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ECO 1020: PRINCIPLES OF MACROECONOMICS

NOTES

THE NATURE AND SCOPE OF ECONOMICS.

 Economics is a social science, which seeks to explain the
economic basis of human societies.
 It is the study of how best the society allocates its scarce
resources among competing alternatives.
 Macroeconomics concern is to understand and improve the
performance of the economy as a whole. It is the study of
aggregate economic behaviors of the economy as a whole.
 In macroeconomics we worry about such national goals as full
employment, control of inflation and economic growth, without
worrying about the wellbeing or behavior of specific individuals
or groups.

Importance of economics:
 Economics covers topics that are highly relevant to many of the
most pressing issues facing today’s world, e.g. free market
versus government controlled markets, resource exhaustion,
pollution, the population explosion, government, inflation, the
EU, their, changing living standards in advance nations, growth
and stagnation among the world’s poorer nations
 Economics provides the skills for analyzing, explaining and
where appropriate offering solutions to economic problems.
 Economics has a core of useful theory that explains how
markets work and that evaluates their performance.

Economic methodology
Economics is often called a social science since the subject matter
is a human being. This means that controlled experiments of the
natural science are impossible. It is therefore difficult to link cause
to effect. Human beings react differently to external economic
events making prediction more difficult than in the natural science.
Fortunately, reaction of groups of individuals to events is more
stable, with extremes canceling each other.
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The term methodology refers to the way in which economists go

about the study of their subject matter. Broadly, economists have
followed positive and normative economics.
Positive economics is concerned with propositions that can be
tested by reference to empirical evidence. It relates to statements of
what is, was or will be. The accuracy of positive statements can be
checked against facts and proved correct or incorrect Thus to say
that, “the rate of inflation in Kenya over the last 12 months has
been 6%”, is a positive statement. By reference to the facts, it can
be proved correct or incorrect.
Normative economics is concerned with propositions, which are
based on value judgments, i.e., statements that are expressions of
opinions. Normative statements, therefore relates to statements of
what should or ought to be the case. Normative statements are
matters of opinion which cannot be proved or disapproved by
reference to the facts, since they are based on value judgments e.g.,
to say that: “the government’s main aim should be the control of
inflation”, is a normative statement since its validity cannot be
checked against any facts. It is a statement, which we may either
agree or disagree, but there is no way of providing that it is correct.
Deduction and Empirical Testing.
The process of deduction and empirical testing is the most
important approach followed by modern economists. In this case, a
theory is proposed, logical deduction applied to develop
predictions, and a test made of these predictions against the facts.
For instance, one theory is that the amount of a commodity
consumers wish to purchase will usually vary with its price. This
prediction can be tested against how consumers actually behave. If
the facts do not support the theory it must be rejected in favor of
other theories which better explain actual observation.
Induction.
This is an alternative methodological approach in economics. The
facts themselves are starting point for this approach, with any
observed pattern or regularity in the facts giving the economist
some guidance. It involves, first, the collection, presentation and
analysis of economic data and then the derivation of relationship
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among observed variables, i.e., the available statistical closely
examined in the search, for the general economic principles.
Graphs and their meanings
 A graph is a visual representation of the relationship l between 2
variables.
 Economists like to use graphs to illustrate relationship between
2 or more variables. Consider for instance the relationship
between grades and studying. In general we expect that
additional hours of study time will lead to higher grades.
 We can be able to see a distinct relationship between hours of
study time and grade- point average
The diagram below illustrates this

Grade point
average
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2
2
1

1 2 3 4 5 6
Study time

 The whole purpose of graphs is to summarize numeral

relationships.
 The upward (positive /direct) slope of the curve indicates that
additional studying is associated with higher grades.
 There are also graphs, which show combinations of two
variables at which some conditions are achieved e.g. PPF of
food and cloth.
A
Food
PPF/PPC
(tones)

0
B
Cloth (Metres)

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Graphs illustrate relationships between direct and inverse
relationships. An example of a direct relationship would be
consumption and income. An increase in disposable income results
to an increase in consumption other factors held constant as
illustrated below: -
Consumption
C
Consumption

Income (Y)

 An example of an inverse/ negative would be the prices of

tickets and attendance in thousands as illustrated in the table
below.
Ticket price (shs) Attendance (thousands)
50 0 50
40 4 Ticket price
30 8
20 12
10 16
0 20 20
Attendance in thousands

Dependent and independent variables

Graphs illustrate the relationship between dependent and
independent variables. The independent variable also referred to as
exogenous variable is the cause or source, it is the variable that
changes first.
The dependent variable is the effect or outcome. It is the variable
that changes because of the change in the independent variable. As
noted in our income – consumption example, income generally is
the independent variable and consumption the dependent variable.
Income causes consumption to be what it is rather than the other
way round.
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Slope line
Lines can be described in terms of their slopes.
The slope of a straight line is the ratio of the vertical change (the
rise or drop) to the horizontal change (the run) between any two
points of the line.
I.e., slope = vertical change for linear relationships
Horizontal change

Slope of a non-linear curve

A
B

Infinite or zero scopes

Prices of
bananas Slope = infinite C Slope = 0
Consumption

Purchases of watches
Divorce rate

 these happen for variables which are unrelated or independent

of one another

The Economic problem/Questions:

 The basic economic problem confronting all societies is how to
allocate scarce resources between alternative uses. Resources
are scarce because the collective desires of society for
consumption at any moment in time exceed the ability to satisfy
those desires.
 The economic problem thus arises because individual’s wants
are virtually unlimited, whilst the resources available to satisfy
those wants are scarce.
Because there are insufficient resources to produce all that is
desired, society is forced to make a choice. These choices are:
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(a) What output will be produced? The society must choose
which goods and services to be produced from the available
resources.
(b) How shall the goods be produced? There are various ways of
producing given output e.g., labor intensive or capital intensive
techniques. The technique chosen must be cost effective.
(c) For whom shall the output be produced? Clearly, if an
output is produced there must be some means of allocating it to
consumers and of deciding who receives what.
In choosing which goods will be produced from scarce resources
society is forced to do without those goods that might otherwise
have been produced. This is very important to the economists, and
in choosing what to produced, the new best alternative forgone or
sacrificed is referred to as opportunity cost (or real cost) of what
is produced. Opportunity cost of a decision to produce or to
consume more of one good is the next best-forgone alternative. A
decision to buy a T.V set, for example, might mean giving up the
purchase of a sofa set. In taking decision about production, the
concept of opportunity cost is vital.

The economizing problem

 The economizing problem stems from 2 related facts
1. Society’s economic wants, i.e., the economic want of its citizens
and institutions are virtually unlimited and insatiable.
2. Economic resources, i.e., the means of producing goods and
services are limited or scarce.
 Economic wants mean the desires of consumers to obtain and
use various goods and services that provide utility, i.e., pleasure
and satisfaction. These wants extend over a wide range of
products, from necessities (food, shelter, and clothing) to
luxuries (perfumes, racecars etc. Over time, wants change and
tend to multiply, fueled by new products.
 Wants are insatiable or unlimited, meaning that our desires for
goods and services cannot be completely satisfied.
 Economic resources are, however limited relative to the wants
that they should satisfy. By economic, that we mean all natural,
human, and manufactured resources that go into the production
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of goods and services. That includes factory and farm buildings
and all the equipment, tools and machinery used to produce
manufactured goods and agricultural goods/products, all
transportation and communication facilities, all types of labor
and land and mineral resources. Economists categorize all these
resources into land, labor, capital and entrepreneurial ability.
 The four types of economic resources highlighted above are
generally scarce or limited in supply. The planet contains only
finite and therefore limited amount of economic resources. Due
to this reason, people must make choices and economize on
resource use.

Type of Economic Systems

Economic systems are concerned with the ownership and control
of resources. The main types of economic systems are:
a) Traditional economy,
b) Market economy,
c) Command economy,
d) Mixed economy.
(a) Traditional Economy.
 A traditional economy is one in which behavior is based
primarily on tradition, custom and habit. Young men follow
their fathers’ occupation, typically, hunting, fishing and tool
making. Women do what their mothers did, typically, cooking
and fieldwork.
 Traditional economy is characterized by few changes in the
pattern of goods produced from year to year, production
techniques follow traditional patterns, except when the effects
of occasional new inventions are felt. Property is often held in
common and the concept of private property not well defined.
 The answers to economic questions of what to produce, how to
produce, and for whom to produce or how to distribute are
determined by traditions.
b) Market Economy.
 In this case, resources are allocated through price mechanism.
This simply means that individuals, as consumers freely choose
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which goods and services they will purchase, and producers
freely choose which goods and services they will provide.
Because of this, market economies are often referred to as free
enterprise or laissez-faire economies.
Characteristics of Market Economies
 Individuals pursue their own self-interest buying and selling
what seems best for themselves and their families.
 People respond to incentives. Other things being equal, sellers
seek high prices while buyers seek low prices.
 There is reliance on price mechanism to allocate resources.
Prices are set in open markets in which would be sellers
compete to sell their wares to would be buyers.
 There is limited role of state. Indeed, in a strictly free
enterprise economy, the only major role performed by the govt.
would be that of creating a framework of rules (i.e. laws) within
which both private individuals and firms could conduct their
affairs.
 There is the existence of the right to own and dispose of
private property. Any individual is free to own and dispose off
factors of production.
(c) Command Economy.
 This is an economy in which resources are allocated by central
planning authority appointed by the state. In this case, key
industries and resources are controlled and owned by the state.
The government issues directives (i.e. instructions) to firms
indicating what they should produce, the quantities that should
be produced, and so on.
The following are some of the advantages of command
economy.
 Because production is not undertaken for profit, there is greater
likelihood that both public goods and merit goods are produced.
The government simply has to issue directive to ensure
production.
 The production and consumption of demerit goods, which
impose, relatively large social costs on the society can be
prevented or limited through taxes or subsidies.
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 Greater equality in the distribution of wealth and income can be
guaranteed in centrally planned economies. In a fully command
economy, there are no private entrepreneurs who derive profits
from combing the factors of production.
Disadvantages:
 With command economy, there is greater reduction of consumer
sovereignty. I.e., the state decides what to produce and the
consumers have much less influence over production than in
market economies. This culminates into shortages of certain
commodities and surfaces of others.
 Moreover, there may be tendency towards bureaucratic
structures. It is the govt. planning departments, which govern
resource allocation. The opportunity cost of employing people
to gather information, process it formulates plans is the
alternative output these people could otherwise have produced.
 There is also less incentive to increase efficiency because profit
motive is absent.
(d) The Mixed Economy.
 Fully traditional, fully centrally controlled and fully free market
economies are useful concepts for studying the basic principles
of resource allocation. However, there is always some mixture
of central control and market determination, with a certain
amount of traditional behavior as well.
 Mixed economy refers to an economy in which both free
markets and governments have significant effects on the
allocation of resources and the distribution of income.
 The degree of mixture varies from economy to economy and
over time.

Production possibility Frontier.

A production possibility frontier joins together the different
combination of goods and services which a country can produce
using all available resources and the most efficient techniques of
production.
The diagram below illustrates this.
A country’s Production possibility Frontier

A
9
Food
(Tones)
 10

.N
.M

0
Cloth (Meters) B

 The straight line (AB), i.e., production possibility frontier

represents constant opportunity costs.
 The diagram shows different combinations of these two
commodities, which can be produced. OA tones can be
produced when all resources are employed in the production of
food while OB meters can be produced when all resources are
used in the production of cloth.
 All points on the PPF represent combinations of food and cloth,
which the country can just produce when all its resources are
employed.
 All points inside the line, such as point M, represent
combinations, which can be produced using less than the
available supply of resources, or by using the available supply
with less than maximum efficiency. Points outside the PPF such
as N, represent combinations which are unattainable.
 To increase the output of cloth from OE to OF meters, it is
necessary to reduce the output of food from OC to OD tones.
Hence, the opportunity cost of increasing the output of cloth
from OE to OF meters is CD tons of food.
 The opportunity cost of increasing the output of cloth from O to
OE meters is only AC tons of food.
The diagram below represent a country’s PPF with increasing
opportunity cost. As additional units of cloth are produced, the
opportunity cost in terms of food increases.

A1

Food
(Tones)

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Cloth B1
(Meters)

 PPF shows what the country can produce at any moment in time
with existing resources. Over time, societies ability to produce
output is likely to increase because of :
(i) Improvements in the productivity of labor,
(ii) Greater technological progress,
(iii) Increase of the size of labor force, etc.
 If the society’s ability to produce output increases, this will be
represented by an outward moment of theatre PPF.
 The slope of the PPF can be interpreted as meaning the rate at
which food can be transformed into a meter of cloth by shifting
resources from food production into cloth production. The slope
of PPF is sometimes called the marginal rate transformation.
When PPF is drawn as a straight line, the opportunity cost and
MRT remain unchanged ,i.e., constant opportunity cost
 Where PPF is drawn in a straight line, the absolute value of the
slope of the line, equal to OA/OB, measures the opportunity
cost in terms of food of producing 1 extra meter of cloth. The
reciprocal of the slope OB/OA measures the opportunity cost in
terms of the cloth of producing 1 extra tone of food.
N.B: This implies those additional meters of cloth produced
require that 0A/0B tons of food be forgone and that OB/OA
meters of cloth be forgone.

Foundations of Economics
Economics began when thoughtful observers asked themselves
how such a complex set of dealings is organized. Who coordinates
the whole set of effects? Who makes sure that all the activities fit
together, providing jobs to produce the things that people want and
delivering things to where they are wanted?
The great insight of the early economists was that an economy
based on free-market transactions is self-organizing.

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The great Scottish economists and political philosopher Adams
Smith was the first to develop this insight. Smith said that self-
interest, not benevolence is the foundation economic order. Smith
said that spontaneously generated social order is relatively
efficient. He said that market society produces ordered behavior
that makes it appear as if people are guided by a hidden hand. He
did not literally mean that a supernatural presence guides economic
affairs. Instead he referred to the amazing emergence of order out
of so many independent decisions. That all individuals respond to
the same set of prices which are determined in markets that
respond to overall conditions of national scarcities and plenty.

The work of Adam Smith (1723 - 90) entitled, “An Enquiry into
the Nature and cause of the wealth of nations” was the first
comprehensive study of economics as a separate and independent
subject. The wealth of Nations develops a theory of prices and
distribution. According to Smith, the prices of commodity are
made up of wages, rent and profits, which are the three original
sources of revenues as well as exchangeable value. Thus the total
national product is distributed among the owners of labor, land and
capital. Smith said that market society produces ordered behavior
that makes it appear as if people are guided by an invisible or
hidden hand. He thus contributed the philosophy of “laissez-faire’’
Smith argued that the market mechanism is a self-regulating
natural order and the state should not intervene through rules and
regulations in the price system. With laissez faire philosophy, he
championed the cause of free international trade. His other
contribution was the nation of specialization and division of labor.

David Ricardo (1772-1823) in his work entitled, “The principles

of political economy and Taxation (1817)” identified three classes
or owners of the factors of production as workers landowners and
capitalists who receive rewards in forms of wages, rents and profits
respectively. But because of his belief in the law of diminishing
returns and in the Malthusian theory of population, Ricardo
visualized the economy eventually reaching a “stationary state” in
the decades to come. Ricardo also developed the theory of
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comparative advantage in which he applied Smith's ideas of
division of the labor and specialization to trade between countries.

Alfred Marshall (1842-1924) wrote a book entitled principles of

economics in 1890. His contribution is one of synthesis linking the
supply conditions of classics economists (based on costs of
production) with utility and demand. He tends to view forces of
supply and demand in the context of time.

John Maynard Keynes (1883-1946) developed his analysis in an

attempts to account for persistence large scale unemployment in
his analysis, developed in “The General Theory of Employment,
Interest and money (1936),” Keynes demonstrated possibility of an
equilibrium level that could persist below the full employment
level.
Keynes also wrote a pamphlet “How to pay for the war (1940)” in
which he called for measures such as high taxes on households, to
reduce consumers demand or resources. This was necessary in
order to control possible inflationary pressures caused by excess
demand for resources during the Second World War.

Milton Friedman who was born in New York in 1912 is well

known for his work on the methodology of economics. Examples
of his book entitled, "Essay in positive Economics, 1953” and the
theory of consumption in his book entitled “A theory of
consumption Function, 1957”. He advocated for a free market
economy. He also advocated for the development of monetarism in
his book Quantity Theory of money.
Economics and Efficiency.
 Economics is a social science that examines the efficiency i.e.,
the best use of scarce resources. Society wants to use its scarce
resources efficiently; as possible from its available resources,
thereby maximizing total satisfaction.
 Full production implies productive and Allocative efficiency.
Productive efficiency is the production of any particular mix of
goods and services in the least costly way. Allocative efficiency,
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however, is production of that particular mix of goods and
services most wanted by society. Allocative efficiency requires
that society produces the right mix of goods and services with
each item being produced at the lower possible unit cost. This
means apportioning limited resources among firms and
industries in such a way that society obtains the combination of
goods and services it wants the most.
 The concept of efficiency was first credited to Italian economic
Vilfred Pareto (1848-1923) who concentrated or the efficiency
aspects of welfare because he believed that to be regarded as
Pareto efficient, it must be impossible to increase the production
of one good without reducing the production of another, or to
increase the consumption of one household without reducing the
consumption of another. Such a situation according to Pareto if
the following conditions are satisfied!
a) The given stock of resources must be allocated in the
production of goods and services in such a way that no re-
allocation can increase the output of one good without
decreasing the output of any other.
b) The combination of goods and the proportion in which they are
produces must be in response to the tastes and preferences of
the community, i.e., the goods produced must be the ones that
the community wants.
c) The distribution of goods and services must be in conformity
with consumers’ preferences, given their tastes and incomes.

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MEASURING DOMESTIC OUTPUT, NATIONAL
INCOME & PRICE LEVEL

The importance of macroeconomic measurement

- Macroeconomics is necessary because there are forces that
affect the economy as a whole that cannot be fully or simply
understood by analyzing individual markets and individual
products. As a problem that is affecting all firms, or many
workers in different industries may need to be tackled at the
level of the whole economy. Certainly, if circumstances are
common across many sectors of the economy, than the analysis
of the whole economy may help us understand what is
happening.
- In macroeconomics, the focus zeroes on the overall business
cycle, overall living standards, inflation, unemployment in the
whole economy, interest rates, etc.
- Macroeconomics provides an explanation for the business
cycles in an economy or at global level. The various business
fluctuations are explained and the respective economic damages
likely to be caused are predicted.

MEASURES OF INCOME AND OUTPUT

There are two measures of importance
1. Gross Domestic Product (G.D.P)
- GDP is the total value of the current production of final goods
and services within the national territory during a given period
of time, normally a quarter or a year.
- It is the value of current production of the final goods and
services obtained at the prevailing market prices produced
within the national boundary.

NB: Current product excludes resale of items produced in another

periods, i.e., excludes transfer of assets regardless the
arrangement or methods of transfer.
- GDP is measured in monetary units.
- Final good - This excludes raw materials and semi-finished
goods used as inputs in the product of other goods.
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Circular flow of income

- For a closed economy, total purchases by domestic consumers
are equal to total revenue of firms.
- Households demand output from firms and they supply inputs of
labor and capital to firms.
- Firms provide output to households and use their earnings to
pay wages for labor and interest or profit capital inputs.
H/HOLD

Goods & Labor& Income = wages +

Purchases capital income
services capital
(outputs)

BUSINESSES

MEASUREMENT OF G.D.P
(a)Expenditure method
- GDP is the sum of market values of all the final demand for
output in the economy in a given period.
- GDP = PcC + P I I + PG G + (Px X – Pm M)
Where,
GDP = Gross Domestic Product
Pc = Consumer price
PI = Price of Investment
Px = Price of Exports
Pm = Price of imports
C = Private Consumption
I = Investment
G = government chonsumption
X = Exports
M = Imports
Px X – Pm M = Net Exports
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NB: Final demand (FD) = Wages + capital income which is
equal to value added Tax.
Capital income = Interest paid on loans + profits

(b) The Value Added method

- GDP in this case is obtained by summing up the value added in
each sector of the economy. The various sectors may include:-
1. Agriculture, Forestry and Fisheries
2. Mining
3. Construction
4. Manufacturing
5. Transportation and public utilities
6. Wholesale and retail trade
7. Finance insurance and real estate
8. Government and Government enterprises
9. Statistical discrepancy used to make correction for any
statistical discrepancy

(c)Income Approach
- GDP is obtained by summing up all incomes of all the factors
i.e., labour and capital which contribute to the production
process. E.g. domestic income (DI) = Labour income +
capital income
- Labour income = remuneration of salaried employees
- Capital income = income of self employed + interest income +
corporate profits + rental income.
- GDP = DI + capital depreciation + indirect taxes (sales & excise
taxes)
- Net domestic product (NDP) = DI + indirect taxes
NDP = GDP - depreciation
Therefore, DI = GDP - depreciation - indirect taxes
NB: GDP: is measured at market prices while DI is measured
using net of taxes
Therefore GDP = DI + Depreciation + indirect taxes

What GDP does not measures

1. Economic activity taking place outside the market economy
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2. Unreported activities e.g. black economy - black economy
is that part of economic activity not recorded in official
statistics (NB: Tax)
3. None marketed activities e.g. housework at home, leisure, do
it by yourself activities, landscaping, etc.
4. Economic bads e.g. pollution, congestion and other
disamenities of modern living. Economic bads are also
referred to as negative outputs.

Gross National product (GNP)

- The total value of income the domestic residents receive in a
given period of time is referred to as Gross National Product
(GNP).
- For a closed economy GNP = GDP.
- For an open economy, GNP = GDP. This is because for an open
economy, GNP would include the income for domestic residents
outside the country.

Reason:
- Parts of incomes of factors of production in the domestic
economy belong to foreigners.
- Some domestic residents may received their income from
abroad e.g. payment for employment while abroad or payment
to stock of shares in a foreign company.
- GDP measures income received from the factors of production
within the national boundaries.
- GNP measures the income of residents of the economy
regardless of its source. The difference between GDP and GNP
can be depicted in the revised flow diagram on the figure on
page five.

Imports
Labor & Income from
capital capital &
Purchases
labor abroad
& exp[orts

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H/HOLH

Wages + capital
Labor & income = income
Purchases capital
Goods &
services

BUSINESSES

Exports
Foreign
Imports labor + Payments to
capital foreign factors
of production

 Let the net factor income (NFI) or net factor payment (NFP)
received from abroad equal earnings of domestic residents on
foreign profits, loans and work remittances minus earnings of
foreigners in the domestic economy; then GNP=GDP+NFI or
NFP
 If NFPO, then GNPGDP. The reverse also applies,
‘mutatis mutandis’.

Measuring price level /price indexes

 The millions of prices of output in the economy make it difficult
to say whether changes in GNP result from price changes or
quantity changes. What is needed is to summarize the vast
number of prices and outputs into simple indexes.
 E.g. the aggregate market value of consumption expenditures is
equal to the sum of the market value of expenditures on all
different types of consumption goods.

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 Suppose that there are N types of consumption gods, for each
type of good, there is a price and physical volume of
consumption. Thus the normal of consumption denoted Pc C, is
equal to
Pc C =P1 C1 + P2 C2 + P3 C3 ++ PN CN -----------------------------(1)
Where C =aggregate consumption
C1, C2….CN = various types of consumption goods
P1, P2…PN= Prices of the corresponding consumption goods.
 We then calculate the average price of consumption goods by
constructing a price index, denoted PC, which is a weighted
average of all the prices of the individual types of consumption
goods. The typical way to calculate this index for year t (P ct) is
as follows:-
Pct =w 1
( ) ( ) ( )
p1 t
p 10
+w 2
p2 t
p 20
+w
p 3t
p30 ( )
+. .. w N
p Nt
pN 0
−−−−−−−−−−−−2

Where w1, w2…, wN = the weights reflecting the varying

importance that is attributed to the various individual prices.
A large weight implies a greater impact on pc (price index, where
w1 + w2 +….+ wN = 1)
Pit = the price of a particular consumption good in year t.
Pio = the price of a particular ‘base year’, t = O
For the base year, the price index = 1
 The resulting price index is sometimes referred to as consumer
price index (CP1) or the consumption price deflator.
 The weights for each price are the same for all the year
 The price index for any given year is weighted average of all the
prices in that year relative to the prices in the base year using
constant weights.
 The real value of consumption (Ct) for a given year therefore is
given by
Ct = Normal value of consumption expenditure for a given year
Consumer price index of the year
Pct C t
Ct = −−−−−−−−−−−−−−−−−−−−−−3
Pct
Real GDP
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 GDP at market prices = the average price level x real
production in the economy; i.e. GDP = P.Q, where P is the
average price level, and Q = real GDP (index of physical
production )
 Real GDP = the sum of all expenditures in the economy i.e., Q
= C + I + G (X-M) where Q = real GDP, C=real consumption, G
= government real consumption, X=real export, M=real import
and I= real investment.
 Using the normal GDP and real GDP, the GDP deflator can be
obtained.
GDP deflator (p) = Normal GDP = GDP
Real GDP Q
Where P is the GDP deflator or implicit GDP price index or price deflator
 P is obtained indirectly or implicitly by dividing GDP (nominal GDP)
Q (real GDP)
Real and Nominal GDP
 Although prices serve as a convenient of market value, they also
distort our perception of real output. Imagine what would
happen to our calculations if all prices were to double from one
year to the next. Obviously, they would lead to a doubling of the
value of final output. Such an increase in GDP does not reflect
an increase in the quantity of goods and services available to us.
 Hence, a change in GDP brought about by changes in price
level can give us a distorted view of economic reality.
 In order to distinguish increases the quantity of goods and
services from increases in their prices, we must construct a
measure of GDP that takes into account price level changes.
 Nominal GDP is the value of final output at current prices,
whereas real GDP is what the value of final output would have
been if prices had not changed (constant prices).
 To calculate real GDP, we are effectively valuing goods and
services at prices of an earlier year.
 Because the price level increases nearly every year, the
distinction between nominal and real GDP must be made when
the economy’s performance is evaluated over time.

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 In calculating real GDP, we can use any year’s prices as a base
year, as long as we consistently value output at the level of
prices prevailing in that year..
 Price index is used to measure changes in the price level by
comparing the price of a basket of goods and services in the
current year to the price of this basket in the selected base year.

GDP and Social Welfare/Economic Wellbeing

 In principle the relationship between GDP per capita and the
economic wellbeing of a nation would be that higher GDP per
capita would imply a higher level of wellbeing; then lower level
of GDP per capita would imply a lower level of wellbeing.
 However, GDP may be a poor measure of economic wellbeing
since
1) It omits certain services by using market value rather than the
true social value of output thereby underestimating the actual
income. In these cases the market value overestimates the
true social value of output thereby overestimating the GDP.
E.g. no considering environmental degradation, pollution and
other effects on the locals.
2) The economic wellbeing resulting from a certain per capita
level depends on the market prices of the output. For a given
GDP per capita, a country with low market price will have a
better economic wellbeing. Compared to the one with a
higher market prices.
3) GDP per capita does not account for the degree of income
inequality in a given nation. An increase in income inequality
will imply a reduction in the value of social indicators and
vice versa e.g. education, health, nutritional level, food
security, etc.

The Problems of Aggregation.

Problems arise in aggregation largely due to:
1) Difficulty of finding an appropriate unit of measurement.
The millions of different goods and services are measured in
different units, e.g. cloth is measured in metres while steel is

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measured in tones. It is impossible to add tones to metres.
This is overcome by using money as a unit of measurement.
2) Difficulty of distinguishing between real and nominal
values. If the value of total output doubles, this does not
necessarily mean that total output itself has doubled. While
part of the increase may be due to an increase in physical
output, part of it may be due to increase in price. However to
estimate real output it is necessary to deflate the value of total
output by an appropriate price index. This converts total
output measured in current prices to total output measured in
constant prices.
3) Difficulty in deciding which price index to use. In most
cases the price indices calculated are the general index of
retail prices and the producer price index. Each one is a
weighted average of the prices of a number of selected goods.
Changes in the deflated total output figures can only give an
estimate of the true changes in the nation’s physical output.
4) Hiding of constituent elements. E.g. an increase in the
economy’s total output tells us nothing about who receives
that output. Distributional factors should always be borne in
mind when considering the effects of changes in aggregate
variables.

SOCIAL ACCOUNTS
 Social accounts are also referred to as macro-accounts for a
whole national economy and its various sectors.
 Social/national accounts deal with records of economic activity.
Those records, organized in a coherent way following
accounting rules are always in balance at the end of the period.
 Macroeconomics provides the analytical tools which allow the
explanation of the results shown in the social accounts. Causal
relationships that explain how economy works are important.
 The strength of the national economic accounts is that they have
a solid inspiration in the macroeconomics of Keynes.

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AGGREGATE DEMAND AND SUPPLY

The Need for Aggregate Model/Statistics:

The aggregate demand model is needed in every economy to assist
in macro-economic analysis. Such national statistics would be
ideal for:
1) Making International Comparisons: In doing this it is
necessary to convert the figures to same currency using a rate
of exchange.
2) Government Planning: A rising real national income with a
fairly constant capital stock will generally be associated with a
fall in unemployment. Similarly, there is likely to be direct
relationship between the level of real national income and the
rate of inflation. As the equilibrium level of national income
reaches the full employment level of national income, so
inflationary pressure is likely to build up in the economy. To
devise appropriate government policies, to combat
unemployment and inflation and to estimate the effects of such
policies, accurate national income statistics are essential.
3) Formulating macroeconomic policy.
4) The aggregate model is needed to explain why prices in
general rise or fall.
5) Explaining what determines changes in the level of aggregate
output

Aggregate Demand
 This is the total quantity of output demanded at alternative
price levels in a given time period, “ceteris paribus”.
 Our view here encompasses the collective demand for all
goods and services rather than the demand for any single good.
 It therefore consists of demand of local consumers, firms, the
government and foreigners in the case of open economy. That
is QD = C + I + G +DX, where DX is export demand, C is local
consumers, I is investment and QD is aggregate demand.
 For closed economy, QD = C + I + G.

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 Aggregate demand can called as planned expenditure since it
the total amount that the people are willing and able to spend.
 The aggregate demand curve indicates how much output
people will buy at different price levels the graph below
illustrates this.

Price The downward slope of the aggregate demand

curve suggests that with a give (constant) level
P1 of income, people will buy more goods and
services at lower prices.

P2

AD

Q1 Q2 Quantity

Reasons why Aggregate Demand (AD) curve slopes

downwards from left to right.
1) The Money Supply Effect: With nominal money supply
remaining unchanged, a rise in the price level will reduce the
real value of money supply. The contractionary money changes
of this kind will in most cases reduce total spending and
therefore cause a fall in demand. Similarly, a fall in price level
will increase the real value of money supply and lead to a rise in
AD.
2) Real Balance Effect: If the general price level should rise
during the course of a year, the real value (or purchasing power)
of the account will fall. This will have the effect of curbing
individuals spending during the year. The reverse also applies,
“mutatis mutandis”.
3) Macroeconomic Effect: As the price level falls, the consumers
may decide to buy goods now which they were planning to buy
in the future. If the price level rises, they may decide to
postpone the purchases which were originally planned for the
present. This effect which depends strongly on expectations of
future inflation rates is called inter-temporal substitution effect.
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4) Foreign Purchases Effect: There may also be international
substitution effect if domestic buyers decide to buy more home
produced gods and fewer imports as the domestic price level
falls, and more imports and fewer home-produced goods as the
price level rises.
5) The Rate of Interest Effect: This assumes that as the price
level rises so will the rate of interest, and rising interest rates
will reduce certain kinds of spending such as consumption
spending on durables goods and investment spending.

Causes of Shifts of AD curve

a. A change in government spending
b. A change in taxation.
c. A change in nominal money supply. A rise in nominal
money supply implies an increase in spending and therefore,
AD shifts to the right. The reverse also applies.

Aggregate Supply
 This refers to the total goods of all final goods and services
that all firms in the economy wish to supply over a given
period of time at alternative price and wage levels, “ceteris
paribus”
 Aggregate supply reflects the various quantities of real output
that the firms are willing and able to produce at alternative
price and wage levels in a given time period.
 The aggregate supply curve indicates that businesses will be
willing to produce and sell more output at higher prices and
less at lower prices. This seems perfectly reasonable because
higher prices help determine the extent to which producers get
compensated for their efforts
NB: Output (Q) = f(PQ, Ci, K, Technology), where Ci = cost of
inputs, K = stock of capital, PQ = price of output.

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Price AS
The upward slope of the AS curve
indicates that higher output will be
associated with higher prices.

Quantity

Causes of Shifts in Aggregate Supply (AS) Curve:

a. The level of money wages: An increase in money wage rates,
ceteris paribus, will raise firms’ costs and so make the
production of marginal units less profitable. Firms will react to
this by reducing output and the AS will shift to the left.
b. Other Input Prices: An increase in the price of an input,
ceteris paribus, will cause AS curve to shift to the left. The
reverse also applies.
c. Available supply of inputs and the state of technology:
Growth in the available supplies of inputs in the economy
and/or an improvement in the state of technology (which raises
productivity of one or more inputs) will shift the AS curve to
the right.

Equilibrium: Real Output and the Price Level:

 In macroeconomics, we can say that the equilibrium level has
been reached when there are no economic forces operating to
change the level of national income.
 This occurs when the total demand for all goods and services
(aggregate demand) is equal to the total supply of these goods
and services (aggregate supply).
 Therefore, at equilibrium, AD = AS
 We can say that the total value of goods and services that
households and other economic agents want to buy is equal to
the total value that firms want to produce when this condition
is satisfied.
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 The point at which AD curve and AS curve intersect is the
equilibrium level of real national income OYE and the
equilibrium price level OPE as illustrated below.

Price Level

P1 AS
At any price level other
than OPE the behaviour of
sellers and buyers is not
PE
compatible.
P2

0
AD

D1 YE S1 Real National Income (Real Output)

 At OP1, producers want sell the quantity 0S1, but people

demand 0D1. the excess supply (surplus) at 0P1 will tend to
push the prices down until equilibrium is reached (at point E).
What responses will the price level 0P2 elicit?

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CLASSICAL AND KEYNESIAN THEORIES OF
EMPLOYMENT AND INCOME DETERMINATION
The Classical Theoretical of Employment.
 The classical theory was developed on the notion that a given
flexible wages and prices, a competitive economy would
operate at full employment. That is , economic forces would
always be generated to ensure that the demand for labor would
always be equal to its supply.
 That for any price level, the normal wage is fully flexible and
adjusts to keep the supply of labor and the demand for labor
equilibrated. Thus the real wage is determined so as to clear the
labor market. Labor is always fully employed in the precise
sense that firms want to hire as much labor, as workers want to
supply at the real wage set in the market place.
Real wage – This is the money wage adjusted for changes in the
price level. It is the value of the marginal product of labor in a
competitive economy.
 The demand curve for labor shows the relationship 1.1 the real
wage and the demand for labor shows the relationship 1.1 the
real wage and households supply of labor.
Real Wage SL This represents labour market equilibrium at a real wage

()
w
p 1 of
()
w
p 1 and the level of employment = 0L1

DL
0
L1 Labour

Q=f ( L, K )
Q1
− With 0L1 units of labour employed, output in the economy
Output will be 0Q1

0
L1 Labour

 So any unemployment which exist at the wage rate ( w/p) 1 must

be due to frictions or restrictive practical in the economy or

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must be voluntary. 0L1 denote the full employment level. OQ1
is the full employment level of output.
 Classical economists say that whatever the level of full
employment level of output produced, the income operated in
producing it will necessarily lead to spending which will just be
sufficient to purchase the goods produced. In other words, the
supply of goods and services creates own demand and there can
be no overproduction. This became known as Say’s Law.
 Classical economists also believes that given a flexible interest
rate and a competitive market for loanable funds, saving and
investment would always be made equal by changes in interest
rates. If investment exceeded saving, the demand for loanable
funds would exceed their supply and this would push interest
rates upwards, bringing forth more saving and combing
investment until they were equal again. However, if saving
exceeded investment interest rates would fall, causing
investment to rise and saving would be reduced.

Keynesian Economics
 Keynes maintained that saving mainly depends on national
income level and is not affected by changes in interest rate.
 He also argued that because of monopoly power in both the
goods and labor markets, wages and prices will tend to be
inflexible at least in the short-run.
 According to the Keynesian theory of employment, the level of
real national income and therefore employment is determined
largely by the level of aggregate demand, not supply creating
own demand-classical view.
 In Keynesian, it is demand which determines how much is being
supplied. Thus if firms produce more than is being demanded,
they will observe an involuntary increase in their inventories of
unsold goods and so will rectify this by cutting back on
production and laying off workers . National income will then
fall until the value of what is produced is equal to the value of
aggregate demand .Moreover, if firms find that they are not
producing enough to satisfy demand, they will experience
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unwanted fall in their inventories. They will attempt to
increase production and live more workers.
 There will thus be one level of national income at which
aggregate demand is equal to the value of production.
 This is called the equilibrium level of income (that level at
which the aggregate demand is equal to the total value of
production).To the Keynesian model, the equilibrium level of
income is not necessarily the same as the full employment level
of income. This is why Keynes called his theory a general
theory.

Determination of the Equilibrium level of income:

Keynesian model is based on the following assumptions
1) Wages and prices are fixed. In the short-run, producers will
respond to changes in demand by changing the quantities they
produce rather price. This implies that the economy is less than
full employment.
2) We ignore the money market and concentrate on real sector of
the economy (i.e., the markets for goods and services and for
labor)
3) Consumption (c) and saving (s) are both directly related to
income (y); that both relationships are linear and so can be
drawn as straight lines. The slope of consumption line measures
the increase in consumption brought about by a one pound
increase in income (marginal propensity to consume) .similarly,
the slope of saving line measures the increase in saving brought
about by one pound increase in income, also called marginal
propensity to save (mps).
4) Investment (I) and government spending (G) are autonomous
i.e., they are independent of income changes.

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Imports (M),
M
Exports (X)
Slope = MPM

X
Consumption C
(C), Saving (S) Slope = MPC
0
The average propensity to consume (APC) is
S equal to total consumption divided by total
Slope = MPS disposable income (C/Yd). The APC varies as
Yd
0 The average propensity to save (APS) is
equal to total saving divided by total
disposable income (S/Yd). The APC falls as
income rises.

Investment (I),
Government
Spending (G) I

5) Taxation (T) is in the form of lump sum taxes only.

6) Exports (x) are autonomous but import (M) depends directly on
income.
7) There is no economic growth. This is because the model is
concerned with the short-run only.
 For equilibrium to be attained, the aggregate demand for the
economy’s goods and services should just be equal to the total
value of goods and services produced.
 Aggregate demand (AD) consists of consumption, investment,
Government spending, exports minus imports (i.e.,
AD=C+I+G+X-R) .The total value of goods and services is
measured by the national income (Y)

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 The income received is either spent on consumer goods or
withdrawn in form of saving and taxes (i.e. Y= C+S+T)
 At equilibrium, AD = Y
C+I+G+X-M=C+S+T
I+G+X=S+T+M
 I, G and X are sometimes called injections (J) into the flow of
income while S, T and M are sometimes called withdrawals (W)
from that flow. Therefore at equilibrium J=W.
 Injections: Additional spending items in the circular flow of
income that do not begin with household consumption
 Withdrawals: Those parts of national income that are not used
to buy domestically-produced consumer goods.
 All the injections (I, G and X) are assumed to be autonomous
(or exogenous). An autonomous variable is on the value of
which is determined outside the model under consideration.
 Determination of the equilibrium level of income. The
equilibrium is where AD=Y and W=J.

AD, J, W
($M)
60

50 45o

AD = C+I+G+X-M
40

30
W=S+T+M

20 J=I+G+X
The 45o line joins together all those
points which are equidistant from
10 the two axes. where AD cuts 45o
line is equilibrium (i.e. AD = Y).
This is stable equilibrium.
0
10 20 30 Ye 50
National Income ($M)

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Consumption and Saving
S&C
100
C
Slope =MPC=4/5

50

40

30
S
20 Slope =MPS = 1/5
10

0
50 100 200 250 Yd
-10

MPS + MPC = 1

Absolute Income Hypothesis

This is based on the contention that consumption depends on
current disposable income.

S&C
Non-linear saving
and consumption
C
lines. If mpc falls as
income rises, the
S mps must rise as
income rises.

Yd

Algebraically, the relationship can be expressed as follows.

C = a + bYd
S = Yd - C
= Yd - a - bYd

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Therefore, S = -a + (1 – b)Yd, the constant a is the intercept term
for the consumption line (i.e., where the consumption line cuts the
vertical axis and is equal to 10 the example). The coefficient b is
the slope of the consumption line and so equal to 1 – mps; mps =
0.8. Thus the equation of the consumption line is C = 10 + 0.8Y d.
The equation of the saving line is S = -10 + 0.2Yd. NB: mpc + mps
= 1.
The following therefore the characteristics of absolute income
hypothesis:
1. C and S are stable functions of current disposable income.
2. The relationship can be linear or non-linear.
3. The mpc lies between 0 and 1 (0<mpc<1)
4. The apc falls as income rises and is greater than the mpc.

Investment
 Investment is the flow of output in a given period that is used to
maintain or increase capital stock in an economy.
 Capital refers to accumulated stocks of machinery, factories and
other durable factors of production.. By increasing capital stock,
investment and spending augments the future productive
capacity of the economy.
 Fluctuations in the firms’ plays a role in determining the level of
output and unemployment in the economy.
The following are the types of investment spending:
1.Fixed Business Investment: This measures the spending by
businesses on plant (the physical structure occupied by a factory
or business office) and equipment (machinery and vehicles).
2.Inventory Investment: Inventories are stocks of raw materials,
unfinished goods in the production process, or finished goods
by firms. Inventory investment is the change, in those stock of
goods in a given period and a rise in inventories implies
positive investment while a decline in inventories implies
disinvestment.
3.Investment in Residential Structures: This includes
expenditures on the maintenance of housing and on the
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production of new housing. NB: When a household purchases
an existing house from other household, no investment occurs in
terms of the economy as a whole, there is no change in capital
stock, only in its’ ownership.
 The total level of investment is referred to gross investment.
That part of investment that raises capital stock is referred to as
net investment.
 Capital tend to wear out over time and are eventually scrapped.
Economists call this capital depreciation. The relationship can
therefore be written as:
I = J + dK -----------------------------------------------------------1
where I = gross investment, J = net investment and d is the
parameter of depreciation, say 5% per year, therefore, dK =
depreciation of capital in the current year. The change capital
stock is equal to the rate of net investment:
K+1 - K = J------------------------------------------------------------ 2
Combining equations one and two, we can write the basic
capital accumulation equation as:
K+1 = (1-d)K + I

Investment and the Rate of Interest:

One way of comparing the expected yield of an investment to its
cost is to calculate present value of the investment and compare
that with the present cost. Interest is viewed as the main
determinant of investment. If present value exceeds present cost,
then the investment is profitable; otherwise, it is unprofitable.
Example 1:
Suppose a machine which has only a known life of two years is
expected to yield Shs 242 each year. The machine’s present cost is
Shs 400 and the rate of interest is 10%. Is investment profitable?
242 242
Pr esent Value = + =Shs 420
1+0 . 1 ( 1+0 .1 )2

PV > PC, therefore, the investment is profitable.

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we can also use the rate of return to calculate the investment
expected and compare with the prevailing rate of interest. If the
rate of return exceeds the rate of interest, the investment will be
profitable. The reverse also applies.
Example 2:
Suppose a machine has a known life of only one year and is
expected to yield Shs 450 at the end of the year. The machine’s
present cost is Shs 400 and the rate of interest is 10%. Is the
investment profitable?. We have to find the rate of return, r, which
raises Shs 400 to Shs 450 in one year.
400(1 + r) = 450.
450−400
r= =12. 5 %
400 .
The rate return > rate of interest, therefore the
investment is profitable.
The aggregate investment curve
indicates that as the rate of interest
falls, more investment projects
Rate of become potentially profitable and the
Interest demand for investment increases.

0 Investment

 The Marginal Efficiency of Investment (MEI) is the expected

rate of return from an additional Shs of planned investment.
 The MEI is likely to decline as more and more investment
projects are undertaken because:
i) most profitable projects will normally be undertaken first,
and
ii) as investment increases, the price of investment goods will
be bid upwards thereby reducing the expected rate of
return.
 A fall in the market rate of interest should make profitable
some investments in the economy which were previously
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unprofitable so that aggregate investment should increase.
Thus aggregate investment in inversely related with the rate
of interest.
 Possible determinants of investment are:
i) the rate of interest,
ii) changes in aggregate demand,
iii) profitability, and
iv)business expectations.
That is , I t =f ( r ,Y t −Y t−1 , β , Π )

EQUILIBRIUM DOMESTIC OUTPUT IN THE

KEYNESIAN MODEL.

Expenditures - Output Approach

 Equilibrium exists when there is no tendency to change. It
follows therefore that national income can only be in
equilibrium when there is no tendency for it to rise or fall. This
can only happen when planned expenditure in one period
exactly equals the planned output for that period. When this is
the case, producers are receiving back in expenditure on their
output an amount which exactly equals the amount they have
paid out to the factors of production for producing output.
 Planned expenditure must therefore be equal to planned output
for equilibrium to be achieved. For example, if planned
expenditure exceeds planned output, then the firms will
experience disinvestment as their stocks are depleted. Their
response to this will be to raise output in the following period,
so that national income will rise. The reverse also, ‘mutatis
mutandis’.
 It is clear that in equilibrium, planned expenditure in the form of
aggregate demand (AD), must be equal to planned output in the
form of aggregate supply (AS). The can be explained as:
AD = C+I+G+X-M
AS = Y
AD = AS in equilibrium
C+I+G+X-M = Y in equilibrium
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 Diagrammatically, the equilibrium can be illustrated as below:

Expenditure

AD
E

45o
YE

 Since both axes have the same scale, the 45 o line which bisect
them gives the set of all points of equality between planned
expenditure and planned output (national income). It therefore
shows all possible equilibrium levels of national income within
the range illustrated. At levels below the equilibrium AD, the
tendency will be to increase the value of national output. At
levels of output (income) above this, AD is less than national
(i.e. AD is insufficient to purchase the existing level of output)
and the tendency will be for the value of national output to fall.
Only when Y is at equilibrium that there is no tendency for
national output to change because AD is just sufficient to
purchase the existing level of output.

Leakages and Injections

 A leakage is a withdrawal of potential spending from the
circular flow of income. A leakage occurs when any part of the
income which results from production of domestic goods and
services is not used to purchase other goods and services.

MONEY AND BANKING

Despite the fact that we are all familiar with money and use it
almost every day of our lives, it is difficult to define exactly what
money is over the years, a variety of commodities have been
accepted as money, ranging from precious metals to cattle. The
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fact is that money is as money does, and therefore anything,
which performs the functions of money, is money. Money is a
means of payment accepted in exchange. It is thus anything, which
is generally acceptable as a medium of exchange, acts as a measure
of value and a store of value.

Functions of money
1. Medium of exchange or means of payment:
Money is unique in performing this function since it is the only
asset that is universally acceptable in exchange for goods and
services. In the absence of a medium of exchange, trade could
only take place if there was a double coincidence of wants.
2. Unit of account:
Money also provides means of expressing value. The prices
quoted for goods and services reflect their relative value and in
this way, money acts as a unit of account.
3. Store of wealth:
Because money can be exchanged immediately for goods and
services, it is a convenient way of holding wealth until goods
and services are required. In this sense money act as a store of
wealth.
4. Standard of deferred payment:
In the modern world, goods are often purchases on credit with
the amount to be repaid being fixed in money terms. It would be
impossible or impractical to fix repayment in term of some other
commodity. It may not always be easy to predict the future
availability or the future requirements of that commodity.
5. Transferring immovable property:
E.g. land; house from one place to the other.

MONEY SU PPLY
 Central banks have the legal mandate to issue currency.
However, in some countries, there are no central banks and this
responsibility lies elsewhere, say, with the treasury. Because of
this monopoly, the Central Bank has an influence on money
supply.
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 The central bank determines the supplies of the monetary base
(also referred to as base money or high-powered money), that
are in form of currency held, and financial institutions reserves
held at the central bank.
 Parts of the money (currency) is held by the public and is called
currency in circulation while the banks as part of vault cash,
hold another part.
 Money supply is importantly influenced by the central bank’s
actions and it is also affected by factors that are not under the
control of the central bank like the portfolio behavior of the
commercial banks and the public’s preference to hold different
financial assets (currency, demand deposits, etc).
 The reason to focus on the central bank balance sheet is to see
how central bank operations affect the stock of high - powered
money. Creating liabilities creates high-powered money when
the central bank requires assets and pays for them. Two main
classes of liabilities of the central bank are currency and bank
deposits at the central bank.
NB: Money supply consists of M1 which refers to currency
(coins and paper money) in the hands of the public and all
checkable deposits (all deposits in commercial banks)

Bank Deposit and the Money Supply

 Bank deposits come into being in three ways:
1. When a bank receives a deposit of cash
2. When a bank buys a security
3. When a bank makes a loan
 One important aspect of bank deposit creations is its effect on
money supply. The examples below record the initial impact of
a $100 creation on the banks assets and liabilities:
a) When a bank receives a deposit of $100 cash, the effect on its
balance sheet is:

Liabilities Assets
Deposits + $100 Notes & coins + $100

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In this case, it is clear that a deposit of cash has no initial
impact on the money supply. The same amount of money exists,
it is simply held in a different form. An individual has simply
exchanged $100.
b) When a bank buys security of $100, the effect on its balance
sheet is:
Liabilities Assets
Deposits + $100 Securities + $100
Here, the banks purchase of $100 increases the money supply
by $100. This is because securities, which are not acceptable in
exchange of goods and services, have been exchanged for a
bank deposit which is acceptable.
c) when a bank grants a loan of $100 ,the effect on its balance
sheet is:
Liabilities Asset
Deposits + $100 Advances + $100

Again, the granting of a $100 loan increases the money supply by

$100. This must be so because deposits, which are immediately
acceptable in exchange for goods and services, have been
exchanges for a debt (an advance) which is repayable at some
future date.

What backs money supply?

 The money supply in any state is essentially backed by or
guaranteed by govt. ability to keep the value of money relatively
stable. This implies the govt. must be fundamentally capable of
enforcing the tools at its disposal to guarantee just the right
amount of money in circulation. This therefore will ensure
stability in the value of money and stability in prices of goods
and services.

The Demand for Money.

There are 3 major motives underlying the demand for money:
a) Transactions motive, which is the demand for money
arising from the use of money in making regular
payments.
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b) Precautionary motive, which is the demand for money to
meet any unforeseen needs.
c) Speculative motive, which results from the uncertainties
about the value of other assets that an individual can hold.
NB Asset demand for money:

Dt
Rate of Rate of
Interest Interest Rate of
Interest

Dm

Da

Amount of money demanded Amount of money demanded

Amount of money demanded
Transactions demand for money Asset demand for money
Total demand for money

Measures of Money Supply

M1 = Currency + Checkable deposits (Demand deposits)
M2 = M1 + Near monies (Certain high liquid financial assets that
do not function directly or fully as a medium of exchange but can
readily be converted into currency and checkable deposits). Near
monies include savings account deposits, time deposits, money
market mutual funds (MMMF), i.e., by making telephone calls,
using the internet, or writing a cheque for $ 500 or more, a
depositor can redeem shares in MMMF offered by a mutual
company.
Therefore, M2 = M1 + Savings deposits + Time deposits +
MMMFs
M3 = M2 + large ($ 100,000 or more) Time deposits

Clearing System:
Refers to the process by which banks settle claims and counter
claims between themselves.
The Money Market
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We can combine the demand for money with the supply of
money to portray the money market and determine the equilibrium
rate of interest. The money market is thus the market in which the
demand for and the supply of money determine the rate of interest
(or the level of interest rate) in the economy.
 We all make basic portfolio choice; we either hold our money or
put it to work. People hold (demand) money (m1) by keeping
cash in their wallets or maintaining positive balances in their
transaction accounts. Money kept in this form earns little or no
interest. However, money lent to someone or used to buy bonds
is likely to earn a higher rate of interest. The choice therefore is
to hold (demand) money or to use it.
 People holding money are forgoing an opportunity to earn
interest. The same applies to people who hold money in
checking accounts.
 The three motives of demand for money create the market
demand for money. People cut on their money balances when
interest rates are very high. At such times, the opportunity cost
of holding money is simply too high.
 The market demand curve for money slopes downwards from
left to right indicating that quantity of money people are willing
and able to hold (demand) increases as interest rates fall, ceteris
paribus. The diagram below illustrates this

All points on the market demand curve

represent the quantity of money people are
willing to hold at specific interest rate.

Money
Demand

q1 q2

 In practice, the position of the money supply curve depends on

the central bank reserve policy, the lending behavior of the
private commercial banks and the willingness of consumers and
the willingness of investors to borrow money.
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 If the central bank decides to supply the same amount of
money at all rates of interest then the supply would be perfectly
inelastic. The point of intersection of money demand and money
supply curves is the equilibrium rate of interest. At this point,
the money demand quantity of money supplied equals the
quantity of money demanded. The diagram below illustrates this
Money
Supply
At equilibrium rate of interest people are
willing to hold as much money as is
available. At any point above the
equilibrium (E), the quantity of money
Money
Demand
people are willing to hold will not be equal
the quantity available, and people will adjust
their portfolios.

M Quantity of money

NB Liquidity trap: the portion

of money demand curve that is
Interest horizontal, people are willing to
Rate hold unlimited amount of money
at some (low) interest rate.
Money
Demand

M1 M2

Credit Creation
 Credit creation is the process by which banks are able to
increase the volume of credit by granting loans. The process
results in an increase in the volume of bank deposits and hence
in the money supply.
 The receipt of new cash by the banking system may lead to
multiple expansion of the bank lending, and multiple increase in
money supply. This is because most of the money lent to one
person will, when spent, find its way back to the banking
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system. The receipts of borrowed money generally deposit in
their own bank accounts. This is the principle of credit creation.
 Assume a hypothetical economy with a single monopoly bank,
which observes a minimum cash ratio. Suppose the bank wishes
to maintain 10% of total deposits in cash in order to meet day
to day demands of its customers, then the banks initial position
(balance sheet) will be as below if total deposit amounts to US
$10,000

The Bank’s initial balance sheet

Liabilities Assets US $
US $ Cash 1,000
Deposits Loans and Investment
10,000 9,0000

10,000 10,000

Credit Multiplier:
Refers to the multiples by which total bank deposits increase
relative to a new cash deposit.

FINANCIAL MARKETS IN KENYA

 A financial market is the total sum of all capital, money and
security market institutions operating a given economy. This
also include individuals, companies, institutions and the govt.
who buy (borrow) and sell (lend) money to different parties at a
price (interest or dividends) determined by market forces of
demand and supply of money.
Financial market in
Kenya

Foreign Capital Security

Monetary Exchange
market Markets
Markets Markets

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Discounting Central Financial Stock

Houses Bank Institutions Exchange
(primary and
secondary
market for
shares)
Building
Bureau De societies
Government Change
treasury bills
or bonds

Govt. Bonds
Mortgage and Stocks
Finance

NSSF Bonds sold

Commercial by financial
banks institutions

Trustee
Orgns Debentures,
bills of
exchange,
Commercial
promissory
Banks notes

Buyers may be individuals companies or the government and banks

CENTRAL BANK & MONETARY POLICY

This is a bank established and managed by the government to

control and guide the other financial institutions in the country and
particularly to advice the government on matters of financial
nature and importance.

Functions of central Bank

1) Issue of currency: The central bank is the sole currency issue
in authority in a country. This function demands a high degree
of trust and efficiency. It is important to keep the actual process
of printing notes and minting coins a secret so as to have just the
right amount of money in circulation. Too much money will
cause inflation and too little of it will cause deflation.

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2) Banker to the government: The central bank provides
banking facilities to the govt. in the same manner the
commercial banks does to the public.
3) Banker to commercial banks: Other banks and financial
institutions maintain an account with the central. These banks
operate their accounts in the same way as an individual operates
his accounts with the commercial bank.
4) Advisor to the government: The central bank thro the ministry
responsible for financial affairs is the sole body to take
decisions of financial nature. The govt. is heavily relies on the
advice of the central bank.
5) Exchange control: The measure taken by the govt. to restrict
the outflow of money to other countries is done by the central
bank. It is the desire of the govt. to allow as little money as
possible to leave the country. The main objective is to maintain
a healthy balance of payment. Due to this reason the
commercial banks are required to provide periodic record to the
central bank in their foreign exchange dealings.
6) Lender of last resort: The central bank extends financial
accommodation to banks in case of emerges to commercial
banks. This happens when commercial banks are temporally in
short of cash.
7) Credit control: This is the controlling of the lending capacity
of the commercial banks and other financial institutions.
Because excessive supply of currency into the economy will be
harmful to economic development, it is incumbent upon the
government through the Central Bank to ensure that there is just
the right amount of money in circulation issued in the form of
credit to the various stakeholders.

The methods employed to control credit

1) Raising the bank rate: This is the rate at which the CB (central
bank) lends is money to the commercial banks. When the bank
rate is raised, the commercial banks will also raise their lending
rates and vice versa.
2) Raising the liquidity ratio: The central bank instructs the
commercial bank to retain a certain portion of their deposits in
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cash form. This tends to reduce the lending capacity of the
commercial banks.
3) Compulsory or special deposits: The central bank instructs the
commercial banks to deposit with it a certain part of their
deposit. This therefore reduces the lending capacity of the
commercial banks.
4) Selective control: If there is too much money in circulation, the
central bank can instruct commercial banks and other financial
institutions to approve loans to only a selected industry.
5) Open market operation: The central bank can instruct
commercial banks and individuals to participate in buying govt.
securities. This will reduce the money that banks have for
lending and that which individuals will have to spend.

Central Banks Balance sheet

Simplified balance sheet of the central bank
Assets Liabilities
Foreign Assets Deposits of banks
Loans to Banks Deposits of Deposits of govt.
govt. Currency notes and coins
Govt. securities Foreign liabilities
Loans to govt. Other liabilities
Other Assets
Total Assets (sources) Total liabilities (uses)

In a considerate central banks’ balance sheet, assets comprise of

1) Net foreign assets
2) Net claims in govt.
3) Net claims on commercial banks
4) Net other items
The liabilities comprise of monetary base, which is the sum of
currency issues and commercial banks reserves at the central bank.
NB: Foreign assets are held by the central bank due to:
1) To pay for govt. imports and external debt servicing
2) As a means to intervene in the foreign exchange market in order
to stabilize the value of domestic money vis-avis its peg.
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3) Often used to gauge the capacity of the economy to withstand
any external or domestic stocks.
 CB makes loans to financial institutions like banks to enable the
borrowing institution meet its liquidity shortage. These loans
constitute an asset for the CB.
 In its function as a banker to the govt., CB also makes loans to
the govt. nowadays; these borrowings are legally stipulated to
limit excessive borrowing by the govt. These also constitute an
asset to the CB.
 Govt. securities are another asset of the CB acquired thus, an
open market operation in which the central bank purchases
Treasury securities from the public rather than directly from the
Treasury. In some economies, central banks allowed to purchase
Treasury securities from the Treasury.
 CBs hold banker’s deposits and govt. deposits because they act
as their bankers.
 Foreign liabilities represent short-term obligations by the central
banks to foreign sources. The largest foreign liabilities of central
bank of Kenya are in respect to Kenya’s relations with the
International Monetary Fund (IMF).
 Other assets may include furniture, buildings, vehicles, etc.
 Currency and notes form part of the monetary base (can also be
referred to as base money or high powered money)
Monetary Policy
 This refers to the use of money and credit controls to influence
macroeconomic activity, i.e., it consists of policies designed to
influence the supply money and / or its price’ (the rate of
interest).
 The figure below illustrates the impact of monetary policy on
the equilibrium rate of interest.

S1 S2
Interest

rate (%

per year) Demand for money

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M1 M2 Quantity of Money (billions of dollars)

Assume that the money supply is initially at M1 and the

equilibrium rate of interest is 7% (E1). The central bank then
increases the money supply to M2, by lowering the reserve
requirement, reducing the discount rate, or mostly, purchasing
additional bonds in the market through Open Market Operations.
The impact of this expansionary monetary policy is evident. If the
market DD (demand) for money is unchanged, the longer money
supply will bring about new equilibrium at E2. At this intersection,
the market rate of interest is 6%. Hence by increasing money
supply, the CB tends to lower equilibrium rate of interest. Or, to
put the matter differently, people are willing to hold larger money
balances only at lower interest rates.
 Were the CB to reverse the policy and reduce the money supply,
interest rate would rise.

Interest rates and spending

 Investment decisions of firms are sensitive to the rate of interest.
Lower interest rates reduce the cost of buying plant and
equipment, making investment rate will result in profitable.
Thus, a lower interest rate will result in a higher rate of desired
investment spending as shown in the diagrams below.

(a) An increase in money supply (b) a reduction in r (c) More investment increases
C +I2 +G
lowers interest rate (r) stimulates aggregate spending
Expenditure C +I1 +G
Interest investment
7 Interest
7

6 6 Investment
Demand
Money
Demand

I1 I2 Income (Output) Yf
M1 M2 Rate of Interest
Quantity of money

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 The increased investment brought about by lower interest rates
represents an increase in total spending as illustrated in figure C
above
According to Keynesian perspective, the CBs objective of
stimulating the economy is achieved in 3 distinct steps:
1.An increase in money supply
2.A reduction in the interest rate
3.An increase in aggregate spending
 If the price level remains constant (as Keynes assumed), the
increases spending implies an increases quantity of goods and
services demanded, i.e., shift in AD as well.
 Lower interest rates might also stimulate consumer spending.
Household appliances, cars and other expensive goods are often
purchased with borrowed money.
 State and local governments are particularly sensitive to money
market conditions and may postpone planned expenditures
when interest rates are too high.

Effectiveness of monetary policy

According to the above illustrations, monetary policy can be an
effective mechanism for altering the rate of aggregate spending.
Monetary policy does not always succeed so easily like that
according to Keynes. He stresses that effectiveness of monetary
policy is dependent in two distinct phenomena:
1. The sensitivity of interest rate to changes in the money supply
(ref. Figure (a) above).
2. The sensitivity of spending decisions to changes in the interest
rates (figure (b) above).

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UNEMPLOYMENT AND INFLATION

 According to the International Labor Office (ILO),

unemployment refers to a pool of people above a specified age
who are without work, are currently available for work and are
seeking work during a period of reference.
 All three conditions must be present for a person to be
considered as unemployed. A person must take clear actions in
pursuit of a job. Such actions include registration at
employment office, application to employers, checking at work
sites (farms, factory gates, market, etc) and placing or
responding to newspaper adverts, etc.
 The unemployment rate refers to the number of unemployed
people as a proportion of the labor force. The labor force refers
to all those with work and all those seeking work, i.e., the sum
of employed plus the unemployed. Individuals that are neither
employed nor seeking work are considered to be out of the labor
force.

Types of Unemployment
1. Frictional unemployment: This type is associated with normal
labor turnover. It occurs because workers vacate certain jobs
and search for others; or because some workers leave the labor
market, thus vacating jobs, while new entrants do not posses the
skills required.
2. Structural unemployment: This is caused by a change in the
structure of demand. When demand for an industry’s product
falls and output contracts, the number of workers employed in
that industry falls. Because particular regions, structural
unemployment often leads to regional unemployment.
3. Seasonal unemployment: This demand for certain products
subject to regular and predictable fluctuations in unemployment,
e.g. there is greater demand for construction workers in the
summer months than in the winter months.
4. Cyclical unemployment: This type of unemployment is
associated with the downsizing of the trade cycle. It is
sometimes called demand deficient unemployment because
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during the downsizing of the cycle aggregate demand falls and
is insufficient to purchase the full employment level of output.
 More recently, views on the causes of unemployment have
changed and following categories are always identified.
5. Voluntary unemployment: This is caused by the operation of
the tax and social security system. It’s difficult to estimate the
extent of this, but there is no doubt that the extent of incentive
for many unemployed workers to accept employment is very
low indeed.
6. Real wage unemployment: There is quite a widely held view
that a great deal of unemployment is caused by relatively high
real wages. Workers price themselves out of jobs.
7. Residual unemployment: This is the label given to that group
of unemployed workers who suffer from mental or physical
disabilities which may limit the number of job opportunities
available to them.
Defining full employment
 Full employment refers to the use of all available resources to
produce want-satisfying goods of services.
 It’s the situation in which the unemployment rate and equal to
the full employment rate and there’s frictional and real GDP of
the economy equals potential output.
Full employment unemployment rate: This is the unemployment
rate at which there is no cyclical unemployment of the
laborforce. It is 1.1 4%and 5%in the USA because some
frictional and structural unemployment unavoidable.

Measuring unemployment:

Number of unemployed claimants

U= Χ 100
Workforce

Costs of unemployment
(a)Social costs of involuntary unemployment are incalculable.
Many long-term unemployed become bored, idle, lose their
friends and suffer from depression. In countries without welfare
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provisions to the poor, unemployment may be very much more
severe in effects. It may lead to a considerable degree of social
deprivation and a miserable existence for the families involved
e.g., starvation.
(b) The costs of both voluntary and involuntary unemployment
to the Exchequer consists of :
(i) Benefits which have to be paid to the unemployed in some
countries,
(ii) The loss of tax revenues which would otherwise have been
received; this consists of lost income tax, and also includes
loss of indirect taxes because of the reduction in spending.
(iii) The costs of national insurance contributions
(c)The economic cost of unemployment represent a waste of
resources and means the economy is producing a lower rate of
output than it could do if there were full employment. This
therefore inhibits the realization of potential output (that rate of
GDP, which would result if all resources were fully employed).

INFLATION
 Inflation refers to a persistent tendency for the general price
level to rise. Inflation affects everybody in one way or another.
 Inflation can have adverse effects on the economy and it may
give rise to the fear of a hyperinflation ( a very rapidly
accelerating inflation which usually leads to the breakdown of
the country’s monetary system)
Effects of inflation:
 Inflation can either be anticipated or unanticipated.
 Anticipated inflation is inflation that all groups and individuals
in the economy are able to product. They able therefore to
protect themselves against it and so it will have no appreciable
effect on the distribution of income and wealth in the economy.
 Unanticipated inflation is that which groups and individuals in
the economy are not able to predict. They are not able therefore
to protect themselves against it.
 Inflation may be unanticipated if

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(a)There is a general failure on the part of the economy as a
whole to predict the inflation correctly so that the actual rate
of inflation exceeds the expected rate.
(b) Certain groups or individuals in the economy fail to
predict the inflation correctly so that they seek lower money
wage increases that are actually necessary to maintain real
wages.
(c)Certain groups or individuals correctly predict the inflation
but are unable to gain full compensation for it (e.g. weak
union or fixed contribution incomes earned).
 Where the inflation is unanticipated, there will be a
redistribution effect, i.e., some people will be made better off
while others made worse-off. The redistribution effects of
unanticipated inflation are:
1. Fixed income earners e.g. rental income or anyone relying on
the return from fixed-interest investments will find the real
value of his or her money being eroded by inflation
moreover, weak unionized workers who cannot gain full
compensation for price rises will lose at the expense of strong
unionized workers who can do so.
2. Lenders will lose while borrowers will gain because when
debts are repaid, their real value will be less than that
prevailing when the loans were made. Even where interest is
payable, borrowers will still gain if the normal rate of interest
is less than the rate of inflation, i.e., a situation where the real
rate of interest is negative.
3. As money incomes rises, earners with the same real income
move into a higher tax bands (unless there are adjusted) and
to pay a bigger proportion of their income in tax. This is
known as fiscal drag. It applies to a country with a
progressive income tax system.
4. If the government is trying to control inflation by means of
prices and incomes policy, it may set an example by resisting
the wage claims of public employers. If, however, private
employers are more willing to concede to wage increases,
there will be redistribution from public sector employers to
private sector employers. This however, depends on the
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relative strengths of the public and private sector unions
and on the ability of the private sector to provide wage
increases.
5. If wage demands are net by squeezing profit margins then the
share of profits in the national income will fall and the share
of wage will rise.
Other costs:
6. Administrative costs of adjustment and the international
effects: with inflation, both firms and households incur costs of
adjusting to the new sets of price. The actions of the unions
have the effect of reducing the economy'’ total output (e.g.
strikes, go-slows and working to rule)
 A country with a fixed exchange rate but with a faster rate of
inflation than its trading parties is likely to develop a deficit on
its balance of payments because the domestic inflation makes its
exports less competitive and its imports relatively more
competitive. This deficit is likely to deplete the country’s
reserves. With flexible exchange rate, the country with faster
inflation is likely to experience a depreciating currency.

Causes of inflation

1) Demand Pull inflation

This occurs when aggregate demand exceeds aggregate output at
the existing price level. It’s thus excess demand, which initiates
inflationary pressure. The diagram below illustrates this:
An increase in aggregate demand shifts the AD
AS curve to the right. At the original price level
OP1, there is excess demand, which pulls the
P2 price level up to OP2.

P1 AD2

AD1
0
Y1 Y2

2) Cost Push Inflation:

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 This occurs when pressure on prices results from an
exogenous rise in costs e.g. rising money wages or other
production costs like costs of imported raw materials are passed
to the consumers in form of high prices.
AS2

Rising production costs shifts the

AS1
AS curve to the left from AS1 to
P2 AS2. With unchanged AD curve the
price level is pushed from OP1 to
P1 OP2.
AD

0
Y1 Y2

Phillips Curve.
This is a curve, which depicts the inverse relationship between
unemployment rate of money wage and inflation.

Annual
percentage
change in
prices

Unemployment

The Monetarists Theory of Inflation.

 To the monetarists, sustained and severe inflation can be
produced only by excessive increases in the money supply.
 Friedman argued that “inflation is always and everywhere a
monetary phenomenon”. He developed expectations –
augmented Phillip’s curve which is a short-run Phillips curve
whose position is determined by the expected rate of inflation.
Friedman said that an inverse relationship may exist between

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the rate of unemployment and the rate of wage in the short-
run, but there is no such relationship in the long run.

Alternative Policy Measures

1) Fiscal and Monetary Policies: These policies affect the level
of aggregate demand and so are often called demand
management policies. They are therefore likely to be only
effective against inflation caused by excess demand.
 A cut in government spending, an increase in taxation or
some combination of the two (i.e. deflationary fiscal policies)
will directly reduce aggregate demand (AD).
 A cut in money supply or a reduction in its rate of growth
(i.e. deflationary monetary policy) should have the same
effect.
 Keynesians place a lot of emphasis on fiscal policy as a
means of controlling AD. However, the monetarists attach
greater degree of importance to the influence of the money
supply.
2) Prices and Incomes Policy: This involves the direct
intervention of the government in an attempt to moderate union
demands for wage increases and to prevent unjustified price
increase. It can be done by setting up of prices and incomes
board to examine proposed price increases and to contribute to
the collective bargaining between employers and unions. The
government can also impose a legislation to regulate or even
freeze wages and prices.
3) Indexation: This is the process by which the value of an
economic variable, such pension or wage can be adjusted in line
with changes in a price index. This is sometimes called index
linking and it works by linking economic variables such as
wages, salaries and interest payments to an index of price
inflation. If the price index rises by 5%, then the wages, salaries
and interest payments should rise automatic by 5%.

Discretionary Fiscal Policy.

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Discretionary policy making is based on discretion if the
government remains free to choose whatever policy action it
believes to be appropriate for the set of circumstances which
prevail at the time.
Discretionary policy is supported by mainstream economists to
keep recessions from deepening or to keep mild inflation from
severe inflation.
Tax revenues fall sharply during recessions and rise briskly during
periods of demand-pull inflation. Therefore, a law or a
constitutional amendment mandating an annually balanced budget
would require that the government increase tax rates and reduce
government spending during recessions and reduce tax rates and
increase government spending during booms. The first set of
actions would worsen recessions and the second set would fuel
inflation.

Non–discretionary Fiscal Policy: Built in stabilizers.

A built in stabilizer is anything that increases the government’s
budget deficit (or reduces its budget surplus) during a recession
and increases its budget surplus (or reduces its budget deficit)
during inflation without requiring explicit actions by policy
makers.
Government expenditure (G) ar5e fixed and assumed to be
independent of the level of GDP. The government decides on a
particular level of spending but does not determine the magnitude
of tax revenues. Instead it establishes tax rates and the tax revenues
then vary directly with the level of GDP that the economy
achieves.

- Line T represents direct

T relationship between tax
revenues and GDP.
Government
Expenditures, G, and
- Government spending G is
Tax revenues, T. assumed to be
constant/independent of GDP.
Surplus
G - As GDP falls in a recession,
deficit occurs automatically
Deficit and alleviates the recession 60
 61

Real Domestic Output

As GDP rises during expansions, surpluses occur automatically

and help offset possible inflation.
The economic importance of the direct relationship between tax
receipts and GDP becomes apparent when we consider that:
a) Taxes reduce spending and AD.
b) Reductions in spending are desirable when the economy is
moving towards inflation, whereas increases in spending are
desirable when the economy is slumping.
 The above figure suggests that the size of the automatic budget
deficit or surpluses, and therefore built-in-stability, depend on
the responsiveness of tax revenues to changes in GDP.
 In progressive tax system, the average tax rate (= tax
revenue/GDP) rises with GDP.
 In a proportional tax system, the average tax rate remains
constant as GDP rises.
 In regressive tax system, the average tax rate falls as GDP rises.
 However, the more the progressive tax system, the greater the
economy’s built-in-stability.

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INTERNATIONAL TRADE AND ECONOMIC GROWTH
AND DEVELOPMENT.

Meaning of International Trade:

 International trade arises for many reasons, but the most
obvious one is that different countries have different factor
endowments, with international mobility of these factors being
severely limited. International Trade, therefore, makes available
to consumers another country products which are only produced
in other country. The term International Trade implies trade
between two or more countries. It involves physical transfer of
goods from one country to another. If a country has a greater
part of her foreign trade with only one country, this is called
bilateral trade. However, if a country trades with more or a
number of countries, buying from some and selling to some, this
is called multilateral trade.

The Theory of Absolute Advantage and Comparative Advantage:

 A country is said to have absolute advantage in the product of
a commodity when it is more efficient than other countries with
a given level of inputs/using the same level of resources.
 The theory of comparative (or relative) advantage shows that
relative costs are important in determining which products are
imported and exported. A country will export a product for
which it has relatively low production costs, and will import a
product for which it has relatively high production costs. The
table below is used as a basis for explanation:

Tons of wheat number of cars that

That can be produced from can be produced from
From X resources X resources
Country A 40 10
,, B 20 8

 Country A has absolute advantage in the product of both wheat

and cars since with a given amount resources, it can produce
more of both goods than country B. However, if we examine the
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domestic opportunity cost ratios, it is clear that each country
has a relative or comparative advantage in the product of one
commodity. In country A, the domestic opportunity cost ratio is
such that 4 tons of wheat must be given up for each car
produced. However, in country B the domestic opportunity cost
ratio is such that only 2.5 tons of wheat must be given up for
each car produced.
 Country B therefore has a comparative advantage in the product
of cars since for each car that is the produced, less wheat is
sacrificed in B than in A.
 Country A, however, has comparative advantage in the product
of wheat. For each tonne of wheat produced, country A must
sacrifice 0.25 cars, whereas in country B each tone of wheat
produced costs more, i.e., 0.4 cars.

Visible and invisible Trade:

 Visible trade consists of the imports and exports of physical
goods.
 Invisible trade consists of the importation and exportation for
services.

Restrictions of International Trade:

1. Fixing import quotas
2. Total ban
3. Tariffs
4. Exchange control

Balance of Trade
Balance of trade is the difference between the visible imports and
visible exports. If a country exports more goods that she imports
during a year she could be said to be having a favorable balance of
trade. But if her imports exceed her exports, she could be said to be
having unfavorable balance of trade.

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Balance of payments
 A country makes and receives payments for imports and exports
of goods. She pays and receives money for visible imports. The
difference between receipts and payments are called balance of
payments on current account.
 If receipts exceed payments the difference is called favorable
balance of payment. If the payments, however, exceeds the
receipts then the difference is called unfavorable balance of
payment.
 A country may invest money in another country by either
loaning money or establishing industries in other country. Such
expenditure is termed as capital expenditure and any difference
between the receipts and payments is called balance of payment
on capital account. The difference between the receipts and
payments on both current and capital account are called the
overall balance of payment.

Terms of Trade:
This is the ratio at which different goods and services are exchanged between two
countries. Term of trade index = index of export prices*100
Index of import prices
 In base year the value of terms of trade index is 100, i.e.,
100/100*100=100. Change in terms of trade is measured by
changes in the value of this index.
 If export prices rise relative to import prices it implies favorable
terms of trade.
 If exports reduce, this implies unfavorable terms of trade.
 If the tot index in one year is greater than its value the previous
year, then there has been favorable movement in the tot. The
reverse also applies.

Trade policy:
It is incumbent upon every govt. to ensure that it adopts policies
that protect its trade. By protection, we refer to barriers to free
trade, which tend to protect the domestic industries against foreign
competition. Some of the key tools used to advance the trade
policy are
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(a)Tariffs (a tax that is levied on imported products;
(b) Quota (A limit imposed on the quantity of goods that may be
imported during a given time period);
(c)Exchange control system (A set of regulations that restricts
domestic residents access to foreign exchange);
(d) Import deposits scheme (a requirement that obliges importers
to deposit a sum of money with the central bank. The sum
deposited is normally related to the value of goods imported;
(e)Public procurement policy (a preference by public sector
agencies for the purchase of domestically produced goods);
(f) Voluntary agreement (an agreement whereby a country
voluntarily restricts exports
(g) Subsidies.

Objectives of trade policies:

1. To collect revenue such as tariff revenue.
2. To protect infant industries
3. To fight dumping (anti-dumping)
4. To apply prohibitions for some commodities (security reasons)
5. To protect the environment
6. To reward interest groups e.g. trade unions may ask for
protection so that output expands in a particular industry
therefore move jobs.

Economic growth:
 Economic growth is an increase in the country’s productive
capacity, identifiable by a sustained rise in national income over
a period of years. A country’ annual rate of economic growth is
measured by taking the average percentage increase in national
income over a long period of time say 5 or 10 yr.
 The figure obtained represents an estimate of the annual rate of
growth in the country’s productive capacity.
 However, a country is said to be enjoying economic
development when it is experiencing economic growth and at
the same time is undergoing major structural changes in its
economy e.g. shift from agriculture to manufacturing.

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 A country’s said to be less developed if it has low real national
income per capital, a large agricultural sector, high population
growth, low capital labor ratio and poor infrastructure.
 A country is however; said to be developed if it has relatively
high real national income per capita and enjoys relatively high
standard of living.

Main Determinants of Economic Growth

1. Growth of labor force: the growth of labor force itself will
depend on; (I) the national increase in the population; (ii)
international migration; and (iii) the participation rate.
 The natural increase in population is determined by the excess
of birth rate over the death rate
 Net immigration will tend to add to a country’s labor force
while net emigration will tend to reduce it.
 The participation rates the proportion of the economically active
population to the total population. A rise in this rate would lead
to an increase in the size of the labor force.
2. Growth of the capital stock: An expansion of a country’s
capital stock throw net investment, just like an expansion of its
labor force increases the country’s stock of productive resources
and so represents another possible source of economic growth.
3. Technical progress: This takes the form of improved technique
of production, improved machinery, inventions or
improvements in education; i.e., it is anything, which improves
the quantity of the capital, stock or labor force.

The effect of technical progress is to raise the productivity capital

and labor.
N.B: Technological unemployment refers to the loss of jobs caused
by technological change, such as the introduction of machinery
that makes some labor skills obsolete.

Benefits and costs of economic Growth

I) Benefits
 It leads to increased std of living
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 It eliminates poverty
 It can redistribute income without making anyone worse off
2) Costs of economic growth
 Growth involves change, which benefits many but may harm
some.
 Growth has an opportunity cost e.g. investment in capital goods
implies forgoing current consumption.
 Continued growth may not be possible for much longer since
earthly resources are finite and largely irreplaceable.
 Growth causes negative externalities e.g. pollution, noise and
increased congestion.

Economic Development:
 This refers to a process in which an economy not only
experiences an increase in the real output per head but also
undergoes major structural changes such as infrastructure
development and a reallocation of resources between the
agricultural, industrial and service sectors.
 Developing countries are characterized by the following key
indicators:
(i) low GNP per capita
(ii) large agricultural sector
(iii) high population growth rate
(iv) low capital labor ratio
(v) Poor infrastructure and social services.

The role of international trade:

(i) It enables a country to get what she cannot produce.
(ii) It enables a country to dispose her surplus goods.
(iii) It enables a country to fields which they have the greatest
advantage over others
(iv) Promotes a healthy competition among local and foreign
producers.
(v) During times of calamities e.g. floods, droughts, etc., supply
of goods can be obtained from other countries.

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(vi) It promotes international understanding when people
intermingle from different countries.

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