1

JKUAT
DEPARTMENT : STACS
UNI T : STA2106–BUSI NESSECONOMI CSI I
PRE- REQUI SI TES : STA2103–BUSI NESSECONOMI CSI
Instr
uct or: Zackay oO.Omol o
Cont act s: E-mai l:zackomol o@y ahoo. com
0722697380
PURPOSEOFTHECOURSE
Byt heendoft hecour set hest udentshoul dhav eagoodunder standi ngoft hewor kingsoft he
economy ,be abl et o cr i
ticize and make pol icy r ecommendat ions on macr o-economi c
perfor mance.
COURSELEARNI NGOUTCOMES
 To under st and t he keydr i
vers oft he economyand be abl et o cr i
ti
cal lyanal yse
macr oeconomi ct rendsi nt heeconomy .
 Toacqui ref irsthandknowl edgeofbasi cmacr oeconomi cconcept sandt hei rlimi tat i
ons.
 To dev elop t he abi lityt o di scer nt he i deol ogi cal,t heor et i
cal ,met hodol ogi caland
techni calsi mi larit
iesanddi fferencesbet weent hev ari
ouscont ribut i
onst ot hesubj ect
thatal lowt hei rclassi f
icat ioni ntodi fferentappr oaches.
 To di scuss t he i mpl icat ion of adopt ing di ff
erent appr oaches t ot he st udy of
macr oeconomi csf ort heunder standi ngoft hepr ocessoft hepol iticaleconomyi nunder -
dev elopedanddev elopedr egi onsandt hedesi gnofeconomi cpol icies.
 Tounder standandappl yandcr iti
cizei mpor tantmacr oeconomi cconcept si nr elat i
ont o
soci o- economi cdev elopmentofeconomi es.
COURSECONTENT
Nationali ncomeaccount ing,ci r
cul arf l
ow ofi ncomeandexpendi tur e,usesofnat ionali ncome
stati
st i
cs; Si mpl e Key nesi an modelofi ncome det ermi nat ion,consumpt ion,i nv est ment,
gover nmentandf or ei gnsect or;Consumpt i
onofsav i
ngsf unct ions,t heor i
esofi nv est ment .The
mul t
iplierandaccel er at oref fect ;Tr adecy cles;Nat ure, dev elopmentandf unct ionsofmoney ,the
demandandsuppl yofmoney ,cr edi tcr eation;Monet ar ypol i
cy ,equi librium i nt hemoneyand
productmar ket s;Publ i
cFi nanceandf i
scalpol i
cy ;I nt ernat i
onalt radet heor ies,f reet radeand
protect ionism,t ermsoft rade,bal anceoft rade,bal anceofpay ment s,i nternat i
onall iquidity
,
exchanger ates,i nt er nat i
onali nst it
ut ions;Appl icationsofequi li
br ium anal ysi sanddi sequi libri
um
analysi s; I nt er medi at e wel fare economi cs; economi c ef ficiency , wel fare cr i
ter i
a and
compensat iont est s; nat i
onal ism andpr i
v ati
zat ion;Ani nt ermedi at et heor yoff act ormar ket s;
TEACHI NGMETHODOLOGY
Lectur e, probl em- basedl ear ning, inst ructor -
faci l
itateddi scussi ons, classpr esent ati
onsby
student s,guestspeaker s, video/ CD- ROM pr esent ations
ASSESSMENT
Assessmentoft hest udent ’
spr ogr essshal lassumet hef ol
lowi ngdi mensi ons:
1. Assi gnment s 10%
2. CAT 10%
3. Gr oupPr ojectPr esent ation 10%
4. EndofSemest erExam 70%
Tot al 100%
ACADEMI CPOLI CI ES
1.At tendance&Cl assPar t
icipat ion:st udent sar eexpect edt oat tendal l classest obeel i
gi blef or
an“ A”gr adepassi nt hiscour se.St udentmustmakesur etheyr eadt her equi r
edt extsand
articlesbef or et hecl asst omeani ngfullypar ticipat edur i
ngcl ass.
2.Assi gnment s:Al l assi gnment smustbet ur nedi natt hebegi nningoft hecl assper iodont he
dat est ipul at ed.Lat esubmi ssionswi llbepenal i
zed10%f oreachdayl at eupt o3day s.
3.Gr oupPr ojectPr esent ation:Anaddendum t hatst i
pul at est henat ureoft hispr ojectwi l
l be
present eddur i
ngt hecour seoft hesemest er.

4.Plagi ari
sm:oranyotherf orm ofacademicmi sconductwil
l r
esultinaf ai
ledgrade.Makesur e
anyi deaormat eri
alt
haty ouquot eorusei nyourworkisappropr i
atelyacknowledged.Please
familiari
zeyoursel
fwithAmer icanPsy chol
ogicalAssociat
ionstyleforcitati
onandreferencing
mat erial
s(Thisinf
ormationwi l
lbefoundi nyourresourcemat er
ial.Feelfreetodi
scusst hi
s
withmei fyouhaveapr oblem) .
TEACHI NGMETHODOLOGY
1
 2
Lecturesandcl assdiscussions
Groupwor k
Assignment sandqui zzes
COURSETEXTS
Hardwi ckP.etal:AnI ntr
oducti
ontoModernEconomi cs,4thEd.(London:ELBS1990)
SUPPLEMENTARYREADI NGS
1.Lipsey ,R.G.:AnIntroducti
ontoPosi
ti
veEconomics, 6thand7thEd.(
London:ELBS1983)
t
h
2.Samuel son,P.A.(1989),Economi
cs,11 Edit
ion,MCgr awandHi l
l,
London
3.Shapi ro,E.(
1982), Macroeconomi
cAnalysi
s,HarcourtBr aceJavanovi
chInc,N/York
4.Todar o, M.P.(1982),EconomicDevel
opmentintheThi rdWorld,
Longman, N/York

2
 3
STA2106–BUSI
NESSECONOMI
CSI
INOTES

THENATUREANDSCOPEOFECONOMI
CS.
 Economi csisa soci alscience,which seekst o expl
ainthe economicbasisofhuman
societies.
 Itist hest udyofhow bestt hesoci et
yall
ocatesitsscarceresourcesamongcompet ing
alt
ernat i
ves.
 Macr oeconomi csconcer nist ounderstandandimprovetheperf
or manceoftheeconomyas
awhol e.Iti
sthest udyofaggr egat
eeconomi cbehavior
softheeconomyasawhol e.
 Inmacr oeconomi cswewor ryaboutsuchnat i
onalgoalsasf ullemploy
ment,controlof
i
nflati
onandeconomi cgr owth,withoutworry
ingaboutthewellbeingorbehavi
orofspecifi
c
i
ndividual sorgroups.

I
mpor
tanceofeconomi
cs:
 Economi cscov erstopicsthatarehighl
yrel ev anttomanyoft hemostpr essingissuesfaci
ng
today’swor l
d,e.g.freemar ketversusgov er nmentcont roll
edmar kets,resourceexhaust i
on,
pollut
ion,the popul at
ion explosi
on,gov er nment ,inf
lation,the EU,t heir,changing li
vi
ng
standardsinadv ancenat i
ons,growthandst agnationamongt hewor l
dspoor ernat i
ons¬¬¬¬
 Economi cs provides the skil
l
sf oranaly zing,expl ai
ning and wher e appr opri
ate off
eri
ng
soluti
onst oeconomi cproblems.
 Economi cshasacor eofusef ult
heorythatexpl ainshow mar ket
swor kandt hatev al
uates
theirperf
ormance.

Economi
cmet
hodol
ogy
Economi csisof t
encal l
edasoci alsci encesi ncethesubjectmat t
eri sahumanbei ng.This
meanst hatcont
rol
ledexper imentsoft henat uralsci
enceareimpossible.I
tisther
efor
ediff
icul
t
tolinkcauset oeffect.Humanbei ngsr eactdiff
erent
lytoexternaleconomicev ent
smaki ng
predicti
onmor edif
ficultthati
nthenat ur alsci
ence.Fort
unatel
y,r
eactionofgroupsofindi
vi
duals
toev ent
si smorestable,withext
remescancel ingeachother
.

Thet er m met hodologyr eferst ot hewayi nwhi checonomi st sgoaboutt hest udyoft heirsubj ect
mat ter.Br oadl y,economi stshav efol l
owedposi tiv
eandnor mativeeconomi cs.
Posi tiveeconomi csi sconcer ned wi th pr oposi ti
onst hatcan bet est ed byr ef erencet o
empi ricalev idence.I tr elatest ost at ement sofwhati s,wasorwi llbe.Theaccur acyofposi t
ive
statement scanbecheckedagai nstf act sandpr ov edcor rectori ncor rectThust osayt hat,“ the
rateofi nflationinKeny aov ert hel ast12mont hshasbeen6%” ,i saposi tiv
est atement .By
referencet othef acts, i
tcanbepr ov edcor rectori ncorrect.
Nor mat i
v eeconomi csi sconcer nedwi thpr opositions,whi char ebasedonv al uej udgment s,
i
.e.,st at ement sthatar eexpr essionsofopi nions.Nor mat ivest at ement s,t heref orer elatest o
statement sofwhatshoul doroughtt obet hecase.Nor mat ivest atement sar emat tersofopi nion
whi chcannotbepr ov edordi sappr ov edbyr eferencet ot hef acts,si ncet heyar ebasedonv alue
j
udgment se. g.,tosayt hat:“thegov ernment ’
smai naim shoul dbet hecont rolofi nflation” ,isa
normat ivest atementsi ncei t
sv aliditycannotbecheckedagai nstanyf act s.Iti sast at ement ,
whi chwemayei theragr eeordi sagr ee, butt herei snowayofpr ov i
di ngt hati tiscor rect.
Deduct ionandEmpi rical Testing.
Thepr ocessofdeduct i
onandempi ri
calt estingi sthemosti mpor tantappr oachf ol l
owedby
moder neconomi sts.I nt hiscase,at heor yi spr oposed,l ogicaldeduct ionappl iedt odev elop
predict i
ons,andat estmadeoft hesepr edi cti
onsagai nstt hef act s.Fori nst ance,onet heor yis
thatt heamountofacommodi tyconsumer swi sht opur chasewi l
lusual lyv arywi thi tspr i
ce.Thi s
predict i
oncanbet estedagai nsthowconsumer sact uallybehav e.Ift hef actsdonotsuppor tt he
theoryi tmustber ejectedi nfav orofot hert heor ieswhi chbet t
erexpl ainact ualobser vat i
on.
Induct i
on.
Thisi sanal ternativemet hodol ogicalappr oachi neconomi cs.Thef act st hemsel v esar est arting
pointf ort hisappr oach,wi t
hanyobser v edpat ternorr egular i
tyint hef act sgi vi
ngt heeconomi st
somegui dance.I tinv olv es,fi
rst ,thecol lection,pr esent ationandanal ysisofeconomi cdat aand
thent heder i
v ati
onofr el ati
onshi pamongobser vedv ar i
ables,i.e.,theav ailablest at i
sticalcl osel y
exami nedi nthesear ch, forthegener aleconomi cpr i
nciples.
3
 4

Gr
aphsandt
hei
rmeani
ngs
 Agr aphi savisualrepresentati
onoft herelati
onshipl bet
ween2vari
abl
es.
 Economi st
sli
ket ousegr aphst oil
lustr
aterelati
onshipbetween2ormorev ar
iabl
es.Consi
der
fori nstance the rel
ationship bet
ween gr ades and study
ing.I
n generalwe expectthat
additionalhoursofstudyt i
mewi l
ll
eadt ohi ghergrades.
 Wecanbeabl et o seeadi sti
nctrelat
ionshipbetweenhour sofst
udytimeandgr ade-poi
nt
average
Thediagr am bel
owi l
lustr
atest his

Grade
poi
nt
av
erage
3
2
2
1 123 4 5 6
St
udytime
 Thewhol epurposeofgr aphsistosummar i
zenumeralrel
ati
onshi
ps.
 The upwar d( posit
ive/ di
rect
)slope ofthe cur
vei ndi
cates t
hataddi
ti
onalst
udy
ing is
associ
atedwithhighergrades.
 Ther earealsographs,whichshowcombi nati
onsoftwov ar
iabl
esatwhi
chsomecondit
ions
areachi
evede.g.PPFoff oodandclot
h.

A
Food
(
tones) PPF

0
B
Cloth(Metr
es)
Graphsil
lust
rat
er el
ati
onshipsbetweendir
ectandinv er
serelati
onships.Anexampl
eofadir
ect
rel
ati
onshipwouldbeconsumpt ionandincome.Ani ncr
easei ndisposablei
nsur
esr
esul
tst
oan
i
ncreaseinconsumptionotherf
actorshel
dconstantasill
ust
ratedbelow: -

Consumpt
ion
C
Consumpt
io
n

I
ncome(
Y)

 An exampleofan inver
se/negat
ivewould bet
hepr
icesoft
icket
sand at
tendancei
n
thousandsasi
l
lust
rat
edinthet
abl
ebelow.
Ti
cketpri
ce(
shs) At
tendance(
thousands)
50 0 50
40 4
30 8 Ticketpr
ice
20 12
10 16

4
 5
0 20
20
At
tendancei
nthousands
Dependentandi
ndependentv
ari
abl
es
Graphs i ll
ustrate t he r elati
onshi p bet ween dependent and i ndependent v ari
ables. The
i
ndependentv ar i
ableal sor eferredt oasexogenousv ar
iableisthecauseorsour ce,iti sthe
variablethatchangesf ir
st.
Thedependentv ariableist heef fectorout come.Itist hev ar
iabl
et hatchangesbecauseoft he
changei nt hei ndependentv ar i
able.Asnot edinouri ncome–consumpt i
onexampl e,income
gener al
lyisthei ndependentv ari
abl eandconsumpt ionthedependentv ar
iabl
e.Incomecauses
consumpt i
ontobewhati ti
sr at herthant heotherwayr ound.
Slopel i
ne
Linescanbedescr ibedi nt ermsoft heirsl
opes.
Thesl opeofast raightl i
nei st her atiooft hevert
icalchange( theri
seordr op)tot hehor izontal
change( therun)bet weenanyt wopoi ntsoftheli
ne.
I.
e.,slope=v erti
cal change forlinearrel
ati
onships
Hori
zont al change

Sl
opeofanon-
li
nearcur
ve

A
B

I
nfi
nit
eorzer
oscopes
Pri
cesof
bananas Sl
ope=i
nfi
nit
e C Sl
ope=0
Consumpt
io
n
Di
vor
cer
ate

Pur
chasesofwat
ches
 t
hesehappenf
orv
ari
abl
eswhi
char
eunr
elat
edori
ndependentofoneanot
her

TheEconomi
cpr
obl
em/
Quest
ions:
 Thebasi ceconomi cpr oblem conf ronti
ngal lsoci et i
esi show t oallocatescar ceresour ces
bet weenal ternativeuses.Resour cesar escar cebecauset hecol l
ectivedesi r
esofsoci etyfor
consumpt ionatanymomenti nt imeexceedt heabi l
ityt osatisfythosedesi res.
 Theeconomi cpr oblem t husar i
sesbecausei ndividual swant sarev ir
tuallyunl imited,whi l
st
ther esourcesav ail
ablet osat i
sf yt hosewant sar escar ce.
Becauset her
ear einsuf fi
cientr esour cest opr oduceal lthati sdesired,societyisf orcedt omakea
choice.Thesechoi cesar e:
(a) Whatout putwi llbepr oduced?Thesoci etymustchoosewhi chgoodsandser vicest obe
producedf rom theav ailabl eresour ces.
(b) How shal lthegoodsbepr oduced?Ther ear ev ar i
ousway sofpr oducinggi v enout pute.g.,
labori nt
ensi veorcapi tal i
ntensi vet echniques.Thet echniquechosenmustbecostef f
ectiv
e.
(c) Forwhom shal ltheout putbepr oduced?Cl early,ifanout putispr oducedt heremustbe
somemeansofal locatingi ttoconsumer sandofdeci dingwhor eceiveswhat .
Inchoosi ngwhi chgoodswi llbepr oducedf rom scar cer esourcessoci etyisf orcedt odowi thout
thosegoodst hatmi ghtot her wisehav ebeenpr oduced.Thi sisv eryimpor t
antt ot heeconomi sts,
andi nchoosi ngwhatt opr oduced, thenewbestal ternativef orgoneorsacr i
ficedi sr eferredtoas
oppor tunitycost( orr ealcost )ofwhati sproduced.Oppor tuni
tycostofadeci siont opr oduceor
toconsumemor eofonegoodi sthenextbest -forgoneal ternativ
e.Adeci si
ont obuyaT. Vset ,f
or
5
 6
example,mightmeangivi
ngupt hepurchaseofasof
aset
.Int
aki
ngdeci
sionaboutpr
oduct
ion,
theconceptofoppor
tuni
tycosti
svit
al.

Theeconomi
zi
ngpr
obl
em
 Theeconomi zi
ngpr oblem stemsf rom 2r elatedf act s
1. Societ y’seconomi cwant s,i.
e.,t
heeconomi cwantofi tsciti
zensandi nstit
utionsarev i
rtually
unli
mi tedandi nsat iabl
e.
2. Economi cresour ces, i
.e.,
themeansofpr oduci nggoodsandser vi
cesar elimitedorscar ce.
 Economi cwant smeant hedesi r
esofconsumer st oobt ainandusev ari
ousgoodsand
servicest hatpr ovideut il
it
y,i.
e.,pleasur eandsat isfacti
on.Thesewant sextendov erawi de
rangeofpr oduct s,f r
om necessi ties( food,shel ter,and cl ot hi
ng)t ol uxur i
es( perf
umes,
racecar set c.Ov ert i
me, want schangeandt endt omul t
iply,fueledbynewpr oducts.
 Want sar einsat i
ableorunl i
mited, meani ngt hatourdesi resforgoodsandser v i
cescannotbe
compl etelysat isfied.
 Economi cr esour cesar e,howev erl imitedr el
at iv
et ot hewant sthatt heyshoul dsati
sfy .By
economi c,thatwemeanal lnat ural,human,andmanuf acturedr esour cest hatgoi ntot he
product ionofgoodsandser vi
ces.Thati ncl udesf actoryandf arm bui l
dingsandal lthe
equipment ,t oolsand machi ner yused t o pr oducemanuf act ur
ed goodsand agr i
cultural
goods/ product s,alltranspor t
ati
onandcommuni cationf acil
iti
es,al ltypesofl aborandl and
andmi ner al resour ces.Economi stscat egorizeal ltheser esour cesi ntoland,labor,capit
al and
entrepr eneur ial abil
ity.
 Thef ourt ypesofeconomi cr esour ceshi ghlightedabov ear egener al
lyscar ceorl i
mitedi n
suppl y.Thepl anetcont ai
nsonl yf i
ni t
eandt her eforel i
mi t
edamountofeconomi cresources.
Duet ot hisreason, peopl emustmakechoi cesandeconomi zeonr esour ceuse.

Ty
peofEconomi
cSy
stems
Economicsyst
emsar econcer
nedwi
tht
heowner
shi
pandcont
rolofr
esour
ces.Themai
nty
pes
ofeconomicsyst
emsar e:
a) Tradi
ti
onaleconomy,
b) Marketeconomy ,
c) Commandeconomy ,
d) Mixedeconomy .
(
a)Tr
adi
ti
onal
Economy
.
 At r
aditi
onaleconomyi sonei nwhi chbehav iorisbasedpr i
maril
yont r
aditi
on,cust
om and
habit
.Youngmenf ol
lowt heirfat
her s’occupat i
on,ty pi
cal
ly,hunti
ng,fi
shingandtoolmaking.
Womendowhatt heirmot hersdid,typicall
y,cookingandf ieldwork.
 Tradi
tionaleconomyi schar act
erizedbyf ewchangesi nthepat ter
nofgoodspr oducedfrom
yeartoy ear,producti
ont echniquesf oll
ow tradi
tionalpatterns,exceptwhent heeffect
sof
occasionalnew inventi
onsar efelt.Pr opert
yi sof tenheldi ncommonandt heconceptof
pri
vatepropertynotwell defi
ned.
 Theanswer st oeconomi cquestionsofwhatt opr oduce,how t oproduce,andforwhom to
produceorhowt odistr
ibutearedet ermi nedbyt r
aditions.
b)Mar
ketEconomy
.
 I nthiscase,r esourcesar eal l
ocatedt hr
oughpr i
cemechani sm.Thi ssi mplymeanst hat
i
ndiv i
dual s,asconsumer sf r
eelychoosewhi chgoodsandser v
icest heywi llpur
chase,and
producer sf reelychoosewhi chgoodsandser vicestheywillprovi
de.Becauseoft his,market
economi esar eoftenreferr
edt oasf reeent erpriseorlai
ssez-f
aireeconomi es.
Charact
er i
sticsofMar ketEconomi es
 I ndi
v i
dual spur suetheirownsel f-
interestbuy ingandsel l
ingwhatseemsbestf orthemsel
v es
andt heirf ami l
i
es.
 Peopl erespondt oincentiv
es.Ot hert hingsbei ngequal,sell
ersseekhi ghpr i
ceswhilebuyers
seekl owpr i
ces.
 Ther ei sr eli
anceonpr icemechani sm t oal locat eresour
ces.Pricesar eseti nopenmar ket
si n
whichwoul dbesel l
erscompet etosel l
t heirwar estowoul dbebuy ers.
 Ther ei slimi tedrol
eofst ate.I
ndeed, i
nast r
ictlyfr
eeenterpri
seeconomy ,theonlymajorrole
performedbyt hegov t
.woul dbet hatofcr eatingaf ramewor kofrules( i
.e.laws)withi
nwhi ch
6
 7
bothpr
ivatei
ndi
vidual
sandfi
rmscouldconductthei
raf
fai
rs.
 Therei
st heexi
stenceoft
her i
ghtt
oownanddi sposeofpri
vat
epr
oper
ty.Anyi
ndi
vi
duali
s
fr
eetoownanddi sposeof
ffact
orsofpr
oduction.
(
b)CommandEconomy
.
 Thisisaneconomyi nwhichresourcesareal l
ocatedbycentralpl
anni
ngaut
hori
tyappoi
nted
bythestate.I
nthi
scase,keyindust
riesandr esourcesarecontr
oll
edandownedbythestate.
Thegov ernmenti
ssuesdi r
ecti
ves( i.
e.instr
ucti
ons)t ofir
msi ndi
cat
ingwhattheyshould
produce,t
hequanti
ti
esthatshouldbepr oduced,andsoon.
Thef
oll
owi
ngar
esomeoft
headv
ant
agesofcommandeconomy
.
 Becausepr oduct
ionisnotunder takenforprofi
t,t
hereisgreat
erli
kelihoodt hatbothpubli
c
goodsandmer i
tgoodsarepr oduced.Thegov er
nmentsimplyhastoissuedirecti
v etoensur
e
producti
on.
 Thepr oducti
onandconsumpt i
onofdemer i
tgoods,whichi mpose,r el
ati
velylargesocial
costsonthesocietycanbepr eventedorli
mitedthr
oughtaxesorsubsidies.
 Greaterequali
tyint hedistr
ibuti
onofweal thandi ncomecanbeguar anteedi ncentral
ly
pl
annedeconomi es.Inaf ul
l
ycommandeconomy ,t
herearenopr i
v ateentrepreneur
swho
deri
veprofi
tsfrom combingthef actor
sofproducti
on.
Di
sadv
ant
ages:
 Withcommandeconomy ,therei sgreaterreductionofconsumersov er
eignt
y .I.
e.,thest ate
decideswhatt oproduceandt heconsumer shav emuchl essinfl
uenceov erpr oductionthan
i
nmar keteconomi es.Thisculmi natesintoshortagesofcertai
ncommodi ti
esandsur facesof
others.
 Mor eover,theremaybet endencyt owar dsbur eaucr
ati
cst r
uctures.I
tist hegov t
.pl anning
department s,whichgov er
nr esour ceall
ocation.Theoppor t
unit
ycostofempl oy i
ngpeopl et o
gatherinformat i
on,processi tformulatespl ansisthealter
nati
v eoutputthesepeopl ecoul d
otherwisehav eproduced.
 Thereisal solessincenti
vet oincreaseef fi
ci
encybecausepr ofi
tmot i
veisabsent .
(
d)TheMi
xedEconomy
.
 Fullytradit
ional,
full
ycentrallycontroll
edandf ull
yfr
eemar keteconomiesareuseful
concept
s
forst udy i
ngt hebasi cprinciplesofr esourceal l
ocati
on.Howev er,t
hereisalway ssome
mi xtur
eofcent ralcontrolandmar ketdeterminati
on,withacer t
ainamountoft radi
ti
onal
behav ioraswel l
.
 Mi xedeconomyr eferstoaneconomyi nwhi chbothf r
eemar ketsandgov er
nmentshave
signifi
cantef f
ectsont heallocationofresourcesandt hedist
ri
buti
onofincome.
 Thedegr eeofmi xturevari
esf rom economyt oeconomyandov erti
me.

Pr
oduct
ionpossi
bil
i
tyFr
ont
ier
.
Apr oducti
onpossibi
li
tyfr
onti
erjoi
nstoget
herthediff
erentcombi
nat
ionofgoodsandservi
ces
whichacount rycanproduceusingal
lavai
labl
eresourcesandthemostef
fi
cientt
echni
quesof
producti
on.
Thediagram belowil
l
ustr
atesthi
s.
Acount
ry’
sPr
oduct
ionpossi
bil
i
tyFr
ont
ier
A

.
N
Food .
M
(
Tones)

0
Cloth(Met
ers) B
 Thest rai
ghtli
ne( AB),i
.e.,productionpossi
bil
ityfronti
errepresentsconstantopport
unity
costs.
 The diagram shows differentcombi nat
ions oft hese two commodi ti
es,which can be
produced.OAt onescanbepr oducedwhenal lresourcesareempl oyedintheproduct
ionof
foodwhi l
eOBmet erscanbepr oducedwhenallresourcesareusedi nthepr
oducti
onofcloth.
 AllpointsonthePPFr epresentcombi nat
ionsoff oodandcl ot
h,whi chthecountr
ycanj ust
7
 8
producewhenal li
tsresourcesareempl oyed.
 Al lpoi nt
sinsi dethel i
ne,suchaspoi ntM,r epr
esentcombi nations,whi chcanbepr oduced
usingl esst hantheav ail
ablesupplyofr esources,orbyusi ngt heav ai
lablesupplywi t
hl ess
thanmaxi mum ef fi
ciency.Point
sout si
det hePPFsuchasN,r epr esentcombi nat
ionswhi ch
areunat tai
nabl e.
 Toi ncreaset heoutputofcl ot
hfrom OEt oOFmet ers,i
tisnecessar yt or educetheoutputof
foodf rom OCt oODt ones.Hence, t
heoppor tunit
ycostofi ncr
easi ngt heout putofclothfrom
OEt oOFmet ersisCDt onesoffood.
 Theoppor tunitycostofincreasi
ngt heout putofclothf r
om Ot oOEmet ersisonlyACt ones
offood.
Thediagr am bel ow repr
esentacount ry’
sPPFwi t
hi ncreasi
ngoppor t
unitycost .Asaddi t
ional
uni
tsofcl otharepr oduced,theopportunit
ycosti ntermsoff oodincr eases.

A1

Food
(
Tones)

Cl oth B1
(Met er
s)
 PPFshowswhatt hecount r
ycanpr oduceatanymomenti nt i
mewi thexi st
ingr esour
ces.
Ov ertime, societiesabi litytopr oduceout puti sl i
kelytoi ncreasebecauseof: (i
)
impr ovement sint hepr oduct ivityoflabor ,
(i
i)Gr eatertechnol ogi calpr ogress,
(i
ii
)Incr easeoft hesi zeofl aborfor ce,et c.
 I fthesoci ety’
sabi lit
yt opr oduceout puti ncr eases,t hiswi l
lber epr esentedbyanout ward
momentoft heatrePPF.
 The sl ope oft he PPF can be i nterpreted as meani ng the rate atwhi ch food can be
transformedi ntoamet erofcl othbyshi ft i
ngr esour cesf rom f oodpr oducti
oni ntocloth
product ion.Thesl opeofPPFi ssomet i
mescal l
edt hemar ginalratet ransformat i
on.When
PPFi sdr awnasast raightl i
ne,t heoppor tunitycostandMRT r emai nunchanged, i.
e.,
const antoppor t
uni tycost
 Wher ePPFi sdr awni nast raightline,theabsol utev alueoft hesl opeoft heline,equalto
OA/ OB,measur est heoppor tunitycosti nt er msoff oodofpr oduci ng1ext r
amet erofcloth.
Ther eciprocaloft hesl opeOB/ OAmeasur est heoppor tuni
tycosti nter msoft heclot
hof
produci ng1ext rat oneoff ood.
N.B: Thi si mpl i
est hoseaddi ti
onalmet ersofcl othproducedr equiret hat0A/ 0Bt onesoff ood
beforgoneandt hatOB/ OAmet ersofcl othbef or gone.

Foundat
ionsofEconomi
cs
Economicsbeganwhent houghtfulobserv
ersaskedt hemselveshow suchacomplexsetof
deal
ingsisorgani
zed.Whocoor di
natesthewholesetofef fect
s?Whomakessurethatallthe
acti
vi
ti
esfitt
ogether,
providingjobstoproducethethi
ngst hatpeopl
ewantanddel
i
ver
ingthings
towheretheyarewanted?
The greatinsi
ghtoft he early economists was t
hatan economy based on fr
ee-market
tr
ansacti
onsisself
-or
ganizing.

ThegreatScot
ti
sheconomist
sandpol i
ti
calphi
l
osopherAdamsSmit
hwast hefi
rstt
odevel
op
thi
sinsi
ght.Smit
hsaidthatsel
f-
int
erest
,notbenevol
enceisthef
oundat
ioneconomicor
der.
8
 9
Smithsai dthatspontaneouslygener at
edsocialorderisrel
ati
vel
yeffi
cient
.Hesai dt hatmarket
soci
et yproducesorderedbehav iort
hatmakesi tappearasifpeopl
eareguidedbyahi ddenhand.
Hedi dnotl i
ter
all
ymeant hatasuper natur
alpr esenceguideseconomicaf f
airs.I nst
eadhe
ref
erredt otheamazi ngemer genceofor deroutofsomanyi ndependentdecisions.Thatall
i
ndividualsrespondtot hesamesetofpr iceswhichar edetermi
nedinmar ket
st hatr espondto
overallcondi
ti
onsofnat ionalscarci
ti
esandplenty.

Thewor kofAdam Smi th(1723-90)ent i

tl
ed, “AnEnquiryintot heNat ureandcauseoft heweal t
h
ofnat ions”wast hef i
rstcompr ehensivest udyofeconomi csasasepar ateandi ndependent
subject .Theweal thofNat i
onsdev elopsat heor yofpr i
cesanddi stri
but i
on.Accor dingt oSmi th,
thepr icesofcommodi tyaremadeupofwages,r entandpr ofit
s,whi char ethet hreeor iginal
sourcesofr evenuesaswel lasexchangeabl ev al
ue.Thust het otalnationalpr oductisdi str
ibuted
amongt heowner sofl abor
,landandcapi tal.Smi t
hsai dthatmar ketsoci etypr oducesor dered
behav iorthatmakesi tappearasi fpeopl ear egui dedbyani nvi
sibleorhi ddenhand.Het hus
contributedt hephi l
osophyof“ lai
ssez- f
air
e’’Smi tharguedt hatt hemar ketmechani sm i sasel f-
regulatingnat uralor derandt hest ateshoul dnoti nter
venet hroughr ul esandr egul
at i
onsi nt he
pri
cesy stem.Wi t
hl aissezfair
ephi losophy,hechampi onedt hecauseoff reei nt
ernationalt r
ade.
Hisot hercont ri
butionwast henat i
onofspeci al i
zati
onanddi visionofl abor.

Dav i
dRicardo( 1772-1823)inhisworkentitl
ed, “Thepr i
ncipl
esofpol i
ticaleconomyandTaxat i
on
(1817)”identi
fi
edt hreeclassesorowner soft hef actor
sofpr oductionaswor ker
slandowners
andcapi tal
ist
swho r eceiv
er ewardsinf or msofwages,r entsandpr ofi
tsr espect
ivel
y.But
becauseofhi sbeliefinthelawofdiminishingr eturnsandi ntheMal thusiant heoryofpopulat
ion,
Ricardovisual
izedt heeconomyev entuall
yr eachinga“ stati
onaryst ate”inthedecadest ocome.
Ricardoalsodev el
opedt hetheoryofcompar at
iveadv antageinwhi chheappl iedSmith'
sideasof
divi
sionofthelaborandspeci ali
zat
iontotradebet weencount ri
es.

Alf
red Mar shall(1842-
1924)wr ote a book enti
tl
ed pri
ncipl
es ofeconomics in 1890.His
contr
ibuti
oni soneofsy nt
hesisli
nkingthesupplycondi
ti
onsofcl assi
cseconomist
s( basedon
costsofpr oducti
on)wit
hut i
l
ityanddemand.Het endstoviewf or
cesofsupplyanddemandi n
thecontextoftime.

John May nard Key nes (1883-1946)dev eloped his analy

sisin an att
emptst o accountfor
persi
stencel argescal eunempl oymenti nhi sanal
ysis,devel
opedin“ TheGeneralTheoryof
Empl oyment ,
Interestandmoney( 1936),”Key nesdemonstratedpossi
bil
i
tyofanequili
bri
um l
evel
thatcouldper si
stbel owthefullempl oy
mentl evel
.
Keynesal sowr oteapamphl et“ Howt opayf orthewar(1940)”inwhichhecall
edformeasures
such ashi gh taxeson househol ds,tor educeconsumer sdemand orr esour
ces.Thi swas
necessaryi nor dert ocont rolpossibleinflati
onarypressurescausedbyexcessdemandf or
resourcesdur i
ngt heSecondWor l
dWar .

Mil
ton Friedman who was bornin New Yor
ki n 1912 is wellknown forhis workon t he
methodologyofeconomics.Examplesofhi
sbookent itl
ed,"
Essayinposi
ti
v eEconomics,1953”
andthetheoryofconsumptioninhi
sbookenti
tl
ed“At heoryofconsumpti
onFunction,
1957”.He
advocat
edf orafreemarketeconomy.Heal
soadvocat edforthedevel
opmentofmonet ari
sm in
hi
sbookQuant it
yTheoryofmoney .

Economi
csandEf
fi
ciency
.
 Economi csi sasoci alsci encet hatexami nest heef ficiencyi .
e. ,thebestuseofscar ce
resources.Soci et
ywant stousei tsscar ceresourcesef fi
ciently;aspossi blefrom it
sav ail
able
resources, t
her ebymaxi mizi ngtotalsatisfacti
on.
 Fullproduct ioni mpl iespr oduct iveandAl l
ocativeef f
iciency .Pr oductiv
eef f
ici
encyi st he
product i
onofanypar t
icularmi xofgoodsandser vicesi nt hel eastcost l
yway .Al
locative
effi
ciency,howev er,ispr oduct ionoft hatpar t
icularmi xofgoodsandser vi
cesmostwant ed
bysoci ety.Al locati
v eef f
iciencyr equirest hatsocietypr oducest her ightmi xofgoodsand
servi
ces wi t
h each i tem bei ng produced att he lowerpossi ble unitcost .This means
appor t
ioningl i
mi tedresour cesamongf i
rmsandi ndustri
esi nsuchawayt hatsociet
yobt ains
thecombi nationofgoodsandser vi
cesi twant sthemost .
 Theconceptofef f
ici
encywasf i
rstcreditedt oItali
aneconomi cVi l
fredPareto(1848- 1923)
9
 10
who concent rat ed ort heef ficiencyaspect sofwel f
arebecausehebel ieved t
hatt o be
regardedasPar etoeffici
ent,itmustbei mpossibletoincreasetheproductionofonegood
wi t
houtr educingt hepr oduct i
onofanot her,
ortoincreasetheconsumpt ionofonehousehol d
wi t
houtr educi ngt heconsumpt ionofanot her.Suchasi t
uationaccordingtoPar etoift he
followi
ngcondi t i
onsaresat isfied!
a) Thegi venst ockofr esourcesmustbeal l
ocatedinthepr oducti
onofgoodsandser v
icesi n
suchawayt hatnor e-
al l
ocationcani ncr
easetheout putofonegoodwi thoutdecreasingt he
outputofanyot her.
b) Thecombi nat ionofgoodsandt heproporti
oni nwhi cht heyarepr oducesmustbei n
responset ot het astesandpr eferencesoft hecommuni t
y,i.
e.,t
hegoodspr oducedmustbe
theonest hatt hecommuni tywant s.
c) Thedi stri
butionofgoodsandser vi
cesmustbei nconformitywithconsumer s’pr
eferences,
giventheirtast esandi ncomes.

10
 11
MEASURI
NG DOMESTI
C OUTPUT,NATI
ONAL I
NCOME & PRI
CE
LEVEL
Thei
mpor
tanceofmacr
oeconomi
cmeasur
ement
- Macr oeconomi csisnecessar ybecauset herearef orcesthataf fecttheeconomyasawhol e
thatcannotbef ul
lyorsi mplyunder stoodbyanal yzi
ngi ndividualmar ketsandi ndivi
dual
products.Asapr oblem thatisaf f
ect i
ngal lfi
rms, ormanywor ker sindif
ferentindustri
esmay
needt obet ackledatt hel eveloft hewhol eeconomy . Cer tai
nly,i
fci rcumstancesar e
commonacr ossmanysect orsoft heeconomy ,thant heanaly sisofthewhol eeconomymay
helpusunder standwhati shappeni ng.
- Inmacr oeconomi cs,thef ocuszer oesont heov erallbusinesscy cl
e,overallli
vi
ngst andar
ds,
i
nflati
on,unempl oymenti nt hewhol eeconomy , i
nterestrates,etc.
- Macr oeconomi csprovidesanexpl anationf orthebusi nesscy clesinaneconomyoratgl obal
l
ev el
.Thev ariousbusi nessf l
uctuationsar eexplainedandt her especti
veeconomi cdamages
l
ikelytobecausedar epr edict
ed.

MEASURESOFI NCOMEANDOUTPUT
Ther
ear etwomeasur esofi mportance
1. GrossDomest i
cPr oduct(G.D.P)
- GDPi sthet ot
alvalueoft hecurrentpr
oduct
ionoff i
nalgoodsandser
viceswithi
nthenat
ional
t
erri
torydur i
ngagi venper i
odoft i
me,nor
mal l
yaquar t
erorayear.
- Itisthev alueofcur rentproducti
onofthefinalgoodsandservi
cesobtainedatthepr
evail
i
ng
marketpricesproducedwi t
hinthenati
onalboundary.

NB:Curr
entproductexcludesresal
eofi t
emsproducedinanot
herper
iods,i
.e.
,excl
udestransf
er
ofasset
sr egardl
esst hear
rangementormethodsoftr
ansfer
.
- GDPi smeasur edinmonet ar
yunits.
- Finalgood-Thi sexcl udesraw materi
alsandsemifini
shedgoodsusedasi nput
si nthe
pr
oductofothergoods.

Ci
rcularfl
owofi ncome
- Foracl osedeconomy ,t
otalpur
chasesbydomesti
cconsumersareequalt
ot ot
alr
evenueof
fir
ms.
- Househol dsdemandout putfrom f
ir
msandtheysupplyi
nput
soflaborandcapit
alt
ofir
ms.
- Fi rmspr ovideout puttohouseholdsanduset hei
rearni
ngstopaywagesf orlaborand
inter
estorpr of
itcapit
ali
nputs.

H/
HOLD

Goods& Labor& Income=wages+

Pur
chases capit
ali
ncome
serv
ices capi
tal
(out
puts)

BUSI
NESSES

MEASUREMENTOFG.
D.P
(
a)Expendi
tur
emethod
- GDPi st
hesum ofmarketval
uesofal
lthefinaldemandf
orout
puti
ntheeconomyi
nagi
ven
peri
od.
- GDP=PcC+PII+PG G+( PxX–Pm M)
Where,
GDP =GrossDomesti
cPr oduct
Pc =Consumerpri
ce
11
 12
PI =PriceofI nv
estment
Px = Pr i
ceofExpor t
s
Pm =Pr i
ceofi mports
C =Pr i
v at
eConsumpt ion
I =Inv estment
G =gov er
nmentconsumpt i
on
X =Expor ts
M =Impor ts
PxX–Pm M =NetExpor t
s
NB:Fi
naldemand(FD)=Wages+capi tali
ncomewhichi
sequal
tov
alueaddedTax.
Capi
tali
ncome=I nterestpaidonloans+prof
it
s

(
b)TheValueAddedmet hod
- GDPint hiscasei sobt ainedbysummi ngupt heval
ueaddedineachsectoroftheeconomy
.
Thevari
oussect orsmayi ncl ude:-
1. Agriculture,Forestr
yandFi sheri
es
2. Mining
3. Const ruction
4. Manuf act uri
ng
5. Transpor tati
onandpubl icutil
it
ies
6. Whol esaleandr et
ailtrade
7. Fi
nancei nsuranceandr ealestate
8. Gover nmentandGov er nmentent erpr
ises
9. Stati
st i
cal di
screpancyusedt omakecor recti
onforanyst
ati
sti
cal
discr
epancy

(
c)IncomeAppr oach
- GDPi sobtainedbysummi ngupal li ncomesofal lthefactorsi.
e.,l
abourandcapi t
alwhich
contri
butetothepr oducti
onpr ocess.E. g.domest icincome( DI)= Labourincome+capi tal
income
- Labourincome=r emunerationofsal ariedempl oyees
- Capitali
ncome=i ncomeofsel fempl oyed+i nterestincome+cor porat
epr ofi
ts+r ental
income.
- GDP=DI+capi taldepreci
at i
on+i ndirecttaxes( sales&exci setaxes)
- Netdomest i
cpr oduct(NDP)=DI+i ndi recttaxes
NDP=GDP-depr eciati
on
Therefor
e,DI=GDP-depr eciati
on-i ndirecttaxes
NB:
GDP:i smeasur edatmar ketpriceswhi leDIi smeasur edusingnetoftaxes
Theref
oreGDP=DI+Depr eci
ation+i ndirecttaxes

WhatGDPdoesnotmeasur es
1. Economicact ivi
tytaki
ngpl aceoutsidethemarketeconomy
2. Unreport
edact i
vit
iese. g.bl ackeconomy-bl ackeconomyi sthatpar tofeconomic
acti
vit
ynotr ecordedinof fici
al st
ati
sti
cs(NB:Tax)
3. Nonemar ketedact i
vit
iese. g.houseworkathome,l eisur
e,doitbyy our
sel
facti
vit
ies,
l
andscaping, et
c.
4. Economic bads e. g.pol lution,congesti
on and otherdisameni
ti
es ofmodernl i
vi
ng.
Economicbadsar ealsor efer r
edtoasnegati
veout put
s.

Gr
ossNati
onal product(
GNP)
- Thetotalvalueofincomet hedomesti
cresi
dentsr
eceivei
nagivenperi
odofti
meisref
erred
t
oasGr ossNat i
onalProduct(
GNP).
- ForaclosedeconomyGNP=GDP.
- Foranopeneconomy ,
GNP=GDP.Thi sisbecauseforanopeneconomy,GNPwoul
dinclude
t
hei
ncomef ordomesticresi
dent
soutsi
dethecount
ry.

Reason:
- Par t
sofi ncomesoff act
orsofproduct
ionint hedomesti
ceconomybelongto
for
eigner
s.
- Somedomest i
cresi
dentsmayrecei
vedthei
rincomefrom abr
oade.
g.pay
mentfor
12
 13
employmentwhileabroadorpay
mentt ostockofshar
esinaf or ei
gncompany.
- GDPmeasur esincomer ecei
vedf r
om thefact
orsofproductionwi t
hinthenational
boundar
ies.
- GNPmeasur estheincomeofresident
softheeconomyr egardlessofit
ssource.The
di
ffer
encebetweenGDPandGNPcanbedepi ctedint
her ev
isedf l
owdiagram onthe
fi
gureonpagefive.

I
mpor
ts
Labor& Incomefrom
Pur
chases capi
tal capit
al&
&exp[
orts l
aborabroad

H/
HOLH

Wages+capit
al
Labor&
Pur
chases i
ncome=income
Goods& capi
tal
ser
vices

BUSI
NESSES

Expor
ts Forei
gn
I
mpor
ts l
abor+ Paymentsto
capit
al for
eignfactor
s
ofproducti
on

 Letthenetf act
orincome( NFI
)ornetf actorpay ment( NFP)recei
vedfrom abroadequal
earni
ngs ofdomest i
cr esident
s on foreign pr
of i
ts,loans and workremit
tances mi
nus
earni
ngsoff orei
gnersinthedomesticeconomy ;thenGNP=GDP+NFIorNFP
 IfNFPO,thenGNPGDP.Ther eversealsoapplies,‘
mut at
ismutandi
s’
.

Measuringpr icel evel/ priceindexes

 Themi l
lionsofpr icesofout putint heeconomymakei tdif
f i
culttosaywhet herchangesi n
GNPr esul tfr
om pr icechangesorquant it
ychanges.Whati sneededi stosummar i
zet hevast
numberofpr icesandout put sintosi mpleindexes.
 E. g.theaggr egatemar ketv alueofconsumpt i
onexpendi turesi sequalt ot hesum oft he
mar ketv alueofexpendi turesonal ldif
ferenttypesofconsumpt iongoods.
 Supposet hatt herear eNt y pesofconsumpt i
ongods,f oreacht ypeofgood,t her
eisapr ice
andphy sicalv olumeofconsumpt ion.Thust henor malofconsumpt iondenot edPcC, isequal
to
PcC=P1C1+P2C2+P3C3++PN CN- --
---
--
--
---
--
---
--
--
--
--
--
---
--
---
--
--
--
--
---
---
--
---
-(
1)
WhereC=aggr egat econsumpt ion
C1,
C2….CN=v ari
oust ypesofconsumpt iongoods
P1,
P2…PN=Pr i
cesoft hecor r
espondi ngconsumpt iongoods.
 Wet hencal culatet heav eragepr iceofconsumpt iongoodsbyconst ructingapr i
ceindex,
denot ed PC,whi ch i s a wei ghted av er
age ofal lt he prices oft he i ndivi
dualt ypes of
consumpt i
ongoods.Thet y picalwayt ocal cul
atethisindexfory eart( Pct)isasf ol
lows:-
13
 14

Wher ew1, w2…, wN=t hewei ght sreflect

ingthev aryi
ngi mpor t
ancet hati
sattr
ibutedtothevari
ous
i
ndi vi
dual prices.
Al ar
gewei ghti mpl
iesagr eat erimpactonpc( pri
cei ndex,wherew1+w2+…. +wN=1)
Pit=thepr iceofapar ti
cularconsumpt i
ongoodi nyeart .
Pio=t hepriceofapar ti
cular‘ basey ear’
,t=O
Forthebasey ear,thepr iceindex=1
 Ther esul ti
ngpr iceindexi ssomet imesr eferr
edt oasconsumerpr iceindex(CP1)ort he
consumpt ionpricedef lator .
 Thewei ghtsforeachpr i
cear et hesamef orallthey ear
 Thepr icei ndexforanygi v eny eariswei ghtedav erageofal lt
hepr i
cesinthatyearrel
ati
veto
thepr i
cesi nthebasey earusi ngconst antwei ghts.
 Ther eal valueofconsumpt i
on( Ct)foragiveny earther ef
oreisgivenby
Ct= Nor malv al
ueofconsumpt i
onexpendi tureforagi v
eny ear
Consumerpr
icei
ndexoft
hey
ear

Real
GDP
 GDP atmar ketpr i
ces =t heav eragepricelevelxr ealpr oductioninthe
economy ;i
.e.GDP=P. Q, wherePi stheaveragepr i
cel evel,andQ=r ealGDP
(i
ndexofphy sicalproducti
on)
 RealGDP=t hesum ofal lexpenditur
esintheeconomyi .e.,Q=C+I+G( X-
M)
whereQ=r ealGDP,C=r ealconsumpt i
on,G=gov ernmentr ealconsumpt i
on,
X=realexpor t,M=realimportandI =reali
nvestment.
 Usingt henor mal GDPandr ealGDP, theGDPdef l
atorcanbeobt ained.
GDPdeflator(p)=Nor mal GDP=GDP
RealGDP Q
WherePi stheGDPdef l
atororimplici
tGDPpr i
ceindexorpr icedeflat
or
 Pisobt ainedindirectl
yorimpl i
citl
ybydivi
ding GDP( nomi nalGDP)
Q(r
eal GDP)
Real
andNomi
nal
GDP
 Althoughpr i
cesser veasaconv eni
entofmar ketv alue,theyalsodi stortour
per ceptionofr eal output .Imaginewhatwoul dhappent oourcal cul at
ionsi fal
l
priceswer et odoubl ef rom oney eartothenext .Obv i
ously,theywoul dl eadto
adoubl ingoft hev alueoff i
naloutput.Suchani ncreasei nGDPdoesnot
reflectani ncreasei nt hequant i
tyofgoodsandser vi
cesav ail
ablet ous.
 Hence, achangei nGDPbr oughtaboutbychangesi npr i
cel evelcangi veusa
distortedv i
ewofeconomi cr
eali
ty.
 Inor dert odi sti
ngui shi ncreasesthequant i
tyofgoodsandser vi
cesf r
om
i
ncr easesi ntheirprices, wemustconst ructameasur eofGDPt hattakesi nto
accountpr i
celev elchanges.
 Nomi nalGDPi sthev alueoff i
naloutputatcur rentpr i
ces,wher easr ealGDP
i
swhatt hev alueoff inaloutputwoul dhav ebeeni fpr i
ceshadnotchanged
(const antpr i
ces) .
 Tocal culaterealGDP, wear eef f
ecti
velyvaluinggoodsandser vicesatpr i
ces
ofanear l
ieryear .
 Becauset hepr icel eveli ncr
easesnear l
yev er yy ear,thedi st
inctionbet ween
14
 15
nominalandr ealGDPmustbemadewhent heeconomy ’
sperf
ormancei s
eval
uat edov ertime.
 Incalculat
ingr ealGDP,wecanuseanyy ear
’spri
cesasabasey ear,aslong
asweconsi stent l
yv al
ueout
putatthelev
elofpri
cesprevaili
ngint
hatyear.
.
 Pri
cei ndexi susedt omeasurechangesinthepricel
ev elbycomparingthe
pri
ceofabasketofgoodsandser v
icesi
nthecurrentyeartothepri
ceoft hi
s
basketi nt
hesel ectedbaseyear.

GDPandSoci
alWel
far
e/Economi
cWel
l
bei
ng
 In pri
nci plet he r elati
onshi p between GDP percapi ta and t he economi c
wellbeingofanat ionwoul dbet hathi gherGDPpercapi tawoul di mplya
higherl evelofwel lbeing;t henl owerl ev elofGDPpercapi tawoul di mplya
lowerlev elofwel l
bei ng.
 Howev er,GDPmaybeapoormeasur eofeconomi cwel lbeingsi nce
1)I tomi tscer tainser vi
cesbyusi ngmar ketvaluer athert hant het ruesoci al
valueofout putt herebyunder est imat i
ngt heactuali ncome.I nt hesecases
themar ketv alueov er esti
mat est het ruesoci alv alueofout putt hereby
over esti
mat i
ngt heGDP.E. g.noconsi deri
ngenv i
ronment aldegr adati
on,
pollutionandot heref f
ect sont hel ocal s.
2) Th eeconomi cwel l
beingr esultingf rom acer tainpercapi tal ev eldepends
ont hemar ketpr i
cesoft heout put .Foragi venGDPpercapi ta,acount r y
withl owmar ketpr icewi l
lhav eabet tereconomi cwel lbeing.Compar edt o
theonewi thahi ghermar ketpr ices.
3) GDPp ercapi tadoesnotaccountf ort hedegr eeofi ncomei nequal i
tyina
givennat ion.Ani ncreasei ni ncomei nequal i
tywi lli
mpl yar educt ionint he
valueofsoci alindicat orsandv isev er sae.g.educat i
on,heal th,nut ri
ti
onal
level,foodsecur i
ty,etc.

TheProblemsofAggr egat ion.

Probl
emsar iseinaggr egat i
onl argel yduet o:
1)Di ffi
cultyoff i
ndinganappr opr iateunitofmeasur ement .Themi ll
ionsofdi ff
erent
goodsandser vi
cesar emeasur edi ndi f
f erentuni ts,e. g.cl othismeasur edi n
met reswhi l
est eeli smeasur edi nt ones.I tisi mpossi bl
et oaddt onest omet res.
Thisi sovercomebyusi ngmoneyasauni tofmeasur ement .
2)Di ffi
cultyofdi sti
ngui shingbet weenr ealandnomi nalv alues.I fthev alueoft otal
outputdoubl es,t hisdoesnotnecessar ilymean t hatt ot
alout puti tselfhas
doubl ed.Whi l
epar toft hei ncr easemaybeduet oani ncr easei nphy sicalout put,
partofi tmaybeduet oi ncreasei npr i
ce.Howev ert oest imat er ealout putiti s
necessar ytodef l
atet hev alueoft otalout putbyanappr opriatepr icei ndex.Thi s
conv ertstotalout putmeasur edi ncur rentpr i
cest ot otalout putmeasur edi n
const antpri
ces.
3)Di ffi
cultyindeci dingwhi chpr iceindext ouse.I nmostcasest hepr icei ndices
calculatedar et hegener alindexofr etailpr icesandt hepr oducerpr i
cei ndex.
Eachonei sawei ght edav er ageoft hepr i
cesofanumberofsel ectedgoods.
Changesi nthedef l
atedt otalout putf igurescanonl ygi veanest imat eoft hetrue
changesi nt henat ion’sphy sical output .
4)Hi dingofconst i
tuentel ement s.E.g.ani ncreasei nt heeconomy ’st otalout put
tel
lsusnot hingaboutwhor ecei vest hatout put.Di stri
butionalf actorsshoul d
alway sbebor nei nmi ndwhenconsi deringt heef fectsofchangesi naggr egate
variables.

15
 16
SOCIALACCOUNTS
 Soci alaccount s are also referr
ed t o as macr o-
account sf ora whol e national
economyandi tsvari
oussect ors.
 Soci al/nati
onalaccount sdealwi t
hr ecordsofeconomi cact iv
ity
.Thoser ecords,
organi zedinacoher entwayf oll
owingaccount ingrulesarealway sinbal anceatt he
endoft heper
iod.
 Macr oeconomi csprovidestheanal yt
icaltoolswhi challow theexpl anati
onoft he
resultsshowni nthesocialaccount s.Causalrelat
ionshipsthatexplainhoweconomy
wor ksar ei
mpor t
ant.
 Thest rengthofthenat i
onaleconomi caccountsi sthattheyhav easol idinspirati
on
i
nt hemacr oeconomi csofKey nes.

16
 17
AGGREGATEDEMANDANDSUPPLY
TheNeedf
orAggr
egat
eModel
/St
ati
sti
cs:
Theaggr
egat edemandmodeli sneededi nev eryeconomyt oassistinmacr oeconomi canal y
si s.
Suchnat
ional stati
sticswoul dbei dealfor:
1) Maki ngI nternationalCompar isons:Indoi ngt hisitisnecessar yt oconv ertthef i
gurest o
samecur rencyusi ngar ateofexchange.
2) Gov ernmentPl anning:Ar i
singrealnat ionalincomewi t
haf airl
yconst antcapi talstockwi l
l
gener al
lybeassoci at
edwi thaf allinunempl oyment .Simil
arly,ther
ei slikelyt obedi rect
rel
ationshi pbet weent hel evelofr ealnat ionalincomeandt her ateofi nfl
ation.Ast he
equili
brium lev elofnat i
onalincomer eachest hef ul
lempl oymentl evelofnat ionalincome,
so inf l
ati
onar ypr essurei sl i
kelyt o build up int he economy .To dev ise appropriate
gover nmentpol i
cies,tocombatunempl oymentandi nfl
ationandt oest i
mat etheef f
ectsof
suchpol i
cies,accur at
enationalincomest ati
sticsareessential.
3) For mul atingmacr oeconomi cpoli
cy.
4) Theaggr egatemodel isneededt oexpl ainwhypr i
cesingener alri
seorf al
l.
5) Expl ainingwhatdet ermineschangesi nt helevelofaggregateout put

Aggr
egat
eDemand
 Thisist het otalquant
ityofout putdemandedatal ternati
vepricel
ev el
sinagi vent i
me
peri
od,“ceterispari
bus”.
 Ourv i
ewher eencompassest hecol l
ecti
vedemandf oral lgoodsandser vi
cesratherthan
thedemandf oranysinglegood.
 I
tthereforeconsi st
sofdemandofl ocalconsumers,firms,thegovernmentandf orei
gners
i
nt hecaseofopeneconomy .Thati sQD =C+I+G+DX,wher eDX i
sexpor tdemand,Ci s
l
ocalconsumer s,Ii
sinvestmentandQD i saggregat
edemand.
D
 Forclosedeconomy ,Q =C+I+G.
 Aggregatedemandcancal ledaspl annedexpendit
uresi nceitthetotalamountt hatthe
peoplearewi ll
ingandabl et
ospend.
 Theaggr egatedemandcur veindicateshowmuchout putpeoplewil
lbuyatdi f
fer
entpr i
ce
l
evelsthegr aphbelowillust
ratesthis.

Thedownwar dslopeoftheaggr egat

e
Pr
ice
demandcur v
esuggest sthatwithagive
(const
ant)l
evelofincome, peopl
ewillbuy
P1
mor egoodsandser vi
cesatlowerpri
ces.

P2
AD
Q1 Q2Quant
it
y

ReasonswhyAggr
egat
eDemand(
AD)cur
vesl
opesdownwar
dsf
rom
l
efttori
ght
.
1) TheMoneySuppl yEf fect:Withnomi nalmoneysuppl yremai ni
ngunchanged,ar i
seinthe
pri
celevelwil
lreducet her ealvalueofmoneysuppl y .Thecont r
acti
onarymoneychangesof
thi
skindwi l
li nmostcasesr educet otalspendingandt hereforecauseaf allindemand.
Simil
arl
y,afalli
npr icelevelwil
lincreasether ealvalueofmoneysuppl yandleadt oari
sein
AD.
2) RealBalanceEffect:Ifthegeneralpr i
celevelshouldr isedur i
ngt hecourseofay ear,
thereal
val
ue( orpurchasingpower )oft heaccountwi llfall.Thiswi l
lhavetheef fectofcur bi
ng
i
ndivi
dualsspendingdur ingthey ear.Thereversealsoappl ies,“mutati
smut andis”.
3) Macroeconomi cEffect:Ast hepr i
celevelfal
ls,t
heconsumer smaydeci det obuygoodsnow
17
 18
whicht heywer epl anningt obuyint hef uture.I ft hepr icelevelr
ises,theymaydeci det o
postponet hepur chaseswhi chwer eoriginall
ypl annedf orthepr esent.Thiseffectwhi ch
dependsst ronglyonexpect ati
onsoff ut
urei nf
lationr atesiscall
edinter-t
emporalsubsti
tuti
on
eff
ect.
4) Forei
gnPur chasesEf fect:Theremayal sobei nter nationalsubsti
tuti
onef f
ectif domest i
c
buyersdeci detobuymor ehomepr oducedgodsandf eweri mportsast hedomest i
cpr ice
l
evel f
alls,
andmor eimpor tsandfewerhome- producedgoodsast hepr i
celevelr
ises.
5) TheRat eofI nt
erestEf fect:Thi
sassumest hatast hepr i
celevelrisessowi l
lt herateof
i
nterest,andr i
singinterestrateswi
llreducecer tainki ndsofspendi ngsuchasconsumpt i
on
spendingondur ablesgoodsandi nvestmentspendi ng.

CausesofShi
ft
sofADcur
ve
a. Achangeingovernmentspendi
ng
b. Achangeintaxat
ion.
c. Achangeinnomi nalmoneysuppl
y.Ari
seinnominalmoneysuppl
yimpl
i
esani
ncr
easei
n
spendi
ngandtherefor
e,ADshif
tst
otheri
ght.Ther
ever
sealsoappl
i
es.

Aggr
egat
eSuppl
y
 Thisref
erst othet ot
algoodsofal lfinalgoodsandser vicesthatallfi
rmsi ntheeconomy
wishtosuppl yov eragi venper i
odoft i
meatal ternat
ivepr i
ceandwagel evel
s,“ceter
is
pari
bus”
 Aggregatesupplyreflect
st hevariousquant it
iesofrealoutputthatthefir
msar ewi l
l
ingand
abletoproduceatal t
ernati
v epr
iceandwagel evel
sinagi ventimeperiod.
 Theaggr egatesupplycur veindicatest hatbusinesseswi llbewill
i
ngt opr oduceandsel l
mor eoutputathi gherpricesandl essatl owerpr i
ces.Thi sseemsper f
ectlyreasonable
becausehigherpr i
ceshelpdet ermi net heextenttowhichpr oducersgetcompensat edfor
thei
reffort
s
NB: Output(Q)=f (PQ,Ci,K,Technology ),wher eCi=costofi nputs,K=st ockofcapi t
al,PQ =
pri
ceofout put.

Pr
ice AS
TheupwardslopeoftheAScurve
i
ndicat
esthathi
gheroutputwi
llbe
associ
atedwit
hhigherpri
ces.

Quant
it
y

CausesofShi
ft
sinAggr
egat
eSuppl
y(AS)Cur
ve:
a. Thel evelofmoneywages:Ani ncr
easei nmoneywager ates,ceterisparibus,wil
lraise
fi
rms’cost sandsomaket hepr oducti
onofmar ginalunitsl esspr ofi
tabl
e.Firmswi l
lreact
tothi
sbyr educi
ngoutputandt heASwi llshif
ttot hel ef
t.
b. OtherInputPr i
ces:Anincreasei nthepr i
ceofani nput ,ceterisparibus,wil
lcauseAScur ve
toshifttotheleft
.Thereverseal soapplies.
c. Avail
ablesuppl yofinput
sandt hestateoft echnol ogy:Growt hint heav ai
lablesuppli
esof
i
nputsi nt heeconomyand/ orani mprov ementi nt hest at eoft echnology( whichraises
productivi
tyofoneormor ei nputs)will
shi f
ttheAScur v
et ot heright.

18
 19
Equi
l
ibr
ium:
Real
Out
putandt
hePr
iceLev
el:
 Inmacr oeconomi cs,wecansayt hattheequi li
bri
um levelhasbeenr eachedwhent her
eare
noeconomi cforcesoper atingtochanget helevelofnationalincome.
 Thisoccurswhent het ot
aldemandf orallgoodsandser vices(aggregatedemand)i sequal
tothetotal supplyoft hesegoodsandser v i
ces(aggregat esupply)
.
 Theref
or e,atequili
brium, AD=AS
 Wecansayt hatthet otalv alueofgoodsandser vi
cesthathousehol dsandot hereconomic
agentswantt obuyi sequalt ot hetotalv aluethatf i
rmswantt oproducewhent hi
s
condit
ionissat isfi
ed.
 Thepoi ntatwhi chADcur veandAScur vei nt
ersectistheequi li
bri
um levelofrealnati
onal
i
ncomeOYEandt heequi librium pr
icelevel OPEasill
ustr
at edbelow.

Pr
iceLev
el

P1 AS
Atanypri
celevelot
her
thanOPEthebehavi
our
ofsel
ler
sandbuy er
sis
PE
notcompati
ble.
P2

0
AD

D1 YE S1 Real
Nat
ional
Income(
Real
Out
put
)

 AtOP1,pr oducer
swantsel lt
hequanti
ty0S1,butpeopl
edemand0D1.t heexcesssuppl
y
(sur
plus)at0P1wi l
ltendtopushthepri
cesdownunt i
lequi
l
ibr
ium i
sreached(atpoi
ntE)
.
Whatr esponseswil
lthepr
icelev
el0P2eli
ci
t?

19
 20
CLASSICAL AND KEYNESI AN THEORI
ES OF EMPLOYMENT AND
I
NCOMEDETERMI NATION
TheClassi
calTheoret
ical
ofEmploy
ment.
 Thecl assicaltheorywasdev elopedont henot i
ont hatagi venflexi
blewagesandpr i
ces,a
compet it
iveeconomywoul doperateatf ul
lempl oyment .Thatis,economi cf or
ceswoul d
alwaysbegener atedtoensurethatthedemandf orlaborwoul dalwaysbeequal toit
ssupply.
 Thatf oranypr icelevel,t
henor malwagei sfull
yf l
exibleandadj ust
st okeept hesupplyof
laborandt hedemandf orlaborequil
ibrated.Thust her ealwageisdet erminedsoast oclear
the l
abormar ket.Laborisalwaysfull
yempl oyedint hepreci
sesenset hatfi
rmswantt ohire
asmuchl abor,aswor kerswanttosuppl yatthereal wageseti nthemar ketplace.
Realwage–Thi sist hemoneywageadj ustedf orchangesi nthepr i
celevel.I
tist hevalueofthe
marginalproductofl abori
nacompet it
iveeconomy .
 Thedemandcur
veforlaborshowst
herel
ati
onshi
p1.
1t herealwageand t
hedemandf
or
l
aborshowst
herel
ati
onship1.
1ther
eal
wageandhouseholdssuppl
yofl
abor
.

Real
Wage SL Thi
srepr
esent
slabourmar
ketequi
l
ibr
ium ata r
eal

wageof andt
hel
evel
ofempl
oyment=0L1

DL
0
L1 Labour

Q1
With0L1uni
tsofl
abourempl
oyed,
out
puti
nthe
Out
put economywil
lbe0Q1

0
L1 Labour
 Soanyunempl oy mentwhi chexi statthewager at
e (w/ p) 1 mustbeduet of ri
ctionsor
restrictivepr acticali ntheeconomyormustbev oluntar y.0L1 denot ethef ul
lempl oyment
l
ev el.OQ1i st hefull employ mentlevelofoutput .
 Classi cal economi stssayt hatwhat everthelev eloffullempl oymentl evelofoutputproduced,
thei ncomeoper atedi npr oducingitwi l
lnecessar i
lyl eadt ospendi ngwhi chwi lljustbe
suffi
ci entt opur chaset hegoodspr oduced.Inot herwor ds,thesuppl yofgoodsandser vi
ces
createsowndemandandt herecanbenoov er production.Thi sbecameknownasSay ’
sLaw.
 Classi caleconomi st salsobel i
ev esthatgiv enaf l
exiblei nterestr at
eand acompet i
ti
ve
mar ketf orl oanabl ef unds,sav i
ngand i nvestmentwoul dal way sbemadeequalbychanges
i
ni nter estr at es.Ifinvestmentexceededsav ing, thedemandf orloanablefundswouldexceed
theirsuppl yandt his woul dpushi nter
estr atesupwar ds,br ingi
ngf ort
hmor esav i
ngand
combi ngi nv estmentunt iltheywer eequalagai n.Howev er,i fsavingexceededi nvestment
i
nterestr at eswoul df al
l,causinginvestmentt or i
seandsav i
ngwoul dber educed.

Key
nesi
anEconomi
cs

 Keynesmai ntainedt hatsavingmai nl

ydependsonnat i
onalincomelevelandi snotaffect
ed
bychangesi ninterestrate.
 Heal soar guedt hatbecauseofmonopol ypoweri nboththegoodsandl abormarkets,wages
andpr iceswilltendt obei nf
lexibl
eatleastintheshor
t-r
un.
 Accor dingtot heKey nesiant heoryofempl oyment,thelevelofrealnationalincomeand
thereforeempl oy menti sdet erminedlargel
ybyt helevelofaggregat
edemand,notsuppl y
creati
ngowndemand- classi
cal vi
ew.
20
 21
 InKey nesian,iti sdemandwhi chdet ermineshow muchi sbei ngsuppl ied.Thusi ffir
ms
producemor et hani sbei ngdemanded,t heywi l
lobser v
eani nvolunt
ar yi ncreaseint heir
i
nv entori
esofunsol dgoodsandsowi l
lrectif
yt hisbycut ti
ngbackonpr oduct i
onandl ay i
ng
offwor kers.Nat ionalincomewi l
lthenf alluntilthevalueofwhati sproducedi sequaltot he
valueofaggr egatedemand. Mor eover,iffirmsf i
ndthatt heyar enotpr oduci ngenought o
satisfydemand,t heywi llexperienceunwant edf alli
nt hei
rinventori
es.Theywi llat
temptt o
i
ncr easeproduct i
onandl ivemor ewor kers.
 Ther ewillthusbeonel evelofnat ionalincomeatwhi chaggr egatedemandi sequaltot he
valueofpr oduction.
 Thisi scall
edt heequi libri
um lev elofi ncome(t hatl
ev elatwhicht heaggr egatedemandi s
equalt ot het otalv alueofpr oduct ion).
Tot heKey nesianmodel ,theequi li
brium levelof
i
ncomei snotnecessar i
lythesameast hef ul
lempl oymentl evelofi ncome.Thi si swhy
Key nescalledhist heoryagener al t
heor y
.

Det
er minationoft heEqui l
ibri
um level ofincome:
Key
nesi anmodel i
sbasedont hef ol
lowi ngassumpt i
ons
1) Wagesandpr ices arefixed.Int heshor t-
run,producerswi llrespondt ochangesi ndemand
bychangi ngt hequant it
iestheypr oducerat herpri
ce.Thisi mpl i
esthatt heeconomyi sless
thanf ullempl oyment .
2) Wei gnoret hemoneymar ketandconcent rateonr ealsectoroft heeconomy( i
e,themar kets
forgoodsandser v
icesandf orlabor )
3) Consumpt ion ( c)and sav ing (s )ar e bot h di
rectl
yr elated toi ncome ( y); thatbot h
relati
onshi psar eli
nearandsocanbedr awnasst r
aightli
nes.Thesl opeofconsumpt i
online
measur est hei ncr
easei nconsumpt i
onbr oughtaboutbyaonepoundi ncreaseini ncome
(mar ginalpr opensit
ytoconsume). si
milar
ly,theslopeofsav i
ngl i
nemeasur esthei ncrease
i
nsav ingbr oughtaboutbyonepoundi ncreaseinincome,al socal l
edmar ginalpropensityto
sav e(mps) .
4) Investment( I)andgov ernmentspendi ng( G)ar eautonomousi .e.
,t heyarei ndependentof
i
ncomechanges.

I
mpor t
s(M),
M
Expor
ts(X)
Sl
ope=
MPM
X
Consumpti
on C
(
C),
Saving(
S) Sl
ope=MPC
0
Theav eragepr opensitytoconsume( APC)
S i
sequalt ototalconsumpt i
ondivi
dedby
Sl
ope=MPS totaldisposablei ncome( C/
Yd)
.TheAPC
variesasYd
Theav er
agepr opensitytosave( APS)is
0 equalt ot ot
alsav ing divi
ded by total
disposableincome( S/Yd)
.TheAPCf al
lsas
i
ncomer ises.

I
nv est
ment(I)
,
Government
Spending(G) I

0
21
 22

5) Taxat i
on( T)isint hefor
m ofl umpsum t axesonly.
6) Expor ts(x)areaut onomousbuti mpor t(M)dependsdi r
ectlyonincome.
7) Ther eisnoeconomi cgrowth.Thisisbecauset hemodel i
sconcernedwit
ht heshort
-r
unonl y
.
 Forequi l
i
br i
um tobeat tai
ned,theaggr egatedemandf ortheeconomy ’
sgoodsandser vi
ces
shoul djustbeequal tot
het otalval
ueofgoodsandser v
icesproduced.
 Aggr egatedemand( AD)consistsofconsumpt i
on,inv
estment ,
Gov er
nmentspending,expor
ts
mi nusi mpor ts(i
.e.,AD=C+I+G+X- R).
Thet otalval
ueofgoodsandser vi
cesi smeasur edby
thenat ionalincome( Y)
 Thei ncomer eceivediseitherspentonconsumergoodsorwi thdrawni
nf orm ofsavingand
taxes( i
.e.Y=C+S+T)
 Atequi li
brium, AD=Y
C+I +G+X- M=C+S+T
I
+G+X=S+T+M
 I,GandXar esomet i
mescal l
edi nj
ecti
ons(J)int
ot heflowofi ncomewhi l
e S,TandM ar e
somet i
mescal ledwithdr
awals(W)f rom t
hatfl
ow.Ther ef
oreatequi l
ibr
ium J=W.
 Inj
ecti
ons:Addi ti
onalspendi
ngi temsi nthecir
cularflow ofincomet hatdonotbegi nwith
householdconsumpt i
on
 Withdrawals:Thosepar t
sofnat i
onalincomethatar enotusedt obuydomest i
call
y-
produced
consumergoods.
 Allt
hei nj
ecti
ons( I
,GandX)ar eassumedt obeaut onomous( orexogenous) .Anautonomous
vari
ableisont hevalueofwhichisdet er
minedoutsidethemodel underconsider
ati
on.
 Determinati
onoft heequil
ibr
ium levelofi
ncome.Theequi li
bri
um iswher eAD=YandW=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
The45olinejoi
nstogetherallt
hose
pointswhichar eequidi
stantfrom
10 thet woaxes.whereADcut s 45o
l
ineisequil
ibri
um (i
.e.AD=Y) .Thi
s
i
sst abl
eequili
bri
um.
0
10 20 30 Ye 50
Nat
ional
Income(
$M)

Consumpt
ionandSav
ing
S&C
100
22

50
 23

C
Sl
ope=MPC=4/
5

S
Sl
ope=MPS=1/
5

50 100 200 250 Yd

MPS+MPC=1

Absol
uteI
ncomeHy
pot
hesi
s
Thi
sisbasedont
hecont
ent
iont
hatconsumpt
iondependsoncur
rentdi
sposabl
eincome.

S&C
Non-l
inear savi
ng
and consumpt i
on
C
l
ines.Ifmpcf all
s
as income r i
ses,
S thempsmustr i
se
asincomeri
ses.

Yd

Al
gebr
aical
l
y,t
her
elat
ionshi
pcanbeexpr
essedasf
oll
ows.
C=a+bYd
S=Yd-C
=Yd-a-bYd
Theref
ore,S=-a+( 1–b) Yd,t
heconst antai stheint
erceptt
ermfort
heconsumpt ionline(i
.e.
,
wheretheconsumptionl
inecutsthev ert
icalaxi
sandisequalt
o10theexample).Thecoef f
ici
ent
bistheslopeoftheconsumptionlineandsoequalt o1–mps;mps=0. 8.Thustheequat i
onof
theconsumpti
onlineisC=10+0. 8Yd.Theequationofthesav
ingl
i
neisS=- 10+0. 2Yd.NB:mpc
+mps=1.
23
 24
Thef
oll
owi
ngt
her
efor
ethechar
act
eri
sti
csofabsol
utei
ncomehy
pot
hesi
s:
1. CandSar establ
efunct
ionsofcurr
entdisposableincome.
2. Therel
ati
onshipcanbeli
nearornon-l
i
near .
3. Thempcliesbetween0and1( 0<mpc<1)
4. Theapcfall
sasincomer i
sesandisgreaterthanthempc.

I
nvest
ment
 I nvestmenti stheflowofout puti
nagivenper i
odt hati
susedt omaintai
norincr
easecapit
al
stockinaneconomy .
 Capi talreferst oaccumul atedstocksofmachi nery
,factori
esandotherdurabl
efactorsof
product i
on..Byi ncreasi
ng capi t
alstock,investmentand spending augmentsthef ut
ure
product i
vecapacityoftheeconomy .
 Fl uctuati
onsi nthef i
rms’play sarol
eindeterminingthelevelofout
putandunemploymentin
theeconomy .
Thefoll
owi ngaret hetypesofinv est
mentspending:
1.FixedBusi nessI nvest ment :Thi smeasur esthespendi ngbybusi nessesonpl ant(thephy sical
struct ur
eoccupi edbyaf actoryorbusi nessof fi
ce)andequi pment( machineryandv ehi
cles).
2.Invent oryI nvest ment :Invent oriesar e st
ocksofr aw materi
al s,unfi
nished goodsi nt he
product ionpr ocess,orf ini
shedgoodsbyf i
rms.I nv entor
yinvestmenti sthechange,i nthose
stockofgoodsi nagi v
enper i
odandar i
seini nvent or
iesimpli
esposi ti
vei nvestmentwhi lea
declinei ninv entori
esi mpli
esdi sinvestment .
3.Invest menti nResi dentialSt ruct ures:Thisi ncludesexpendi turesont hemai ntenanceof
housi ngandont hepr oduct i
onofnewhousi ng.NB:Whenahousehol dpurchasesanexi sting
housef rom ot herhousehol d,noi nvestmentoccur sint er
msoft heeconomyas awhol e,
therei snochangei ncapi t
al stock, onlyinit
s’owner ship.
 Thet otallev elofi nv estmenti sr eferr
edt ogr ossi nvestment.Thatpar tofi nv
estmentt hat
raisescapi tal stocki sreferredt oasneti nvestment .
 Capi taltendt owearoutov ertimeandar eev ent uall
yscrapped.Economi stscallthiscapi tal
depr eciati
on.Ther el ati
onshi pcant herefor
ebewr it
tenas:
I=J+dK- ---
----
--
--
--
-----
--
---
--
---
---
----
----
---
--
--
--
--
--
--
----
--
----
--
---
--
--
--
--
--
--
--
----
-1
wher
eI=grossinvest
ment,J=netinvest
mentanddist
heparameterofdepr
eci
ati
on,say5%
pery
ear
,ther
efore,dK=depreci
ati
onofcapi
tali
nthecur
rentyear
.Thechangecapit
alstock
i
sequal
totherateofneti
nvestment:
K+1-K=J-
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
--
-2
Combi
ningequat
ionsoneandt
wo,
wecanwr
it
ethebasi
ccapi
tal
accumul
ati
onequat
ionas:
K+1=(
1-d)
K+I

I
nvest
mentandt
heRat
eofI
nter
est
:
Onewayofcompar i
ngt heexpectedyiel
dofani nvestmenttoitscostistocalcul
atepresent
valueoft heinv
estmentandcompar ethatwiththepresentcost
.Int
erestisvi
ewedast hemai n
determinantofi nvestment.Ifpresentv al
ue exceeds pr
esentcost,then t
he inv
estmenti s
profi
table;Ot
herwise,i
tisunprof
it
able.
Exampl
e1:
Supposeamachinewhi
chhasonlyaknownl
i
feoft
woyear
sisexpectedt
oyiel
dShs242each
year
.Themachine’spr
esentcosti
sShs400andther
ateofinter
estis10%.Isi
nvest
ment
prof
it
abl
e?

PV>PC,
ther
efor
e,t
hei
nvest
menti
spr
ofi
tabl
e.

24
 25
wecanal souset herateofret
urntocal
culat
etheinv
estmentexpectedandcomparewi
ththe
pr
evail
i
ngr ateofint
erest
.Ift
herateofr
etur
nexceedstherat
eofinter
est,
thei
nvest
mentwil
lbe
pr
ofi
table.Therev
ersealsoappl
ies.
Exampl
e2:
Supposeamachinehasaknownlif
eofonlyoneyearandisexpectedtoyi
eldShs450att
heend
ofthey ear
.Themachine’
spresentcostisShs400andt her ateofint
eresti
s10%.Isthe
i
nvestmentprof
it
abl
e?.Wehavetofindther
ateofretur
n,r,whi
chr ai
sesShs400toShs450in
oneyear.
400(
1+r
)=450.

.Ther
ater
etur
n>r
ateofi
nter
est
,ther
efor
ethei
nvest
menti
spr
ofi
tabl
e.

The aggregat
e i nvest
ment cur ve
i
ndicat
esthatast herat
eofi nterest
fal
ls, more investment pr ojects
Rateof becomepotenti
all
yprofi
tabl
eandt he
I
nterest demandforinv
estmentincreases.

0 I
nvest
ment

 TheMar gi nalEfficiencyofI nvestment( MEI )ist heexpect edr at

eofr eturnf r
om an
addit
ional Shsofpl annedi nvestment .
 TheMEIi sl ikel
yt odecl ineasmor eandmor ei nvestmentpr oj
ectsar eundertaken
because:
i
) mostpr of
itablepr ojectswi l
lnormallybeunder takenfirst
,and
i
i) asi nv estmenti ncr eases,thepr i
ceofi nvestmentgoodswi l
lbebidupwar dsthereby
r
educi ngt heexpect edrateofr et
urn.
 Af al
lint hemar ketr at eofi nter
estshoul dmakepr ofi
tablesomei nvestmentsint he
economywhi ch wer e pr evi
ousl yunpr of
itable so thataggr egateinvestmentshoul d
i
ncrease.Thusaggr egat einvestmenti ninversel
yr el
atedwi thther at
eofinterest
.
 Possibl
edet erminant sofi nvestmentar e:
i
) t her ateofi nterest,
i
i) changesi naggr egat edemand,
i
ii
)pr ofitabili
ty,and
i
v)busi nessexpect ations.

EQUI
LIBRI
UM DOMESTI
COUTPUTI
NTHEKEYNESI
ANMODEL.

Expendi
tur
es-Out
putAppr
oach
 Equil
i
bri
um exi
stswhent hereisnot endencytochange.I tfoll
owst her
efor
et hatnational
i
ncomecanonlybei nequil
ibr
ium whent herei
snot endencyforittor
iseorfal
l.Thiscanonl y
happenwhenplannedexpendi t
ureinoneper iodexactl
yequal stheplannedoutputfort hat
peri
od.Whenthi
sist hecase,producersarerecei
vi
ngbacki nexpenditureontheiroutputan
amountwhichexact
lyequalstheamountt heyhavepaidoutt othefactor
sofpr oduct
ionf or
25
 26
producingout put.
 Plannedexpendi turemustt heref
or ebeequal toplannedout putf orequil
i
brium t
obeachi eved.
Forexampl e,ifplannedexpendi t ureexceedspl annedout put,thent hefir
mswi llexper
ience
disi
nvestmentast heirstocksar edepl eted.Theirresponset ot hi
swi l
lbet orai
seout putin
thefoll
owingper iod,sothatnat i
onal incomewi l
lrise.Thereversealso,‘mutati
smut andi
s’.
 Itisclearthati nequi l
i
brium,pl annedexpendi turei ntheform ofaggr egat
edemand( AD),
mustbeequalt oplannedout puti nthef or
m ofaggr egatesuppl y(AS).Thecanbeexpl ained
as:
AD=C+I +G+X- M
AS=Y
AD=ASi nequi li
bri
um
C+I+G+X- M =Yi nequili
brium
 Diagrammat icall
y,theequili
bri
um canbei l
l
ustr
atedasbel ow:

Expendi
tur
e

AD
E

45o
YE

 Sincebot haxeshav et hesamescal he45o l

e,t inewhi chbisectt hem givest hesetofal l
pointsofequal it
ybet weenpl annedexpendi tureandpl annedout put(nati
onalincome) .It
theref
or eshowsal lpossibleequil
ibr
ium level
sofnat i
onalincomewi thi
nther angeil
l
ustrated.
Atl ev
elsbel ow theequi l
ibrium AD,t hetendencywi l
lbet oi ncreasethev al
ueofnat ional
output.Atlevelsofoutput( income)abov ethis,ADislessthannat ional(i
.e.ADisinsuf
ficient
topur chaset heexisti
ngl evelofout put)andt hetendencywi llbef orthev al
ueofnat ional
outputt ofal
l.OnlywhenYi satequi li
bri
um thatthereisnot endencyf ornat i
onaloutputt o
changebecauseADi sjustsuf f
ici
enttopurchaset heexisti
nglevelofoutput .

LeakagesandI
nject
ions
 Aleakageisawithdr
awalofpotenti
alspendi
ngfrom theci
rcul
arfl
owofincome.Aleakage
occurswhenanypartoftheincomewhi chresul
tsfr
om product
ionofdomesti
cgoodsand
serv
icesi
snotusedtopurchaseothergoodsandser
vices.

MONEYANDBANKI
NG
Despitet
hefactthatweareallfamil
i
arwi t
hmoneyandusei talmostev ery
dayof
ourliv
es,i
tisdif
fi
culttodef
ineexactl
ywhatmoneyisov erthey ears,
av ar
ietyof
commodi t
ieshavebeenaccept edasmoney ,r
angi
ngfrom pr eciousmet alsto
catt
le.Thefactisthatmoneyisasmoneydoes,andt herefor
eany t
hing,whi ch
perf
ormst hefunctionsofmoney ,ismoney .Moneyisameansofpay ment
acceptedinexchange.Itisthusany t
hing,whichi
sgener al
lyaccept ableasa
medium ofexchange,act
sasameasur eofv al
ueandastoreofv alue.

Funct
ionsofmoney
26
 27
1.Medi
um ofexchangeormeansofpay
ment
:
Moneyisuni
queinperfor
mingthi
sfunct
ionsinceitist
heonlyassett
hatisuni
versal
ly
accept
abl
einexchangeforgoodsandserv
ices.I
nt heabsenceofamedium ofexchange,
tr
adecoul
donlytakepl
aceifther
ewasadoubl ecoinci
denceofwants.
2.Uni
tofaccount
:
Moneyal
soprovi
desmeansofexpressi
ngvalue.Thepr
icesquot
edf orgoodsandser
vices
r
efl
ectt
hei
rrel
ati
veval
ueandi
nt hi
sway ,moneyactsasaunitofaccount.
3.Storeofweal
th:
Becausemoneycanbeexchangedimmediat
elyf
orgoodsandser
vices,i
tisa
conveni
entwayofholdi
ngwealthunti
lgoodsandservi
cesarerequir
ed.In
thi
ssensemoneyactasastoreofweal
th.
4.Standar
dofdeferr
edpay
ment:
I
nt hemodernworl
d,goodsareoft
enpurchasesoncreditwitht
heamountt oberepai
dbeing
fi
xedinmoneyterms.I
twouldbeimpossibl
eorimpractical
tofi
xrepaymentinter
m ofsome
othercommodit
y.Itmaynotal
waysbeeasyt opredi
ctthefutur
eavai
labi
l
ityorthefut
ure
requi
rement
softhatcommodity.
5.Tr
ansfer
ri
ngimmovablepropert
y:
E.
g.l
and;housef
rom oneplacetotheot
her
.

MONEYSUPPLY
 Cent r
albankshav ethel egalmandat etoi ssuecur r
ency .Howev er,insomecount ri
es,t here
arenocent ralbanksandt hisresponsi bi
litylieselsewher e,say,wit
ht het reasury.Becauseof
thi
smonopol y,theCent ral Bankhasani nf l
uenceonmoneysuppl y.
 Thecent ralbankdet er
mi nest hesuppl iesoft hemonet arybase( alsor eferr
edt oasbase
moneyorhi gh-power edmoney ),t hatarei nf orm ofcur rencyheld,andf inancialinst i
tutions
reserveshel datt hecent ral bank.
 Par t
soft hemoney( currency )ishel dbyt hepubl icandi scal l
edcur rencyi ncirculationwhi l
e
thebanksaspar tofv aultcash, hol danot herpar t
.
 Moneysuppl yisimpor tant lyinfluencedbyt hecent ralbank’sactionsandi tisalsoaf fected
byf actorst hatar enotundert hecont roloft hecent ralbankl i
kethepor tf
oliobehav i
oroft he
commer cialbanksandt hepubl ic’
spr eferencet ohol ddiffer
entf i
nanci alasset s( currency ,
demanddeposi ts,et
c) .
 Ther easont of ocusont hecent ral bankbal ancesheeti stoseehowcent r
al bankoper ations
affectt hest ockofhi gh-power edmoney .Cr eatingliabil
i
tiescreateshi gh- power edmoney
whent hecent ralbankr equi resasset sandpay sfort hem.Twomai ncl assesofl iabi l
i
tiesof
thecent r
al bankar ecur r
encyandbankdeposi t
satt hecent ralbank.
NB: Moneysuppl yconsistsofM1whi chr efer stocur rency(coinsandpapermoney )int he
handsoft hepubl icandal lcheckabl edeposi ts( alldepositsincommer ci
al banks)

BankDepositandt heMoneySuppl y
 Bankdeposi tscomei nt
obeinginthreeways:
1.Whenabankr ecei
vesadepositofcash
2.Whenabankbuy sasecuri
ty
3.Whenabankmakesal oan
 Onei mportantaspectofbankdeposi tcr
eat
ionsisi
tseff
ectonmoneysupply
.
Theexamplesbel owrecor
dt heini
ti
alimpactofa$100creati
ononthebanks
asset
sandl i
abili
ti
es:
a)Whenabankr eceiv
esadepositof$100cash, theeff
ectonit
sbal
ancesheet
i
s:

Li
abi
l
iti
es Asset
s

27
 28
Deposits+$100 Notes&coins+$100
Inthiscase,i ti
scl eart
hatadeposi tofcashhasnoi nit
iali
mpactonthe
moneysuppl y.Thesameamountofmoneyexi sts,itissimplyheldina
dif
ferentform.Anindivi
dualhassimplyexchanged$100.
b)Whenabankbuy ssecurit
yof$100, t
heeffectonit
sbalancesheetis:
Li
abili
ties Assets
Deposits+$100 Securi
ti
es+$100
Here,thebankspur chaseof$100i ncreasesthemoneysuppl yby$100.Thi
s
i
sbecausesecur it
ies,whicharenotaccept ableinexchangeofgoodsand
servi
ces,havebeenexchangedf orabankdepositwhichisacceptabl
e.
c)whenabankgr antsaloanof$100, theeff
ectonitsbalancesheeti
s:
Li
abili
ties Asset
Deposits+$100 Advances+$100
Again,t
hegrant
ingofa$100loanincr
easesthemoneysuppl
yby$100.Thi
smustbesobecause
deposit
s,whichareimmediatel
yacceptabl
einexchangeforgoodsandservi
ces,hav
ebeen
exchangesf
oradebt(anadvance)whichi
srepay
abl
eatsomef ut
uredat
e.

Whatbacksmoneysuppl y?
 Themoneysuppl yinanystateisessenti
allybackedbyorguar
anteedbygovt.abil
i
tyt okeep
thevalueofmoneyr el
ati
vel
ystable.Thi
simpl i
esthegovt
.mustbef undamental
l
ycapabl eof
enfor
cingthetool
satitsdisposaltoguaranteejustt
heri
ghtamountofmoneyi ncirculat
ion.
Thistheref
orewil
lensurestabi
li
tyinthev al
ueofmoneyandst abi
li
tyinpri
cesofgoodsand
servi
ces.

TheDemandf orMoney .
Ther
eare3maj ormot i
v esunderlyi
ngt hedemandf ormoney:
a) Transacti
onsmot i
ve,whi chist hedemandformoneyarisi
ngf
rom t
heuseofmoney
i
nmaki ngr egularpayment s.
b) Precauti
onar ymotive,whichi sthedemandformoneytomeetanyunfor
eseenneeds.
c) Speculati
vemot i
ve,whi chr esult
sfrom t
heuncertai
nti
esaboutt
hev alueofother
assetsthatani ndi
vidualcanhol d.
NBAssetdemandf ormoney :

Dt
Rateof Rateof
I
nter
est I
nter
est Rateof
I
nter
est

Dm

Da

Amountofmoneydemanded Amountofmoneydemanded Amountofmoneydemanded

Tr
ansact
ionsdemandf
or Assetdemandf
ormoney Tot
aldemandf
ormoney
money
Measur
esofMoneySuppl
y
M1=Cur
rency+Checkabl
edeposi
ts(
Demanddeposi
ts)
28
 29
M2=M1+Nearmoni es(Cer t
ainhi
ghli
quidfinanci
alassetst hatdonotf unct
iondir
ectl
yorfull
y
asamedi um ofexchangebutcanr eadil
ybeconv ertedintocur rencyandcheckabledeposi
ts).
Nearmoni esincl
udesav ingsaccountdeposi ts,ti
medeposi ts,moneymar ketmutualfunds
(MMMF),i.
e.,bymakingtelephonecall
s,usingtheinternet
,orwr it
ingachequef or$500ormor e,
adeposi
torcanredeem shar esinMMMFof f
eredbyamut ualcompany .
Ther
efor
e, M2=M1+Sav i
ngsdeposit
s+Ti medeposi ts+MMMFs
M3=M2+l arge($100,000ormor e)Timedeposi ts

Clear
ingSyst
em:
Refer
stotheprocessbywhi
chbanksset
tl
ecl
aimsandcount
ercl
ai weent
msbet hemsel
ves.

TheMoneyMar
ket
Wecancombi nethedemandf ormoneywi tht hesuppl yofmoneyt opor t
rayt hemoneymar ket
anddetermi net heequili
bri
um rateofi nterest.Themoneymar ketisthust hemar keti nwhi cht he
demandf orandt hesupplyofmoneydet erminet her ateofi nterest(orthel evel ofinterestr ate)in
theeconomy .
 Weal lmakebasi cportf
oliochoi ce;weei therhol dourmoneyorputi ttowor k.Peopl ehol d
(demand)money( m1)bykeepi ngcashi nt heirwal l
etsormai ntainingposi tivebal ancesi n
theirtransact i
onaccount s.Moneykepti nt hisf or m earnsl it
tleornoi nt
er est.Howev er
,
moneyl entt osomeoneorusedt obuybondsi slikelytoear nahi gherr ateofi nterest.The
choicet hereforeistohold(demand)moneyort ousei t
.
 Peopl ehol dingmoneyar ef orgoinganoppor tunitytoear ninterest.Thesameappl iest o
peopl ewhohol dmoneyi nchecki ngaccount s.
 Thet hreemot i
vesofdemandf ormoneycr eat et hemar ketdemandf ormoney .Peopl ecuton
theirmoneybal anceswheni nterestr at
esar ev eryhi gh.Atsucht i
mes, theoppor t
uni t
ycostof
holdingmoneyi ssimplytoohi gh.
 Themar ketdemandcur vef ormoneysl opesdownwar dsf rom lef ttor ighti ndicatingt hat
quant i
tyofmoneypeopl earewi lli
ngandabl et ohol d( demand)i ncreasesasi nterestr ates
fal
l,ceterisparibus.Thediagram bel owi l
l
ust rat est his

Al
lpoi
ntsont
hemar
ketdemandcur
ve
r
epr
esentt
hequant
it
yofmoneypeopl
e
ar
ewi
l
li
ngt
o hol
datspeci
fi
cint
erest

Money
Demand

q1 q2

 Inpr actice,theposit
ionoft hemoneysuppl ycurvedependsont hecent ralbankr eserv
e
policy,t he lendi
ng behavioroft he pri
v at
e commer cialbanks and t he wil
li
ngness of
consumer sandt hewil
li
ngnessofinvestor
st oborr
owmoney .
 Ifthecent ralbankdecidestosupplythesameamountofmoneyatal lratesofinter
estthen
thesuppl ywoul dbeper f
ectl
yinelasti
c.Thepoi ntofi nter
secti
onofmoneydemandand
moneysuppl ycurvesistheequil
ibri
um r ateofinter
est.Att hi
spoint,themoneydemand
quant it
yofmoneysuppl i
edequalst hequant i
tyofmoneydemanded.Thedi agram below
i
llustratesthMo
is ney
Supply

Atequili
bri
um rateofinter
estpeopleare
wil
li
ngt oholdasmuchmoneyasi s
avai
lable.Atanypointabov ethe
29
equi
libri
um (E),t
hequant i
tyof money
peoplearewi l
l
ingtohol dwillnotbe
equal t
hequantityavai
labl
e, andpeopl
e
wil
ladjustthei
rportf
olios.
 30

Money
Demand

M Quant
it
yofmoney

NBLiquidi
tytrap:t
hepor t
ion
ofmoneydemandcur v
ethat
i
shor i
zontal
,peopleare
I
nter
est
Rate wil
li
ngtoholdunl i
mited
amountofmoneyatsome
(l
ow)inter
estrate.
Money
Demand

M1 M2

THRIFTINSTITUTIONS
 Sav ingsandl oanassociati
ons,mut ualsavingsbanksandcr edi
tuni onssuppl ementthe
commer cialbanksandar eknowncol lect
ivelyassav i
ngsort hrif
tinsti
tuti
onsorsi mply
“thr
ift
s”.
 Sav ingsandl oani nst
it
uti
onsandmut ualsavingsbanksacceptt hedeposi tsofhouseholds
andbusinessesandt henuset hefundst ofi
nancehousi ngmor tgagesandt oprovideot
her
l
oans.Cr editunionsacceptsdepositsfrom andl oanmember s,whoar eagr oupofpeople
whowor kf orthesamecompany .Theyalsoof f
ercheckabledeposits.

BanksandThr i
ftFai
lures
Banksandt hri
ftsofferfinancialser
vicestov ari
ousstakeholders.Alt
houghbanksandt hr
if
ts
remaintheonlyinst
ituti
onsthatof f
ercheckabledepositsthathavenor est
ri
ctionsoneit
herthe
numberorsi zeofcheques,t hei
rsharestot otalfi
nancialasset
s( val
ueoft hingsowned)are
decl
ini
ng.
(Ref
.McConnel Page246)

Cr
editCreat i
on
 Cr editcreati
onist heprocessbywhi chbanksar eabletoincreaset hevol
umeofcr editby
grantingloans.Thepr ocessr esultsinanincreaseinthevolumeofbankdeposi tsandhence
i
nt hemoneysuppl y.
 Ther eceiptofnewcashbyt hebanki ngsystem mayl eadtomul t
ipl
eexpansionoft hebank
l
endi ng,andmul ti
pleincreasei nmoneysuppl y.Thi
sisbecausemostoft hemoneyl entto
oneper sonwi l
l,
whenspent ,findi t
swaybackt othebankingsy stem.Ther eceiptsof
borrowedmoneygener al
lydeposi ti
nthei
rownbankaccount s.Thisistheprincipl
eofcr edit
creation.
 Assumeahy potheti
caleconomywi thasinglemonopol ybank, whichobservesami nimum
cashr ati
o.Supposet hebankwi shestomai ntain10%oft otaldepositsincashi norderto
meetdayt odaydemandsofi tscust omers,thenthebanksi nit
ialposit
ion(balancesheet )wil
l
30
 31
beasbel
owi
ftot
aldeposi
tamount
stoUS$10,
000

TheBank’si
nit
ial
bal
ancesheet
Li
abil
it
ies US$ Asset
s US$
Deposi
ts 10,
000 Cash 1,000
LoansandI
nvest
ment 9, 0000
10,
000 10,000

Credi
tMul
ti
pli
er:
Refer
stot
hemul t
ipl
esbywhi
cht
otal
bankdeposi
tsi
ncr
easer
elat
ivet
oanewcashdeposi
t.

FI
NANCI
ALMARKETSI
NKENYA
 Af
inanci
almar
keti
sthet
otalsum ofal
lcapi
tal
,moneyandsecur
it
ymar
keti
nst
it
uti
ons
operat
ingagi veneconomy.Thisalsoi
ncludei
ndi
vidual
s,companies,i
nst
it
uti
onsandt he
govt.whobuy( bor
row)andsell(l
end)moneytodi f
fer
entpart
iesatapr i
ce( i
nter
estor
di
vidends)det
erminedbymarketfor
cesofdemandandsupplyofmoney.
Fi
nancial
mar
keti
n
Kenya

Foreign Capi
tal Securi
ty
Monetary Exchange
market Markets
Markets Mar ket
s

Di
scounti
ng Cent
ral Fi
nanci
al St
ock
Houses Bank I
nsti
tut
ion Exchange
s (pr
imary
and
secondary
marketfor
Buil
ding
BureauDe soci
eties
Governmen Change
ttr
easury
bi
ll
sor
bonds
Govt.
Mort
gag Bondsand
e Stocks
Fi
nance

Commerci
a
NSSF Bondssold
byfi
nancial
lbanks i
nsti
tut
ions

Tr
ust
ee
Or
gns Debenture
s,bi
ll
sof
exchange,
Commer ci
a
promissor
lBanks ynotes

31
Buy
ersmaybei
ndi
vi
dual
scompani
esort
hegov
ernmentandbanks
 32

CENTRALBANK&MONETARYPOLI
CY

Thi
sisabankestabli
shedandmanagedbyt hegover
nmentt ocont
rolandgui
de
theotherf
inanci
alinsti
tut
ionsi
nt hecountr
yand par t
icul
arl
yto advi
cethe
gover
nmentonmat t
ersoffi
nanci
alnat
ureandimport
ance.

Funct
ionsofcent
ral
Bank
1)Issueofcur rency:Thecent r
albanki st hesol ecur rencyi ssuei naut hor i
tyina
count r
y .Thi sf unct i
ondemandsahi ghdegr eeoft rustandef fi
ciency .Itis
i
mpor t
antt okeept heact ualpr ocessofpr i
ntingnot esandmi nt i
ngcoi nsa
secr etsoast ohav ej ustt herightamountofmoneyi nci rculation.Toomuch
moneywi llcausei nf l
at i
onandt ool i
ttleofi twill causedef lati
on.
2)Bankert ot hegov ernment :Thecent ralbankpr ov idesbanki ngf aci l
iti
est othe
gov t.int hesamemannert hecommer ci albanksdoest ot hepubl ic.
3)Bankert ocommer cialbanks:Ot herbanksandf i
nanci ali nst i
tutionsmai nt
ain
anaccountwi ththecent ral.Thesebanksoper at et heiraccount si nthesame
wayasani ndivi
dual oper ateshi saccount swi t
ht hecommer cialbank.
4)Adv i
sort othegov er nment :Thecent ralbankt hr ot hemi ni stryresponsi blefor
financi alaf fairsist hesol ebodyt ot akedeci sionsoff i
nanci alnat ur e.The
gov t.isheav ilyreli
esont headv iceoft hecent ral bank.
5)Exchangecont rol
:Themeasur et akenbyt hegov t.t or est r
ictt heout flow of
moneyt oot hercount ri
esi sdonebyt hecent ralbank.I tist hedesi reoft he
gov t.t oal l
ow asl i
ttlemoneyaspossi blet ol eav et hecount r
y .Themai n
obj ectivei st omai ntainaheal thybal anceofpay ment .Duet ot hisr easont he
commer cialbanksar er equi r
edt opr ov ideper iodi cr ecor dt ot hecent ralbank
i
nt heirfor eignexchangedeal i
ngs.
6)Lenderofl astr esort :Thecent r albankext endsf inanci alaccommodat i
ont o
banks i n case ofemer ges t o commer ci
albanks.The happens when
commer cialbanksar etempor allyinshor tofcash.
7)Cr editcont rol:Thi si st he cont rolling oft he l endi ng capaci ty oft he
commer cialbanksandot herf i
nanci ali nst i
tutions.Becauseexcessi vesuppl y
ofcur rencyi ntotheeconomywi l
lbehar mf ult oeconomi cdev elopment ,i
tis
i
ncumbentupont hegov ernmentt hrought heCent r
alBankt oensur et hat
ther eisj ustt her ightamountofmoneyi nci rcul ationi ssuedi nt hef or m of
credi ttot hev ar
iousst akehol der s.

Themet
hodsempl
oyedt
ocont
rol
credi
t
1)Raisi
ngt hebankr ate:Thisist herateatwhi chtheCB( centralbank)lendsis
money t othe commer ci
albanks.When t he bank r atei sr aised,the
commer ci
albankswi ll
alsoraisetheirl
endingr at
esandv iseversa.
2)Raisi
ngt heliqui
dit
yr ati
o:Thecent ralbanki nstr
uctst hecommer ci
albankt o
ret
ainacer tainportionoft heirdeposit
si ncashf orm.Thi st endstor educe
thelendingcapacityofthecommer cialbanks.
3)Compul soryorspeci aldeposits:Thecent ralbanki nstructsthecommer cial
bankst odepositwi t
hitacer tainpartoftheirdeposit.Thisthereforereduces
32
 33
thelendingcapaci tyoft hecommer ci
albanks.
4)Selecti
vecont r
ol:Iftherei stoomuchmoneyi nci r
culat
ion,thecentralbank
cani nstructcommer ci
albanksandot herf i
nanciali
nstit
ut i
onstoappr ove
l
oanst oonl yaselectedi ndustr
y.
5)Openmar ketoperation:Thecent r
albankcani nstr
uctcommer ci
albanksand
i
ndividualst oparti
cipatei nbuyinggovt.securi
ti
es.Thiswi l
lreducethemoney
thatbankshav eforlendi ngandt hatwhichindi
vidualswil
lhav etospend.
Cent
ral
BanksBal
ancesheet

Simpl i
fi
edbalancesheetoft
hecent
ral
bank
Asset s Li
abilit
ies
ForeignAsset s Deposi t
sofbanks
Loanst oBanksDepositsofgov
t. Deposi t
sofgov t
.
Gov t
.securit
ies Currencynot esandcoi ns
Loanst ogovt. Foreignliabil
it
ies
OtherAssets Otherliabil
it
ies
Total Asset
s( sour
ces) Total l
i
abi l
i
ties(uses)

Inaconsi der atecent r albanksbal ancesheet ,asset scompr iseof

1) Netf or eignasset s
2) Netcl ai msi ngov t.
3) Netcl ai msoncommer cial banks
4) Netot heri t
ems
Theliabilitiescompr iseofmonet arybase,whi chi st hesum ofcur rencyissuesandcommer cial
banksr eser vesatt hecent ral bank.
NB:For eignasset sarehel dbyt hecent r
al bankduet o:
1) Topayf orgov t
.impor t sandext ernaldebtser vicing
2) Asameanst oi nt ervenei nt hef oreignexchangemar keti nor dert ost abi
lizet hev al
ueof
domest i
cmoneyv is-
av isitspeg.
3) Of tenusedt ogauget hecapaci tyoft heeconomyt owi thstandanyext ernalordomest i
c
stocks.
 CBmakesl oanst of inanci alinst i
tutionsl i
kebankst oenabl et hebor rowi ngi nst i
tutionmeet
itsliqui di tyshor t
age.Thesel oansconst i
tuteanassetf ortheCB.
 I ni tsf unct ionasabankert ot hegov t.,CBal somakesl oanst othegov t.Nowaday s;these
bor rowi ngsar el egal lyst ipul ated tol i
mi texcessi ve borrowi ng byt he gov t.These al so
const i
tut eanassett ot heCB.
 Gov t
.secur iti
esar eanot herassetoft heCBacqui redthus, anopenmar ketoper ati
oni nwhi ch
thecent ralbankpur chasesTr easur ysecur i
ti
esf rom t hepubl icr athert handi rectl
yf rom t he
Treasur y.I nsomeeconomi es,cent ralbanksal lowedt opur chaseTr easur ysecur i
tiesf rom
theTr easur y .
 CBshol dbanker ’sdeposi t
sandgov t.deposi t
sbecauset heyactast heirbanker s.
 For eignl i
abi l
iti
esr epr esentshor t
-term obl igationsbyt hecent ralbankst of oreignsour ces.
Thel ar gestf orei
gnl iabi l
itiesofcent ralbankofKeny aar einrespectt oKeny a’sr elati
onswi th
theI nt er national Monet ar yFund( IMF) .
 Ot herasset smayi ncl udef ur niture,bui ldings, vehi cles,etc
 Cur rencyandnot esf or m par toft hemonet arybase( canal sober eferr edt oasbasemoney
orhi ghpower edmoney )
Monet aryPol icy
 Thi sr ef er stot heuseofmoneyandcr editcont rol stoi nfl
uencemacr oeconomi cact i
vit
y ,i.
e.,
itconsi st sofpol iciesdesi gnedt oinf luencet hesuppl ymoneyand/ori tspr ice’(ther ateof
interest ).
 Thef igur ebel owi llustr atest hei mpactofmonet arypol i
cyont heequi li
br ium rat eofi nterest.

33
 34

S1 S2
I
nter
est

r
ate(
%

pery
ear
) Demandf
ormoney

M1 M2 Quant
it
yofMoney(
bil
l
ionsofdol
l
ars)

Assumet hatt hemoneysuppl yisinitial

lyatM1andt heequi li
bri
um r ateof
i
nter estis7%( E1).Thecent r
albankt heni ncreasest hemoneysuppl ytoM2,by
l
ower ing the r eserver equirement,r educi ng the discountr ate,ormost l
y,
purchasi ngaddi ti
onalbondsi nt hemar kett hroughOpenMar ketOper at
ions.The
i
mpactoft his expansi onarymonet arypol i
cyi s evi
dent.Ift he mar ketDD
(demand)f ormoneyi sunchanged, t
hel ongermoneysuppl ywi l
lbringaboutnew
equilibri
um atE2.Att hisintersect
ion,themar ketrateofint
erestis6%.Henceby
i
ncr easingmoneysuppl y,theCBt endst olowerequi l
i
bri
um rateofi nt
erest.Or,t
o
putt hemat t
erdi ff
erently,peoplearewi lli
ngt ohol dlar
germoneybal ancesonly
atloweri nterestrates.
 Wer etheCBt or ever
set hepolicyandr educet hemoneysuppl y,i
nterestrat
e
woul dr i
se.

I
nter
estr
atesandspendi
ng
 I
nvestmentdecisi
onsoff ir
msar esensi
ti
vetotherateofi nt
erest.Lower
i
nterestrat
es reduce the costofbuy i
ng pl
antand equipment,maki ng
i
nvestmentrat
ewi l
lresulti
nprof
it
abl
e.Thus,al
oweri
nter
estratewill
resul
tin
ahigherr
ateofdesir
edi nvest
mentspendi
ngasshowninthediagramsbelow.

(
a) An i
ncr
ease i
n money (
b)ar
educt
ioni
nr (
c) Mor
e i
nvest
ment
C+I
2+G
suppl
ylower
sint
erestr
ate(
r) st
imul
ates i
ncr
eases aggr
egate
Expendi
tur
e C+I
1+G
I
nter
est
7 I
nter
est
7

6 6 I
nvest
men
tDemand
Money
Demand

I
1 I
2
I
ncome(
Out
put
) Yf
M1 M2 Rat
eofI
nter
est
Quant
it
yofmoney
 Theincr
easedinvestmentbroughtaboutbyloweri
nter
estr
atesr
epr
esentsan
i
ncreaseint
otalspendingasillust
ratedi
nfi
gur
eCabov e
Accordi
ngtoKey nesi
anper specti
v e,t
heCBsobject
iveofsti
mulat
ingthe
economyisachievedin3distinctsteps:
34
 35
1.Ani ncr easei nmoneysuppl y
2.Ar educt ioni ntheint erestrate
3.Ani ncr easei naggr egat espending
 Ift he pr ice levelr emai nsconst ant(asKey nesassumed) ,the increases
spendi ngi mpliesani ncreasesquantit
yofgoodsandser vi
cesdemanded, i.
e.,
shifti nADaswel l
.
 Loweri nterestratesmi ghtalsost i
mulateconsumerspendi ng.Househol d
appl iances,car s and ot herexpensive goods are of
ten pur chased with
borr owedmoney .
 State and l ocalgov ernments are part
icul
arl
ysensi
tiv
et o moneymar ket
condi t
ionsandmaypost poneplannedexpenditur
eswheni nt
er estrat
esar e
toohi gh.

Ef
fect
ivenessofmonet
arypol
i
cy
According tot he abov ei l
lustr
ations,monet ar
y policy can be an effect
ive
mechani sm f
oralter
ingt herateofaggr egatespendi
ng.Monet ar
ypol i
cydoesnot
al
way s succeed so easi lylike thataccor di
ng to Keynes.He st r
esses that
ef
fectivenessofmonet arypol i
cyisdependenti ntwodisti
nctphenomena:
1.Thesensi tivi
tyofinterestratetochangesi nthemoneysuppl y(ref.Fi
gure(a)
abov e)
.
2.Thesensi t
ivi
tyofspendi ngdeci sionst ochangesint heint
erestrates(fi
gure
(b)above).

UNEMPLOYMENTANDI
NFLATI
ON
 Accor di
ngt otheI nternati
onalLaborOf fi
ce( I
LO),unempl oymentr eferst oapoolof
peopleabov easpeci fi
edagewhoar ewi t
houtwor k,arecur rentl
yav ailablef orwor k
andar eseekingwor kdur i
ngaper i
odofr efer
ence.
 Allthreeconditi
onsmustbepr esentforaper sontobeconsi deredasunempl oy ed.A
personmustt akecl earact i
onsi npur suitofaj ob.Suchact i
onsi ncluder egi stration
atempl oymentof f
ice,appl icati
on to empl oy er
s,checki ng atwor ksi t
es( f
arms,
factorygates,mar ket,etc)andpl acingorr espondingt onewspaperadv erts,et c.
 Theunempl oymentr atereferstot henumberofunempl oyedpeopl easapr opor tion
ofthel aborforce.Thel aborf orcer ef
erst oallthosewi t
hwor kandal lthoseseeki ng
work,i .
e.,t
hesum ofempl oyedpl ust heunempl oyed.Individualst hatar enei ther
empl oyednorseeki ngwor kar econsideredt obeoutoft hel aborf orce.

Ty
pesofUnempl
oyment
1.Fri
ct i
onalunempl oyment :Thi st ypei sassoci ated withnor mall abort urnover
.I t
occur sbecausewor kersv acatecer tai
nj obsandsear chf orothers; orbecausesome
wor kersleavethelabormar ket,thusv acat i
ngjobs, whi
lenewent r
ant sdonotposses
theski l
lsrequi
red.
2.Structuralunempl oyment:Thi siscausedbyachangei nthest ruct ur
eofdemand.
Whendemandf orani ndust r
y’spr oductf al
lsandout putcont r
act s,thenumberof
wor kers employed int hati ndust ryf all
s.Because par ti
cularr egions,st r
uctural
unempl oy mentoftenleadst oregional unemployment .
3.Seasonalunempl oyment :Thisdemandf orcertainproductssubj ectt or egularand
predictablef l
uctuati
ons i n unempl oyment ,e. g.therei s great er demand f or
const r
uctionworkersinthesummermont hsthani nthewi ntermont hs.
35
 36
4.Cycli
calunempl oyment:Thi st ype of unempl oy ment i s associated wit
ht he
downsi zing of t he t r
ade cy cle. Iti s somet imes cal l
ed demand def icient
unempl oy mentbecausedur ingt hedownsi zingoft hecy cleaggregatedemandf all
s
andisinsuf f
icientt opurchaset hef ullempl oy mentl evelofout put.
 Mor erecent ly,v iewsont hecausesofunempl oymenthav echangedandf ol
lowi ng
categoriesar eal way sident i
fi
ed.
5.Voluntaryunempl oyment :Thi siscausedbyt heoper ati
onoft het axandsoci al
securi
tysy stem.I t
’sdif
ficulttoest i
mat et heext entoft his,butthereisnodoubtt hat
theextentofi ncent i
veformanyunempl oyedwor kerstoacceptempl oy mentisv er y
l
owi ndeed.
6.Realwageunempl oyment :Ther ei squi teawi delyhel dv i
ew thatagr eatdealof
unempl oy menti scausedbyr el
ativel
yhi ghr ealwages.Wor kerspri
cet hemselv
esout
ofjobs.
7.Residualunempl oy ment:Thi sisthel abelgiv ent othatgr oupofunempl oyedwor kers
whosuf ferf rom ment alorphy sicaldisabiliti
eswhi chmayl imitthenumberofj ob
opportuni t
iesav ail
abletot hem.
Def
ini
ngf
ullempl
oyment
 Ful lempl oy mentr efer
st otheuseofal lavail
abl
er esourcesto producewant-
satisfyi
nggoodsofser vi
ces.
 I t
’st hesituati
oninwhi chtheunempl oymentr at
eandequalt ot
hefullemployment
rateandt here’
sf r
icti
onalandrealGDPoft heeconomyequal spotent
ialout
put.
Fullempl oy
mentunempl oymentrate:Thisistheunemploymentrateatwhichther
eisno
cyclicalunempl oymentoft helaborf
orce.Iti
s1.14%and5%i ntheUSAbecausesome
fr
ictionalandst ructur
alunempl oymentunav oi
dabl
e.

Measur
ingunempl
oyment
:

Cost
sofunempl
oyment
(
a)Socialcost s of inv olunt ary unempl oy ment ar ei ncalculable.Many l ong-term
unempl oyedbecomebor ed,i dle,l oset heirf riendsandsuf f
erf r
om depr ession.I n
count r
ieswi t
houtwel farepr ov i
sionst ot hepoor ,unempl oy mentmaybev erymuch
moresev ereineffects.I tmayl eadt oaconsi der abledegr eeofsoci aldepri
v at
ionand
ami serableexistencef ort hef ami li
esinv ol vede. g. ,
starvation.
(
b)The cost s ofbot hv olunt ary and i nv olunt ary unempl oy mentt ot he Exchequer
consistsof:
(i
) Benef it
swhichhav et obepai dt ot heunempl oy edinsomecount r
ies,
(i
i) Thel ossoft axr ev enueswhi ch woul d ot herwisehav ebeen r eceived;t his
consi st
sofl osti ncomet ax ,andal soi ncl udesl ossofi ndi
recttaxesbecauseof
thereduct i
oni nspendi ng.
(i
ii
)Thecost sofnat ional insur ancecont r
ibut ions
c)Thee
( conomi ccostofunempl oy mentr epr esentawast eofr esourcesandmeanst he
economyi sproduci ngal owerr ateofout putt hani tcoul ddoi fther
ewer ef ul
l
empl oyment .Thist heref orei nhibitst her ealizationofpot ent i
aloutput(thatr ateof
GDP, whichwoul dr esul tifal lr
esour ceswer ef ull
yempl oyed) .

36
 37

I
NFLATI
ON
 Infl
ati
onreferstoaper si
stenttendencyf orthegeneralpr
iceleveltori
se.I
nflat
ion
affect
severybodyinonewayoranot her.
 Infl
ati
oncanhav eadverseeffect
sont heeconomyandi tmaygi v
er i
setothefearof
a hy per
inf
lati
on(av eryrapidl
yaccel er
atinginf
lat
ionwhi chusuall
yleadstot he
breakdownoft hecountr
y’smonet ar
ysy st
em)
Ef
fect
sofi
nfl
ati
on:
 Inf
lationcanei therbeant icipat edorunant icipat ed.
 Anticipat edi nflat ioni si nflat i
ont hatal lgr oupsandi ndiv idual sint heeconomyar e
ablet opr oduct .Theyabl et her ef oret opr otectt hemsel v esagai nsti tandsoi twi l
l
havenoappr eci abl eef fectont hedi st ri
but ionofi ncomeandweal thint heeconomy .
 Unant icipat edi nf lationi st hatwhi chgr oupsandi ndividual si ntheeconomyar enot
abletopr edi ct.Theyar enotabl et herefor et opr ot ectt hemsel vesagai nsti t.
 Inf
lationmaybeunant i
ci pat edi f
(a)Ther ei sagener alf ailureont hepar toft heeconomyasawhol et opr edictt he
inflat i
oncor r ect lysot hatt heact ual rateofi nflat i
onexceedst heexpect edr ate.
(b)Cer t
ai ngr oupsori ndi v i
dual si ntheeconomyf ai ltopr edi ctthei nflationcor r
ect ly
sot hatt heyseekl owermoneywagei ncr easest hatar eact uallynecessar yt o
mai ntainr eal wages.
(c)Cer t
ai ngr oupsori ndi vidual scor rect lypr edi ctt hei nfl
at ionbutar eunabl et ogai n
full compensat ionf ori t( e.g.weakuni onorf ixedcont ribut i
oni ncomesear ned) .
 Wher et hei nf l
at i
oni sunant icipat ed,t her ewi llbear edi st r
ibut i
onef fect ,i.e.,some
peoplewi llbemadebet terof fwhi leot her smadewor se- off.Ther edi stribut i
on
eff
ect sofunant icipat edi nf lationar e:
1.Fi xedi ncomeear ner se. g.r entali ncomeorany oner elyingont her etur nf rom
fixed- interesti nv est ment swi l
lf i
ndt her ealv alueofhi sorhermoneybei ng
er oded byi nf lationmor eov er,weakuni oni zed wor ker swho cannotgai nf ull
compensat i
onf orpr icer i
seswi llloseatt heexpenseofst ronguni oni zedwor kers
whocandoso.
2.Lender swi lll osewhi lebor r
ower swi llgai nbecausewhendebt sar er epai d,t heir
realv aluewi llbel esst hant hatpr ev ail
ingwhent hel oanswer emade.Ev enwher e
inter esti spay abl e,bor rower swi llst i
llgai ni ft henor malr ateofi nter esti sl ess
thant her ateofi nflat ion, i.e.,asi tuat i
onwher et her eal rat eofi nteresti snegat ive.
3.Asmoneyi ncomesr ises,ear nerswi tht hesamer eali ncomemov ei nt oahi gher
taxbands( unl esst her ear eadj ust ed)andt opayabi ggerpr opor tionoft heir
incomei nt ax.Thi si sknownasf i
scaldr ag.I tappl iest o acount rywi tha
pr ogr essi vei ncomet axsy stem.
4.I ft hegov ernmenti st ryingt ocont roli nflat i
onbymeansofpr i
cesandi ncomes
pol icy ,i
tmaysetanexampl ebyr esistingt hewagecl aimsofpubl icempl oy ers.If,
howev er ,privat eempl oy er sar emor ewi l
lingt oconcedet owagei ncr eases, there
wi llber edist ribut ionf rom publ icsect orempl oy erst opr ivatesect orempl oy ers.
Thi showev er ,dependsont her elat i
v est rengt hsoft hepubl icandpr i
v at esect or
uni onsandont heabi l
ityoft hepr ivatesect ort opr ovidewagei ncreases.
5.I fwagedemandsar enetbysqueezi ngpr of i
tmar ginst hent heshar eofpr ofitsin
thenat i
onal incomewi llfal landt heshar eofwagewi l
l rise.
Ot
hercost
s:
6.Admi nistr
ati
vecostsofadjust
mentandt heinter
nat
ionalef
fects:
withinf
lat
ion,
bothfir
msandhousehol dsincurcostsofadjust
ingtothenewset sofpri
ce.The
acti
onsoft heunionshavetheeffectofr
educingtheeconomy'’t
otalout
put(e.g.
str
ikes,go-sl
owsandwor ki
ngt orule)

37
 38
 Acount
rywi
thaf
ixedexchanger
atebutwi
thaf
ast
err
ateofi
nfl
ati
ont
hani
tst
radi
ng
parti
esisli
kelyt
odevel
opadef i
citonit
sbalanceofpaymentsbecauset hedomest i
c
i
nflati
on makes it
s exportsless competit
ive and it
si mport
sr el
ati
vel
y mor e
compet i
ti
ve.Thisdefi
citisl
ikel
yt odepl
etet hecountry’
sreserves.Withflexi
ble
exchangerate,t
hecountrywi
thfasteri
nfl
ati
oni sl
ikel
ytoexperi
enceadepr eciat
ing
currency
.

Causesofi
nfl
ati
on
1)DemandPul
li
nfl
ati
on
Thisoccurswhenaggregatedemandexceedsaggregat
eoutputattheexi
sti
ngpri
celev
el.It
’s
thusexcessdemand,whichini
ti
atesi
nfl
ati
onar
ypressur
e.Thediagr
am bel
owi l
l
ust
rat
esthis:
Anincreaseinaggr egat
edemandshif
tsthe
AS ADcur vetot heright.Att
heori
ginalpr
ice
l
evelOP1,t hereisexcessdemand,whi ch
P2 pul
lsthepri
cel ev
el uptoOP2.

P1 AD2

AD1
0
Y1 Y2

2)CostPushI
nfl
ati
on:
 Thisoccurswhenpressureonpr i
cesresul
tsfrom anexogenousri
seincost
se.g.
ri
singmoneywagesorot herproduct
ioncostsli
kecostsofimport
edrawmateri
als
arepassedtot
heconsumer si
nf or
m ofhighpri
ces.
AS2

AS1
Risi
ngproducti
oncostsshif
ts
theAScurvetot hel
eftf
rom AS1
P2 toAS2.WithunchangedAD
curvethepri
celevel
ispushed
P1 from OP1toOP2.
AD

0
Y1 Y2

Phi
l
li
psCur
ve.
Thi
sisacur
ve,whichdepi
ctst
hei
nver
ser
elat
ionshi
pbet
weenunempl
oymentr
ateof
moneywageandinfl
ati
on.

Annual
per
cent
age
change i
n
38
pr
ices
 39

Unempl
oyment

TheMonet
ari
stsTheor
yofI
nfl
ati
on.
 To the monet arists,sustained and sev er
ei nfl
ation can be produced only by
excessi
veincreasesi nthemoneysuppl y.
 Fri
edmanar guedt hat“i
nfl
ationisalway sandev er
ywher eamonet aryphenomenon”.
Hedev el
opedexpect ati
ons–augment edPhil
li
p’scur vewhichisashor t
-runPhi
ll
ips
curvewhoseposi ti
onisdet ermi
nedbyt heexpectedr ateofinfl
ati
on.Fri
edmansai d
thataninverser elati
onshipmayexi stbetweent her ateofunempl oymentandt he
rateofwageint heshor t-
run,butthereisnosuchr elati
onshi
pi nthelongrun.

Al
ter
nat
ivePol
i
cyMeasur
es
1) FiscalandMonet aryPol i
cies:Thesepol i
ciesaf f
ectt helev elofaggregat edemandandsoar e
oftencal l
eddemandmanagementpol ici
es.Theyar et herefor
el i
kel ytobeonl yef fective
againsti nflationcausedbyexcessdemand.
 Acuti ngov ernmentspendi ng,ani ncreasei nt axati
onorsomecombi nationoft het wo
(i
.e.def l
ationar yfiscalpol ici
es)wi l
ldi r
ect l
yr educeaggr egatedemand( AD) .
 Acuti nmoneysuppl yorar educt ioni ni tsr ateofgr owth( i
.e.deflati
onar ymonet ary
policy )shoul dhav ethesameef fect.
 Key nesi anspl aceal otofemphasi sonf iscalpol icyasameansofcont rol
lingAD.
Howev er,themonet ar i
st sat tachgr eaterdegr eeofi mpor t
ancet othei nfluenceoft he
moneysuppl y .
2) PricesandI ncomesPol i
cy :Thi si nvolvest hedi recti nterventi
onoft hegov ernmenti nan
attemptt omoder ateuni ondemandsf orwagei ncreasesandt opr eventunj ustifi
edpr ice
i
ncr ease.I tcanbedonebyset ti
ngupofpr icesandi ncomesboar dt oexami nepr oposed
priceincr easesandt ocont ributet ot hecol lect i
vebar gainingbet weenempl oyersanduni ons.
Thegov er nmentcanal soimposeal egislati
ont or egulat eorev enfreezewagesandpr ices.
3) Indexation:Thi si st hepr ocessbywhi cht hev alueofaneconomi cv ari
able,suchpensi onor
wagecanbeadj ust edi nlinewi thchangesi napr i
cei ndex.Thi sissomet i
mescal l
edi ndex
l
inkingandi twor ksbyl i
nki ngeconomi cv ari
abl essuchaswages,sal ari
esandi nterest
pay ment st oani ndexofpr icei nflation.Ifthepr icei ndexr isesby5%, thenthewages, salaries
andi nterestpay ment sshoul dr i
seaut omat i
cby5%.

Di
scr
eti
onar
yFi
scal
Pol
i
cy.
Discr
eti
onarypoli
cymaki
ngisbasedondi
scret
ionifthegov
ernmentremainsfr
eetochoose
whateverpol
icyacti
oni
tbel
i
evestobeappr
opriat
ef ort
hesetofci
rcumstanceswhi
chprevai
lat
theti
me.
Discr
eti
onar
ypoli
cyissupportedbymainstr
eam economi
stst
okeepr
ecessi
onsf
rom deepeni
ng
ortokeepmildi
nfl
ati
onfrom sever
einf
lati
on.
Taxr
evenuesf
all
shar
plydur
ingr
ecessi
onsandr
isebr
iskl
ydur
ingper
iodsofdemand-
pul
l
39
 40
i
nf l
ati
on.Therefore,alaworaconst i
tuti
onalamendmentmandat inganannual l
ybal
ancedbudget
wouldr equi
rethatthegov er
nmentincreasetaxratesandreducegov er
nmentspendingduri
ng
recessionsandr educetaxratesandincreasegovernmentspendi
ngdur ingbooms.Thefi
rstset
ofactionswouldwor senr
ecessionsandt hesecondsetwouldfuelinfl
ation.

Non–di
scr
eti
onar
yFi
scal
Pol
i
cy:
Bui
l
tinst
abi
l
izer
s.
Abuilti
nstabil
i
zerisany
thi
ngt hati
ncreasesthegover
nment’sbudgetdefici
t(orr
educesi
ts
budgetsurpl
us)duri
ngarecessionandi ncr
easesi
tsbudgetsur
plus(orreducesit
sbudgetdef
ici
t)
duri
nginfl
ati
onwithoutr
equi
ringexpli
citacti
onsbypol
icymakers.
Governmentexpenditure(G)ar5ef i
xedandassumedt obeindependentofthelevelofGDP.The
governmentdecidesonapar t
icularl
evelofspendi
ngbutdoesnotdeterminethemagni tudeof
taxrevenues.I
nsteaditestabl
ishestaxratesandthet
axrevenuesthenvarydirectl
ywiththelev
el
ofGDPt hattheeconomyachi ev es.

-LineTr epresentsdirect
T
relati
onshi pbetweent ax
Gov er
nment revenuesandGDP.
Expendi
tur
es,G,and
Taxrevenues,
T.
-Gov ernmentspendi ngGi s
Sur
plus assumedt obe
G const ant/independentof
Def
ici
t GDP.
-AsGDPf allsinarecession,
Real
Domest
icOut
put def i
citoccur sautomat i
call
y
andal leviatestherecession

AsGDPrisesdur
ingexpansi
ons,
sur
plusesoccuraut
omat
ical
l
yandhel
pof
fsetpossi
ble
i
nfl
ati
on.
Theeconomici
mport
anceoft
hedir
ectrel
ati
onshi
pbet
weent
axr
ecei
ptsandGDP
becomesappar
entwhenweconsi
dert
hat:
a)Taxesr educespendi ngandAD.
b)Reduct i
onsinspendi ngaredesi r
ablewhent heeconomyi smov ingtowardsinfl
ation,
whereasi ncreasesinspendi ngar edesirablewhent heeconomyi sslumping.
 Theabov efi
guresuggest st hatthesizeoft heaut omaticbudgetdef ici
torsurpluses,
andt hereforebui l
t-
in-
stabil
ity,dependont her esponsi v
enessoft axrevenuest o
changesi nGDP.
 Inprogressivetaxsy st
em, theav eragetaxr ate( =taxrev enue/GDP)riseswithGDP.
 Inapr oporti
onal t
axsystem, t
heav eraget axr ateremainsconst antasGDPr ises.
 Inregressivetaxsystem, t
heav eragetaxr atef al
lsasGDPr ises.
 Howe ver,themor ethepr ogressivet axsy stem,t hegr eatertheeconomy ’sbui l
t-
in-
stabi
li
ty.

I
NTERNATIONALTRADEANDECONOMI
CGROWTHAND
DEVELOPMENT.

40
 41
Meani
ngofI
nter
nat
ional
Trade:

 Internationaltradear i
sesf ormanyr easons,butt hemostobv iousonei sthat
differentcount r
ies hav e dif
ferentf actorendowment s,withi nternati
onal
mobi lit
yoft hesef actorsbeingsev erelyli
mi t
ed.Internati
onalTr ade, t
heref
or e,
makesav ail
ablet o consumer sanot hercount rypr oductswhi ch are only
produced i n othercount ry
.The t erm I nter
nationalTr ade i mpl i
es trade
bet weent woormor ecount ries.Itinvolvesphy sicaltr
ansferofgoodsf rom
onecount rytoanot her.Ifacount r
yhasagr eaterpar tofherf orei
gnt rade
wi t
honl yonecount r
y,thisiscal ledbi l
ateraltrade.Howev er,i facount r
y
tradeswi thmor eoranumberofcount ri
es,buyingf rom someandsel li
ngt o
some, thisiscalledmul t
il
ateraltr
ade.

TheTheor
yofAbsol
uteAdv
ant
ageandCompar
ati
veAdv
ant
age:

 Acount r
yissaidtohav eabsol uteadv ant
ageint heproductofacommodi t
y
when iti s more effi
cientt han ot hercount r
ies wit
h a gi ven l
ev elof
i
nputs/usi
ngt hesamelev elofresources.
 Thetheoryofcompar ative( orrel
ative)advant
ageshowst hatrelat
ivecosts
areimportantindeterminingwhi chpr oductsareimportedandexpor ted.A
countr
ywi l
lexportaproductf orwhi chithasrelati
vel
ylowpr oducti
oncost s,
andwilli
mpor taproductforwhi chithasrelat
ivel
yhighproducti
oncost s.The
tabl
ebelowi susedasabasi sf orexplanat
ion:

Tonesofwheat numberofcar
sthat
Thatcanbepr
oducedf
rom canbepr
oducedf
rom
Fr
om Xr
esour
ces Xr
esour
ces
Count
ry A 40 10
,
, B 20 8

 CountryA hasabsol uteadvant agei nthepr oductofbot hwheatandcar s

sincewi t
hagi venamountr esour ces, i
tcanpr oducemor eofbot hgoodst han
countryB.Howev er,ifweexami net hedomest icopportunit
ycostr ati
os,itis
cleart
hateachcount ryhasar elat i
veorcompar ati
veadv antageinthepr oduct
ofonecommodi t
y.Incount r
yA,t hedomest icopportunitycostrati
oi ssuch
that4t onnesofwheatmustbegi venupf oreachcarpr oduced.Howev er,i
n
countryBt hedomest icopportuni tycostr ati
oi ssucht hatonly2.5t onnesof
wheatmustbegi venupf oreachcarpr oduced.
 CountryBt hereforehasacompar ati
v eadvant ageinthepr oductofcarssi nce
foreachcart hatisthepr oduced, lesswheati ssacrif
icedi nBthaninA.
 CountryA,howev er,hascompar at i
veadv ant ageinthepr oductofwheat .For
eachtonneofwheatpr oduced, count ryAmustsacr ifi
ce0. 25cars,whereasi n
countryBeacht oneofwheatpr oducedcost smor e,i
.e.,
0.4car s.

Vi
sibl
eandi
nvi
sibl
eTr
ade:

 Vi
sibl
etradeconsi
stsoft
heimpor
tsandexpor
tsofphysi
calgoods.
 I
nvi
sibl
et r
adeconsi
stsoft
heimport
ati
onandexpor
tat
ionforser
vices.

Rest
ri
cti
onsofI
nter
nat
ional
Trade:
1.Fi
xi
ngi
mpor
tquot
as
41
 42
2.Totalban
3.Tari
ffs
4.Exchangecont
rol

BalanceofTrade
Balanceoft r
adeisthediff
erencebet
weenthev i
si
bleimport
sandv isi
bleexports.I
facount r
y
exportsmor egoodsthatsheimport
sduri
ngay earshecouldbesaidt obehav i
ngaf avorabl
e
balance oftrade.Butifheri mpor
tsexceed herexpor
ts,she could be sai
dt o be havi
ng
unfavorabl
ebalanceoftr
ade.

Bal
anceofpay
ment
s
 Acount rymakesandr eceivespay ment sforimportsandexpor t
sofgoods.
Shepay sandr ecei
vesmoneyf orv i
sibleimport
s.Thedi fferencebet ween
receiptsandpay mentsar ecall
edbal anceofpay mentsoncur rentaccount.
 Ifrecei ptsexceedpay ment sthedi fferenceiscalledf avorablebalanceof
payment .Ifthepay ments,howev er,exceedsther eceiptsthent hediff
erence
i
scal ledunf avorablebalanceofpay ment .
 Acount r
ymayi nvestmoneyi nanot hercountrybyei therloaningmoneyor
establishingindustri
esinot hercountry.Suchexpendi t
ureist ermedascapi tal
expendi tureandanydi f
ferencebetweent herecei
ptsandpay ment si
scal led
balanceofpay mentoncapi t
alaccount .Thediff
erencebet weent hereceipts
andpay ment sonbot hcur r
entandcapi t
alaccountar ecal ledt heov erall
balanceofpay ment .

Ter
msofTr
ade:
Thi
sistherati
oatwhichdif
fer
entgoodsandservicesareexchangedbet
ween
twocount
ri
es.Ter
m oftr
adei
ndex=indexofexpor
tpr i
ces*
100
I
ndexofi
mpor
tpr
ices
 I
nbasey eart hevalueoft ermsoftradeindexi s100,ie,100/
100*100=100.
Changei ntermsoft radeismeasuredbychangesi nthev al
ueofthi
sindex.
 I
fexpor tpr i
cesriser el
ativetoimportpricesitimpliesfavor
abletermsof
trade.
 I
fexpor t
sreduce, t
hisimpl i
esunf
avorablet
er msoftrade.
 I
ft hetotindexi noney earisgr
eaterthani tsval
uet heprevi
ousyear,then
therehasbeenf avorablemov ementi
nt hetot.Thereverseal
soappli
es.

Tr
adepol
i
cy:
I
ti si ncumbentuponev er ygov t.toensur ethatitadoptspol
ici
est hatprotectit
s
trade.Bypr otect
ion,wer ef ertobar ri
erst ofr
eet r
ade,whichtendt oprotectthe
domest ici ndustr
iesagai nstf or
ei gncompet it
ion.Someoft hekeyt oolsusedt o
adv ancet het r
adepolicyar e
(a)Tar iffs( ataxthatisleviedoni mpor tedproducts;
(b)Quot a( Al i
mitimposedont hequant ityofgoodst hatmaybei mporteddur i
ng
agi vent imeperiod);
(c)Exchange cont rolsy stem ( A setofr egulati
ons thatrestr
icts domest i
c
resident saccesstof oreignexchange) ;
(d)I mpor tdeposi tsscheme( ar equi r
ementt hatobligesimporter
st odeposi ta
sum ofmoneywi t
hthecent ral bank.Thesum deposi tedi
snor mall
yr el
atedto
thev alueofgoodsi mpor t
ed;
(e)Publ i
cpr ocur
ementpol i
cy( apr eferencebypubl icsectoragenciesf orthe

42
 43
purchaseofdomesti
cal
lypr
oducedgoods)
;
(
f)Voluntaryagr
eement(anagreementwher
ebyacount
ryv
olunt
ari
l
yrest
ri
cts
exports
(
g)Subsidies.

Obj
ect
ivesoft
radepol
i
cies:
1.Tocoll
ectr
evenuesuchast arif
frevenue.
2.Toprot
ectinf
anti ndust r
ies
3.Tofi
ghtdumpi ng( antidumping)
4.Toapplypr
ohibiti
onsf orsomecommodi t
ies(secur
it
yreasons)
5.Toprot
ecttheenv ironment
6.Torewardinterestgr oupse. g.tr
adeunionsmayaskf orprotect
ionsot
hat
out
putexpandsi napar t
icul
arindustr
ytheref
oremov ej
obs.

Economi
cgr
owt
h:
 Economi c gr owthi s an i ncrease i nt he count ry’
s pr oduct i
ve capaci ty
,
i
dentifi
ablebyasust ainedr i
sei nnat ionalincomeov eraper iodofy ear s.A
country’annualr ateofeconomi cgr owthi smeasur edbyt aki
ngtheav erage
percentagei ncr
easei nnat i
onali ncomeov eralongper iodoft i
mesay5or10
yr.
 Thef i
gureobt ainedr epr esentsanest i
mat eoft heannual rateofgrowt hi nt he
country’
spr oductivecapaci t
y.
 Howev er,acount ryissai dt obeenj oy i
ngeconomi cdev elopmentwheni tis
experi
encingeconomi cgr owthandatt hesamet i
mei sunder goingmaj or
str
ucturalchangesi ni t
seconomye. g.shiftf r
om agr i
culturet omanuf actur i
ng.
 Acount ry’
ssai dt obel essdev elopedi fithasl ow realnat i
onalincomeper
capit
al,al argeagr iculturalsect or ,highpopul ati
ongr owt h,low capitallabor
rat
ioandpoori nfrastruct ure.
 Acount ryishowev er;sai dt obedev elopedi fithasrelativelyhighrealnat i
onal
i
ncomepercapi taandenj oysrelativelyhighst andardofl iving.

Mai
nDet
ermi
nant
sofEconomi
cGr
owt
h
1.Gr owt hofl aborf orce:t hegr owt hoflaborf orcei tselfwilldependon;( I
)t he
nati
onali ncr easei nt hepopul ati
on;(ii
)int ernationalmi grati
on;and( i
ii
)t he
part
icipat i
onr ate.
 The nat urali ncreasei npopul ationisdet ermi nedbyt heexcessofbi rt
hr ate
overthedeat hr ate
 Neti mmi gr ation wi l
lt end t o add to a count ry ’
sl aborf orce whi l
e net
emigr ationwi l
l t
endt or educei t.
 Thepar ti
cipat ionr atest hepr opor ti
onoft heeconomi call
yact i
vepopul at
iont o
thetot alpopul ati
on.Ar iseint hisratewoul dleadt oani ncreaseint hesizeof
thelaborf or ce.
2.Gr owt hoft hecapi t
alst ock:Anexpansi onofacount ry’
scapi t
alstockt hrow
neti nv estment ,justl ike an expansi on ofi t
sl aborf orce increases t he
countr y’
sst ockofpr oduct i
ver esourcesandsor epresentsanot herpossi ble
sourceofeconomi cgr owt h.
3. Techni calpr ogr ess:Thi st akest heform ofi mpr ov edt echniqueofpr oduction,
i
mpr ov ed machi nery ,inv entions ori mpr ovement si n educat i
on;i .
e.,iti s
anything, whi chi mpr ov est hequat i
tyofthecapi tal,stockorl aborforce.
43
 44

Theef f
ectoftechnical
progr
essistoraisethepr
oducti
vi
tycapi
talandlabor.
N.B:Technol ogi
calunempl oy
mentr efer
st ot he l
oss ofj obs caused by
technol
ogicalchange,suchast heint
roducti
onofmachinerythatmakessome
l
aborskill
sobsolete.

Benef
it
sandcost
sofeconomi
cGr
owt
h
I
) Benef
it
s
 Itl
eadst oincreasedstdofl i
ving
 Iteli
mi natespov ert
y
 Itcanr edistr
ibuteincomewi thoutmaki nganyoneworseoff
2)Costsofeconomi cgrowth
 Growt hinv ol
v eschange,whichbenef it
smanybutmayhar m some.
 Growt hhasanoppor tuni
tycoste. g.invest
menti ncapitalgoodsimpl i
es
forgoingcur rentconsumption.
 Continued gr owth may notbe possi bl
ef ormuch l ongersince earthl
y
resourcesar ef i
nit
eandl ar
gel yi
rrepl
aceable.
 Growt h causes negat ive exter
nalit
ies e.
g.pollut
ion,noise and i
ncreased
congest ion.

Economi
cDev
elopment
:
 Thisr ef
er st o apr ocessi n which an economynotonl yexper i
encesan
increasei nt her ealout putperheadbutal soundergoesmaj orstr
uct
ur al
changessuchasi nfrast
ructuredev el
opmentandar eall
ocat
ionofresources
bet weent heagr icultural
,industri
alandservi
cesect
ors.
 Dev elopmentcount ri
esar echaracteri
zedbythefol
lowi
ngkeyi ndi
cat
ors:
(
i)lowGNPpercapi ta
(
ii
)largeagr icul
tural sector
(
ii
i)
highpopul at
iongr owthrat e
(
iv)
lowcapi tal l
aborr atio
(
v)Poori nfrastructureandsoci alservi
ces.

Ther
oleofi
nter
nat
ional
trade:
(
i)Itenablesacount r
yt ogetwhatshecannotpr oduce.
(
ii
)Itenablesacount r
yt odisposehersurpl
usgoods.
(
ii
i)
Itenablesacount rytof i
eldswhichtheyhav ethegr eat
estadvantageover
others
(
iv)
Promot esahealthycompet i
ti
onamongl ocalandforei
gnproducers.
(
v)Duringt i
mesofcal amitiese.g.f
loods,drought
s,etc,suppl
yofgoodscanbe
obtainedfrom othercountri
es.
(
vi)
Itpr omot es i
nternati
onalunder st
anding when peopl einter
mi ngl
efrom
diff
erentcountri
es.

44