’, then a

revaluation will move it to ‘Pr’. Equally, a devaluation will

lower the price to ‘Pd’. A government can achieve this by

157
either buying their currency, thus reducing supply from S to
S1, or by selling the currency, thus increasing supply from S
to S2.

The effects of changing exchange rates on the external

economy using Marshall–Lerner and J-curve analysis

Any change in the exchange rate will affect the price and
thus the quantity of exports and imports. This will in turn
affect both the current account and also AD as AD = C + I
+ G + X − M. Marshall–Lerner shows the conditions under
which a change in the exchange rate of a country’s currency
leads to an improvement or worsening of a country’s
balance of payments. If a country’s exchange rate rises so
that exports are more expensive and imports are cheaper
then, if Marshall–Lerner holds, the volume and value of
exports will fall while the volume and value of imports will
rise. This results in a deterioration in the current account.

Equally, a fall in the value of a country’s exchange rate will,

assuming Marshall–Lerner holds, lead to an improvement in
the current account, as exports rise and imports fall. This,
however, may not happen immediately. Contracts have
been signed at the old value and cannot be changed. It
also takes time for exporters and importers to react to the
change. This gives rise to the J-curve effect. The diagram
shows that devaluation/depreciation leads to an immediate
worsening of the current account with this only benefiting
from the devaluation/ depreciation in the longer run.

158
CHAPTER 9

ECONOMIC
DEVELOPMENT AND
GLOBALIZATION
ECONOMIC DEVELOPMENT
Economic growth and development are linked. While
growth is possible without development because growth is
just an increase in real GDP, development cannot take
place if there is no growth.

Economic development is a far more comprehensive idea

than economic growth. In addition to a rise in real output, it
involves changes in the composition of this output and a
consequent shift in the allocation of resources as well as the
reduction of poverty, inequalities and unemployment. In
addition, development can refer to the availability of
education and literacy rates as well as health and life
expectancy.

Amartya Sen stated that development is about creating

freedom for people and removing obstacles to greater
freedom. Greater freedom enables people to choose their
own destiny. Obstacles to freedom, and hence to
development, include poverty, lack of economic
opportunities, corruption, poor governance, lack of
education and lack of health.

Classification of economies in terms of their level of

development

Criteria for evaluating a country’s level of development are

GDP per capita, the level of industrialization, the general
standard of living, and the amount of technological
infrastructure.

160
The United Nations classifies countries into three groups:

1. Developed countries are those which have a high level of

economic growth and security.

2. Transitional countries are those which are in a process of

moving from a centrally planned economy to a mixed or
free market economy.

3. Developing countries are those that have a low GDP per

capita and, normally, rely heavily on agriculture as the
primary industry.

Classification of economies in terms of their level of

national income

The World Bank assigns the world’s economies to four

income groups – low, lower-middle, upper-middle, and
high-income countries. Examples of these groups for 2021
are shown in Table below. This information is revised every
year.

161
Indicators of living standards and economic
development

Living standards refers to the amount and quality of

material goods and services available to the population of a
country. It includes many aspects such as: income; housing;
employment; hours of work required to purchase
necessities; education; environmental quality.

Monetary indicators

GDP per capita is the most widely used monetary measure

of living standards. IT, together with GNI and NNI, are easy
to obtain and give an ‘at a glance’ comparison without
needing further understanding. Real and per capita allow
for different inflation rates and different levels of
population. GDP is a production concept, but the way that
it is constructed makes it equal to the total income earned
in the production process. Some of this income is paid to
non-residents, while residents receive some income from
production in other countries. GDP can be adjusted for
“net income from abroad” to arrive at the concept of gross
national income, GNI, which is more relevant for the well-
being of residents of a country. In turn, by deduction,
capital consumption NNI can be achieved. Unfortunately,
there are a number of difficulties involved in using the
figures:

162
1. Work v leisure time: a higher per capita income ignores
that one country may have shorter working hours and/or
offer longer holidays to its workers.

2. Shadow economy: GDP includes production that is

exchanged in the market, but it does not include black
market activities nor ones you may do yourself. Cleaning
your own house is not counted, but hiring a cleaner to
do the work is. Activities such as self-employment may
not be (fully) reported or taxation figures used to
calculate NI may be subject to tax evasion.

3. What expenditure does or does not show: this is a

question of quantity, or money spent, which is
measurable, against quality. It shows what is spent on
environmental protection, but not whether the air and
water are cleaner. Equally, it shows how much is spent on
education, but not the proportion of the population who
are literate.

4. Income distribution is ignored because these

measurements are only averages.

Using these measures to compare standard of living

between countries has the further difficulty of currency
conversion, as the exchange rate may not reflect accurately
what money can buy in each country. One way round this is
to use purchasing power parity (PPP). This takes into
account the local purchasing power of the currency, using a

163
basket of goods, and is a better guide to actual living
standards.

An example would be: if a pair of trousers cost $40 in the

US and an identical pair cost €32 in Italy and the exchange
rate meant that this was equivalent to $60 then the PPP
would be 60/40 = 1.5. This means that for every dollar
spent in US it takes £1.50 dollars to buy the same trousers
in Italy using the euro.

Although there are problems with these monetary

measures, they do indicate when a country is materially
better or worse off in terms of jobs and incomes. In most
countries, a significantly higher GDP per capita is an
indicator of improvements in everyday life along with
aspects such as education and health.

Non-monetary indicators

A non-monetary indicator is anything which contributes to

the standard of living or development of a country, but
does have directly a value in terms of money. While there is
no agreement as to which factors to include, the following
are often referred to:

1. Unemployment rate: people may be unemployed with

low, or no, incomes and unable to access goods
available to the majority of society.

2. Social cohesion: if society does not have the same basic

goals and cultural norms then there may be lack of

164
 support for those with disadvantages. The ability of
economies to work efficiently and develop effectively
depends on the establishment of an environment in
which legal rights, especially property and contractual
rights, are enforced and protected. There is evidence
which shows that countries where the law applies equally
to all and have developed strong institutional and legal
frameworks have performed better in terms of sustained
growth and human development.

3. Level of corruption: corruption is present in every

country, but its effects are especially damaging in those
which are still developing. The amount of corruption is
negatively linked to the level of investment and
economic growth, that is to say, the more corruption, the
less investment and the less economic growth. And the
lower the standard of living for many citizens.

4. Degree of equality and equity: there are many countries

where groups of people based on gender, sexual
orientation, ethnicity, etc. are disadvantaged and often
excluded from well-paid jobs or from taking a wider role
in society.

Composite indicators

Human Development Index (HDI)

The problems of using GDP/GNP to compare living

standards and economic development between countries
over time has led to the development of other measures,

165
the best known being the Human Development Index
(HDI). This measures changes in development levels over
time and compares development levels in different
countries. The 2019 report includes:

1. a long and healthy life: life expectancy at birth

2. education index: mean years of schooling and expected

years of schooling

3. a decent standard of living: GNP per capita (PPP US$)

Measure of Economic Welfare (MEW)

The Measure of Economic Welfare (MEW) was the work of

Nordhaus and Tobin as an alternative to just using GDP.
MEW took national output as a starting point, but adjusted
it to include an assessment of the value of leisure time and
the amount of unpaid work in an economy. This increased
the welfare value of GDP. On the other hand, the value of
the environment damage caused by industrial production
and consumption was also included which reduced the
welfare value of GDP.

Multidimensional Poverty Index (MPI)

The Multidimensional Poverty Index (MPI) identifies

multiple deprivations at the household and individual level
in health, education and standard of living (Table below).

MPI uses three dimensions and ten indicators which are:

166
1. education: years of schooling and child enrollment (1/6
weight each, total 2/6)

2. health: child mortality and nutrition (1/6 weight each,

total 2/6)

3. standard of living: electricity, flooring, drinking water,

sanitation, cooking fuel and assets (1/18 weight each,
total 2/6).

A person is multidimensionally poor if they are deprived in

one-third or more (means 33% or more) of the weighted
indicators (out of the ten indicators). Those who are
deprived in one half or more of the weighted indicators are
considered living in extreme multidimensional poverty.

167
MPI is significant as it recognizes poverty from different
dimensions compared to the conventional methodology
that measures poverty only from the income or monetary
terms.

Kuznets curve

The Kuznets curve is an inverted U curve, although

variables along the axes are often mixed and matched, with
inequality or the Gini coefficient on the y-axis and
economic development, time or per-capita incomes on the
x-axis.

The curve claims to show that as an economy develops,

initially inequality increases, but that after a certain average
income is reached, inequality then decreases. This assumes
that a country which is industrializing (and mechanizing
agricultural production) will draw people into urban areas
improving their standards of living, but causing greater
inequality with those still in rural areas. Only at a later stage

168
will the benefits of growth reach these people and start to
close the gap. Although this was based on historical
evidence, the “East Asian miracle” showed low inequality
and high output, while in some more autocratic countries
there has been high inequality and low output.

Comparison of economic growth rates and living

standards over time

Assuming that the cost of living has not changed by more

than the growth in income, then an increase in real GDI per
capita should indicate not only economic growth, but also a
rise in the standard of living. Table below shows how
economic growth of New Zealand has changed over the
period 2015–2019 using real GDP.

Between countries

In any comparison of living standards between countries, it

is important to remember that GDP/GNP/NNI per capita is
an average figure. It ignores the fact that income may be
very unequally distributed so that only some people have a
higher standard of living than those in the other country.

Comparing growth rates can be equally problematical.

Many of the problems mentioned above apply again, e.g.
the black economy leading to understating of real GDP. In
addition, in countries where literacy levels are low, for
example Niger has one of the lowest literacy rates in the
world where just over 19 per cent of adults can read and
write, information provided by individuals may not exist or

169
be unreliable. Another issue is how countries value
government services which are provided free. These
methods not only vary between countries, but individual
countries sometimes change how they are estimated.

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Characteristics of countries at different levels of
development

1. Population growth and structure

Measurement and causes of changes in birth rate, death

rate, infant mortality and net migration

Birth and death rates are two key factors in population

growth. They are both measured per thousand of the
population per year. As countries develop, health and
education services improve leading to lower birth and
death rates. Also important is the infant mortality
rate which is again improved health care will lead to a

decline. The two developed countries in Table below have

much lower rates than the other countries. The greater the
difference between the birth and death rates, the higher is
the population growth. This difference is called the natural
increase. This can be seen in Table below.

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In addition, migration plays a part in determining
population growth. In many developing countries there is,

often, a net outflow, emigration, of people seeking

employment and higher standards of living in other
countries, whereas in countries, such as the UK, there is a
net inflow, or immigration. The difference between
emigration and immigration is net migration.

It is often assumed that migration is increasing, but the

number of people living outside their country of birth has
been a relatively stable percentage of the world’s
population for a long time, although with substantial
fluctuations. Equally, although ten countries, United States,
Germany, Russia, Saudi Arabia, United Kingdom, United
Arab Emirates, Canada, France, Australia, and Spain
dominate global migration, the majority of people from

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developing countries in fact go to another such country.
Among the factors causing migration are:

1. lack of safety, including war and crime

2. crop failure, including drought and flooding

3. lack of opportunities, including employment and

education

4. poverty.

Optimum population

The optimum population is the population size that results

in the maximum income per head. Given the stock of
natural resources, production methods and the capital
stock of a country, there will be a definite population size
corresponding to the highest per capita income.

If the population of a country is less than the optimum,

there will not be enough people to fully use all of the
resources. If an increase in population results in an increase
in per capita income then the country is under-populated.
If, however, the population is above the optimum there will
be too many people to work efficiently and produce the
maximum goods so the per capita income falls.

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Level of urbanization

Urbanization is the increase in the proportion of people

living in towns and cities. This has become very important
in developing countries.

Urbanization is about a concentration of people. The

majority of the world’s population live in urban areas, but
most people do not live in cities. The majority of global
urbanization is currently happening in small towns. This is
even the case in Asia and Africa where urbanization is
increasing fastest, although the pace is slower than has
been predicted.

While the growth of cities and towns can lead to economic

growth and increased prosperity, it is also true that these
large urban areas can result in poverty and crime.

2. Income distribution

The Lorenz curve is a graphical representation showing the

extent of inequality in the distribution of income in an
economy. The more unequal the distribution of income in
an economy, the more divergent the Lorenz curve will be
from the diagonal line of absolute equality.

Calculation of Gini coefficient and Lorenz curve analysis

Figure below shows how Lorenz curves can demonstrate

the distribution of income in, and between, countries, in
this case countries X and Y. The 45 degree line represents a
totally even distribution of income. The greater the degree

174
of inequality, the further the Lorenz curve will be below the
45 degree line. The difference between the 45 degree line
and the Lorenz curve is called the inequality gap. It is clear
that this is the case with Country X, indicating that income
is more unevenly distributed in Country X than in Country Y.

The Gini coefficient can be calculated using the formula:

Gini Coefficient = a/ (a+b) , where ‘a’ is the area above the
Lorenz curve and ‘b’ is the area below the Lorenz curve (see
Figure below). The higher is the value of the Gini

coefficient, the more unequal is income distributed so 0 is

perfect equality and 1 is perfect inequality. Values for
different countries for 2021 are shown in Table below.

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3. Economic structure

The economic structure relates to the fact that any

economy can be divided into a number of different sectors.
There are three such sectors although one of them (the
secondary sector) is often divided into two parts.

Employment composition: primary, secondary and

tertiary sectors

1. Primary: The primary sector is concerned with extractive

activities and examples would include forestry, fishing,
agriculture, mining, quarrying and oil extraction.

2. Secondary: The secondary sector can be divided into

two parts. Firstly, it is concerned with manufacturing

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 activities and examples would include car production,
computers and textiles. Secondly, it is concerned with
construction activities and examples would include the
building of roads, houses and factories.

3. Tertiary: The tertiary sector is concerned with the various

services that are provided in an economy, such as
financial services, education and health.

Countries vary enormously in the division of their economy

into these three distinct sectors. Table below shows the
division of a range of countries into these three sectors on
the basis of the proportion of the workforce that work in the
different sectors.

The figures for the size of the primary, secondary and

tertiary sectors in any particular country will not be static,
but will change over a period of time as a country becomes

177
more developed. It would be expected that the size of the
primary sector would fall, the size of the secondary sector
would first grow and then shrink and the size of the tertiary
sector would continually grow.

Pattern of trade at different levels of development

The global economy has grown continuously since the

Second World War. Global growth has been accompanied
by a change in the pattern of trade, which reflects changes
in the structure of the global economy. These changes
include: the rise of regional trading blocs;
deindustrialisation in many advanced economies; the
increased participation of former communist countries; and
the emergence of China and India.

Demographic change affects trade through its impact on

countries’ comparative advantage and on import demand.
An ageing population, migration, educational
improvements and women’s participation in the labour
force have and will continue to be important in changing
trade patterns.

Traditionally the pattern of trade has been reflected by:

1. developed countries having a greater share of global

trade than developing countries

2. developed countries usually export valuable

manufactured goods such as electronics and cars and

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 import cheaper primary products such as tea and coffee
from developing countries

3. the greatest volume of trade occurring between the

developed, rich countries, especially between countries
such as Germany, Japan, the United Kingdom and the
United States.

Changing patterns are as follows:

1. Developed countries have seen the comparative

advantage they once had in manufacturing shift to
developing countries especially to those in Asia such as
China and South Korea. The developed countries are
importing far more manufactured goods, but are
exporting services.

2. The greatest shift has been in the exporting of goods,

both traditional manufactured ones and hi-tech, by China
and India.

3. Some countries have resources which are now in high

demand for electric bar batteries, mobile phones, etc. As
these are essential for modern technological equipment,
countries producing them will see exports and trade
increase.

4. Trading agreements, especially bilateral ones, such as

that between Canada and the EU, and trading blocs,
such as the EU and MERCOSUR, result in trade diversion
towards trade creation with its members.

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Relationship between countries at different levels of
development

International aid

International aid is the giving of money and/or goods by

one country to another or by an organization to another
country.

Forms of aid

Aid comes in a variety of forms and classifications. One way

is shown in Table below:

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Reasons for giving aid

Countries provide aid for a wide variety of reasons. Aid

programs often serve several purposes simultaneously. It is
difficult, therefore, to state which might be the most
important. The reasons include:

1. to promote economic development, sometimes through

international organizations

2. to help in the reduction of poverty

3. to promote a country’s exports by requiring the recipient

country to

4. use the aid to purchase the donor country’s products

5. to relieve suffering caused by natural or man-made

disasters such as earthquakes or diseases

6. to try to prevent the destruction of the environment

7. to help improve their own security by preventing friendly

governments from falling under the influence of
unfriendly ones or as payment for the right to establish
or use military bases in the aid receiving country or to
combat international terrorism, and other crimes

8. to achieve a country’s political goals including getting

support for its positions in international organisations, or
to increase its diplomats’ access to foreign officials

9. to increase the influence of its language, culture or

religion.

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Effects of aid

There is no agreement on whether international aid is

good, bad or somewhere between. This is because the
effect of aid often depends on the political situation in the
country. Table below sets out some of the positive and
some of the negative effects.

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Importance of aid

Importance of foreign aid clearly overlaps with many of the

points given in the previous sections. Table below list some
of the areas of importance with a brief explanation.

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Trade and investment

Foreign direct investment (FDI) has become a key

element of trade between different countries. Traditionally
a firm in one country would invest in either the natural
resources of another country by, for example, opening a
mine or would set up a factory in another country, often to
get round trade barriers. Today, however, rather than
businesses in one country simply trading with international
partners, more and more companies are buying controlling
stakes in foreign enterprises.

Global value chains (GVCs) have increased the

interdependency between trade and FDI as companies
combine trade with investment to organise the supply of
inputs, to expand in new markets, to access knowledge,
and to provide services to consumers.

In addition, whereas thirty years ago FDI was mainly from

the developed countries to the developing ones, nowadays
many developing countries such as China, India and the
UAE have invested in other countries. This has created a
more global world and a great expansion of trade.

The World Bank has said that FDI is not only about capital,
but increasingly about sharing technology and intangible
assets such as know-how or brands in conjunction with local
capital or tangible assets of domestic investors.

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Role of multinational companies (MNCs)

Definition of MNC

Multinational corporations (MNCs) – sometimes called

transnational corporations – are firms that operate in a
number of different countries. They have their head offices
in one country, but have operations in a number of other
countries.

Activities of MNCs

MNCs indulge in a range of activities including:

1. factories to manufacture the whole product

2. factories to manufacture parts which are then sent to

factories in other countries

3. factories to assemble parts from other factories in

different countries u expanding their size through
mergers and takeovers

4. sponsoring relevant university courses and employing

the best graduates

5. FDI (see above and below)

6. supporting cultural, sporting, etc. activities.

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Consequences of MNCs

Among the top twenty firms are Royal Dutch Shell, Sinopec
Group, Toyota and Glencore International. Royal Dutch
Shell’s revenue in 2019 at $344.9 billion is greater than the
majority of countries.

Over a number of years the total FDI received can amount

to many times a country’s GDP. While FDI increases growth
and employment in a country and, therefore, has a
multiplier effect, it may not be entirely beneficial as profits
are sent back to the home country of the MNC while they
may bring with them their own skilled workforce rather than
training people in the developing country. In some cases
this can lead to economic dependency where one country
exploits the resources of another for the former’s benefit. In
Nigeria the oil industry is totally dependent on the FDI
received from a number of foreign firms. In addition,
domestic businesses may not be able to compete with
MNCs and go out of business allowing the MNC to gain a
larger market share. MNCs have been accused, also, of:
avoiding paying the correct amount of tax due to tax
avoidance schemes; imposing their culture on the country;
and not acting in socially-responsible ways.

MNCs do, however, bring considerable benefits including:

1. employment and training for the labour force, together

with transfer of skills

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2. significant tax revenues enabling the country to spend
more on, for example, education and health

3. greater investment with often this providing extra income

for local suppliers

4. incentives to domestic firms to improve their

competitiveness through the competition they provide

5. greater consumer and business choice

6. greater GDP through their spending and investment.

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Foreign Direct Investment (FDI)

Definition of FDI

UNCTAD defines FDI as “investment made to acquire

lasting interest in enterprises operating outside of the
economy of the investor”. It is investment in the form of a
controlling ownership in a business in one country by an
individual or organisation based in another country. It
involves the idea of direct control as against just an
investment.

Consequences of FDI

Some of the main consequences, both positive and

negative, are set out in Table below:

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External debt

External debt consists of the part of the total debt of a

country that is owed to people, firms, banks, international
financial organisations which are external to the country
together with foreign governments.

Causes of debt

The main causes of external debt in recent years have

been:

1. persistent trade deficits leading to borrowing money to

pay for the goods and services and to support the
exchange rate

2. high internal debts caused by consistently spending

more than revenue

3. high inflation leading to having to borrow with high

interest rates which make repayment ever more difficult;
Argentina has defaulted on its debts on a number of
occasions, the last being in 2020

4. misuse of funds: funds are often used to boost

consumption rather than for capital investment; in other
cases corruption plays a part over lending by foreign
banks.

Consequences of debt

External debt in itself is not a problem. Indeed, economic

theory suggests that a reasonable level of debt should help

189
both developing and developed countries enhance their
economic growth. This is true especially if the debt is a
result of investment in areas such as infrastructure, new
production methods, etc.

The negative consequences come about because the debt

is too large. Among these consequences are:

1. Decline in economic growth as the servicing of the debt

of the country causes large outflows of money

2. Decline in economic development as repaying the debt

will mean less money for education, infrastructure, health
care, etc.

3. Loss of confidence as lenders worry about whether they

will lose their money and are hesitant to lend more. This
often leads to high interest rates on future loans

4. Fall in the external and internal values of the currency to

the point where the currency may become unusable in
terms of buying imports or even buying these imports in
shops.

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Role of the International Monetary Fund (IMF) and
World Bank

The International Monetary Fund (IMF) is one of the

agencies that keep track of the country’s external debt.

It aims to offer:

1. policy advice to governments and central banks based

on analysis of economic trends and cross-country
experiences

2. research, statistics, forecasts, and analysis based on

tracking of global, regional, and individual economies
and markets

3. loans to help countries overcome economic difficulties

4. concessional loans to help fight poverty in developing

countries

5. technical assistance and training to help countries

improve the management of their economies.

The World Bank group consists of five agencies:

1. The International Bank for Reconstruction and

Development (IBRD) lends to governments of middle-
income and creditworthy low-income countries.

2. The International Development Association (IDA)

provides interest-free loans, called credits, and grants to
governments of the poorest countries.

191
3. The International Finance Corporation (IFC) provides
loans, equity and technical assistance to stimulate private
sector investment in developing countries.

4. The Multilateral Investment Guarantee Agency (MIGA)

provides guarantees against losses caused by non-
commercial risks to investors in developing countries.

5. The International Centre for Settlement of Investment

Disputes (ICSID) provides international facilities for
conciliation and arbitration of investment disputes.

Both the IMF and the World Bank aim to try to help
countries with debt problems to overcome them through a
mixture of advice and aid.

192
GLOBALIZATION
Globalization is the spread of products, technology,
information and jobs across national borders and cultures.
In economic terms, it describes an interdependence of
nations around the globe fostered through free trade.

There are lots of possible causes of globalization, but the

main ones are shown in Table below.

The consequences of globalization include:

1. Economic growth: adopting a more open trade policy

allows a country to profit from international trade and
FDI leading to the introduction of new technologies and
a higher competitiveness. MNCs provide new jobs and
skills

2. Consumers enjoy a greater choice of goods and services

at lower prices

193
3. Global trade cycle: as countries are increasingly
interconnected, a crises in one country may cause
problems in other countries. This can be true for changes
in the business cycle and financial crashes

4. Tax competition: to attract MNCs, many countries have

engaged in tax competition both in terms of taxes on
profits, thus gaining more FDI, and to attract foreign
workers

5. MNCs may drive local companies out of business u

deindustrialisation in developed countries.

Distinction between a free trade area, a customs union,

a monetary union and full economic union

Free trade area: A free trade area consists of countries

which have removed barriers to trade between themselves,
but maintain their own individual barriers against non-
member countries. Free trade areas include: European Free
Trade Area - EFTA (EEA), NAFTA and South Asian Free
Trade Area –SAFTA.

Customs union: In contrast, a customs union has free trade

between its members, but common external tariff barriers
against all non-members. An example of a common market
is the Caribbean Community (CARICOM).

Monetary union: In the case of a monetary union, the

members adopt the same currency. This implies a common
central bank which controls the quantity of money and the

194
rate of interest and by so doing seeks to influence the rate
of inflation in the member countries.

18 members of the EU have formed a monetary union with

the euro (€) as its currency. It is called the Eurozone.
Although each member has kept its own central bank, the
Eurozone is managed by the European Central Bank which
sets monetary policy.

Full economic union

Economic Union is the highest form of integration

encompassing the features of a common market, but going
further to develop some harmonization of economic
policies. The EU, for example, has developed a range of
policies in such areas as competition, agriculture and social
policies.

The Common Agricultural Policy (CAP) is one such

example. CARICOM has also moved in this direction by
creating the CARICOM Single Market and Economy
(CMSE).

CMSE members have adopted measures to converge and

coordinate their macroeconomic policies, harmonize
foreign investment decisions and facilitate technology
transfer. In monetary and fiscal policy there are measures to
coordinate exchange rate and interest rate policy as well as
coordinate indirect taxes and national budget deficits.

195
In some ways economic integration into regional trading
blocs can be regarded as a “second best solution” in that it
enables members to enjoy the benefits of comparative
advantage, but involves protectionist policies against non
members and consequently stops short of allowing all
nations in the world to benefit from free trade.

Trade Creation and Trade Diversion

A feature of customs unions and higher forms of economic

integration is that member nations experience both trade
creation and trade diversion.

Trade Creation

As a result of trade barriers being removed when a country

enters a customs union, it can now buy goods at a lower
price. For example, before joining the EU, if Malta wished
to buy pasta from Italy it would have to pay a tariff thereby
raising the price in Malta. Now Malta is a member of the
EU, the tariff has been abolished and consumers can now
purchase the pasta at a lower price, increasing their
welfare. This shifting of consumption from high to low cost
producer is known as trade creation.

Trade creation occurs when the removal of tariff barriers

results in an increase in consumer welfare. In Figure below,
DH and SH represent the domestic demand for and supply
of tomatoes in Ireland. Assuming that:

1. Ireland imports tomatoes from Spain

196
2. The supply of tomatoes from Spain is perfectly elastic, so
that the supply curve is Sw

3. Ireland imposes a tariff on Spanish tomatoes equal to

P2P1.

The effective supply curve for tomatoes from Spain is,

therefore, Sw + Tariff.

Originally, the quantity of tomatoes in Ireland will be Q1 of

which OQ2 is produced in the UK and Q2Q1 is imported.
The price will be P1. At this price Irish citizens’ consumer
surplus is given by the areas 1 + 2.

If Ireland and Spain enter into a customs union the tariff will
be removed and the price of Spanish tomatoes falls to P2.
Consumption of tomatoes in Ireland increases to OQ3 of
which OQ4 is supplied by Irish producers and Q4Q3
imported. Trade creation has resulted as there has been a
movement away from high cost production to low cost
production. Irish consumer surplus has now been increased
by:

1 + 2 + 3+ 4

The overall welfare gain is, however, only areas 2 + 4 since

area 1 represents a redistribution of producer surplus to
consumers and area 3 a redistribution from the government
to consumers (lost tariff revenue).

In this case there has been a net gain in welfare for Ireland.

197
Trade diversion

Trade diversion is when a tariff is imposed so that

consumers can no longer benefit from low cost supply.
Assume that before the creation of the customs union the
UK is importing tomatoes from the cheapest world
producers. In the Figure below, DH and SH again represent
the UK domestic demand for and supply of tomatoes and
Sw represents the world supply curve. Before the customs
union, there were no tariffs on tomatoes. OQ3 tomatoes
would be consumed with OQ4 produced in the UK and
Q2Q3 imported.

198
Lorem ipsum do lor If now the UK and Spain become part of a customs union,
sit amet, con sect
then a tariff is imposed on imported tomatoes from outside
etuer adipiscing elit.
Morbi com modo, the customs union meaning it is cheaper for the UK to
ipsum magna sed purchase tomatoes from less efficient producers such as
phar etra gravida,
Spain. The price rises to Sw + tariff. The demand falls to Q1,
orci magna rhon cus
neque, id pulvinar but UK production increases to Q2 with Q2Q1 being
odio lorem non imported from Spain. The results will be:
turpis.
1. consumer welfare falls by 1 + 2 + 3 + 4

2. government revenue rises shown by 3

3. producer surplus rises by 1

4. deadweight loss (lost by consumers, but not gained by

government/ producer) 2 + 4

199